Chap 10&11

Loan Portfolio Selection and
Risk Measurement
Chapters 10 and 11
Saunders & Allen Chapters 10 & 11 2
The Paradox of Credit
Lending is not a buy and holdprocess.
To move to the efficient frontier, maximize
return for any given level of risk or
equivalently, minimize risk for any given
level of return.
This may entail the selling of loans from the
portfolio. Paradox of Credit Fig. 10.1.
Return
The Ef f icient
Frontier
A
B
C
Risk
0
Figure 10.1 The paradox of credit.
Managing the Loan Portfolio According to the
Tenets of Modern Portfolio Theory
Improve the risk-return tradeoff by:
Calculating default correlations across assets.
Trade the loans in the portfolio (as conditions
change) rather than hold the loans to maturity.
This requires the existence of a low transaction
cost, liquid loan market.
Inputs to MPT model: Expected return, Risk
(standard deviation) and correlations
The Optimum Risky Loan
Portfolio Fig. 10.2
Choose the point on the efficient frontier
with the highest Sharpe ratio:
The Sharpe ratio is the excess return to risk
ratio calculated as:
p
f
p
rR
o

Return (R
p
)
r
f
A
B
D
C
Risk (o
p
)
Figure 10.2 The optimum risky loan portf olio
Problems in Applying MPT to
Untraded Loan Portfolios
Mean-variance world only relevant if
security returns are normal or if investors
have quadratic utility functions.
Need 3
rd
moment (skewness) and 4
th
moment
(kurtosis) to represent loan return distributions.
Unobservable returns
No historical price data.
Unobservable correlations
KMVs Portfolio Manager
Returns for each loan I:
R
it
= Spread
i
+ Fees
i
(EDF
i
x LGD
i
) r
f

Loan Risks=variability around EL=EGF x
LGD = UL
LGD assumed fixed: UL
i
=
LGD variable, but independent across borrowers: UL
i
=

VOL is the standard deviation of LGD. VVOL is valuation
volatility of loan value under MTM model.
MTM model with variable, indep LGD (mean LGD): UL
i
=

) 1 ( EDF EDF
2 2
) 1 (
i i
EDFiVOL LGD EDFi EDFi +
2 2 2
) 1 ( ) 1 (
i i i
VVOL EDFi EDFiVVOL LGD EDFi EDFi + +
Valuation Under KMV PM
Depends on the relationship between the
loans maturity and the credit horizon date:
Figure 11.1: DM if loans maturity is less
than or equal to the credit horizon date
(maturities M
1
or M
2
).
MTM if loans maturity is greater than
credit horizon date (maturity M
3
). See
Appendix 11.1 for valuation.
0
Figure 11.1 Loan maturity ( M) v ersus loan horizon ( H).
M
1
M
2
= H M
3
Date
Correlations
Figure 11.2 joint PD is the shaded area.

GF
= o
GF
/o
G
o
F

GF
=

Correlations higher (lower) if isocircles are
more elliptical (circular).
If JDF
GF
= EDF
G
EDF
F
then correlation=0.

