Stochastic calculus and Merton model for credit risk issues (KMV)

Theodor M.

Date: 12 Nov. 2020

(Volatility of bond portfolio investments when risk-to-default is considered: 2 clients, one investor)

1. Two companies from the Food & Beverage sector wish to finance some investments for a 5-year
horizon term. They apply to the same investor, BNP Paribas. The value of their assets is 𝑨𝟏𝟎 =
𝟐𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎 euros and 𝑨𝟐𝟎 = 𝟏𝟐, 𝟎𝟎𝟎, 𝟎𝟎𝟎 euros while their volatilities is 𝝈𝟏 = 𝟐𝟎% and 𝝈𝟐 = 𝟑𝟎%.
Their asset log-returns are uncorrelated. The risk-free rate in Euro-zone is now considered to be 𝒓 =
𝟏%. Also, the first company has 10,000 shares of issued stock while the second has 4,000 shares of
issued stock.

Each company issues a zero-coupon bond, the notionals being 𝑵𝟏 = 𝟏𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎 𝒆𝒖𝒓𝒐𝒔 and 𝑵𝟐 =
𝟒, 𝟎𝟎𝟎, 𝟎𝟎𝟎 euros.

a. Find the price per share of each company, as well as the value, spread and volatility of each bond.

b. Find the volatility of the investors’ portfolio.

c. How can the investor protect him/herself against movements of the asset values?

Answer:

a. We need to find the equity value in each case.

The equity value can be seen as the call option on the assets when the strike price is the face value.

Therefore shareholders’ equity is 𝐶(𝐴𝑖𝑡 , 𝐹𝑖 ) = 𝐴𝑖𝑡 𝑁(𝑑1𝑖 ) − 𝐹𝑖 𝑒 −𝑟(𝑇−𝑡) 𝑁(𝑑2𝑖 ), 𝑑1𝑖 =

𝐴 𝜎2
ln( 𝑡 )+(𝑟+ )(𝑇−𝑡)
𝐹 2
, 𝑑2𝑖 = 𝑑1𝑖 − 𝜎𝑖 √𝑇 − 𝑡, 𝐹𝑖 = face value of bond 𝑖.
𝜎1 √𝑇−𝑡

The equity value is 𝐸01 = 𝐶(𝐴10 , 𝐹𝑉1 ) = 10,609,182.192952 for the first company while for the second it
𝐸01
is 𝐸02 = 𝐶(𝐴20 , 𝐹𝑉2 ) = 8,272,204.315. The price per share therefore would be 𝑃01 = =
10000
𝐸02
1,060.9182, 𝑃02 = 4000 = 2068.05 euros/share.

The debt value is 𝑨𝟎 − 𝑬𝟎 = 𝟗, 𝟑𝟗𝟎, 𝟖𝟏𝟕. 𝟖𝟎𝟕 which is also the bond value, the entire debt of the
company consisting of only one bond.
𝑭𝑽 𝟏𝟎,𝟎𝟎𝟎,𝟎𝟎𝟎
The yield to maturity of the bond is given by 𝑫𝟎 = 𝒆−𝟓𝒚 𝑭𝑽 ⇒ 𝟓𝒚 = 𝒍𝒐𝒈 (𝑫 ) = 𝒍𝒐𝒈 ( 𝟗𝟑𝟗𝟎𝟖𝟏𝟕
) ⇒
𝟎
𝒚 = 𝟏. 𝟐𝟓% ⇒ 𝒔 = 𝟎. 𝟐𝟓%
𝐴
The debt volatility is given by 𝜎𝐷 = 𝜎𝐴 ⋅ 𝐷0 ⋅ 𝑁(−𝑑1 ) ⇒ 𝜎𝐷1 = 1.26%, while 𝜎𝐷2 = 1.96%.
0

REMARK: The higher the solvability, the lower will be the debt volatility and therefore the riskiness of
the bond.

b. The investor’s portfolio is composed of two zero-coupon bonds.

