Mathematical Credit Analysis

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 Probability of Default

• This chart shows rating migrations and the probability of default for
alternative loans. Note the increase in default probability with longer
loans.

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 Mathematical Credit Analysis

• Credit Analysis
 Debt as a sold put Option
 Merton Model
 Monte Carlo Simulation

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 General Payoff Graphs from Holding Investments with Future
Uncertain Returns

Stock Payoff versus Price if Purchased or Sold Stock at $40

50
40
30
20
10 Ending Stock Price
Payoff

0
-10 0 10 20 30 40 50 60 70 80
-20
-30
-40
-50
Purchase at $40 Sell Stock Short

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 Payoff Graphs from Call Option – Payoffs when Conditions
Improve

Call Option Payoff Patterns

40

30

20
10
Payoff

0
0 20 40 60 80
-10 Ending Value
-20 Bought call Sold Call
-30
-40

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 Payoff Graphs from Buying Put Option – Returns are realized
to buyer when the value declines

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 Payoff Graphs from Selling Put Option – Value Changes with
Value Decreases

Put Option Payoff Pattern from

Selling Put -- Lender Perspective
10
5
0
-5 0 20 40 60 80 100 120
Payoff

-10
Ending Firm Value
-15
-20
-25
-30
-35
-40

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 Payoff to
claimholders At maturity date T, the
debt-holders receive
face value of bond F
as long as the value of
Value of the company and the firm V(T) exceeds
changes in value to equity and F and V(T) otherwise.
debt investors
They get F - Max[F -
V(T), 0]: The payoff of
riskless debt minus the

Equity payoff of a put on V(T)

with exercise price F.

F Equity holders get

Max[V(T) - F, 0], the
payoff of a call on the
firm.

Debt

V(T)

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Payoff to
debt holders

Credit spread is the payoff from selling

a put option

A1 B A2 Assets
The payoffs to the bond holders are limited to the amount lent B
at best.

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 The Black-Scholes/Merton Approach

• Consider a firm with equity and one debt issue.

• The debt issue matures at date T and has principal F.
• It is a zero coupon bond for simplicity.
• Value of the firm is V(t).
• Value of equity is E(t).
• Current value of debt is D(t).

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 Merton’s Model

• Merton’s model regards the equity as an option on the assets of the firm
• In a simple situation the equity value is
max(VT -D, 0)

where VT is the value of the firm and D is the debt repayment required

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 Merton’s Model Assumptions

• Markets are frictionless, there is no difference between borrowing and lending

rates
• Market value of the assets of a company follow Brownian Motion Process with
constant volatility
• No cash flow payouts during the life of the debt contract – no debt re-payments
and no dividend payments
• APR is not violated

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 Merton‘s Structural Model (1974)

• Assumes a simple capital structure with all debt represented by one zero
coupon bond – problem in project finance because of amortization of
bonds.
• We will derive the loss rates endogenously, together with the default
probability
• Risky asset V, equity S, one zero bond B maturing at T and face value
(incl. Accrued interest) F
• Default risk on the loan to the firm is tantamount to the firm‘s assets VT
falling below the obligations to the debt holders F
• Credit risk exists as long as probability (V<F)>0
• This naturally implies that at t=0, B0<Fe-rT; yT>rf, where πT=yT-rf is the
default spread which compensates the bond holder for taking the default
risk

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 Merton Model and Credit Spreads

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 Merton Model Propositions

• Face value of zero coupon debt is strike price

• Can use the Black-Scholes model with equity as a call or debt as a put option to directly
measure the value of risky debt
• Can use to compute the required yield on a risky bond:
 PV of Debt = Face x (1+y)^t
 or
 (1+y)^t = PV/Face
 (1+y) = (PV/Face)^(1/t)
 y = (PV/Face)^(1/t) – 1
 With continual compounding = - Ln(PV/Face)/t
• Computation of the yield allows computation of the required credit spread and computation of
debt value
• Borrower always holds a valuable default or repayment option. If things go well repayment
takes place, borrower pays interest and principal keeps the remaining upside, If things go bad,
limited liability allows the borrower to default and walk away losing his/her equity.

