Credit Risk Modelling: A Primer

By: A V Vedpuriswar

September8,2017
 MarketRiskvsCreditRiskModelling

Comparedtomarketriskmodeling,creditriskmodelingis
relativelynew.
Creditriskismorecontextual.
Thetimehorizonisusuallylongerforcreditrisk.
Legalissuesaremoreimportantincaseofcreditrisk.
Theupsideislimitedwhilethedownsideishuge.
Ifcounterpartydefaults,whilethecontracthasnegativevalue,
thesolventpartytypicallycannotwalkawayfromthecontract.
Butifthedefaultingpartygoesbankrupt,whilecontracthasa
positivevalue,onlyafractionofthefundsowedwillbereceived.

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 Data
Thereareseriousdatalimitations.
Marketriskdataareplentiful.
Butdefault/bankruptcydataarerare.

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Liquidity
Marketpricesarereadilyavailableforinstrumentsthatgiverise
tomarketrisk.
However,mostcreditinstrumentsdon'thaveeasilyobserved
marketprices.
Thereislessliquidityinthepricequotesforbankloans,
comparedtointerestrateinstrumentsorequities.
Thislackofliquiditymakesitverydifficulttopricecreditriskfora
particularobligorinamark-to-marketapproach.
Toovercomethislackofliquidity,creditriskmodelsmust
sometimesusealternativetypesofdata(historicallossdata).

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Distributionoflosses
Marketriskisoftenmodeledbyassumingthatreturnsfollowa
normaldistributionthoughsometimesitdoesnotholdgood.
Thenormaldistribution,however,iscompletelyinappropriatefor
estimatingcreditrisk.
Returnsintheglobalcreditmarketsareheavilyskewedtothe
downsideandarethereforedistinctlynon-normal.
Banks'exposuresareasymmetricinnature.
Thereislimitedupsidebutlargedownside.
Thedistributionexhibitsafattail.

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Correlation&Diversification

Diversificationisthemaintoolforreducingcreditrisk.
Formostobligors,hedgesarenotavailableinthemarket.
Buttherearelimitstodiversification.
Aloanportfoliomightlookwelldiversifiedbyitslargenumber
ofobligors.
Buttheremightstillbeconcentrationriskcausedbyalarge
singleindustry/countryexposure.
Alsocorrelationscandramaticallyshootupinacrisis.

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Expected,unexpectedandstresslosses

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ExpectedLoss
The expected loss (EL) is the amount that an institution
expectstoloseonacreditexposureoveragiventimehorizon.
EL = PD x LGD x EAD
IfweignorecorrelationbetweentheLGDvariable,theEAD
variableandthedefaultevent,theexpectedlossforaportfolio
isthesumoftheindividualexpectedlosses.
Howshouldwedealwithexpectedlosses?
Inthenormalcourseofbusiness,afinancialinstitutioncanset
asideanamountequaltotheexpectedlossasaprovision.
Expectedlosscanbebuiltintothepricingofloanproducts.

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Unexpectedloss

Unexpected lossistheamountbywhichpotentialcreditlosses
mightexceedtheexpectedloss.
Traditionally, unexpected loss is the standard deviation of the
portfoliocreditlosses.
But this is not a good risk measure for fat-tail distributions,
whicharetypicalforcreditrisk.
To minimize the effect of unexpected losses, institutions are
requiredtosetasideaminimumamountofregulatorycapital.
Apart from holding regulatory capital, however, many
sophisticated banks also estimate the necessary economic
capitaltosustaintheseunexpectedlosses.

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 StressLosses
Stresslossesarethosethatoccurinthetailregionofthe
portfoliolossdistribution.
Theyoccurasaresultofexceptionalorlowprobabilityevents
(a0.1%or1in1,000probabilityinthedistributionbelow).
Whiletheseeventsmaybeexceptional,theyarealso
plausibleandtheirimpactissevere.
Additionalcapitalwillcomeinhandyinsuchsituations.

