15.

433 INVESTMENTS
Class 17: The Credit Market
Part 1: Modeling Default Risk

Spring 2003
 The Corporate Bond Market

25
20

15
10
5

0
-5

-10
Apr-71

Apr-73

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Apr-81

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Apr-87

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Apr-01
Mortgage Rates (Home Loan Mortgage Corporation) FED Fund Spread

Figure 1: Mortgage and FED rates, Source : www.federalreserve.gov/releses/hr

20
18
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10
8
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4
2
-
Jan-19
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Jan-99

AAA BAA Spread

Figure 2: Corporate rating spreads, Source : www.federalreserve.gov/releses/hr

 16%
14%
12%
10%
8%
6%
4%
2%
0%

Baa1

Baa2

Baa3
Aa1

Aa2

Aa3

A1

A2

A3
Aaa

Ba1

Ba2

Ba3

Caa
B1

B2

B3
1 Year Maturity 30 Years Maturity

Figure 3: Corporate rating spreads, Source : Moody’s

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
BB

D
BBB­
AA+

A+

BBB+

B­
B+

B
A­

BB­
BB+
AA-

BBB

CCC
AAA

AA

BBB AAA AA-

Figure 4: Corporate rating migration for industry-sector, Source : Standard Poor’s.

 Bond Valuation with Default Risk

Cashflow Conditioning on Survival 100

c/2

0.5 1 1.5
τi
2 2.5 3 3.5 4

Non-Default
Default
RandomDefaultTime τ%

Figure 5: Chart cash flow Conditioning on survival.

Assuming no default risk,

8
�
P0 = er·ti + 100 · er·4 (1)
i=1

How does the default risk affect the bond price?

 Modelling Default Risk

Modelling default risk is central to the pricing and hedging of credit sen­
sitive instruments.

Two approaches to modelling default risk:

• Structural approach, ”first-passage”: default happens when the to­

tal asset value of the firm falls below a threshold value (for example,
the firm’s book liability) for the first time.

• Reduced-form, ”intensity-based”: the random default time τ� is gov­

erned by an intensity process λ.

For pricing purpose, the reduced-form approach is adequate, and will be

the focus of this class.
 Modelling Random Default Times

The probability of survival up to time t:

P rob(τ� ≥ t) (2)

The probability of default? before time t:

P rob (τ� < 0) = 1 − P rob (τ� ≥ t) (3)

We assume that T� is exponentially distributed with constant default

intensity λ:

Survival Probability:

( )
Prob τ% ≥ t = e- λt

0
0 100
t (year)

Figure 6: Survival Probability.

 Default Probability and Credit Quality

One-Year default probability = 1 − eλ

Default intensity λ =?

D
CCC
B­
B
B+
BB­
BB
BB+
BBB­
BBB
BBB+
A-
A
A+
AA-
AA
AA+
AAA

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

AAA AA+ AA AA- A+ A A­ BBB+ BBB BBB­ BB+

BB BB­ B+ B B­ CCC D

Figure 7: Survival Probability.

 AAA AA+ AA AA- A+ A A- BBB+ BBB
AAA 91.95% 4.11% 2.86% 0.48% 0.16% 0.20% 0.12% 0.04% 0.04%
AA+ 2.31% 84.71% 8.75% 2.88% 0.19% 0.48% 0.10% 0.00% 0.38%
AA 0.62% 1.36% 85.42% 7.24% 2.60% 1.49% 0.25% 0.50% 0.22%
AA- 0.00% 0.15% 3.44% 83.67% 8.61% 3.02% 0.50% 0.23% 0.15%
A+ 0.00% 0.03% 0.83% 4.47% 82.27% 8.08% 2.75% 0.46% 0.40%
A 0.08% 0.06% 0.49% 0.66% 5.25% 82.50% 5.44% 3.18% 1.11%
A- 0.14% 0.04% 0.11% 0.35% 1.13% 8.58% 77.39% 7.21% 3.00%
BBB+ 0.00% 0.00% 0.08% 0.13% 0.59% 2.26% 8.32% 75.24% 8.36%
BBB 0.07% 0.03% 0.07% 0.17% 0.45% 0.93% 2.24% 7.83% 77.76%
BBB- 0.05% 0.00% 0.11% 0.21% 0.11% 0.69% 0.59% 2.67% 9.46%
BB+ 0.17% 0.00% 0.00% 0.08% 0.08% 0.51% 0.34% 0.67% 4.21%
BB 0.00% 0.00% 0.12% 0.06% 0.06% 0.37% 0.18% 0.31% 1.59%
BB- 0.00% 0.00% 0.00% 0.05% 0.09% 0.05% 0.28% 0.33% 0.52%
B+ 0.00% 0.03% 0.00% 0.10% 0.00% 0.03% 0.23% 0.10% 0.13%
B 0.00% 0.00% 0.07% 0.00% 0.00% 0.14% 0.21% 0.00% 0.14%
B- 0.00% 0.00% 0.00% 0.00% 0.18% 0.00% 0.00% 0.36% 0.00%
CCC 0.19% 0.00% 0.00% 0.00% 0.19% 0.00% 0.19% 0.19% 0.56%
D 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Figure 8: Survival Probability, Migration table, Source: RiskMetrics T M .

