Topic 9:

Credit Risk II

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Estimating Default Probabilities
We can estimate default probabilities by using:

1) historical data
• Historical data provided by rating agencies can be
used to estimate the probability of default.

2) credit spreads/credit risk premium

• The credit spread is the extra rate of interest per
annum required by investors for bearing a particular
credit risk.
• -bond yield minus risk-free rate
• Credit default swap spread/premium

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Table 1 Cumulative Average Default
Rates of bonds (1970-2013, Moody’s)
Time (Years)
% 1 2 3 4 5 7 10
Aaa 0.000 0.013 0.013 0.037 0.104 0.241 0.489
Aa 0.022 0.068 0.136 0.260 0.410 0.682 1.017
A 0.062 0.199 0.434 0.679 0.958 1.615 2.759
Baa 0.174 0.504 0.906 1.373 1.862 2.872 4.623
Ba 1.110 3.071 5.371 7.839 10.065 13.911 19.323
B 3.904 9.274 14.723 19.509 23.869 31.774 40.560
Caa-C 15.894 27.003 35.800 42.796 48.828 56.878 66.212
(15.894) (11.109) (8.797) (6.996) (6)
How to read this Table?
• A company with an initial credit rating Aa has a probability of 0.022%
of defaulting by the end of the first year (this means 99.978% of
non-default), and it has a probability of 0.068% of defaulting by the
end of the second year, and so on.
• Default prob in y2= 0.068-0.022 (unconditional)
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Table 1 Cumulative Average Default
Rates of bonds (1970-2013, Moody’s)

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Historical Default Probabilities
• The probability of a bond defaulting during a
particular year can be calculated from Table 1.
• For example, the probability that a bond initially
rated Aa will default during the second year of
its life, will be 0.068% − 0.022% = 0.046%.
• Thus, as seen from the Table 1, bond initially rated
Aa has default rate during the
– Year-one = 0.022%
– Year-two = 0.068 - 0.022 = 0.046%
– Year-three = 0.136 - 0.068 = 0.068%
– Year-four = 0.260 – 0.136 = 0.124%
– Year-five = 0.410 – 0.260 = 0.150%

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 Do Default Probabilities Increase with
Time?
• As shown from the table, for a company that starts with a
good credit rating, its default probabilities may tend
to increase with time.
– Why? The reason is although the bond issuer is initially
considered to be creditworthy (paid the interest and
principal on time), but when the more time that elapses,
there is increasing possibility that its financial health
(financial position) will decline.

• On the other hand, for a company that starts with a poor

credit rating, default probabilities may tend to
decrease with time. (improve credit risk)
– This is because for a bond with a poor credit rating, the
next year or two may be critical for the survival of the
bond. If the bond issuer survives this period, its financial
health is likely to have improved.
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 Hazard Rate (Default Intensity)
1. Default intensity (or hazard rate) is the
probability of default during a specific time which
is conditional on “no earlier default”.
2. No default probability is the zero-default
probability starting from time zero (i.e. from the
beginning time you start to hold an asset) to a
specific time.
3. Unconditional default probability is the
probability of default during a specific time as
seen from time zero (at the beginning time).

𝑈𝑛𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦

𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦=𝐻𝑎𝑧𝑎𝑟𝑑 𝑟𝑎𝑡𝑒=
𝑁𝑜 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦

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Table 1 Cumulative Average Default
Rates of bonds (1970-2013, Moody’s)
Time (years)
% 1 2 3 4 5 7 10
Aaa 0.000 0.013 0.013 0.037 0.104 0.241 0.489
Aa 0.022 0.068 0.136 0.260 0.410 0.682 1.017
A 0.062 0.199 0.434 0.679 0.958 1.615 2.759
Baa 0.174 0.504 0.906 1.373 1.862 2.872 4.623
Ba 1.110 3.071 5.371 7.839 10.065 13.911 19.323
B 3.904 9.274 14.723 19.509 23.869 31.774 40.560
Caa-C 15.894 27.003 35.800 42.796 48.828 56.878 66.212

Unconditional default prob. during Y3

=35.800 - 27.003 = 8.797%.
No-default prob. from Y0 to Y2
= 100 - 27.003 = 72.997% Hazard rate of Caa-C bonds during Y3
= 0.08797 ∕ 0.72997 = 12.05%