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MeasuringCreditloss

Insimpleterms,acreditlosscanbedescribedasadecrease
inthevalueofaportfoliooveraspecifiedperiodoftime.
Sowemustestimateboththecurrentvalueandthefuture
valueoftheportfolioattheendofagiventimehorizon.
Therearetwoconceptualapproachesformeasuringcredit
loss:
Default mode paradigm
Mark-to-market paradigm

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Defaultmodeparadigm

Acreditlossoccursonlyintheeventofdefault..
Thisapproachissometimesreferredtoasthetwo-state model.
Theborrowereitherdoesordoesnotdefault.
Ifnodefaultoccurs,thecreditlossisobviouslyzero.
Ifdefaultoccurs,exposureatdefaultandlossgivendefaultmust
beestimated.
CreditRiskPlusisbasedonthisparadigm.

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Mark-to-market(MTM)paradigm
Here,acreditlossoccursif:
theborrowerdefaults
theborrower'screditqualitydeteriorates(creditmigration)

Thisisthereforeamulti-state paradigm.
Therecanbeaneconomicimpactevenifthereisnodefault.
CreditMetricsisbasedonthisparadigm.

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Mark-to-marketparadigmapproaches
Therearetwowell-knownapproachesinthemark-to-market
paradigm:
thediscountedcontractualcashflowapproach
therisk-neutralvaluationapproach

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DiscountedContractualCashflowApproach

Thecurrent value of a non-defaulted loanismeasuredasthe

presentvalueofitsfuturecashflows.
Thecashflowsarediscountedusingmarket-determinedcredit
spreadsforobligationsofthesamegrade.
Ifexternalmarketratescannotbeapplied,spreadsimpliedby
internaldefaulthistorycanbeused.
Thefuture value of a non-defaulted loanisdependentonthe
riskratingattheendofthetimehorizonandthecreditspreads
forthatrating.
Therefore,changesinthevalueoftheloanaretheresultofcredit
migrationorchangesinmarketcreditspreads.
Intheevent of a default,thefuturevalueisdeterminedbythe
recoveryrate,asinthedefaultmodeparadigm.
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Risk-NeutralValuationApproach

Pricesareanexpectationofthediscountedfuturecashflowsinarisk-neutral
market.
Thesedefaultprobabilitiesarethereforecalledrisk-neutraldefaultprobabilities
andarederivedfromtheassetvaluesinarisk-neutraloptionpricingapproach.
Eachcashflowintherisk-neutralapproachdependsontherebeingnodefault.
Forexample,ifapaymentiscontractuallydueonacertaindate,thelender
receivesthepaymentonlyiftheborrowerhasnotdefaultedbythisdate.
Iftheborrowerdefaultsbeforethisdate,thelenderreceivesnothing.
Iftheborrowerdefaultsonthisdate,thevalueofthepaymenttothelenderis
determinedbytherecoveryrate(1-LGDrate).
Thevalueofaloanisequaltothesumofthepresentvaluesofthesecash
flows.

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StructuralandReducedFormModels

Structuralmodelslookatthevaluesoftheassetsand
liabilitiesofthefirm.
Reducedformmodelslookatdefaultasasuddenevent.

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StructuralModels
Probabilityofdefaultisdeterminedby

thedifferencebetweenthecurrentvalueofthefirm'sassets
andliabilities,and
bythevolatilityoftheassets.
Structuralmodelsarebasedonvariablesthatcanbeobserved
overtimeinthemarket.
Assetvalueisinferredfromequityprices.
Thelowertheassetvalue,thehighertheprobabilityofdefault.
Structuralmodelsaredifficulttouseifthecapitalstructureis
complicatedandassetpricesarenoteasilyobservable.
MertonModelisthebestexampleofstructuralmodels.
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ReducedFormModels(1)
Reducedformmodelsdonotattempttoexplaindefaultevents.
Instead,theyconcentratedirectlyondefaultprobability.
Default events happen unexpectedly due to one or more exogenous events
(observableandunobservable),independentoftheborrower'sassetvalue.
ObservableriskfactorsincludechangesinmacroeconomicfactorssuchasGDP,
interestrates,exchangerates,inflation.
Unobservableriskfactorscanbespecifictoafirm,industryorcountry.
Reduced-form models explain correlations by assuming a particular functional
relationshipbetweenthedefaultprobabilityandbackgroundfactor.
Forexample,thecorrelationbetweendefaultsacrossobligorscanbemodeledby
theloadingsoncommonriskfactorssay,industrialandcountry.
Correlations among PDs for different borrowers arise from the dependence of
differentborrowersonthebehavioroftheunderlyingbackgroundfactors.

