Chapter 22

Credit Risk

May 22, 2009

20.28. Suppose a 3-year corporate bond provides a coupon of 7% per year payable semiannu-
ally and has a yield of 5% (expressed with semiannual compounding). The yields for all
maturities on risk-free bonds is 4% per annum (expressed with semiannual compound-
ing). Assume that defaults can take place every 6 months (immediately before a coupon
payment) and the recovery rate is 45%. Estimate the default probabilities assuming (a)
that the unconditional default probabilities are the same on each possible default date
and (b) that the default probabilities conditional on no earlier default are the same on
each possible default date.

Solution (a) Assuming that the unconditional default probabilities are the same on each
possible default date. The calculation are as follows:

Time Default Recovery Risk-free Loss given Discount PV of expe-

(years) probability rate(%) value($) default($) factor cted loss($)
0.5 Q 45 109.97 64.97 0.9802 63.68Q
1 Q 45 108.63 63.63 0.9608 61.14Q
1.5 Q 45 107.27 62.27 0.9418 58.64Q
2 Q 45 105.87 60.87 0.9231 56.19Q
2.5 Q 45 104.45 59.45 0.9048 53.79Q
3 Q 45 103.5 58.5 0.8869 51.88Q
Total 345.33Q
The bond pays a coupon of 3.5 every six months and has a continuously com-
pounded yield of 5% per year. Its market price is 105.3289. The risk-free value of the
bond is obtained by discounting the promised cash flows at 4%. It is 108.2837. The
total loss from defaults should therefore be equated to 108.2837−105.3289 = 2.9548.
The value of Q implied by the bond price is therefore given by 345.33Q = 2.9548,
or Q = 0.0086. The implied probability of default is 1.72% per year.
(b) Assuming that the default probabilities conditional on no earlier default are the
same on each possible default date.The calculation are as follows:

1
 Time Default Recovery Risk-free Loss given Discount PV of expe-
(years) probability rate(%) value($) default($) factor cted loss($)
0.5 Q 45 109.97 64.97 0.9802 63.68Q
1 Q(1-Q) 45 108.63 63.63 0.9608 61.14Q(1-Q)
1.5 Q(1-Q)2 45 107.27 62.27 0.9418 58.64Q(1-Q)2
2 Q(1-Q)3 45 105.87 60.87 0.9231 56.19Q(1-Q)3
2.5 Q(1-Q)4 45 104.45 59.45 0.9048 53.79Q(1-Q)4
3 Q(1-Q)5 45 103.5 58.5 0.8869 51.88Q(1-Q)5
That is

63.68Q+61.14Q(1−Q)+58.64Q(1−Q)2 +56.19Q(1−Q)3 +53.79Q(1−Q)4 +51.88Q(1−Q)5 = 2.9548

or Q = 0.0097. The implied probability of default is 1.94% per year.

20.29. A company has 1- and 2-year bonds outstanding, each providing a coupon of 8% per
year payable annually. The yields on the bonds (expressed with continuous compound-
ing) are 6.0% and 6.6%, respectively. Risk-free rates are 4.5% for all maturities. The
recovery rate is 35%. Defaults can take place halfway through each year. Estimate the
risk-neutral default rate each year.

Solution The yields imply that the price of the 1-year bond is
108
= 101.89
1 + 6.0%
the price of the 2-year bond is
8 108
+ = 102.55
1 + 6.6% (1 + 6.6%)2

the price of the similar 1-year risk-free bond is

108
= 103.35
1 + 4.5%
the price of the similar 2-year risk-free bond is
8 108
+ = 106.55
1 + 4.5% (1 + 4.5%)2

First we consider the 1-year corporate bond.

Table 1 below calculates the expected loss from default in terms of Q on the assumption
that defaults can take place halfway through each year, or at time 0.5 years.
The expected value of the risk-free bond at time 0.5 years is

108e−0.045×0.5 = 105.60

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 Table 1:Calculation of loss from de-
fault on a bond in terms of the default probabilities per year, Q. Notional principal=$100
Time Default Recovery Risk-free Loss given Discount PV of expe-
(years) probability rate(%) value($) default($) factor cted loss($)
0.5 Q 35 105.60 68.64 0.9778 67.11Q

The expected loss is 67.11Q. Let

67.11Q = 103.35 − 101.89

We obtain a value for Q equal to 2.18%.

