Bonds above BBB rating are considered investment grade, while lower rated bonds are considered speculative.
3 ways to estimate bond default probabilities
Historical: collect data from firms that start w/ same credit rating
From bond price: bond price already reflects expected loss from default. Approximate: s = h(1 - R). Exact: PV(loss) = PV(bond @ rf) - PV(bond @ y)
Using equity price: unless the 2 previous techniques this one is not subject to infrequently updated ratings. Instead it infers the bond price at any time from firm's stock price, where p(default) = N(-d2)
3 credit risk mitigation methods
Netting: net any transaction for which money is due against amts that may be owed to that same counterparty
Collateral requirementes: in form of cash or mktable securities
Downgrade trigger: certain actions occur upon credit downgrade
2 approaches to model default bond correlation
Structural models: correlate stochastic processes
Reduced form models: assume hazard rates for different companies follow a stochastic process and are correlated w/ macroeconomic variables
Multivariate distribution of 2 or more rdm variables which are both between 0 and 1. It can be used to describe the degree to which 2 or more probabilities are dependent on each other.
Suppose tA and tB are the times to default
x = N-1[Q(t)]
, where Q(t) is the cum p(default)
Then x is a normally dist rdm var
The joint probability of A and B defaulting can be generated from a multivariate normal dist by calculating the prob of observing these transformed variables xA and xB from a joint standard normal dist w/ a correlation coeff ρ
One-factor model:xi = ai + √(1 - ai²)Zi
Q(T|F) = N[N-1[Q(t)] - √(ρ)F] / √(1 - ρ)
Attempts to determine a dollar amt that credit losses will not exceed w/ some high prob.