Global Energy Management Institute
Credit Related Issues
January 22, 2004
Stuart M. Turnbull
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Outline of Talk
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Information for pricing credit instruments
The use of equity prices
The Eliot Spitzer Effects
Counterparty risk
Implications
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Information Requirements
What information do we need to price a credit sensitive
instrument, such as a bond or credit default swap?
Usual List
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The probability of default over the appropriate horizon.
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The recovery rate if default occurs.
Agencies analyze these.
How will the probability of default be affect if there are
defaults within the sector? This raises the issue of
default dependence.
Default dependence also arises when we have
counterparty risk and in structured products.
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Use of Equity Prices
Firms like KMV and Kamakura use equity prices to
estimate the probability of default.
Moody-KMV use traditional analysis + KMV
Credit Grades uses credit default swap data plus
equity data.
Using equity data to identify positions in the fixed
income markets.
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Interaction Between Debt and Equity Markets
Debt Markets
Credit markets use
equity prices.
Equity markets look at credit ratings, bond
spreads, credit default prices.
Equity Markets
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The Changing Nature of Useful Information
Over the last five years there has been a revolution in
the type of data used in the credit evaluation of
loans and bonds.
Before the equity analyst paid little, if any, attention
to credit issues.
Credit analysts and rating agencies ignored
information from the equity markets.
Data
Equity Analysts
Credit Analysts
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The Changing Nature of Useful Information
Now equity analyst are far more sensitive to credit
issues.
Credit analysts and rating agencies use information
from the equity markets.
Is this circular? Hopefully not.
Data
Equity Analysts
Credit Analysts
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Counterparty Risk
Will the supplier default on the contract?
If I buy credit protection, will the protection seller default?
How do we measure default dependence? A common
approach uses the correlation of equity returns.
Again we are using equity data to measure a credit related
event.
How valid is this approach in the real world?
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The Eliot Spitzer Effects
Like equity analysts, credit analysts are also being affected.
Similar to equity analysts, the FSA in London requires
the same independence of credit analysts. The Bond
Association has recommended the same for credit
analysts in the U. S.
Implications
1 Less coverage.
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May lead to more volatility, as investors will not have
the same level of appropriate information to interpret
corporate and economic events.
3 Will this impact the resources a firm commits to
communicating to the investment community?
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Summary
Credit information affects equity markets and equity
information affects credit markets.
Rating agencies are using equity information to assist in their
analysis.
New rules will affect the level of coverage.
They already affect how firms communicate with analysts and
how analysts communicate with investors.
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Implications
Firms should consider the package of information they use to
communicate with
rating agencies,
credit and equity analysts
and investors
and the methods of communication.
Corporate governance issues also affect the firm’s ability
to effectively communicate market participants.
If aggregate information flow is decreasing, investors are
more likely to penalize a firm if there are surprises.
Enhance the risk management function to reduce the
likelihood of unpleasant surprises.
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