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Hazard Rate (Default Intensity) (cont’d)
• From Table 1, we can calculate the probability of a Caa-C bond
defaulting during the Year-3 is 35.800 - 27.003 = 8.797%.
We will refer this as the unconditional default probability during
the Year-3.
• Meanwhile, we can find that the probability that the Caa-C
rated bond will survive (no default on interest payment and
principal payment) until the end of Year-2 is 100 - 27.003 =
72.997%.
We refer this as the no default probability for Caa-C bond from
time zero until the end of Year-2 = 72.997%

𝑈𝑛𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦

𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦=𝐻𝑎𝑧𝑎𝑟𝑑 𝑟𝑎𝑡𝑒=
𝑁𝑜 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦
= 0.08797 ∕ 0.72997 = 12.05%.
• Thus, the Default Intensity (Hazard rate) for Caa-C bond during
the Year-3 conditional on no earlier default = 12.05%.

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Hazard Rate (Default Intensity) (cont’d)
• What is the Default Intensity (Hazard rate) for Baa bond
during the Year-4 conditional on no earlier default?
Default Intensity (Hazard rate) = (1.373 – 0.906) / (100 – 0.906) =
0.4670/99.094 = 0.0047 x 100 = 0.47%

• What is the Default Intensity (Hazard rate) for B bond during

the Year-2 conditional on no earlier default?
Default Intensity (Hazard rate) = (9.274 – 3.904) / (100 – 3.904) =
5.37/96.096 = 0.0559 x 100 = 5.59%
• What is the Default Intensity (Hazard rate) for Aa bond during
the Year-3 conditional on no earlier default?
Default Intensity (Hazard rate) = (0.136 – 0.068) / (100 – 0.068) =
0.068/99.932 = 0.0007 x 100 = 0.07%

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 Credit Default Swaps (CDS)
• A kind of derivative that has become very important in
credit markets is credit default swap (CDS)  the
purpose is to hedge against the risk.
• In a credit default swap, the credit protection buyer
pays a fee to the credit protection seller (investment
bank/ insurance company) to get protection from the
default of a reference asset.
• The protection seller will make the payment to the
protection buyer (for the losses) in occurrence of a credit
event.
• Credit event is defined as a failure to make a payment as
it becomes due.
• The default company is known as reference entity.
• The simplest type of CDS (plain vanilla CDS) is an
instrument that provides “insurance against the risk of a
default” by a particular company.
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Credit Default Swaps (CDS) (cont’d)
• The insurance buyer (CDS buyer) obtains the
right to sell bonds issued by the default
company for their face value when a credit event
occurs.
• The insurance seller (CDS seller) agrees to
buy the bonds for their face value when a
credit event occurs as contracted.
• The total face value of the bonds that can be
sold is known as the credit default swap’s
notional principal.
• The CDS buyer continues to make periodic
payments to the seller until the end period of
the CDS, or until a default event occurs. These
payments are usually made in arrears every
quarter.
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 Credit Default Swaps (CDS) (cont’d)
• The CDS Premium (i.e. the periodic payments) paid
by a buyer, also known as the credit default spread, is
paid for life of CDS contract or until a default event
occur.
• For example, for a bond value of $100 million with 5-year
protection against company A (the reference entity), a
buyer that pays a CDS premium of 100 basis points
(100 bps = 1%) per year, is actually paying $1 million
per year (0.01 x 100 million).
• If there is a default event, the buyer has the right to
sell bond(s) with a face value of $100 million issued by
company A for $100 million. Therefore, the CDS buyer will
transfer the risk to CDS seller if company A defaults. CDS
seller will pay to CDS buyer.

