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									Credit Risk and Credit Modeling


Mingsung Tang
mingsung.tang@bofasecurities.com

April 26, 2004

Banc of America Securities, Credit Strategy Group




                                                    1
Two different views of credit risk


 Credit risk for buy-and-hold investors
    Typical users: bank loan portfolios, insurance company portfolios
    Mission: control and manage ultimate losses
    Concerns: economic / agency / regulatory capital
    Tools: risk ratings / scores, risk limits, industry concentrations
    Preference: stability, predictability, not be “arb”-ed

 Credit risk for total-return investors
    Typical players: mutual funds, hedge funds, trading desks
    Mission: mark-to-market value gains / losses
    Concerns: relative value considerations
    Tools: hedging, rating arbitrage, capital structure arbitrage, relative value
    Preference: volatility, “arb”




                                                                                     2
High grade corporate bond market

Ticker    Issuer                       Mdy / SP $MV (billion)
F         Ford Motor Co               A3 / BBB-     $62.745
GE        General Elec Co             Aaa / AAA     $56.175
GM        General Motors Corp          A3 / BBB     $54.212        Highly concetrated credit market
C         Citigroup Inc                Aa1 / AA-    $46.632
HSBA LN   HSBC Hldgs Plc                Aa3 / A+    $35.514
BAC       Bank Of America Corp          Aa2 / A+    $30.689
VZ        Verizon Comm Inc               A2 / A+    $27.883                             Rest
MWD       Morgan Stanley                Aa3 / A+    $25.462                             17%
GS        Goldman Sachs Grp Inc         Aa3 / A+    $23.936
DCX GR    Daimlerchrysler Ag           A3 / BBB     $23.883     Top 25
JPM       Jp Morgan Chase & Co           A1 / A+    $23.747      36%
TWX       Time Warner Inc           Baa1 / BBB+     $22.982
CMCSA     Comcast Corp               Baa3 / BBB     $22.281
                                                                                                 Next 100
WFC       Wells Fargo & Co             Aa1 / AA-    $21.117
                                                                                                  17%
ONE       Bank One Corp                  Aa3 / A    $19.226
CSGN VX   Credit Suisse Grp             Aa3 / A+    $17.490
FON       Sprint Corp               Baa3 / BBB-     $17.071
LEH       Lehman Brothers Hldgs Inc       A1 / A    $16.989
AIG       American Intl Grp           Aaa / AAA     $16.471
WB        Wachovia Corp                  Aa3 / A    $15.685              Next 25       Next 50
MER       Merrill Lynch & Co Inc        Aa3 / A+    $15.602               14%           16%
COP       Conocophillips                 A3 / A-    $15.543
DTE GR    Deutsche Telekom          Baa2 / BBB+     $14.059
WMT       Wal-Mart Stores Inc          Aa2 / AA     $13.653
CIT       CIT Grp Inc                     A2 / A    $12.757




                                                                                                            3
Recent defaults of high grade issuers …


     Defaulted Issuer                Default Date Year Ago Rtg $Par (billion)
     WorldCom                            31-Jul-02   A3 / BBB+      $29.007
     Qwest Capital Funding             31-Dec-02 Baa1 / BBB+        $12.903
     Enron Corp                        31-Dec-01 Baa2 / BBB+          $9.668
     Finova Corp                       28-Feb-01      Baa1 / A-       $6.305
     Pacific Gas & Electric Co          30-Apr-01        A3 / A       $4.972
     Southern California Edison Co     31-Jan-01         A2 / A       $4.620
     AT&T Canada                       30-Sep-02    Baa3 / BBB        $2.959
     Comdisco Inc                        31-Jul-01 Baa1 / BBB+        $2.822
     NRG Energy Inc                    30-Sep-02   Baa3 / BBB-        $2.455
     Kmart                             31-Jan-02    Baa3 / BB+        $2.383
     TXU Eastern Funding Co            29-Nov-02     Baa1 / NA        $2.139
     Ladlaw Inc                        31-May-00    Baa3 / BBB        $1.999
     Owens Corning                      31-Oct-00  Baa3 / BBB-        $1.329
     Teleglobe                         31-May-02 Baa1 / BBB+          $1.224

