Sources:

Suresh Sundaresan, (2009).

 Graduate School of Management
Faculty of Economics and Business
Universitas Indonesia
Outline
 Defaults, Business Cycles and Recoveries
 Rating Agencies and Credit Ratings
 Structural Models of Defaults (PD, LGD)
 Implementing Structural Models: The KMV
(Kealhofer, McQuown, Vacisek) Approach Costs of
Financial Distress and Corporate Debt Pricing
 Reduced – Form Models
 Credit Spread Puzzle
Defaults, Business Cycles and Recoveries
 Credit risk
 the possibility of defaults by one of the counterparties in a
financial transaction
 Probability of default
 Affected future cash flows of future financial transaction (e.g.
Market value of the default debt will less than its face value) --
-- potentially unanticipated losses
 Current market price (value) of the transaction in a default-
risk security is the risk-adjusted PV of future-promised cash
flows.
 Rating agency
 Default risk is any missed or delayed disbursement of contractual
obligations
 Debt classification by rating agencies
 Investment grade
 Non-investment (speculative) grade
 Credit default in the US
 In the 1990s ---- USD 22,093 (due to massive default of
speculative-grade companies)
 1999-2002 ----- USD 41,812 to USD 212,029 (60% of the
volume of defaults comes form investment-grade
companies)
Why Default?
 Miss payments to creditors on a timely basis
 Fail to pay contractual obligations (paying
promised coupons, contractual sinking fund
payments)
 File for bankruptcy protection under Chapter 11 (US);
liquidate the business
 Enter into workouts that lead to exchange offers, by
replacing the old debt contract with new one (an
example of credit event)
UNDANG-UNDANG REPUBLIK INDONESIA NOMOR 37 TAHUN
2004 TENTANG KEPAILITAN DAN PENUNDAAN KEWAJIBAN
PEMBAYARAN UTANG
 Debitor yang mempunyai dua atau lebih Kreditor dan
tidak membayar lunas sedikitnya satu utang yang
telah jatuh waktu dan dapat ditagih, dinyatakan pailit
dengan putusan Pengadilan, baik atas
permohonannya sendiri maupun atas permohonan
satu atau lebih kreditornya Pasal 2 ayat 1)
 Permohonan sebagaimana dimaksud pada ayat (1)
dapat juga diajukan oleh kejaksaan untuk kepentingan
umum.
Caused of default (Business Cycles)
 Macroeconomic factor such recession
 May slow-down and correlated defaults by many firms
within the same industry (More likely firms to defaults
in recession)
 Resale value of assets much lower in recession, however
 The value of assets might be higher when other firms in
the same industry doing better
 Company or industry-specific- factors
 Lack of liquidity or insolvency
Recovery Rates
 Debt securities differs in-terms of
 Seniority in the capital structure
 Level of protection
 Recovery rates is the price of the bond immediately
after default as a percent of its face value ------ 70% of
the par value in the event of default (for bank loans
and senior secured debt securities)
 Recovery rates tend to decrease as default rates
increase
 Bank loans
 Senior secured debt securities
Recovery Rates; Moody’s: 1982 to 2009
Class Mean(%)
1st lien bank loan 65.6

2nd lien bank loan 32.8

Sen Unsec. bank loan 48.7

Senior Secured 49.8

Senior Unsecured 36.6

Senior Subordinated 30.7

Subordinated 31.3

Junior Subordinated 24.7

Factors affecting recovery rates
 Relative bargaining position of lenders and borrowers
(corporate bonds vs government bonds)
 Availability of secured collateral and its value under
financial distress
 The presence of multiple creditors and the existence of
bank debt
Rating agencies and credit ratings
 Information about a borrower’s financial health comes
from two sources: rating agencies and market prices.
 Credit Ratings
 Investment grades
 Below investment grades or junk grades
 Average default rates are predictably much lower for the
investment grade debt, compared to below investment
grades
 Rating agencies also supply information on migration
probability (the moving from one category to another)
Credit ratings
 In the S&P rating system, AAA is the best rating.
After that comes AA, A, BBB, BB, B, CCC, CC, and
C
 The corresponding Moody’s ratings are Aaa, Aa, A,
Baa, Ba, B,Caa, Ca, and C
 Bonds with ratings of BBB (or Baa) and above are
considered to be “investment grade”
Review of Option Types
 A call is an option to buy
 A put is an option to sell
 A European option can be exercised only at the end
of its life
 An American option can be exercised at any time
Option Positions
 Long call
 Long put
 Short call
 Short put
Long Call
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
Short Call
Profit from writing one European call option: option
price = $5, strike price = $100

Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30
Long Put
Profit from buying a European put option: option
price = $7, strike price = $70

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
Short Put
Profit from writing a European put option: option price
= $7, strike price = $70

Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30
Structural Models of Default
 Merton (1974) and Black and Scholes (1973)
 Equity holders have a valuable put option when they
borrow money form bondholders.
 Equity holders may exercise the option when the firm’s
assets below the PV of the loan obligations
 If the value of implicit put option is high, the corporate
borrowers will walk away from their debt obligations by
putting the firm’s assets to the lenders
Value of risky debt
 Corporate debt investors are essentially short a put
option
 When value of the firm is low---the equity holders can
put the firm to bond investors and walk away form
their contractual debt obligations
 Value of risky debt= Value of risk-free debt – value of
put; or
 Value of put = Value of risk-free debt – Value of risky
debt
The Spread
 The spread:
 The value of the put option on the assets of borrower
with a strike price equal to the promised value of debt
obligations.
 the spread should increase with volatility; leverage;
and increasing in time to maturity
Option pricing model- Valuing debt
 Managers have the option to walk away from the debt
holders, due to the limited liability of the owners
 If we have the value of conservation requirement as of:
V=S+D
 Where V is total value of the firm
 S is the value of equity, and
 D is the market value of debt

Max  F ,VT  = F − max  0, F − VT 

 In the situation of financial distress, pay-off to the
debt holders at time T:
Max  F ,VT  = F − max  0, F − VT 
 Where:
 F =strike price
 T –t = time to maturity
 Pay-off to maturity: Max 0,VT − F 
 Where
 V is the value of the firm at date T (Spot price of underlying
asset)
 F is the face value of debt (Strike price)
Payoffs to Equity and Corporate
Bondholders

Source: Sundaresan, (2009);pp.207

•Bondholders have the right to take over the firm when the
value of the firm at maturity date T is less than or equal to F
(Face amount/Strike price)
•The compensation to be received by creditors upon
reaching the lower reorganization boundary is specified-----
the bondholders will receive VT(spot price of underlying
asset) at date T once they take over.
Value of call option of zero coupon
(discount) bond

 If sv is the volatility of firm’s assets, the value of the

equity (Black-Scholes model):
S = Vt N (d1 ) − Fe− r (T −t ) N (d 2 )

 Where N (d1) is the cumulative normal density

evaluated at d
1
Value of debt at maturity
 At maturity, the bondholders will get:

 The payoff of the risky corporate bond consists of 2

parts:
 F= what the buyer of a risk-free discount bond will get;
and
 The value of a put option on the assets of the firm
Value of put option
 Since the equity holders own the put option, they can
sell the firm’s assets with the strike price equal to the
face value of the debt. Thus, the value of corporate
debt:

 r is default free (risk-free rate)

 Merton (1974): the default spread between corporate
and treasury discount securities, and define the yield
to maturity (R) of corporate discount bond at date t:
Default spread (credit spread)
 Default spread = R-r

 If debt ratio (d) is

 And (T-t) is time to maturity, then

 Default spread is increasing with leverage (d) and in the
volatility of the firm’s underlying assets
Effect of Operating Risk on Default Premium
(Spread)
 Effect of leverage on spread can be explained as:
 A firm with higher leverage expect to borrow in the
corporate debt market with higher premium; in similar
way the operating risk of the underlying business
increases . Therefore, risk premium should increase. As
predicted by Merton’s Model).
The Term Structure of Interest Rate
 The behavior of risk premium with respect to term of
maturity depends on the level of leverage (too high or
too low) --- known as term structure of default
premium or risk structure of interest rate
 When leverage ratio is small , the term premium is
increasing
 When leverage ratio is very high, Merton’s Model
implies that short-term debt set a higher risk premiums
The Term Structure of Interest Rate
 Sarig and Warga (1989) found that the shape of risk
premium is similar to the prediction of Merton’s (1974)
 Merton’s model is consistent with the shape of default
premium structure --- on average yield’s spread
increasing as rating declines
Probability of Default (PD) and Loss Given Default
(LGD)
 A value of credit-risky bond, consist of 3 terms:
 The present value of otherwise identical risk-free debt

 Discounted loss given default (LGD)

 Probability of default (PD)

= -
Probability of Default (PD) and Loss Given
Default (LGD)
 If μ is the expected return on asset, the real life
probability of default ( ) can be written as:
Market Price
 Market price reflects credit risk
 Increasing credit risk ----- lowering prices
 Credit risk ----- affect recovery rate on loan or bond
obligations
 Investors are interesting in determining the probability
of default (leading to credit event) and potential
recovery rates in the event of default
 Both of the probability of default and recovery rate
determine the value of a credit-risky security
Implementing Structural Models: The KMV
Approach
 Credit risk assessment process
 Determine the value of assets (V) and their
volatility
 Calculate the distance to default (DD)
 Determination of Expected Default Frequency
Value of Equity
 Value of the equity represents by the stock
price and driven by the following factors:
 Value of the firm’s assets (V)
 The volatility of the assets (σ)
 The leverage ratio (L)
 The coupon on long term debt (c) and
 The risk-free rate (r)
Distance to Default (DD)
 DD is the difference between the value of the firm and the
par value of debt (a unit of standard deviation of the firm’s
value
 KMV sets the default point as somewhere between short
term debt (STD) and the total debt as the total of the short
term debt and half the value of the long term debt
 The default point (DPT):