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The CDS Market
• In 1998 & 1999, the International Swaps and
Derivatives Association developed a standard
contract for trading credit default swaps in the over-
the-counter market (investment bank/ insurance co).
• Banks and other financial institutions are both buyers
and sellers of CDS protection.
• Banks sometimes use credit default swaps to hedge an
exposure to a borrower. (Banks are worried that
borrowers are unable to service their loans)
• Banks tend to be net buyers of protection, and
insurance companies tend to be net sellers of
protection.
• The total notional principal underlying outstanding
contracts was peaked at $58 trillion in December 2007
and fell to about $21 trillion in December 2013.
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 The CDS Market (cont’d)
• During the credit turmoil (subprime mortgage crisis) that
started in August 2007, regulators became concerned that
CDSs were a source of systemic risk, a part due to the
big losses experienced by insurance company AIG.
• AIG was a big CDS seller of protection on the AAA-
rated tranches created from mortgages. The protection
proved very costly to AIG, and a failure of AIG
would have led to big losses elsewhere in the
financial system. AIG was bailed out by the United
States government in September 2008.
• CDSs have come under criticism during the European
sovereign debt crisis (2008-2012). Some legislators feel
that speculative activity in credit default swap
markets has exacerbated the fiscal debt problems
of countries, such as Greece.
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The CDS Market (cont’d)
• During 2007 and 2008, trading ceased in many types
of credit derivatives, but plain vanilla CDSs which
provide protection against a single company or
country defaulting continued to trade actively.
• Naked CDS positions on sovereign debt were banned
in Europe in 2013. (Naked CDS allow traders to
speculate or take large bets on certain financial
products. Buyer normally doesn’t own the underlying
corporate or sovereign debt insured)
• The advantage of CDSs over other credit
derivatives is that the way they work is
straightforward. Other derivatives such as ABS,
CDOs lack this transparency.

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The CDS Market (cont’d)
• There were a huge number of CDS contracts
outstanding with the Lehman Brothers
(investment bank) as the reference entity
(default company), when Lehman Brothers declared
bankruptcy in September 2008.
• The recovery rate (determined by an auction
process) was only about 8%, so the payout to
the buyers of protection was equal to about
92% (100 minus 8%) of the notional principal.
• During 2008 global financial crisis, there were
market predictions saying some sellers of CDS
protection would be unable to pay and that
more further bankruptcies would occur.

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CDS Structure
90 bps per year
Default Default
Protection Protection
BUYER, A SELLER, B
Payoff if there is a
default by the
reference entity

Figure 1: Credit Default Swap

• Suppose that two parties enter into a 5-year CDS on

December 20, 2015.
• Assume that the notional principal is $100 million,
and the buyer agrees to pay 90bps (0.9%) per year
(quarterly in arrears) for protection against default
by the reference entity (default company).

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CDS Structure (cont’d)
• If the reference entity does not default, the buyer
receives no payoff and pays approximately
$225,000 (=0.25 x 0.0090 x 100,000,000) in each
quarter at 20th of March, June, Sept and Dec of
each year of 2016, 2017, 2018, 2019 and 2020.
• Now assume that the buyer notifies the seller of a
credit event happens on May 20, 2018 (i.e. 5
months into the third year).
• If the contract specifies physical settlement, the
protection buyer has the “right to sell” to the
protection seller the bonds that issued by the
reference entity after default happened, with a face
value of $100 mil for $100 mil.

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 CDS Structure (cont’d)
• If the contract specifies cash settlement, a two-
stage auction process will be used to determine the
mid-market value of the cheapest default bond in
several days after the credit event.
• Suppose the auction indicates the cheapest-to-deliver
default bond worth $35 per $100 of face value (i.e.
recovery rate 35%), the protection seller’s cash
payoff to the protection buyer is $65 mil only.
• Then, the protection buyer will get back the
remaining recovery price of $35 per $100 of face
value later, after the bond was sold-off in the second-
stage of auction market.

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CDS Structure (cont’d)
• For example, thru cash settlement, when a default
event happens, a protection buyer for $10 mil sells
$10 mil par value of bonds in the auction market,
and assuming a recovery rate of 40%, the buyer
will be compensated $6 mil (i.e. 60% of $10 mil)
by the seller.
• As the bond trade that occurs in the auction take
place at the final auction price, the protection
buyer will receive $4 mil for the bonds.
• Thus, in total the protection buyer still receives
$10mil, and able to pass off the $10 mil par value of
bonds to another bond buyer in the auction market.

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Figure: Cash and Physical Settlement

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CDS Structure (cont’d)
• The regular payments from the protection
buyer to the protection seller will be ended when
there is a credit event.
• However, because these payments are made in
arrears, a final accrual payment by the buyer is
usually required.
• In our example, where there is a default on 20th of
May 2018, the buyer would be required to pay to
the seller the amount of the annual payment
accrued between March 20, 2018 and May 20,
2018 (approx. 2/3 x $225,000 = $150,000)
but then no further payments would be required.

