978-1118999493 Chapter 6 Lecture Note

subject Type Homework Help
subject Pages 3
subject Words 625
subject Authors Barbara S. Petitt, Jerald E. Pinto, Wendy L. Pirie

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31
CHAPTER 6
CREDIT ANALYSIS MODELS
PROBLEMS
2013 by CFA Institute.
Campbell Fixed Income Analytics provides credit analysis services on a consulting basis to
fixed income managers. A new hire, Liam Cassidy, has been asked by his supervisor, Malcolm
Moriarty, to answer some questions and to analyze a corporate bond issued by Dousing
Dragons (DD). Moriarty is trying to assess Cassidys level of knowledge.
Moriarty asks Cassidy:
“Why are clients willing to pay for structural and reduced form model analytics when
they can get credit ratings for free?”
Cassidy identifies the following limitations of credit ratings:
Limitation A e issuer-pays model may distort the accuracy of credit ratings.
Limitation B Credit ratings tend to vary across time and across the business cycle.
Limitation C Credit ratings do not provide an estimate of a bond’s default probability.
Cassidy is asked to consider the use of a structural model of credit risk to analyze DD’s
bonds. Cassidy knows that holding DD’s equity is economically equivalent to owning a type of
security that is linked to DD’s assets. However, Cassidy cannot remember the type of security
or why this is true. Moriarty provides a hint:
“It is true because equity shareholders have limited liability.
Moriarty asks Cassidy to analyze one of DD’s bonds using data presented in Exhibit 1 and
a reduced form model.
32 Part I: Learning Objectives, Summary Overview, and Problems
EXHIBIT 1 Dousing Dragons, Inc. Credit Analysis Worksheet
Coupon rate: 0.875% Coupon Payments: Semiannual
Face value: 1,000
Today’s date: August 15, 2014 Maturity date: August 15, 2018
Payment
dates:
Risk-Free
Zero
Coupon
Yields
(%)
Credit
Spread
(%)
Total
Yield
(%)
Years to
Maturity
Discount
Factor
Cash
Flow
Present
Value
Risk-Free
Discount
Factor
Risk-Free
Present
Value
2/15/2015 0.13 0.12 0.25 0.50 0.99880 4.38 4.3747 0.9994 4.3774
8/15/2015 0.20 0.24 0.44 1.00 0.99560 4.38 4.3607 0.9980 4.3712
2/15/2016 0.23 0.31 0.54 1.50 0.99200 4.38 4.3450 0.9966 4.3651
8/15/2016 0.28 0.37 0.65 2.00 0.98710 4.38 4.3235 0.9944 4.3555
2/15/2017 0.32 0.38 0.70 2.50 0.98270 4.38 4.3042 0.9920 4.3450
8/15/2017 0.35 0.39 0.74 3.00 0.97810 4.38 4.2841 0.9896 4.3344
2/15/2018 0.44 0.43 0.87 3.50 0.97010 4.38 4.2490 0.9848 4.3134
8/15/2018 0.47 0.46 0.93 4.00 0.96370 1,004.38 967.9210 0.9814 985.6985
Total value: 998.1623 1,016.1606
Moriarty also asks Cassidy to discuss the similarities and differences in the analysis of
asset-backed securities (ABS) and corporate debt. Cassidy states that:
Statement 1. Credit analysis for ABS and corporate bonds incorporates the same credit
measures: probability of default, expected loss, and present value of ex-
pected loss.
Statement 2. Credit analysis for ABS and corporate bonds is different due to their
future cash flow structures.
Statement 3. Credit analysis for ABS and corporate bonds can be done using either a
structural or a reduced form model.
1. Which of Cassidys stated limitations of credit ratings is incorrect?
A. Limitation A
B. Limitation B
C. Limitation C
2. Given Moriartys hint, Cassidy should most likely identify the type of security as a European:
A. put option.
B. call option.
C. debt option.
3. e model chosen by Moriarty to analyze one of DD’s bonds requires that:
A. the equity of DD is traded.
B. the assets of DD are traded.
C. some of the debt of DD is traded.
Chapter 6 Credit Analysis Models 33
4. Compared to a structural model, which of the following estimation approaches will
Moriartys choice of credit model allow him to use?
A. Implicit
B. Historical
C. Calibration
5. Compared to a structural model, an advantage of the model chosen by Moriarty to ana-
lyze DD’s bond is most likely that:
A. its measures reflect the changing business cycle.
B. it requires a specification of the companys balance sheet.
C. it is possible to estimate the expected present value of expected loss.
6. Based on Exhibit 1, the present value of the expected loss due to credit risk on the bond
is closest to:
A. 1.84.
B. 16.16.
C. 18.00.
7. Based on Exhibit 1, the present value of the expected loss due to credit risk relating to the
single promised payment scheduled on February 15, 2017, is closest to:
A. 0.04.
B. 0.08.
C. 0.11.
8. Which of Cassidys statements relating to the similarities and differences between the
credit analysis of ABS and corporate bonds is incorrect?
A. Statement 1
B. Statement 2
C. Statement 3

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