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

2. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 2 Returns, Standard Deviations, and Frequency Distributions: 1926-1996 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. – 90% + 90% 0% Average Standard Series Annual Return DeviationDistribution Large Company Stocks12.7%20.3% Small Company Stocks17.734.1 Long-Term Corporate Bonds6.08.7 Long-Term Government Bonds5.49.2 U.S. Treasury Bills3.83.3 Inflation3.24.5

3. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 3 Debt vs Equity Risk Value of future cash flows Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Contractual int. & principal No upside Senior claims Control via restrictions AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity

4. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 4 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%

5. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 5 Debt vs Equity 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 RiskEquity Risk

6. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 6 Credit Risk versus Market Risk

7. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 7 CreditMetrics Methodology l Establishes the exposure profile of each obligor in a portfolio. l Computes the volatility in value of each instrument caused by possible upgrades, downgrades, and defaults. l Taking into account correlations between each of these events, it combines the volatility of the individual instruments to give an aggregate portfolio volatility.

8. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 8 CreditMetrics Roadmap 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 ExposuresValue-at-risk due to creditCorrelations

9. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 9 Provisions of Bonds l Secured or unsecured l Call provision l Convertible provision l Put provision (putable bonds) l Floating rate bonds l Sinking funds

10. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 10 Default Risk and Ratings l Rating companies  Moody’s Investor Service  Standard & Poor’s  Duff and Phelps  Fitch l Rating Categories  Investment grade  Speculative grade

11. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 11 Bond Credit Ratings

12. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 12 Factors Used by Rating Companies l Coverage ratios l Leverage ratios l Liquidity ratios l Profitability ratios l Cash flow to debt

13. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 13 Medians of Key Ratios : 1993-1995

14. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 14 Process of Ratings and Rate Estimation l We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class. l 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.

15. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 15 Interest Coverage Ratios and Bond Ratings If Interest Coverage Ratio isEstimated Bond Rating > 8.50AAA 6.50 - 8.50AA 5.50 - 6.50A+ 4.25 - 5.50A 3.00 - 4.25A– 2.50 - 3.00BBB 2.00 - 2.50BB 1.75 - 2.00B+ 1.50 - 1.75B 1.25 - 1.50B – 0.80 - 1.25CCC 0.65 - 0.80CC 0.20 - 0.65C < 0.20D

16. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 16 Spreads Over Long Bond Rate for Ratings Classes

17. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 17 Volatilities from “Transition Matrix”

18. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 18 Construction of Volatility Across Credit Horizons

19. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 19 Defaults and Recovery Rates

20. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 20 The Distribution of Returns

21. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 21 A Picture of a BBB Bond’s Value Distribution

22. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 22 Calculating Mean and Standard Deviation

23. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 23 CreditMetrics creditmetrics.com

25. n igiddy@stern.nyu.edu

26. n www.stern.nyu.edu

27. www.giddy.org

29. Copyright ©1998 Ian H. Giddy Credit Risk Analysis 29 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