Assessment of Credit Risk in Project Finance

Dequan Kong1; Robert L. K. Tiong2; Charles Y. J. Cheah3; Andre Permana4; and Matthias Ehrlich5

Abstract: In project finance, raising sufficient funds via the debt channel is a key task for all project companies and sponsors. Before
furnishing a loan, lenders typically need to ascertain the ability of the project company to service principal payments plus interest. This
paper aims to establish a quantitative model to analyze default risks and loan losses in infrastructure projects. Acting as an assessment
system, the model will help lenders evaluate their exposure to default risk by monitoring the changes in credit quality of the project
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company. The model uses a conditional credit rating transition matrix to predict the probability of default and the net present value
technique to estimate the maximum default loss. The Hong Kong-Canton highway project is used as a case study to illustrate the
techniques and output of the proposed credit risk model. The model can be used to assist lenders and investors in making sound
investment decisions, price contracts, and allocate capital. Similarly, it can also help project sponsors evaluate those critical measures that
they must control in order to secure favorable loan terms by minimizing the risk of default and improving the bankability of a project.
DOI: 10.1061/共ASCE兲0733-9364共2008兲134:11共876兲
CE Database subject headings: Risk management; Assessments; Financial management; Construction management.

Introduction largely target the creditworthiness of an entire firm in general

Traditional credit analysis focuses on the company’s balance
sheet and income statements to determine whether a borrower is
generating sufficient cash flow to service its debts. Analyses of
the industry, business plan, and management skills collectively
provide a gauge on whether sufficient cash flows are likely to
persist over the life of the outstanding liabilities, and whether or
not liabilities are likely to expand or contract in the future. When
an infrastructure project is implemented on the basis of project
finance, lenders also need to scrutinize the associated cash flows
and creditworthiness thoroughly to ascertain the ability of the
private sponsor to service the loan repayments. Under a build-
operate-transfer 共BOT兲 procurement a private sector finances the
development and services and maintains the facilities in a varying
degree during the concession period of usually 25– 30 years. Pri-
vate and public sponsors can have a share in the special purpose
vehicle 共SPV兲. During the concessionaire period the concession-
aire receives in return either a regular payment as availability fee
or revenues based on user fees.
Although models for assessing credit risks have been built by
some financial institutions and credit agencies, these models
1
School of Civil and Environmental Engineering, Nanyang Techno-
logical Univ., 50 Nanyang Ave., Singapore 639798, Singapore.
2
Professor, School of Civil & Environmental Engineering, Nanyang
Technological Univ., N1-B1b-17 Singapore 639798, Singapore 共corre-
sponding author兲. E-mail: clktiong@ntu.edu.sg
3 Since the model is generic in nature, it can be applied to projects
School of Civil and Environmental Engineering, Nanyang Techno-
logical Univ., Singapore 639798, Singapore.
4
School of Civil and Environmental Engineering, Nanyang Techno-
logical Univ., Singapore 639798, Singapore.
5
School of Civil and Environmental Engineering, Nanyang Techno-
logical Univ., Singapore 639798, Singapore.
Note. Discussion open until April 1, 2009. Separate discussions must
be submitted for individual papers. The manuscript for this paper was
submitted for review and possible publication on July 14, 2006; approved
on March 31, 2008. This paper is part of the Journal of Construction
Engineering and Management, Vol. 134, No. 11, November 1, 2008.
©ASCE, ISSN 0733-9364/2008/11-876–884/$25.00.
rather than specific projects that may be funded “off-balance
sheet” via SPV. The focus of this research is limited to these types
of projects, such as those procured under a BOT scheme. The
objective is to set up a quantitative model to assess the default
risk of a project sponsor by estimating the default loss of a loan
based on the cash flow profile of an infrastructure project and
financial metrics of the project company. Properly designed, such
a quantitative model would act as an assessment system to evalu-
ate the lenders’ exposure to the default of the project company by
monitoring changes in its credit quality. Similarly, it is also im-
portant for project sponsors to understand those critical measures
that they must control to improve a project’s credit quality in
order to secure more favorable terms for the loan contract. The
constituents of the quantitative model developed in this paper, and
their interconnections, will help to serve this purpose. This is
analogous to corporations that are very concerned with the credit
ratings of their bonds. It is important to know how the ratings are
determined as these will ultimately affect the costs of financing
new investments.
The developed BOT credit risk model reports the “default-
riskiness” of a project, which essentially comprises maximum de-
fault losses over a range of confidence levels. Key inputs for
deriving this default riskiness are credit ratings, market data, and
financial information. The model accounts for the particular fea-
tures of individual projects through adjustments to these input
data based on specific industry and macroeconomic variables.
such as power, water supply, and transportation in developed and
developing countries.
Literature Review
A number of scholarly works on BOT have been published since
the proliferation of interests in this topic in the early 1990s. These
scholarly works cover a wide spectrum of BOT-related issues,
which include, but are not limited to, the effects of regulation

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J. Constr. Eng. Manage. 2008.134:876-884.