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CDS Structure (cont’d)
• Several large banks are market makers in the CDS
market. For a five-year CDS on a company, a market
maker might quote: bid 250 basis points, offer
260 basis points.
• This means that, the market maker is prepared to
buy protection by paying 250 basis points per
year (i.e. 2.5% of the principal per year), and to
sell protection for 260 basis points per year (i.e.
2.6% of the principal per year).

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Credit Indices
• [Link]: An equally weighted portfolio of 125
investment grade North American companies.
• iTraxx Europe: An equally weighted portfolio of 125
investment grade European companies.
• The index is the average of the credit default spreads
on the reference companies in the underlying portfolio.
• Suppose that the five-year [Link] index is quoted
by a market maker as bid (buy) 165 basis points,
offer (sell) 166 basis points.
• The quotes mean that, an investor can buy CDS protection
on all 125 companies in the index for 166 basis points per
company from the market maker, or
• the investor can sell CDS protection on all 125 companies
in the index for 165 basis points per company to the
market maker.
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Credit Indices (cont’d)
• Suppose an investor wants to buy $800,000 of
protection on each company. The total cost is
0.0166 x 800,000 x 125 companies = $1,660,000
per year.
• When one company defaults, the investor receives
the usual CDS payoff, and the annual payment is
reduced by 1,660,000∕125 = $13,280 per
company.
• There is an active market in buying and selling CDS
index protection for maturities of 3, 5, 7, and 10
years. The maturities for these types of contracts on
the index are usually December 20 and June 20.

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Using the Credit Default Spreads to
Predict Default Probabilities
Average hazard rate between time-zero and time-t
also equals to a good approximation of:

𝑠 (𝑡 )
𝜆=
1− 𝑅
where s(t) is the credit default spread (CDS)
calculated for a maturity of t, and R is the
recovery rate.

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Example 3
Suppose that the CDS spreads for 3-year, 5-year and 10-year
instruments are 50, 60 and 100 basis points (or 0.5%, 0.6% and
1%) and the expected recovery rate is 60%. What is the average
hazard rate between year 3 & 5, year 5 & 10 and year 3 & 10?

• The average hazard rate over 3 years is approximately 0.005∕(1 −

0.6) = 0.0125=1.25%
• The average hazard rate over 5 years is approximately 0.006∕(1 −
0.6) = 0.015
• The average hazard rate over 10 years is approximately 0.01∕(1 −
0.6) = 0.025
• Thus, the average hazard rate between year 3 and year 5 = (5x
0.015 - 3x 0.0125) ∕ (5-3) = 0.01875
• The average hazard rate between year 5 and year 10 = (10x 0.025
- 5x 0.015) ∕ (10-5) = 0.035
• The average hazard rate between year 3 and year 10 = (10x 0.025
- 3x 0.0125) ∕ (10-3) = 0.2125 / 7 = 0.0304

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Credit Risk Management in Banks

1. Proactive strategies
• Review customer credit history and report
• Review bank’s internal data. In the absence of credit history or
report (from a credit bureau), banks may create own database to
monitor borrower behaviors to determine borrower’s credit
worthiness
2. Diversify credit risk
• Diversification reduces firm-specific credit risk (i.e. risk exposure
to a single borrower or borrowers in the same business type)
• Diversification does not eliminate systematic credit risk, which
refers to factors that simultaneously increase the default risk of
all borrowers in the economy (eg. Recession, unemployment,
financial crisis, lockdown due to a pandemic)
• Systematic credit risk is a type of market risk since it is non-
diversifiable

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Credit Risk Management in Banks (cont.)

3. Invest in low-risk assets (low-risk loans)

• Tradeoff: Interest income may be too low since low-risk
(high quality) assets are typically low-yielding
4. Maintain sufficient credit risk capital
• Tiers 1 and 2 capital should be large enough to fully absorb
credit risk losses (8% capital adequacy ratio)
5. Purchase credit risk insurance
• Credit default swaps have credit risk exposure too if the
insurer defaults (e.g. AIG in the 2008 US subprime
mortgage crisis)

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THE END

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