Outline the options that can be used in place of the credit ratings issued by rating agencies.
The idea
When an agency rating is missing or too slow, a risk manager can use several substitutes. Internal ratings and scorecards use the bank's own borrower data. Market-implied measures back default probabilities out of CDS spreads or bond spreads. The hazard rate is close to: Hazard = spread ÷ (1 − R). Here R is the recovery rate. Equity-based structural models, in the Merton tradition, treat equity as a call option on the firm's assets and use equity value, equity volatility and debt to estimate distance to default. Accounting-based scores such as the Altman Z-score weight financial ratios. The score is: Z = 1.2 × working capital ÷ assets + 1.4 × retained earnings ÷ assets + 3.3 × EBIT ÷ assets + 0.6 × market equity ÷ liabilities + 1.0 × sales ÷ assets. Z above 2.99 is safe, below 1.81 is distress and in between is a grey zone. Market-implied default probabilities are risk-neutral and include liquidity premiums, so they tend to overstate real-world default frequencies.
Formulas
Altman Z-score
Z = 1.2 × X₁ + 1.4 × X₂ + 3.3 × X₃ + 0.6 × X₄ + 1.0 × X₅
- X₁
- working capital ÷ total assets
- X₂
- retained earnings ÷ total assets
- X₃
- EBIT ÷ total assets
- X₄
- market value of equity ÷ total liabilities
- X₅
- sales ÷ total assets
Above 2.99 is safe, below 1.81 is distress, and between them is a grey zone. X₄ uses market equity over liabilities, not over assets.
A practice question
Which of the following is a market-based substitute for an agency rating?
- A default probability backed out of the issuer's CDS spread - correct
- A bank's internal scorecard grade built from borrower financial statementsWhy not: This is an internal rating built from accounting data, not a market-implied measure.
- A regression of default on accounting ratios from historical loan filesWhy not: This is a statistical scoring model on accounting data, not market prices.
- A published agency transition matrix applied to the borrower's ratingWhy not: This uses the agency rating itself and so is not a substitute for it.
CDS spreads (and bond spreads and equity prices) carry market views of credit risk. From a CDS spread, a hazard rate of about spread / (1 - R) can be inferred.
A harder one
Which set of inputs does a Merton-type structural model use to estimate a firm's default probability?
- Agency rating history and the average recovery rate for its seniority classWhy not: Describes a rating-based approach, not a model of the firm's assets and liabilities.
- Five accounting ratios with fixed weightsWhy not: Describes the Altman Z-score, which is an accounting-based score, not a structural model.
- The CDS spread and the risk-free rateWhy not: Describes a reduced-form, spread-implied hazard rate approach, not a structural model.
- Equity value and volatility, plus the debt's face value and maturity - correct
A Merton-type model treats equity as a call option on firm assets, using observed equity value and volatility with the debt structure to infer asset value, asset volatility and distance to default.
The hardest tier
An analyst scores a manufacturer with the original Altman Z-score, Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5. The ratios are: X1 (working capital/assets) 0.15, X2 (retained earnings/assets) 0.20, X3 (EBIT/assets) 0.10, X4 (market equity/total liabilities) 0.80, X5 (sales/assets) 1.10. Zones are: above 2.99 safe, 1.81 to 2.99 grey, below 1.81 distress. The score and zone are:
- Z = 2.37, safe zoneWhy not: Computes Z correctly but treats 1.81 as the lower bound of the safe zone; the safe zone starts above 2.99.
- Z = 1.27, distress zoneWhy not: Omits the sales/assets term (1.0 x 1.10), which removes 1.10 from the score.
- Z = 2.37, grey zone - correct
- Z = 4.67, safe zoneWhy not: Swaps the weights on X3 and X5, giving the 3.3 weight to sales/assets instead of EBIT/assets.
Z = 0.18 + 0.28 + 0.33 + 0.48 + 1.10 = 2.37. That lies between 1.81 and 2.99, so the firm is in the grey zone.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in External and Internal Credit Ratings
- Describe the scales used by external rating agencies, how ratings are assigned, and how a rating connects to the chance of default.
- Distinguish default probabilities that are conditional from those that are unconditional, defining each.
- Define the hazard rate, then apply it to find the unconditional probability that a credit asset defaults.
- Define the recovery rate and, with it, compute the loan's expected loss.
- Contrast ratings built on a point-in-time basis with those built through the cycle, and explain each.
- Weigh internal ratings against external ones, noting the strengths of each.
- Describe a rating transition matrix, calculate with it, interpret it, and explain what it is used for.
- Outline how credit default swap spreads, bond prices and stock prices tend to move when a credit rating is upgraded or downgraded.
- Explain where credit ratings have failed in the past and what difficulties arise when they are relied on for investment decisions.