Let 𝑋𝑡𝑖 = value of bond I at time 𝑡 and Π𝑡 is the portfolio’s value. Because the bonds are zero coupon and
have the same maturity, the proportion of each bond’s value out of the portfolio’s total value is
constant.

𝒅𝚷𝒕 𝒅𝑿𝟏𝒕 𝑿𝟏𝒕 𝒅𝑿𝟐𝒕 𝑿𝟐𝒕 𝒅𝚷𝒕 𝟐

𝟏𝟐 𝟐 𝟐
𝟒 𝟐
𝚷𝒕 = 𝑿𝟏𝒕 + 𝑿𝟐𝒕 ⇒ = 𝟏 ⋅ + 𝟐 ⋅ ⇒ 𝒗𝒂𝒓 ( ) = 𝝈𝟏 ⋅ ( ) + 𝝈𝟐 ⋅ ( ) ⇒ 𝝈𝑷
𝚷𝒕 𝑿𝒕 𝚷𝒕 𝑿𝒕 𝚷𝒕 𝚷𝒕 𝟏𝟔 𝟏𝟔

𝟏𝟐 𝟐 𝟒 𝟐
= √𝝈𝟐𝟏 ⋅ ( ) + 𝝈𝟐𝟐 ⋅ ( ) = 𝟏. 𝟎𝟔%
𝟏𝟔 𝟏𝟔

c. The investor has to face risks from exposures on 2 companies. The risk factors are the assets of each
company. Therefore we can see the bonds as instruments on company’s assets and so, because the
portfolio value can be written as 𝚷𝒕 = 𝑭𝑽𝟏 𝒆−𝒓(𝑻−𝒕) + 𝑭𝑽𝟐 𝒆−𝒓(𝑻−𝒕) − 𝒑𝒖𝒕(𝑨𝟏𝒕 , 𝑭𝑽𝟏 ) − 𝒑𝒖𝒕(𝑨𝟐𝒕 , 𝑭𝑽𝟐 )
we have that:

𝚫𝚷 = −𝚫𝒑𝒖𝒕𝟏 − 𝚫𝒑𝒖𝒕𝟐 = 𝑵(−𝒅𝟏𝟏 ) + 𝑵(−𝒅𝟐𝟏 ) = 𝟎. 𝟏𝟎𝟒𝟖

On the market we cannot trade units of the company’s assets but we can trade units of the company’s
shares. We can obtain that from the sensitivity of the call option value on company’s assets.
𝝏𝒄(𝒕,𝑨𝒕 )
𝚫𝟏𝒔𝒉𝒂𝒓𝒆 = 𝚫𝑬𝟏 = 𝝏𝑨𝒕
= 𝑵(𝒅𝟏𝟏 ) = 𝟎. 𝟗𝟕𝟎𝟑.

𝚫𝟐𝒔𝒉𝒂𝒓𝒆 = 𝚫𝑬𝟐 = 𝑵(𝒅𝟐𝟏 ) = 𝟎. 𝟗𝟐𝟒𝟖

A position on the portfolio of (𝟏, 𝑵𝟏 , 𝑵𝟐 ) in 1 bonds each, 𝑵𝟏 shares of type 1 and 𝑵𝟐 shares of type 2
would give a risk-neutral investment if 𝚫𝚷 + 𝑵𝟏 𝚫𝟏 + 𝑵𝟐 𝚫𝟐 = 𝟎 ⇒ 𝑵𝟏 ⋅ 𝟎. 𝟗𝟕𝟎𝟑 + 𝑵𝟐 ⋅ 𝟎. 𝟗𝟐𝟒𝟖 =
−𝟎. 𝟏𝟎𝟒𝟖.
−𝟎.𝟏𝟎𝟒𝟖−𝑵𝟏 ⋅𝟎.𝟗𝟕𝟎𝟑
For any integer 𝑵𝟏 chosen, we can choose 𝑵𝟐 = 𝟎.𝟗𝟐𝟒𝟖
. Obviously we can obtain only
approximations but we choose the closest integer to 𝑵𝟐 in order to obtain as best hedge as possible.

