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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 - PowerPoint PPT Presentation
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Fin431x (Ch 20&21) 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
Fin431x (Ch 20&21) 2
Overview of Credit AnalysisAnalysis of Covenant
Analysis of Collateral
Analysis of Issuer’s Ability to Pay
•Business risk
•Corporate governance risk
•Financial risk
Fin431x (Ch 20&21) 3
Analysis of Business Risk
• Business risk is the risk associated with operating cash flows, such as industry trends, operating environment, profitability, competition
Fin431x (Ch 20&21) 4
Corporate Governance Risk
Ownership structure of the corporationSee four key elements evaluated by S&P on
page 452.
Fin431x (Ch 20&21) 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
Fin431x (Ch 20&21) 6
Financial RiskCash 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 firmWorking 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.
Fin431x (Ch 20&21) 7
Case
Lear Corp. (LEA)
A high-yield bond
http://www.lear.com/index.jsp
Fin431x (Ch 20&21) 8
Credit Risk Modeling
Credit risk models are used to measure, monitor, and control a portfolio’s credit risk.
Difficulties:1. Credit default is a rare event2. Types of borrowers vary widely
Fin431x (Ch 20&21) 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
Fin431x (Ch 20&21) 10
Reduced-form Models
Treating default as an exogenous eventModel it with a Poisson processJarrow-turnbull ModelDuffie-Singleton Model
Fin431x (Ch 20&21) 11
Exercises
1. Question 4, chapter 20