Transcript Measuring and Managing Credit Risk: Understanding the EDF

Measuring & Managing Credit Risk:
Understanding the EDF™ Credit Measure for Public Firms
2004
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
1: THE CRITICAL ISSUE IN CREDIT
2: CALCULATING THE EDF CREDIT MEASURE
3: TESTING THE EDF CREDIT MEASURE
AGENDA
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
SECTION
1
THE CRITICAL ISSUE IN CREDIT
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
The Critical Issue in Credit
• The critical element in successfully managing a
credit risk portfolio is that you must manage the
dynamics of credit risk
• Why? A handful of names whose risk has changed
explains most of the risk in credit portfolios
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
A Handful of Names Drive Most of the Risk
Managing outliers is important because a relatively
small segment that disproportionately drive risk –
most of the portfolio requires very little attention
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Objectives in Modeling Default Risk
• Measure credit risk in terms of default
probabilities rather than ordinal rankings
• Provide the most accurate forward-looking, causal
model
• Provide frequent updates and early warning of
changes in credit quality
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Validation
Moody’s KMV EDF credit measures
• Have been tested on over 29 years of data
representing over 4,000 defaults in the United States
alone, as well as on smaller samples in various
countries around the globe
• Outperform internal and agency ratings, simple
Merton models and statistical scoring models in
anticipating credit events and default
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDFs Predict Future Default Rates
Predicted and Actual Default Rates
Cohorts Reformed
16.63%
18.00%
EDF (Predicted)
16.00%
15.21%
Observed Default History
14.00%
12.00%
10.00%
8.00%
3.82% 3.57%
6.00%
4.00%
1.25% 1.05%
0.09% 0.07%
0.42% 0.44%
2.00%
0.00%
.02%-.20%
.21%-.70%
.71%-2.0%
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2.01%-7.0%
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7.01%-20%
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
The EDF Credit Measure
• EDF means Expected Default Frequency—the
probability that a firm will default within a given time
horizon
• We provide EDF term structures out to 5 years
• EDF Ranges from 2 to 2000 basis points
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
The EDF Credit Measure
• A company with a current EDF credit measure of 2%
has a 2% probability of defaulting within the next
twelve months. If we create a portfolio of 1000 such
companies, on average, 20 default over the next
year, and 980 do not.
• A company with a 2% EDF credit measure is 10
times more likely to default than a firm with a 0.20%
EDF credit measure.
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
SECTION
2
CALCULATING THE EDF CREDIT MEASURE
Expected Default Frequency for firms with publicly
traded equity
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Drivers to the EDF Credit Measure
• Leverage
– Market Value of Assets
vs.
– Book Value of Liabilities
• Risk
– Volatility of Asset Value
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Leverage
Market Value
of Assets
Defaulted
November 2001
Default Point
(Liabilities Due)
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
The Market Value of Assets
• The market value of the business, reflecting the equity
market’s expectations of future cash flows
• Not directly observable—implied from the market value of
equity and the book liabilities using option pricing theory
• Reflects deterioration & improvement before book assets or
earnings
• Market values are dynamic and forward looking; they are the
source of the model’s predictive power
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Calculating Market Value of Assets
• Equity derives its value from the cash flows of the firm.
• Equity is a call option on the firm’s assets: the right,
but not the obligation, to “buy” the firm’s assets from
the lender by re-paying the debt.
Standard Options Terms
KMV Approach (Vasicek/Kealhofer Model)
Call Option Value = Market Value of Equity
Strike Price = Book Liabilities
Implied Underlying Asset Value
Implies Market Value of Assets
For more quantitative detail, please see the Moody’s KMV paper Modeling Default Risk.
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Using Options Framework to Solve for
Market Value of Assets
Option
Value
We can calculate the
implied option value
0
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When we
know the
Asset Value,
and the Strike
Price
Strike Price
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Underlying
Asset Value
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Using Options Framework to Solve for
Market Value of Assets
Equity
Value
(Option
Value)
For public firms, we can
observe the “option value”
and the strike price
And Calculate the
Implied Asset Value
0
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Liabilities
Due
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Underlying
Asset Value
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
The Default Point
• A measure of the liabilities due in the event the firm
is in distress
• Non-cash and long-term obligations put less
financial stress on the firm
• Firms often increase leverage as they deteriorate
• The Default Point captures the point where the
typical firm defaults
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Default Point: An Example
Market Value of
Assets
Total Liabilities
Defaulted
Default Point
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Asset Volatility: A Measure of Business Risk
• The uncertainty around the market value of the
business
• Reflects the degree of difficulty in forecasting the
future cash flows
• Quantifies business risk: larger firms in the same
industry tend to have lower volatility
• Computed by “de-levering” Equity Volatility
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Asset Volatility: A Critical Driver
Rising Equity Market Cap
But a Dramatically
Higher EDF
Because of rising
Asset Volatility
Time
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Putting It All Together
Value
Distribution of
asset value at
horizon
Asset Volatility
(1 Std Dev)
Asset
Value
Distance-to-Default =
3 Standard deviations
Default Point
EDF
Today
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1 Yr
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Time
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
How do we move from Distance to Default to
a probability?
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
• We cannot use a
statistics textbook.
• The probability from the
Normal distribution is
too low.
• Credit risk isn’t normal!
• Statistics books don’t go
beyond 3.49—we see
firms that are 4-6
standard deviations from
default subsequently
defaulting.