 The distance to default is the number of standard

deviations assets have to lose before getting to the default
point (DPT). It is calculated as follows:
Distance to Default DD)
Effective Default Frequency (EDF)
 EDF is the probability of default for a
horizon ranging from 1 to 5 years.
 It is determined by
 Stock prices; implied market value
 Asset volatility using both market data
and company’s financial statements
 Leverage ratio; historical data on default
and bankruptcy to determine EDF and
given the distance to default
The KMV Approach--- Asset value
 To aspects in implementing structural models are:
 Value of the asset
 Volatility of the asset
 These information can be obtained from the market
 Value of assets = value of the equity ---- based on
Merton model, equity is a call option of the asset which
strike price equal to face value of debt

 Equity Volatility:
Conceptual framework for calculating EDF
Subordinated of Corporate Debt
 The Black and Cox Approach to Subordinated Debt
Valuation (1976)

 Value of the firm

Safety Covenants
 Debt covenant (indenture): an agreement between bond
issuer and bondholders
 Net-worth constraints or safety covenants
 If the value of the firm (V) drops to a specific level ,
bondholders have the right to take over the firm and obtain
a pre-specified compensation of a certain amount from the
original promised payments --- down-and –out option
 This option is automatically expires when the underlying
asset reaches a pre-specified low value (X)and the firm is
taken over by the bondholders
 The bondholders will get Y
 The shareholders will get X-Y, or 0; whichever is higher
Safety Covenants
Cost of Financial Distress and Corporate
Debt Pricing
 In reality, debt holders much be proactive.
 They usually may monitor firm’s performance (health)
frequently before the maturity debt
 In practice ---- semiannually coupon payments; to
examine whether there is enough money to make
payments
 Re-negotiation and workout
 In sovereign bonds: reschedule interest and principal
payments
 Debt holiday---to give the borrower to recover its
financial health
Cost of Financial Distress and Corporate
Debt Pricing
 Financial distress occurs when the liquid assets of the
firm are not sufficient to meet obligations of the debt
contracts (a mismatch between the firm’s CAs and its
current obligations (John, 1993)
 Ways to deal with financial distress:
 Partially liquidated existing assets
 Negotiating with debt holders
 Issuing additional claims
Reduced From Models
 Directly model the probability of default
rate and the recovery rate
 Focus: the time to default
 Assumption: default is conducted by a Poisson process
 Default is a surprise event with a hazard rate of λ
 If the firm survives at time t
 The probability that it will default between t to t+Δt = λΔt
Reduced From Models-Example
 A zero coupon bond
 2 years left to maturity
 At date t, if there is no default the bond will pay $100; if there
is default, the bond will pay $ 50
 Recovery rate ® is assumed 50% of par value
 Probability of default of each node is 5%
 At t=1, the bond may default at either of the two nodes with a
probability of 5%
 What the value of risk-free bond will be on date t=1 at the
up node and at the down node.
 Need to specify the evolution of risk free rates of each node
 The expected payoff is discounted at the risk-free rate of 11%
Likelihood of Default at Each Node, Conditional on
Surviving until That Time
Probability Distribution of Risk-Free Rates
Reduced From Models-Example
 The value of credit-risky zero coupon bond can be
calculated as follows:

0.95 x100 + 0.05 x50

 Value of the bond at t=1 vu = = 87.83784
1.11

 The value of the bond at the lower node at date t=1:

v = 0.95x100 + 0.05x50 = 89.44954

d 1.09
The yield of the risky bond at date t=1, at the up node

100 −1 = 13.8462
87.83784
The yield at the down node:

100 −1 = 11.7949%
89.44954
 Yield of a risky bond can be expressed in terms of
default intensity λ , recovery rate R, and risk-free rate
r:

 Credit risk spread is determined by the risk-neutral

probability of default and the loss given default
Credit Spreads Puzzle
 Two fundamental factors in determining credit
spreads
 Probability of default
 Recovery risk
 However, those factors can only explain 25% of the
fluctuation of credit spreads ---- corporate bonds are
seldom active in secondary markets
 Therefore, the inability of credit model to explain
credit spreads ----- credit spreads puzzle
Credit Spreads Puzzle
 Chen (2008) and Chen, Collin-Dufresne and Goldstein
(2007) explained the observed credit spreads.
 Credit spreads depends on :
 The expected terminal price of zero coupon bond ( a
function of expected recovery rates and likelihood of
defaults
 Market price of risk and the covariance of risky bond
price with market return