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ReducedFormModels(2)
Default in the reduced form approach is assumed to follow a Poisson
distribution.
APoissondistributiondescribesthenumberofeventsofsomephenomenon
(inthiscase,defaults)takingplaceduringaspecificperiodoftime.
It is characterized by a rate parameter (t), which is the expected number of
arrivalsthatoccurperunitoftime.
InaPoissonprocess,arrivalsoccuroneatatimeratherthansimultaneously.
And any event occurring after time t is independent of an event occurring
beforetimet.
Itisrelevantforcreditriskmodelingbecause
Thereisalargenumberofobligors.
Theprobabilityofdefaultbyanyoneobligorisrelativelysmall.
It is assumed that the number of defaults in one period is independent of
thenumberofdefaultsinthefollowingperiod.

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 Incorporatingcorrelationsinthemodel
Thecorrelationbetweendefaultprobability(PD)andexposureat
default(EAD)isparticularlyimportantforderivativeinstruments,
wherecreditexposuresareparticularlymarket-driven.
Aworseningofexposuremayoccurduetomarketeventsthattend
toincreaseEADwhilesimultaneouslyreducingaborrower'sability
torepaydebt(thatis,increasingaborrower'sprobabilityofdefault).
Theremayalsobecorrelationbetweenexposureatdefault(EAD)
andlossgivendefault(LGD).
LGDisfrequentlymodeledasafixedpercentageofEAD,with
actualpercentagedependingontheseniorityoftheclaim.
ButabetterapproachistomodelLGDasarandomvariableorto
treatitasbeingdependentonothervariables.

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PopularCreditRiskModels

Merton
Moody'sKMV
CreditMetrics
CreditRisk+
CreditPortfolioView

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TheMertonModel

Thismodelassumesthatthefirmhasmadeonesingleissue
ofzerocoupondebtandequity.
LetVbevalueofthefirmsassets,Dvalueofdebt.
Whendebtmatures,debtholderswillreceivethefullvalueof
theirdebt,DprovidedV>D.
EquityholderswillreceiveV-D.
IfV<D,debtholderswillreceiveonlyapartofthesumsdue
andequityholderswillreceivenothing.
ValuereceivedbydebtholdersattimeT=Dmax{D-VT,0}
Thevaluereceivedbydebtholdersrangesfrom0toD.

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ThePayofffromDebt

Examine:Dmax{D-VT,0}
Disthepayofffrominvestinginadefaultriskfreeinstrument.
Ontheotherhand,-max{D-VT,0}isthepayofffromashort
positioninaputoptiononthefirmsassetswithastrikeprice
ofDandamaturitydateofT.
Thusriskydebtlongdefaultriskfreebond+shortput
optionwithstrikepriceD.

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Valueoftheput

Valueoftheputcompletelydeterminesthepricedifferential
betweenriskyandrisklessdebt.
Ahighervalueoftheputincreasesthepricedifference
betweenriskyandrisklessbonds.
Asvolatilityoffirmvalueincreases,thespreadontherisky
debtincreasesandthevalueoftheputincreases.

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Valueofequity
LetEbethevalueofthefirmsequity.
LetEbethevolatilityofthefirmsequity.
Claimofequity =VTDifVTD
=0otherwise
ThepayoffisthesameasthatofalongcallwithstrikepriceD.

