08.2 corporate credit analysis

Copyright © 2018 CapitaLogic Limited
This presentation file is prepared in accordance with
Chapter 8 of the text book
“Managing Credit Risk Under The Basel III Framework, 3rd ed”
Website : https://sites.google.com/site/crmbasel
E-mail : crmbasel@gmail.com
Chapter 8
Corporate
Credit Analysis

Copyright © 2018 CapitaLogic Limited 2
Declaration
 Copyright © 2018 CapitaLogic Limited.
 All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
 Authored by Dr. LAM Yat-fai (林日辉),
Director, CapitaLogic Limited,
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration,
CFA, CAIA, CAMS, FRM, PRM.

Corporate borrowers
 Listed company
 Shares traded on stock exchange
 Equity prices observable
 Audited annual/semi-annual financial statements
 Private firm
 Owned privately
 Audited annual financial statements
 Annual revenue > EUR 5 mn

Traditional corporate credit analysis
 Macro analysis
 Country risk
 Industry risk
 Qualitative analysis
 Management
 Business
 Operation
 Quantitative analysis
 Financial ratios
 Comprehensive
 Expensive
 Experience oriented
 Subjective
 Potential inconsistency

Outline
 Black-Scholes option valuation model
 Merton’s corporate default model
 Financial ratios
 Altman’s family of Z-scores
 Appendices

Call payoff of Ford Motor
Payoff = Max[ST - 10, 0]
0
1
2
3
4
5
5 6 7 8 9 10 11 12 13 14 15
Equity price

Assumptions of
Black-Scholes formulas
 Exercised at maturity only
 No dividend payment
 Constant volatility
 Constant risk-free rate
 No transaction cost and tax
 Equity prices follow a GBM

 S0 : Current equity price
 σ : Volatility
 r : Risk-free rate
 K : Strike price
 T : Time to maturity
 c : Call value
S0, , r, K,T  c

 Call value
 At maturity
 Probability of equity price < strike price
     
1
2
0 1 2
0
2
d
1 1
-
2
d
2 1 2
-
2
c = S Φ d - Kexp -rT Φ d
2S σ
ln + r + T
K 2 1 τ
where d = Φ(d ) = exp - dτ
2σ T 2π
1 τ
d = d - σ T Φ(d ) = exp - dτ
22π
1 - Φ(d )


  
        
 
 
 
 
 


Example 8.2

Historical volatility
 Return
 Average(…)
 Volatility
 Stdev(…)
 Nasdaq
 https://www.nasdaq.com
N
2
k
k=1
(μ - μ)
SD =
N - 1
σ = 250SD
k
k
k-1
N
k
k=1
N
0
Price
μ = ln
Price
μ
μ =
N
Price1
= ln
N Price
 
 
 
 
 
 

Example 8.1

Interbank rate
 London Interbank Offer Rates
 Average lending rates with maturity up to one
year among AA rated banks in U.K.
 A proxy of short term risk-free rates for major
currencies
 https://research.stlouisfed.org/fred2/release?rid=2
53
 All interbank rates
 http://stooq.com

Currency and maturity
Currency
 USD
 EUR
 GBP
 JPY
 CHF
 CNY
 HKD
Maturity
 Overnight
 1 week
 1 month
 2 months
 3 months
 6 months
 12 months

Outline
 Appendices

Liabilities
Equity
Simple asset structure

Simple asset structure
0
10
20
30
40
50
60
0 20 40 60 80 100
Equity Liabilities

Merton’s corporate default model
 Asset value = Equity value + Liability value
 Equity value observable from market
 Only book value registered for liabilities
 Therefore, asset value is not observable directly
 Market value of equity can be modeled as a
call option on asset value of a company
 All liabilities are assumed to mature in one year

Equity vs call payoff
 
 
 
T T
0 1 2
0 E
A
0
2
A
1
0
0
A
2 1 A
E = Max A - L,0
E = Φ(d ) - Lexp -rT Φ(d )
E σ
where σ =
E + 1 - LGD L
σ
ln + r + T
L 2
d =
σ T
d = d -
A
σ T
A
  
  
   
Equity
AssetsLiabilities
0
0
AKnown E ,L,σ ,r,T
Unkno n Aw

Market value of equity
= Equity price No. of shares

Asset volatility vs equity volatility
 Gear ratio formula proposed by JPMorgan
 Assuming average LGD = 0.5
 EA
0
0
0 E
0
E
= σ ×
E + 1 - LGD L
E σ
=
E
σ
+ 0.5L

