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Credit Rating

Credit-risk arises from the possibility that borrowers, bond


issuers, and counter-parties in derivatives transactions may
default.
Ratings changes relatively infrequently.
Ratings change only when there is reason to believe that a
long-term change in the firms creditworthiness has taken
place.
Rating agencies try to rate through the cycle.
Internal credit ratings: The internal ratings based (IRB)
approach in Basel II allows bank to use their internal ratings
in determining the probability of default, PD.
Under the advanced IRB approach, they are also allowed to
estimate the loss given default, LGD, the exposure at
default, EAD, and the maturity, M.

Altmans Z-score
For publicly traded manufacturing companies, the
original Z-score was
Z = 1.2*working capital + 1.4*Retained earnings + 3.3*
EBIT + 0.6*Market value of equity + 0.999*sales
If Z-score > 3, the firm is unlikely to default. If it is
between 2.7 and 3.0, we should be on alert. If it is
between 1.8 and 2.7, there is a good chance of default.
If it is less than 1.8, the probability of a financial
embarrassment is very high.

Historical Default Probability


For investment-grade bonds, the probability of default in
a year tends to be an increasing function of time.
For bonds with a poor credit rating, the probability of
default is often a decreasing function of time.

Default intensities (hazard rate)


(t) at t is defined so that (t)t is the probability of
default between time t and t +t conditional on no
default between time 0 and time t.

Recovery rates: the bonds market value immediately


after a default as a percent of its face value = 1 LGD.
Recovery rates are significantly negatively correlated
with default rates.
Average recovery rate = 0.52 6.9*average default rate.
A bad year for the default rate is usually doubly bad
because it is accompanied by a low recovery rate.

Recovery Rates

Recovery rates are significantly negatively correlated


with default rates.

Credit Default Swaps

A Credit Default Swap (CDS) is a contract in which a buyer pays a


payment to a seller to take on the credit risk of a third party.

In exchange, the buyer receives the right to a payoff from the seller if
the third party goes into default or on the occurrence of a specific credit
event named in the contract (such as bankruptcy or restructuring).

To give an example
Say there is a person A who lends Rs. 1000 to person B on Monday. Person
B promises to pay him back on Friday. But there is a possibility that person
B may default in paying back person A in the event of a bankruptcy etc.

Therefore, person A gets into a contract with a person C to take over the
credit risk of this transaction, in case person B defaults.

According to the contract, person A pays a one-time premium of Rs. 100


to person C.

Now, imagine two situations


Situation A: Person B pays back Rs. 1000 to person A. Since person B has
not defaulted, the transaction ends between persons A & B, and also
between persons A & C.

Situation B: Person B defaults in his payment to person A. Now, according


to the contract between persons A & C, It becomes the obligation of person
C to pay back Rs. 1000 to person A.

Diagrammatically explaining
Person B (Borrows Money
from A)

Person C (takes
on the credit risk
of B)

Person A (lends money to B


& enters into a contract with
C)

Therefore
This contract, which:

Transfers the credit risk from one person to another


Is exercised when one party defaults in its payment
Consists of a swap of a buyer and a seller (in our example, person A
is a seller to person B and a buyer to person C)

is called a Credit Default Swap.

Now
One party of the CDS contract is called the protection buyer while the
other party is called the protection seller.

Protection Buyers are mostly banks and financial institutions but


Protection Sellers could be anybody with an appetite for risk, such as
hedge funds and insurers in the US.

In all CDS contracts, a protection buyer transfers his Credit Risk of a third
party transaction to a protection seller.

So what is Credit Risk?


Credit risk is the risk involved in all transactions of borrowing and lending. If you
lend money, what are the chances that the borrower will make the repayment?

In case the borrower is likely to promptly return the money, then you have a low
credit risk, and in case there is a high probability of default then you have a high
credit risk.

So each borrowing and lending has its own element of risk involved.

Types of credit events

Bankruptcy : where the reference entity becomes bankrupt


or suffers an analogous
Failure to pay : where the reference entity fails to make a
payment of interest or principal
Obligation default : where the reference entity defaults on
one of its obligations
Repudiation/Moratorium : where the reference entity
repudiates or declares a moratorium over some or all of its
debts
Restructuring : where the reference entity arranges for
some or all of its debts to be restructured causing a
material change in their credit worthiness

Heres another diagram

So
A credit default swap resembles an insurance policy. You pay the
premium and the insurance company undertakes to make good your
loss.

So, everything depends on the happening of the credit event. If no default occurs
then the protection seller would not make any payment.

Also
Like any other Over The Counter (OTC) derivatives contract, CDS contracts
are negotiated directly between the two parties.

But most of these contracts follow the standard terms and conditions of
the International Swaps and Derivatives Association (Isda), which
makes them look like a standardized product.

To sum Up
A Credit Default Swap (CDS) is a credit derivative contract between two
counterparties, whereby the "buyer" pays periodic payments to the "seller" in
exchange for the right to a payoff if there is a default or credit event in
respect of a third party.

They typically apply to municipal bonds, corporate debt and mortgage


securities and are sold by banks, hedge funds and others.

Like most financial derivatives, credit default swaps can be used to hedge
existing exposures to credit risk, or to speculate on changes in credit spreads.

Credit Spread

Acredit spreadis the difference in yield between two bonds


of similar maturity but differentcreditquality.
A credit spread can also refer to an options strategy where
a highpremiumoption is sold and a low premium option is
bought on the sameunderlying security.
As thedefault riskof the issuer increases, its spread
widens.
Credit spreads also fluctuate due to changes in expected
inflation and changes in the supply of credit and demand
for investment within particular markets.

Asset swap
Asset swaps provide a convenient reference point for
traders in credit markets because they give direct
estimates of the excess of bond yields over LIBOR or
swap rates.

CDS Spreads and Bond Yields


A CDS can be used to hedge a position in a corporate bond.
Suppose that an investor buys a five-year corporate bond
yielding 7% per year for its face value and at the same time
enters into a five-year CDS to buy protection against the
issuer of the bond defaulting.
Suppose that the CDS spread is 200 basis points or 2% per
annum. The effect of the CDS is to convert the corporate
bond to a risk-free bond (at least approximately).
If the bond issuer does not default, the investor earns 5%
per year (when the CDS spread is netted against the
corporate bond yield).

If the bond issuer does default, the investor earns 5%


up to the time of the default. Under the terms of the
CDS, the investor is then able to exchange the bond for
its face value.
This face value can be invested at the risk-free rate for
the remainder of the five years.
This argument shows that the n-year CDS spread should
be approximately equal to the excess of the par yield on
an n-year corporate bond over the par yield on an n-year
risk-free bond.
CDSBond Basis = CDS Spread Bond Yield Spread

ESTIMATING DEFAULT PROBABILITIES


FROM CREDIT SPREADS
= s(T) /1 R
where s(T) is the credit spread (which should in theory
be expressed with continuous compounding) for a
maturity of T,
R is the recovery rate,
and is the average hazard rate between time zero and
time T