                                                                   $85 billion




                                                                                 4
… and fallen angels


     Fallen Angels                 Mdy / SP    Highest Rtg $MV (billion)
     El Paso Corp                  Caa1 / B-   Baa2 / BBB+     $12.428
     Williams Cos Inc                B3 / B+   Baa2 / BBB+       $9.183
     Tyco Intl Ltd               Ba2 / BBB-       Baa1 / A-      $8.933
     Georgia-Pacific Corp         Ba3 / BB+        A1 / AA       $8.061
     Calpine Corp               Caa1 / CCC+     Baa3 / BB+       $7.991
     HCA Inc                     Ba1 / BBB-         A3 / A-      $7.336
     JC Penney Co Inc             Ba3 / BB+        A1 / AA       $4.660
     Tenet Healthcare Corp          B1 / BB-        A3 / A-      $3.868
     Dynegy Inc                 Caa2 / CCC+    Baa1 / BBB+       $3.838
     Abitibi-Consolidated Inc     Ba1 / BB+    Baa3 / BBB-       $3.538
     Xerox Corp                      B1 / B+      AA2 / AA       $3.275
     Delhaize Grp                 Ba1 / BB+         A3 / A-      $3.251
     Rite Aid Corp                 Caa1 / B-       A3 / A+       $2.545
     Lucent Technologies Inc       Caa1 / B-         A2 / A      $2.507

                                                              $81 billion




                                                                            5
Historical default rates (source: Moody’s)




                                             6
                  Corporate Default and Spread Incom ($ in billions)




             $0
                   $5
                           $10
                                  $15
                                          $20
                                                 $25
                                                         $30
                                                                $35
                                                                                                      $40




    Feb-99
    Apr-99
    Jun-99
    Aug-99
    Oct-99
    Dec-99
    Feb-00
    Apr-00
                                                                                                            Risk and reward




    Jun-00
    Aug-00
                                                                       Spread Income




    Oct-00
    Dec-00
    Feb-01
    Apr-01
    Jun-01
    Aug-01
    Oct-01
    Dec-01
    Feb-02
    Apr-02
    Jun-02
    Aug-02
    Oct-02
    Dec-02
                                                                       Corporate Default (Notional)




    Feb-03
    Apr-03
    Jun-03
    Aug-03
    Oct-03
    Dec-03
7
We didn’t start the fire …
                                                 That was then (December, 1996)
                              600
   Spread to Treasury (bps)
                              500

                              400

                              300
                                    >Aa3    A1            A2              A3      Baa1     Baa2      Baa3
                              200

                              100

                                0


                                                 This is now (December, 2001)
                              600
 Spread to Treasury (bps)




                              500

                              400
                                     >Aa3   A1       A2          A3        Baa1     Baa2          Baa3
                              300

                              200

                              100

                                0




                                                                                                            8
A real world example
Portfolio Overview
                                                                                                 Client vs. US High Grade Tracking Index
                 March 15, 2004        Index     Client
                                                                                                0%    2%         4%   6%      8%        10%   12%   14%   16%
                                       %$D        %$D
Portfolio Spread                      54 bps     103 bps             Aerospace&Defense
Spread Pickup                           NA       50 bps                 Autos&Autoparts
Portfolio Duration                    5.71 yrs   6.03 yrs
                                                                      Banks - European+
Number of Issuers                       366        78
# of Issuers Account for 80% Weight     147        38             Banks - North American
5% Spread Tightening                  -19 bps    -29 bps
                                                                         Basic Industries
5% Spread Widening                    26 bps     37 bps
5% Upside Tail                        1.10%      1.73%                         Brokerages