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Valuingtheputoption

Assumethefirmvaluefollowsalognormaldistributionwith
constantvolatility,.
Lettheriskfreerate,rbealsoconstant.
AssumedV=Vdt+Vdz(GeometricBrownianmotion)
Thevalueoftheput,pattime,tisgivenby:
p=Ke-r(T-t)N(-d2)SN(-d1)
p=De-r(T-t)N(-d1+T-t)VtN(-d1)
d1=[1/T-t][ln(Vt/D)+(r+2(T-t)]

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Valuingthecalloption

Thevalueofthecallisafunctionofthefirmvalueandfirm
volatility.
Firmvolatilitycanbeestimatedfromequityvolatility.
Thevalueofthecallcanbecalculatedby:
c=SN(d1)Ke-r(T-t)N(d2)
c=VtN(d1)De-r(T-t)N(d1-T-t)

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TherealmeaningoftheMertonmodel

Ifacompanyisdoingwellandthemarketvalueriseswell
abovethedebtvalue,theequityholderscanexercisethecall
optionandbuythefirmfromthedebtholders.
Ifthecompanyisnotdoingwell,theequityholderscan
exercisetheputoptionandsellthefirmtothedebtholders.
Equityholdersarenotunderobligationtocompensatethe
debtholders.Thisisthevalueoftheput.

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Problem
Afirmhasissueditsdebtintheformofazerocouponbond
witharedemptionvalueof$50mn.Ifthefirmvalueis$40
mn,whatisthevalueofthedebtandequity?
SinceV<D,Valueofdebt=40
Valueofequity=0.
Ifthefirmsvaluerisesto60,whatwillhappen.
NowV>D.Sothevalueofdebtis50andthevalueofequity
is10.

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Problem
Thecurrentvalueofthefirmis$60millionandthevalueofthezerocoupon
bondtoberedeemedin3yearsis$50million.Theannualriskfreeinterest
rateis5%whilethevolatilityofthefirmvalueis10%.UsingtheMerton
Model,calculatethevalueofthefirmsequity.
Valueofequity=Ct=VtxN(d)De-r(T-t)xN(d-T-t)
d=[1/T-t][ln(Vt/D)+(r+2)(T-t)]
Ct = 60xN(d)(50)e-(.05)(3)xN[d-(.1)3]
d = [.1823+(.05+.01/2)(3)]/.17321
= .3473/.17321=2.005
Ct = 60N(2.005)(50)(.8607)N(2.005-.17321)
= 60N(2.005)(43.035)N(1.8318)
= (60)(.9775)(43.035)(.9665)
= $17.057million
V = value of firm, D = face value of zero coupon debt
= firm value volatility, r = interest rate
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Problem
Intheearlierproblem,calculatethevalueofthefirmsdebt.
Dt = De-r(T-t)pt
= 50e-.05(3)pt
= 43.035pt
Basedonputcallparity
pt = Ct+De-r(T-t)V
Or pt = 17.057+43.03560 =.092
Dt = 43.035-.092 =$42.943million
Alternatively,valueofdebt
= FirmvalueEquityvalue =6017.057
= $42.943million

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Problem
Thevalueofafirmsassetsis$100mnwithanannualized
volatilityof0.2.Theriskfreerateofreturnis.05andthedebtis
structuredasazerocouponbondwitharedemptionvalueof$70
mnandmaturityof4years.Findthevalueofequity.
Valueofequity=valueofcalloption.
UsingOptioncalculator,C=$43.8mn.
Valueofput=1.12
Valueofriskfreebond=70exp(-.05x4)=57.31
Valueofdebttakingintoaccountrisk=57.31-1.12=56.19
Valueofequity=100-56.19=43.81
Wecanalsoworkoutthecreditspread.
56.19=70exp(-rX4).Sor=0.0549.
Creditspread=.0549-.05=.0049=49basispoints
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Problem
Thevalueofanemergingmarketfirmsassetis$20million.
The firms soleliability consists of apurediscount bondwith
facevalueof$15millionandoneyearremaininguntilmaturity.
At the end of the next year, the value of firms assets will
eitherbe$40millionor$10million.
Therisklessinterestrateis20percent.
Compute the value of the firms equity and the value of the
firmsdebt.

