CH26HullOFOD5Ebw.pptVIP

Chapter 26Credit Risk Credit Ratings In the SP rating system, AAA is the best rating. After that comes AA, A, BBB, BB, B, and CCC The corresponding Moody抯 ratings are Aaa, Aa, A, Baa, Ba, B, and Caa Bonds with ratings of BBB (or Baa) and above are considered to be 搃nvestment grade? Information from Bond Prices Traders regularly estimate the zero curves for bonds with different credit ratings This allows them to estimate probabilities of default in a risk-neutral world Typical Pattern (See Figure 26.1, page 611) Spread over Treasuries Maturity Baa/BBB A/A Aa/AA Aaa/AAA The Risk-Free Rate Most analysts use the LIBOR rate as the risk-free rate The excess of the value of a risk-free bond over a similar corporate bond equals the present value of the cost of defaults Example (Zero coupon rates; continuously compounded) Example continued One-year risk-free bond (principal=$1) sells for One-year corporate bond (principal=$1) sells for or at a 0.2497% discount This indicates that the holder of the corporate bond expects to lose 0.2497% from defaults in the first year Example continued Similarly the holder of the corporate bond expects to lose or 0.9950% in the first two years Between years one and two the expected loss is 0.7453% Example continued Similarly the bond holder expects to lose 2.0781% in the first three years; 3.3428% in the first four years; 4.6390% in the first five years The expected losses per year in successive years are 0.2497%, 0.7453%, 1.0831%, 1.2647%, and 1.2962% Summary of Results (Table 26.1, page 612) Recovery Rates(Table 26.3, page 614. Source: Moody抯 Investor抯 Service, 2000) Probability of Default Reason Why This Analysis is Simplistic Bonds are assumed to be zero-coupon The equation: Prob. of Def.?1-Rec. Rate)=Exp Loss% assumes that the claim in the event of default equals the no-default value of the bond A More Complete Analysis: Definitions Risk-Neutral Probability of DefaultPage 61