5% Downside Tail                      -1.49%     -2.26%     Capital Goods - Manufacturing
5% Upside Tracking Tail                 NA       0.53%
                                                                      Consumer Products
5% Downside Tracking Tail               NA       -0.66%
                                                                                    Energy
Sector                                 Index     Client
                                                                                   Finance
Aerospace&Defense                        2.49%      4.69%
Autos&Autoparts                                                          Food&Beverage
                                         6.86%      9.68%
Banks - European+                        3.21%      1.18%               Gaming&Lodging
Banks - North American                   9.45%      1.66%
                                                                               Healthcare
Basic Industries                         4.71%      6.54%
Brokerages                               3.99%      5.55%                 Insurance - Life

Capital Goods - Manufacturing            1.81%      7.03%                Insurance - P&C
Consumer Products                        1.24%      1.03%
                                                                                     Media
Energy                                   5.61%      2.49%
Finance                                  5.84%      1.15%                Pharmaceuticals
Food&Beverage                            4.45%      2.40%                            REITs
Gaming&Lodging                           0.24%      1.41%
                                                                                      Retail
Healthcare                               0.59%      0.31%
Insurance - Life                         1.80%      1.24%                   Supermarkets
Insurance - P&C                          2.00%      2.90%
                                                                               Technology
Media                                    5.73%     11.20%
Pharmaceuticals                          2.05%      0.41%           Telecom - European+