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Solution
Define V as the value of the firms assets. In a binomial
framework,
V,T,u=40
V,T-1=20
V,T,d=10
DefineEasthevalueofthefirmsequity,andKastheface
valueofthefirmsdebt.K=15.then
ET,u=25=40-15
ET-1
ET,d=0
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Solution(Continued)
LetcurrentassetvaluebeV.
Attheendof aperiod,assetvaluescanbeV(1+u) ie40or
V(1+d)ie10.
Ifthefirmsassetshaveanuptick,thenu=[40-20)/20]=1.0.
Thevalueofdisd=[(10-20)/20]=-0.5.
Therefore,withr=0.20,

=9.72
Thevalueofthefirmsassetsiscurrently20,V=E+D,
Valueoffirmsdebt=20-9.72=10.28 36
 Afirmsmarketvalueofdebtis$40mnandmarketvalueofequityis$60mn.The
debthasafacevalueof$50mnwith5yeartimetomaturity.Theriskfreerateof
interestis3%.Findtheimpliedvolatilityofthemarketvalueoftheasset.Ifthefirm
recapitalizesitselfbyfloatingequityof$20mn,whatwillbetheimplicationforthe
firmscreditrating?
S=100.C=60.r=.03.t=5.K=50
Usingtheoptioncalculator,impliedvolatility=33.4
Valueofputoption=3.04
Valueofdebt=50exp(-5x.03)3.04=43.035-3.04=$40mn.
40=50exp(-rx5)orr=.0446=4.46%Socreditspread=1.46%
Supposethefirmrecapitalisesitselfraisingequityof$20mnandbringingdown
thedebtto$30mn.
S=100,volatility=33.4r=.03t=5K=30
Usingoptioncalculator,p=.4983
Valueofdebt=30exp(-.05X3)-.4983=$25.32mn
25.32=30exp(-rx5)orr=.0339=3.39%.Socreditspread=.39%
Soreductionincreditspread=1.46.39=1.07=107basispoints
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Problem
Calculatetheriskneutralprobabilityofdefaultintheearlier
case.
Beforerecapitalization,
d2=[.6931-.1289]/[.334xSqrt(5)]=0.7554orN(d2)=.775
Soriskneutralprobabilityofdefault=1-.775=.225
Afterrecapitalisation,
d2=[1.2040-.1289]/[.334xSqrt(5)=1.4395orN(d2)=.925
Soriskneutralprobabilityofdefault=1-.925=.075

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Problem

Afirmhasissueddebtwithaprobabilityofdefaultof10%and
arecoveryrateof40%.Whatisthevalueofthevulnerable
option?
Optionvalue=.9c+(.1)(.4)c=.94c
Sothevulnerableoptionisworth94%ofthevalueofthe
optionthatisfreeofdefaultrisk.

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Complexcapitalstructures

Inreallife,capitalstructuresmaybemorecomplex.
Theremaybemultipledebtissuesdifferingin
maturity,
sizeofcoupons
seniority.

Equitythenbecomesacompoundoptiononfirmvalue.
Eachpromiseddebtpaymentgivestheequityholderstheright
toproceedtothenextpayment.
Ifthepaymentisnotmade,thefirmisindefault.
Afterlastbutonepaymentismade,Mertonmodelapplies.

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BlackandCoxModel
Thismodelhasanexplicitbarrierfunction.
Thevalueofthefirmcandropbelowthisbarrieratanypointprior
tothematurityofthedebt.
Inthatcase,thefirmgoesintodefault.
Thusthebarrierfunctionreplacesdebtvalueinthismodel.
Thebarrierfunctioncanbemodelledas:
At=Kfort<T(wherekissomeconstant.)
At=Dfort=T(Disthevalueofdebt.)
Thusthemodelallowsearlydefaultwhenthevalueofthefirmfalls
belowathresholdvalue.
Theprobabilityofdefaultisgreater,comparedtoMertonmodel.
Thecreditspreadishigher,comparedtoMertonmodel.
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LongstaffandSchwartzmodel

Mertonmodelassumethattheriskfreerateremainsconstant.
Mertonmodelassumesthatthetermstructureofinterestrateisflat.
LongstaffandSchwartzusetimevaryinginterestrate
Thusdr=(-r)dt+tdw
istherateofmeanreversion.
ristheshortterminterestrate.
isthelongrunaverageshortterminterestrate.
tisthevolatilityofshortterminterestrate.