Probability of default
 
0
1
2 1
A
A
2
2
A
ln + r + T
L 2
d =
T
d = d -
σ
σ
σ T
PD = 1 - Φ d
A   
  
   
Example 8.3

Major contributions
 Market’s view of credit quality can be derived
from observable
 Market value of equity
 Book value of liabilities
 Volatility of equity
 To determine the credit quality of a list
company
 The PD should never be used directly

Credit quality vs Merton’s PD
Credit quality Credit rating ECAI Plus PD Merton’s PD
Good BBB or above
Below
single digit
Below 1%
Moderate BB and B Single digit
Between 1%
and 10%
Bad CCC or below Double dight Above 10%

Outline
 Appendices

Financial statements
 Balance sheet
https://finance.yahoo.com/quote/F/balance-
sheet?p=F
 Income statement
https://finance.yahoo.com/quote/F/financials?p=F
 Cash flow statement
https://finance.yahoo.com/quote/F/cash-flow?p=F
Example 8.4

Financial ratios
 Liquidity ratios
 Leverage ratios
 Return on investment ratios
 Turnover ratios
 Operating profitability ratios
 Operating efficiency ratios
 Coverage ratios
 Growth ratios

Liquidity ratios
Example 8.5
Current assets
Current ratio =
Current liabilities
Cash + Marketable securities
+ Account receivables
Quick ratio =
Current liabilities
Cash + Marketable securities
Cash ratio =
Current liabilities

Leverage ratios
Total liabilities
Liabilities to equity ratio =
Total equity
Total liabilities
Liabilities to assets ratio =
Total assets
Total equity
Equity to assets ratio =
Total assets

ROI ratios
Earnings before interest and taxes
Return on total assets =
Total assets
Return on total equity =
Total equity
Earnings before interest and tax
Return on common equity =
es
Common equity

Peer analysis and trend analysis
 Peer analysis
 Comparison with
 Other similar corporations
 Industry statistics
 average, median, mode
 lower bound, upper bound
 Trend analysis
 Comparison with
 A corporation’s own history

Financial ratios
 Advantages
 Direct measure of a company’s financial healthiness
 Published regularly
 Audited at least annually
 Disadvantages
 Financial ratios highly industry specific
 Large no. of financial ratios
 Inconsistency among less related financial ratios
 Book value <> economic value
 Subject to accounting cosmetics
 Peer figures and industry statistics difficult to collect from private
firms and emerging industries

Outline
 Appendices

Linear discrminant analysis
 A minimum set of financial ratios which
explain the majority of the credit quality of a
corporation
 A simple linear formula to summarize the
credit quality of a corporation into a single
number
 Two cutoff values to classify the credit quality
of a corporation into good, moderate or bad

Explanatory variables (1)
 EBIT/Total tangible assets
 Net available for total
capital/Total capital
 Sales/Total tangible assets
 Sales/Total capital
 EBIT/Sales
 Net available for total
capital/Sales
 Log(Tangible assets)
 Interest coverage
 Log(Interest coverage)
 Fixed charge coverage
 Earnings/Debt
 Earnings, 5-year maturity
 Cash flow/Fixed charges
 Cash flow/Total debt

Explanatory variables (2)
 Working capital/Total debt
 Current ratio
 Working capital/Total
assets
 Working capital/Cash
expenses
 Retained earnings/Total
assets
 Book equity/Total capital
 Market value of equity
equity/Total capital
 5-year market value of
equity equity/Total capital
 Market value of equity
equity/Total liabilities
 Standard error of estimate
of EBIT/Total tangible
assets
 EBIT drop
 Margin drop
 Capital lease/Assets
 Sales/Fixed assets

Altman’s Z-score for
listed manufacturing companies (1)
 Explanatory variables
1
2
3
4
5
X =
Total liabilities
Current assets - Current liabilities
X =
Total assets
Retained earnings
X =
Total assets
X =
Total assets
Total reveune
X =
Total assets

Altman’s Z-score for
listed manufacturing companies (2)

 Good Z > 2.99
 Moderate 1.81 < Z < 2.99
 Bad Z < 1.81
1 2 43 5Z = 0.6X + 1.2X + 1.4X + + 0..3X 999X3
Example 8.7

Altman’s Z’-score for
private manufacturing companies (1)
1
2
3
4
5
value of equity
X =
Total liabilities
X =
Total assets
Retained earnings
X =
Total assets
X =
Total assets
Total revenue
X =
Book
Total assets

Altman’s Z’-score for
private manufacturing companies (2)

 Good Z’ > 2.90
 Moderate 1.23 < Z’ < 2.90
 Bad Z’ < 1.23
1 2 43 5Z' = 0.42X + 0.717X + 0.847X + + 0.93.10 X 98X7
Example 8.8

