fic

CS FIRSTBOSTON April 26, 1995

FIXED INCOME RESEARCH BULLETIN
Implied Default Proailitie!" A Ne# Approa$% to Ri!&' Det
Clayton Perry 212/909-2682
Summary Implied default probabilities are a useful mechanism for ealuatin! ris"y
debt# $ather than discountin! promised cashflo%s at a hi!h rate %hich reflects
the dan!er that they %ill not be receied& %e hae more directly identified the
implied default probability in a set of 'r!entinian eurobonds by discountin!
expected cashfio%s at the ris"-free rate# (urthermore& %e hae remoed some
of the apparent inconsistencies inherent in assumin! different probabilities
for similar bonds in the same time period# )hus %e& hae !enerated a set of
probabilities a!ainst %hich inestors can measure their o%n opinions about
the ris"iness of the securities to decide upon relatie alue#
T%i! 'ear %a! #it(e!!ed turmoil i( emer)i() det mar&et! o( a !$ale u(!ee( !i($e
t%e Brad' re!tru$turi()* Follo#i() t%e Me+i$a( de,aluatio( i( De$emer- !%o$&
#a,e! !pread a! far afield a! Pola(d a(d T%aila(d a! i(,e!tor! fled for t%e !afet' of
S#it.erla(d a(d /erma('* I( a( e(,iro(me(t $%ara$teri.ed ' t%i! !ort of 0ri!&
redu$tio( at a(' pri$e0 it i! plau!ile t%at differe(t ri!&! ma' e pri$ed
i($o(!i!te(tl'- or i(deed t%at e1ui,ale(t ri!&! offer #idel' differi() retur(!*
Our approa$% to ide(tif'i() !u$% po!!iilitie! i! to a(al'.e t%e proailit' of
default #%i$% i(,e!tor! %a,e pri$ed i(to ea$% of a !et of !imilarl' ri!&' o(d!* T%e
re!ult i! merel' a differe(t #a' of !tati() relati,e ,alue- ut %a! t%e ad,a(ta)e of
e+pre!!io( i( term! of t%e !pe$ifi$ ri!& t%at i(,e!tor! are $o($er(ed #it% 2 t%e
$%a($e! t%at t%e' #ill )et t%eir mo(e' a$&* T%e !tati!ti$ #e $al$ulate i! t%e rate of
default o( t%e o(d #%i$% #ould )i,e a( e+pe$ted retur( 3(et of proailit'
#ei)%ted $redit lo!!e!4 e1ual to t%e ri!& free rate of retur(* 5e %a,e ta&e( a! our
!ample t%e (o(2Brad' dollar o(d! i!!ued ' Ar)e(ti(a* T%e!e %a,e ee( fa,ored
for t%i! e+po!itio( pri($ipall' e$au!e t%ere are fi,e o(d! of t%e !ame $la!! #it% a
rea!o(al' re)ular maturit' !$%edule* Later ulleti(! #ill deal #it% Brad' o(d!
a(d ot%er $la!!e! of ri!&' det*
This memorandum is for informative purposes only. Under no circumstances is it to be used or considered as an offer to sell, or a solicitation of an offer to buy
any security. Additional information is available upon request. esults based on hypothetical pro!ections or past performance have certain inherent limitations.
There is no certainty that the parameters and assumptions used can be duplicated "ith actual trades. Any results sho"n do not reflect the impact of commissions
and#or fees, unless stated. $inancial futures and options are not appropriate for all investors. Their relative merits should be carefully "ei%hed. &here information
has been obtained from outside sources. 't is believed to be reliable but is not represented to be accurate or complete. This document may not be reproduced in
"hole or in part or other"ise made available "ithout our "ritten consent This firm may from time to time perform investment ban(in% for, or solicit investment
ban(in% or other business from any company mentioned. &e or our employees may from time to time have a lon% or short position in any contract or security
discussed.
$i)ed 'ncome esearch
*ethodolo!y Suppo!e 'ou are due to re$ei,e a pa'me(t i( o(e 'ear6! time* If 'ou are 7889 !ure
'ou #ill $olle$t- it i! !e(!ile to di!$ou(t t%at pa'me(t at t%e rele,a(t ri!& free rate-
t%e 7 2'ear U*S* Trea!ur' ill 'ield* T%e le!! !ure 'ou are of re$ei,i() t%e pa'me(t
t%e %i)%er #ill e t%e di!$ou(t rate applied a(d t%e le!! #ill e t%e pre!e(t ,alue of
t%e pa'me(t* No# !uppo!e 'ou are 7889 $ertai( of )etti() either pa'me(t + or
pa'me(t '- #%ere ' i! a !maller amou(t* If 'ou di!$ou(t ot% at t%e ri!& free rate
'ou )et t#o (et pre!e(t ,alue!- o(e of #%i$% #ill e $orre$t* To ,alue t%i! 0eit%er
or0 pa'me(t t%e mo!t lo)i$al t%i() to do i! to a!!i)( proailitie! to ea$% of
pa'me(t + a(d pa'me(t ' a(d ta&e a( a,era)e of t%e t#o NP:! #ei)%ted ' t%e
a!!i)(ed proailitie!*
I( our e+ample- pa'me(t + repre!e(t! t%e $a!%flo# !$%eduled o( a o(d- #%ile
pa'me(t ' repre!e(t! t%e re$o,er' ,alue 2 t%e amou(t t%e o(d i! #ort% i( t%e
e,e(t of a default* T%e mar&et pri$e of t%e o(d i( it! fi(al $oupo( period #ill
repre!e(t t%e proailit' #ei)%ted a,era)e 2 or e+pe$ted ,alue 2 of t%e!e t#o
amou(t! di!$ou(ted at t%e ri!&2free rate* T%i! i! repre!e(ted al)erai$all' a!
follo#!"
c (1 - d) + Rd
P= _____________
1 + r
#%ere P ; dirt' pri$e of o(d
$ ; $a!%flo#
d = the proailit' of default i( t%i! period
R = recovery pro$eed! i( e,e(t of default
r = risk free di!$ou(t rate
For e+ample- !uppo!e a ri!&' 72'ear .ero $oupo( o(d i! tradi() at a pri$e of <=*==- )i,i() a 'ield
of >89* If t%e di!$ou(t rate o( t%e 7 2'ear U*S* Trea!ur' ill i! ?9 a(d t%e a!!umed re$o,er' rate
o( t%e ri!&' o(d i! =89- t%e( t%e e1uatio( e$ome!@
100 (1 - d) + 38d
83.33 ; AAAAAAAAAAA
1.05
Sol,i() for t%e default rate d )i,e! a mar&et implied default proailit' of 7B*<?9*
If t%e o(d %a! t#o $a!%flo#! remai(i()- t%e pri$e !%ould e1ual t%e !um of t%e t#o di!$ou(ted
e+pe$ted ,alue!* Ho#e,er t%e $al$ulatio( of t%e !e$o(d e+pe$ted ,alue i! !li)%tl' more $ompli$ated
e$au!e #e mu!t allo# for t%e fa$t t%at t%e o(d ma' default i( t%e fir!t $oupo( period* T%erefore
our #ei)%t! are (o# t%e default proailit' i( t%e !e$o(d period conditional o( ma&i() it t%rou)%
t%e fir!t period* T%i! $o(ditio(alit' i! e+pre!!ed ' multipl'i() ot% term! ' t%e proailit' of (o
>
$i)ed 'ncome esearch
default i( t%e fir!t period (1-d). 5e $a( &eep e+te(di() t%i! for ( !$%eduled $a!%flo#! i( t%e !ame
ma((er* Note t%at ea$% period6! proailitie! mu!t e multiplied ' t%e proailit' of (o default i(
all t%e pre,iou! period!*
If #e a!!ume t%at t%e proailit' of default i( ea$% of t%e i(di,idual $oupo( period! i! t%e
!ame #e $a( $ollap!e t%i! e1Citio( to t%e follo#i()@
T%i! i! re$o)(i.ale a! a( e+te(!io( of t%e !imple 'ield to maturit' $al$ulatio( #%i$% o(e
#ould (ormall' !ol,e for t%e di!$ou(t rate- r- from t%e &(o#( pri$e a(d $a!%flo# !$%edule*
T%i! di!$ou(t rate or 'ield #ould u!uall' refle$t opi(io(! of t%e ri!&i(e!! of t%e $a!%flo#
!$%edule* +ur approach separates this discount factor from the ris" %ei!htin! by usin!
the ris" free discount rate from the ,#S# )reasury spot cure and confinin! e-pectations
to the top line of the e.uation# If #e a!!ume a re$o,er' ,alue- #e $a( a$& out a ,alue for d
' iteratio( i( t%e !ame ma((er a! o(e #ould $o(,e(tio(all' $al$ulate 'ield to maturit' '
iterati() for r*
T%e met%odolo)' #e %a,e emplo'ed i! !et out dia)rammati$all' elo#* T%e proailit' of
)etti() to a poi(t o( t%i! i(omial tree i! t%e produ$t of t%e proailitie! ide(tified o( ea$%
ra($% ta&e(*
/-hibit 1# Binomial Tree of Default Probabilities
Cumulati,e T%e $al$ulatio(! #e %a,e de!$ried ao,e $a( e !ol,ed for d to )i,e t%e default
Default proailit' a!!umed for ea$% !i()le period* If a orro#er %a! det #it% ma('
Proailit' maturitie! out!ta(di() or %a! det #%i$% $apitali.e! i(tere!t or amorti.e!- t%e per
period default rate $a( e e!pe$iall' u!eful* For ma(' i!!uer! %o#e,er- of more
=
$i)ed 'ncome esearch
i(tere!t i! t%e $umulati,e default proailit'- t%e $%a($e t%at a o(d #ill (ot ma&e it to a
parti$ular poi(t o( our i(omial tree* For i(!ta($e- mo!t i(,e!tor! #ill e i(tere!ted i( t%e
proailit' t%at t%eir o(d #ill (ot default efore maturit'* T%i! i! t%e proailit' t%at #e #ill
)et to t%e ottom ri)%t o+ o( our i(omial tree- #%i$% i! Du!t t%e produ$t of all t%e i(di,idual
per2period proailitie! of !ur,i,al*
37Ed74372d>4F372dn4
A)ai( if #e a!!ume $o(!ta(t per2period proailitie!- t%e proailit' of (o default up to a(d
i($ludi() period n is
372d4
n
T%i! mea(! t%at t%e $umulati,e proailit' of default #ill e
7 2 37 2 d4
(
A!!e!!i() a T%e a!!e!!me(t of t%e re$o,er' ,alue of t%e o(d i( t%e e,e(t of default i! ot%
$ecoery 0alue diffi$ult a(d $ru$ial to t%e re!ult!* A $orporate o(d !%ould %a,e !ome ,alue i(
default from t%e $laim! t%at o(d2%older! %a,e o( t%e a!!et! of t%e $ompa('*
Se$ured det pre!e(t! fe# prolem!- #%ile u(!e$ured det #ill %a,e a $laim o(
u(e($umered a!!et! #%i$% #ill pre!umal' e !old at !ome di!$ou(t to full ,alue
i( t%e $a!e of li1uidatio(* A!!e!!i() t%e pri$e t%e!e a!!et! #ould fet$% i( a
!ituatio( of di!tre!!- alo() #it% t%e $o!t! of li1uidati() t%e $ompa(' #ill pre!e(t
!ome prolem!- ut t%e de)ree of a$$ura$' !%ould e rea!o(ale*
So,erei)( det- %o#e,er- pre!e(t! )reater diffi$ult'* Creditor! are (ot i( a po!itio(
to $lo!e do#( t%e $ou(tr' a(d !ell off road!- rid)e! a(d dam!* O( t%e ot%er %a(d-
a promi!e to pa' a future !erie! of $a!%flo#! a(d e,e( pa!t oli)atio(! i( default
proal' mea(! more from a !o,erei)( !tate t%a( from a $orporate e(tit'*
T%erefore it i! diffi$ult to ima)i(e !u$% det e,er tradi() at .ero* E,e( t%e
defaulted paper of Lieria- o(e of t%e #orld6! poore!t $ou(trie!- trade! at arou(d
>*?9 of fa$e ,alue*
T%i! i! $o(firmed ' %i!tori$al a(al'!i!* Prior to t%e mo!t re$e(t Brad'
re!tru$turi()- defaulted Lati( Ameri$a( det traded at pri$e! et#ee( ><*<<
3Bra.il4 a(d GH*?8 3Ar)e(ti(a4* Of $our!e- t%e!e pri$e! (o dout too& a$$ou(t of
t%e %i)% proailit' of re!tru$turi()- a(d t%erefore #ere !ome#%at more )e(erou!
t%a( #e !%ould u!e %ere*
5e approa$% t%i! o( t%e a!i! t%at defaulted paper #ould %a,e a ,alue relati,e to
t%e $a!%fio#! !till to e paid o( t%e o(d* I(,e!tor! mi)%t a!!ume a pa'me(t rate-
for e+ample- of =8 $e(t! o( t%e dollar a(d take the present vale o! that percenta"e
o! the re#ainin" cash!lo$s as the price o! the de!alted paper. T%i! i! t%e amou(t
t%at #ould e reali.ale o( t%e da' of default- a(d a$$ordi()l' $o(!titute! our R*
T%e effe$t of t%i! i! t%at R i! (ot $o(!ta(t ut $%a()e! t%rou)%out t%e life of t%e
G
C S FIRSTBOSTON
(i-ed Income $esearch
o(d- #%i$% appear! more t%eoreti$all' $o(!i!te(t t%a( a $o(!ta(t (umer* Of
$our!e #e do (ot &(o# #%at di!$ou(t rate! #ill e pre,aili() at ea$% $oupo( date-
a(d !i($e #e are ,alui() e,er't%i() toda' #e are i(tere!ted i( t%e di!$ou(ted
,alue of ea$% of t%e R6! t

