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Credit Rating and Credit Risk Modeling

Credit Rating and Credit Risk Modeling. 1. Major components of corporate bond credit analysis 2. Business risk 3. Corporate Governance Risk 4. Financial Risks 5. Alternative credit risk models. Overview of Credit Analysis. Analysis of Covenant Analysis of Collateral

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Credit Rating and Credit Risk Modeling

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  1. Credit Rating and Credit Risk Modeling 1. Major components of corporate bond credit analysis 2. Business risk 3. Corporate Governance Risk 4. Financial Risks 5. Alternative credit risk models

  2. Overview of Credit Analysis • Analysis of Covenant • Analysis of Collateral • Analysis of Issuer’s Ability to Pay • Business risk • Corporate governance risk • Financial risk

  3. Analysis of Business Risk • Business risk is the risk associated with operating cash flows, such as industry trends, operating environment, profitability, competition

  4. Corporate Governance Risk • Ownership structure of the corporation • See four key elements evaluated by S&P on page 452.

  5. Financial Risk • Interest rate coverage ratio: measuring the number of times interest charges are covered on a pretax basis. One is defined as EBITDA/interest expenses. See page 454. • Leverage ratio – example is the ratio of total debt to EBITDA for a trailing 12-month period

  6. Financial Risk • Cash flow: see alternative cash flow measures on page 455: company with a high percentage of assets in cash and marketable securities is in a much stronger position than a company whose primary assets are illiquid real estate. • Net assets: may refer to liquidation value of a firm • Working capital: the stronger the companies liquidity measure, the better it can weather a downturn in business and reduction in cash flow. – should look at different items as well.

  7. Case • Lear Corp. (LEA) • A high-yield bond • http://www.lear.com/index.jsp

  8. Credit Risk Modeling • Credit risk models are used to measure, monitor, and control a portfolio’s credit risk. • Difficulties: • Credit default is a rare event • Types of borrowers vary widely

  9. Structural Models • Originated from option pricing models where common stockholders can be viewed as having a call option on the value of the assets with the right being granted by the bondholders • BSM – page 497. • The option is triggered when the firm defaults

  10. Reduced-form Models • Treating default as an exogenous event • Model it with a Poisson process • Jarrow-turnbull Model • Duffie-Singleton Model

  11. Exercises • Question 4, chapter 20

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