Scribd
Upload
14 views

Lecture 4 Script

This document discusses structural modeling of credit risk by linking default and recovery rates to an underlying model of a firm's stochastic asset value. It explains how risky debt payoffs can be decomposed into a risk-free bond plus a short put option. This decomposition is useful when default risk is borne by a third party, such as a private insurer or government guarantee, as the value of the guarantee is equal to the value of the put option. The document provides an example of valuing a government guarantee on corporate debt using a replicating portfolio approach.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
14 views

Lecture 4 Script

This document discusses structural modeling of credit risk by linking default and recovery rates to an underlying model of a firm's stochastic asset value. It explains how risky debt payoffs can be decomposed into a risk-free bond plus a short put option. This decomposition is useful when default risk is borne by a third party, such as a private insurer or government guarantee, as the value of the guarantee is equal to the value of the put option. The document provides an example of valuing a government guarantee on corporate debt using a replicating portfolio approach.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
You are on page 1/ 2

PROFESSOR: We'll now turn to structural modeling

of credit risk, which differs from statistical approaches


by linking default and recovery rates to an underlying
model of the stochastic evolution of a firm's asset
value.
You probably remember from your introductory finance courses
that the payoffs on the debt and equity of a corporation as
of the maturity date of the debt, time T,
can be represented as functions of the firm's total asset
value, V sub T. Specifically, zero coupon risky debt
receives its promised face value of F as long
as the firm's asset value is sufficiently high
to cover the promised payment.
If the asset value is at less than F,
the debt holders get whatever the asset value turns out
to be.
That is, they become the equity holders of the corporation.
The equity, then, is like a call option
with a strike price of F on the value of the assets at time T
since once the debt is paid off the equity holders
have a claim equal to the remaining value of the assets.
The sum of the debt and equity is, of course, the total asset
value and it would be represented on a payoff diagram
simply as a 90-degree line running through
the (0,0) point.

The payoff diagram for the risky debt


can be further decomposed into the sum of two components.
The first is a risk-free bond with a face value of F.
The second is a short put option.

Clearly, from the diagram on the left,


the sum of the two positions is identical to that
of risky debt.

The decomposition is useful when the default risk


is borne by someone other than the bondholder.
For example: when a risky loan is guaranteed
by a private insurance contract or by a government guarantee,
the value of the guarantee is just
the value of the put option.
With the guarantee, the bondholder
has a safe claim that can be valued separately,
discounting the payoff at the risk-free rate.
This example is a reminder that, because credit guarantees are
like put options on a company's assets,
they can be valued on binomial trees,
either using a replicating portfolio approach
or risk neutral pricing, which, as always,
are equivalent mathematically.
Here we have a company, XYZ, whose assets
are currently worth $100 and next period
will be worth $140 or $70.
Imagine it has debt with face value of $90,
and that debt is guaranteed by a third party.
We want to know what the value of that guarantee
is from the perspective of the guarantor.
Since we haven't looked at a replicating portfolio
approach for a few weeks, I'll review it here
by answering the question that way.
Well, the payout by the guarantor
will be 0 if the assets are worth $140 and the payout
will be $20 if the assets are only worth $70.
To use the replicating portfolio approach,
we also need information on the risk-free rate.
Here, that information is represented by one-step tree
showing that a risk-free bond with a certain payoff of $100
currently sells for $95.
We replicate the payoff of the guarantee
by buying a fraction X of the risk-free bond
and a fraction Y of the risky firm assets.

Solving for X and Y, we find that X is equal to -0.4,


and Y is equal to 0.2857.
The guarantor has the equivalent of a highly leveraged
long position in the assets of the firm.
The cost of the guarantee to the issuer
is the cost of that replicating portfolio, which
we can calculate based on the bond
price and the current asset price to be $9.43.
From the perspective of the guaranteed bond holders,
the value of the guarantee is a positive $9.43.

You might also like