#%ere" a ; e+pe$ted per$e(ta)e pa'out i( e,e(t of default*
Our e+ample- Ar)e(ti(a- %a! a #ell2de,eloped i(fra!tru$ture a(d i! #ell e(do#ed #it% (atural
re!our$e!* Out!ta(di() det i! o(l' =G9 of /DP* T%i! #ould lead u! to elie,e t%at a fi)ure of
arou(d =8 $e(t! o( t%e dollar #ould e a rea!o(ale i(,e!tor e+pe$tatio( a! to t%e po!t2default
pa'out o( Ar)e(ti(a paper* Due to t%e aritrar' (ature of !u$% a( e!timate a(d t%e !e(!iti,it' of our
$al$ulatio(! to it- #e %a,e al!o deri,ed t%e implied proailitie! a!!o$iated #it% pa'out rate! of
7?9 a(d G?9*

Some of t%e!e re!ult! de!er,e $omme(t* Implied per2period default proailitie! i( )e(eral i($rea!e
#it% maturit'- a fa$t #e deal #it% furt%er elo#* Note t%at t%e 7IIB- 7III a(d >888 o(d! all %a,e
,er' !imilar rate! #it% a i) Dump out to >88=* T%i! i! more appare(t from t%e plot elo# of t%e
0implied default $ur,e*0
Fixed Income Research

