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    Overview

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    wwongvg
    This document discusses three main approaches to predicting and valuing corporate default: 1. The empirical method relies on historical financial data but fails to anticipate new situations like Enron and Worldcom. 2. The structural method, like Merton's model, uses stock market data to imply default probabilities. Moodys' widely used KMV model enhances Merton's approach. 3. The reduced form method uses bond market data in a framework like Hull and White's, which bootstraps yield curves to derive default probabilities. However, stock market methods like KMV seem better able to explain credit default swap spreads.

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    Overview

    Uploaded by

    wwongvg
    17 views9 pages
    This document discusses three main approaches to predicting and valuing corporate default: 1. The empirical method relies on historical financial data but fails to anticipate new situations like Enron and Worldcom. 2. The structural method, like Merton's model, uses stock market data to imply default probabilities. Moodys' widely used KMV model enhances Merton's approach. 3. The reduced form method uses bond market data in a framework like Hull and White's, which bootstraps yield curves to derive default probabilities. However, stock market methods like KMV seem better able to explain credit default swap spreads.

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    This document discusses three main approaches to predicting and valuing corporate default: 1. The empirical method relies on historical financial data but fails to anticipate new situations like Enron and Worldcom. 2. The structural method, like Merton's model, uses stock market data to imply default probabilities. Moodys' widely used KMV model enhances Merton's approach. 3. The reduced form method uses bond market data in a framework like Hull and White's, which bootstraps yield curves to derive default probabilities. However, stock market methods like KMV seem better able to explain credit default swap spreads.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    17 views9 pages

    Overview

    Uploaded by

    wwongvg
    This document discusses three main approaches to predicting and valuing corporate default: 1. The empirical method relies on historical financial data but fails to anticipate new situations like Enron and Worldcom. 2. The structural method, like Merton's model, uses stock market data to imply default probabilities. Moodys' widely used KMV model enhances Merton's approach. 3. The reduced form method uses bond market data in a framework like Hull and White's, which bootstraps yield curves to derive default probabilities. However, stock market methods like KMV seem better able to explain credit default swap spreads.

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    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 9

    Predicting and Valuing Default

    Approaches
    1. Empirical Method.
    Relies on financial/accounting data.
    Picks up patterns in history: what
    accounting.structures prevail before defaults?
    2. Structural Method.
    Relies on Stock Market data.
    Variations on the seminal Merton Model.
    3. Reduced Form Method.
    Relies on Bond Market data.
    Relativistic framework (a la BDT for IR
    modeling).
    Empirical Method Failures
    The Enron and Worldcom bankruptcies in 2001
    highlight a fundamental problem with the
    empirical method. It is backward looking--both
    in terms of patterns relating accounting data to
    default and in terms of the actual data itself.
    Moodys Case Studies:
    Enron
    Worldcom
    Bally's
    Market-Adjusted Ratings
    Moodys notes that the standard bond ratings
    process may not be as accurate or timely as
    market-based information.
    They now market a product called Market Implied
    Ratings (MIR):
    Moodys MIR
    Structural Model in Practice
    Mertons model (also known as the Black-Scholes
    Model) is the benchmark structural model. All of
    the relevant information about the default risk of
    the company, and the price of that risk is
    contained in the stock market.
    In practice, the Moodys KMV model is probably
    the most widely used variant. While the KMV
    model is proprietary, much has been written about
    it by Moodys economists.
    KMV Features
    The benchmark riskfree rate is the swap curve--not the
    Treasury curve.
    There is time-varying market risk premium.
    There is a liquidity premium based on the firms access to
    capital markets.
    Expected Recovery is time-varying.
    Equity is treated as a perpetual down-and-out option on the
    firms assets.
    Bankruptcy trigger is a percentage (e.g., 70%) of total firm
    liabilities.
    The translation from the EqRNW default probability to the
    physical probability is made by comparing the two
    historically.
    Reduced Form Model
    A popular reduced form model is that of Hull and White.
    The term structure of EqRNW default probabilities is
    obtained from a series of Corporate and Treasury bonds.
    Example:
    5-Year 0-coupon Treasury yields 5%.
    5-Year 0-coupon Corporate yields 5.5%
    T = 100 exp(-.05 5) = 77.8801
    C = 100 exp(-.055 5) = 75.9572
    PV of cost of default = $1.9229.
    If we assume 0 recovery on default, then:
    100 (p) (exp(-.05 5) = 1.9229, where p is the EqRNW probability of
    default.
    p = 2.47%.
    Hull White Model
    Since there few 0-coupon corporates, the
    implementation of the model entails
    bootstrapping both the Treasury and Corporate
    yield curves. Also, recovery is not 0, so the
    recovery rate would be estimated using relevant
    historical data.
    Comparing Models
    Heres a link to a 2005 study from KMV that
    compares the Merton, Moodys KMV, and
    Hull-White models in terms of their ability
    to explain Credit Default Swap spreads.
    It is intriguing that the KMV model -- which
    uses stock market information--does a better
    job than the Hull and White model which
    uses bond market information.

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