TOPIC 10

MANAGEMENT OF
CREDIT RISK
 Topic Highlights
1) Types of Credit Risk
2) Credit Recovery Rate
3) Credit Risk Models
4) Credit Migration Probabilities
5) Option Pricing Theory and Price of Bond with
different Credit Risk
6) Credit Risk of Derivatives
7) Credit Derivatives
 Credit Risk
• Credit risk is the possibility of default by one of the
counterparties in a financial transaction.
• Probability of default affects the future cash flows of the
financial transaction; hence the current market price
(value) of the transaction, which is the risk-adjusted
present value of future cash flows.
• Default is defined as any missed or delayed disbursement
of contractual obligations (interest, sinking funds or
principal), bankruptcy, receivership or distressed
exchanges

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 Credit Risk
• Credit risk includes three types of risk:
(1) The risk that the issuer will default (default risk)
(2) The risk that the credit spread will increase (credit
spread risk), and
(3) The risk that an issue will be downgraded
(downgrade risk)

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 Credit Risk
• Each event of default is defined as a credit event. Each credit
event is costly:
 Costly renegotiations  Debt service reductions
 Potential liquidations  Reorganizations
 Lenders may get less than what was contractually
specified
• Default may be the result of:
– Macroeconomic factors, such as recession
– Company or industry specific factors
• Debt securities that are subject to default risk can differ
significantly in terms of
 Their seniority in the capital structure (e.g. secured
versus unsecured; 1st charge holders versus 2nd charge
holders; debt versus equity etc)
 Level of protection they may have by way of security etc. 5
 Credit Rating Agencies
• Credit rating agencies analyze the credit quality of an issuer
and assign a rating to the issuer's obligations. If the credit risk
of an issuer increases, investors will demand a higher yield on
that firm's obligations to compensate them for the higher level
of risk.
• Moody’s, Standard & Poor, Fitch, Rating Agency Malaysia
(RAM) etc produce information about the credit standing of
borrowers. Borrowers will have to pay money to have their
debt rated.

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 Credit Rating Agencies
• The credit quality of most issuers and their obligations is not
fixed and steady over a period of time, but tends to undergo
change. For this reason changes in ratings occur so as to
reflect variations in the intrinsic relative position of issuers
and their obligations.
• A change in rating may thus occur at any time in the case of
an individual issue. Such rating change should serve notice
that Moody's observes some alteration in creditworthiness, or
that the previous rating did not fully reflect the quality of the
bond as now seen. While because of their vary nature,
changes are to be expected more frequently among bonds of
lower ratings than among bonds of higher ratings.

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 Limitations of External Credit Ratings
• Obligations carrying the same ratings are not claimed to be of
absolutely equal credit quality. In a broad sense, they are alike
in position, but since there are a limited number of ratings
classes used in grading thousands of bonds, the symbols
cannot reflect the same shadings of risk which actually exist.
• As ratings are designed exclusively for the purpose of grading
obligations according to their credit quality, they should not
be used alone as a basis for investment operations. For
example, they have no value in forecasting the direction of
future trends of market price.

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• The matter of market price has no bearing whatsoever on the
determination of ratings, which are not to be construed as
recommendations with respect to "attractiveness". The
attractiveness of a given bond may depend on its yield, its
maturity date or other factors for which the investor may
search, as well as on its credit quality, the only characteristic
to which the rating refers.
• Since ratings involve judgments about the future, on the one
hand, and since they are used by investors as a means of
protection, on the other, the effort is made when assigning
ratings to look at "worst" possibilities in the "visible" future,
rather than solely at the past record and the status of the
present. Therefore, investors using the ratings should not
expect to find in them a reflection of statistical factors alone,
since they are an appraisal of long-term risks, including the
recognition of many non-statistical factors.

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• Difference between external ratings by ratings agency and
internal ratings by bank. Though ratings may be used by the
banking authorities to classify bonds in their bank
examination procedure, Moody's ratings are not made with
these bank regulations in mind. Moody's Investors Service's
own judgment as to the desirability or non-desirability of a
bond for bank investment purposes is not indicated by
Moody's ratings.
• Moody's ratings represent the opinion of Moody's Investors
Service as to the relative creditworthiness of securities.

