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9.1 Introduction

Since 1990, credit-related financial crises and consequent defaults by governments, companies, and individuals have spurred developments in credit risk analysis.

Crises include the following:

  • The collapse of the Japanese bubble and its aftermath (1989-present).
  • The Mexican "tequila crisis" (1994-1995).
  • The Asian crisis, also known as the Asian contagion (1997-1998).
  • The Russian debt crisis (1998).
  • The global financial crisis (began in 2008).

Traditional credit ratings were only partially effective in capturing the changes in the default risks.

As a result, additional tools to quantify and manage risks have been developed.

9.1.1 Overview of Credit Analysis Models

There are four measures that are often estimated to quantify the credit risk.

  • Probability of default
  • Present value of the expected loss
  • Loss given default
  • Expected loss on the bond

9.1.2 Probability of default, loss given default, expected loss, and present value of the

expected loss, and describe the relative importance of each across the credit spectrum Probability of Default

  • Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations. PD is used in a variety of credit analyses and risk management frameworks.

Present Value of the Expected Loss

  • The present value of the expected loss is conceptually the largest price one would be willing to pay on a bond to a third party (e.g., an insurer) to entirely remove the credit risk of purchasing and holding the bond.
  • The present value of the expected loss is the most important credit risk measure, followed by expected loss and, finally, probability of default.
  • The present value of the expected loss is the most important credit risk measure because when one considers the purchase or sale of the bond, one is interested in the exact dollar difference one should pay or receive on the bond relative to an otherwise identical and riskless government bond.
  • Also, the present value of the expected loss is the preferred measure because it includes the probability of default, the loss given default, the time value of money, and the risk premium in its computation. The expected loss is second best, including both the default probability and loss given default. The default probability is the least inclusive measure.
  • The present value of the expected loss is the most complex credit risk measure to calculate because it involves two modifications to the expected loss:
  • The first modification is to explicitly adjust the probabilities to account for the risk of the cash flows (the risk premium).
  • The second modification is to include the time value of money in the calculation- that is, the discounting of the future cash flows to the present.

Loss given Default

  • Loss given default is the amount of the remaining coupon and principal payments lost in the event of default.
  • Loss given default is equal to 1 – Recovery rate
  • Recovery rate is the percentage of the position received or recovered in default.

Expected Loss on the Bond

  • The expected loss is equal to the probability of default multiplied by the loss given default.

Lesson Wrap-Up

This lesson should leave you able to explain the introduction in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain overview of credit analysis models in your own words.
  2. Explain probability of default, loss given default, expected loss, and present value of the in your own words.
  3. State one exam-style risk, valuation, or market implication of the introduction.