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 Default Occurs at Maturity of Debt if V(T)<F

Asset Value

VT

V0

Probability of default

T Time

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 Black-Scholes Assumptions with Respect to Firm Value

• Firm value is lognormal; constant volatility; deterministic interest rate; no

frictions.
 E(t) = Call[V(t),F,T]
 D(t) = Exp[-r(T-t)]*F – Put[V(t),F,T]
• Put-call parity implies also:
 D(t) = V(t) – Call[V(t),F,T]
• Firm value is simply sum of equity and debt:
 V(t) = E(t) + D(t).

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 Equity Price Method

Following the Merton’s model, the fair value of the Put is

The annual protection fee will be the cost of Put divided by the number of years.

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 Applying Option Valuation Model

• Merton showed value of a risky loan

• F(t) = Be-it[(1/d)N(h1) +N(h2)]
• Written as a yield spread
• k(t) - i = (-1/t)ln[N(h2) +(1/d)N(h1)]
• where k(t) = Required yield on risky debt
• ln = Natural logarithm
• i = Risk-free rate on debt of equivalent maturity

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 Merton Model and Recovery Rate

• If Merton’s model applies, the probability of default can be computed.

• It is the probability that firm value will exceeds debt face value at T.
 Debt Value = Face at Risk Free Rate less Value of Put Option
 Put Option Value = Probability of Default x Cost When Default
• Black-Scholes formulation allows one to divide the value of the put option into
probability of default and recovery rate

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 Enron EDF and Bond Ratings – KMV Model Default Probability in
Blue, Implied Default Probability from Bond Ratings in Red

Enron remained
investment grade until
three months before
bankruptcy

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 Subordinated Debt Payoff

Payoff to
claimholders

Equity
F+U
Subordinated
F debt

Debt

Financial Statement Analysis and Credit Spreads

V(T)
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 Subordinated Debt

• Let the firm have subordinated debt with face value of U.

• The subordinated debt holders receive U if firm value exceeds U + F.
• If firm value is less than U + F but less than F, they receive nothing.
• If firm value is less than U + F but more than F, they get what is left.

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 Payoff and Pricing of Subordinated Debt

• Subordinated debt with face value of U pays :

 Max[V - F,0] – Max[V - (F+U), 0]
• If V > F+U, the value of the firm is greater than the value of senior plus junior:
 the payoff is V - F - (V - (F+U)) = U.
• If F < V < F+U, the value of the firm is greater than the senior debt, but less than junior:
 the payoff is V - F.
• If V < F, the firm value is less than the face value of the senior debt:
 the payoff is 0.
• The value of subordinated debt is
 Call[V,F,T] – Call[V,F+U,T].

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 Merton‘s Model With Subordinated Debt

• So the joint probability of both obligors defaulting would be:

N2 is the standard normal distribution with correlation ρ among the

2 variables

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 Class 4: Model Assessment

• Various ratios that some use to assess management performance are most
appropriate for testing the validity of a model. Examples of these ratios include:
 EBITDA/Revenue
 Working Capital – Activity Ratios
o Inventory Turnover
o AR/Revenues;
o AP/Expenses
o Income Tax Payable/Income Taxes
 Depreciation Rate – Depreciation Expense/Gross PP&L
 Depreciation Expense to Cap Exp
 Average Interest Rate – Interest Expense/Average Debt
 Capital Expenditure/Capacity

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 Other Ratios in Financial Modeling

• Other ratios should be computed in financial models to test the validity of

assumptions and the structure of the model. For these ratios, the historic levels
can be used to make forecasts of relevant assumptions.
• Examples include average interest rate, depreciation rate, working capital ratios,
dividend payout ratio, EBITDA/Sales

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 Defaults in 2005

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