Qualitative models Credit scoring Term structure derivation Other models

Credit risk

Part 1: Individual loan risk

Saunders, chapter 10

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Content

Qualitative models

Credit scoring

Term structure derivation

Other models

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Credit risk overview

• Credit risk: Possibility of loss resulting from borrower’s failure

to repay a loan More
• Credit risk may lead to financial institution’s failure U.S. data

• Example: Washington Mutual Media 1 Media 2

• Credit risk management Media

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Measuring credit risk

• Traditional models
• Qualitative models
• Credit scoring models
• New models
• Term structure derivation of credit risk
• Mortality rate models
• RAROC
• Option models

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Qualitative models

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Qualitative models

• The bank may lack public information about potential

borrowers
• Gather private information from the borrower and external
sources (e.g., credit rating agencies)
• Evaluate borrower’s probability of default and make credit
decision based on
• borrower-specific factors
• market-specific factors

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Borrower-specific factors

• Reputation
• Leverage
• Volatility of earnings
• Collateral

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Market-specific factors

• Business cycle
• Level of interest rates

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Credit scoring

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Credit scoring models

• Measure borrower’s probability of default using borrower’s

characteristics
• Notable models
• Linear probability model
• Logit model
• Linear discriminant model

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Linear probability model

PDi = β1 Xi1 + β2 Xi2 + ... + βn Xin

• Develop the model: linear regression with historical loans,

determine which characteristics lead to default event
(PD = 1)
• Statistical significance
• Economic significance

• Predict probability of default for new loans

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Example

• Bank A’s credit risk department determine from historical

consumer loans that the likelihood of default for its customers
are mostly determined by two factors: debt-to-monthly income
(DTI ) and credit score (CS)

PDi = 0.1DTI − 0.001CS

• A prospective customer has debt-to-monthly income = 10 and
credit score = 700. Estimate PD
• Another customer has debt-to-monthly income = 5 and credit
score = 800. Estimate PD

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Logit model

• Linear probability model can return PD outside [0, 1]

• Logit model fixes this by converting PDi to its standard
logistic function

1
f (PDi ) =
1 + e −PDi

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Linear discriminant model

• Use borrower characteristics of historical loans to divide

borrowers into high or low default risk classes
• Use the model to categorize future loans as high or low risk
• Most famous: Altman’s Z-score, developed for publicly traded
manufacturing firms in the U.S.

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Altman’s Z-score model

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

• X1 : Working capital / Total assets

• X2 : Retained earnings / Total assets
• X3 : EBIT / Total assets
• X4 : Market value of Equity / Book value of Liabilities
• X5 : Sales / Total assets

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Altman’s Z-score model

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

• Z < 1.81: high default risk

• 1.81 ≤ Z ≤ 2.99: in-determinant
• Z > 2.99: low default risk

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Example

• A potential corporate customer has the following financial

ratios:
• Working capital / Total assets = 0.3
• Retained earnings / Total assets = 0.05
• EBIT / Total assets = 0.2
• Market value of Equity / Book value of Liabilities = 0.5
• Sales / Total assets = 1.5

• Calculate Z-score and comment on the firm’s riskiness

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Weaknesses of credit scoring models

• Coefficients may vary over time or industry

• Omitted variables: macrofactors, borrower reputation...
• Linear discriminant models ignore difference in probabilities of
default in practice

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Term structure derivation

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Promised return on a loan

• A loan has a stated interest rate in the contract

• Components:
• Base rate (BR): LIBOR, Feds fund (interbank) rate, prime rate
• Default risk premium ϕ
k = BR + ϕ

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Promised return including fees

• Origination fee – of
• Compensating balance – b: locked in transaction account
• Required reserve ratio on the transaction account RR
of + BR + ϕ
k=
1 − b(1 − RR)

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Expected return on a loan

• Customer might default on the loan

• Call p the probability of full repayment
• 1 − p is probability of default, and the bank receives nothing

1 + E (r ) = p(1 + k) + (1 − p)0
E (r ) = p(1 + k) − 1

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Promised return and Expected return

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Term structure derivation of credit default risk

• Market-based method
• The corporate borrower (or a comparable firm) have
outstanding publicly traded bonds
• Derive probability of default from the corporate bond yield
and risk-free yield (Treasuries)

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Yields to maturity

Treasury Strips

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Term structure derivation of credit default risk

• Use a risk neutral valuation method (expected return on risky

and risk-free assets should be the same)
• Consider the simple case: bank receives nothing if customer
defaults (recovery given default = 0)
• Call i the risk-free rate on treasury strip
p(1 + k) = 1 + i

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Example

• One-year Treasury bill yield Ref

• One-year corporate zero-coupon bond yield is 8%

• What is the probability of default? The risk premium?