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
From Distance-to-Default to EDF
• Moody’s KMV uses actual default rates for
companies in similar risk ranges to determine a
functional relationship
• Requires a large database of actual defaults
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
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Moody’s KMV Public Company Default Database
1973–2001
90
• Over 29 years of data
• Over 4,900 defaults
• Over 400,000 company-years
80
70
50
40
30
20
10
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01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
19
81
19
80
19
79
19
78
19
77
19
76
19
75
19
74
0
19
73
Number of Defaults
60
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Scaling DD to EDF
Form a “bucket of similar DD
companies 1/1/1978
4.8
4.8
1 year later, how many
have defaulted?
4.8
4.8
4.8
4.8
2 years later...
4.8
4.8
4.8
4.9 4.95 5.0
4.9 4.95 5.0
4.9 4.95 5.0
5.1
5.1
5.1
5.1
5.2
5.1
5.2
5.1
5.2
• Repeat the exercise for all ranges of DD
• Measure forward default observations for periods from 1 year to 5 years
• Form new buckets every year through the present and repeat steps
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Scaling DD to EDF Credit Measures
Expected
Default
Frequency
EDF
43 bp
Distance
to Default
DD 4s
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Summary: Measuring EDF
• Estimate asset value and asset volatility
– Equity is a call option on asset value
– Solve for implied asset value and volatility
• Calculate Distance to Default
– Contractual obligations determine Default Point
– Number of standard deviations from default
• Scale Distance to Default to EDF
– Assign EDF using actual historical default rates
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Credit Measures
• We have been working on developing EDF credit
measures and helping lenders and investors on real
credit portfolios since 1989.
• We are on about the 5th generation of the VasicekKealhofer EDF model.
• Experience pays off—we provide the most accurate
and timely assessment of credit and default risk.
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
SECTION
3
TESTING THE EDF CREDIT MEASURE
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Credit Measure Results
Can Market Information Improve Ratings?
• Moody’s KMV uses equity market information to
determine a firm’s probability of default: the EDF
credit measure.
• Here we sort the Non-Financial Single B firms on
12/31/92 by their EDF, as shown on the next slide.
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
103 B-Rated Firms as of 12/31/92
14
12
10
Number
of Firms
8
6
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Defaults 6 Months Later
14
12
10
Number
of Firms
8
6
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Defaults 1 Year Later
14
12
10
Number
of Firms
8
6
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Defaults 2 Years Later
14
12
10
Number
of Firms
8
6
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Defaults 3 Years Later
14
12
10
Number
of Firms
8
6
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Defaults 4 Years Later
14
12
10
Number
of Firms
8
6
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
Defaults 4 Years Later
14
Number
of Firms
12
• 103 Non-Financials Rated Single B as of December 1992
• 14 Defaults in 4 Years
• 13 defaults from the above-median EDF companies
10
• Non-Defaulting firms had 2.26% EDF
• Defaulting firms had 13.89% EDF
8
6
Equally rated firms are not the same risk
Market data can add precision to traditional
analysis and accounting-based evaluations
4
2
0
0.150.65
Low Risk
0.671.14
1.152.04
2.162.63
2.693.33
EDF Range
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3.695.32
5.648.49
8.8420.00
High Risk
40
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Predictive Power
Random
Chance
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Provides Early Warning
EDF Prior to Default
Total Universe
10
9
8
7
Median EDF of firms
that subsequently
default
6
5
Weakest Quartile
EDF all firms
4
3
2
1
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-1
0
s
yr
-2
s
yr
-3
s
yr
-4
s
yr
1 to 60 Months Prior to Default
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yr
Benchmark: Median EDF
for period for all firms
0
-5
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Provides Early Warning
EDF Prior to Default
Total Universe
10
9
8
Weakest Quartile EDF, firms
that subsequently default
7
6
5
Weakest Quartile
EDF all firms
4
3
1
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-1
0
s
yr
-2
s
yr
-3
s
yr
-4
s
1 to 60 Months Prior to Default
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yr
Benchmark: Median EDF
for period for all firms
0
yr
Median EDF of firms
that subsequently
default
Best Quartile EDF, firms
that subsequently default
2
-5
42
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Provides Early Warning
EDF Prior to Default
Total Universe
10
9
8
Weakest Quartile EDF, firms
that subsequently default
7
6
5
Median EDF of firms
that subsequently
default
Weakest Quartile
EDF all firms
4
3
Best Quartile EDF, firms
that subsequently default
2
1 to 60 Months Prior to Default
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0
-2 yrs
-3 yrs
-4 yrs
0
-1 yr
Benchmark: Median EDF
for period for all firms
1
-5 yrs
43
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
EDF Predictive Power
Validated Defaults in Firms with $300mm or more in sales
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45
Upgrade/Downgrade Study
90%
85%
Non-investment
Downgrades
80%
Non-investment grade
Upgrades
75%
Investment grade
Upgrades
70%
65%
Investment grade
Downgrades
60%
55%
50%
-12
-9
-6
-3
Months before upgrade/downgrade
-1
The test was fairly conservative – to signal a ratings change, a firm had to have an EDF™
credit measure that indicated a full notch or more difference at the point X months ahead
of the rating change. This means the EDF had to be 2 or more times the EDF of its grade.
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Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
To Learn More
Please contact your Moody’s KMV client representative or visit us
online at www.moodyskmv.com.
Contact Moody’s KMV via e-mail at [email protected]
or call us at:
NORTH AND SOUTH AMERICA, CALL:
+1 (866) 321-MKMV (6568) or +1 (415) 296-9669
EUROPE, THE MIDDLE EAST, AFRICA, CALL:
+44 (20) 7778-7400
ASIA PACIFIC, CALL:
+81 (3) 3218-1160
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