) 1 ( ) 1 (
) (
F F G G
F G GF
EDF EDF EDF EDF
EDF EDF JDF

Firm F
Firm G
Firm Fs
Debt Pay of f
100
100(1-LGD)
Market Value
of Assets - Firm G
Market Value
of Assets - Firm F
Face Value of Debt
Figure 11.2 Value correlation.
Role of Correlations
Barnhill & Maxwell (2001): diversification can
reduce bond portfolios standard deviation from
$23,433 to $8,102.
KMV diversifies 54% of risk using 5 different
BBB rated bonds.
KMV uses asset (de-levered equity) correlations,
CreditMetrics uses equity correlations.
Correlation ranges:
KMV: .002 to .15
Credit Risk Plus: .01 to .05
CreditMetrics: .0013 to .033
Calculating Correlations using KMV PM
Construct asset returns using OPM.
Estimate 3-level multifactor model. Estimate coefficients and then
evaluated asset variance and correlation coefficients using:
First level decomposition:
Single index model composite market factor constructed for each firm.
Second level decomposition:
Two factors: country and industry indices.
Third level decomposition:
Three sets of factors: (1) 2 global factors (market-weighted index of
returns for all firms and return index weighted by the log of MV); (2) 5
regional factors (Europe, No. America, Japan, SE Asia, Australia/NZ);
(3) 7 sector factors (interest sensitive, extraction, consumer durables,
consumer nondurables, technology, medical services, other).
CreditMetrics Portfolio VAR
Two approaches:
Assuming normally distributed asset values.
Using actual (fat-tailed and negatively skewed)
asset distributions.
For the 2 Loan Case, Calculate:
Joint migration probabilities
Joint payoffs or loan values
To obtain portfolio value distribution.

The 2-Loan Case Under the
Normal Distribution
Joint Migration Probabilities = the product
of each loans migration probability only if
the correlation coefficient=0.
From Table 10.1, the probability that obligor 1
retains its BBB rating and obligor 2 retains its
a rating would be 0.8693 x 0.9105 = 79.15% if
the loans were uncorrelated. The entry of
79.69% suggests a positive correlation of 0.3.
Mapping Ratings Transitions to
Asset Value Distributions
Assume that assets are normally distributed.
Compute historic transition matrix. Figure 11.3
uses the matrix for a BB rated loan.
Suppose that historically, there is a 1.06%
probability of transition to default. This
corresponds to 2.3 standard deviations below the
mean on the standard normal distribution.
Similarly, if there is a 8.84% probability of
downgrade from BB to B, this corresponds to 1.23
standard deviations below the mean.
Joint Transition Matrix
Can draw a figure like Fig. 11.3 for the A rated
obligor. There is a 0.06% PD, corresponding to
3.24 standard deviations below the mean; a 5.52%
probability of downgrade from A to BBB,
corresponding to 1.51 std dev below the mean.
The joint probability of both borrowers retaining
their BBB and A ratings is: the probability that
obligor 1s assets fluctuate between 1.23o to
+1.37o and obligor 2s assets between 1.51o to
+1.98o with a correlation coefficient=0.2.
Calculated to equal 73.65%.
Class:
Transition Prob. (%):
Asset (o):
Def
1.06
2.30
CCC
1.00
2.04
B
8.84
1.23
BB
80.53
BBB
7.73
1.37
A
0.67
2.39
AA
0.14
2.93
AAA
0.03
3.43
Figure 11.3 The link between asset v alue v olatility ( )
and rating transition f or a BB rated borrower.
Calculating Correlation
Coefficients
Estimate systematic risk of each loan the
relationship between equity returns and
returns on market/industry indices.
Estimate the correlation between each pair
of market/industry indices.
Calculate the correlation coefficient as the
weighted average of the systematic risk
factors x the index correlations.
Two Loan Example of
Correlation Calculation
Estimate the systematic risk of each company by
regressing the stock returns for each company on
the relevant market/industry indices.
R
A
= .9R
CHEM
+ U
A
R
Z
= .74R
INS
+ .15R
BANK
+ U
Z

A,Z
=(.9)(.74)
CHEM,INS
+ (.9)(.15)
CHEM,BANK
Estimate the correlation between the indices.
If
CHEM,INS
=.16 and
CHEM,BANK
=.08, then
AZ
=0.1174.

Joint Loan Values
Table 11.1 shows the joint migration probabilities.
Calculate the portfolios value under each of the
64 possible credit migration possibilities (using
methodology in Chap.6) to obtain the values in
Table 11.3.
Can draw the portfolio value distribution using the
probabilities in Table 11.1 and the values in Table
11.3.