 关e.g., Subprasom and Chen 共2007兲兴; the BOT experience in a
particular city or country 关e.g., Shen et al. 共1996兲 on China;
Zhang and Kumaraswamy 共2001兲 on Hong Kong, and Chang; and
Chen 共2001兲 on Taiwan兴; financing strategies 关e.g., Schaufel-
berger and Wipadapisut 共2003兲; tendering issues 共Wang et al.
1998兲; and risk management 共Thomas et al. 2006兲兴. Broadly
speaking, there are two key elements of successful privately fi-
nanced projects, namely, risk management and financial strate-
gies. Tiong 共1990兲 identified ten main risks during construction
and operation of BOT projects, and proposed a set of solutions to
each of them. He indicated that the most difficult issue faced by a
project sponsor in raising debt is the lender’s requirement of the
host governments’ support. However, governments are typically
averse to risks and do not wish to provide any financial guaran-
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tees 共Tiong 1995兲. In other words, promoters are expected to
manage risks related to completion, cost overrun, facility perfor-
mance, and financing if they want to increase their chances of
winning the concession.
It is commonly acknowledged that the availability of finance is
the most important factor underlying the success of all BOT
projects. While many have focused on the “investing” side of the
equation 共which, by the writers’ interpretation, include issues re-
lated to project evaluation and risk management兲, less work has
been done to study the “financing” part 共which refers, quite sim-
ply, to sources of funds兲. Since BOT projects typically represent
off-balance sheet arrangements with high leverage ratios, it is
important for the sponsor to ensure “bankability” of the project
and convince the lenders to support the project.
To protect their interests, lenders obviously have to assess their
exposure to default by the borrower and default models represent
a strategic component of the set of quantitative tools available to
them. A reliable default risk model enables analysts to make in-
formed credit decisions by associating default probability with
borrowers 共Sobehart and Stein 2000兲. Such a model can be used
as a monitoring tool for screening obligors, for performing risk/
return analysis of credit portfolios, or for capital allocation and
loan pricing. In general, there are three kinds of default risk
models:
• Structural model;
• Reduced form model; and
• Rating based model.
In the so-called structural approach, one makes explicit assump-
tions about the dynamics of a firm’s assets, its capital structure, as
well as its debt and shareholders. It is then supposed that the firm
defaults if its assets are not sufficient to pay off the due debt. In
this situation, corporate liabilities can be considered as contingent
claims on the firm’s assets. Recognizing that a firm may default
well before the maturity of the debt, one may alternatively assume
that the firm goes bankrupt when the debt service cover ratio
共DSCR兲 falls below one. Therefore default occurs when the SPC
has not made a scheduled payment, or has violated debt contracts.
While this structural approach is economically appealing, some
implied credit spread properties hardly match empirical observa-
tions 共the credit spread is the excess yield demanded by bond
investors for bearing the risk of borrower default兲. This is due to
the fact that the structural framework assumes that default can be
anticipated by bond investors, which is often not the case in
reality.
In the reduced form approach, default occurs completely un-
expectedly. The stochastic structure of default is directly pre-
scribed by an intensity or compensator process. Defaultable bond
prices can be represented in terms of the intensity or the compen-
sator, leading to tractable valuation formulas very similar to those
JOURNAL OF CONSTRUCTION ENGINEERING AND MANAGEMENT © ASCE / NOVEMBER 2008 / 877
J. Constr. Eng. Manage. 2008.134:876-884.
arising in ordinary default-free term structure modeling. Due to
the unpredictability of defaults, the implied credit spread proper-
ties are empirically quite plausible.
Rating based models generally assume that changes in defined
variables which drive credit quality are normally distributed. The
variables vary and are chosen based on the underplaying credit
portfolio. The probability of a borrower’s change in credit quality
共including default兲 within a given time horizon can be expressed
as the probability of a standard normal variable falling between
various critical values. These critical values are calculated using
the borrower’s current credit rating and historical data on credit
rating migrations. They are generally presented in the form of a
matrix of probabilities that a borrower with one rating might
move into another rating category during a year. This matrix is
commonly known as the “transition matrix.” For example, for an
A-rated credit according to Moody’s Investors Services, the cells
within the row of the matrix will correspond to probabilities that
its rating will change to Aaa, Aa, Baa, Ba, B, Caa, Ca, C, or that
the obligor will default. The closer the rating category is to the
current rating, the higher the probability of a move to that
category.
The transition probabilities play a crucial role in the calcula-
tion of the joint distribution of ratings for bonds that compose a
portfolio. Belkin et al. 共1998兲 presented a one-parameter repre-
sentation of credit risk and transition matrices. Nickell et al.
共2001兲 also showed that different transition matrices may be iden-
tified across various factors, such as the obligor’s domicile and
industry and the stage of business cycle. However, it is difficult to
apply these previous research results directly to infrastructure
projects, since the panel data these researchers used were not
from privately financed projects. As a result, the structure of their
models is not cohered with the characteristics of privately fi-
nanced infrastructure projects. This gives rise to the need for de-
veloping the BOT credit risk model in this paper, which is
essentially a rating based model.
Default and Default Riskiness
Default
Default risk can be defined as the risk of loss arising from the
failure to a counterpart to make a contractual payment. This con-
cerns the potential value of the debt 共including loans and bonds兲
borrowed by the project company if it fails to meet its obligations
in accordance with the agreed upon terms. The lender needs to
manage the risk in individual credits or transactions as well as the
credit risk exposure in their entire portfolio. It is also important to
analyze and model credit risk from the perspective of a project
sponsor.
Default risk has three main components 共Dowd 1998兲:
1. Probability of default: the probability that the counterpart
will fail to make a contractual payment;
2. Recovery rate: the proportion of claim that can be recovered
if the counterpart defaults; and
3. Credit loss: credit loss 共or default loss兲 is related to the
amount the bank or bondholder stands to lose in default. This
is usually interpreted as the replacement value to the contract
in the event of default, the net of whatever the expected
amount is to be recovered. It is important to note that default
loss is specific to a given facility because it depends on the
structure of the facility 共Nishiguchi et al. 1998兲.
Privately financed infrastructure projects are based on nonre-
 Rt +1
Inputs
Financial Ratios of Project Ri = rj
r1
λti ,1
Sub Model 1: Sub Model 2: λti ,2 r2
Default Loss Default Probability
M
λ ti , m
Project’s Cash Credit Quality Rt = ri
Flows Index
Ri = rj rm
Credit Change
Indicator
Tt Tt+1 Time
Conditional Credit
Rating Transition Fig. 2. Credit rating transition
Matrix (CCRTM)
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Default Loss Default