REITs                                    1.32%      3.06%       Telecom - North American
Retail                                   2.25%      5.53%
                                                                                  Tobacco
Supermarkets                             0.96%      1.48%
Technology                               2.02%      0.00%                  Transportation
Telecom - European+                      3.47%      0.31%                Utilities - Electric
Telecom - North American                 6.11%     13.78%
                                                                    Utilities - Natural Gas
Tobacco                                  0.30%      1.82%
Transportation                           2.13%      0.00%        NonCorp - Higher Rated
Utilities - Electric                     5.32%      4.01%
                                                                  NonCorp - Lower Rated
Utilities - Natural Gas                  1.48%      2.22%
NonCorp - Higher Rated                   6.64%      0.00%                                            Index %$D             Client %$D
NonCorp - Lower Rated                    5.94%      6.92%
                                                                                                                                                                9
Portfolio tail risk
Client Portfolio Tail Risk Allocation (sorted by risk contribution)
                                                           226 bps
                                                                                                                             Portfolio Tail Risk Allocation (by issuer)
Issuer        %$D   Spread    5%Dn    P-5%Dn    P-Sprd       P-Tail   Ratio   P-Ratio
FON        6.005%    77 bps -3.62%     -3.33%   4.6 bps   20.0 bps     21%       23%
F          3.010%   204 bps -6.08%     -4.53%   6.1 bps   13.6 bps     33%       45%                                                   FON
                                                                                                                                        9%
PEMEX-z    4.398%   139 bps -3.63%     -2.93%   6.1 bps   12.9 bps     38%       47%
CVC        2.078%   271 bps -6.46%     -5.72%   5.6 bps   11.9 bps     42%       47%                                     F
DISH       1.978%   204 bps -5.22%     -4.55%   4.0 bps    9.0 bps     39%       45%                                    6%
GM         4.314%   126 bps -3.08%     -2.08%   5.4 bps    9.0 bps     41%       61%
VZ         6.503%    25 bps -1.45%     -1.28%   1.6 bps    8.3 bps     17%       20%
CCK        0.932%   403 bps -10.25%    -8.50%   3.8 bps    7.9 bps     39%       47%                  PEMEX-z
YUM        2.668%   112 bps -3.15%     -2.66%   3.0 bps    7.1 bps     35%       42%                    6%
GR         2.512%    66 bps -3.12%     -2.51%   1.7 bps    6.3 bps     21%       26%
GS         3.701%    29 bps -1.56%     -1.58%   1.1 bps    5.8 bps     18%       18%
AM         0.874%   521 bps -6.24%     -5.61%   4.6 bps    4.9 bps     84%       93%                   CVC
TWX        1.970%    98 bps -2.78%     -2.45%   1.9 bps    4.8 bps     35%       40%                   5%                                                                           Rest
                                                                                                                                                                                    47%
LTR        1.989%   187 bps -2.90%     -2.09%   3.7 bps    4.2 bps     64%       89%
ED         3.658%    36 bps -1.29%     -1.08%   1.3 bps    3.9 bps     27%       33%
                                                                                                       DISH
TYC        1.364%   100 bps -3.54%     -2.84%   1.4 bps    3.9 bps     28%       35%                    4%
WY         1.739%   104 bps -2.42%     -1.98%   1.8 bps    3.4 bps     43%       52%
OI         0.443%   455 bps -8.96%     -7.28%   2.0 bps    3.2 bps     51%       63%
                                                                                                           GM
KR         1.480%    52 bps -2.65%     -2.17%   0.8 bps    3.2 bps     20%       24%
                                                                                                           4%
DHI        0.920%   158 bps -4.60%     -3.47%   1.5 bps    3.2 bps     34%       46%
TGT        2.862%     8 bps -1.29%     -1.05%   0.2 bps    3.0 bps      6%        8%                               VZ
SFI        1.206%   218 bps -2.81%     -2.48%   2.6 bps    3.0 bps     78%       88%                               4%
MEX-z      1.242%   108 bps -2.85%     -2.27%   1.3 bps    2.8 bps     38%       48%                                    CCK
CMCSA      1.329%    78 bps -2.33%     -1.98%   1.0 bps    2.6 bps     34%       40%                                    4%
                                                                                                                               YUM
NS CN      0.462%   567 bps -7.58%     -5.60%   2.6 bps    2.6 bps     75%      101%                                            3%     GR
                                                                                                                                               GS      AM
RCI/B CN   0.717%   185 bps -4.14%     -3.57%   1.3 bps    2.6 bps     45%       52%                                                   3%
                                                                                                                                               3%      2%
