Fixed Income and Credit Risk

Prof. Michael Rockinger

E - 2 - Credit Risk
Reduced Form Approach / Intensity Approach

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Learning Objectives

Part 1:
Some statistics
Definitions and notations

Part 2:
−→ Reduced Form Approach / Intensity based models

Part 3:
Structural based models
KMV - (BS) Merton model

Part 4:
CDS

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Reduced form approach

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Zero-coupon zero-recovery bond when rates are known
Assume that the yield curve is flat at the level of r and it will stay so
over [t, T].
There is a zero-coupon bond that pays 1 at T but only if τ > T .
Assume that in case of default bondholders get nothing:
zero recovery rate.
Risk-neutral valuation still applies, hence, it must be that t−price of
the defaultable zero, denoted by D(t, T), is
h i
D(t, T) = E∗t e−r(T−t) 1τ>T = e−r(T−t) P∗t [τ > T] ≡ e−r(T−t) p∗ (t, T) s.t.
 RT 
∗ − t λ∗u du
p (t, T) = Et e
∗

and λ∗u is the default intensity under the risk-neutral measure.

When interest rates are known, the price of defaultable zero-recovery
zero-coupon bond is the discounted conditional survival probability
under the risk-neutral measure.
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Zero-coupon zero-recovery bond with stochastic rates
Assume that recovery rate is still zero but interest rates are
stochastic. Risk-neutral pricing implies:
 RT 
D(t, T) = E∗t e− t ru du 1τ>T
 RT 
= Et e
∗ − t ru du ∗
E [1τ>T |interest path]
 RT 
⇒ D(t, T) = E∗t e− t (ru +λu )du ,
∗

λ∗u is the risk-neutral default intensity.

If default intensities are independent from short rates under the

risk-neutral measure then,

D(t, T) = Z(t, T)p∗ (t, T).

.
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Zero-coupon bond with non-zero recovery

The general case of defaultable zero-coupon bond valuation is the

one where bondholder gets some recovery amount R > 0 upon
default (this amount is stochastic in principle). In such case,
risk-neutral valuation implies:
 RT   Rτ 
D(t, T) = E∗t e− t ru du 1τ>T + E∗t e− t ru du R 1τ<T

Modeling R is very difficult because recovery rates observed in

practice exhibit lots of variation even among firms with the same
credit rating and of the same industry.
There is no ‘real-time’ statistics on recovery rates also because
litigation takes time.

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Credit spreads
Define credit spread s(t, T) as the difference in yields of defaultable
and riskless zero-coupon bonds:

ln D(t, T) − ln Z(t, T)
s(t, T) = − .
T −t
There’s a term structure of credit spreads (a.k.a. yield spreads). The
goal of credit risk modeling is to match the observed spread term
structure (matching the term structure of rates simultaneously).
If short rates and default intensities are correlated, spreads vary not
only because of variation in credit quality.
If short rates and default intensities are risk-neutral independent, then
the term structure of spreads is just the term structure of default risk:

p∗ (t, T)
s(t, T) = − .
T −t

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Yield spreads in CIR: example (1)

Consider a CIR model for risk-neutral default intensity:

dλt = κ(θ − λt )dt + σ λt dWt∗ .

p

Assume for simplicity that default intensity is risk-neutral independent

from the short rate.
Consider two issuers that only differ in their initial default intensity λ0 :
high-quality issuer with λ0 = 0.05 and low-quality issuer with
λ = 0.4. Other parameters of the CIR process are identical for both
issuers: κ = 0.5, θ = 0.2, and σ = 0.1.
You can compute the term structure of survival probabilities and yield
spreads for two issuers the exact same way as you priced
zero-coupon bonds under CIR-driven short rates.

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Yield spreads in CIR: example (2)

λ0 = 0.05
λ0 = 4

3
Yield spread, %

0 5 10 15 20

Maturity (horizon)

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Term structure of yield spreads: stylized facts

The picture on a previous slide is correct for highly-rated issuers. The

term structures of IG yield spreads are usually upward sloping
indeed.

The story is more complicated for speculative-grade debt. There is

evidence of flat-ish, hump-shaped, and downward-sloping yield
spread term structures for HY debt. Some of these shapes cannot be
matched by Vasicek/CIR-type models.

This opens door for more advanced models such as forward (LMM)
models

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