1. Prof Ian Giddy Stern School of Business New York University
LIB
Credit Risk Analysis
Prof Ian Giddy
Stern School of Business
New York University

2. Returns, Standard Deviations, and Frequency Distributions: 1926-1996
Average Standard Series Annual Return Deviation Distribution
Large Company Stocks 12.7% 20.3%
Small Company Stocks
Long-Term Corporate Bonds
Long-Term Government Bonds
U.S. Treasury Bills
Inflation
– 90% 0%
+ 90%
Source: © Stocks, Bonds, Bills, and Inflation 1997 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

3. Assets Liabilities Debt vs Equity Risk Debt Equity Value of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights

4. Total Firm Risk Probability Return on Assets 68% 95% > 99%
– – 48.2%
– – 27.9%
– – 7.6%
0 12.7% % % %

5. Debt vs Equity Risk Debt Risk Equity Risk Probability Return on Assets
68%
95%
> 99%
Return on Assets
– – 48.2%
– – 27.9%
– – 7.6%
0 12.7% % % %
Debt Risk
Equity Risk

6. Credit Risk versus Market Risk

7. CreditMetrics Methodology
Establishes the exposure profile of each obligor in a portfolio.
Computes the volatility in value of each instrument caused by possible upgrades, downgrades, and defaults.
Taking into account correlations between each of these events, it combines the volatility of the individual instruments to give an aggregate portfolio volatility.

8. CreditMetrics Roadmap
Exposures
Value-at-risk due to credit
Correlations
Compute exposure profile of each asset
Compute the volatility of value caused by upgrades/downgrades and defaults
Compute correlations
Portfolio value-at-risk due to credit

9. Provisions of Bonds
Secured or unsecured
Call provision
Convertible provision
Put provision (putable bonds)
Floating rate bonds
Sinking funds

10. Default Risk and Ratings
Rating companies
Moody’s Investor Service
Standard & Poor’s
Duff and Phelps
Fitch
Rating Categories
Investment grade
Speculative grade

11. Bond Credit Ratings

12. Factors Used by Rating Companies
Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt

13. Medians of Key Ratios : 1993-1995
To estimate the cost of debt, we will estimate a bond rating for the firm, using financial ratios. This page provides the averages for key ratios used by S&P to rate manufacturing firms between 1993 and 1995.
We will actually build the entire analysis around the first ratio (pre-tax interest coverage ratio = EBIT/Interest expenses) to
Keep the analysis simple (It is relatively straightforward to expand it to include multiple ratios)
Focus on a ratio that will change as the leverage changes
Focus on a ratio that has been shown to be highly correlated with ratings.

14. Process of Ratings and Rate Estimation
We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class.
We then estimate a spread over the long term bond rate for each ratings class, based upon yields at which these bonds trade in the market place.
The interest coverage ratios in the previous table are medians. We use the ratios for large manufacturing firms to develop the table on the next page.
We also estimate a spread over the long term government bond rate at each rating, using the average yield to maturity on 5 long-term straight bonds within each ratings class and comparing to the treasury bond rate.

15. Interest Coverage Ratios and Bond Ratings
If Interest Coverage Ratio is Estimated Bond Rating
> 8.50 AAA AA A+ A A–
BBB BB B+ B
B –
CCC CC C
< 0.20 D
These are interest coverage ratio/ratings classes for large manufacturing firms.
The ratios need to be much higher for smaller firms to get similar ratings. (See ratings.xls spreadsheet)

16. Spreads Over Long Bond Rate for Ratings Classes
This is the default spread over and above the long term (15 year) treasury bond rate at the time of this analysis. (June 1997)

17. Volatilities from “Transition Matrix”

18. Construction of Volatility Across Credit Horizons

19. Defaults and Recovery Rates

20. The Distribution of Returns

21. A Picture of a BBB Bond’s Value Distribution

22. Calculating Mean and Standard Deviation

23. CreditMetrics
creditmetrics.com

29. Ian H. Giddy Professor of Finance Stern School of Business
New York University
44 West 4th Street, New York, NY 10012, USA
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