DPH        1.010%   145 bps -3.52%     -2.46%   1.5 bps    2.5 bps     41%       59%
CCU        1.096%    56 bps -2.42%     -2.21%   0.6 bps    2.4 bps     23%       25%
DCX GR     1.345%    96 bps -2.79%     -1.79%   1.3 bps    2.4 bps     34%       53%
WMI        2.045%    35 bps -1.54%     -1.16%   0.7 bps    2.4 bps     23%       30%
ICI LN     1.029%    72 bps -2.97%     -2.14%   0.7 bps    2.2 bps     24%       34%                                          Portfolio Tail Risk Allocation (by sector)
AWE        1.268%   118 bps -2.01%     -1.73%   1.5 bps    2.2 bps     59%       68%
BLL        1.134%   179 bps -2.44%     -1.91%   2.0 bps    2.2 bps     73%       94%
KRB        0.707%    51 bps -2.98%     -3.03%   0.4 bps    2.1 bps     17%       17%                                           Media
MO         1.816%   136 bps -2.57%     -1.14%   2.5 bps    2.1 bps     53%      119%                                           16.5%
L          0.677%   111 bps -3.57%     -3.02%   0.7 bps    2.0 bps     31%       37%                                                                                     Rest
                                                                                                                                                                        25.2%
MWD        1.084%    28 bps -1.86%     -1.87%   0.3 bps    2.0 bps     15%       15%
DF         0.611%   202 bps -3.59%     -3.16%   1.2 bps    1.9 bps     56%       64%
TOL        0.592%   123 bps -4.00%     -2.81%   0.7 bps    1.7 bps     31%       44%
KFT        1.550%    34 bps -1.23%     -1.06%   0.5 bps    1.6 bps     28%       32%
ASN        0.804%    39 bps -2.15%     -1.98%   0.3 bps    1.6 bps     18%       20%
LNR        0.790%   257 bps -2.36%     -1.99%   2.0 bps    1.6 bps    109%      129%
POLAND-z   1.282%    56 bps -1.55%     -1.17%   0.7 bps    1.5 bps     36%       48%    Telecom - North American
OCR        0.415%   286 bps -3.99%     -3.59%   1.2 bps    1.5 bps     72%       80%             13.5%
BA         1.094%    38 bps -1.72%     -1.29%   0.4 bps    1.4 bps     22%       29%
ASD        0.923%   117 bps -2.11%     -1.52%   1.1 bps    1.4 bps     55%       77%                                                                                                Aerospace&Defense
BP/ LN     2.092%     5 bps -0.72%     -0.65%   0.1 bps    1.4 bps      7%        7%                                                                                                       4.0%
TRP CN     1.742%    68 bps -1.16%     -0.78%   1.2 bps    1.4 bps     59%       87%
RTN        1.073%    35 bps -1.71%     -1.24%   0.4 bps    1.3 bps     21%       29%                                                                                            Retail
BSY LN     1.116%    68 bps -1.39%     -1.18%   0.8 bps    1.3 bps     49%       57%                                                                                            4.5%
HLT        0.664%   159 bps -4.08%     -1.94%   1.1 bps    1.3 bps     39%       82%
NVR        0.636%   141 bps -2.67%     -1.96%   0.9 bps    1.2 bps     53%       72%                    Autos&Autoparts
RCL        0.453%   210 bps -4.83%     -2.57%   1.0 bps    1.2 bps     44%       82%                         12.2%                                                      Basic Industries
                                                                                                                                                                             7.4%
CZR        0.295%   234 bps -6.19%     -3.60%   0.7 bps    1.1 bps     38%       65%
A CN       0.226%   245 bps -6.00%     -4.53%   0.6 bps    1.0 bps     41%       54%
                                                                                                                                                            NonCorp - Lower Rated
AABA NA    1.179%    17 bps -1.42%     -0.83%   0.2 bps    1.0 bps     12%       20%                                                 Capital Goods -
                                                                                                                                                                   7.6%
THX        0.395%   210 bps -2.74%     -2.46%   0.8 bps    1.0 bps     77%       85%                                                 Manufacturing
                                                                                                                                          9.1%
CAT        1.091%    10 bps -1.15%     -0.88%   0.1 bps    1.0 bps      9%       11%                                                                                                                    10
AIG        1.240%    23 bps -0.96%     -0.71%   0.3 bps    0.9 bps     24%       33%
  Tracking tail risk
Client Portfolio Tracking Tail Risk Allocation
                                                              66 bps                       Portfolio Tracking Tail Risk Allocation (by issuer)
Issuer     Spread     Client     Index   OW/UW    Pickup       T-Tail   T-Ratio
FON         77 bps   6.005%    1.022%     4.98%   3.8 bps   13.9 bps       27%
CVC        271 bps   2.078%    0.000%     2.08%   5.6 bps    9.8 bps       58%                  FON                               Rest
PEMEX-z    139 bps   4.398%    0.698%     3.70%   5.1 bps    8.8 bps       58%                  21%                               23%
DISH       204 bps   1.978%    0.000%     1.98%   4.0 bps    7.1 bps       57%