2. The current situation of the assets of an enterprise is that it has 𝐴0 = 11,234,000$ and the debt is
𝐷0 = 10,000,000$. The remaining is equity.

The stochastic process followed by the assets is 𝑑𝐴𝑡 = 0.08𝐴𝑡 𝑑𝑡 + 0.13𝐴𝑡 𝑑𝐵𝑡1 ,

while the process for the debt is 𝑑𝐷𝑡 = 0.11𝐷𝑡 𝑑𝑡 + 0.22𝐷𝑡 𝑑𝐵𝑡2 where 𝐵𝑡1 , 𝐵𝑡2 are uncorrelated
Brownian motions.

a. What is the probability that the company will default in 1 year if default would be considered that
𝐴 𝑇 < 𝐷𝑇 ?

b. What is the confidence interval 95% for the debt value in 6 months?

Solution:
𝝈𝟐 𝟎.𝟏𝟑𝟐 𝟎.𝟐𝟐𝟐
(𝝁− )𝑻+𝝈𝑩𝟏𝑻 +𝟎.𝟏𝟑𝑩𝟏𝟏 +𝟎.𝟐𝟐𝑩𝟐𝟏
a. 𝑨𝑻 = 𝑨𝟎 𝒆 𝟐 = 𝑨𝟎 𝒆𝟎.𝟎𝟖− 𝟐 , 𝑫𝑻 = 𝑫𝟎 𝒆𝟎.𝟏𝟏− 𝟐
 𝟏𝟑𝟐
𝟎.𝟎𝟖−𝟎.
𝑨𝟎 𝒆 𝟐 𝟏 𝟐 𝟏 𝟐 𝑫𝟎 …
So 𝟐𝟐𝟐
⋅ 𝒆𝟎.𝟏𝟑𝑩𝟏−𝟎.𝟐𝟐𝑩𝟏 < 𝟏 ⇔ 𝒆𝟎.𝟏𝟑𝑩𝟏−𝟎.𝟐𝟐𝑩𝟏 < 𝒆 = 𝜶 ⇔ 𝒆𝟎.𝟏𝟑𝑿−𝟎.𝟐𝟐𝒀 < 𝜶 where
𝟎.𝟏𝟏−𝟎. 𝑨𝟎
𝑫𝟎 𝒆 𝟐
𝟎.𝟐𝟐𝟐 𝟎.𝟏𝟏𝟐
𝑫𝟎 𝟎.𝟎𝟑−( 𝟐 − 𝟐 )
(𝑿, 𝒀) ∼ 𝑵(𝟎, 𝑰𝟐 ) and 𝜶 = 𝒆 = 𝟎. 𝟖𝟕𝟒𝟐
𝑨𝟎

The probability requested is therefore 𝑷(𝟎. 𝟏𝟑𝑿 − 𝟎. 𝟐𝟐𝒀 < 𝒍𝒏(𝜶)) = 𝑷 (𝑵(𝟎, 𝟎. 𝟏𝟑𝟐 + 𝟎. 𝟐𝟐𝟐 ) <
𝒍𝒏(𝜶)
𝒍𝒏(𝜶)) = 𝑷 (𝑵(𝟎, 𝟏) < ) = 𝑵(−𝟎. 𝟓𝟐𝟔𝟏) ≈ 𝟑𝟎%
√𝟎.𝟏𝟑𝟐 +𝟎.𝟐𝟐𝟐

𝟎.𝟐𝟐𝟐
𝟎.𝟏𝟏−
𝟐 +𝟎.𝟐𝟐√𝟏𝒁
b. 𝑫𝑻 = 𝑫𝟎 𝒆 𝟐 𝟐 and the 95% confidence interval for 𝒁 ∼ 𝑵(𝟎, 𝟏) is
𝟏.𝟗𝟓 𝟏.𝟗𝟓
[−𝑵−𝟏 ( 𝟐 ) , 𝑵−𝟏 ( 𝟐 )] = [−𝟏. 𝟗𝟓, 𝟏. 𝟗𝟓] therefore the debt in 6 months would be, with 95%
confidence between 7,695,119$ and 14,159,473$.

