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The main aim of this paper is to present basic characteristics of CreditMetrics model and its model application. The importance of accurate credit risk quantification is growing nowadays in global economy just like in local economies. CreditMetrics approach is designed to measure the risk of credit loss caused by changes in the creditworthiness of borrowers. Loss does not occur only in the case of counterparty's default, but also upon its transition into worse rating category. The output of this model, however, is the entire distribution function of portfolio value. We will present application of this method for single bond. For this purpose we will use analytical method. We will use methods of formal logic such as: analysis, synthesis, deduction and comparison. The result will be comprehensive overview of CreditMetrics results under the conditions of local economy. We will also mention test results of various renowned agencies, which reflect the accuracy of this model.
This study extends the literature on the pricing of low-grade bonds by examin- ing the performance of low-grade bond funds. The findings reveal that over the long run low-grade bond fund returns are approximately equal to the returns provided by an index of high-grade bonds. The relative risks of high and low-grade bonds are more difficult to assess. Because of their shorter durations, low-grade bonds are less sensitive to movements in interest rates than high-grade bonds. On the other hand, low-grade bonds are much more sensitive to changes in stock prices than high-grade bonds. When adjusted for risk using a simple two-factor model, the returns on low- grade bond funds are not statistically different from the returns on high-grade bonds. The Journal ofFinance, Vol. XLVI, No. 1 (March 1991), pp. 28-48. (Reprinted with permission of The Journal of Finance.)
This book brings together classic writings on the economic nature and organization of firms, including works by Ronald Coase, Oliver Williamson, and Michael Jensen and William Meckling, as well as more recent contributions by Paul Milgrom, Bengt Holmstrom, John Roberts, Oliver Hart, Luigi Zingales, and others. Part I explores the general theme of the firm's nature and place in the market economy; Part II addresses the question of which transactions are integrated under a firm's roof and what limits the growth of firms; Part III examines employer-employee relations and the motivation of labor; and Part IV studies the firm's organization from the standpoint of financing and the relationship between owners and managers. The volume also includes a consolidated bibliography of sources cited by these authors and an introductory essay by the editors that surveys the new institutional economics of the firm and issues raised in the anthology.
This chapter analyzes and measures the association between aggregate default and recovery rates on corporate bonds, and seeks to empirically explain this critical relationship. After a brief review of the way credit-risk models explicitly or implicitly treat the recovery rate variable, Section 13.2 examines the recovery rates on corporate bond defaults over the period 1982-2002. We attempt to explain recovery rates by specifying rather straightforward linear, logarithmic, and logistic regression models. The central thesis is that aggregate recovery rates are basically a function of supply and demand for the securities. Our econometric univariate and multivariate time-series models explain a significant portion of the variance in bond recovery rates aggregated across all seniority and collateral levels. In Sections 13.3 and 13.4 we briefly examine the effects of the relationship between defaults and recoveries on credit VaR (value at risk) models as well as on the procyclicality effects of the new capital requirements proposed by the Basel Committee, and then conclude with some remarks on the general relevance of our results. Credit-risk models can be divided into three main categories: (1) first generation structural-form models, (2) second generation structural-form models, and (3) reduced-form models. Rather than going through a discussion of each of these well-known approaches and their advocates in the literature, we refer the reader to our earlier report for ISDA (2001) which carefully reviews the literature on the conceptual relationship between the firm’s probability of default (PD) and the recovery rate (RR) after default to creditors.*
This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the 'separation and control' issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears the costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.
In 1985 the EC Commission announced its 1992 single market initiatives. To a significant extent these initiatives — which had been promised at the inception of the Europe Common Market about 30 years earlier but never implemented — were the result of increasing confidence among European statesmen that deregulated private-sector economic activity could produce superior growth performance among the EC countries than would continuation of government income policies and other forms of direct intervention in markets. The renewed confidence in the private sector followed bold but successful economic reforms undertaken in Britain and France, deregulation of financial services, and privatization of an array of government enterprises, including several that had previously been heavily subsidized by the state.
