Credit Risk Modelling : The Basics

By: A V Vedpuriswar

October 4, 2009
Introduction to Credit Risk Modelling

Credit risk modeling helps to estimate how much credit is 'at risk'
due to a default or changes in credit risk factors.

By doing so, it enables managers to price the credit risks they face
more effectively.

It also helps them to calculate how much capital they need to set
aside to protect against such risks.

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Market Risk vs Credit Risk Modelling
 Compared to market risk modeling, credit risk modeling is a relatively new science.

 Credit risk models are not a simple extension of market risk models.

 Credit risk is more contextual.

 The time horizon is usually longer for credit risk.

 Legal issues are more important in case of credit risk.

 The upside is limited while the downside is huge.

 If the counterparty defaults, while the contract has negative value, the solvent party
typically cannot walk away from the contract.

 But if the defaulting party goes bankrupt, while the contract has a positive value,
only a fraction of the funds owed will be received.

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Data

There are serious data limitations.

Market data is plentiful.

But bankruptcy data are rare.

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Liquidity
Market prices are readily available for instruments that give rise to
market risk.

However, most credit instruments don't have easily observed market

prices.

There is less liquidity in the price quotes for credit instruments, such as
bank loans, compared to interest rate instruments or equities.
This lack of liquidity makes it very difficult to price credit risk for a
particular obligor in a mark-to-market approach.

To overcome this lack of liquidity, credit risk models must sometimes
use alternative types of data (historical loss data).

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 Distribution of losses
Market risk is often modeled by assuming that returns follow a normal
distribution though sometimes it does not hold good.

The normal distribution, however, is completely inappropriate for

estimating credit risk.

 Returns in the global credit markets are heavily skewed to the downside
and are therefore distinctly non-normal.

Banks' exposures are asymmetric in nature.

There is limited upside but large downside.

The distribution exhibits a fat tail.

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Correlation & Diversification
Diversification is the main tool for reducing credit risk.

For most obligors, hedges are not available in the market.

But there are limits to diversification.

A loan portfolio might look well diversified by its large number of

obligors.

But there might still be concentration risk caused by a large single

industry/country exposure.
Also correlations can dramatically shoot up in a crisis.

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Expected, unexpected and stress losses

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Expected Loss
The expected loss (EL) is the amount that an institution expects to
lose on a credit exposure over a given time horizon.
EL = PD x LGD x EAD

If we ignore correlation between the LGD variable, the EAD

variable and the default event, the expected loss for a portfolio is the
sum of the individual expected losses.

How should we deal with expected losses?

In the normal course of business, a financial institution should set

aside an amount equal to the expected loss as a provision.
Expected loss can be built into the pricing of loan products.

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Unexpected loss

Unexpected loss is the amount by which potential credit losses might

exceed the expected loss.

Traditionally, unexpected loss is the standard deviation of the portfolio

credit losses.
But this is not a good risk measure for fat-tail distributions, which are
typical for credit risk.

To minimize the effect of unexpected losses, institutions are required

to set aside a minimum amount of regulatory capital.

Apart from holding regulatory capital, however, many sophisticated

banks also estimate the necessary economic capital to sustain these
unexpected losses.

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Stress Losses

Stress losses are those that occur in the tail region of the portfolio
loss distribution.

They occur as a result of exceptional or low probability events (a

0.1% or 1 in 1,000 probability in the distribution below).

While these events may be exceptional, they are also plausible and
their impact is severe.

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Measuring Credit loss

In simple terms, a credit loss can be described as a decrease in the

value of a portfolio over a specified period of time.

So we must estimate both current value and the future value of the
portfolio at the end of a given time horizon.

There are two conceptual approaches for measuring credit loss:

– default mode paradigm
– mark-to-market paradigm

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Default mode paradigm
A credit loss is considered to have occurred only if a borrower defaults
within the modeled time horizon.

This approach is sometimes referred to as the two-state model.

The obligor either does or does not default.

If no default occurs, the credit loss is obviously zero.

If default occurs, exposure at default and loss given default must be
estimated.

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Mark-to-market (MTM) paradigm
Here , a credit loss occurs if:
– the borrower defaults
– the borrower's credit quality deteriorates (credit migration)

The mark-to-market paradigm is therefore a multi-state paradigm.

The mark-to-market paradigm recognizes that there can be an economic

impact even if the borrower does not default.

A true mark-to-market approach would take market-implied values in

different non-defaulting states.

