CHAPTER 5.

CREDIT RISKS AND CREDIT DERIVATIVES

Question 5.1. The current value of the firm is $60 million, the principal amount due in 3 years
on the zero-coupon bond is $50 million, the annual interest rate, 𝑟, is 5%, and the volatility on the
firm, 𝜎, is 10%.
1. Using the Merton model, calculate the value of the firm's equity at 𝑡
2. Calculate the current value of the firm’s debt as a portfolio of risk-free debt and a short position
in a put on firm value with an exercise price of the face value of debt.
3. Calculate the current value of the firm’s debt as the difference between the total firm value
and the value of equity priced as a call option

Question 5.2. A firm has an asset value of $110.00 million with asset volatility of 20.0% per
annum. Its only debt is a zero-coupon bond with face value of $85.0 million that matures in four
years. The riskfree rate is 5.0%. Which is nearest to the current value of the firm's debt?
a) $1.67 million
b) $41.30 million
c) $55.47 million
d) $64.52 million

Question 5.3. Assume that the face value on a firm's zero-coupon debt with five years
remaining to maturity is equal to $100 million. Also assume that the current value of this debt
is $77 million. Compute the credit spread for this scenario if the risk-free rate (implied by the
zero-coupon bond price) is 4%.

QUANTITATIVE RISK MANAGEMENT 2

1
Question 5.4. Consider a firm with value of $120 million. It has junior debt maturing in five
years with face value of $50 million and senior debt maturing in five years with face value of
$100 million. The interest rate is 10% and the volatility is 20%.
1. Calculate the value of the subordinated debt
2. The credit spread on subordinated debt and senior debt

Question 5.5. Suppose a firm with a value of $120 million has a bond outstanding with a face
value of $100 million that matures in five years. The current interest rate is 10% and the
volatility of the firm is 20%.
1. What is the probability that the firm will default on its debt if the expected return on the firm,
μ, is 15%?
2. What is the expected loss given default?

Question 5.6. Suppose your portfolio contains a senior unsecured bond issued by Triple-Bee,
Inc. The bond with a credit rating of BBB matures in five years and pays a 6% coupon. If the
recovery rate is 51.13%, what is the 1% credit VaR, given the following 1-year forward zero rates
for the next four years and the 1-year transition probabilities of a bond with a BBB rating?
Assume the bond’s market price is $106.
One-Year Forward Zero Curves Rate for Each Rating Class (%)
Rating class Year 1 Year 2 year 3 Year 4
AAA 3.6 4.17 4.73 5.12

QUANTITATIVE RISK MANAGEMENT 2

2
 AA 3.65 4.22 4.78 5.17
A 3.72 4.32 4.93 5.32
BBB 4.1 4.67 5.25 5.63
BB 5.55 6.02 6.78 7.27
B 6.05 7.02 8.03 8.52
C 15.05 15.02 14.03 13.52
And historical rating transition matrix:

Rating Rating to
from AAA AA A BBB BB B CCC Default
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%
A 0.09% 2.27% 91.05% 5.52% 0.70% 0.26% 0.01% 0.10%
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% 5.21%
CCC 0.22% 0.00% 0.22% 1.30% 2.38% 11.24% 64.86% 19.78%

Question 5.7. A non-dividend paying firm financed with 100% equity issues a zero-coupon
bond with a principal amount of $50 million due in three years. What are the values of the
different components of the firm's capital structure at the maturity date of the bond if the firm
value at that time is $40 million?
A. $50 million in debt and $10 million in equity.
B. $10 million in debt and $30 million in equity.
C. $50 million in debt and $40 million in equity.
D. $40 million in debt and $0 in equity.

Question 5.8. A firm has an asset value (V) of $110.00 million with asset volatility of 30.0%
per annum. Its only debt is a zero-coupon bond with face value of $80.0 million that matures in
five years. The riskfree rate is 4.0%. The Black-Scholes Merton (BSM) price of a put option,p, on
the firm's assets with strike price equal to the face value of the bond is $6.95 million; i.e.,
p(V=110, F=80, sigma=0.30, T=5, s=0.04) = $6.95 million. Which is nearest to the current value
of the firm's debt?
QUANTITATIVE RISK MANAGEMENT 2

3
a) $6.95 million
b) $41.30 million
c) $58.55 million
d) $65.50 million

Question 5.9. Consider the following assumptions about a firm with two classes of debt (senior
and subordinated) both of which are five year zero-coupon bonds:
Firm value (V) = $100.0 million with volatility of 20.0% per annum
Face value of senior debt (F) maturity in five (5) years = $60.0 million
Face value of subordinated debt (U) maturity in five (5) years = $40.0 million
Riskless rate = 3.0%
c(V,F,T) = c(100,60,5) = $49.33
c(V,F+U,T) = c(100,100,5) = $24.33
Which is NEAREST to the value of the subordinated debt?
a) $10.67
b) $25.00
c) $31.00
d) $35.67

QUANTITATIVE RISK MANAGEMENT 2