Credit VAR Measures
Calculate the mean using the values in
Table 11.3 and the probabilities in Tab 11.1.
Mean =

Variance =

Mean=$213.63 million
Standard deviation= $3.35 million
i
i
i
V p
=
64
1
2
64
1
) ( Mean V p
i
i
i

=
Calculating the 99
th
percentile
credit VAR under normal
distribution

2.33 x $3.35 = $7.81 million
Benefits of diversification. The BBB loans
credit VAR (alone) was $6.97million.
Combining 2 loans with correlations=0.3,
reduces portfolio risk considerably.

Calculating the Credit VAR
Under the Actual Distribution
Adding up the probabilities (from Table 11.1) in
the lowest valuation region in Table 11.3, the 99
th

percentile credit VAR using the actual (not
normal) distribution is $204.4 million.
Unexpected Losses=$213.63m - $204.4m = $9.23
million (>$7.81m).
If the current value of the portfolio = $215m, then
Expected Losses=$215m - $213.63m = $1.37m.
CreditMetrics with More Than 2
Loans in the Portfolio
Cannot calculate joint transition matrices
for more than 2 loans because of
computational difficulties: A 5 loan
portfolio has over 32,000 joint transitions.
Instead, calculate risk of each pair of loans,
as well as standalone risk of each loan.
Use Monte Carlo simulation to obtain
20,000 (or more) possible asset values.
Monte Carlo Simulation
First obtain correlation matrix (for each pair of
loans) using the systematic risk component of
equity prices. Table 11.5
Randomly draw a rating for each loan from that
loans distribution (historic rating migration)
using the asset correlations.
Value the portfolio for each draw.
Repeat 20,000 times! New algorithms reduce
some of the computational requirements.
The 99
th
% VAR based on the actual distribution is
the 200
th
worst value out of the 20,000 portfolio
values.
MPT Using CreditMetrics
Calculate each loans marginal risk contribution =
the change in the portfolios standard deviation
due to the addition of the asset into the portfolio.
Table 11.6 shows the marginal risk contribution of
20 loans quite different from standalone risk.
Calculate the total risk of a loan using the
marginal contribution to risk = Marginal standard
deviation x Credit Exposure. Shown in column
(5) of Table 11.6.
Figure 11.4
Plot total risk exposure using marginal risk
contributions (column 6 of Table 11.6) against the
credit exposure (column 5 of Table 11.4).
Draw total risk isoquants using column 5 of Table
11.6.
Find risk outliers such as asset 15 which have too
much portfolio risk ($270,000) for the loans size
($3.3 million).
This analysis is not a risk-return tradeoff. No
returns.
0
9
8
7
6
5
4
1
2
3
0
Credit Exposure ($ Millions)
14 12 10
Isoquant Curv e of
Equal Total Risk
= $70,000
8 6 4
15
7
14
13
6
16
5
12 10
9
20 1
18
8
2 16
Figure 11.4 Credit limits and loan selection in CreditMetrics.
Default Correlations Using Reduced Form Models
Events induce simultaneous jumps in default intensities.
Duffie & Singleton (1998): Mean reverting correlated
Poisson arrivals of randomly sized jumps in default
intensities.
Each assets conditional PD is a function of 4 parameters:
h (intensity of default process); (constant arrival prob.); k
(mean reversion rate); u (steady state constant default
intensity).
The jumps in intensity follow an exponential distribution
with mean size of jump=J.
So: probability of survival from time t to s:

