Managing Financial Risk Week VII Notes
Managing Financial Risk Week VII Notes BU.230.730.53.SP16
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This 2 page Class Notes was uploaded by Kwan on Tuesday May 3, 2016. The Class Notes belongs to BU.230.730.53.SP16 at Johns Hopkins University taught by Nicola Fusari in Spring 2016. Since its upload, it has received 32 views. For similar materials see Managing Financial Risk in Finance at Johns Hopkins University.
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Date Created: 05/03/16
Risk VII Tuesday, May 3, 15:41 1. Introduction to Corporate Default 2. Rating Agencies and Credit Rating 3. The Merton Model 4. Vasicek Model 5. Review of the main concepts Corporate Default Denition: Credit Risk refers to the possibility of incurring a loss as a result of the counterparty not being able to meet its nancial obligations. Example: when you enter into a long forward contract you are exposed to the risk that your counterparty will not deliver the underlying of the forward contract. Example: when you buy a corporate or a sovereign debt, you are bearing the cost associated with the probability of the rm defaulting or the country not repaying the obligation. Ratings Investment Grades Aaa: highest quality, minimal credit risk Aa: high quality, low credit risk A: upper-medium quality, low credit risk Baa: medium quality, moderate credit risk Speculative Grades Ba: speculative element, substantial credit risk B: speculative, high credit risk Caa: poor quality, very high credit risk Ca: highly speculative, likely or very close to default C: lowest quality, typically in default Merton Model: implementation Up to now everything seems pretty similar to what we have done for the valuation of financial options. However now we have different inputs in our formula. Merton Model: implementation Up to now everything seems pretty similar to what we have done for the valuation of financial options. However now we have different inputs in our formula. Instead of the stock price (St) and its volatility, now we have the assets value (At) and the volatility of the asset (A), which are both unobservable! We would like to use observable quantities to say something about At and A. All we can observe are the stock price (assuming that the company in quoted on the market) and we can estimate its volatility. Risk Neutral vs Real Probabilities The probabilities provided for example by Moody's are based on real defaults of companies and are "real" probabilities (RP). When computing VaR and ES those are the probabilities that you should be using. The Merton Model and the Vasicek Model are pricing models (like Black and Scholes) and as such they deliver risk-neutral probabilities (RNP).RNP are dierent form RP and are in general larger. If you have to evaluate a nancial product written on the value of the rm you should be using the RNP. Some companies provide as a service a wayto transform RNPinto RP.This is not theoretically easy to do and it is subject to a lot of discretion in how to do it. The main idea is that the ranking of RNPand RP is the same.