T%e mai( feature of t%e tale i! t%at t%e (umer! appear fairl' !mall* Ho#e,er- #%e( #e loo& at t%e
c#lative default rate implied- t%e ma)(itude ri!e! rapidl'* T%i! i! t%e proailit' t%at a o(d #ill
default efore t%e )i,e( date- i( t%i! $a!e it! maturit'* T%e re!ult! are !et out elo#*
T%i! )i,e! a $learer ,ie# of #%ere t%e mar&et i! pla$i() it! et!* Naturall' t%e lo()er i! a o(d6!
maturit'- t%e )reater t%e $%a($e it #ill default efore maturit'* Note t%at e,e( i( t%e $a!e of t%e
!malle!t re$o,er' ,alue i(,e!tor! elie,e t%ere i! (earl' a %alf $%a($e t%at t%e De$ >88= o(d
#ill (ot pa' it! full !$%edule of $a!%flo#!*
H
Fixed Income Research
/-tendin! the T%e pri($ipal prolem #it% t%i! approa$% i! o(e of i($o(!i!te($'* Be$au!e #e are
*odel to 1on- a!!umi() $o(!ta(t per period default rate! t%rou)%out t%e life of a o(d- #e )et t%e
Constant a(omalou! re!ult t%at t%e proailit' of default ' t%e !ame i!!uer i( t%e !ame
2efault $ates period #ill e differe(t #%e( mea!ured o( differe(t o(d!* Of $our!e t%i! ma' e a
re!ult of i($o(!i!te(t mar&et e%a,ior- ut e1uall' it ma' !%o# a maturit' effe$t*
I( t%e !ame #a' a! 'ield2to2maturit' di!$ou(t! all $a!%flo#! at a u(iform rate i(
!pite of a (o(2$o(!ta(t term !tru$ture- t%e a!!umptio( of $o(!ta(t per period
default rate! o,er time ma' e u(rea!o(ale* I(,e!tor! ma' e more $ertai( of a
$ou(tr'6! e$o(omi$ pro!pe$t! i( t%e !%ort term t%a( a fe# 'ear! from (o#- or a
!$%eduled ele$tio( $ould i($rea!e default proailit' i( it! #a&e* A! for $orporate
i!!uer!- o(e $a( e(,i!a)e a (e# produ$t lau($% or out$ome to liti)atio( #%i$% ma'
dramati$all' alter t%eir $redit 1ualit'*
T%erefore #e %a,e e+te(ded t%e model to ta&e a$$ou(t of t%e po!!iilit' of
,aria($e i( default rate! o,er time* T%e met%odolo)' i! merel' to a!!ume t%at t%e
!%orte!t o(d determi(e! t%e implied default rate for it! lifetime- a(d t%at t%e
$a!%flo#! o( all ot%er o(d! duri() t%at period !%ould e #ei)%ted ' t%at
proailit'* T%e (e+t lo()e!t o(d t%e( determi(e! t%e proailit' u(til it!
maturit' a(d !o o(* T%u! if a o(d mature! after = $oupo( period! #e #ould #or&
out t%e $o(!ta(t per2period default proailit' for t%at !e$urit' a$$ordi() to our
fir!t met%od* T%i! #ould )i,e u! d1% d& a(d d= for e,er' o(d o( t%e $ur,e* T%e
e1uatio( for t%e (e+t o(d #ould u!e t%o!e t%ree rate! a! )i,e(- a(d #e #ould t%e(
e ale to a$& out a $o(!ta(t ,alue of d for t%e remai(i() period! i( t%at o(d*
T%i! pro$e!! $a( e repeated for e,er' o(d to )i,e t%e 0mar)i(al0 per2period
default rate for ea$%@ t%at i!- t%e rate of d t%at applie! for t%e fi(al period! of t%at
o(d6! life* I( t%i! #a' #e $a( 0oot!trap0 a $redit $ur,e i( mu$% t%e !ame #a'
t%at a !erie! of $oupo( o(d! $a( e u!ed to )e(erate a !pot $ur,e i( 'ield term!*
T%e re!tri$tio( i! t%at #e are o(l' deali() #it% a %a(dful of i!!ue!- a(d t%u! $a(
o(l' ,ar' t%e default proailit' a fe# time!* Ne,ert%ele!! t%i! #ill )i,e a
rea!o(ale i(di$atio( of t%e !%ape of t%e 0$redit $ur,e0 a(d ma' !%o# up aritra)e
opportu(itie!*
Mat%emati$all' t%i! i(trodu$e! (o(2$o(!ta(t default rate!* T%e e1uatio( (o#
e$ome! more $ompli$ated ut !till ma(a)eale"

(i-ed Income $esearch
Be$au!e #e are 3t%eoreti$all'4 ,ar'i() t%e default rate! e,er' period- #e lo!e t%e ailit' to u!e
e+po(e(tial term! a(d mu!t i(trodu$e produ$t (otatio(* T%i! merel' %ar&! a$& to our i(omial
tree a(d t%e (otio( of multipl'i() e,er' term ' all t%e proailitie! t%at mu!t e !ati!fied to
rea$% t%at poi(t*

T%u! for t%e 7?9 re$o,er' rate- t%e implied proailit' of default i( ea$% of t%e !emi2a((ual
period! up to Au)u!t 7IIH (d1%d&%d3) i! =*7 9* T%ereafter t%e implied rate e$ome! G*H9 u(til
Jul' 7IIB (d'%d5) a(d !o o( a! !%o#( i( t%e tale elo#*

T%i! )i,e! a more a$$urate pi$ture of t%e time at #%i$% t%e mar&et i! etti() Ar)e(ti(a #ill fail
o( pa'me(t!* B' o($e more multipl'i() t%rou)% t%e!e per2period proailitie!- #e $a(
)e(erate a more $o(!i!te(t pi$ture of $umulati,e proailitie! a! follo#!*