p(t,s) = exp{o(s-t)+|(s-t)h(t)}
where |(t) = -(1 e
-kt
)/k
o(t) = -u[t + |(t)] [/(J+k)][Jt ln(1 - |(t)J)]
Numerical Example
Suppose that =.002, k=.5, u=.001, J=5, h(0)=.001 (corresponds to an
initial rating of AA).
Correlations across loan default probabilities:
V
c
=common factor; V=idiosyncratic factor. As v0, corr0 As v1,
corr1.
If v=.02, V=.001, V
c
=.05: the probability that loan
i
intensity jumps
given that loan
j
has experienced a jump is = vV
c
/(V
c
+V) = 2%. If v=
.05 (instead of .02), then the probability increases to 5%.
Figure 11.5 shows correlated jumps in default intensities.
Figure 11.6 shows the impact of correlations on the portfolios risk.
= vV
c
+ V
150
100
50
0
Marketwide
Credit Ev ent
Year
Source: Duffe and Singleton (1998), p.25.
The figure shows a portion of a simulated sample path of total default arrival
intensity (exactly 1,000 firms). An X denotes a default event.
Calendar
Time
3.4 3.2 3.8 3.6 3 2.8 2.6 2.4 2.2 4
Figure 11.5 Correlated def ault intensities.
0
0.7
0.5
0.6
0.3
0.4
0.1
0.2
0
Time Windowm (Day s)
70
High Correlation
Medium Correlation
Low Correlation
60 90 80 50 40 30 20 10 100
Source: Duffe and Singleton (1998), p.27.
The figure shows the probabilty of an m-day interval within
10 years having four or more defaults (base case).
Figure 11.6 Portf olio def ault intended.
Appendix 11.1: Valuing a Loan that Matures
after the Credit Horizon KMV PM
Maturity=M
3
in Figure 11.1. Use MTM to value loans.
Four Step Process:
1. Valuation of an individual firms assets using random sampling
of risk factors.
2. Loan valuation based on the EDFs implied by the firms asset
valuation.
3. Aggregation of individual loan values to construct portfolio
value.
4. Calculation of excess returns and losses for portfolio.
Yields a single estimate for expected returns (losses) for
each loan in the portfolio. Use Monte Carlo simulation
(repeated 50,000 to 200,000 times) to trace out distribution
Step 1: Valuation of Firm Assets at
3 Time Horizons Fig. 11.7
A
0 ,
A
H ,
A
M
valuations. Stochastic process generating A
H,
A
M
:

The random component c= systematic portion f + firm-specific portion
u. Each simulation draws another risk factor.
Using A
H
and

A
M
can calculate EDF
H
and EDF
M

ln A
H
= ln A
0
+ (-.5o
2
)t
H
+ oc
H
\t
H
(11.21)
where A
H
= the asset value at the credit horizon date H,
= the expected return (drift term) on the asset valuation,
o = the volatility of asset returns,
t
H
= the credit horizon time period,
c
H
= a random risk term (assumed to follow a standard normal
distribution).
Step 2: Loan Valuation Using
Term Structure of EDFs
Convert EDF into QDF by removing risk-adjusted ROR.

Also value loan as of credit horizon date H:

V
0
= PV
0
(1 LGD) + PV
0
(1-QDF)LGD (11.22)

where V
0
= the loans present value,
PV
0
= the present value factor using the riskfree rate to discount the loans cash flows to time t=0,
QDF = the (cumulative) risk neutral quasi-EDF,
LGD = the loss given default
V
H|ND
= C
H
+ PV
H
(1 LGD) + PV
H
(1-QDF)LGD (11.23)

where V
H|ND
= the loans expected value as of the credit horizon date given that
default has not occurred,
C
H
= the cash flow on the credit horizon date,
PV
H
= the present value factor using the riskfree rate as the discount factor to
discount the loans cash flows to time t=H.

However, there is a possibility that the loan will default on or before the credit horizon date. The expected
value of the loan given default is:

V
H|D
= (C
H
+ PV
H
)LGD
(11.24)
V
H
= (EDF) V
H|D
+ (1-EDF) V
H|ND
(11.25)
Step 3: Aggregation to Construct Portfolio
Sum the expected values V
H
for all loans in
the portfolio.

