Prof Ian Giddy Stern School of Business New York University LIB Credit Risk Analysis Prof Ian Giddy Stern School of Business New York University

Returns, Standard Deviations, and Frequency Distributions: 1926-1996 Average Standard Series Annual Return Deviation Distribution Large Company Stocks 12.7% 20.3% Small Company Stocks 17.7 34.1 Long-Term Corporate Bonds 6.0 8.7 Long-Term Government Bonds 5.4 9.2 U.S. Treasury Bills 3.8 3.3 Inflation 3.2 4.5 – 90% 0% + 90% Source: © Stocks, Bonds, Bills, and Inflation 1997 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Assets Liabilities Debt vs Equity Risk Debt Equity Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights

Total Firm Risk Probability Return on Assets 68% 95% > 99% – 3 – 48.2% – 2 – 27.9% – 1 – 7.6% 0 12.7% + 1 33.0% + 2 53.3% + 3 73.6%

Debt vs Equity Risk Debt Risk Equity Risk Probability Return on Assets 68% 95% > 99% Return on Assets – 3 – 48.2% – 2 – 27.9% – 1 – 7.6% 0 12.7% + 1 33.0% + 2 53.3% + 3 73.6% Debt Risk Equity Risk

Credit Risk versus Market Risk

CreditMetrics Methodology Establishes the exposure profile of each obligor in a portfolio. Computes the volatility in value of each instrument caused by possible upgrades, downgrades, and defaults. Taking into account correlations between each of these events, it combines the volatility of the individual instruments to give an aggregate portfolio volatility.

CreditMetrics Roadmap Exposures Value-at-risk due to credit Correlations Compute exposure profile of each asset Compute the volatility of value caused by upgrades/downgrades and defaults Compute correlations Portfolio value-at-risk due to credit

Provisions of Bonds Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds

Default Risk and Ratings Rating companies Moody’s Investor Service Standard & Poor’s Duff and Phelps Fitch Rating Categories Investment grade Speculative grade

Bond Credit Ratings

Factors Used by Rating Companies Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt

Medians of Key Ratios : 1993-1995 To estimate the cost of debt, we will estimate a bond rating for the firm, using financial ratios. This page provides the averages for key ratios used by S&P to rate manufacturing firms between 1993 and 1995. We will actually build the entire analysis around the first ratio (pre-tax interest coverage ratio = EBIT/Interest expenses) to Keep the analysis simple (It is relatively straightforward to expand it to include multiple ratios) Focus on a ratio that will change as the leverage changes Focus on a ratio that has been shown to be highly correlated with ratings.

Process of Ratings and Rate Estimation We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class. We then estimate a spread over the long term bond rate for each ratings class, based upon yields at which these bonds trade in the market place. The interest coverage ratios in the previous table are medians. We use the ratios for large manufacturing firms to develop the table on the next page. We also estimate a spread over the long term government bond rate at each rating, using the average yield to maturity on 5 long-term straight bonds within each ratings class and comparing to the treasury bond rate.

Interest Coverage Ratios and Bond Ratings If Interest Coverage Ratio is Estimated Bond Rating > 8.50 AAA 6.50 - 8.50 AA 5.50 - 6.50 A+ 4.25 - 5.50 A 3.00 - 4.25 A– 2.50 - 3.00 BBB 2.00 - 2.50 BB 1.75 - 2.00 B+ 1.50 - 1.75 B 1.25 - 1.50 B – 0.80 - 1.25 CCC 0.65 - 0.80 CC 0.20 - 0.65 C < 0.20 D These are interest coverage ratio/ratings classes for large manufacturing firms. The ratios need to be much higher for smaller firms to get similar ratings. (See ratings.xls spreadsheet)

Spreads Over Long Bond Rate for Ratings Classes This is the default spread over and above the long term (15 year) treasury bond rate at the time of this analysis. (June 1997)

Volatilities from “Transition Matrix”

Construction of Volatility Across Credit Horizons

Defaults and Recovery Rates

The Distribution of Returns

A Picture of a BBB Bond’s Value Distribution

Calculating Mean and Standard Deviation

CreditMetrics creditmetrics.com

igiddy@stern.nyu.edu

www.stern.nyu.edu

www.giddy.org

Ian H. Giddy Professor of Finance Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0332; Fax 212-995-4233 Email: ian.giddy@nyu.edu World Wide Web: http://giddy.org