16%

14%

12%

10%

8%

6%

4%

2%

0%
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3

Figure 9: One-Year Default Rates by Modified Ratings, 1983-1995, Source: Moodys (1996).
 Pricing A Defaultable Bond

For simplicity, let’s first assume that the riskfree interest rate r is a
constant. Consider a τ -year zero-coupon bond issued by a firm with
default intensity λ:

P0 = $100 · e−r·τ · P rob(τ� ≥ τ ) (4)

P0 = $100 · e−r·τ · e−λ·τ (5)

P0 = $100 · e−(r+λ)·τ (6)

where we assume that conditioning on a default, the recovery value of

the bond is 0 (we have also assumed risk-neutral pricing).

The yield on the defaultable bond is r + λ, resulting in a credit spread

of λ.
 Time Variation of Default Probability

10

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Dec-01
GDP Growth / Chain QQQ% Linear (GDP Growth / Chain QQQ%)

Figure 10: Chart Annual GDP Growth Rate, source: Bureau of Economic Analysis Stochastic
 Default Intensity

In general, the credit quality of a firm changes over time.

A more realistic model is to treat the arrival intensity as a random

process.

Suppose that intensities are updated with new information at the begin­
ning of each year, and are constant during the year. Then the probability
of survival for t years is
� �
E e−λ0 +λ1 +···+λt−1 (7)

For example,
� �
λt+1 − λt = k λ¯ − λt + εt+1 (8)

Can you calculate the probability of survival for τ years? What is the
price of a τ -year zero-coupon bond? What if the riskfree interest rate is
also stochastic?
Example: A portfolio consists of two long assets $100 each. The prob­
ability of default over the next year is 10% for the first asset, 20% for
the second asset, and the joint probability of default is 3%. What is
the expected loss on this portfolio due to credit risk over the next year
assuming 40% recovery rate for both assets.

Probabilities:

0.1 · (1 − 0.2) − def ault probability of A (9)

0.2 · (1 − 0.1) − def ault probability of B (10)
0.03 − joint def ault probability (11)

Expected losses:

0.1 · (1 − 0.2) · 100 · (1 − 0.4) = 4.8 (12)

0.2 · (1 − 0.1) · 100 · (1 − 0.4) = 10.8 (13)
0.03 · 200 · (1 − 0.4) = 3.6 (14)

4.8 + 10.8 + 3.6 = $19.2 mio. (15)

Example: Assume a 1-year US Treasury yield is 5.5% and a Eurodollar

deposit rate is 6%. What is the probability of the Eurodollar deposit to
default assuming zero recovery rate)?
1 1−π
= (16)
1.06 1.055
π = 0.5% (17)
Example: Assume a 1-year US Treasury yield is 5.5% and a and a
default probability of a one year CP is 1%. What should be the yield on
the CP assuming 50% recovery rate?
1 1−π 0.5π
= + (18)
1+x 1.055 1.055
= 6% (19)
 Some Practitioner’s Credit Risk Model

RiskMetrics: CreditM etricsT M

http://riskmetrics.com/research

Credit Suisse Financial Products: CreditRisk+

http://www.csfb.com/creditrisk

KMV Corporation / CreditM onitor T M

http://www.kmv.com

Focus:
BKM Chapter 14

• p. 415-422 (definitions of instruments, innovation in the bond mar­

ket)

• p. 434-441 (determinants of bond safety, bond indentures)

Style of potential questions: Concept check questions, p. 448 ff. ques­

tion 31
 Questions for Next Class

Please read:

• Reyfman,

• Toft (2001), and

• Altman, Caouette, Narayanan (1998).