Probability
estimate the maximum default loss of debts in the event of de-
fault. On the other side, a conditional credit rating transition ma-
trix 共CCRTM兲 is developed to predict the probability of default.
After estimating the probability of default and the maximum de-
Distribution of Default Loss
fault loss for an individual project, the model will then report the
default riskiness of the project.
Default-riskiness

Submodel for Default Probability

Fig. 1. Core of model
course 共or limited-recourse兲 finance, which means that once the
project company defaults, the outstanding debt lent to the project
will not be repaid. Therefore, under the nonrecourse condition,
only two of the components above will be of major concern:
probability of default and credit loss.
Default Riskiness
In this paper, default riskiness is defined as the maximum default
loss at the respective level of confidence. This maximum is not to
be confused with the maximum default loss possible. Instead, the
maximum default loss with which we are concerned is an upper
bound on a confidence interval for the estimated default loss. If
we choose a 95% confidence level, this tells us the maximum loss
to expect from default is 95% in this case.
It also follows that the expected default loss 共EDL兲 can be
found by specifying a probability density function 共either a theo-
retical one such as a normal distribution or an empirical one based
on real-world data兲 for the variable and then computing its mean.
If x is the estimated default loss at some future date with a prob-
ability density function of f共x兲, the EDL is
Over the last several years a number of credit risk models have
been developed to measure future default loss based on transitions
in credit ratings. In such models, the matrix of rating transition
probabilities, the so-called credit rating transition matrix, plays a
crucial role in calculating the distribution of ratings. In this re-
search, a model for estimating a conditional credit rating transi-
tion matrix is proposed 共i.e., the right-hand side of Fig. 1兲. The
idea of “conditioning” is to incorporate credit quality dynamics
that are specific to the project into the general transition matrix.
Credit quality dynamics is achieved by considering the total asset
turnover, which is revenue divided by asset, earnings before in-
terest, tax, depreciation, and amortization divided by asset, the
DSCR, and the debt ratio. The mechanics of developing the
CCRTM will be discussed in the following subsections. First, we
define some of the terminologies.
Credit Rating Grade
In the mathematical model, the credit rating grade of the project
company is labeled as a vector R with elements 兵r1 , r2 , . . . , rm其.
The grade rm is of highest creditworthiness 共e.g., by Moody’s
convention, this would be “Aaa”兲, and the default grade is r1. The
credit rating grade at time t is then simply labeled as Rt. Rt is
random variant. The probability pti is the probability of the event

