Appendix I. Bloomberg’s Equity Volatility and Credit Risk (OVCR) Function7
Appendix II. The Moody’s KMV Model8
Amato, Jeffrey, 2005, “Risk Aversion and Risk Premia in the CDS Market,” Bank for International Settlements, Quarterly Review (December), pp. 55–68.
Bloomberg, “Inferring Default Probabilities from Capital Structure Information,” Version 1.0, Equity Valuation and Credit Risk Function (OVCR).
Segoviano, Basurto, A. Miguel, and Manmohan Singh, 2008, “Counterparty Risk in the Over-the-Counter Derivatives Market,” IMF Working Paper No. 08/258 (Washington: International Monetary Fund).
Singh, Manmohan, 2003, “Are Credit Default Swap Spreads High in Emerging Markets? An Alternative Methodology for Proxying Recovery Value,” IMF Working Paper No. 03/242 (Washington: International Monetary Fund).
Singh, Manmohan, and Carolyn Spackman, 2009, “The Use (and Abuse) of CDS Spreads During Distress,” IMF Working Paper No. 09/62 (Washington: International Monetary Fund).
Manmohan Singh is a Senior Economist with IMF’s Monetary and Capital Markets Department, Karim Youssef is an Economist with IMF’s Strategy, Policy, & Review Department. The authors wish to thank Darrel Duffie, Kenneth Singleton, Inci Ötker-Robe, Andre Santos, Laura Kodres, Mohamed Norat, Jiri Podpiera, and Martin Mühleisen for their helpful comments. The views expressed are those of the authors and do not reflect those of the IMF.
Probability of default or distress is used here in a broader context, to include conditional probabilities of default, joint probability of default, distance to distress, and joint default dependence (i.e., via the off-diagonal elements of the distress dependence matrix).
Bloomberg’s OVCR function (Equity Volatility and Credit Risk) converts equity prices, leverage, and implied volatility to a CDS spread. This ‘theoretical’ equity implied CDS spread can be compared to actual CDS spread.
In most models, including those using CDS and Moody’s EDF data, the general assumption has been to hold recovery value constant (in the range of 20–40). The probability of default (i.e., the hazard rate) and the recovery value more or less offset each other when bonds trade near par. Such approximation works poorly when bonds trade at high spreads.
To further augment the use of stochastic recovery, the cheapest priced Citi and Goldman bonds illustrate that their bond prices have traded well below par in the recent crisis, despite the implicit forbearance offered to bondholders of large financial institutions, unlike the bondholders of GM, Chrysler or even Fannie Mae and Freddie Mac (Figure 4).
See IMF Working Paper No. 08/258 (page 14, second paragraph) states: “using CDS data after Lehman’s default will require the use of variable recovery value assumption, or in its absence, CTD bonds.” There may be other factors such as funding costs during crisis that can contribute towards probability estimates.
See Bloomberg’s “Inferring Default Probabilities from Capital Structure Information,” version 1.0.
See Moody’s EDF™ 8.0 Model Enhancements.