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 Market Price and Credit Risk
• Information content in stock and bond prices provide
information on credit risk. Generally: increase in credit risk
results in lower equity and bond prices.
• Assuming that markets are efficient, we expect equity and
yield spreads to provide a better ‘discovery’ of credit risks.
• Investors are hence interested in determining:
• Probability of default (leading to a credit event)
• Potential recovery rates in the event that default occurs
• Taking a and b above together, the ‘probability of default and
the recovery rates’ determine the value of a credit-risky
security.

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 Market Price and Credit Risk
Factors that affect the recovery rates:
• Relative bargaining positions of lenders and borrowers
• Bankruptcy code and its enforceability
• Ability of lenders to have access to borrower’s collateral in
the event of default
• Availability of secured collateral and its value under financial
distress
• Presence of multiple creditors
• Existence of bank debt – typically ‘senior’ in ranking and
secured

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 Credit Recovery Rate
Example
Given the following payoffs, calculate the default
probability and average recovery rate for each of the
tranches that promised to pay $150 (senior debt), $100
(mezzanine debt) and $50 (subordinated debt).
Number of Defaults Probability Total Payoffs
0 0.729 $300
1 0.243 $240
2 0.027 $180
3 0.001 $120

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 Credit Risk Models
KMV Model (Refer to Sundaresen, page 645-646)
• Attempts to calculate the expected default frequency (EDF)
for different horizons.
• Equity prices are used in conjunction with balance sheet
information to estimate: (1) Probability of default and (2)
Distance to default
• Formula for Distance to default = V – D(V,t)
VσV
Where: V = estimated value of firm (equity plus debt)
D(V,t) = estimated default point
VσV = estimated volatility of firm value
• EDF is the probability of default calculated for a horizon
ranging from 1 to 5 years (kept in database).

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Example
Suppose you are given the following information regarding
Henderson Ltd in March 2010:
Book value of all liabilities: $7.5 billion
Estimated default point: $4.8 billion
Market value of equity: $25.0 billion
Estimated market value of firm (V): $32.8 billion
Estimated volatility of firm value σ: 30%
Estimate the firm’s distance-to-default (DD)
Solution:
• Formula for DD = Distance from default point (in nominal terms)
= V – D(V,t) = $32.8b – $4.8b = $28.0b
• Given: 1 standard deviation is 30%
In nominal terms, this is equal to VσV = $32.8b x 0.3 = $9.84b
• Distance to default (DD) = $28.0b / $9.84b = 2.85 s.d.
• The DD information is then applied to the KMV database to find EDF.
Of all the firms that were 2.85 standard deviations from default, how
many actually defaulted within one year? The answer that is
obtained provides us EDF.
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 Credit Migration Probabilities
• Assuming the following one-year credit migration (transition)
matrix:
Baa Ba B
Baa 0.85 0.10 0.05
Ba 0.12 0.75 0.13
B 0.03 0.07 0.90
• Interpretation: There is a 85% probability a firm currently with
Baa ratings will maintain its ratings one-year later.
• Interpretation: There is only a 10% probability a firm currently
with B ratings will be upgraded one year later.

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 Credit Migration Probabilities
• To find the probabilities of migration in two years time, find
two-year migration (transition) matrix by multiplying one-year
migration matrix with itself.
• To find the probabilities of migration in three years time, find
three-year migration (transition) matrix by multiplying two-year
migration matrix with one-year migration matrix.
• From previous example, two-year migration matrix will be:
Baa Ba B
Baa 0.73600.16350.1005
Ba 0.19590.5836 0.2205
B 0.06090.1185 0.8206

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 Credit Migration Probabilities
Using MS Excel
• Key in one-year transition matrix in say cells A1 to C9.
• To find two-year transition matrix, select 9 empty cells you
want the output to be in, say cells A6 to C8. After select cells
A6 to C8, press F2 button.
• Then, in the top left corner cell, type:
=MMULT(A1;C3,A1;C3)
• Then, press ‘Select’ key and hold for a while. Lastly, press ‘Ctrl’
+ ‘Enter’ keys simultaneously.