冕
+⬁ that at time t the credit rating of project company is ri.
EDL = xf共x兲dx 共1兲
−⬁ Credit Rating Transition
Consider a sample of obligor ratings observed at t and t + 1. Sup-
Eq. 共1兲 effectively represents a type of cost information and
pose the initial rating at t , Rt, and identical but that at t + 1 , Rt+1, a
should always be subtracted from the expected profit derived
given obligor may be in any one of m different terminal states
from the contract. Such information is not only useful for budget-
corresponding to default and m − 1 nondefault ratings categories
ary purposes, but also to set up default reserves, price, and rank
because of the change of its macroeconomic environment, finan-
prospective contracts, and guide purchases or sale decisions.
cial state, and other factors. Fig. 2 shows this transition.
The probability that the grade of project company is r j at time
t + 1 共i.e., Rt+1 = r j兲 on the condition that at time t the grade is ri
Modeling Default Riskiness 共i.e., Rt = ri兲 is labeled as ␭i,j
t

Core Structure of Model ␭i,j

t
= Prob兵Rt+1 = r j兩Rt = ri其 共2兲
Fig. 1 shows the core structure of the model. On one side, net The credit rating transition matrix at time t , ⍀ can thus be repre-
t

present value 共NPV兲 analysis of project cash flows is applied to sented by elements of ␭i,jt

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 Table 1. Rules of Credit Quality Index for Appraising Project Compa-
ny’s Credit Worthiness
Characteristic of project company
Credit quality index⬎ 0
Credit quality index= 0
Credit quality index⬍ 0
Credit worthiness
Good; the larger the positive value,
the better is the quality
Normal
Bad; the larger the negative value,
the poorer is the quality
Zt = − 0.157 + 3.41共R/A兲t + 1.70共EBITDA/A兲t + 0.383共DSC兲t
− 2.16共D/A兲t 共4兲
where R / A denotes the total asset turnover, which is revenue
divided by asset; EBITDA/A denotes earnings before interest, tax,
depreciation, and amortization divided by asset; DSCR= debt ser-
vice coverage ratio; and D / A = debt ratio.
The above subset has an R-square value of 87.7, an adjusted
R-square value of 87.3, and a Mallows’ C p statistic of 3.9 关which
is less than 5—the number of parameters in Eq. 共4兲兴. Therefore,
the overall fitness of this subset model is good.

冢 冣
␭t1,1,␭t1,2, . . . ,␭1,m
t
Conditional Credit Rating Transition Matrix
␭t2,1,␭t2,2, . . . ,␭2,m
t
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⍀ =
t
共␭i,j
t
兲m⫻m = 共3兲 The rating transitions can be assumed to reflect an underlying,
] continuous credit change indicator, Y 共Belkin et al. 1998兲. It is
␭m,1
t t
,␭m,2 t
, . . . ,␭m,m also assumed that Y has a linear relationship to the credit cycle.
This mechanism can be applied to establish the relationship be-
The j column of the matrix ⍀t can also be conveniently labeled as tween credit change indicator, Y, and the credit quality index, Z
⍀tj.
Y t = ␥Zt + 冑1 − ␥2␧t
As mentioned, some financial institutions and credit agencies
共5兲
build and publish their credit rating transition matrices annually,
but these matrices are not tailored to the context of a specific
where Zt = CQI at time t; ␥ = coefficient of regression 共which has
project company. Somehow, these general transition matrices
been estimated as 0.0244兲; and ␧t = standard random error term
need to be moderated to reflect the financial health of a project
共with mean= 0 and standard variation= 1兲.
company. This leads to the concept of credit quality index 共CQI兲.
Y t has a standard normal distribution. Then, conditional on an
initial credit rating ri at the beginning of a period, we can partition
Credit Quality Index
the Y t value into a number of disjoint bins 共ŷ g , ŷ g+1兴.
The credit quality index, labeled Zt, defines the credit state of the
The credit rating at the end is
borrower during the period from time t to t + 1. It is an indicator

冦 冧
of the borrower’s credit worthiness, and the default rate of the
borrower is obviously related to it. The index is designed to be r1 , if Y t 艋 ŷ 1
positive in “good days,” implying a lower downgrading and lower r2 , if ŷ 1 ⬍ Y t 艋 ŷ 2
default probability and a higher upgrading probability. The index r3 , if ŷ 2 ⬍ Y t 艋 ŷ 3
is negative in “bad days,” implying a higher downgrading and
default probability and a lower upgrading probability. Table 1 ......
summarizes the rules for appraising credit worthiness of a project rm−1 , if ŷ m−2 ⬍ Y t 艋 ŷ m−1
company. rm , if ŷ m−1 ⬍ Y t
In this research, financial data of project companies which are
involved in large scale infrastructure projects are used to estimate By adopting the same form as Eq. 共2兲
the parameters of the linear model for Zt. These data are drawn
from Moody’s 1999 Project Finance Sourcebook, Moody’s 2001
␭i,j
t
= Prob兵ŷ j−1 ⬍ Y t 艋 ŷ j兩Zt其
Project and Infrastructure Finance Sourcebook, and the database
of the Securities and Exchange Commission 共SEC兲 of the United = Prob兵ŷ j−1 ⬍ ␥Zt + 冑1 − ␥2␧t 艋 ŷ j其
States. The final data set used in this research consists of 142
valid records drawn from 65 borrowers. Table 2 summarizes the
output of the regression analysis.
By running a series of stepwise regressions, the best subset has
= Prob 再 ŷ j−1 − ␥Zt
冑1 − ␥ 2
⬍ ␧t 艋
ŷ j − ␥Zt
冑1 − ␥2 冎
been determined as follows: such that

