Lecture 14

Credit Default Risk

 Measuring default risk
• Default risk is the primary component of
credit risk.
• It represents the probability of default (PD),
as well as the loss given default (LGD)

• Default risk can be measured using two

approaches:
– Actuarial methods
– Market-price methods
• Actuarial measures of default probabilities are
provided by credit rating agencies , which classify
borrowers by credit ratings that are supposed to
quantify default risk

• Such ratings are external to the firm.

• Similar techniques can be used to develop

internal ratings
 Default rates and credit ratings
• A credit rating is an “evaluation of
creditworthiness” issued by a rating agency
• These ratings represent objective (or
actuarial) probabilities of default
• the agencies have published studies that
track the frequency of bond default in the
United States, classified by initial ratings for
different horizons.

• These frequencies can be used to convert

ratings to default probabilities.
• The agencies use a number of criteria to
decide on the credit rating, among other
accounting ratios

• Table on the next slide presents median

value for selected accounting ratios for
industrial corporations
S&P’s Financial Ratios Across
Ratings
 Historical Default Rates
• The following table displays display historical
default rates as reported by Moody’s.

• These default rates describe the proportion of

firms that defaulted

• For example, borrowers with an initial Moody’s

rating of Baa experienced an average 0.34%
default rate over the next year, and 7.99% over
the following ten years
Moody’s Cumulative Default Rates
(Percent), 1920–2002
 Recovery Rates
• Credit risk also depends on the loss given default
(LGD)

• This can be measured as one minus the recovery

rate , or fraction recovered after default.
• Bankruptcy process creates a pecking order for a
company’s creditors.
• This specifies the order in which creditors are paid,
thereby creating differences in the recovery rate
across creditors.
• Within each class, however, creditors should be
treated equally.
 Estimates of Recovery Rates
• Credit rating agencies measure recovery
rates using the value of the debt right after
default
• This is viewed as the market’s best estimate
of the future recovery and takes into account
the value of the firm’s assets, the estimated
cost of the bankruptcy process, and various
means of payment (e.g., using equity to pay
bondholders), discounted into the present.
• The recovery rate depend on a number of
factors
• The status or seniority of the debtor
• The state of the economy
• Table on next slide shows recovery rates for
corporate debt.
• Moody’s, for instance, estimates the average
recovery rate for senior unsecured debt at
f=49%
Moody’s Recovery Rates for U.S.
Corporate Debt
 Measuring Default Risk
from Market Prices
• Credit risk can also be assessed from market
prices of securities whose values are affected by
default.
• This includes corporate bonds, equities, and credit
derivatives
• Since financial markets have access to large
amount of information, securities should
theoretically provide up-to-date and accurate
measure of credit risk
 Calculating PD from Bond
Prices
• Assume for simplicity that a bond makes only
one payment of $100 in one period.
• We can compute a market-determined yield y*
from the price p* as Rs.100
p* 
(1  y*)

• This can be compared with the risk-free yield y

over the same period
• The payoffs on the bond can be described by
a simplified default process, which is
illustrated in Figure

• At maturity, the bond

can be in default or not

Its value is $100

if there is no default
• But if the bond defaults, its value will be
100*recovery rate (f).
• If π is the probability of default, how can we
value this bond now?
• The current price must be the mathematical
expectation of the values in the two states,
discounting the payoffs at the risk-free rate
• After rearranging terms

• which implies a default probability of

• The equation further simplifies into

• what does this equation tell?

 Multiple periods
• For multiple periods,
the probability of
default is given by

• Which can be re-

written as

 (1  y*)T 
 (1  f )  1   T 
• or
 (1  y ) 
 An example of calculating default prob
• We wish to compare a 10-year Treasury
bond and a 10-year zero issued by OGDC
which is rated A by PACRA. The respective
yields are 6% and 7%, using semiannual
compounding. Assuming that the recovery
rate is 45% of the face value, what does the
credit spread imply for the probability of
default?
 Example cont..
• Using equation
 (1  y )T 
• Therefore, the  (1  f )  1   T 
cumulative  (1  y*) 
probability of
defaulting during
 (1  .03) 20 
next ten years is  (1  .45)  1   20 
16.8%.  (1  . 035) 

  0.09231 / .55
  0.1678
 Credit Derivatives
• Credit derivatives are the latest tool in the
management of portfolio credit risk

• Credit derivatives are contracts that pass

credit risk from one counterparty to another.
• Why credit derivatives?
• Though banks are there because of
diversification advantage, banks still tend to
be too concentrated in geographic or
industrial sectors
 Why credit derivatives? cont..
• This is because their comparative advantage
is “relationship banking,” which is usually
limited to a clientele banks know best
• it has been difficult to lay off this credit
exposure, as there is only a limited market for
secondary loans
• In addition, borrowers may not like to see
their bank selling their loans to another party,
even for diversification reasons
 Types of CD by instruments
• Table in the next slide provides a breakdown
of the credit derivatives market by
instruments,
• The largest share of the market consists of
plain-vanilla, credit default swaps, typically
with 5-year maturities
• The next segment consists of synthetic
securitization, or collateralized debt
obligations (CDOs)
Credit Derivatives by Type Percentage of
Total Notionals
 Credit Default Swaps
• In a credit default swap contract, a protection
buyer (say A) pays a premium to the
protection seller (say B), in exchange for
payment if a credit event occurs
• The premium payment can be a lump sum or
periodic
• The contingent payment is triggered by a
credit event (like default of rating
downgrades) on the underlying credit
Credit Default Swap
 An example
• The protection buyer, call it A, enters a 1-year credit
default swap on a notional of $100 million worth of
10-year bonds issued by XYZ. The swap entails an
annual payment of 50bp. The bond is called the
reference credit asset
• At the beginning of the year, A pays $500,000 to the
protection seller. Say that at the end of the year,
Company XYZ defaults on this bond, which now
trades at 40 cents on the dollar. The counterparty
then has to pay $60 million to A. If A holds this bond
in its portfolio, the credit default swap provides
protection against credit loss due to default.
 Credit Default Swap

• It is important to realize that entering a credit

swap does not eliminate credit risk entirely.

• Instead, the protection buyer decreases

exposure to the reference credit but assumes
new credit exposure to seller

• To be effective, there has to be a low

correlation between the default risk of the
underlying credit and of the counterparty.