Analysis Of Credit Risk
Consider our previous example where we were evaluating a 3 year, $100 par, zero coupon corporate bond. Its recovery rate is 60% and benchmark rates are flat at 3%. We calculated the exposures at the end of Years 1, 2, and 3 as $94.26, $97.09, and $100, respectively.
CVA was calculated as $2.15. The bond price today = value of risk free bond − CVA = . Assume that default only occurs at year end.
The cash flows on this bond in the event of default and corresponding internal rate of return (IRR), as well as the IRR if the bond does not default, are shown in Figure 26.1.
Figure 26.1: Expected Rates of Return
At the end of Year 1, there are two possible outcomes: default or no default. If default occurs, a recovery of 60% of exposure or 0.6 × 94.26 = $56.56 occurs. Similarly, in Years 2 and 3, in case of default, the recovery amounts are $58.25 and $60, respectively.
If the bond defaults in Year 1, the investor’s IRR is calculated as:
Similarly, the IRR in case default occurs in Years 2 and 3 are:
If the bond does not default over its life, the investor would earn an IRR of:
Relative Credit Risk Analysis
While comparing the credit risk of several bonds, the metric that combines the probability of default as well as loss severity is the expected loss. Everything else constant, for a given period, the higher the expected loss, the higher the credit risk.
Elsa Jaitley is comparing three corporate bonds for inclusion in her fixed income portfolio. For the next year, Jaitley has collected the following information on the three bonds:
On a relative basis, which bond has the highest risk? Based on this information, what would be an appropriate trading strategy?
Solution
Credit risk can be evaluated based on the expected loss.
Since the exposure and recovery amounts are given per $100 par,
For example, for bond Y, LGD = 88 − 45 = $43.
Based on expected loss, Bond Z is the most risky while Bond Y has the least credit risk.
Because we are not given the market price of the three bonds, no trading strategy can be recommended based on only this information.