Variables

Credit Risk Analysis

Presented by:
Abhishek Sharma
Mridul Vaishnav
Geetansh
Ganesh
Ravi
Rahul
Sudhanshu
 Credit risk analysis

1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions
 ● Recovery rate

The ratio amount received from the amount given is recovery rate.

Recovery rate =Amount received/amount given in total

● Loss given default (LGD) = 1- recovery rate

YIELD of AAA-rated bond,Altman Z-score

Z-score is widely applied in finance for credit analysis to predict the possibility of a
firm going into bankruptcy.

It is weighted average of five ratios based on a firm’s balance sheet and income
statement.

FORMULA

Z=3.3X₁+0.99X₂+0.6X₃+1.2X₄+1.4X₅…..
Classifications-

Based on ranges of Z-scores we could classify public firms into 4 categories-

1.Safe 2.On Alert 3.Good chances of going bankrupt within 2 years
4.Probability of financial distress is very high.

Eidelnan (1995) finds that Z score correctly predicted 72% of bankruptcies two
years prior to the event.
Example
Number of shares outstanding: 1,000,000;
Share price: $20;
Dividend per share: $0.50;
Sales: $10,000,000;
EBIT: $4,000,000;
Net income: $1,000,000;
Accounts receivable: $200,000;
Accounts payable: $100,000;
Inventory: $300,000;
Total assets: $50,000,000; and
Total liabilities: $20,000,000.
Calculation

X1=EBIT/Total Assets=4,000,000/50,000,000=0.08

X2=Net Sales/Total Assets=10,000,000/50,000,000=0.2

X3=Market Value of equity/Total liabilities=share price*number of shares

outstanding(MVE)/Total liabilities=20*1,000,000/20,000,000=1

X4=Net Working capital/Total assets=Account receivables-Account Payables+inventory/Total

assets=200,000-100,000+300,000/50,000,000=400,000/50,000,000=0.008

X5=Retained earnings/Total assets=(Net income-Dividend per share*number of shares

outstanding)/Total assets=(1,000,000-0.5*1,000,000)/50,000,000=500,000/50,000,000=0.01
Z - score calculation

X1=0.08

X2=0.2

X3=1

X4=0.008

X5=0.01

Z=3.3X1+0.99X2+0.6X3+1.2X4+1.4X5

=3.3*0.08+0.99*0.2+0.6*1+1.2*0.008+1.4*0.01=1.0876
KMV Model
● It was developed by Kealhofer, McQuown, and Vasicek (KMV), a leading provider of
quantitative credit analysis tools.
● Acquired by Moody’s Corporation in 2002.
● Moody’s Analytics further pioneered the sophisticated application of modern financial
theory and statistical analysis to manage credit risk more effectively.
● A large number of world financial institutions are subscribers of the model.
● The KMV model, relies on an extensive empirical testing and it is implemented using a
very large proprietary database.
● A fundamental quantity in the KMV model is the Expected Default Frequency.
● The EDF is the probability that a given firm will default within 1 year according to the KMV
methodology.
Expected Default Frequency

● Expected default frequency (EDF) is a credit measure that determines the

likelihood of a company defaulting on its debt obligations over a time horizon,
usually one year.
● KMV model is based on the structural approach to calculate EDF (credit risk
is driven by the firm value process).

– It works best when applied to publicly traded companies, where the value of
equity is determined by the stock market.

– The market information contained in the firm’s stock price and balance
sheet are translated into an implied risk of default.
Three steps to derive the actual probabilities of default:

1. Estimation of the market value and volatility of the firm’s asset.

2. Calculation of the distance to default, an index measure of default risk.

3. Scaling of the distance to default to actual probabilities of default using a default

database.
Estimation of firm value V and volatility of firm value σv

● Usually, only the price of equity for most public firms is directly observable,
and in some cases, part of the debt is directly traded.
● Using option pricing approach:

equity value, E = f( V, σv, K, c, r) and

volatility of equity, σE = g ( V, σv, K, c, r )

where K denotes the leverage ratio in the capital structure, c is the average
coupon paid on the long-term debt, r is the risk free rate.
Distance to Default
Distance to default

df = E(Vt)-d*/σv,

= ln(Vo/d*)+(µ-((σv^2)/2)T)/σv(√T)

Where,

Vo is the current market value of firm,

default point, d* = short-term debt + (½)*long-term debt

µ is the expected net return on firm value,

σv is the annualized firm value volatility and

T is the time to maturity of firm’s debt
Key features in KMV Model
1. Dynamics of EDF comes mostly from the dynamics of the equity values.

2. Distance to default ratio determines the level of default risk.

• This key ratio compares the firm’s net worth to its volatility.

• The net worth is based on values from the equity market, so it is both timely and
superior estimate of the firm value.

3. Ability to adjust to the credit cycle and ability to quickly reflect any deterioration in
credit quality.

4. Work best in highly efficient liquid market conditions.

Weakness of KMV Approach

• It requires some subjective estimation of the input parameters.

• It is difficult to construct theoretical EDF’s without the assumption of normality of

asset returns.

• Private firms’ EDFs can be calculated only by using some comparability analysis
based on accounting data.

• It does not distinguish among different types of long-term bonds according to

their seniority, collateral, covenants, or convertibility
Thank You…