Credit Risk

Lecture 6B
 Legal, Operational,
Market Risk Credit Risk
Fundamentals and Integrated Risk
Management Management
Management
• CHAPTER 2- • CHAPTER 10- • CHAPTER 18- • CHAPTER 24-
Fundamentals of Introduction to Introduction to Operational Risk
Probability Market Risk Credit Risk • CHAPTER 25-
• CHAPTER 3- • CHAPTER 11-Sources • CHAPTER 19- Liquidity Risk
Fundamentals of of Market Risk Measuring Actuarial • CHAPTER 26-Firm-
Statistics • CHAPTER 12- Default Risk Wide Risk
• CHAPTER 4-Monte Hedging Linear Risk • CHAPTER 20- Management
Carlo Methods • CHAPTER 13- Measuring Default
Nonlinear Risk: Risk from Market
Options Prices
• CHAPTER 14- • CHAPTER 23-
Modeling Risk Managing Credit
Factors Risk
• CHAPTER 15-VAR
Methods
III. Measuring Default Risk from
Market Prices
Ref: CHAPTER 20- Measuring Default Risk from
Market Prices
Financial Risk Manager Handbook, Fifth
Edition, PHILIPPE JORION
 Default Risk from Market Prices
• Credit risk can also be assessed from market prices
of securities whose values are affected by default.
– These include corporate bonds, equities, and credit
derivatives.
• In principle, these should provide more up-to-date
and accurate measures of credit risk because
financial markets have access to a very large
amount of information and are forward-looking
 Default Risk from Market Prices
• Bond Prices: Information about the market prices of
credit-sensitive bonds can be used to infer default risk.
– the yield on a corporate bond can be broken down into a
default probability, a recovery rate, and a risk-free yield.
• Equity Prices: The advantage of using equity prices is
that they are much more widely available and of much
better quality than corporate bond prices.
– equity can be viewed as a call option on the value of the firm
and how
– a default probability can be inferred from the value of this
option.
A. USING BOND PRICES
 Spreads and Default Risk
• Assume for simplicity that the bond makes
only one payment of $100 in one period. We
can compute a market-determined yield y∗
from the price P∗ as
• This can be compared with the risk-free yield
over the same period y.
 Spreads and Default Risk
• The payoffs on the bond can be described by a
simplified default process
• At maturity, the bond can be in default or not.
• Its value is $100 if there is no default and f ×
$100 if default occurs, where f is the fractional
recovery. We define π as the default rate over
the period.
Spreads and Default Risk
 Spreads and Default Risk
• Using risk-neutral pricing, the current price must be the
mathematical expectation of the values in the two states,
discounting the payoffs at the risk-free rate.

• Note that the discounting uses the risk-free rate y because

there is no risk premium with risk-neutral valuation.
 Spreads and Default Risk
• After rearranging terms

• which implies a default probability of

• Assuming that yields and default probabilities are

small, and dropping second order terms, this
simplifies to
 Spreads and Default Risk
• Let us now consider multiple periods, which
number T.
• Assuming one payment only, and using
cumulative default probability Π

• for which a very rough approximation is

 Example 1: Deriving Default Probabilities
• We wish to compare a 10-year U.S. Treasury strip and a 10-
year zero issued by International Business Machines (IBM),
which is rated A by S&P and Moody’s. The respective yields
are 6% and 7%, using semi annual compounding. Assuming
that the recovery rate is 45% of the face value, what does
the credit spread imply for the probability of default?

• π(1 − f ) = 1 − (1 + y/2)^20/(1 + y∗/2)^ 20 = 0.0923.

