Global Energy Management Institute

1
Global Energy Management Institute

• Credit Related Issues
• January 22, 2004
• Stuart M. Turnbull

2
Outline of Talk

1. Information for pricing credit instruments
2. The use of equity prices
3. The Eliot Spitzer Effects
4. Counterparty risk
5. 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
• 1 The probability of default over the appropriate
  horizon.
• 2 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.

4
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.

5
Interaction Between Debt and Equity Markets
Debt Markets
Credit markets use equity prices.
Equity Markets
Equity markets look at credit ratings, bond
spreads, credit default prices.
6
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
8
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?

9
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.
• 2 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?

10
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
  firms 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.