 However, because of data and liquidity issues some banks use internal
prices based on loss experiences.

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Mark-to-market paradigm approaches
There are two well-known approaches in the mark-to-market
paradigm :
– the discounted contractual cash flow approach
– the risk-neutral valuation approach

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Discounted Contractual Cashflow Approach

 In the discounted contractual cash flow approach, the current value of a non-
defaulted loan is measured as the present value of its future cash flows.

 The cash flows are discounted using credit spreads which are equal to market-
determined spreads for obligations of the same grade.

 If external market rates cannot be applied, spreads implied by internal default

history can be used.

 The future value of a non-defaulted loan is dependent on the risk rating at the end
of the time horizon and the credit spreads for that rating.

 Therefore, changes in the value of the loan are the result of credit migration or
changes in market credit spreads.

 In the event of a default, the future value is determined by the recovery rate, as in
the default mode paradigm.

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Risk-Neutral Valuation Approach

 This approach is derived from derivatives pricing theory.

 Prices are an expectation of the discounted future cash flows in a risk-neutral market.

 These default probabilities are therefore called risk-neutral default probabilities and are derived
from the asset values in a risk-neutral option pricing approach.

 Each cash flow in the risk-neutral approach depends on there being no default.

 For example, if a payment is contractually due on a certain date, the lender receives the payment
only if the borrower has not defaulted by this date.

 If the borrower defaults before this date, the lender receives nothing.

 If the borrower defaults on this date, the value of the payment to the lender is determined by the
recovery rate (1 - LGD rate).

 The value of a loan is equal to the sum of the present values of these cash flows.

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Structural and Reduced Form Models

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Structural Models
 Probability of default is determined by the difference between the
current value of the firm's assets and liabilities, and also by the
volatility of the assets.

Structural models are based on variables that can be observed over

time in the market.

Asset values are inferred from equity prices.

Structural models are difficult to use if capital structure is

complicated and asset prices are not easily observable.

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Reduced Form Models
Reduced form models do not attempt to explain default events.

Instead, they concentrate directly on default probability.

Default events are assumed to occur unexpectedly due to one or more

exogenous events (observable and unobservable ), independent of the
borrower's asset value.

Observable risk factors include changes in macroeconomic factors such

as GDP, interest rates ,exchange rates ,inflation.

Unobservable risk factors can be specific to a firm, industry or country.

Correlations among PDs for different borrowers are considered to arise

from the dependence of different borrowers on the behavior of the
underlying background factors.

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Reduced Form Models
 Default in the reduced form approach is assumed to follow a Poisson distribution.

 A Poisson distribution describes the number of events of some phenomenon (in this
case, defaults) taking place during a specific period of time.

 It is characterized by a rate parameter (t), which is the expected number of arrivals

that occur per unit of time.

 In a Poisson process, arrivals occur one at a time rather than simultaneously.

 And any event occurring after time t is independent of an event occurring before time
t.
 It is therefore relevant for credit risk modeling – 
– There is a large number of obligors.
– The probability of default by any one obligor is relatively small.
– It is assumed that the number of defaults in one period is independent of the number of defaults in the
following period.

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Credit Risk Models

Merton

Moody's KMV

Credit Metrics

Credit Risk+

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Merton and KMV models

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The Merton Model

This model assumes that the firm has made one single issue of zero
coupon debt and equity.

Let V be value of the firm’s assets, D value of debt.

When debt matures, debt holders will receive the full value of their
debt, D provided V > D.

If V < D, debt holders will receive only a part of the sums due and
equity holders will receive nothing.

Value received by debt holders at time T = D – max {D-VT, 0}

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The payoff has two components

Examine : D – max {D-VT, 0}

D is the pay off from investing in a default risk free instrument.

On the other hand, - max {D-VT, 0} is the pay off from a short
position in a put option on the firm’s assets with a strike price of D
and a maturity date of T

Thus risky debt ☰ long default risk free bond + short put option
with strike price D

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Value of the put

Value of the put completely determines the price differential

between risky and riskless debt.

A higher value of the put increases the price difference between

risky and riskless bonds.

As volatility of firm value increases, the spread on the risky debt
increases and the value of the put increases.

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Value of equity
Let E be the value of the firm’s equity.

Let E be the volatility of the firm’s equity.

Claim of equity = VT – D if VT ≥ D
= 0 otherwise

The pay off is the same as that of a long call with strike price D.

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Valuing the put option

Assume the firm value follows a lognormal distribution with

constant volatility, .

