7_credit_risk - CREDIT RISK Credit risk overview Credit...

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CREDIT RISK J. Wei, Department of Management, U of T 1 MGTD78 Credit risk overview Credit ratings, Altman’s Z-score Estimating default probabilities - using historical data - using bond prices - using Merton’s model Estimating credit losses Credit risk mitigation CreditMetrics
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CREDIT RISK OVERVIEW J. Wei, Department of Management, U of T 2 MGTD78 Credit risk: possibility that borrowers, bond issuers or counterparty of a derivatives contract may default Measure of credit risk large public companies: credit / bond rating small companies / businesses: banks internal rating individuals: credit history and credit scoring Two key elements in assessing credit risk: probability of default and recovery rate
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CREDIT RATINGS J. Wei, Department of Management, U of T 3 MGTD78 Standard and Poor’s: AAA, AA, A, BBB, BB, B and CCC Moody’s: Aaa, Aa, A, Baa, Ba, B and Caa Aside from AAA and Aaa, all others are subdivided, e.g., AA+, AA, AA–, Aa1, Aa2, Aa3, etc Minimum “investment grade”: BBB– or Baa3; below which: “junk bonds” Most banks have their own internal ratings systems for borrowers
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ALTMAN’S Z-SCORE J. Wei, Department of Management, U of T 4 MGTD78 using five accounting ratios to predict default (pioneered in 1968) The Z-score: Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 0.999X 5 where, X 1 : Working capital / Total asset X 2 : Retained earnings / Total asset X 3 : EBIT / Total asset X 4 : market value of equity / Book value of total liabilities X 5 : Sales / Total assets Z > 3.0: unlikely to default 2.7 < Z < 3.0: on alert 1.8 < Z < 2.7: moderate chance of default Z < 1.8: high chance of default Example: please see Excel file “xls_spreadsheet7_altman_Zscore”
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ESTIMATING DEFAULT PROBABILITIES J. Wei, Department of Management, U of T 5 MGTD78 Approaches: using historical data using bond prices using Merton’s model using CDS spreads (later lecture)
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USING HISTORICAL DATA J. Wei, Department of Management, U of T 6 MGTD78 Historical data provided by rating agencies Table 14.1 [cumulative default rates (%), 1970 – 2007, Moody’s]: Interpretation (examples): probability of a “Baa” bond defaults by the end of Year 1 is 0.17%, by the end of Year 2 is 0.48%, by the end of Year 5 is 1.84%, etc probability of an “A” bond defaults in Year 3: 0.22% – 0.09% = 0.13% Rating 1 2 3 4 5 7 10 15 20 Aaa . 0 00 . 0 00 . 0 00 . 0 03 . 0 10 . 0 25 . 0 53 . 1 00 . 1 20 Aa . 0 01 . 0 02 . 0 04 . 0 11 . 0 18 . 0 34 . 0 52 . 1 09 . 1 88 A . 0 02 . 0 09 . 0 22 . 0 34 . 0 47 . 0 76 . 1 31 . 2 40 . 4 08 Baa . 0 17 . 0 48 . 0 88 . 1 36 . 1 84 . 2 79 . 4 35 . 7 60 . 10 51 Ba . 0 13 . 3 02 . 5 30 . 7 65 . 9 81 . 13 47 . 18 43 . 27 53 . 34 85 B . 4 66 . 10 20 . 15 57 . 20 33 . 24 69 . 32 53 . 40 92 . 50 21 . 52 38 Caa . 17 72 . 27 91 . 36 12 . 42 60 . 47 84 . 54 54 . 64 93 . 70 30 . 72 78 Term (years)
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This note was uploaded on 05/10/2011 for the course MGT D78 taught by Professor Wei during the Spring '11 term at University of Toronto- Toronto.

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7_credit_risk - CREDIT RISK Credit risk overview Credit...

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