T%ere are $a,eat! i( t%e i(terpretatio( of t%e!e (umer!- a! di!$u!!ed elo#- ut t%e' pro,ide
t%e mar&et6! e!t e!timate of #%e( Ar)e(ti(a i! mo!t li&el' to default o( it! oli)atio(!*
T%e o,erall me!!a)e i! t%at if i(,e!tor! elie,e t%at t%ere i! le!! t%a( a ?89 $%a($e t%at
Ar)e(ti(a #ill default i( t%e (e+t ei)%t 'ear!- t%e' $a( ear( more premium t%a( t%e' re1uire
o,er a ri!&le!! a!!et*
<
Fi+ed I($ome Re!ear$%
5e !tre!! t%at t%ere are !implif'i() a!!umptio(! emplo'ed i( our model* Fir!tl' #e %a,e a!tra$ted from
all li1uidit' a(d ta+ effe$t! i( the mar&et- a!!umi() i(!tead t%at our u(i,er!e of o(d! i! %omo)e(eou! i(
re!pe$t of t%e!e attriute!* T%i! doe! (ot !eem too re!tri$ti,e a( a!!umptio( #%e( deali() #it%
euroo(d! i!!ued i( rea!o(ale !i.e* More importa(tl' #e %a,e a!!umed (o $orrelatio( et#ee( U*S*
i(tere!t rate! a(d rate! of default* I($orporate o(d! t%i! ma' (ot e ea!il' defe(dale- ut t%e !i.e of
Ar)e(ti(a6! det urde( relati,e to it! /DP 2 =G9 2 mea(! t%at rate! #ould %a,e to ri!e mu$% furt%er
t%a( i! li&el' i( t%e (e+t $ouple of 'ear! for t%e i($rea!e i( det !er,i$i() to %a,e a !i)(ifi$a(t impa$t o(
Ar)e(ti(a6! fi(a($e!* B' ma&i() t%e!e a!!umptio(! #e %a,e ee( ale to reapprai!e t%e!e !e$uritie! i(
term! t%at are more dire$tl' rele,a(t to t%e i(,e!tor! #%o u' t%em*
I
CS FIRST BOSTON *une 15,1995
FIXED INCOME RESEARCH BULLETIN
Implied Default Proailitie! Part >"
Appli$atio( to Brad' Bo(d!
Clayton Perry 212/322-4998
Summary (ollo%in! our earlier analysis of default probabilities priced into ris"y euro
bonds& the purpose of this paper is to adapt the methodolo!y to collaterali5ed
6rady bonds# 6y calculatin! the default probability& %e can more accurately
alue the arious component parts of a 6rady bond and thus assess the true
return to country ris"# 7e illustrate this by sho%in! the considerable differ-
ences bet%een conentionally calculated stripped yields and those %or"ed out
usin! the implied default probability method#
T%i! paper refere($e! a(d e+te(d! t%e a(al'!i! de,eloped i( our earlier ulleti(
(#plied )e!alt Pro*a*ilities% + ,e$ +pproach to Risky )e*t% CS Fir!t Bo!to(
Fi+ed I($ome Re!ear$%- April 7II?* T%e met%odolo)' emplo'ed %ere i! e+plai(ed
i( detail i( t%at puli$atio( a(d re$apped o(l' riefl' %ere*
I( t%e pre,iou! paper #e di!$u!!ed t%e $o($ept of mar&et implied rate! of default
a(d loo&ed at appl'i() t%i! to differe(t i!!ue! ' t%e !ame orro#er to $reate a
a!i$ term !tru$ture of default proailit'* T%e aim of t%i! report i! to ame(d t%e
met%odolo)' !li)%tl' to appl' to Brad' o(d! a(d to e+ami(e t%e ,aluatio(
impli$atio(! a$ro!! differe(t i!!uer!* 5e e)i( ' re,i!iti() t%e a(al'!i! outli(ed
pre,iou!l'*
$ecappin! the Suppo!e 'ou are due to re$ei,e a pa'me(t i( o(e 'ear6! time* If 'ou are 7889 !ure
*ethodolo!y 'ou #ill $olle$t- it i! !e(!ile to di!$ou(t t%at pa'me(t at t%e rele,a(t ri!& free rate-
t%e 72Kear U*S* Trea!ur' ill 'ield* T%e le!! !ure 'ou are of re$ei,i() t%e pa'me(t*
t%e %i)%er #ill e t%e di!$ou(t rate applied a(d t%e le!! #ill e t%e pre!e(t ,alue of
t%e pa'me(t* No# !uppo!e 'ou are 7889 $ertai( of )etti() either pa'me(t - or
pa'me(t y- #%ere y i! a !maller amou(t* If 'ou di!$ou(t ot% at t%e ri!& free rate
'ou )et t#o (et pre!e(t ,alue!- o(e of #%i$% #ill e $orre$t* To ,alue t%i! 0eit%er
This memorandum is for informative purposes only. Under no circumstances is it to be used or considered as an offer to sell, or a solicitation of an offer to buy
any security. Additional information is available upon request. esults based on hypothetical pro!ections or past performance have certain inherent limitations.
There is no certainty that the parameters and assumptions used can be duplicated "ith actual trades. Any results sho"n do not reflect the impact of commissions
and#or fees, unless stated. $inancial futures and options are not appropriate for all investors. Their relative merits should be carefully "ei%hed. &here information
has been obtained from outside sources. 't is believed to be reliable but is not represented to be accurate or complete. This document may not be reproduced in
"hole or in part or other"ise made available "ithout our "ritten consent This firm may from time to time perform investment ban(in% for, or solicit investment
ban(in% or other business from any company mentioned. &e or our employees may from time to time have a lon% or short position in any contract or security
discussed.
Fixed Income Research
or0 pa'me(t t%e mo!t lo)i$al t%i() to do i! to a!!i)( proailitie! to ea$% of pa'me(t - a(d
pa'me(t y a(d ta&e a( a,era)e of t%e t#o NP:! #ei)%ted ' t%e a!!i)(ed proailitie!*
I( our e+ample- pa'me(t - repre!e(t! t%e $a!% flo# !$%eduled o( a o(d- #%ile pa'me(t y
repre!e(t! t%e re$o,er' ,alue 2 t%e amou(t t%e o(d i! #ort% i( t%e e,e(t of a default* T%e
mar&et pri$e of t%e o(d i( it! fi(al $oupo( period #ill repre!e(t t%e proailit' #ei)%ted
a,era)e 2 or e+pe$ted ,alue 2 of t%e!e t#o amou(t! di!$ou(ted at t%e ri!&2free rate* T%i! i!
repre!e(ted al)erai$all' a! follo#!"
P= c (( - d) +Rd
( + r
#%ere P ; pri$e i($ludi() a$$rued i(tere!t
$ ; $a!% flo#
d ; t%e proailit' of default! i( t%i! period
R = re$o,er' pro$eed! i( e,e(t of default
r = ri!& free di!$ou(t rate
For e+ample- !uppo!e a ri!&' 72'ear .ero $oupo( o(d i! tradi() at a pri$e of <=*==- )i,i() a
'ield of >89* If t%e di!$ou(t rate o( t%e 7 2'ear U*S* Trea!ur' ill i! ?9 a(d t%e a!!umed
re$o,er' rate o( t%e ri!&' o(d i! =89- t%e( t%e e1uatio( e$ome!@
<=*== ; 788 37 2 d ) + =8 d
7*8?
Sol,i() for t%e default rate d )i,e! a mar&et implied default proailit' of 7B*<?9*
If t%e o(d %a! t#o $a!% flo#! remai(i()- t%e pri$e !%ould e1ual t%e !um of t%e t#o di!$ou(ted
e+pe$ted ,alue!* Ho#e,er- t%e $al$ulatio( of t%e !e$o(d e+pe$ted ,alue i! !li)%tl' more
$ompli$ated e$au!e #e mu!t allo# for t%e fa$t t%at t%e o(d ma' default i( t%e fir!t $oupo(
period* T%erefore- our #ei)%t! are (o# t%e default proailit' i( t%e !e$o(d period $o(ditio(al
o( ma&i() it t%rou)% t%e fir!t period* T%i! $o(ditio(alit' i! e+pre!!ed ' multipl'i() ot% term!
' t%e proailit' of (o default i( t%e fir!t period (1-d). 5e $a( &eep e+te(di() t%i! for (
!$%eduled $a!% flo#! i( t%e !ame ma((er* Note t%at ea$% period6! proailitie! mu!t e
multiplied ' t%e proailit' of (o default i( all t%e pre,iou! period!*


