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The Public EDF Model. CreditEdge Tutorial. Developed by: The Market Information Lab Fall 2009. Credit Risk in Financial Markets. Limitless Opportunities Dynamic Credit Environment Numerous Market Sectors Complexity of Financial Statements Bottom Line:

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the public edf model

The Public EDF Model

CreditEdge Tutorial

Developed by:

The Market Information Lab

Fall 2009

slide2

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?
slide3

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
structure of the products
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

slide5

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
slide6

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
slide7

How CreditEdge Works

  • Public Company Probability of Default
  • Internal Company Data / External Market Conditions
  • Portfolio Management with many companies
check your understanding
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

slide9

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)
slide10

Calculation of EDF

Formula:

Default Point

X Asset Volatility

Market Value

of Assets

slide11

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)

slide12

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

slide13

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
slide14

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

check your understanding1
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

putting it all together
Putting it All Together

The Ratio Decreased, what does that mean?

check your understanding2
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

slide20

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
slide21

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?

slide22

GE Asset Volatility

GE Asset Volatility = 0.88%

check your understanding3
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

ge edf calculation
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?

distance to default
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?

graphical interpretation of edf
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

check your understanding4
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

slide28

The CreditEdge Interface

  • Portfolio creation and management
  • Company Analysis
  • Charting Tool
  • Solver and calculator scenario analysis
slide29

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
slide30

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
slide31

Chart Building

  • Sample Chart – EDF only
  • How EDF calculation points factor in
  • GM Comparison to Toyota
check your understanding5
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

slide33

Scenario Analysis with Solver

  • Solver overview and definition
  • Sample Analysis – Volkswagen
  • Sample Analysis – GM
  • Calculator feature
check your understanding6
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

slide35

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