The Public EDF Model Developed by: The Market Information Lab Fall 2009 CreditEdge Tutorial

Credit Risk in Financial Markets Limitless Opportunities Dynamic Credit Environment Numerous Market Sectors Complexity of Financial Statements Bottom Line: How likely is it that we get paid back?

Tutorial Overview CreditEdge Overview What/Who/How for CreditEdge Calculating Expected Default Frequency (EDF) Calculating the Three Drivers The CreditEdge Interface Building and Portfolio Analyzing a Company Graphically Estimation Using Scenario Analysis

Structure of the Products Moody’s Credit Rating Agency Moody’s KMV CreditEdgeRiskCalc MIL Product Public Co. Credit RiskPrivate Co. Credit Risk Subsidiary

What is CreditEdge? Product developed by Moody’s CompanyProduct developed by Moody’s Company Calculation of Public Company DefaultCalculation of Public Company Default Likelihood of Lender Getting Paid BackLikelihood of Lender Getting Paid Back Unbiased Comparison of Public CompaniesUnbiased Comparison of Public Companies

Who Uses CreditEdge? LendersLenders Access counterparty riskAccess counterparty risk Determines likelihood of getting paid backDetermines likelihood of getting paid back i.e. Barclaysi.e. Barclays Large CorporationsLarge Corporations Analysis of Internal Credit RiskAnalysis of Internal Credit Risk Gauge of competitor credit statusGauge of competitor credit status i.e. Hewlett-Packardi.e. Hewlett-Packard Fixed Income Investors/AnalystsFixed Income Investors/Analysts

How CreditEdge Works Public Company Probability of Default Internal Company Data / External Market Conditions Portfolio Management with many companies

Check Your Understanding Question: Which of these financial analysts would NOT benefit from CreditEdge? A. Fixed Income Analysts B. Credit Risk Lenders C. Internal Corporate Financial Analyst D. Equity Analysts E. All of the Above Can Benefit CreditEdge

Expected Default Frequency Definition – The Probability that a company’s value will fall below a threshold where its unable to pay back its creditors Three EDF Drivers for calculation: Default Point Market Value of Assets Asset Volatility Case Application: General Electric (GE)

Calculation of EDF EDF = Market Value of Assets Default Point X Asset Volatility Formula:

Default Point Defined – A threshold where the company’s value is not sufficient to payback what it owes Between Total Liabilities and ST Liabilities Empirical Studies Reveal Accurate Formula Default Point = ST Liabilities + ½ (LT Liabilities)

GE Default Point Total Liabilities - ST Liabilities __________________ LT Liabilities Default Point ST Liabilities + (1/2) LT Liabilities DEFAULT POINT 246,133,000 + (1/2) 433,675, ,788, ,113, ,675, ,970,500 Source: Capital IQ Note: Numbers are in Thousands

Market Value of Assets Market Capitalization of Assets Book Value of Liabilities: Senior Claims Market Capitalization of Equity: Junior Claims Formula: MV Assets = Market Cap. + BV Liabilities

GE Market Value of Assets Market Cap. + BV Liabilities __________________ Market Value of Assets 118,940, ,778, ,728,000 Source: Capital IQ

Check Your Understanding Question: Warren Buffet decides to purchase $50 billion in Senior Unsecured Corporate Bonds from GE. What will happen to GE’s EDF A. It will remain the same B. It will increase because of the increase to GE’s Default Point C. It will decrease because of the increase to GE’s Market Value of Assets D. It will increase because the increase to MV of Assets will not have as great of an effect as the Default Point increase. EDF = Market Value of Assets Default Point X Asset Volatility

Calculating New Default Point

Calculating New MV of Assets

Putting it All Together The Ratio Decreased, what does that mean? Numbers in Billions Debt Raised 50 Category of Capital LIABILITY/DEBT Assumption: Asset Volatility Remains Constant New Ratio: Default Point ÷ MV of Assets Old Ratio: Default Point ÷ MV of Assets Default Point 488 Default Point 463 Market Value of Assets 848 Market Value of Assets799 New Ratio Old Ratio

Check Your Understanding Question: Warren Buffet decides to purchase $50 billion in Senior Secured Corporate Bonds from GE. What will happen to GE’s EDF? A. It will remain the same B. It will increase because of the increase to GE’s Default Point C. It will decrease because of the increase to GE’s Market Value of Assets D. It will decrease because the increase to MV of Assets will have a greater effect as the Default Point increase. EDF = Market Value of Assets Default Point X Asset Volatility

Uncertainty (Volatility) of a Firm High Volatility = Greater Probability Of Default Equity Return v. Asset Return Formula: Asset Volatility = Standard Deviation of MV of Assets Asset Volatility

GE Asset Volatility Standard Deviation Formula  Apply to Stock Market X-Bar = Expected Return X = Actual Return N = Number of Observations GE Share Price How do we get Asset Volatility? Where’s our Book Value of Liabilities?

GE Asset Volatility GE Asset Volatility = 0.88%

Check Your Understanding Question: An decrease in GE’s asset volatility will: A. Will have no effect on EDF B. Cause EDF to Increase C. Cause EDF to Decrease D. Asset Volatility has nothing to do with EDF EDF = Market Value of Assets Default Point X Asset Volatility

GE EDF Calculation EDF = Market Value of Assets Default Point X Asset Volatility Formula: EDF = 433,351, ,728,000 X 0.88% EDF = %... What does it mean?

Distance to Default Distance to Default = $ 365,373,500 How likely will it be for MV Assets to fall below Default Point? Distance to Default Distance to Default = Market Value of Assets – Default Point

Graphical Interpretation of EDF Asset Volatility = 0.88% EDF = 0.477% = Chance GE will Default in 1 Year EDF = Probability that Asset Value will fall below the Default Point

Check Your Understanding Question: What is the conceptual definition of a 1 Year EDF? A. It’s the probability that a firm will pay back its creditors in a year’s time. B. It’s the probability that a firm will not be able to pay back its creditors in a year’s time. C. It’s the number of standard deviations a firm is away from its default point. D. It’s the expected return on a firm’s stock. E. None of the Above

The CreditEdge Interface Portfolio creation and management Portfolio creation and management Company Analysis Company Analysis Charting Tool Charting Tool Solver and calculator scenario analysis Solver and calculator scenario analysis

Creation and Analysis of a Portfolio Create a Portfolio Adding companies to portfolio Analysis by EDF and credit rating Average EDF across portfolio Adjusting the time period

Individual Company Credit Analysis Sample Company – General Motors EDF highlights and ratings Current v. previous EDF Base Company Profile Company news and key developments Company SEC filings

Chart Building Sample Chart – EDF only How EDF calculation points factor in GM Comparison to Toyota

Check Your Understanding Question: What are the tasks you can't do with the Chart tool? A. Export as an Excel B. Chart Portfolio items C. Custom time series D. We can do all the above E. None of the Above

Scenario Analysis with Solver Solver overview and definition Sample Analysis – Volkswagen Sample Analysis – GM Calculator feature

Check Your Understanding Question: Holding everything else constant, if the MV of assets increases, what happens to GE’s EDF? A. Increases B. Decreases C. Stays the Same EDF = Market Value of Assets Default Point X Asset Volatility

Wrap-Up and Conclusion Other Moody’s KMV tutorials RiskCalc Tutorial MKMV Integration with Capital IQ MKMV Integration with Crystal Ball Words of wisdom on tool learning Questions and support