Question #13

Structural models are not suitable when the company has complex balance sheets or when there are significant off-balance sheet liabilities. Reduced form models would be appropriate in such a situation. (Module 28.4, LOS 28.d) Philip Bagundang, CFA, is an experienced analyst working for the corporate credit department of a global investment bank. Bagundang is evaluating the proposed two-year, zero coupon, £100 par Shumensko bond. Using a 2% probability of default assumption, Bagundang calculates the CVA on the bond to be £1.820. Two-year, risk-free zero-coupon bonds currently yield 0.8%. Bagundang is evaluating a three-year, zero-coupon bond issued by Alligator, Inc. Using a hazard rate of 2% and estimated recovery rate of 70%, and a flat 2.5% benchmark yield curve, a partial table of analysis is completed as shown in Exhibit 1. Exhibit 1: Alligator, Inc. Bond Year Exposure Loss given default Probability of survival Probability of default Expected loss 1 95.18 28.55 98.00% 2.00% 0.5711 2 3 100.00 30.00 94.12% Bagundang asks his assistant, Diane Monera, to summarize how structural models can be viewed as options on the firm's assets. Monera states that shareholders have limited liability and can, therefore, be viewed as having a long call option on the firm's assets with a strike price equal to the par value of debt. In addition, she adds, debtholders can be viewed as having a long position in a risk-free zero-coupon bond and a position in another instrument she can't quite remember. Finally, Bagundang asks Monera to prepare a short summary table of structural versus reduced form models. Exhibit 2 shows her summary. Exhibit 2: Structural vs. Reduced Form Models Structural Reduced Form Default risk Parameter estimation Exogenous Option pricing theory Endogenous Default intensity