1 Global Energy Management Institute Credit Related Issues January 22, 2004 Stuart M. Turnbull

2 Outline of Talk 1Information for pricing credit instruments 2The use of equity prices 3The Eliot Spitzer Effects 4Counterparty risk 5Implications

3 Information Requirements What information do we need to price a credit sensitive instrument, such as a bond or credit default swap? Usual List 1The probability of default over the appropriate horizon. 2The recovery rate if default occurs. Agencies analyze these. How will the probability of default be affect if there are defaults within the sector? This raises the issue of default dependence. Default dependence also arises when we have counterparty risk and in structured products.

4 Use of Equity Prices Firms like KMV and Kamakura use equity prices to estimate the probability of default. Moody-KMV use traditional analysis + KMV Credit Grades uses credit default swap data plus equity data. Using equity data to identify positions in the fixed income markets.

5 Interaction Between Debt and Equity Markets Debt Markets Equity Markets Credit markets use equity prices. Equity markets look at credit ratings, bond spreads, credit default prices.

6 The Changing Nature of Useful Information Over the last five years there has been a revolution in the type of data used in the credit evaluation of loans and bonds. Before the equity analyst paid little, if any, attention to credit issues. Credit analysts and rating agencies ignored information from the equity markets. Data Equity AnalystsCredit Analysts

7 The Changing Nature of Useful Information Now equity analyst are far more sensitive to credit issues. Credit analysts and rating agencies use information from the equity markets. Is this circular? Hopefully not. Data Equity Analysts Credit Analysts

8 Counterparty Risk Will the supplier default on the contract? If I buy credit protection, will the protection seller default? How do we measure default dependence? A common approach uses the correlation of equity returns. Again we are using equity data to measure a credit related event. How valid is this approach in the real world?

9 The Eliot Spitzer Effects Like equity analysts, credit analysts are also being affected. Similar to equity analysts, the FSA in London requires the same independence of credit analysts. The Bond Association has recommended the same for credit analysts in the U. S. Implications 1Less coverage. 2May lead to more volatility, as investors will not have the same level of appropriate information to interpret corporate and economic events. 3Will this impact the resources a firm commits to communicating to the investment community?

10 Summary Credit information affects equity markets and equity information affects credit markets. Rating agencies are using equity information to assist in their analysis. New rules will affect the level of coverage. They already affect how firms communicate with analysts and how analysts communicate with investors.

11 Implications Firms should consider the package of information they use to communicate with rating agencies, credit and equity analysts and investors and the methods of communication. Corporate governance issues also affect the firm’s ability to effectively communicate market participants. If aggregate information flow is decreasing, investors are more likely to penalize a firm if there are surprises. Enhance the risk management function to reduce the likelihood of unpleasant surprises.