Table 2. Regression Analysis

Model
summary Constant x2 x3 x7 x9
Beta — −0.157 3.407 1.697 0.383 −2.164
Std. error — 0.052 0.274 0.362 0.014 0.090
T — −3.000 12.440 4.680 27.900 −23.970
P — 0.003 0.000 0.000 0.000 0.000
R square 87.7% — — — — —
Adjusted R square 87.3% — — — — —
Std. error of the estimate 0.150 — — — — —

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J. Constr. Eng. Manage. 2008.134:876-884.

 Table 3. Conditional Credit Rating Transition Probability Matrix 共Credit Change Index= −0.027兲
Rating at end of year
Rating at the 共%兲
beginning of
the year Aaa Aa A Baa Ba B Caa-C Default
Aaa 91.782 6.816 1.110 0.271 0.022 0.000 0.000 0.000
Aa 1.204 91.336 6.408 0.748 0.194 0.033 0.000 0.077
A 0.073 2.351 91.189 5.368 0.738 0.119 0.022 0.142
Baa 0.036 0.249 3.995 89.071 5.511 0.726 0.075 0.036
Ba 0.018 0.082 0.409 4.853 87.001 5.831 0.477 1.329
B 0.000 0.036 0.129 0.644 6.214 85.185 3.693 4.100
Caa-C 0.000 0.018 0.037 0.343 1.363 5.734 78.087 14.419
Default 0.000 0.000 0.000 0.000 0.000 0.000 0.000 100.000
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冉冑 冊
冦 冧
ŷ j − ␥Zt or downgrade: if it is positive, it is more likely to cause the
⌽ j=1 project company to transit to a higher rating grade; if it is nega-
1 − ␥2

冉冑 冊 冉 冑 冊
tive, it is more likely to cause the project company to transit to a
ŷ j − ␥Zt ŷ j−1 − ␥Zt lower rating grade. As a whole, by incorporating the project’s
␭i,j
t
= ⌽ −⌽ 1⬍j=m−1 共6兲
1 − ␥2 1 − ␥2 characteristics into the credit rating transition matrix 关Eqs.

冉冑 冊
共4兲–共6兲兴, the accuracy of the prediction of default can be
ŷ m−1 − ␥Zt
1−⌽ j=m improved.
1−␥ 2

Eq. 共6兲 establishes the relationship between the conditional credit

rating transition matrix 共i.e., a conditional ⍀t兲 and the credit qual- Modeling Distribution of Default Time
ity index.
In short, the credit change indicator 共CCI兲, which is derived As outlined in the previous section, the conditional credit rating
from the CQI of a project company, is used to condition a general transition matrix represents the probability of the borrower’s rat-
transition matrix into a transition matrix that is specific to the ing grade change from one to another. Ultimately, it can be used
project company. The annual credit rating transition matrix in to predict the probability of the borrower’s state of credit rating at
structured finance was used from 1988 to 2002 共Violi 2004兲. For a 1-year time horizon during the project life cycle. By simply
illustrative purposes, assume that for a particular project com- counting the probability of the default grade, the distribution of
pany, its CQI is −1.097. Then, using Eq. 共5兲, its CCI would be the probability of default can then be estimated.
−0.027. Using Eq. 共6兲, the conditional credit rating transition ma- The distribution of the project company’s credit rating grade,
trix is obtained as shown in Table 3. labeled ␣t, is a vector that describes all probabilities of the credit
For another project company, if its CQI is 1.003, then its credit rating grades of a project company
change indicator is 0.024, and the conditional credit rating tran-
␣t = 共pt1,pt2, . . . ,pmt兲 共t = 1,2, . . . ,n兲 共7兲
sition matrix is as shown in Table 4.
Comparing the three tables, it can be seen that the effects of where ptj = probability
of having a credit rating grade of r j at time
the credit change indicator that are imposed on the general tran- t.
sition matrix are to cause the shift of the probability density func- According to the total probability formula, ptj can be rewritten
tion of rating toward better or poorer credit states. Fig. 3 as follows:
illustrates such an effect. As Fig. 3 shows, the positive credit
m
change indicator shifts the transition towards better credit direc-
tion, while the negative shifts the transition towards poorer credit ptj = Prob兵Rt = r j其 = 兺
i=1
Prob兵Rt−1 = ri其 ⫻ Prob兵Rt = r j兩Rt−1 = ri其
direction. Therefore, the credit change indicator is a driving force,
which drives the project company’s credit worthiness to upgrade Then