3. Suppose that the share price of the company XYZ follows the geometric Brownian motion, 𝒅𝑺𝒕 =
𝟎. 𝟎𝟐𝑺𝒕 𝒅𝒕 + 𝟎. 𝟏𝟕𝑺𝒕 𝒅𝑩𝒕 based on the historical data of the log-returns of the company.

Also, the current share price is 𝑺𝟎 = 𝟖𝟑. 𝟓 𝒆𝒖𝒓𝒐𝒔 and the company has no outstanding debt, but
wishes to contract a loan for 5 years term and the borrowing notional is 𝑭𝑽 = 𝟏𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎 euros.

There are no preferred shares, and the no. of outstanding shares is 𝟏𝟒𝟗, 𝟕𝟎𝟎.

The interest rate curve is flat at 𝒓 = 𝟐%

a. What is the probability that the company will default on its loan?

b. How can the investor protect against a default on this company?

c. How can the investor protect against a decline in company’s asset values?

d*. Suggest a strategy that the lender can benefit from, in case of an increase in interest rates.

e. Suggest a strategy to protect against the decline of the euros relative to dollars for the 5 years term.

The loan is considered to be a zero-coupon bond.

Answers:

a. The probability of default is 𝑃(𝐴 𝑇 < 𝐹𝑉) = 𝑃(𝐴5 < 𝐹𝑉) where 𝑃 is the probability measure in a risk-
neutral world. Here, the share price is behaving on average as it is in a risk-neutral world because 𝜇𝑆 =
𝜎 2
𝐴
𝑙𝑛( 0 )+(𝑟− 𝐴)𝑇
𝐹𝑉 2
0.02 = 𝑟 so 𝑃(𝑑𝑒𝑓𝑎𝑢𝑙𝑡) = 𝑃(𝐴 𝑇 < 𝐹𝑉) = 𝑁(−𝑑2 ) where 𝑑2 = 𝜎𝐴 √𝑇
.

But we don’t know either 𝐴0 (the current value of the company’s assets) or 𝜎𝐴 .

We have however the following nonlinear system of equations with unknowns 𝐴0 , 𝜎𝐴 :

𝐴 Φ(𝑑1 ) − 𝜎𝐴 𝑒 −𝑟𝑇 Φ(𝑑2 ) = 𝐸0

{ 0
𝜎𝐸 𝐸0 = 𝜎𝐴 𝐴0 Φ(𝑑1 )
There is no manual recipe for solving this accurately, but Newton’s method in 2 dimensions usually
works properly.

I use MATLAB’s fsolve to quickly dissolve this problem.

See the APPENDIX for the Merton function developed in-house, that takes as input the market cap
volatility, its value, the risk-free interest rate, the loan expiry and its notional and returns the asset
values and its volatllity.

We obtain 𝐴0 = 23,914,529.57 and 𝜎𝐴 = 20.97%.

The probability of default is 𝑁(−𝑑2 ) = 0.02992%, that is because, the debt to asset ratio is below 50%
and the average return on equity is 2% = risk-free rate of return. So it is extremely improbable that a call
exercises its option.

b. A lender can be protected by entering into a CDS. However the probability of default is so low, that
the spread is negligible.

c. Δ𝑠ℎ𝑎𝑟𝑒 = Δ𝐸 = Δ𝑐𝑎𝑙𝑙 . The bond holder has a short put-to-default on his risky bond embedded, so in
order to neutralize the risk of declining the asset’s value, he should short shares of the stock.

Therefore, the amount of shares that ought to be sold is: −Δ𝑝𝑢𝑡𝑡𝑜 ⋅no_of_shares_outstanding=
𝑑𝑒𝑓𝑎𝑢𝑙𝑡

𝑁(−𝑑1 ) ⋅ 149,700, that means shorting 21 stocks.

d. The cash-flows depend very little on interest rates, as only principal is repaid. However there are
plenty of solutions such as entering interest rate options, or a swaption.

e. A currency swap at a fixed exchange rate, where only one cash-flow will be swapped. This is a
particular type of currency swap and it is usually traded OTC.

