TW3421x - An Introduction to Credit Risk Management Default Probabilities External credit ratings. Dr. Pasquale Cirillo.
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1 TW3421x - An Introduction to Credit Risk Management Default Probabilities External credit ratings Dr. Pasquale Cirillo Week 4 Lesson 2
2 Credit ratings A credit rating is meant to provide reliable information about credit quality. It can be a number, a combination of letters, but it is just of way of communicating a much more important quantity: the probability of default.
3 Credit ratings Baa1 AAA 2.5 A credit rating is meant to provide reliable information about credit quality. It can be a number, a combination of letters, but it is just of way of communicating a much more important quantity: the probability of default. Rating fully determines the PD of a company! CCC+
4 Credit ratings Credit ratings describe the creditworthiness of corporate bonds. A credit rating is indeed an attribute of a bond issue, NOT of a company.
5 Credit ratings Why do we say that a company has a certain rating then? Credit ratings describe the creditworthiness of corporate bonds. A credit rating is indeed an attribute of a bond issue, NOT of a company.
6 Rating agencies Moody s, S&P and Fitch are the 3 major rating agencies. They control more than 90% of the ratings market. Their ratings are considered comparable. These trademarks are the property of their respective owners. Their use here is only for didactic purposes.
7 Investment and speculative grades Investment Grade BBB-/Baa3 Speculative Grade
8 Example: S&P From S&P website
9 The stability of ratings One of the objectives of rating agencies is ratings stability. They try to avoid the so-called ratings reversal. This means that ratings change only when there is a clear reason to think that the creditworthiness of a company will experience a long-term change.
10 The stability of ratings One of the objectives of rating agencies Boom is ratings stability. They try to avoid the so-called ratings reversal. GDP Growth 0 Recession Recovery This means that ratings change only when there is a clear reason to think that Slump the creditworthiness of a company will experience a long-term change. Time Rating agencies rate through the cycle.
11 Two types of products Rating agencies typically provide two types of products, in terms of PD: Historical default probabilities. Equity-based predictions (in the cycle).
12 Two types of products Rating agencies typically provide two types of products, in terms of PD: Historical default probabilities. Today. Equity-based predictions (in the cycle). Next week (Merton, KMV, etc.)
13 Historical PD This table is a typical example of transition matrix, produced by rating agencies. It contains information about the possibility that a bond (company) in a given rating class moves to another class in 1 year. Rating at the end of the year (%) Initial Rating AAA AA A BBB BB B CCC DF AAA AA A BBB BB B CCC The last column contains the probability of default by the end of the year.
14 Historical PD This table is a typical example of transition matrix, produced by rating agencies. It contains information about the possibility that a bond (company) in a given rating class moves to another class in 1 year. Rating at the end of the year (%) Initial Rating AAA AA A BBB BB B CCC DF AAA AA A BBB BB B CCC The last column contains the probability of default by the end of the year.
15 Historical PD This table is a typical example of transition matrix, produced by rating agencies. It contains information about the possibility that a bond (company) in a given rating class moves to another class in 1 year. The last column contains the probability of default by the end of the year. Rating at the end of the year (%) Initial Rating AAA AA A BBB BB B CCC DF AAA AA A BBB BB B CCC These are historical data. To be more precise: averages over long time periods.
16 Historical PD This table is a typical example of transition matrix, produced by rating agencies. It contains information about the possibility that a bond (company) in a given rating class moves to another class in 1 year. The last column contains the probability of default by the end of the year. Rating at the end of the year (%) Initial Rating AAA AA A BBB BB B CCC DF AAA AA A BBB BB B CCC These are historical data. To be more precise: averages over long time periods.
17 Historical PD This table is a typical example of transition matrix, produced by rating agencies. It contains information about the possibility that a bond (company) in a given rating class moves to another class in 1 year. The last column contains the probability of default by the end of the year. Rating at the end of the year (%) Initial Rating AAA AA A BBB BB B CCC DF AAA AA A BBB BB B CCC These are historical data. To be more precise: averages over long time periods.
18 Historical PD This table is a typical example of transition matrix, produced by rating agencies. It contains information about the possibility that a bond (company) in a given rating class moves to another class in 1 year. The last column contains the probability of default by the end of the year. Rating at the end of the year (%) Initial Rating AAA AA A BBB BB B CCC DF AAA AA A BBB BB B CCC These are historical data. To be more precise: averages over long time periods.
19 Historical PD Rating agencies also produce cumulative PD over larger time horizons. What is the PD of a CCC bond by the end of the second year? What is the probability that the same bond defaults during the second year? PD increases over time Initial Years Rating AAA BBB B CCC This table only contains certain classes, just to save space.
20 Historical PD Rating agencies also produce cumulative PD over larger time horizons. What is the PD of a CCC bond by the end of the second year? What is the probability that the same bond defaults during the second year? Initial Years Rating AAA BBB B CCC This table only contains certain classes, just to save space.
21 Historical PD Rating agencies also produce cumulative PD over larger time horizons. What is the PD of a CCC bond by the end of the second year? What is the probability that the same bond defaults during the second year? Initial Years Rating AAA BBB B CCC This table only contains certain classes, just to save space =7.13
22 Unconditional PD Rating agencies also produce cumulative PD over larger time horizons. What is the PD of a CCC bond by the end of the second year? What is the probability that the same bond defaults during the second year? Initial Years Rating AAA BBB B CCC This table only contains certain classes, just to save space =7.13% unconditional PD
23 Conditional PD What is the probability that a CCC bond will default during the second year given that it does not default during the first year? The answer is the so-called conditional probability. Initial Years Rating AAA BBB B CCC This table only contains certain classes, just to save space.
24 Conditional PD We first compute the probability of not defaulting by the end of year 1, that is =80.21 (or ). As we have seen, the unconditional probability of defaulting during the second year is =7.13 (or ). Hence, the conditional probability is /0.8021=0.0889, or 8.89%. Initial Years Rating AAA BBB B CCC This table only contains certain classes, just to save space.
25 Hazard rates The ratings, and hence the PDs, we have seen so far are always defined in years: 1 year, 2 years, etc. What happens if we are interested in shorter periods? Even in this case, rating agencies provide short-term ratings. These ratings are related to hazard rates. The hazard rate (or default intensity) is the conditional probability of default computed for an infinitesimal time period of length!t 0.
26 Hazard rates The ratings, and hence the PDs, we have seen so far are always defined in years: 1 year, 2 years, etc. What happens if we are interested in shorter periods? Even in this case, rating agencies provide short-term ratings. These ratings are related to hazard rates. The hazard rate (or default intensity) is the conditional probability of default computed for an infinitesimal time period of length!t 0. Since we would need differential calculus to deal with hazard rates, we stop here. You simply have to remember that ratings can be defined also for very short periods.
27 Thank You
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