Table 4. Conditional Credit Rating Transition Probability Matrix 共Credit Change Index= 0.024兲
Rating at end of year
Rating at the 共%兲
beginning of
the year Aaa Aa A Baa Ba B Caa-C Default
Aaa 92.531 6.239 0.979 0.232 0.018 0.000 0.000 0.000
Aa 1.374 91.862 5.847 0.658 0.168 0.028 0.000 0.064
A 0.087 2.643 91.498 4.883 0.648 0.103 0.019 0.120
Baa 0.044 0.290 4.434 89.219 5.019 0.640 0.066 0.288
Ba 0.022 0.097 0.470 5.354 87.128 5.338 0.427 1.164
B 0.000 0.044 0.151 0.735 6.809 85.189 3.404 3.669
Caa-C 0.000 0.022 0.043 0.0397 1.533 6.250 78.467 13.288
Default 0.000 0.000 0.000 0.000 0.000 0.000 0.000 100.000

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J. Constr. Eng. Manage. 2008.134:876-884.

 Negative Positive m

Probability
Credit Credit
Change Change Pd共t兲 = Prob兵Rt = r1兩Rt−1 = rk其 ⫻ Prob兵Rt−1 = rk其
Index Index k=2

It can be proven that Pd共t兲 = pt1 − pt−1

1 共t = 1 , 2 , . . . , n兲 after a series
of simplifications by applying the total probability formula. Using
Probability Density
Eq. 共8兲 and since p01 is known at time 0, we can write

再 冎
Function

␣0 · ⍀01 − p01 t=1

Pd共t兲 = 共11兲
␣t−1 · ⍀t−1
1 − ␣t−2 · ⍀t−2
1 t艌2
Together, Eqs. 共10兲 and 共11兲 are used to calculate the distribution
of default time for the project company concerned. Effectively,
Credit Rating only two types of input parameters are required: the initial distri-
bution of the project company’s credit rating grade, ␣0, and the
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Fig. 3. Credit change indicator’s effect on credit rating transition

conditional ⍀t for each period t 共which can be estimated using the
procedure outlined in the previous section兲.

ptj = ␣t−1 · ⍀t−1

j 共t = 1,2 . . . n; j = 1,2, . . . ,m兲
following the notations developed in Eqs. 共5兲 and 共6兲 previously.
Moreover, it can be further deduced that
␣t = ␣t−1 · ⍀t−1 共t = 1,2, . . . ,n兲
Eq. 共9兲 shows that the credit state ␣t of a project company is
related to two factors: the conditional credit rating transition ma-
trix and distribution of the credit rating grades in the previous
state. It also follows that
共8兲
Case Study: HK-Canton Highway Project
The HK-Canton Highway Project consists of the design and con-
struction of the highway linking the border of the Territory of
共9兲 Hong Kong at the Huanggan interchange with Guangzhou. The
highway forms Phase I of the Guangzhou-Shenzhen-Zhuhai
共GSZ兲 Superhighway being undertaken by a joint venture be-
tween a company controlled by the Guangdong Provincial Bureau
of Communications and a wholly owned subsidiary of Hopewell
Holdings. Upon project completion, the highway would have a

冉兿 冊
t−1 total length of 122.8 km. The highway runs the length of the
eastern corridor of the Pearl River Delta, connecting in its final
␣t = ␣0 · ⍀k 共1 艋 t 艋 n兲 共10兲
k=0
stage with primary roads east of Guangzhou and ultimately with
the proposed Guangzhou ring road.
Eq. 共10兲 shows that if ␣0 共the initial credit state兲 and ⍀t 共the credit The total highway project was estimated at United States dol-
rating transition matrix兲 are known, the credit state at any time lars 1,206 million. Any cost overruns were to be borne by the
can also be calculated. Contractor Consortium under the Completion Guarantee, GITIC
When the project company’s credit rating is at default grade at 共Guangdong International Trust and Investment Corporation兲 and
time t 共i.e., Rt = r1兲, it is regarded that it is in the state of default. Hopewell Holdings under the Contractor Sponsors’ Guarantee,
The probability of occurrence of that event is hereby denoted as and in certain circumstances by Hopewell Holdings under the
Pd共t兲. To simplify the calculation, it is also assumed that once the Hopewell Undertaking and Guarantee.
project company is in default, it will always be in default. Based
on this assumption
Default Risk Analysis of Base Case Analysis
Pd共t兲 = Prob兵R0 ⫽ r1 艚 . . . 艚 Rt−1 ⫽ r1 艚 Rt = r1 艚 Rt+1 From the projected cash flows of the HK-Canton Highway
Project, the selected financial ratios and derived credit quality
= r 1 艚 . . . 艚 R n = r 1其
index, Z, and credit change indicator, Y, from 1994 to 2002 are
which is mathematically equivalent to calculated and shown in Table 5 and Fig. 4. The credit quality

