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Credit Risk and Credit Modeling

Credit Risk and Credit Modeling. Mingsung Tang mingsung.tang@bofasecurities.com April 26, 2004 Banc of America Securities, Credit Strategy Group. Two different views of credit risk. Credit risk for buy-and-hold investors Typical users: bank loan portfolios, insurance company portfolios

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Credit Risk and Credit Modeling

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  1. Credit Risk and Credit Modeling Mingsung Tangmingsung.tang@bofasecurities.comApril 26, 2004Banc of America Securities, Credit Strategy Group

  2. Two different views of credit risk • Credit risk for buy-and-hold investors • Typical users: bank loan portfolios, insurance company portfolios • Mission: control and manage ultimate losses • Concerns: economic / agency / regulatory capital • Tools: risk ratings / scores, risk limits, industry concentrations • Preference: stability, predictability, not be “arb”-ed • Credit risk for total-return investors • Typical players: mutual funds, hedge funds, trading desks • Mission: mark-to-market value gains / losses • Concerns: relative value considerations • Tools: hedging, rating arbitrage, capital structure arbitrage, relative value • Preference: volatility, “arb”

  3. High grade corporate bond market

  4. Recent defaults of high grade issuers …

  5. … and fallen angels

  6. Historical default rates (source: Moody’s)

  7. Risk and reward

  8. We didn’t start the fire …

  9. A real world example

  10. Portfolio tail risk

  11. Tracking tail risk

  12. The efficiency frontier

  13. The landscape of credit risk models

  14. New tools for credit and portfolio analysis • Credit OAS Model • Links credit market with equity market and option market through Merton’s model (1974) • Generates forward-looking credit risk and relative value measures that help to avoid credit “blow-ups” before they happen • Well-suited to bank and finance companies • A step up from traditional equity based credit models • Lighthouse • Credit OAS Model for portfolios • Saddle-Point Methodology provides semi-closed form solution for portfolio tail risk without restrictions on distribution assumption • Calculates portfolio’s tail risk and each underlying credit’s contribution to portfolio tail risk • Customized optimization module that generates optimal hedging allocations

  15. Risk concentration on the move …

  16. … or not

  17. The valuation of debt in Merton’s model Issuer’s Asset: Current Value = $10 billion Value Change = “Random Walk” Asset Volatility = 50% Dividend Distribution = 0% Risk Free Rate = 3% Proposed Debt Issue: Face Amount = $5 billion Maturity = 5 years Coupon = 0% Question: Value of Debt? Debt Value = $4.30 - Put = $4.30 - BS ( S, X, r, T,  ) Assume that r = 3%, Debt Value = $4.30 - $0.87 = $3.43, Credit Spread = 454 bps

  18. The credit “cliff” …

  19. Use equity price to predict credit spread …

  20. Implied volatility tells more about credit …

  21. Credit OAS illustrated

  22. Defining Credit Risk Expected Spread Widening Credit Risk = Expected Spread Widening x Duration

  23. Credit OAS in action: WCOM

  24. Credit OAS on the Web (www.bofa.com/coas)

  25. Sector summary

  26. Issuer Home Page

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