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 Managing Credit Risk
• Credit risk or default risk is the risk that the
counterparty will not pay off in a financial
transaction.
• Credit ratings are widely used to assess credit risk.

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 Managing Credit Risk
• Option Pricing Theory and Credit Risk
– Here we use option pricing theory to understand the
nature of credit risk. Consider a firm with assets with
market value A0, and debt with face value of F due at T.
The market value of the debt is B0. The market value of
the stock is S0.
– Refer to Table 15.5 for the payoffs to the suppliers of
capital. Note how the stock is like a call option on the
assets. Its payoff is
• S0 = Max(0, AT – F)

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 Managing Credit Risk
• Option Pricing Theory and Credit Risk
– Using put-call parity for stocks, we have
S0 + P0 = C0 + F(1 + r)-T
– Using put-call parity for assets, we have
A0 + P0 = S0 + F(1 + r)-T
• Rearrange:
P0 = S0 – A0 + F(1 + r)-T
• This put is the value of limited liability to the
stockholders. Rearranging, we obtain
S0 = A0 + P0 – F(1 + r)-T
• But, by definition, S0 = A0 – B0. Setting these equal,
we obtain B0 = F(1 + r)-T – P0
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 Managing Credit Risk
• Option Pricing Theory and Credit Risk (continued)
– Thus, the bond subject to default risk is equivalent to a
risk-free bond and a put option written by the
bondholders to the stockholders.
– The Black-Scholes-Merton formula adapted to price
the stock as a call would be
S0  A 0 N (d 1 )  F e  r T N (d 2 ) c

– Using B0 = A0 – S0, we can obtain the value of the

bonds.
B0  F e  r T N (d 2 )  A 0 (1  N (d 1 ))
c

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 Managing Credit Risk
• Credit Risk of Derivatives
– Current credit risk is the risk to one party that the other
will be unable to make payments that are currently due.
– Potential credit risk is the risk to one party that the
counterparty will default in the future.
– In options, only the buyer faces credit risk.
– FRAs and swaps have two-way credit risk but at a given
point in time, the risk is faced by only one of the two
parties.

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 Managing Credit Risk
• The Credit Risk of Derivatives (continued)
– Typically all parties pay the same price on a derivative,
regardless of their credit standing. Credit risk is
managed through
• limiting exposure to any one party (primary method)
– e.g. syndicated loan
• collateral
• periodic marking-to-market
• (by dealers) captive derivatives subsidiaries
• netting

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 Managing Credit Risk
• Netting
– Netting: several similar processes in which the amount
of cash owed by one party to the other is reduced by
the amount owed by the latter to the former.
• Bilateral netting: netting between two parties.
• Multilateral netting: netting between more than two
parties; essentially the same as a clearinghouse.
• Payment netting: Only the net amount of a payment
owed from one party to the other is paid.
• Cross-product netting: payments from one type of
transaction are netted against payments for another
type of transaction.

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 Managing Credit Risk
• Netting (continued)
• Closeout netting: netting in the event of default,
where all transactions between two parties are
netted against each other; see example in Chance &
Brooks (2010).

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 Managing Credit Risk
• Credit Derivatives: A family of derivative instruments that
have payoffs contingent on the credit quality of a particular
party. Types include
– Total return swaps: Refer to Figure 15.4. Credit derivative
buyer purchases swap from credit derivative seller in which
the buyer pays the total return on a specific bond. If that
return is reduced by some credit event, this loss is passed
through automatically in the swap.

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 Managing Credit Risk
• Credit Derivatives (continued)
– Credit default swap: A swap in which the credit derivatives
buyer pays a periodic fee to the credit derivatives seller. If
the buyer sustains a credit loss from a third party, it then
receives payments from the credit derivatives seller to
compensate.

Refer to Figure 15.5. This is really more like an option.
– Credit spread option: An option in which the underlying is
the yield spread on a bond.

Refer to Figure 15.6.

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 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. 33 33
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 Managing Credit Risk
• Credit Derivatives (continued)
– Credit linked security: This is a bond or note that pays off
less than its face value if a credit event occurs on a third
party. Refer to Figure 15.7.

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