CCK        403 bps   0.932%    0.000%     0.93%   3.8 bps    6.1 bps       61%
YUM        112 bps   2.668%    0.000%     2.67%   3.0 bps    5.6 bps       53%
VZ          25 bps   6.503%    1.612%     4.89%   1.2 bps    4.9 bps       25%
GR          66 bps   2.512%    0.087%     2.43%   1.6 bps    4.8 bps       33%
AM         521 bps   0.874%    0.000%     0.87%   4.6 bps    3.7 bps      125%
LTR        187 bps   1.989%    0.095%     1.89%   3.5 bps    3.0 bps      117%
TYC        100 bps   1.364%    0.000%     1.36%   1.4 bps    2.9 bps       47%
ED          36 bps   3.658%    0.144%     3.51%   1.2 bps    2.8 bps       45%
                                                                                                                                               YUM
GS          29 bps   3.701%    1.313%     2.39%   0.7 bps    2.7 bps       26%                                                                  8%
OI         455 bps   0.443%    0.000%     0.44%   2.0 bps    2.5 bps       81%
DHI        158 bps   0.920%    0.000%     0.92%   1.5 bps    2.5 bps       58%    CVC
                                                                                  15%
GM         126 bps   4.314%    2.774%     1.54%   1.9 bps    2.4 bps       80%
SFI        218 bps   1.206%    0.000%     1.21%   2.6 bps    2.2 bps      120%
NS CN      567 bps   0.462%    0.000%     0.46%   2.6 bps    2.0 bps      130%
RCI/B CN   185 bps   0.717%    0.000%     0.72%   1.3 bps    2.0 bps       68%                                                           CCK
                                                                                                                                         9%
TGT          8 bps   2.862%    0.578%     2.28%   0.2 bps    1.8 bps       10%
KR          52 bps   1.480%    0.393%     1.09%   0.6 bps    1.7 bps       33%
BLL        179 bps   1.134%    0.000%     1.13%   2.0 bps    1.7 bps      122%
WY         104 bps   1.739%    0.692%     1.05%   1.1 bps    1.6 bps       66%                   PEMEX-z
                                                                                                                          DISH
                                                                                                   13%
ICI LN      72 bps   1.029%    0.079%     0.95%   0.7 bps    1.5 bps       45%                                            11%
DPH        145 bps   1.010%    0.118%     0.89%   1.3 bps    1.5 bps       86%
WMI         35 bps   2.045%    0.382%     1.66%   0.6 bps    1.5 bps       40%
CCU         56 bps   1.096%    0.226%     0.87%   0.5 bps    1.5 bps       33%
MO         136 bps   1.816%    0.227%     1.59%   2.2 bps    1.4 bps      150%
DF         202 bps   0.611%    0.000%     0.61%   1.2 bps    1.4 bps       86%            Portfolio Tracking Tail Risk Allocation (by sector)
TOL        123 bps   0.592%    0.000%     0.59%   0.7 bps    1.3 bps       58%
LNR        257 bps   0.790%    0.000%     0.79%   2.0 bps    1.1 bps      179%
F          204 bps   3.010%    2.788%     0.22%   0.5 bps    1.1 bps       41%                                                       Rest
ASD        117 bps   0.923%    0.000%     0.92%   1.1 bps    1.1 bps      100%                                                       24%
ASN         39 bps   0.804%    0.051%     0.75%   0.3 bps    1.1 bps       28%
OCR        286 bps   0.415%    0.000%     0.41%   1.2 bps    1.1 bps      112%          Media
KRB         51 bps   0.707%    0.221%     0.49%   0.2 bps    1.0 bps       24%          31%
POLAND-z    56 bps   1.282%    0.155%     1.13%   0.6 bps    1.0 bps       62%
HLT        159 bps   0.664%    0.000%     0.66%   1.1 bps    1.0 bps      108%
BSY LN      68 bps   1.116%    0.065%     1.05%   0.7 bps    1.0 bps       74%
NVR        141 bps   0.636%    0.000%     0.64%   0.9 bps    1.0 bps       94%
TRP CN      68 bps   1.742%    0.188%     1.55%   1.1 bps    0.9 bps      119%
BP/ LN       5 bps   2.092%    0.164%     1.93%   0.1 bps    0.9 bps       10%
RCL        210 bps   0.453%    0.000%     0.45%   1.0 bps    0.9 bps      108%
AWE        118 bps   1.268%    0.657%     0.61%   0.7 bps    0.8 bps       87%
L          111 bps   0.677%    0.332%     0.35%   0.4 bps    0.8 bps       46%
CZR        234 bps   0.295%    0.000%     0.29%   0.7 bps    0.8 bps       85%
KFT         34 bps   1.550%    0.519%     1.03%   0.3 bps    0.8 bps       44%
A CN       245 bps   0.226%    0.000%     0.23%   0.6 bps    0.8 bps       74%                                                              Capital Goods -
TWX         98 bps   1.970%    1.648%     0.32%   0.3 bps    0.7 bps       44%                                                              Manufacturing
                                                                                                                                                 22%
THX        210 bps   0.395%    0.000%     0.40%   0.8 bps    0.7 bps      122%
RTN         35 bps   1.073%    0.407%     0.67%   0.2 bps    0.6 bps       38%
FME GR     276 bps   0.314%    0.000%     0.31%   0.9 bps    0.6 bps      147%     Telecom - North American
AABA NA     17 bps   1.179%    0.198%     0.98%   0.2 bps    0.6 bps       28%               23%
BA          38 bps   1.094%    0.509%     0.59%   0.2 bps    0.6 bps       38%
PL           8 bps   0.915%    0.000%     0.91%   0.1 bps    0.5 bps       13%
                                                                                                                                                              11
The efficiency frontier


