Lecture17 - 11/2/2010 MGMT 4370 / MGMT 7760 Risk Management...

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11/2/2010 1 MGMT 4370 / MGMT 7760 Risk Management Aparna Gupta Lally School of Management and Technology Office: PITTS 2104 Email: guptaa@rpi.edu Phone: x2757 Debt Migration Bankruptcy is an event , it is a final point in a process beyond which a corporation ceases to be in its current form. Analysts can not just focus on this event, because if they did they will ignore lots of useful information. Therefore, Credit rating agencies do not simply focus on the event of default . At discrete points in time, they revise their credit ratings of corporate bonds. This evolution of credit quality is very important for investor holding a portfolio of corporate bonds. This is Credit Migration , described by a migration matrix consisting of average transition rates. Transition matrices play a major role in credit evaluation systems, and are used in CreditMetrics – an approach for portfolio credit-risk measurement (topic of this lecture). 2 Aparna Gupta, Lally School, RPI Bankruptcy vs. Default Bankruptcy : situation in which the firm is liquidated, and the proceeds from the asset sale are distributed to the various claimholders according to the prescribed priority rules. Default : defined as the event when a firm misses a payment on a coupon and/or reimbursement of payment on a coupon and/or reimbursement of principal at debt maturity. Debt Migration Matrix From/To AAA AA A BBB BB B CCC/C D AAA 90.81 8.33 0.68 0.06 0.12 0.00 0.00 0.00 AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0.00 A0 . 0 9 2 . 2 7 91.05 5.52 0.74 0.26 0.01 0.06 BBB 0.02 0.33 5.95 86.93 5.30 1.17 0.12 0.18 BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06 B 0.00 0.11 0.24 0.43 6.48 83.46 4.07 5.20 CCC/C 0.22 0.00 0.22 1.30 2.38 11.24 64.86 19.79 4 Aparna Gupta, Lally School, RPI CreditMetrics and Credit Migration Approach to Estimate Portfolio Credit Risk Four steps of Credit Migration Approach 1. Specify a rating system, with rating grades, together with the probabilities of migrating from one credit quality to another over the credit risk horizon. 2. Specify a risk horizon, usually taken to be one year. 3. Specify forward discount curve at the risk horizon for each credit category. This allows valuing bonds using the zero-curve corresponding to the potential future credit ratings of the issuers. In case of default, value of the instrument should be estimated in terms of recovery rate, which is given as %age of face value. 4. Information from the first three steps is combined to calculate the forward distribution of the change in the portfolio value consequent on credit migration. 5 Aparna Gupta, Lally School, RPI Estimating Portfolio Credit Risk P(c) = Change in value of Portfolio in the worst-case scenario at the (1- c) percent confidence level (99% confidence if c=1%) V 0 = Current marked-to-market value of the portfolio; FV = Forward value of the portfolio = V 0 (1+PR), PR = Promised return; EV = Expected value of the portfolio = V 0 (1+ER), ER = Expected return; EL = Expected Loss = FV – EV; Credit VaR = (EV – V 0 ) – P(c).
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This note was uploaded on 01/27/2011 for the course MGMT 4370 taught by Professor Gupta during the Fall '10 term at Rensselaer Polytechnic Institute.

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Lecture17 - 11/2/2010 MGMT 4370 / MGMT 7760 Risk Management...

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