Fixed Income Research
If #e a!!ume t%at t%e proailit' of default i( ea$% of t%e i(di,idual $oupo( period! i! t%e
!ame #e $a( $ollap!e t%i! e1uatio( to t%e follo#i()@
T%e met%odolo)' #e %a,e emplo'ed i! !et out dia)rammati$all' elo#* T%e proailit' of
)etti() to a poi(t o( t%i!2i(omial tree i! t%e produ$t of t%e proailitie! ide(tified o(
ea$% ra($% ta&e(*
/-hibit 1# Binomial Tree of Default Probabilities
)he 6rady Brad' o(d! are di!ti()ui!%ed from Euroo(d! mai(l' ' $ollaterali.atio( of
2ifference !ome pa'me(t!* U(der t%e term! of t%e !e$urit'- t%e i!!uer %a! defea!ed t%e
pri($ipal #it% U*S* Trea!ur' STRIPS of t%e !ame maturit'- a(d $ollaterali.ed
!e,eral $oupo( pa'me(t! o( a rolli() a!i! #it% a %i)% 1ualit' !e$urit' 3u!uall'
AA or etter4* T%e a$tual term! of t%e Brad' i!!ue! ,ar' ' i!!uer@ #e refer reader!
#%o are u(familiar #it% t%e mar&et to +n (ntrodction to .#er"in" /ontries
0i-ed (nco#e (nstr#ents% CS Fir!t Bo!to( Ma' 7II=*
T%e !imple #a' to i($orporate t%i! $ollaterali.atio( of !ome $a!% flo#! i(to our
model i! to adDu!t t%e $al$ulatio( of a re$o,er' ,alue- R- to refle$t t%e i($lu!io( of
t%e $ollaterali.ed $oupo(! a(d pri($ipal at t%eir full di!$ou(ted ,alue* U!i()
Me+i$o a! t%e e+ample- t%i! mea(! t%at t%e re$o,er' ,alue for default i( t%e !i+t%
$oupo( period #ould e t%e di!$ou(ted ,alue of t%e !i+t%- !e,e(t% a(d ei)%t%
$oupo(!- a(d t%e di!$ou(ted pri($ipal* I( )e(eral term! t%i! i! t%e follo#i()@

1ote that %e hae assumed no recoery oer and aboe the collateral* T%i! i! a
,er' importa(t a(d !ome#%at aritrar' a!!umptio(- a! t%e o(d i( default #ould
Fixed Income Research
%a,e !ome ,alue attriutale to t%e promi!ed $oupo( flo# out!ide of t%e $ollateral-
a(d a(' Dud)eme(t ma' a#ard $reditor! more t%a( Du!t t%e $ollateral ,alue*
Ho#e,er #e Du!tif' our a!!umptio( o( t%e )rou(d! t%at it #ill repre!e(t t%e a!e
$a!e- a(d t%at- %a,i() defea!ed !ome of t%e pa'me(t!- t%e i!!uer i! le!! li&el' to
feel $ompelled to pa' out more t%a( t%e' alread' %a,e*
Armed #it% t%i! i(formatio(- #e $a( (o# #or& t%rou)% t%e e1uatio( o( t%e pre,iou!
pa)e to a$& out t%e implied default rate! for a !erie! of Brad' o(d!* Mo!t i!!uer!
%a,e a Di!$ou(t a(d a Par o(d- a floati() rate a(d fi+ed rate =82'ear o(d
re!pe$ti,el'- #%i$% %a,e rea!o(al' u(iform !tru$ture! a$ro!! i!!uer! a(d t%u! le(d
t%em!el,e! to $ro!!2mar&et $ompari!o(* For t%e floati() rate Di!$ou(t o(d!- #e
a!!ume $oupo(! to e fi+ed a$$ordi() to LIBOR for#ard rate!*
T%e follo#i() tale !ummari.e! our fi(di()!*

'pplications8 T%e $ollaterali.atio( of !ome $a!% flo#! allo#! t%e di,i!io( of t%e pri$e amo() t%e
Pricin! ,ariou! $ompo(e(t! a! follo#!*
Compo(e(t!
P ; P) E P$ E Pp
#%ere P ; pri$e i($ludi() a$$rued i(tere!t
P" ; pri$e of $oupo( )uara(tee
Pc ; pri$e of ri!&' $oupo( !tream
Pp ; pri$e of pri($ipal redemptio(
(i-ed Income $esearch

Co(,e(tio(all' t%i! i! !plit a! !%o#( elo#* T%e fir!t part i! t%e $ollaterali.ed 3a(d t%u! $ertai(4
fir!t t%ree $oupo(!- t%e !e$o(d t%e ri!&' !tream of $oupo(! follo#i() t%e fir!t t%ree- a(d t%e la!t part
i! t%e pri($ipal* B' putti() a ,alue to t%e fir!t a(d la!t pie$e! #e $a( #or& out #%at pri$e i! $%ar)ed
for t%e ri!&' $oupo( !tream 3P$4 a(d t%u! )e(erate t%e 'ield o( t%at pie$e of t%e o(d*
To !tart #it% t%e ea!ie!t- t%e pri($ipal of t%e o(d i! appro+imatel' e1ui,ale(t to off2t%e2ru(
U*S* Trea!ur' STRIPS* 5e !a' appro+imatel' e$au!e alt%ou)% t%e STRIPS !e$ure t%e
redemptio( pa'me(t- t%e!e !e$uritie! are (ot otai(ale efore maturit' a(d $a((ot t%erefore e
traded li&e a (ormal !e$urit'* Ho#e,er- for $urre(t purpo!e! t%e pri($ipal i! treated a! Trea!ur'
STRIPS- a(d t%u! ,alued a! follo#!*
Pp; 788
37Ern4
n

T%e !plit et#ee( t%e fir!t part of t%e o(d- t%e $oupo( $ollateral- a(d t%e ri!&' $oupo( !tream i!
t%e mo!t i(tere!ti()* Co(,e(tio(all' t%e approa$% %a! ee( to ta&e t%e $ollaterali.ed $oupo(! a!
$ertai( $a!% flo#! a(d di!$ou(t t%em at t%e ri!& free rate* T%i! ,alue 3alo() #it% t%e pri($ipal
,alue ao,e4 i! !utra$ted from t%e pri$e a(d t%e remai(der i! t%e $o!t of t%e re!t of t%e $oupo(
!tream*
T%e prolem #it% t%i! approa$%- depi$ted i( e+%iit =- i! t%at it )i,e! (o ,alue to t%e rolli()
$ollateral pa!t t%e fir!t t%ree $oupo(!* It implie! t%at i( ei)%tee( mo(t%!- if t%ere i! (o default-
'ou %a,e a( u($ollaterali.ed $oupo( !tream #%e( i( fa$t 'ou #ill !till %a,e a partiall'
$ollaterali.ed $oupo( !tream* T%u! t%e $o(,e(tio(al met%od $learl' o,er!implifie! t%e impa$t of
t%e $ollateral u(le!! t%e o(d default! i( t%e fir!t period*
5e elie,e t%at t%e $orre$t #a' to ,alue t%e )uara(tee i! to pri$e it a! a !et of $o(ti()e(t $a!%
flo#!* Loo& a)ai( at our i(omial tree o( t%e follo#i() pa)e* Ea$% of t%e o+e! repre!e(t! a
$ertai( $a!% flo# at a $ertai( poi(t i( time- a(d t%u! %a! a &(o#( di!$ou(ted ,alue*
Furt%ermore- from our earlier $al$ulatio( #e &(o# t%e ,alue! for d t%at t%e mar&et implie!- a(d
t%u! t%e proailit' of )etti() ea$% of t%e flo#!* T%e produ$t of t%e di!$ou(ted ,alue a(d t%e
proailit' of re$ei,i() it )i,e! t%e e+pe$ted ,alue- #%i$% i! #%at t%e ri!& (eutral i(,e!tor
#ould e #illi() to pa' for a $o(ti()e(t $a!% flo#*
Fi+ed I($ome Re!ear$%
)herefore the fair alue of the !uarantee 9P!: is the total e-pected alue of t%e top half of
the tree& leain! the e-pected alue of the bottom half of t%e tree as the price of the
scheduled coupon stream 3P-4*

Mat%emati$all'- t%e fair pri$e of t%e $oupo( )uara(tee $a( (o# e e+pre!!ed a! follo#!"

