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Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms 2004.

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Presentation on theme: "Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms 2004."— Presentation transcript:

1 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms 2004

2 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 2 1: THE CRITICAL ISSUE IN CREDIT 2: CALCULATING THE EDF CREDIT MEASURE 3: TESTING THE EDF CREDIT MEASURE AGENDA

3 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 3 1 THE CRITICAL ISSUE IN CREDIT SECTION

4 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 4 The Critical Issue in Credit The critical element in successfully managing a credit risk portfolio is that you must manage the dynamics of credit risk Why? A handful of names whose risk has changed explains most of the risk in credit portfolios

5 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 5 A Handful of Names Drive Most of the Risk Managing outliers is important because a relatively small segment that disproportionately drive risk – most of the portfolio requires very little attention

6 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 6 Objectives in Modeling Default Risk Measure credit risk in terms of default probabilities rather than ordinal rankings Provide the most accurate forward-looking, causal model Provide frequent updates and early warning of changes in credit quality

7 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 7 Validation Moodys KMV EDF credit measures Have been tested on over 29 years of data representing over 4,000 defaults in the United States alone, as well as on smaller samples in various countries around the globe Outperform internal and agency ratings, simple Merton models and statistical scoring models in anticipating credit events and default

8 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 8 EDFs Predict Future Default Rates

9 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 9 The EDF Credit Measure EDF means Expected Default Frequencythe probability that a firm will default within a given time horizon We provide EDF term structures out to 5 years EDF Ranges from 2 to 2000 basis points

10 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 10 The EDF Credit Measure A company with a current EDF credit measure of 2% has a 2% probability of defaulting within the next twelve months. If we create a portfolio of 1000 such companies, on average, 20 default over the next year, and 980 do not. A company with a 2% EDF credit measure is 10 times more likely to default than a firm with a 0.20% EDF credit measure.

11 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 11 2 CALCULATING THE EDF CREDIT MEASURE Expected Default Frequency for firms with publicly traded equity SECTION

12 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 12 Drivers to the EDF Credit Measure Leverage – Market Value of Assets vs. – Book Value of Liabilities Risk – Volatility of Asset Value

13 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 13 Leverage Market Value of Assets Default Point (Liabilities Due) Defaulted November 2001

14 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 14 The Market Value of Assets The market value of the business, reflecting the equity markets expectations of future cash flows Not directly observableimplied from the market value of equity and the book liabilities using option pricing theory Reflects deterioration & improvement before book assets or earnings Market values are dynamic and forward looking; they are the source of the models predictive power

15 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 15 Calculating Market Value of Assets Equity derives its value from the cash flows of the firm. Equity is a call option on the firms assets: the right, but not the obligation, to buy the firms assets from the lender by re-paying the debt. Standard Options Terms Call Option Value Strike Price Implied Underlying Asset Value KMV Approach (Vasicek/Kealhofer Model) = Market Value of Equity = Book Liabilities Implies Market Value of Assets For more quantitative detail, please see the Moodys KMV paper Modeling Default Risk.Modeling Default Risk

16 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 16 Using Options Framework to Solve for Market Value of Assets Option Value Underlying Asset Value 0 When we know the Asset Value, and the Strike Price We can calculate the implied option value Strike Price

17 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 17 Using Options Framework to Solve for Market Value of Assets Equity Value (Option Value) 0 And Calculate the Implied Asset Value For public firms, we can observe the option value and the strike price Underlying Asset Value Liabilities Due

18 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 18 The Default Point A measure of the liabilities due in the event the firm is in distress Non-cash and long-term obligations put less financial stress on the firm Firms often increase leverage as they deteriorate The Default Point captures the point where the typical firm defaults

19 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 19 Default Point: An Example Defaulted Market Value of Assets Default Point Total Liabilities

20 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 20 Asset Volatility: A Measure of Business Risk The uncertainty around the market value of the business Reflects the degree of difficulty in forecasting the future cash flows Quantifies business risk: larger firms in the same industry tend to have lower volatility Computed by de-levering Equity Volatility

21 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 21 Asset Volatility: A Critical Driver Time Rising Equity Market Cap Because of rising Asset Volatility But a Dramatically Higher EDF

22 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 22 Putting It All Together 1 Yr Distribution of asset value at horizon Asset Value Today EDF Time Value Default Point Distance-to-Default = 3 Standard deviations Asset Volatility (1 Std Dev)

23 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 23 How do we move from Distance to Default to a probability?

24 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 24 We cannot use a statistics textbook. The probability from the Normal distribution is too low. Credit risk isnt normal! Statistics books dont go beyond 3.49we see firms that are 4-6 standard deviations from default subsequently defaulting.