Then we consider the 5-year corporate bond.
Table 2 below calculates the expected loss from default in terms of Q on the assumption
that defaults can take place halfway through each year, or at times 0.5, 1.5 years.
The expected value of the risk-free bond at time 1.5 years is

108e−0.045×0.5 = 105.60

The expected value of the risk-free bond at time 0.5 years is

8e−0.045×0.5 + 108e−0.045×1.5 = 108.77

Table 2:Calculation of loss from de-

fault on a bond in terms of the default probabilities per year, Q. Notional principal=$100
Time Default Recovery Risk-free Loss given Discount PV of expe-
(years) probability rate(%) value($) default($) factor cted loss($)
0.5 Q 35 105.60 68.64 0.9778 67.11Q
1.5 Q 35 108.77 70.66 0.9347 66.04Q
Total 133.15Q

The expected loss is 133.15Q. Let

133.15Q = 106.55 − 102.55

We obtain a value for Q equal to 3.00%.

Since
3.00% × 2 − 2.18% = 3.82%

Thus the risk-neutral default rate in the first year is 2.18% and in the second year is
3.82%.

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22.30. Explain carefully the distinction between real-world and risk-neutral default proba-
bilities. Which is higher? A bank enters into a credit derivative where it agrees to pay
$100 at the end of 1 year if a certain company’s credit rating falls from A to Baa or
lower during the year. The 1-year risk-free rate is 5%. Using Table 22.6, estimate a
value for the derivative. What assumptions are you making? Do they tend to overstate
or understate the value of the derivative.
Solution Real world default probabilities are the true probabilities of defaults which can be
estimated from historical data. Risk-neutral default probabilities are the probabilities
of defaults in a world where all market participants are risk neutral and which can be
estimated from bond prices. Risk-neutral default probabilities are higher. This means
that returns in the risk-neutral world are lower. From Table 22.6, the probability of a
company moving from A to Baa or lower in one year is 5.92%, thus the value of the
derivative is
0.0592 × 100 × e−0.05×1 = 5.6313
The approximation in this is that the real-world probability of a downgrade is used. To
value the derivative correctly the risk-neutral probability of a downgrade should be used.
Since the risk-neutral probability of a default is higher than the real-world probability,
it seems likely that the same is true of a downgrade. This means that 5.63 tends to
understate the value of the derivative.
22.31. The value of a company’s equity is $4 million and the volatility of its equity is 60%.
The debt that will have to be repaid in 2 years is $15 million. The risk-free interest
rate is 6% per annum. Use Merton’s model to estimate the expected loss from default,
the probability of default, and the recovery rate in the event of default. Explain why
Merton’s model gives a high recovery rate. (Hint: The Solver function in Excel can be
used for this question.)
Solution Merton’s model is
E0 = V0 N (d1 ) − De−rT N (d2 )
where
ln V0 /D + (r + σV2 /2)T √
d1 = √ and d2 = d1 − σV T
σV T
and
σE E0 = N (d1 )σV V0
In this case,
E0 = 4, σE = 60%, r = 0.06, T = 2, D = 15
Using the Solver function in Excel, there are
V0 = 17.0839, σV = 0.1576, d2 = 1.0105
The market value of the debt is V0 − E0 , or 13.0839. The present value of the promised
payment on the debt therefore is
15e−0.06×2 = 13.3038

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 The expected loss from default is
13.3038 − 13.0839
= 1.65%
13.3038
And the probability of default is

N (−d2 ) = 0.1561

i.e., 15.61%. But there is

(1 − R) × Q = 1.65%
Thus the recovery rate is
15.61 − 1.65
R= = 89.43%
15.61
The reason the recovery rate is so high is as follows. There is a default if the value of
the assets moves from 17.08 to below 15. A value for the assets significantly below 15 is
unlikely. Conditional on a default, the expected value of the assets is not a huge amount
below 15.

22.32 Suppose that a bank has a total of $10 million of exposures of a certain type. The 1-
year probability of default averages 1% and the recovery rate averages 40%. The copula
correlation parameter is 0.2. Estimate the 99.5% 1-year credit VaR.

Solution In this case,

√ !
N −1 (0.01) + 0.2N −1 (0.995))
V (0.995, 1) = N √ = 0.0946
1 − 0.2

Showing that the 99.5% worst case default rate is 9.46%. The 1-year 99.5% credit VaR
is therefore 10 × 0.0946 × (1 − 0.4)or $0.57 million.