Credit Risk Management

Market Based Models of Credit Risk

• Prof. Ashok Thampy

 Black-Scholes Option Model
• Assumptions
– Stock Prices follow a Generalized Weiner Process
– No Transaction Costs, Taxes, Dividends, Risk less Arbitrage
– Short Selling Permitted
– Security Trading is continuous
– Risk free rate is constant for all maturities
CALL OPTION PUT OPTION
Payoff

E Stock E Stock
price price
 Equity as a call option on a firm
Value
Of
Equity, E

Value of
0
D Assets, A
-L

Due to limited liability, the loss of equity

holders is limited to L, the equity capital.
Payoff to equity holders of a levered firm
Is similar to that of a call option on the
Equity of the firm. D is debt.
 Merton Model
• Merton (1974) applied option pricing theory
to valuation of risky loans and bonds.
• Bonds in the model are zero coupon bonds.

OPTIONALITY OF A LOAN:PAYOFF TO A BANK LENDER

D=face value
of debt

0 A1 D A2 Value of Assets
 Merton Model
Consider a 1 year loan, D, to a firm, repayable at the end of the year
Value of assets of firm at end of year = A
If value of firm’s assets is A2 > D, owners have incentive to repay D
If value of firm’s assets is A1< D, owners have no incentive to repay D

OPTIONALITY OF A LOAN:PAYOFF TO A BANK LENDER

0 A1 D A2 Assets
 Merton Model
If market value of assets is A2 > D, then loan is repaid and banker
earns face value, D.
If market value of asset is A1< D, then firm defaults and bankers loss
Is (D-A1).
If market value of asset = 0, then banker’s loss is D.
OPTIONALITY OF A LOAN:PAYOFF TO A BANK LENDER

0 A1 D A2 Assets
 Merton Model
Payoff to the writer of a put option on a stock

0
X Stock Price (S)

Payoff
-
PAYOFF FROM WRITING A PUT OPTION -SIMILAR TO
LOAN PAYOFF FOR A BANK
Relationship between risky bond
and risk-free bond payoffs
• Payoff to Risk free bond =
Payoff to risky bond + Payoff to put option
 Merton Model
• Payoff from a bank loan is similar to the payoff to
writing a put option on the assets of the borrowing
firm.
• Lenders to a firm are selling an option to the
equity holders – the option to put the assets of the
firm to the lenders if the value of the assets fall
below the borrowed amount.
• Model that values put option on assets of a firm –
similar to the model that values a put option on the
equity of the firm.
 Option Model
• Value of a put option on stock
= f(S, X, r, s, )
• Value of a default option on a risky loan
= f(A, D, r, A , )
 Option Model
• Equity can be seen as an option on the value of the
underlying assets of the firm
• E = h(A, D, r, A , )
• Value of the equity-call option on the assets of the
firm is a function of:
– The assets of the firm (A)
– The face value of debt (D)
– Risk free interest rate (r)
– A is the volatility of assets
–  is the time to maturity of debt, D.
 Option Model
• E = h(A, D, r, A , )
• The problem is that the value of assets and the
volatility of assets cannot be directly observed
since the firm’s assets are not traded directly.
– One equation and two unknowns.
• KMV uses another relationship to get around this
problem:
• The observable volatility of the equity of the firm,
E is a function of the “unobservable” volatility of
a firm’s asset value, A .
• E = g(A )
 Option Model
• KMV uses these two equations:
• E = h(A, D, r, A , )
• E = g(A )
• Two equations and two unknowns – so the two
equations can be solved for A and A .
• D, the default exercise point, is taken as the value
of all short-term liabilities (one year and under)
plus half the book value of long term debt
outstanding. (One variations of the model take D
to be all liabilities that fall due within one year)
 Merton Model: Example
• Say a firm ABC has assets
of Rs. 100.
• 4 year zero coupon debt
has face value of Rs. 70. Assets 100 Debt ?
• Asset price volatility is
Equity ?
20% and risk free rate is
5%. Total 100 Total 100
• What is the value of debt?
What is the value of
equity?
Merton Model: Valuing equity
 Merton Model: Valuing debt directly
• We know that:
risky bond + put option = risk free bond
Therefore,
V(risky bond) = V(risk-free bond) – V(put-option)
We can write this as:
D0 = D.e-rT – [D.e-rT.N(-d2)-A0.N(-d1)]
N(-d1) = N(-1.592) = 0.056; N(-d2)=N(-1.192)=0.117
D0 = V(risk free bond) – V(put option) = 57.31 – 1.115
= 56.20
 Merton Model: credit spread
• We know that the difference in yield
between the risky debt and risk free debt is
due to credit risk.
• Solving for yield to maturity of debt, we
get: 56.21 = 70.e(-y.4) ; solving for y, we get
y=5.485%.
• Credit spread = 5.485% - 5% = 0.485%
 KMV Model