Rememer for t%e purpo!e! of t%i! $al$ulatio( #e %a,e alread' !utra$ted t%e ,alue of t%e
pri($ipal a(d #e a!!ume .ero re$o,er' of (o(2$ollaterali.ed flo#!- !o t%e re$o,er' i! defi(ed"

T%i! )i,e! a ,alue for t%e $oupo( !trip a! follo#!"
Fixed income Research
No# #e $a( !u!titute t%e!e ,alue! for differe(t part! of t%e o(d 3P$- P) a(d Pp4
a$& i(to t%e ori)i(al e1uatio( a(d $ollap!e term! to )i,e t%e follo#i()"

T%i! i!- of $our!e- our ori)i(al- ri!&' o(d pri$e e1uatio( #it% t%e pri($ipal e+pre!!ed !eparatel'*
Ha,i() t%u! $lo!ed t%e loop- #e $a( loo& at t%e $urre(t pri$i() of Brad' o(d! a(d allo$ate ,alue
to ea$% of t%e t%ree $ompo(e(t!- a! !%o#( i( t%e follo#i() tale*

'pplications8 T%e reallo$atio( of ,alue i( t%e pri$e of a Brad' o(d %a! importa(t impli$atio(!
)he )rue for mea!ure! of relati,e ,alue* O(e of t%e mo!t fre1ue(tl' u!ed i(di$ator! i( t%e
Stripped ;ield Brad' mar&et i! !tripped 'ield* T%i! i! t%e i(ter(al rate of retur( o( t%e ri!&' $a!%
flo#!- a(d i! t%u! $omparale to a( u($ollaterali.ed Euroo(d i!!ued ' t%e !ame
orro#er*
I( order to $al$ulate t%e !tripped 'ield- #e mu!t e ale to fairl' a!!i)( t%e
proportio( of t%e pri$e of t%e o(d t%at i! attriutale to t%e ri!&' $oupo( !tream a!
o(l' t%e( $a( #e mea!ure t%e true retur( to $ou(tr'2!pe$ifi$ ri!&*
T%e follo#i() tale !et! out t%e true !tripped 'ield! offered o( Brad'6! a(d
$o(tra!t! t%em #it% t%e $o(,e(tio(all' $al$ulated mea!ure* T%e true !tripped 'ield
i! )e(erall' %i)%er ' arou(d 788 *p*- de!pite t%e fa$t t%at t%e $oupo( )uara(tee i!
)e(erall' #ort% le!! 3a(d t%u! t%e $oupo( !tream more4 u(der our met%od* T%e
rea!o( for t%i! i! t%at t%e i($lu!io( i( t%e !tripped $oupo( !tream of a proailit'
#ei)%ted portio( of t%e fir!t t%ree $a!% flo#! out#ei)%! t%e %i)%er pri$e paid*
Fi+ed I($ome Re!ear$%
+ther T%rou)% our pre,iou!l' di!$u!!ed default proailit' met%odolo)'- #e %a,e ee(
Co(!ideratio(! ale to more a$$uratel' $apture t%e pri$e of t%e differe(t ri!&! i(%ere(t i( a Brad'
o(d* T%i!- i( tur(- %a! allo#ed u! to $al$ulate a true !tripped 'ield a(d t%u! a
more $o(!i!te(t mea!ure of ,aluatio(*
T%i! a(al'!i! a!!ume! ri!& (eutralit' o( t%e part of i(,e!tor! !u$% t%at t%e' are
#illi() to pa' L7 for ea$% dollar of e-pected pre!e(t ,alue* Moreo,er #e %a,e
a!!umed for t%i! paper t%at i( t%e e,e(t of default- t%ere #ould e (o pa'me(t
ot%er t%a( t%e $ollateral* T%i! a!!umptio( i! ope( to deate- ut #e (ote t%at
rela+i() it #ould $%a()e t%e (umer! )i,e( ut (ot t%e ,alidit' of t%e a(al'!i!*
Fi(all'- #e earlier me(tio(ed t%e li1uidit' prolem a!!o$iated #it% t%e pri($ipal
$ollateral* Alt%ou)% t%e redemptio( pa'me(t i! defea!ed #it% Trea!ur' STRIPS-
t%ere i! (o #a' of rea&i() t%at out of t%e o(d efore t%e !$%eduled maturit'*
T%erefore- a(' aritra)e #ould rel' o( !#appi() t%at amou(t a$& to it! pre!e(t
,alue u!i() a =82'ear .ero2$oupo( !#ap* I( fa$t a(' reali.atio( of t%e e+pe$ted
,alue of $oupo( pa'me(t! #ould al!o rel' o( !#appi() t%em- !o for aritra)e
purpo!e! all flo#! !%ould e di!$ou(ted from t%e !#ap $ur,e*
0 ~
/onditional default ri!& refer! to t%e pro!pe$t of o(d default i( a $ertai( period- a!!umi() (o prior default*
U(li&e $umulati,e default ri!&- $o(ditio(al default ri!& (eed (ot ri!e loo&i() for#ard* Co(,e(tio(all'- %o#e,er-
emer)i() mar&et parti$ipa(t! pre!ume it doe!*
T%e pre!umptio( i! rea!o(ale for !tro() $redit!- e$au!e t%eir 1ualit' %a! !o mu$% more !$ope to de$a' t%a( to
impro,e* For #ea& $redit!- %o#e,er- t%e pre!umptio( !%ould e re,er!ed* O,er time- lo# )rade o(d! t%at do (ot
default are li&el' to impro,e* T%e!e ar)ume(t! $a( e refi(ed u!i() t%e t%eor' of Mar&o, $%ai(!*
Empiri$all'- default term !tru$ture! for U*S* $orporate o(d! are ri!i() for A rati()! ut !teepl' i(,erted for
!i()le2B* A Mar&o, $%ai( approa$% e+plai(! t%e e,ide($e remar&al' #ell- i($ludi() t%e %umped term !tru$ture!
of Ba a(d Baa $redit!*
T%e di!$repa($' et#ee( mar&et a!!e!!me(t a(d ri!& !u))e!t! a( attra$ti,e aritra)e opportu(it' for lo()er2term
i(,e!tor!" u' $ale(dar !pread! i( lo#er2)rade o(d!*
)erm Structure of 2efault $is"
(ntrodction For lo()er time period!- t%e re1uired premium $a(
e !%o#( to e1ual d(1+r4M(1-d)% #%ere d i! t%e
A! o(d! a)e- t%eir default ri!&! $%a()e* :ie#ed $o(ditio(al default rate a(d r i! t%e future ri!&2free
from t%e date of pur$%a!e- ea$% !u$$e!!i,e $oupo( rate* I($orporati() po!iti,e po!t2default pa'out!
i! le!! li&el' to e paid- !o t%e c#lative default a(d ri!& a,er!io( furt%er $ompli$ate! t%e
ri!& ri!e!* But #e mi)%t al!o a!&" %o# li&el' i! t%e relatio(!%ip- ut %i)%er future default ri!&! are !till
(e+t $oupo( to e defaulted- a!!umi() (o prior a!!o$iated #it% %i)%er future premium! o,er ri!&2
defaultN T%i! i! &(o#( a! t%e conditional default free i(tere!t rate!*
ri!&* It! term !tru$ture i(di$ate! #%et%er t%at ri!&
ri!e! or fall! o,er time* Conventional View of Forward Default Risk
I( emer)i() mar&et!- t%e term !tru$ture of default I( emer)i() mar&et!- default ri!& i! t'pi$all'
ri!& i! t'pi$all' pri$ed a! if it #ere flat or ri!i()* pri$ed a! if it #ere 3a4 ri!i() for all t'pe! loo&i()
T%i! paper mar!%al! e,ide($e !u))e!ti()- o( t%e for#ard- a(d 34 !teeper- t%e lo#er t%e i(itial $redit
$o(trar'- t%at t%e term !tru$ture for #ea& $redit! rati()*
(aturall' de$li(e!*
7
For e+ample- i( April 7II?- o(e2'ear- fi,e2'ear-
T%e term !tru$ture of default ri!& matter! to a(d ei)%t2'ear Ar)e(ti(e dollar Euroo(d! traded
i(,e!tor!- e$au!e it ou)%t to i(flue($e i(tere!t re!pe$ti,el' at H88 p- B88 p- a(d BB? p !pread!
rate!* A! a( illu!tratio(- !uppo!e t%e $o(ditio(al o,er U*S* Trea!urie!* A!!umi() a po!t2default
default ri!&! are 78 a!i! poi(t! 3p4 toda' a(d H pa'out ratio of 7?9 of fa$e ,alue- t%e implied
p tomorro#- t%at t%ere i! (o po!t2default pa'out- $o(ditio(al default ri!&! e!$alate to 78*79 for
a(d t%at ri!&2free i(tere!t rate! ru( > p per da'* 'ear! fi,e t%rou)% ei)%t from H*I9 for 'ear o(e*
>