4. Suppose that a firm has contracted a zero coupon bond with principal N = 10,000,000 euros for 9
years term and another coupon-paying bond with principal N = 5,000,000 euros for a 6-years term, the
coupon being paid annually with 5% payments. The total value of assets is 𝑨𝟎 = 𝟐𝟎, 𝟐𝟐𝟓, 𝟏𝟐𝟓. 𝟓𝟒
euros. Find a confidence interval 95% for the debt in 5 years term if the asset is estimated to follow
the process 𝒅𝑨𝒕 = 𝟎. 𝟏𝑨𝒕 𝒅𝒕 + 𝟎. 𝟐𝟐𝑨𝒕 𝒅𝑩𝒕 and the interest rate term structure is constant at 𝒓 = 𝟒%
level.

Solution:

𝐷(𝑡, 𝐴𝑡 ) = 𝐹1 𝑒 −𝑟(𝑇−𝑡) + 𝐵(𝑡; 𝐹2 , 𝑐, 𝑇 − 𝑡) − 𝑝𝑢𝑡(𝐴𝑡 , 𝐹1 + 𝐹2 ) (𝐹1 = 10,000,000, 𝐹2 =

5,000,000, 𝐵(𝑡; … ) =bond value with coupons) and 𝑓(𝑥) = 𝑝𝑢𝑡(𝑥; 𝐹) (the put value) is a decreasing
function of 𝑥 because 𝑓 ′ (𝑥) = Δ𝑝𝑢𝑡 < 0, ∀𝑥 > 0 so 𝐷(𝑡, 𝑥) is increasing in x.

Therefore, in order to find interval of confidence for 𝐷(5, 𝐴5 ) we need to find confidence interval for
𝐴5 .
𝜎2
(𝜇− )⋅5+𝜎√5𝑍
𝐴5 = 𝐴0 𝑒 2 ⇒ 𝐼95% (𝐴5 ) =
0.222 1.95 0.222 1.95
(0.1− )⋅5+0.22√5𝑁−1 (− ) (0.1− )⋅5+0.22√5𝑁−1 ( )
[𝐴0 𝑒 2 2 , 𝐴0 𝑒 2 2 ]=[11,843,164.615;81,459,052.015]
The put values in each case are 𝑝(𝐴5 = 11,843,164.615; 𝑇 = 5 𝑦𝑟𝑠; 𝑟 = 0.04; 𝜎 = 22%; 𝑁 =
15,000,000) = 2568716 and 𝑝(𝐴5 = 81,459,052.015; … ) = 211.643 and the bonds values are
𝐵(𝑡 = 5, 𝑇 = 9, 𝐹𝑉1 = 10,000,000 𝐸, 𝑐 = 0%) = 10,000,000𝑒 −0.04⋅(9−5) = 10,000,000𝑒 −0.16 =
8,521,437 and 𝐵(𝑡 = 5, 𝑇 = 9, 𝐹𝑉2 5,000,000, 𝑐 = 5%) = 5,166,461 therefore the total debt value
including the embedded put-to-default on short position lies in [13,687,899 −
2,568,715; 13,687,899 − 211] = [11,119,184; 13,1687,688]
APPENDIX
function sol=merton(E0,sigE,r,T,D)
d1 = @(x)(log(x(1)/D)+(r+x(2)^2/2)*T)/(x(2)*sqrt(T));
d2 = @(x)d1(x)-x(2)*sqrt(T);
f1 = @(x) x(1)*normcdf(d1(x))-D*exp(-r*T)*normcdf(d2(x))-E0;
f2 = @(x)sigE*E0-x(1)*x(2)*normcdf(d1(x));
f = @(x)[f1(x),f2(x)];
sol = fsolve(f,[E0,sigE]);
end