Let the risk free rate, r be also constant .

The value of the put, P at time, t is given by:

P = e-r(T-t) D N (-d + T-t) – V t N(-d)

d = [1/  T-t] [ln (V t /D) + (r+ ½ 2 (T-t)]

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Problem

The current value of the firm is $60 million and the value of the
zero coupon bond to be redeemed in 3 years is $50 million. The
annual interest rate is 5% while the volatility of the firm value is
10%. Using the Merton Model, calculate the value of the firm’s
equity.

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Solution

 Formula is: St = V x N(d) – Fe-r(T-t) x N (d-T-t)

 d = [1/  T-t] [ln (V t /D) + (r+ ½ 2) (T-t)]

 V = value of firm

 F = face value of zero coupon debt

  = firm value volatility

 r = interest rate

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Solution

 S = 60 x N (d) – (50)e-(.05)(3) x N (d-(.1)3)

 d = [.1823 +( .05+.01/2)(3)]/.17321
= .3473/ .17321 = 2.005

 S = 60 N (2.005) – (50) (.8607) N (2.005 - .17321)

 = 60 N (2.005) – (43.035) N (1.8318)

 = (60) (.9775) – (43.035) (.9665)

 = $17.057 million

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Problem

 In the earlier problem, calculate the value of the firm’s

debt.

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Solution

 Dt = Fe-r(T-t) – pt

 = 50e-.05(3) – pt

 = 43.035 – pt

 Based on put call parity

 pt = Ct + Fe-r(T-t) – V

 Or pt = 17.057 + 43.035 – 60 = .092

 Dt = 43.035 - .092 = $42.943 million

 Alternatively, value of debt

 = Firm value – Equity value = 60 – 17.057

 = $42.943 million

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Complex capital structures

In real life, capital structures may be more complex.

There may be multiple debt issues differing in

– maturity,
– size of coupons
– seniority.

Equity then becomes a compound option on firm value.

Each promised debt payment gives the equity holders the right to
proceed to the next payment.

If the payment is not made, the firm is in default.

After last but one payment is made, Merton model applies.

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KMV Model

Default tends to occur when the market value of the firm’s assets
drops below a critical point that typically lies
– Below the book value of all liabilities
– But above the book value of short term liabilities

The model identifies the default point d used in the computations.

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KMV Model

 The KMV model assumes that there are only two debt issues.

 The first matures before the chosen horizon and the other matures
after that horizon.

 The distance to default can be calculated as:

lnV0  l nD  (r   v2 / 2)T
v T

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KMV Model

The distance to default is a proxy measure for the probability of

default.

As the distance to default decreases, the company becomes more

likely to default.

As the distance to default increases, the company becomes less

likely to default.

The KMV model, unlike the Merton Model does not use a normal
distribution.

Instead, it assumes a proprietary algorithm based on historical

default rates.

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KMV Model

Using the KMV model involves the following steps:

– Identification of the default point, D.
– Identification of the firm value V and volatility 
– Identification of the number of standard deviation moves that
would result in firm value falling below D.
– Use KMV database to identify proportion of firms with distance-
to-default, δ who actually defaulted in a year.
– This is the expected default frequency.
– KMV takes D as the sum of the face value of the all short term
liabilities (maturity < 1 year) and 50% of the face value of longer
term liabilities.

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Problem

Consider the following figures for a company. What is the

probability of default?
– Book value of all liabilities : $2.4 billion
– Estimated default point, D : $1.9 billion
– Market value of equity : $11.3 billion
– Market value of firm : $13.8 billion
– Volatility of firm value : 20%

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Solution

Distance to default (in terms of value) = 13.8 – 1.9

= $11.9 billion

Standard deviation = (.20) (13.8)

= $2.76 billion

Distance to default (in terms of standard deviation)

= 4.31

We now refer to the default database.

If 5 out of 100 firms with distance to default = 4.31 actually defaulted,
probability of default = .05

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Problem

Given the following figures, compute the distance to default:

– Book value of liabilities : $5.95 billion
– Estimated default point : $4.15 billion
– Market value of equity : $ 12.4 billion
– Market value of firm: $18.4 billion
– Volatility of firm value : 24%

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Solution

 Distance to default (in terms of value) = 18.4 – 4.15 = $14.25 billion

 Standard deviation = (.24) (18.4) = $4.416 billion

 Distance to default (in terms of standard deviation) = 3.23

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