Jon Stevenson, CFA, is an experienced equity fund manager who has recently taken a position with Lohsi Clearview, a UK-based hedge fund that has combined a wide range of strategies to deliver impressive returns over the last five years. One of the fund's strategies is to invest in high-credit-risk fixed income instruments. The fund has an excellent track record of identifying bonds in this sector that subsequently outperform the market.

　　Stevenson wishes to familiarize himself with the fund's strategies and has started by looking at some of the techniques used in analyzing fixed income instruments. Exhibit 1 shows the firm's approach to analyzing credit risk.

　　Stevenson is surprised that the fund uses credit ratings to filter out investment grade bonds as not worthy of consideration. In his experience, rating agencies have often been wrong and he intends to send a note to his supervisor stating the following points arguing that credit ratings should not be relied upon as a filter:

　　Point 1: Ratings are volatile over time, which reduces their usefulness as an indication of a debt offering's default probability.

　　Point 2: Ratings do not implicitly depend on the business cycle stage, whereas a debt offering's default probability does.

　　Stevenson has no experience with structural models and is interested in learning more. He finds an analysis that has been completed for a recent bond issue. The results are shown in Exhibit 2.

　　1. Which of the credit analysis models shown in Exhibit 1 can only be used under the assumption that the issuing company's assets trade in a frictionless market?

　　A. Structural models.

　　B. Reduced form models.

　　C. Both structural models and reduced form models.

　　2. When using reduced form models, which of the following statements is most accurate.

　　A. It must be assumed that the riskless rate of interest is constant over time.

　　B. The time T value of the company's assets has a lognormal distribution.

　　C. For a given state of the economy, whether a company defaults depends only on company-specific considerations.

　　3. Which of Stevenson's points regarding the reliability of credit ratings is most accurate?

　　A. Point 1 only.

　　B. Point 2 only.

　　C. Neither point is correct.

　　4. According to the structural model shown in Exhibit 2, the maximum amount an investor holding the bond would pay to a third party to remove the risk of default would be:

　　A. $0.65.

　　B. $22.86.

　　C. $23.51.

　　5. The results shown in Exhibit 2 indicate that the:

　　A. Time value of money discount exceeds the risk premium for risk of credit loss.

　　B. Risk premium for risk of credit loss exceeds the time value of money discount.

　　C. Risk premium for risk of credit loss is $0.65.

　　6. If the volatility estimate is changed to 30% in the structural model shown in Exhibit 2, the calculated value of IMC Bond would most likely:

　　A. Remain the same.

　　B. Decrease.

　　C. Increase

　　1. Solution: A.

　　Structural models require that the company's assets trade in a frictionless arbitrage free market.

　　2. Solution: C.

　　Reduced form models assume that given the macroeconomic state variables, a company's default represents idiosyncratic risk. Structural models assume a constant (non-stochastic) risk-free rate and that the time T value of the assets is characterized by a lognormal distribution.

　　3. Solution: B.

　　Ratings tend to be stable over time, which reduces their correlation to default probabilities; hence, Point 1 is incorrect.

　　4. Solution: C.

　　The maximum amount an investor would to pay to remove the credit risk is the present value of the expected loss.

　　5. Solution: B.

　　The time value of money discount will always reduce the present value of expected loss. Because the present value of expected loss in this case is higher than the expected loss, the risk premium for risk of credit loss must be larger than the time value of money discount.

　　6. Solution: B.

　　Under the option analogy of the structural model, risky debt can be viewed as a portfolio comprising a long position in risk-free debt and a short put option on the company's asset with a strike price equal to the face value of the risky debt. When the asset volatility increases, the value of the put option increases and the value of the portfolio with short exposure to the put option will decrease. Hence the computed value of risky debt will be lower.

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