Chapter 24 Principles of Corporate Finance Eighth Edition Credit Risk Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Topics Covered  The Value of Corporate Debt  Bond Ratings and the Probability of Default  Predicting the Probability of Default  Value at Risk

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Risky Bonds The risk of default changes the price of a bond and the YTM. Example We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value? A:

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Risky Bonds Example We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value? A: Bond ValueProb 1,050.80= = = expected CF

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Risky Bonds Example – Continued Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Interest Rates, Risk, and Maturity Difference between promised yield (YTM) on bond and risk- free rate, percent Maturity, years

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Key to Bond Ratings The highest quality bonds are rated triple-A. Investment grade bonds have to be equivalent of Baa or higher. Bonds that don’t make this cut are called “high-yield” or “junk” bonds.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Bond Ratings and Financial Ratios Three years of median ratio data by bond rating (1998 – 2000).

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Bond Ratings and Default Default rates of corporate bonds by S&P’s rating at time of issue

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Bond Ratings and Yield Spreads Yield spread, percent Yield spreads Note these are promised yields Actual Returns?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Market Based Analysis KMV Value, $ millions The market value of WorldCom assets, as default approached Default date

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Default Probability Probability of default over next year Moody’s estimate of WorldCom’s probability of default Default date

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Value at Risk (VaR) Value at Risk = VaR  Newer term  Attempts to measure risk  Risk defined as potential loss  Factors  Asset value  Daily Volatility  Days  Confidence interval

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Value at Risk (VaR) Standard Measurements  10 days  99% confidence interval  VaR

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Value at Risk (VaR) Example You own a $10 mil portfolio of IBM bonds. IBM has a daily volatility of 2%. Calculate the VaR over a 10 day time period at a 99% confidence level.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Value at Risk (VaR) Example  You also own $5 mil of AT&T, with a daily volatility of 1%. AT&T and IBM have a.7 correlation coefficient.  What is the VaR of AT&T and the combined portfolio?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Ratings Changes

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Yields and Ratings Alcan bond price changes, relative to changes in the bond rating