25 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 25 From Distance-to-Default to EDF Moodys KMV uses actual default rates for companies in similar risk ranges to determine a functional relationship Requires a large database of actual defaults

26 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 26 Moodys KMV Public Company Default Database 1973–2001 Over 29 years of data Over 4,900 defaults Over 400,000 company-years

27 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 27 Scaling DD to EDF Form a bucket of similar DD companies 1/1/1978 4.8 4.94.955.0 5.1 5.2 4.8 4.94.955.0 5.1 5.2 4.8 4.94.955.0 5.1 5.2 4.8 1 year later, how many have defaulted? 2 years later... Repeat the exercise for all ranges of DD Measure forward default observations for periods from 1 year to 5 years Form new buckets every year through the present and repeat steps

28 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 28 Scaling DD to EDF Credit Measures Distance to Default Expected Default Frequency EDF 43 bp DD 4s

29 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 29 Summary: Measuring EDF Estimate asset value and asset volatility – Equity is a call option on asset value – Solve for implied asset value and volatility Calculate Distance to Default – Contractual obligations determine Default Point – Number of standard deviations from default Scale Distance to Default to EDF – Assign EDF using actual historical default rates

30 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 30 EDF Credit Measures We have been working on developing EDF credit measures and helping lenders and investors on real credit portfolios since 1989. We are on about the 5th generation of the Vasicek- Kealhofer EDF model. Experience pays offwe provide the most accurate and timely assessment of credit and default risk.

31 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 31 3 TESTING THE EDF CREDIT MEASURE SECTION

32 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 32 EDF Credit Measure Results Can Market Information Improve Ratings? Moodys KMV uses equity market information to determine a firms probability of default: the EDF credit measure. Here we sort the Non-Financial Single B firms on 12/31/92 by their EDF, as shown on the next slide.

33 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 33 103 B-Rated Firms as of 12/31/92 EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00

34 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 34 Defaults 6 Months Later EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00

35 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 35 Defaults 1 Year Later EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00

36 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 36 Defaults 2 Years Later EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00

37 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 37 Defaults 3 Years Later EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00

38 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 38 Defaults 4 Years Later EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00

39 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 39 Defaults 4 Years Later EDF Range Number of Firms EDF Range High Risk Low Risk 0 2 4 6 8 10 12 14 0.15- 0.65 0.67- 1.14 1.15- 2.04 2.16- 2.63 2.69- 3.33 3.69- 5.32 5.64- 8.49 8.84- 20.00 103 Non-Financials Rated Single B as of December 1992 14 Defaults in 4 Years 13 defaults from the above-median EDF companies Non-Defaulting firms had 2.26% EDF Defaulting firms had 13.89% EDF Equally rated firms are not the same risk Market data can add precision to traditional analysis and accounting-based evaluations

40 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 40 EDF Predictive Power Random Chance

41 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 41 EDF Provides Early Warning 1 to 60 Months Prior to Default Median EDF of firms that subsequently default Weakest Quartile EDF all firms Benchmark: Median EDF for period for all firms

42 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 42 EDF Provides Early Warning 1 to 60 Months Prior to Default Weakest Quartile EDF, firms that subsequently default Best Quartile EDF, firms that subsequently default Median EDF of firms that subsequently default Weakest Quartile EDF all firms Benchmark: Median EDF for period for all firms

43 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 43 EDF Provides Early Warning 1 to 60 Months Prior to Default Weakest Quartile EDF, firms that subsequently default Best Quartile EDF, firms that subsequently default Median EDF of firms that subsequently default Weakest Quartile EDF all firms Benchmark: Median EDF for period for all firms

44 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 44 EDF Predictive Power Validated Defaults in Firms with $300mm or more in sales

45 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 45 50% 55% 60% 65% 70% 75% 80% 85% 90% -3-6-9-12 Months before upgrade/downgrade Non-investment grade Upgrades Investment grade Downgrades Non-investment Downgrades Investment grade Upgrades Upgrade/Downgrade Study The test was fairly conservative – to signal a ratings change, a firm had to have an EDF credit measure that indicated a full notch or more difference at the point X months ahead of the rating change. This means the EDF had to be 2 or more times the EDF of its grade.

46 Measuring & Managing Credit Risk: Understanding the EDF Credit Measure for Public Firms COPYRIGHT © 2004 MOODYS KMV COMPANY. ALL RIGHTS RESERVED.WWW.MOODYSKMV.COM 46 To Learn More Please contact your Moodys KMV client representative or visit us online at www.moodyskmv.com.www.moodyskmv.com Contact Moodys KMV via e-mail at info@mkmv.cominfo@mkmv.com or call us at: NORTH AND SOUTH AMERICA, CALL: +1 (866) 321-MKMV (6568) or +1 (415) 296-9669 EUROPE, THE MIDDLE EAST, AFRICA, CALL: +44 (20) 7778-7400 ASIA PACIFIC, CALL: +81 (3) 3218-1160


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