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Recovery given default ̸= 0

• Consider the full case: bank receives γ from each dollar of the
defaulted loan (recovery given default = γ)

p(1 + k) + (1 − p)γ(1 + k) = 1 + i
1+i
ϕ=k −i = − (1 + i)
γ + p − pγ

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Example

• Same i and k as before, with p = 0.97, γ = 0.6

• Calculate ϕ

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Multiperiod credit default risk

• Given survival in year i − 1, a bond has a probability of default

for year i
• Call marginal default probability in year i: 1 − pi
• Cumulative default probability in the first 2 years

Cp = 1 − p1 p2

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Determine default probability in year 2

• Expected return on a two-year treasury bond for the next two

years

(1 + i2 )2 = (1 + i1 )(1 + f1 )

• Expected return on the treasury bond in the second year

(1 + i2 )2
1 + f1 =
1 + i1
• Expected return on the corporate bond in the second year

(1 + k2 )2
1 + c1 =
1 + k1

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Determine default probability in year 2

• No arbitrage in year 2

p2 (1 + c1 ) = 1 + f1
1 + f1
p2 =
1 + c1

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Example

• Treasury zero-coupon bond yields Ref

• One-year and two-year corporate zero-coupon bond yields are

8% and 9%
• Calculate 1 − p2 and Cp

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Other models

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Mortality rate derivation

• Use historical default rate of debt instruments: how many

bonds of the same type default each year after issue
• Similar concept: use marginal mortality rate (MMR) for each
year in the loan’s life cycle

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Hypothetical MMR curve

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Actual estimates over the 1971–2014 period

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RAROC model

• Risk-adjusted return on capital

• Net income on a loan’s expected risk (capital at risk)
• Compare RAROC against ROE: whether the loan creates
equity value

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RAROC model: nominator

• Net income on loan = (Spread + Fees) x Loan Value

• Example: Loan amount = $100 million,
Loan interest rate = 10%,
Cost of funding 9%,
Fees: 0.1% of loan amount

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RAROC model: denominator

• Estimate loan risk with duration model

• Measure change in a loan’s market value due to a unlikely
decline in credit quality

∆R
∆LN = −DLN × LN ×
1+R
where R = BR + ϕ
• A rare shock to credit quality → shock to ϕ → shock to R

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Hypothetical yield spread change distribution

• Usually measure bond ϕ at 99 percentile of distribution

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Example

• Potential loan of $100 million from a AAA firm,

Duration = 5, same net income as in previous example
Pool of 500 bonds from similar AAA firms
Current average interest rate on AAA bonds = 4%
Last year, the 99% worst case is 1.1 percentage point increase
in risk premium: only 5 out of 500 bonds do worse than that
• Loan risk? RAROC?

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Option valuation model

• Use option valuation theory to price loans

• Extract risk premium from the model and data

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Equity as option for company’s owners

• A company (bank’s borrower)’s equity has payoff similar to a
long call on asset

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Liabilities as option for the bank (lender)

• The debt holder has payoff similar to a short put on asset

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Market value of a loan

1
L(τ ) = Be −iτ [ N(h1 ) + N(h2 )]
d
• τ : remaining time to loan maturity
• d = Be −iτ /A leverage ratio
• N(hi ): area under the standardized normal distribution up
to value hi (cumulative probability)
0.5σ 2 τ − ln(d)
• h1 =
στ
0.5σ 2 τ + ln(d)
• h2 =
στ
• σ 2 : variance of value of the borrower’s assets
Normal Table Calculator

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Risk premium

• Default risk premium that the borrower should be charged:

−1 1
ϕ = k(τ ) − i = ln[ N(h1 ) + N(h2 )]
τ d
• k(τ ): required yield on risky debt (promised return)
• i: risk-free rate on debt of same maturity
Example 10-8

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Estimate default probability

• Technical default if asset value is smaller than debt value:

A<B
• Asset value may fluctuate in a year with standard deviation σ
• Calculate the probability that A falls below B during the year

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Expected default frequency – EDF

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Example

• Asset A follows normal distribution with mean µ = 100 and

standard deviation σ = 5. Debt B = 88.35
• After one year, A < B if asset value falls by more than 11.65
(= 100 − 88.35), or a change of −2.33σ
• Equivalent to 1% probability from standard normal
distribution table
Normal Table

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 Problem sets

• Chapter 10: 9, 10, 11, 19, 20, 22, 23, 25, 26, 27, 29, 30, 34,
37, 38, 41, Minicase

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