                                            Spread to Swap vs 5% Tail Risk
                        350


                        300
 Spread to Swap (bps)




                        250


                        200


                        150


                        100


                        50


                         0
                         0.0%   -0.5%   -1.0%    -1.5%     -2.0%     -2.5%   -3.0%   -3.5%   -4.0%
                                                     5% Downside Risk




                                                                                                     12
The landscape of credit risk models



                        Fundamental          Statistical Default        First Generation           Second Generation
                       Credit Research       Explanatory Model          Structural Model            Structural Model


Implementation   Rating Agencies         Altman Z-score            Moody's KMV,                 Credit OAS Model
   Example       Wall Street Research    BondScore, RiskCalc       CreditGrade


   Model         Fundamental credit      Estimate default risk     Long term default risk and   Short term MTM risk and
  Objective      worthiness                                        implied spread               relative value


 Market Data     Financial ratios        Financial ratios          Equity price                 Equity price, option price,
    Input                                                          and price history            credit spread


   Model         Rating letter           Credit risk score         Default risk estimate        Credit Risk
   Output        Rating watch/outlook                              Implied credit spread        Credit OAS




                                                                                                                              13
New tools for credit and portfolio analysis

 Credit OAS Model
    Links credit market with equity market and option market through
      Merton’s model (1974)
    Generates forward-looking credit risk and relative value measures
      that help to avoid credit “blow-ups” before they happen
    Well-suited to bank and finance companies
    A step up from traditional equity based credit models

 Lighthouse
    Credit OAS Model for portfolios
    Saddle-Point Methodology provides semi-closed form solution for
      portfolio tail risk without restrictions on distribution assumption
    Calculates portfolio’s tail risk and each underlying credit’s contribution
      to portfolio tail risk
    Customized optimization module that generates optimal hedging
      allocations




                                                                                  14
Risk concentration on the move …




                                   15
… or not




           16
The valuation of debt in Merton’s model
                                                             $16
 Issuer’s Asset:                                                                  Payoff to Debt    Asset Value Distribution
                                                             $14
 Current Value = $10 billion
 Value Change = “Random Walk”                                $12




                                  Potential Payoff to Debt
 Asset Volatility = 50%
 Dividend Distribution = 0%                                  $10
 Risk Free Rate = 3%
                                                             $8
 Proposed Debt Issue:
                                                             $6
 Face Amount = $5 billion
                                                             $4
 Maturity = 5 years
 Coupon = 0%
                                                             $2

 Question:                                                   $0
                                                                   $0   $2   $4    $6       $8     $10     $12         $14     $16   $18   $20
 Value of Debt?
                                                                                        Asset Value on Maturity Date




                  Debt Value = $4.30 - Put = $4.30 - BS ( S, X, r, T,  )

    Assume that r = 3%,         Debt Value = $4.30 - $0.87 = $3.43,                                  Credit Spread = 454 bps




                                                                                                                                                 17
The credit “cliff” …


                             800 bps


                             700 bps


                             600 bps
                                                            Oct. 2002
Ford Spread to LIBOR (bps)




                             500 bps


                             400 bps


                             300 bps

                                                 Current
                             200 bps                                                              Jan. 2000

