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Ch11 –part D Term Structure Based Methods

Ch11 –part D Term Structure Based Methods. If we know the risk premium we can infer the probability of default. Expected return equals risk free rate after accounting for probability of default. p (1+ k ) = 1+ i

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Ch11 –part D Term Structure Based Methods

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  1. Ch11 –part DTerm Structure Based Methods • If we know the risk premium we can infer the probability of default. Expected return equals risk free rate after accounting for probability of default. p (1+ k) = 1+ i • May be generalized to loans with any maturity or to adjust for varying default recovery rates. • The loan can be assessed or priced using the inferred probabilities from comparable quality bonds. • Cumulative default rates can be computed by linking marginal (one-period) probabilities Cumulative 2 year = 1-(p1 x p2)

  2. Bond Yields – 11/6/09 Source: Yahoo Finance

  3. Corporate Bond Spreads/Treasury – 11/6/09

  4. Bond Term Spreads – 11/6/09

  5. Implied K – Single Period Spread Text Example: i = .10, p = .95, y = .90 so, th = .0055 Additional Example: I = .05, p = .7, y = .60. so, th = .1431 Additional Example: I = .05, p = .7, y = .1. so, th = .3884

  6. Cumulative Probability of Default Cp = 1-[(p1)x(p2)] p1= .95, p2 = .9318, so cumulative probability = .1148

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