Table 5. HK-Canton Highway: Financial Ratios and Credit Changes Indicator 共Base Case兲
Debt Credit Credit
service Debt/ EBITDA/ Revenue/ quality change
Year ratio total asset asset asset index, Z indicator, Y
1994 1.183 0.687 0.072 0.078 −0.798 −0.019
1995 1.329 0.661 0.161 0.175 −0.206 −0.005
1996 1.071 0.610 0.182 0.197 −0.082 −0.002
1997 1.296 0.549 0.223 0.242 0.357 0.009
1998 1.348 0.472 0.245 0.267 0.667 0.016
1999 1.391 0.377 0.264 0.291 1.003 0.024
2000 1.587 0.265 0.311 0.347 1.590 0.039
2001 1.678 0.136 0.335 0.375 2.038 0.050
2002 1.879 0.000 0.359 0.401 2.541 0.062

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J. Constr. Eng. Manage. 2008.134:876-884.

 0.07 100,0

0.05
Credit Change Indicator

Probability (%)
99,5

0.03

0.01 99,0

-0.01
98,5
0 100 200 300 400 500
-0.03
Default Loss (USD Million)
1994 1995 1996 1997 1998 1999 2000 2001 2002
Year Fig. 6. Default loss distribution: HK-Canton highway project 共base
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case兲
Fig. 4. Credit change indicator 共base case兲

index and credit change indicator are calculated by using Eqs. 共4兲 Traffic Variation and Default Risk
and 共5兲, respectively.
Figs. 7 and 8 shows the default risk probabilities with changes in
The calculated default probability by the BOT credit risk
ratio of actual traffic volume with the expected traffic volume. It
model as developed in this paper for the base case of the HK-
can be seen from the figure that when the actual traffic volume is
Canton Highway Project is shown in Fig. 5. This figure shows
only 70% of the expected volume of the base case, the default
that the annual default probability of the base case of HK-Canton
probability is still lower than Moody’s average 1-year default rate
Highway ranges from 0.094 to 0.21%. The figure also indicates
of investment-grade bonds, which is 0.16%. It can be concluded
that the default probabilities for 2 / 3 of the total number of years
that the HK-Canton Highway Project is not so sensitive to the
are lower than Moody’s average 1 year default rate of investment-
variation of the actual traffic volume.
grade bonds, 0.16% 共the dashed line in Fig. 5兲. The average
Furthermore, the government also provided a guarantee to the
1-year default probability of the highway’s base case is 0.1570%,
lender that if the project could not collect enough toll revenues to
and it is far less than 0.30%, the average 1-year default rates of
corporate bonds with Moody’s “Baa” rating. Consequently, it is
safe to conclude that the default risk faced by the lenders in this
highway project is relatively low. Actual Traffic
Default Probability
Fig. 6 shows the distribution of probability of default loss of Volume/Expected Traffic
(‰)
Volume
the base case if the project company defaults at any year between
1993 and 2002. The expected default loss is equal to United 0.7 1.486

States dollars 2.62 million, which turns out to be approximately 0.8 1.457
5% of the discounted bank facilities. 0.9 1.428
Therefore, as a whole, the default analysis of base case shows 1.0 1.401
that the credit worthiness of the HK-Canton Highway project is
1.1 1.373
rather high.
1.2 1.346
1.3 1.320
0,25

Fig. 7. Default probability and actual traffic volume

0,20 1,500
Default Probability of
Investment-grade
1,475
Default Probability

Bond

0,15 1,450
Default Probability

1,425

0,10 1,400

1,375

0,05 1,350

1,325

0,00 1,300
1994 1995 1996 1997 1998 1999 2000 2001 2002 0,6 0,7 0,8 0,9 1 1,1 1,2 1,3 1,4
Year
Actual Traffic Volume/Expected Traffic Volume
Fig. 5. Annual default probability: HK-Canton highway project 共base
case兲 Fig. 8. Traffic volume and default risk

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J. Constr. Eng. Manage. 2008.134:876-884.