A ri!&2(eutral i(,e!tor 3i*e*- #illi() to a$$ept a(' For $ompari!o(- t%e 'ield differe(tial et#ee(
et e+pe$ted to rea& e,e(4 #ill $%ar)e 7> p triple2A U*S* $orporate o(d! a(d $orre!po(di()
i(tere!t for a o(e2da' loa(- e$au!e %i! e+pe$ted U*S* Trea!urie! t'pi$all' ri!e! from 7827? p o(
pa'a$& per dollar i! II*I89 time! L7*887> or t#o2'ear paper to G82?8 p o( =82'ear paper*
rou)%l' t%e ri!&2free )ro!! retur( of L7*888>*
Similarl'- %e #ill $%ar)e a( a,era)e 78 p per da' I(tuiti,el'- it ma&e! !e(!e for triple2A i(tere!t
for a loa( repa'ale i( t#o da'!- e$au!e %i! premium! to #ide( loo&i() for#ard* No $redit %a!
e+pe$ted retur( per dollar i! II*I89 time! II*IG9 e,er defaulted i( a 'ear it #a! rated triple2A*
time! L7*8878 !1uared- or rou)%l' t%e ri!&2free Ho#e,er- !ome triple2A $redit! %a,e defaulted
)ro!! retur( of L7*888G* T%e dail' i(tere!t rate after %a,i() de$a'ed to lo#er $redit rati()!* I(
fall! e,e( t%ou)% t%e $umulati,e default ri!& ri!e!* proailit' term!- t%e' %a,e (o#%ere to )o ut
do#(*
Note i( t%e pre$edi() e+ample t%at for t%e fir!t
da'- t%e re1uired i(tere!t premium o,er t%e ri!&2 It al!o ma&e! !e(!e for default ri!&! to i(itiall' ri!e
free rate i! 78 p- t%e !ame a! t%e default ri!&* For more 1ui$&l' for- !a'- !i()le2A $redit! t%a( for
t%e !e$o(d da' of t%e t#o2da' loa(- t%e re1uired triple2A $redit!* Ha,i() lar)e !er,i$i() $u!%io(!-
future i(tere!t rate i! < p- or a future premium of triple2A $redit! de$a' i( t%e fir!t i(!ta($e to ot%er
H p- a)ai( t%e !ame a! t%e $o(ditio(al default ri!&* A2le,el!- #%ere immediate default ri!&! remai(
lo#* Si()le2A $redit! te(d to de$a' !oo(er to !u
T%i! poi(t %a! ee( emp%a!i.ed '- amo() ot%er!- i(,e!tme(t )rade- #%ere prope(!itie! to default are
J*S* Fo(!* 0U!i() Default Rate! to Model t%e Term mu$% %i)%er*
Stru$ture of Credit Ri!&-0 0inancial +nalysts 1ornal.
Septemer2O$toer 7IIG* pp* >?2=>@ a(d L*T* Niel!e(-
J* Saa2Re1ueDo- a(d P* Sa(ta2Clara- 0Default Ri!& a(d Cla'to( Perr'- (#plied )e!alt Pro*a*ilities2 + ,e$
I(tere!t Rate Ri!&" T%e Term Stru$ture of Default +pproach to Risky )e*t. Fi+ed I($ome Re!ear$%
Spread!0* INSEAD 5or&i() Paper* Ma' 7II=* Bulleti(- CS Fir!t Bo!to(* >H April 7II?*
Term Stru$ture of Default Ri!&
T%e $%art ao,e o( t%e default %i!tor' of U*S* To !tre()t%e( t%e i(tuitio( for t%i! re!ult- ima)i(e a
i(,e!tme(t2)rade $orporate o(d!- di!ti()ui!%ed ' li(dfolded ma( #a(deri() o( a( u(fe($ed roof*
letter rati() out to a te(2'ear %ori.o(- le(d! T%e !tarti() po!itio( $orre!po(d! to a( i(itial
!upport to t%i! ,ie#* Ea$% term !tru$ture i! rati()- #%ile falli() off t%e roof $orre!po(d! to
)e(erall' ri!i()* Moreo,er- t%e lo#er t%e i(itial default* For a ma( !tarti() $lo!e to t%e ed)e-
$redit 1ualit'- t%e !teeper t%e term !tru$ture*
=
di!a!ter ma' !eem immi(e(t* But if %e %a!
!ur,i,ed for a #%ile2#it%out faili()- t%e $%a($e!
Revised 3ie$ o! 0or$ard )e!alt Risk are %e %a! #or&ed part #a' a$& to t%e $e(tre- a(d
%e($e i! le!! li&el' to fall i( t%e (e+t i(!ta(t*
O( refle$tio(- t%e default term !tru$ture $a((ot ri!e Co(,er!el'- a ma( !tarti() at t%e $e(tre i! ou(d to
for t%e #ea&e!t $redit!* T%e latter are more li&el' $ome $lo!er to t%e ed)e- !o %i! $o(ditio(al ri!&! of
to default i( t%e (ear2term- ut t%e' al!o %a,e more falli() mu!t i($rea!e*
up!ide* Moreo,er- t%e lo()er t%e' )o #it%out
defaulti()- t%e more li&el' t%e' are to %a,e Mat%emati$all'- #e are predi$ti() a for#ard
impro,ed i( 1ualit'* For e+ample- if a #ea& default ri!& $o(ditio(al o( a( i(itial rati() a(d (o
!o,erei)( $redit li&e Bul)aria $a( !er,i$e it! Brad' i(terim default* O,er time- t%e i(terim %i!tor'
o(d! pu($tuall' for t%e (e+t 7? 'ear!- t%e $%a($e! $ou(t! for more- relati,e to t%e i(itial a!!e!!me(t*
are $reditor! #ill (o lo()er dema(d t%e 7?88 p He($e- t%e differe(tial default ri!& et#ee( t%e
default !pread! t%e' $arr' toda'* Note t%at t%i! !tro()e!t a(d #ea&e!t $redit! !%ri(&! o,er time*
re!ult doe! (ot %i()e o( our elief t%at Bul)aria i!
ultimatel' 0emer)i()0 rat%er t%a( 0!umer)i()0* To $o(!ider a (umeri$ e+ample- !uppo!e t%ere are
It i! !impl' t%e o!er,atio( t%at 7? 'ear! of t#o $redit 1ualitie!" Stro() 3S4 a(d 5ea& 354*
!u$$e!!ful det !er,i$i() i! more li&el' t%a( (ot to Curre(t 4 $redit! (e,er default- #%ile $urre(t 5
i(di$ate impro,ed $redit 1ualit'* $redit! default 789 of t%e time* From o(e period
to t%e (e+t- a!!umi() (o prior or $urre(t default* 5
$redit! %a,e a >89 $%a($e of !#it$%i() to S- #%ile
Co(ditio(al default ri!&! $al$ulated from data i( S $redit! %a,e a ?9 $%a($e of !#it$%i() to 5*
