The Public EDF Model

1. The Public EDF Model CreditEdge Tutorial Developed by: The Market Information Lab Fall 2009

2. Credit Risk in Financial Markets • Limitless Opportunities • Dynamic Credit Environment • Numerous Market Sectors • Complexity of Financial Statements • Bottom Line: • How likely is it that we get paid back?

3. Tutorial Overview • CreditEdge Overview • What/Who/How for CreditEdge • Calculating Expected Default Frequency (EDF) • Calculating the Three Drivers • The CreditEdge Interface • Building and Portfolio • Analyzing a Company Graphically • Estimation Using Scenario Analysis

4. Structure of the Products Moody’s Credit Rating Agency Subsidiary Moody’s KMV MIL Product MIL Product CreditEdge RiskCalc Public Co. Credit Risk Private Co. Credit Risk

5. What is CreditEdge? • Product developed by Moody’s Company • Calculation of Public Company Default • Likelihood of Lender Getting Paid Back • Unbiased Comparison of Public Companies

6. Who Uses CreditEdge? • Lenders • Access counterparty risk • Determines likelihood of getting paid back • i.e. Barclays • Large Corporations • Analysis of Internal Credit Risk • Gauge of competitor credit status • i.e. Hewlett-Packard • Fixed Income Investors/Analysts

7. How CreditEdge Works • Public Company Probability of Default • Internal Company Data / External Market Conditions • Portfolio Management with many companies

8. Check Your Understanding Question: Which of these financial analysts would NOT benefit from CreditEdge? A. Fixed Income Analysts B. Credit Risk Lenders C. Internal Corporate Financial Analyst D. Equity Analysts E. All of the Above Can Benefit CreditEdge

9. Expected Default Frequency • Definition – The Probabilitythat a company’s value will fall below a threshold where its unable to pay backits creditors • Three EDF Drivers for calculation: • Default Point • Market Value of Assets • Asset Volatility • Case Application: General Electric (GE)

10. Calculation of EDF Formula: Default Point X Asset Volatility Market Value of Assets

11. Default Point • Defined – A threshold where the company’s value is not sufficient to payback what it owes • Between Total Liabilities and ST Liabilities • Empirical Studies Reveal Accurate Formula Default Point = ST Liabilities + ½ (LT Liabilities)

12. Note: Numbers are in Thousands GE Default Point 679,788,000 - 246,113,000 • Total Liabilities • - ST Liabilities • __________________ • LT Liabilities 433,675,000 Default Point ST Liabilities + (1/2) LT Liabilities 246,133,000 + (1/2) 433,675,000 DEFAULT POINT 462,970,500 Source: Capital IQ

13. Market Value of Assets • Market Capitalization of Assets • Book Value of Liabilities: Senior Claims • Market Capitalization of Equity: Junior Claims • Formula: • MV Assets = Market Cap. + BV Liabilities

14. GE Market Value of Assets 118,940,000 + 679,778,000 • Market Cap. • + BV Liabilities • __________________ • Market Value of Assets 798,728,000 Source: Capital IQ

15. Check Your Understanding Question: Warren Buffet decides to purchase $50 billion in Senior Unsecured Corporate Bonds from GE. What will happen to GE’s EDF A. It will remain the same B. It will increase because of the increase to GE’s Default Point C. It will decrease because of the increase to GE’s Market Value of Assets D. It will increase because the increase to MV of Assets will not have as great of an effect as the Default Point increase. Default Point X Asset Volatility Market Value of Assets

16. Calculating New Default Point

17. Calculating New MV of Assets

18. Putting it All Together The Ratio Decreased, what does that mean?

19. Check Your Understanding Question: Warren Buffet decides to purchase $50 billion in Senior Secured Corporate Bonds from GE. What will happen to GE’s EDF? A. It will remain the same B. It will increase because of the increase to GE’s Default Point C. It will decrease because of the increase to GE’s Market Value of Assets D. It will decrease because the increase to MV of Assets will have a greater effect as the Default Point increase. Default Point X Asset Volatility Market Value of Assets

20. Asset Volatility • Uncertainty (Volatility) of a Firm • High Volatility = Greater Probability Of Default • Equity Return v. Asset Return • Formula: • Asset Volatility = Standard Deviation of MV of Assets

21. GE Asset Volatility Standard Deviation Formula  Apply to Stock Market GE Share Price X-Bar = Expected Return X = Actual Return N = Number of Observations How do we get Asset Volatility? Where’s our Book Value of Liabilities?

22. GE Asset Volatility GE Asset Volatility = 0.88%

23. Check Your Understanding Question: An decrease in GE’s asset volatility will: A. Will have no effect on EDF B. Cause EDF to Increase C. Cause EDF to Decrease D. Asset Volatility has nothing to do with EDF Default Point X Asset Volatility Market Value of Assets

24. GE EDF Calculation Formula: Default Point X Asset Volatility EDF = Market Value of Assets 433,351,500 EDF = X 0.88% 798,728,000 EDF = 0.477446 %... What does it mean?

25. Distance to Default Distance to Default = Market Value of Assets – Default Point Distance to Default Distance to Default = $ 365,373,500 How likely will it be for MV Assets to fall below Default Point?

26. Graphical Interpretation of EDF EDF = Probability that Asset Value will fall below the Default Point Asset Volatility = 0.88% EDF = 0.477% = Chance GE will Default in 1 Year

27. Check Your Understanding Question: What is the conceptual definition of a 1 Year EDF? A. It’s the probability that a firm will pay back its creditors in a year’s time. B. It’s the probability that a firm will not be able to pay back its creditors in a year’s time. C. It’s the number of standard deviations a firm is away from its default point. D. It’s the expected return on a firm’s stock. E. None of the Above

28. The CreditEdge Interface • Portfolio creation and management • Company Analysis • Charting Tool • Solver and calculator scenario analysis

29. Creation and Analysis of a Portfolio • Create a Portfolio • Adding companies to portfolio • Analysis by EDF and credit rating • Average EDF across portfolio • Adjusting the time period

30. Individual Company Credit Analysis • Sample Company – General Motors • EDF highlights and ratings • Current v. previous EDF • Base Company Profile • Company news and key developments • Company SEC filings

31. Chart Building • Sample Chart – EDF only • How EDF calculation points factor in • GM Comparison to Toyota

32. Check Your Understanding Question: What are the tasks you can't do with the Chart tool? A. Export as an Excel B. Chart Portfolio items C. Custom time series D. We can do all the above E. None of the Above

33. Scenario Analysis with Solver • Solver overview and definition • Sample Analysis – Volkswagen • Sample Analysis – GM • Calculator feature

34. Check Your Understanding Question: Holding everything else constant, if the MV of assets increases, what happens to GE’s EDF? A. Increases B. Decreases C. Stays the Same Default Point X Asset Volatility Market Value of Assets

35. Wrap-Up and Conclusion • Other Moody’s KMV tutorials • RiskCalc Tutorial • MKMV Integration with Capital IQ • MKMV Integration with Crystal Ball • Words of wisdom on tool learning • Questions and support