Contemporary Credit Risk

Models

Bappaditya Mukhopadhyay
Management Development Institute,
2002
Understanding and Modeling
Default Risks
Linear Probability Models

Logistic Models

Other Models
 Traditional Approach:
Credit Scoring System: Altman’s Z – Score
model
Z= 1.2 X1+ 1.4 X2 + 3.3 X3 + 0.6 X4+ 1.0 X5
X1: Working Capital/ Total assets
X2: Retained Earnings/Total assets
X3: EBIT/Total assets
X4: Market Value of Equity/ Total Assets
X5: Sales/ Total Assets
Issues
`Cut off’ value of Z: 1.81
Works well under normal conditions
Suffers from standard Econometrics
Problems?…. Multicollinearity….
….Therefore prone to type I and type II
errors
 Loans as Options: The KMV Model

Loans (Debt) are like `put Options’.

Differences:
Value of Put option on stocks
= f(S, X, r, S, T-t)
Value of Default option on risky loans
= f(A, X, r, A, T-t)
… So how to estimate A, andA ?

For A… use ``structural” relationships

For volatility … use relationship between
volatility of a firm’s asset and its stock price.
Expected Default Probability (EDF) can be
calculated
Most importantly, market value of risky loan
is:….
Calculation of EDF

What is EDF?
Suppose Mean Asset Value, A = 100 crores
St. Deviation Asset Value,σA = 10 crores
Value of Debt (Face value), B = 80 crores

Distance from default = (10-80)/10 = 2 standard deviations

ImpliesTheoretical EDF = 2.5 %.
Empirical EDF
Advantages and Disadvantages of
KMV

Advantages:
Reflects information signals
Applicable to any public company
Structural Model

Disadvantages:
Assumption of normality
What about non listed ones
Constant debt structure
Problems with BS model...
 Merton’s Valuation Model

L(T-t)= B e-r(T-t) {(1/d) N(h1) + N(h2)}

d: Leverage ratio
h1: - [ ½  2(T-t) – ln (d) ]/ (T-t)
h2: - [ ½  2(T-t) + ln (d) ]/ (T-t)
A Numerical Example:

B = 100,000
(T-t)= 1 year
i = 5%
d = 0.9
σ = 12%

h1= -.938 h2 = 8.18

N(h1)=.174 N(h2) = .793
L(T-t) = 93,866.
Credit Metrics
Uses VAR approach
Based on `Rating Migration’
Transition probability matrix
Adjust default probability
Capital Requirements
Technical Issues and Problems

Rating Migration
Stable Markov Process: `` No serial correlation with
previous movements”
Transition matrix same across borrower types
Bond aging?
Bond Covenants?
McKinsey Model: Macro Simulation

Similar to the Credit Metrics Approach

Crucial difference: Transition probabilities are
not constant- depends upon Business
cycles
Divide past into samples of `recession’ and
`non recession’. Calculate separate transition
probabilities- simulate scenarios.
 Some Other Models….
KPMG’s Loan Analysis System (LAS): Risk
Neutral Valuation approach
Example: Zero coupon yield on Treasury bonds
and bonds issued by corporations
Maturity Treasury(%) Corp rate(%) EDL
1 year 5.00 5.25 0.2497%
2 Years 5.00 5.50 0.9950%

P(e-(T-t)rf - e-(T-t)rc )/ Pe-(T-t)rc = Exptd default loss

… Other Models

The Insurance approach: CSFP Credit Risk

Plus Model

Different framework: We ask ` What is the

probability that n loans will default out of N’
Loan Portfolio Selection (KMV
Metrics)
Portfolio selection problem
Returns = (Spreads + Fees) – (Exptd Loss)
= (Spreads + Fees) – (EDF . LGD)
Risks (Unexpected loss)
= LGD(EDF)(1 – EDF)
Correlations= usually low
Loan Portfolio Selection

Three Approaches:

Credit Metrics Approach

Modern Portfolio Theory Selection Approach

Simulations Approach
New Challenges and Way Ahead

Underlying Dynamic process

Tackling non symmetric distributions

Integrating with Principal Agent Analysis

Integrating with Qualitative factors

THANK YOU!