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RendlemanandBarttermodel

dr=rdt+rdz
rfollowsGeometricBrownianmotion
Thisisthesameprocessassumedforstockprices.
Interestratesaremeanreverting.
Butthismodeldoesnotincorporatemeanreversion.

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KMVModel(1)

Defaulttendstooccurwhenthemarketvalueofthefirms
assetsdropsbelowacriticalpointthattypicallylies
Belowthebookvalueofallliabilities
Butabovethebookvalueofshorttermliabilities
Themodelidentifiesthedefaultpointdusedinthe
computations.
Thedistancetodefaultiscalculatedas:

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KMVModel(2)
The distance to default, d 2 is a proxy measure for the
probabilityofdefault.
Asthedistancetodefaultdecreases,thecompanybecomes
morelikelytodefault.
As the distance to default increases, the company becomes
lesslikelytodefault.
The KMV model, unlike the Merton Model does not use a
normaldistribution.
Instead,itassumesaproprietaryalgorithmbasedonhistorical
defaultrates.

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KMVModel(3)
UsingtheKMVmodelinvolvesthefollowingsteps:
Identificationofthedefaultpoint,D.
IdentificationofthefirmvalueVandvolatility
Identificationofthenumberofstandarddeviationmovesthat
wouldresultinfirmvaluefallingbelowD.
Use KMV database to identify proportion of firms with
distance-to-default,whoactuallydefaultedinayear.
Thisistheexpecteddefaultfrequency.
KMV takes D as the sum of the face value of the all short
termliabilities(maturity<1year)and50%ofthefacevalue
oflongertermliabilities.

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Problem
Considerthefollowingfiguresforacompany.Whatistheprobabilityof
default?
Bookvalueofallliabilities :$2.4billion
Estimateddefaultpoint,D :$1.9billion
Marketvalueofequity :$11.3billion
Marketvalueoffirm :$13.8billion
Volatilityoffirmvalue :20%

Solution
Distancetodefault(intermsofvalue) =13.81.9=$11.9billion
Standarddeviation =(.20)(13.8)=$2.76billion
Distancetodefault(intermsofstandarddeviation) = 11.9/2.76 =
4.31
Wenowrefertothedefaultdatabase.If 5outof100firmswithdistanceto
default=4.31actuallydefaulted,probabilityofdefault=.05
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Problem
Giventhefollowingfigures,computethedistancetodefault:
Bookvalueofliabilities : $5.95billion
Estimateddefaultpoint : $4.15billion
Marketvalueofequity : $12.4billion
Marketvalueoffirm : $18.4billion
Volatilityoffirmvalue : 24%

Solution
Distancetodefault(intermsofvalue)=18.44.15=$14.25
billion
Standarddeviation=(.24)(18.4)=$4.416billion
Distancetodefault(intermsof)=14.25/4.42=3.23
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HowTrafiguramanagescreditrisk
Trafigurahasaformalcreditprocessbywhichitestablishescreditlimitsforeach
counterparty.
Besidessoftinformation,thecompanyalsousestheKMVMoodys
methodology.
Creditofficersarelocatedacrosstheworldtomakeafirsthandassessmentof
thecreditrisk.
Wherecreditexposuretoacounterpartyexceedstheprescribedlimit,Trafigura
purchasespaymentguaranteeorinsurancefromprimefinancialinstitutions.
Thecompanyalsopurchasespoliticalriskcoverinspecificgeographies.
Trafiguraalsomonitorscreditriskconcentrationbyindustryandgeography
closely.
85%ofthecompanysderivativesareexchangetradedorcentrallycleared.
IncaseofOTCtradeswhichmakeuptheremaining15%,Trafiguradealswith
bluechipbanksandmarketparticipants.
Creditlimitsandcollateralareusedtominimizecreditriskexposure.Theuseof
standardizedcontractsisanotherriskmitigationtechnique.
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