Source: Moody’s KMV

 Calculating the theoretical EDF

+ A

A=Rs.100m

- A

D=Rs.80m
Default
region

t=0 t= 
 Distance to Default
• Suppose:
– A = Rs. 100 m
– A= Rs. 10 m
– D = Rs. 80 m
– If =1 year, then the EDF is the area in red, where the
value of assets fall below D.
• Under the assumption that asset values are
distributed normally,
– Distance to default = ( A − D) = 100 − 80 = 2 standard deviations
A 10
 Distance to Default
• Under the assumption
that asset values are
distributed normally
and growing at rate g,
– Distance to default = A(1 + g ) − D
A
In the previous example, for A = Rs. 100m, D = Rs. 80 m,
SDA = Rs. 10 m, and g =10%, then
Distance to default = (110-80)/10 = 3SD
 Distance to Default
• If assets are normally distributed, there is a
95% probability that asset values will vary
between plus and minus 2 SD from their
mean values.
• Thus there is a 2.5% probability that asset
values will rise more than 2, and a 2.5%
probability that asset values will fall by
more than 2.
• Theoretically, there is a 2.5% probability of
default or expected default frequency (EDF)
= 2.5%.
 EDF
• Instead of using the theoretical EDF, KMV
generates an empirical EDF, based on a
historical database of firm defaults.
• Methodology of the empirical EDF:
suppose the firm has a distance to default of
2SD. What percentage of firms with a 2SD
distance to default actually defaulted within
one year? This gives the empirical EDF.
 KMV’s Empirical EDF
Number of firms that defaulted
with assets values of 2 from D
at the beginning of the year
Empirical EDF =
Total population of firms with
asset valu es of 2 from D at
the beginning of the year
KMV has built a world wide database of firms and firm defaults
That produce the empirical EDF scores.
 Mapping Distance to Default to EDF
frequency
Historical
default

EDF

Distance to Default
 Why empirical EDF?
• Theoretical EDFs overpredict defaults.
• The empirical EDFs correct for this.
• KMVs EDF scores perform quite well in
predicting defaults since it takes the market
information contained in stock prices into
account which is not taken into account in
financial ratios and has a small part to play
(if at all) in ratings by credit rating agencies.
 Advantages of the KMV Credit
Monitor Model
• Applicable to any public company
• Forward looking since it uses stock market
data rather than “historic” book value
accounting data
• Strong theoretical foundation on modern
corporate finance and option theory
IL&FS Transportation Networks
Chart 1: IL&FS Transportation Networks Ltd. Rating Actions
⁕ CARE withdraws -
12% 18.7.2018
PD CARE INDRA ICRA

10% WD ⁕ ICRA downgrade to

A4 - 23.7.2018
A4
8% PD increase starts - 29.5.2017 A4+ ⁕ IN-DRA downgrade
A3+ to A4+ - 25.7.2018
A2
6%
A2+
A1
4%

2%

0%
Jan-17 Jul-17 Jan-18 Jul-18
 Weaknesses of the KMV Credit
Monitor Model
• Difficult to estimate theoretical EDFs without the
assumption of normality of asset returns.
• Application to private firms based on
comparability of accounting data with listed firms
• Does not distinguish among debt of different
levels of seniority
• Assumption that the debt structure is unchanged
even if asset value has changed significantly.
Merton model cannot capture the behaviour of
firms that seek to maintain constant or target
leverage ratio over time
 Default rates from bond prices
Zero coupon corporate
Yield
Bond (grade B)
18%
Zero coupon treasury
15.8% bond
11%

10%

Time
 Risk Neutral Probability from bond
yields
• Under RN valuation, the expected return on the risky bond
must equal the risk free return (the return on the risk free
treasury bond)
• P1.(1+k1) = 1 + i1
• Where p1 = implied RN probability of repayment in year 1
• 1+k1 = promised return on risky one year corporate bond
• 1+i1 = risk free return on 1 year T bill
• For simplicity, we assume that LGD = 1, ie. If the issuer
defaults, the bondholders receive nothing.
 Implied RN probability

Higher the recoverable amount, lower the risk premium, .

Higher collateral → higher  → lower risk premium.

 RN probabilities and observed
probabilities
• Let  be the spread between return on one year
risk free security and a 1 year risky asset.
•  = p1* x LGD, where p1* is RN probability
•  =  + u , where  is expected loss and u is
unexpected loss
•  = t x LGD, where t = historic default probability
(from rating transition matrix)
 RN probabilities and natural
probabilities
• p1* x LGD = (t x LGD) + u = 
• Thus, given some LGD, the difference
between p1* and t is a risk premium that reflects
the unexpected default probability.
• Example:  = 1%, LGD = 40%, t = 1%, then
• p1* x LGD = (t x LGD) + u = 
• p1* x 0.4 = (0.01 x 0.4) + u = 0.01
• Solving: p1* = 2.5% and u = 0.6%
RAROC Models
RAROC Models
 RAROC Models
• Some FIs use the following approach to
estimate the loan risk:
Loan risk = Unexpected default rate x LGD
The unexpected default rate is the extreme
default rates – 99 percentile historic default
rate of borrower of the same rating type
 Risk neutral probabilities and
valuation
• RN probabilities can be used to set the
required risk premium or spread on a loan.
• Example (From Ginzberg et al 1994)
– One year loan of $1 with expected PV of $1, ie.
Expected NPV = 0
– r = one year risk free rate = 4%
– p1* = RN probability of default = 6.5%
– LGD = 33.434%
 Risk neutral probabilities and
valuation

E ( PV ) =
(1 − p )(1 + r + s )+ p (1 − LGD )
*
1
*
1
=1
1+ r
=
(0.935 )(1.04 + s ) + 0.065 (0.66566 )
=1
1 + 0.04

Solving: We get s = 2.6%

 Valuation of loan using E(NPV)
• Assume a 4 year loan, face value = $100m
• Fixed rate 15% coupon on loan
• Risk free rate = 4%
• LGD = 1
• Risk neutral probability of default, pi*=10%
Valuation of loan using E(NPV)

$15 $15 $15

$115
0.9 0.9 0.9
0.9

0.1 0.1 0.1

0.1 $0
$0 $0 $0

1year 2 year 3year 4 year

 Summary
• Default rates can be obtained from information
contained in market prices
• Merton models equity as call option on firm’s
assets
• KMV commercialized the idea with its KMV
Credit Monitor
• Implied default rates can be obtained from bond
yield spreads
• RN probabilities are useful in valuing loans and
setting spreads