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W5-Credit Risk
Credit Risk * Definition of Credit Risk * Credit risk represents the loss that would incur if a counterparty or an issuer of securities/other instruments fails to perform under its contractual obligations It also happens upon a deterioration in the credit quality of third parties whose securities or other instruments (including over-the-counter (OTC) derivatives) that the other party holds How to Estimating Default Probabilities Credit Ratings Altman’s Z-score Historical Data Credit Default Swaps Spread (CDS Spread) Others * Estimating Default Probabilities: Credit Ratings Credit Rating is to provide information about credit quality Ratings change relatively infrequently Ratings change only when there is long-term change in the company’s creditworthiness In the SP/Fitch rating system AAA, AA, A, BBB, BB, B, CCC, CC and C The corresponding Moody’s ratings are Aaa, Aa, A, Baa, Ba, B, Caa, Ca and C Bonds with ratings of BBB (or Baa) and above are considered to be “investment grade” Most banks have their own internal ratings systems for borrowers * Estimating Default Probabilities: Altman’s Z-score (Manufacturing companies) The use of accounting ratio to predict default by Edward Altman X1=Working Capital/Total Assets X2=Retained Earnings/Total Assets X3=EBIT/Total Assets X4=Market Value of Equity/Book Value of Liabilities X5=Sales/Total Assets Z=1.2X1+1.4X2+3.3X3+0.6X4+0.99X5 If the Z3.0 default is unlikely if 2.7Z3.0 we should be on alert if 1.8Z2.7 there is a moderate chance of default if Z1.8 there is a high chance of default * * Estimating Default Probabilities: Historical Data Historical data provided by rating agencies can be used to estimate the probability of default Cumulative Average Default Rates % (1970-2007, Moody’s) The table shows the probability of default for companies starting with a particular credit rating. A company with an initial credit rating of Baa has a probability of 0.170% of defaulting by the end of the first year, 0.478% by the end
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