P
t
V =
i
i
t
V (11.26)

where
P
t
V = the value of the loan portfolio at date t=0,H,

i
t
V
= the value of each loan i at date t=0,H.
Step 4: Calculation of Excess Returns/Losses
Excess Returns on the Portfolio:

Expected Loss on the Portfolio:

Repeat steps 1 through 4 from 50,000 to 200,000 times.
H
R =
F
P
P P
H
R
V
V V
0
0
(11.27)

where R
H
= the excess return on the loan portfolio from time period 0 to
the credit
horizon date H,

P
H
V
= the expected value of the loan portfolio at the credit
horizon date,
P
V
0 = the present value of the loan portfolio,
R
F
= the riskfree rate.
0
|
V
V V
EL
H ND H
H

= (11.28)
A Case Study: KMV PM valuation of 5 yr maturity
$1 loan paying a fixed rate of 10% p.a.
Using Table 11.8:

V
0
= PV
0
(1 LGD) + PV
0
(1-QDF)LGD = 1.2103(.50) + (1.0675)(.50)
= $ 1.1389
Table 11.8
Valuing the Loans Present Value

Time
Period

(1)
Cash
flows
per
period

(2)
Discount
Factor
F
tR
e

(3)
Risk-free
Present
Value of
Cashflows
(2) x (3) = (4)
EDF
i

cumulative

(5)
QDF
i

cumulative

(6)
Risky
Present
Value of
Cashflows
(7)
1 .10 .9512 .0951 .0100 .0203 .0932
2 .10 .9048 .0905 .0199 .0471 .0862
3 .10 .8607 .0861 .0297 .0770 .0795
4 .10 .8187 .0819 .0394 .1088 .0730
5 1.10 .7788 .8567 .0490 .1414 .7356
Totals 1.2103 1.0675

Valuing the Loan at the Credit Horizon Date =1
Using Table 11.9:

V
H|ND
= C
H
+ PV
H
(1 LGD) + PV
H
(1-QDF)LGD = 0.10 +
1.1723(.50) + (1.0615)(.50) = $ 1.2169
V
H|D
= (C
H
+ PV
H
)LGD = (0.10 + 1.1723)(.50) = $ 0.63615
V
H
= (EDF) V
H|D
+ (1-EDF) V
H|ND
= (.01)(.63615) + (.99)(1.2169)
= $ 1.2111
Time
Period

(1)
Cash
flows
per
period

(2)
Discount
Factor
F
tR
e

(3)
Risk-free
Present
Value of
Cashflows
(2) x (3) = (4)
EDF
i

cumulative

(5)
QDF
i

cumulative

(6)
Risky
Present
Value of
Cashflows
(7)
1 .10 1 0
2 .10 .9512 .0951 .0100 .0203 .0932
3 .10 .9048 .0905 .0199 .0471 .0862
4 .10 .8607 .0861 .0297 .0770 .0795
5 1.10 .8187 .9006 .0394 .1088 .8026
Totals 1.1723 1.0615

KMVs Private Firm Model
Calculate EBITDA for private firm j in industry
j
.
Calculate the average equity mulitple for industry
i

by dividing the industry average MV of equity by
the industry average EBITDA.
Obtain an estimate of the MV of equity for firm j
by multiplying the industry equity multiple by
firm js EBITDA.
Firm js assets = MV of equity + BV of debt
Then use valuation steps as in public firm model.

Credit Risk Plus Model 2 - Incorporating Systematic
Linkages in Mean Default rates
Mean default rate is a function of factor sensitivities to different independent
sectors (industries or countries).

Table 11.7 shows as example of 2 loans sensitive to a single factor (parameters
reflect US national default rates). As credit quality declines (m gets larger),
correlations get larger.

AB
= (m
A
m
B
)
1/2

=
N
k 1
u
Ak
u
Bk
(o
k
/m
k
)
2
(11.20)
where
AB
= default correlation between obligor A and B,
m
A
= mean default rate for type A obligor,
m
B
= mean default rate for type B obligor,
u
A
= allocation of obligor A's default rate volatility across N
sectors,
u
B
= allocation of obligor B's default rate volatility across N
sectors,
(o
k
/m
k
)
2
= proportional default rate volatility in sector k.

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Loan Portfolio Selection and

Saunders & Allen Chapters 10 & 11 6

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