We assess whether two popular accounting-based measures, Altman’s (1968) Z-Score and Ohlson’s (1980) O-Score, effectively summarize publicly-available information about the probability of bankruptcy. We compare the relative information content of these Scores to a market-based measure of the probability of bankruptcy that we develop based on the Black–Scholes–Merton option-pricing model, BSM-Prob. Our tests show that BSM-Prob provides significantly more information than either of the two accounting-based measures. This finding is robust to various modifications of Z-Score and O-Score, including updating the coefficients, making industry adjustments, and decomposing them into their lagged levels and changes. We recommend that researchers use BSM-Prob instead of Z-Score and O-Score in their studies and provide the SAS code to calculate BSM-Prob.
This study compares the market value of firms that reorganize in bankruptcy with estimates of value based on management's published cash flow projections. We estimate firm values using models that have been shown in other contexts to generate relatively precise estimates of value. We find that these methods generally yield unbiased estimates of value, but the dispersion of valuation errors is very wide-the sample ratio of estimated value to market value varies from less than 20% to greater than 250%. Cross-sectional analysis indicates that the variation in these errors is related to empirical proxies for claimholders' incentives to overstate or understate the firm's value.
Size of the MarketDistressed Securities InvestorsInvestment StrategiesCapital Structure ArbitrageBonds Versus Loans
This paper provides empirical evidence that takeovers can facilitate the efficient redeployment of assets of bankrupt firms. Bidders for bankrupt firms are generally in related industries and often have some prior relationship to the target, suggesting they are well informed with respect to both the value and best use of the target's assets. For a sample of 55 acquisitions in Chapter 11, we find that firms merged with bankrupt targets show significant improvements in operating performance, while matching non-bankrupt transactions show no significant improvement. We also find positive and significant abnormal stock returns for the bidder and bankrupt target at the announcement of the acquisition.Journal of Economic LiteratureClassification Numbers: G33, G34.
This study provides evidence that transactions costs discourage debt reductions by financially distressed firms when they restructure their debt out of court. As a result, these firms remain highly leveraged and one-in-three subsequently experience financial distress. Transactions costs are significantly smaller, hence leverage falls by more and there is less recurrence of financial distress, when firms recontract in Chapter 11. Chapter 11 therefore gives financially distressed firms more flexibility to choose optimal capital structures.
In this article we discuss a scoring system (EMS model) for emerging markets corporate bonds. The scoring system provides an empirically based tool for the investor to use in making relative value determinations. The EMS model is an enhanced version of the statistically proven Z-score model (Altman, 1968) designed for US companies. Unlike the original Z-score model, our approach can be applied to non-manufacturing companies and manufacturers, and is relevant for privately held and publicly owned firms. The adjusted EMS model incorporates the particular credit characteristics of emerging markets companies, and is best suited for assessing relative value among emerging markets credits. The EMS model combines fundamental credit analysis and rigorous benchmarks together with analyst-enhanced assessments to reach a modified rating, which can then be compared with agency ratings (if any) and market levels. We have included a summary of Mexican companies for which we have applied the EMS model.
This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a ''spot exchange rate.'' Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps.
Four types of bankruptcy prediction models based on financial statement ratios, cash flows, stock returns, and return standard deviations are compared. Based on a sample of bankruptcies from 1980 to 1991, results indicate that no existing model of bankruptcy adequately captures the data. During the last fiscal year preceding bankruptcy, none of the individual models may be excluded without a loss in explanatory power. If considered in isolation, the cash flow model discriminates most consistently two to three years before bankruptcy. By comparison, the ratio model is the best single model during the year immediately preceding bankruptcy. Quasi-jack-knifing procedures suggest that none of the models can reliably predict bankruptcy more than two years in advance.
Eastern Airlines' bankruptcy illustrates the devastating effect on firm value of court-sponsored asset stripping, i.e., the use of creditors' collateral to invest in high-variance negative net present value projects. During its bankruptcy, Eastern's value dropped over 50%. A substantial portion of this value decline occurred because an overprotective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear that Eastern should have been shut down. The failure of Eastern's Chapter 11 demonstrates the importance of having a bankruptcy process that protects a distressed firm's assets, not simply from a run by creditors, but also from overly optimistic managers and misguided judges.
We estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. Our estimates for 1951 to 2000, 2.55 percent and4.32 percent, are much lower than the equity premium produced by the average stock return,7.43 percent. Our evidence suggests that the high average return for 1951 to 2000 is due to a decline in discount rates that produces a large unexpected capital gain. Our main conclusion is that the average stock return of the last half-century is a lot higher than expected.
We investigate the financial recontracting of firms completing distressed exchanges and those reorganizing under Chapter 11. We find that recovery rates for creditors, on average, are higher in distressed exchanges than in Chapter 11 reorganizations, as are equity deviations from absolute priority. The difference in deviations potentially provides valuable information on the higher costs of formal reorganization. Also, cash is used more extensively to redeem creditors' claims in Chapter 11 than in distressed exchanges. The greater use of cash can be attributed to provisions of the Bankruptcy Code that permit conservation of cash and facilitate asset sales.
We provide comprehensive data on the attributes and outcomes of the restructuring process for a sample of 49 financially distressed firms that restructured by means a prepackaged bankruptcy. Our findings complement previous research on out-of-court restructurings and traditional Chapter 11 filings. By most measures, including the time spent in reorganization, the direct fees as a percent of pre-distress assets, the recovery rates by creditors, and the incidence of violation of absolute priority of claimholders, we find that prepacks lie between out-of-court restructurings and traditional Chapter 11 bankruptcies.
We report that 31% of the firms completing leveraged recapitalizations between 1985 and 1988 subsequently encounter financial distress. Following their recaps, the distressed firms exhibit (1) poor operating performance due largely to industry-wide problems, (2) surprisingly low proceeds from asset sales, and (3) negative stock price reactions to economic and regulatory events associated with the demise of the market for highly-leveraged transactions. The incidence of distress is not related to several characteristics that have previously been linked with poorly-structured deals. We thus attribute the high rate of distress primarily to unexpected macroeconomic and regulatory developments.
Here we provide a comprehensive look at direct costs associated with chapter 7 business bankruptcy liquidations by examining cases from five geographically dispersed judicial districts. This Article measures chapter 7 direct costs, which are essentially out-of-pocket administrative costs associated with chapter 7 proceedings. Examples of direct costs include attorneys' fees, filing fees, and other professional fees. Part II describes the procedures we followed in gathering data. Part II also sets forth several assumptions we made when describing direct costs. Each time an assumption needed to be made, we took the assumption that produced the lowest bankruptcy costs. Accordingly, the data in this Article is a conservative estimate of chapter 7 costs. Part III describes the characteristics of the debtors and cases in our sample. Part IV discusses the actual cost measurements and quantifies the costs of chapter 7 business bankruptcy. Part V uses statistical analysis to identify determinants of chapter 7 costs. Part VI summarizes our major conclusions.
This paper examines the conditions under which bank lenders make concessions by taking equity in financially distressed firms. A simple model is developed which shows that the role banks play in debt restructurings depends upon the financial condition of the firms as well as the existence of public debt in the firm's capital structure and the ability of public debt to be restructured. Empirically, I find that for firms with public debt outstanding, banks never make concessions unless public debtholders also restructure their claims. When banks do take equity, on average they obtain a substantial proportion of the firm's stock, and they maintain their position for over two years. Finally, subsequent to the restructuring, firms in which banks hold stock perform better than firms in which banks do not take equity.
This article empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Longstaff and Schwartz (1995), Leland and Toft (1996), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986–1997.
The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true
to expectations, we find that the predicted spreads in our implementation of the Merton model are too low. However, most of
the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer
models tend to severely overstate the credit risk of firms with high leverage or volatility and yet suffer from a spread underprediction
problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly
those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier
bonds while scarcely affecting the spreads of the safest bonds.