Altman’s Z”-score for
non-manufacturing companies (1)
1
2
3
4
Book value of equities
X =
Total liabilities
X =
Total assets
Retained earnings
X =
Total assets
X =
Total assets

Altman’s Z”-score for
non-manufacturing companies (2)

 Good Z” > 2.60
 Moderate 1.10 < Z” < 2.60
 Bad Z” < 1.10
1 2 43Z" = 1.05X + 6.56X + 3.26X + 6.72X
Example 8.9

Limitations and contributions
 Limitations
 U.S. corporations
 Middle 20th century
 Contributions
 Linear discrminant analysis
 Simple and intuitive
 The most popular methodology adopted by
financial institutions
 Own customer base and re-calibrate regularly

Credit quality vs assessment results
Credit quality Credit rating Merton’s PD
Altman’s
Z-score
Good BBB or above Below 1%
Above upper
cutoff
Moderate BB and B
Between 1%
and 10%
Between upper
and lower
cutoffs
Bad CCC or below Above 10%
Below lower
cutoff

Consolidated corporate
credit assessment
Example 8.10
Date Credit
quality
Credit
rating
PD Altman’s
Z-score
Credit
assessment
result Change
Change
Credit
quality
Overall

credit assessment
 Credit quality
 Summary option of credit rating, Merton’s model
and Altman’s Z-score
 Credit rating
 Upper end or lower end in the range of credit
quality
 PD
 Lookup from the ECAI Plus rating scale

credit assessment
Credit rating
Merton’s
model
Altman’s
Z-score
Overall
Good Good Good Good
Good Moderate Moderate Moderate
Good Bad Moderate ???
Moderate Moderate Bad Moderate
Moderate Bad Bad Bad
45Copyright (c) 2018 LAM Yat-fai

Outline
 Appendices

Interbank rates
CAD
Rate Canadian Dealer Offered Rate (CDOR)
Publisher Investment Industry Regulatory Organization of Canada
Description Based on bid rates for Canadian bankers' acceptances
AUD
Rate Bank Bill Swap Reference Rate (BBSW)
Publisher Australian Financial Markets Association
Description Based on rates for certain short-term securities issued by specified banks operating in Australia
NZD
Rate New Zealand Bank Bill Reference Rate (BKBM)
Publisher New Zealand Financial Markets Association
Description Based on middle rates for discount securities issued by specified banks registered in New Zealand
SKK
Rate Stockholm Interbank Offered Rate (STIBOR)
Publisher Swedish Bankers‘ Association
Description
An interbank borrowing rate based on interest rates for unsecured interbank borrowing in the Swedish
interbank market
DKK
Rate Copenhagen Interbank Offered Rate (CIBOR)
Publisher Danish Bankers Association
Description
An interbank borrowing rate based on interest rates for unsecured interbank borrowing in the Danish
interbank market

Morningstar Financials

Jones, Mason and Rosenfeld approach
 0 1 2
1
A
2
0
2
A
A1
0
E = Φ(d ) - Lexp -rT Φ(d )
ln + r + T
L 2
d =
σ T
d = d -
A
σ
A
σ
T
  
  
    0
0 A
Known E ,L,r,T
Unknown A ,σ
 AE 0 10σσ = AE Φ d
A A A,t
E E E,t
dA = μ Adt + σ AdW
dE = μ Edt + σ EdW

Jones, Mason and Rosenfeld approach
 
 
     
0
0A
0
1 2
E 0
A
A
2
0
1
2
0
A
A
Let X = E
Y = Φ(d ) - Lexp -rT Φ(d )
Z = σ E
W = Φ d
Minimize f , = X - Y + Z - W
Subject to
A
A
σ
σ
0σ
0



Moody’s KMV model
– DD and EDF
Distance
to Default
PD
0.43%
3.4
0
0 A
Distance to default
A - Default point
=
A σ

Merton’s model vs
Moody’s KMV model
Merton’s model
 Academic research
 Opened to public
 All liabilities unified to mature
in one year
 Default point at total liabilities
level
 Asset value follows a log-normal
distribution
 Asset value grows at risk-free
rate
 PD calculated by closed form
formulas
KMV model
 Propriety approach
 Commercial secret
 Liabilities divided into short and
longer terms
 Default point somewhere
between short and longer term
liabilities
 Asset value follows an empirical
distribution
 Asset value grows at an
estimated drift
 PD estimated by mapping
“distance to default” to empirical
default database

08.2 corporate credit analysis

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08.2 corporate credit analysis