                             100 bps


                               0 bps
                                       $0   $5             $10          $15          $20    $25       $30     $35
                                                                        Ford Equity Price




                                                                                                                    18
Use equity price to predict credit spread …


                                200 bps

                                                             11-Oct-2002
                                180 bps
    US High Grade Average ASW




                                160 bps



                                140 bps



                                120 bps



                                100 bps
                                                         30-Apr-2003

                                 80 bps
                                          25   27   29          31         33      35    37   39

                                                    US High Grade Average Equity Price




                                                                                                   19
Implied volatility tells more about credit …


                                 200 bps
                                                                                       11-Oct-2002

                                 180 bps
     US High Grade Average ASW




                                 160 bps



                                 140 bps



                                 120 bps



                                 100 bps
                                                     30-Apr-2003

                                  80 bps
                                           30   35          40         45         50         55         60   65

                                                      US High Grade Average Option Implied Volatility




                                                                                                                  20
                             Credit OAS illustrated

                             48%                                                                          2000 bps



                             38%
                                                                                                          1500 bps




                                                                                                                     Model Projected Spread Change
Equity Return Distribution




                             28%
                                                                                                          1000 bps

                             18%

                                                                                                          500 bps
                              8%


                                                                                                          0 bps
                             -2%



                             -12%                                                                         -500 bps
                                     20%       35%                     50%                       65%   80%

                                            Firm Leverage (Debt over Debt + Equity Market Cap)




                                                                                                                     21
Defining Credit Risk

                                                                  Expected Spread Widening

               40%



               30%
 Probability




               20%



               10%



               0%
                -200 bps   -100 bps    0 bps         100 bps        200 bps     300 bps      400 bps
                                      Spread Widening / Tightening Scenarios




                      Credit Risk = Expected Spread Widening x Duration




                                                                                                       22
Credit OAS in action: WCOM
                                  160%                                                                                                                     $16
                                                                          Option Implied Volatility                 Equity Price



  Option Implied Volatility (%)
                                  140%                                                                                                                     $14
                                  120%                                                                                                                     $12




                                                                                                                                                                 Equity Price
                                  100%                                                                                                                     $10
                                          80%                                                                                                              $8
                                          60%                                                                                                              $6
                                          40%                                                                                                              $4
                                          20%                                                                                                              $2
                                           0%                                                                                                              $0
                                             1/2/02   1/16/02   1/30/02       2/13/02         2/27/02           3/13/02            3/27/02    4/10/02

                                          600                                                                                                          1,600
                                                                          Spread to Swap              Credit Risk
                                                                                                                                                       1,400
                                          500
                                                                                                                                                       1,200
            Credit Spread (bps)




                                                                                                                                                                 Credit Risk (bps)
                                          400
                                                                                                                                                       1,000
                                          300                                                                                                          800
                                                                                                                                                       600
                                          200
                                                                                                                                                       400
                                          100
                                                                                                                                                       200
                                            0                                                                                                          0
                                            1/2/02    1/16/02   1/30/02      2/13/02         2/27/02          3/13/02          3/27/02       4/10/02
                                          600                                                                                                          0
                                                                     Spread to Swap              Credit OAS
                                                                                                                                                       -100
                                          500
                                                                                                                                                       -200
                    Credit Spread (bps)




                                                                                                                                                                          Credit OAS (bps)
                                                                                                                                                       -300
                                          400
                                                                                                                                                       -400
                                          300                                                                                                          -500
                                                                                                                                                       -600
                                          200
                                                                                                                                                       -700
                                                                                                                                                       -800
                                          100
                                                                                                                                                       -900
                                            0                                                                                                          -1,000
                                            1/2/02    1/16/02   1/30/02      2/13/02          2/27/02          3/13/02             3/27/02   4/10/02



                                                                                                                                                                                             23
Credit OAS on the Web (www.bofa.com/coas)




                                            24
Sector summary




                 25
Issuer Home Page




                   26

								
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