1. Risk Measurement and Management
Week 12 –November 9, 2006

3. Cash Flows in Credit Default Swap

4. Expected Cost of Default
Exposure
Probability of default
Estimated based on option pricing
KMV approach
Use of Moody’s historical data
Probability of default each period
Payment of fee in case of non-default

5. CEU using KMV (Simplified)
CEU 2002 (billions) Market value of long-term debt = $ Book value of current liabilities = Total value of liabilities = $ Market value of equity Market value of assets = $12.9 Estimated standard deviation of change in market value* = 54%
Market value  standard deviation of percent change = $7.0 billion
* Derived from LEAPs table

6. Default Point
Estimated default point assumed to midway between book value of current liabilities and long-term debt
Book value of CEU long-term debt is $5.0 billion and current liabilities $ 2 billion
Default point estimated to be $ 6.0 billion
We do not have KMV estimates based on historical data to fine-tune this estimate of default

7. Estimated Distance to Default
Market value to default point = $6.9 $7
$12.9
$2.0 CL
CL+LTD
TMV
Default point (estimated as midpoint) = $6

8. Simplified KMV Approach
Freqency
Probability of Default = 16.2%
.985*
Value
$6 Billion
$12.9 Billion

9. More Likely Alternative
Moody’s two-year default rate for B2 rated bonds is .137
At the end of two years, .863 or 86.3 of the bonds have not defaulted
As an estimate of the six-month default rate, we can use:

10. Default Swap Pricing
Present value of expected fees (paid if no default) = present value of expected losses in case of default
Risk-free rate appropriate assuming risk-neutrality (generally assumed in derivative pricing)
Solution sensitive to all estimates

11. Estimates: Expected Cash Flows

12. Calculation of Fee
Present value of default payments equal to present value of fees:
Fee therefore (under these assumptions) is $ 314,850 every six months
Net return to Charles Bank on loan is 9.8% on $50 million minus $619,700 per year, equivalent to an annual rate of 8.54%

13. FAB and CEU Credit Risk What are choices?
Retain risk
Portfolio implications
Why not enter a swap arrangement with the hedge funds or lower-rated bank?
What would be characteristics in terms of cash flows and risk of a credit-linked note?

14. For Next Classes
Start research in order to have good questions for our visits to San Francisco financial firms
We will discuss Chapters 23 and 24 on November 16 and the Basel II case
There is no class Thanksgiving week, our last class is November 30