Lecture 13

Lecture 13 - Credit Risk and Credit Derivatives Businesses...

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Credit Risk and Credit Derivatives Businesses try to account for credit risk, if a company goes bankrupt. With the recent bankruptcies of several airlines, Delphi car parts, and the talk of whether GM or Ford will follow, this has been particularly important at many banks. Many institutions hold portfolios of corporate bonds which are clearly liable to bankruptcy by the corporation that issued them. However there is also counterparty risk: my supplier or buyer (or competitor!) could go out of business. Credit Rating Agencies such as Moody’s, S&P, and Fitch, try to rate corporate bonds. Moody’s uses Aaa, Aa, A, Baa, Ba, B, and Caa. S&P uses AAA, AA, A, BBB, BB, B, and CCC. Both then add pluses or minuses (or numerals). Fitch is getting larger and trying to compete with the big two. In other industries there are smaller rating agencies; for instance A.M. Best in insurance. Moody’s ratings at or better than Baa and S&P at or better than BBB are considered “investment grade.” This cutoff might seem arbitrary, but many regulated institutions (banks, insurers, pension funds, etc) are required to hold only investment grade assets. Since these industries are protected by insurance against failing, they are prevented from taking on a level of risk that is socially inadvisable. Why do some bonds (corporate or international) pay a higher interest rate than “risk-free” US Treasuries? Presumably this compensates for the risk involved. (Liquidity is also important but for now we skip that.) We can split the risk into two parts: the probability of default (the company going bankrupt) and the recovery rate (how much is lost when it goes bankrupt).
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The ratings from the rating agencies are generally correlated with the probability of default over various time horizons. However the rating agencies are often criticized for changing their ratings a bit too late, so judgment must be reserved on this topic. Define λ as the instantaneous probability of default, so that the probability of default by a company over a very short interval of time is λ(t) and V(t) is the cumulative probability of survival up to then, so dV/dt = λ(t)V(t). When a company goes bankrupt it enters a long and complicated process where the various creditors are paid according to complicated rules and procedures. Many are paid less than the amount owed them. Many bonds are split into tranches of payment schedules. The bankruptcy proceedings judge which assets are to be liquidated (sold off, with the money to go to creditors) or if some creditors would agree to a change in order to get a possibility of a greater return (e.g., a trade of debt for equity). The recovery rates for each sort of debt indicate the average “haircut” that each creditor takes. The recovery rates and default probabilities are the basic reasons why corporate bonds trade at
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Lecture 13 - Credit Risk and Credit Derivatives Businesses...

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