 serve the repayment of bank facilities plus interest, the govern-
ment would make up for the shortfall. This guarantee gave strong
support for the joint venture to seek finance for the project.
Conclusion
Default models represent a strategic component of the set of
quantitative tools. Such a model can be used as a monitoring tool
for screening obligors, for performing risk/return analysis of
credit portfolios, or for capital allocation and loan pricing. The
BOT credit risk model has been designed to act as an assessment
system to evaluate the lenders’ exposure to the default of the
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project company by monitoring its changes in credit quality. For
each project, the model reports the maximum default loss at a
certain confidence level, the so-called default riskiness of the
debt, using credit ratings and financial information as input. The
model accounts for the particular features of a project through
adjustments to input data based on the specific project variables.
The model can be applied to infrastructure projects such as
power, water supply, and transportation. It will also assist project
sponsors in evaluating those critical measures that they need to
control in order to secure favorable loan terms, minimizing the
risk of default and improving the bankability of a project.
The maximum default loss with which the research is con-
cerned is an upper bound on a confidence interval for the esti-
mated default loss. In other words, it is a measure of default-
related “value-at-risk” 共VaR兲 共Dowd 1998兲. This default-riskiness
concept is extremely useful. It can be used to assist borrowers in
making decisions, price contracts, allocate capital, etc. Since it
estimates the maximum likely loss from the counterparty’s default
and ignores market risks, it is a natural complement to traditional
VaR, which looks at market risks but ignores default-related risks.
The BOT credit risk model is a hybrid one that combines two
credit risk modeling approaches: 共1兲 a statistical model deter-
mined through empirical analysis of historical data; and 共2兲 the
NPV technique used to evaluate the default loss. The statistical
approach deduces the project company’s future credit quality. The
deduction serves as a statistical distillation of the historical credit
rating data and can be used to discriminate different credit quality.
The second modeling approach starts with a stylized mathemati-
cal representation of valuing the debts considering default risk.
The goal of this type of quantitative risk assessment is to repre-
sent debt value and incorporate the project-specific characteristics
into the model, based on NPV technique.
The model for estimating the conditional transition matrix is
thus proposed. The idea is to adopt an established framework with
an optimal number of parameters and an optimal amount of re-
quired data, within which one can incorporate credit quality dy-
namics into the transition matrix. To implement the technique, a
CQI, which indicates the credit state of the project’s financial
state, is built. The model of building the CQI includes the most
relevant financial series, such that the forecasted CQI represents
the credit state well, even with only a small number of series. The
next step is to condition the transition matrix by the forecasted
credit quality index. The model of conditioning the transition ma-
trix by the derived credit change indicator covers events that lead
to upgrading and downgrading, as well as default. The technique
of conditional transition matrix improves the accuracy of credit
loss simulation.
The case study on HK-Canton Highway shows that the default
risk that lenders in the highway are exposed to is relatively low.
The annual default probability for the base case of HK-Canton
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J. Constr. Eng. Manage. 2008.134:876-884.
Highway ranges from 0.094 to 0.21%. The average 1-year default
probability of the highway’s base case is 0.1570%, and it is far
less than 0.30%, the average 1-year default rates of bonds with
Moody’s “Baa” rating.
Notation
The following symbols are used in this paper:
D / A ⫽ debt ratio;
Dt ⫽ discount factor for year t;
d ⫽ year of default;
it ⫽ interest rate of loan;
m ⫽ maturity of loan;
NPVd ⫽ loan value if there is default;
NPV0 ⫽ loan value if there is no default;
Ot ⫽ outstanding balance of loan for year t;
Pd共t兲 ⫽ probability of occurrence of state of default
event that is when project company’s credit
rating is at default grade at time t 共i.e., Rt = r1兲;
Pt ⫽ loan disbursements 共repayments兲 lender
makes 共receives兲 to 共from兲 project company at
year t; company’s credit rating is at default
grade at time t 共i.e., Rt = r1兲;
ptj ⫽ probability of having credit rating grade of r j
at time t;
R / A ⫽ total asset turnover, which is revenue divided
by asset;
Rt ⫽ credit rating grade at time t;
Rt+1 ⫽ credit rating grade at time t + 1;
rm ⫽ highest creditworthiness grade 共e.g., by
Moody’s convention, this would be “Aaa”兲;
r1 ⫽ default grade;
r1 , r2 , . . . , rm ⫽ credit rating grade of project company
共vector R兲;
Zt ⫽ credit quality index, credit state of borrower
during period from time t to t + 1;
␣t ⫽ distribution of project company’s credit rating
grade, vector that describes all probabilities of
credit rating grades of project company;
␣0 ⫽ initial credit state;
␥ ⫽ coefficient of regression;
␧t ⫽ standard random error term 共with mean= 0
and standard variation= 1兲;
␭i,j
t
⫽ probability that grade of project company is
r j at time t + 1 共i.e., Rt+1 = r j兲 on condition that
at time t grade is ri 共i.e., Rt = ri兲;
⍀t ⫽ credit rating transition matrix at time t; and
⍀tj ⫽ j column of matrix ⍀t.
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