Mood'O! I(,e!tor! Ser,i$e* /orporate 5ond )e!alts
a(d )e!alt Rates 1670-166'% Ja(uar' 7II?*
)erm Structure of 2efault $is"
Loo&i() for#ard- t%e $o(ditio(al default ri!& for S G*>9 i( t%e fir!t 'ear to 7*=9 i( t%e te(t% a(d
i! 8*?9 3i*e*- ?9 $%a($e of !#it$%i() to 5- #%i$% 8*?9 i( t%e t#e(tiet%*
%a! 789 default ri!&4 for t%e !e$o(d period a(d P T%e default term !tru$ture i! !teepl' i(,erted
8*<B?9 3?9P<89 ; G9 $%a($e of pat% S2525 for !i()le2B* Co(ditio(al default ri!& drop! to
plu! I89P?9 ; G*B?9 $%a($e of pat% S2S254 for G*I9 i( t%e fourt% 'ear from B*I9 i( t%e fir!t*
t%e t%ird* T%e $orre!po(di() ri!& for 5 i! <9 for P T%e default term !tru$ture for Ba $redit! i!
t%e !e$o(d period a(d H*?9 for t%e t%ird* He($e- %umped* T%e $o(ditio(al default ri!& ri!e! to
default ri!&! ri!e loo&i() for#ard for $urre(tl' >*?9 i( 'ear! t#o t%rou)% fi,e from a( i(itial
Stro() $redit!- a(d de$li(e loo&i() for#ard for 7*B9- t%e( de$li(e! )raduall' to 7*89*
$urre(tl' 5ea& $redit!*
To furt%er te!t t%e re,i!ed ,ie#- t%e Appe(di+
T%e Appe(di+ refi(e! t%e!e t%eme!- u!i() t%e e+plore! %o# #ell a Mar&o, $%ai( $a( repli$ate t%e
mat%emati$al t%eor' of Mar&o, $%ai(!* Ba!i$all'- o!er,ed default profile!* T%e fit i! e+$elle(t*
t%e e,olutio( of $redit 1ualit' i! a Mar&o, $%ai( to
t%e e+te(t t%at t%e $urre(t rati() !uper!ede! all T%i! i! (ot to $laim t%at forei)( o(d!- parti$ularl'
prior rati() i(formatio(* T%e a(al'!i! $o(firm! !o,erei)( o(d!- e+%iit t%e !ame default profile!
t%at $o(ditio(al default ri!&! ultimatel' te(d to a! U*S* $orporate!* 5%ile t%e rati() a)e($ie!
$o(,er)e* I( t%e !%ort ru(- %o#e,er- #it% more !tri,e to e(!ure t%at a!!i)(ed )rade! are
t%a( t#o $redit 1ualitie!- for#ard default ri!&! $a( $omparale a$ro!! i!!uer t'pe!- t%ere i! (o
ri!e a(d later fall or ,i$e2,er!a* )uara(tee t%at t%e' !u$$eed- or e,e( t%at it i!
po!!ile* E,e( for U*S* $orporate!- future default
For e,ide($e- #e tur( a)ai( to t%e default re$ord of rate! ma' depart from %i!tori$ ,alue!* Our $laim
U*S* $orporate o(d!# T%e fa$i() $%art! i! rat%er t%at t%e 1ualitati,e patter(! predi$ted '
i($orporate !u2i(,e!tme(t2)rade $redit! i(to t%e t%eor' a(d $o(firmed i( o(e importa(t data !et 2
$ompari!o(! a(d e+te(d t%e %ori.o( to >8 'ear!* e!pe$iall'- t%e i(,erted default term !tru$ture for
Note t%at- $o(trar' to t%e $o(,e(tio(al ,ie#- ut #ea& $redit! 2 are li&el' to re$ur i( ot%er!*
$ompatile #it% our re,i!ed ,ie#"
From a( i(,e!tme(t per!pe$ti,e- t%e mai( pra$ti$al
Time ultimatel' (arro#! t%e ri!& )ap! implied impli$atio( i! to re$omme(d $ale(dar !pread! o(
' differe(t $redit rati()!* T%e a,era)e lo()2dated o(d! for emer)i() mar&et!* A follo#2
differe($e i( $o(ditio(al default ri!&! et#ee( up paper elaorate! t%i! t%emQ*
i(,e!tme(t a(d !pe$ulati,e )rade! !%ri(&! from
)erm Structure of 2efault $is"
Appendix: Default as a arkov C!ain !impli$it'- #e $o(!trai( our !ear$% i( t%e follo#i()
#a'!"
A Mar&o, $%ai( i! a !e1ue($e of tra(!itio(! from
o(e !tate to a(ot%er- #%ere t%e $o(ditio(al 2 a(' $redit $la!!e! lo#er t%a( B i)(ored*
proailitie! of tra(!itio( depe(d o(l' o( t%e 2 $redit! allo#ed to mo,e at mo!t t#o $la!!e! up
tra(!itio( it!elf- (ot o( %i!tor' or timi()* T%e or do#( per
e,olutio( of $redit 1ualit' $a( e ,ie#ed a! a 2 )
1
a!!umed to e+a$tl' e1ual t%e o!er,ed
Mar&o, $%ai( i( #%i$% t%e !tate! are t%e ,ariou! a,era)e! for t%e !ample 3#%i$%- amo() ot%er
$redit rati()!- pro,ided t%at $urre(t rati()! ma&e t%i()!- re1uire! !i()le2A $redit! to %a,e 8*879
pa!t rati()! irrele,a(t* lo#er o(e2period default rate! t%a( Aa4
5e #ill u!e t%e follo#i() termi(olo)'" T%e!e $o(!trai(t! mea( t%at t%e P matri+ !ele$ted
doe! (ot 'ield t%e e!t po!!ile fit* Moreo,er-
n (umer of fea!ile !tate!- laelled 7 to n e$au!e t%e e!timati() e1uatio(! are %i)%l' (o(2
p
t
i8 0tra(!itio(0 proailit'- )i,e( $urre(t !tate li(ear- #e do (ot tr' to $al$ulate !i)(ifi$a($e
i- of mo,i() to !tate 8 i( e+a$tl' t period! le,el!* Ne,ert%ele!!- it i! $lear from t%e $%art! o(
P
t
n+n matri+ #it% i8 eleme(t p
t
i8* Al!o t%e t%e fa$i() pa)e t%at t%e e!timated term !tru$ture!
t2time! produ$t of P #it% it!elf 3#%ere a tra$& t%e o!er,ed ,alue! remar&al' #ell*
matri+ produ$t P9 %a! i8 eleme(t pi1:18 E
*** E pin :n84
dt $o(ditio(al default ri!& i( period t% )i,e(
i(itial !tate i
)
t
$olum( ,e$tor #it% n eleme(t! di
RD3i4 lo()2ru( proailit' of ei() i( !tate 8-
)i,e( i(itial !tate i
To tr' to Srepli$ateT t%e $orporate default data 6m C%art ?
u!i() a Mar&o, $%ai(- #e !ear$% for a P a(d )
1
sch t%at t%e
e1uatio(! )
t
= P
t
)
1
appro+imatel' de!$rie t%e o!er,atio(!* For