10/28/2019

Credit Risk Analytics

Session 11

Dilip Kumar 1

Motivation: KMV’s Credit Monitor

Comparison of KMV (Kealhofer, McQuown and Vasicek)-
produced EDF (Expected Default Frequency) scores and S&P
ratings for Enron Corp
On December 2, 2001, Enron a $50 billion company filed for
bankruptcy, making it the then largest bankruptcy in US history
As the below figure shows, the S&P rating for Enron stayed constant
throughout the period Dec 1996 – Nov 2001. On November 28, 2001,
Enron’s debt was downgraded to junk status!

Dilip Kumar 2

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Motivation: KMV’s Credit Monitor

Dilip Kumar 3

Structural Models
History
Originally proposed by Black and Scholes (1973) in their option pricing paper
Discussed in great depth by Merton (1974)
In the 90s, lot of commercial entities started offering default prediction services
using the basic option pricing framework. Key players: KMV, Moodys etc.
It is constructive to think of these models of default risk as cause-and-
effect models
We first define conditions under which borrowers are likely to default
Then, based on publicly traded securities, we estimate the probability of these
conditions occurring.

Dilip Kumar 4

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The Merton Model: Basic Framework

Consider a bank that has lend a certain amount (D) to a firm on short-
term basis (T-year)
D is the face value of the loan
Assume that the loan has been made on a discount basis (no interim payments)
After T years, how does the payoff of the bank lender look like?
If the value of firm’s asset falls below D, the owners have an incentive (option) to
default and turn over the remaining assets of the firm to the lender
Basic Framework: Default occurs if the value of assets falls below a critical
value associated with firm’s liabilities.

Dilip Kumar 5

The Merton Model: Basic Framework

Dilip Kumar 6

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The Merton Model: Basic Framework

Let us clarify the basic setup: We have a bank that has loaned a certain
amount (D) to a firm on short-term basis (T-year)
D is the face value of the loan
Assume that the loan has been made on a discount basis (no interim payments)
We critically assume that the equity holders wait till maturity (T years)
before they decide whether to default or not
The probability that at maturity the value of the assets is less than the
value of liabilities is then the default probability
What is this probability?
What inputs do we need to identify this probability?

Dilip Kumar 7

The Merton Model: Basic Framework

If we assume value of financial assets follow a lognormal distribution
= +

The distribution of the terminal value of assets (at time T) is

1
ln ≈ ln + − − , −
2
The probability of default is the probability that the value of (log)assets is
less than the value of (log)liabilities.

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The Merton Model: Basic Framework

The probability of default is then given by
1
ln − ln − − −
=Φ 2
−
This is fairly straightforward to compute, right?
Yes, provided we know , ,
In a more fundamental sense, we need to know the market value of the firm’s assets
– which can be significantly different from the book value of assets
Unless we have a time series of the market value of assets, we cannot estimate other
parameters such as ,
How then do we compute the default probability?
Option pricing theory provides the answer
Dilip Kumar 9

The Merton Model: Basic Framework

The payoff to the equity holder can be represented as

The payoff to the equity holder is identical to the payoff of a long call
option on the value of the firm’s assets
The option itself is struck at a strike price of “D”

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The Merton Model: Implementation

Value of equity = Value of call option on the firm’s value
First, note that unlike corporate bonds, equity tends to be more liquid; hence, its
value is available at relatively high frequency (for publicly listed companies).
Hence, we get one equation with no data issues.
We now need to estimate two unknown variables using the above equation
Current value of firm’s assets [market value and not book value!]
Volatility of the assets’ value
Where are we going to get the extra equation/constraint from?
While volatility of firm’s value is not the same as that of firm’s equity value,
the above identity implies that there is “some” relationship between the two
As might be evident, the exact relationship depends on the actual model used for
valuing the call option.
Let us illustrate this idea using the familiar BSM framework
Dilip Kumar 11

The Merton Model: Implementation

Let us use the following notation
E: Value of firm’s equity (observable)
E : Volatility of firm’s equity [can be estimated from data or use implied vol.]
A: Value of firm’s assets (unknown, to be estimated)
A : Volatility of firm’s asset
D: Debt outstanding = Strike price of option
rf: risk-free rate
T: Maturity of debt = Maturity of option
c = c(A, D, rf, A, T) = Black-Scholes pricing formula for European Call option
 = (A, D, rf, A, T) = Black-Scholes delta for European Call option
The following two equations hold
E=c
E E = [] A A
Now, we are ready to solve for A and A. Time for simple illustration
Dilip Kumar 12

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The Merton Model: Implementation

Consider company ISDM; it is currently trading at $100. Based
on historical data, volatility of ISDM equity prices has been
estimated as 80%.
ISDM has a one-year zero-coupon bond outstanding; the face
value of this bond is $150. Risk-free rate is 12%. What is the
value of the firm’s assets? What is its volatility?
Firm value: 231.317
Volatility of firm value: 36.16%

Dilip Kumar 13

The Merton Model: Implementation

Having estimated A and A, we next turn our attention to computing
probability of default (which is our ultimate goal!)
From your derivative course, you might remember that the probability of an option
finishing In-The-Money is N(d2)
Hence, the probability of the option finishing Out-of-The-Money is 1 – N(d2).
In our example, this turns out to be 8.8%.
However, as we discussed in the derivatives course, this number should be
used with caution as it represents the risk neutral probability
We need real-world probability!
That’s precisely what KMV provide; before discussing this, we need to introduce one
more term: Distance-to-default.

Dilip Kumar 14