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Prediction and Preemption of Corporate Failures

Prediction and Preemption of Corporate Failures. The Contingent Claims Approach to Corporate Vulnerability Analysis: Estimating Default Risk and Economy-wide Risk Transfer. Michael Gapen, IMF Dale Gray, Moody’s M f Risk Cheng Hoon Lim, IMF Yingbin Xiao, IMF.

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Prediction and Preemption of Corporate Failures

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  1. Prediction and Preemption of Corporate Failures The Contingent Claims Approach to Corporate Vulnerability Analysis: Estimating Default Risk and Economy-wide Risk Transfer Michael Gapen, IMF Dale Gray, Moody’s MfRisk Cheng Hoon Lim, IMF Yingbin Xiao, IMF

  2. Motivation for corporate sector vulnerabilities is clear. • Corporate failures can be expensive. • Lost output and employment. • Can cause banking system distress. • Could transfer risk onto the public sector. Recent crises have highlighted inter-connectedness. • Capital moves faster. • Risk transmission has been faster. • Isolated problems became widespread. • Need approach that captures these factors.

  3. Expansion of Contingent Claims Models • Merton paper in 1974 • KMV model, began in 1990 • Moody’s Riskcalc, CreditGrades, MfRisk models • Improved accuracy • Gives default probabilities, values of debt • Incorporates volatility • Uses forward looking market information • Expansion of risk management

  4. Outline Introduce market-based approach to vulnerability Corporate sector distress Economy-wide risk transfer Conclusions

  5. Estimating Default Risk Three elements determine default risk. • Value of assets: market value of firm assets. • Asset risk: uncertainty of asset value. • Capital structure: debt/equity, book value of debt. As market value of assets declines relative to debt, default risk increases. Problem: Value of assets is unobservable.

  6. Value and risk flows from assets to liabilities Balance sheet relationship • The value of junior equity is equal to: Max [ Assets – default free value of debt , 0]. • Market value and volatility of equity is used to estimate value and volatility of firm assets. Junior Equity Assets Senior Debt

  7. Steps to Estimating Default Probability Estimate asset value and volatility. Calculate distress barrier. Book value of short-term debt, half long-term debt, plus interest. Calculate distance to distress. Relates (1) and (2). (market value of assets – distress barrier) (market value of assets)*(asset volatility) Calculate default probability. Can come from formula in (1) or via mapping to historical default data.

  8. Value of Assets Relative to Distress Barrier Asset Probability Distribution Distance to Distress* Asset, $ Million Default Probability * Distance to Distress = Assets - Distress Barrier Assets * Asset Volatility

  9. Contingent Claim Vulnerability Indicators • Value of Equity and Junior Claims • Volatility • Debt Structure • Other Information Market & Financial Information Calibrated Values • Implied Asset Value • Implied Asset Volatility • Distance to distress • Expected Default Probability • Credit Spreads • Firm level indicators • Sectoral analysis – treat sector as a quasi-firm. Individual Firm Market Value Balance Sheets Market Value Balance Sheets For Sectors and Sub-sectors

  10. Case Study:Corporate Vulnerabilities in Brazil 2002 • Sector level balance sheets end-2001. • Sector-weighted market prices of equity. • Estimate sector assets and distress barrier. • Compute distance to distress and default probability. • Did this approach appropriately capture vulnerabilities?

  11. Brazil: Distance to distress in March 2002

  12. Brazil: Distance to distress Sept 2002

  13. Utility Sector Assets vs. Distress Barrier

  14. Utility Sector: Distance to distress and Probability of default September 2002 Default Probability in percent (1yr ahead) Dec 2002 March 2002

  15. Case Study Conclusions • Peak vulnerabilities more V-shaped. • Selected individual defaults. • Differentiation between domestic and exporters. • Aggregated approach captured these subtleties. • What if defaults were widespread? • What if banking sector vulnerabilities increase? • Can this approach capture risk transfer between sectors?

  16. Estimating Economy-wide Risk Transfer Three Examples of Risk Transmission 1 Negative Shock to Corporate Sector Corporates Banks / Financial Institutions Government / Monetary Authority 2 Banking Sector Crisis or Deposit Run Banks / Financial Institutions Government / Monetary Authority 3 Negative Shock to Gov’t and to Banks Holding Gov’t Securities Banks / Financial Institutions Government / Monetary Authority Corporates

  17. Risk Transmission from Corporate Sector to Banks to Public Sector:Initial Stage Contingent Liability of Government Corporate Sectors Banks Equity Risky Debt Value Expected Loss

  18. Risk Transmission from Corporate Sector to Banks to Public Sector: Final State Corporate Sectors Banks Contingent Liability of Government Equity Risky Debt Value Expected Loss

  19. Valuing the Implicit Guarantee Estimate value and volatility of assets. Calculate the distress barrier. Compute book value of short-term, half long-term, interest for financial sector. Assume recovery rates. Recapitalization may not be full. Estimate value of guarantee. Use second pricing relationship. Value of guarantee is Max [ Distress barrier – Assets, 0 ]

  20. Case Study: Estimating Risk Transfer in Thailand 1997 • Sector level balance sheets end-1996. • Sector-weighted market prices of equity. • Estimate sector assets and distress barrier. • Compute distance to distress and estimate guarantee. • Did this approach capture eventual recapitalization?

  21. Thailand: Value of Financial Sector Guarantee in 1997

  22. Conclusions Examined contingent claims approach to default risk. • Probability of default based on: capital structure, distress barrier, value and volatility of assets. • Value and volatility of equity (junior claim) as proxy. • Option pricing captures first and second moments. Assess vulnerabilities retroactively in two cases. • Aggregated methodology shows promise. • Procedure is flexible, applies to integrated balance sheets. • Allows for estimation of risk transfer.

  23. Applications of Macrofinancal Risk Framework • Risk measures from: • Default Indicators/Distance-to-Distress • Spreads • Transfer or Convertibility Risk • Sensitivity Measures • Risk transfer between sector balance sheets • Analyze effects of capital inflows and outflows • Sovereign credit spreads and default probabilities • Assessing impact of different policies and debt structures across sectors

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