• Hence, π = 9.23%/(1 − 45%) = 16.8%. Therefore, the
cumulative (risk neutral) probability of defaulting during the
next 10 years is 16.8%.
 Example 1: Deriving Default Probabilities
• This number is rather high compared with the historical record for this
risk class.
– Moody’s reports a historical 10-year default rate for A credits around 3% only.
• If these historical default rates are used as the future probability of
default, the implication is that a large part of the credit spread reflects
a risk premium.
• For instance, assume that 80 basis points out of the 100-basis-point
credit spread reflects a risk premium. We change the 7% yield to 6.2%
and find a probability of default of 3.5%.
• π(1 − f ) = 1 − (1 + 6.0%/2)^20/(1 + 6.2%∗/2)^ 20 = 0.0192.
• Π= 0.0192/ (1 − 0.45 )= 3.5%
• This is more in line with the actual default experience of such issuers.
B. USING EQUITY PRICES: MERTON
MODEL
 Equity and Debt as Options
• Merton’s model regards the equity as an option on the
assets of the firm
• Consider a firm with total value V that has one bond due in
one period with face value D.
• If the value of the firm exceeds the promised payment, the
bond is repaid in full and stockholders receive the remainder.
• However, if V is less than D, the firm is in default and the
bondholders receive V only. The value of equity goes to zero.
• ET = Max(VT − D, 0)
– Equity can be viewed as a call option on the firm value with strike
price equal to the face value of debt.
 Equity and Debt as Options
• ET = Max(VT − D, 0)
• Because the bond and equity add up to the firm value, the
value of the bond must be
• BT = VT − ST = VT − Max(VT − D, 0) = Min(VT , D)
• The current stock price, therefore, embodies a forecast of
default probability in the same way that an option embodies
a forecast of being exercised.
• Note that the bond value can also be described as
• BT = D − Max(D − VT , 0)
• a long position in a risky bond is equivalent to a long position in a
risk-free bond plus a short put option
 Equity and Debt as Options
• This approach is particularly illuminating because
it demonstrates that corporate debt has a payoff
akin to a short position in an option, explaining
the left skewness that is characteristic of credit
losses.
• In contrast, equity is equivalent to a long position
in an option due to its limited-liability feature.
– In other words, investors can lose no more than their
equity investment.
 Pricing Equity and Debt
• Assume that the firm value follows the geometric
Brownian motion process:
• dV = μV dt + σV dz
• To price a claim on the value of the firm, we need to
solve a partial differential equation with appropriate
boundary conditions.
• The corporate bond price is obtained as
• B = F (V, t), F (V, T) = Min[V, BF ]
• where BF = D is the face value of the bond to be repaid at
expiration, or the strike price.
 Pricing Equity and Debt
•• Similarly,
  the equity value is
• E = f (V, t), f (V, T) = Max[V − BF , 0].
• The Black-Scholes-Merton option pricing model enables the
value of the firm’s equity today, E0, to be related to the value
of its assets today, V0, and the volatility of its assets, sV
, Where
,
• τ = T − t is the time to expiration, r the risk-free interest rate,
and σ the volatility of asset value.
• The option value depends on two factors, x = De−rτ / V and
σ√τ .
 Firm Volatility
• Note that this application is different from the
BS model, where we plug in the value of V and
of its volatility, σ = σV, and solve for the value
of the call.
• Here we observe the market value of the
firm’s equity, E and the equity volatility σS and
must infer the values of V and its volatility.
• This can only be done iteratively.
 Equity Value as a function of Firm Value

•  E0 = VN(d1) − De−rτN(d2)

• Defining = N(d1) as the hedge ratio, we have
• (Value of Equity related to Firm value)
• Firm Volatility
• Defining σE as the volatility of (dE/E), we have
(σE E) = (σVV) and
• σV = (1/ ) σE(E/V)
Debt Value as a function of Firm Value

•  B= V-S= V-V N(d1) − Ke−rτN(d2)

• = V( 1- N(d1)) + Ke−rτN(d2) = V N(-d1) + Ke−rτ N(d2)
• Or B/Ke−rτ = N(d2) + V/Ke−rτ N(-d1)
• = N(-d1) dV (Value of Debt related to Firm value)
 Annualized credit spread
• B = Ke−(r+s)τ= K e−rτe−sτ
• B/ K e−rτ= e−sτ
• B/Ke−rτ = N(d2) + V/Ke−rτ N(-d1)
• Thus e−sτ = N(d2) + V/Ke−rτ N(-d1)
• Or s = -(1/ τ) ln (N(d2) + V/Ke−rτ N(-d1)
 Risk-Neutral Dynamics of Default
• In the Black–Scholes model, N(d2) is also the
probability of exercising the call, or that the
bond will not default.
• Conversely, 1 − N(d2) = N(−d2) is the risk-
neutral probability of default.
 Merton Model
E
 E E0   V V0  N (d 1 )  V V0
V

This equation together with the option pricing

relationship
E0 = VN(d1) − De−rτN(d2)
enables V0 and σ V to be determined from E0
and σE
Use Excel Solver
 Example
• A company’s equity is $3 million and the volatility of the equity
is 80%. The risk-free rate is 5%, the debt to be repaid is $10
million and time to debt maturity is 1 year
• Using Excel Solver
• V0=12.40 and sv=21.23%
• The probability of default is N(−d2) or 12.7%
• Market value of debt= 12.40-3=9.40. This corresponds to a
discount rate of 6.24%
• The present value of the promised payment (discounted at risk
free rate =5%) is 9.51
• Expected loss = (9.51-9.40)/9.40 = 1.2% of its no default value
 Pricing Credit Risk
• At maturity, the credit loss is the value of the risk-
free bond minus the corporate bond, CL = BF − BT.
• B= De−rτN(d2) + V[1 − N(d1)= De−rτN(d2) + V N(-d1)
• At initiation, the expected credit loss (ECL) is
• BF e−rτ − B = De−rτ − {De−rτN(d2) + V[1 − N(d1)]}
• = De−rτ [1 − N(d2)] − V[1 − N(d1)]
• = De−rτN(−d2) − VN(−d1)
• = N(−d2)[De−rτ − VN(−d1)/N(−d2)]