Question

Explain how default is measured - and then depicted to investors - on the Street? What are five determinants of bond safety? What is a CDO?

Answer 1

Exposure at Default (EAD)

Exposure at default (EAD) is the total value a bank is exposed to when a loan defaults. Using the internal ratings-based (IRB) approach, financial institutions calculate their risk. Banks often use internal risk management default models to estimate respective EAD systems. Outside of the banking industry, EAD is known as credit exposure.

There are two methods to determine exposure at default. Regulators use the first approach, which is called foundation internal ratings-based (F-IRB). The second method, called advanced internal ratings-based (A-IRB), is more flexible and is used by banking institutions. Banks must disclose their risk exposure. A bank will base this figure on data and internal analysis, such as borrower characteristics and product type. EAD, along with loss given default (LGD) and the probability of default (PD), are used to calculate the credit risk capital of financial institutions.

• Exposure at default (EAD) is the predicted amount of loss a bank may be exposed to when a debtor defaults on a loan.
• Exposure at default, loss given default, and the probability of default is used to calculate the credit risk capital of financial institutions

Determinants of Bond Safety

Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer's financial ratios. The key ratios used to evaluate safety are:

1. Coverage ratios—Ratios of company earnings to fixed costs. For example, the times-interest-earned ratio is the ratio of earnings before interest payments and taxes to interest obligations. The fixed-charge coverage ratio adds lease payments and sinking fund payments to interest obligations to arrive at the ratio of earnings to all fixed cash obligations (sinking funds are described below). Low or falling coverage ratios signal possible cash flow difficulties.

2. Leverage ratio—Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds.

3. Liquidity ratios—The two common liquidity ratios are the current ratio (current assets/current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the firm's ability to pay bills coming due with cash currently being collected.

4. Profitability ratios—Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm's overall financial health. The return on assets (earnings before interest and taxes divided by total assets) is the most popular of these measures. Firms with higher return on assets should be better able to raise money in security markets because they offer prospects for better returns on the firm's investments.

5. Cash flow-to-debt ratio—This is the ratio of total cash flow to outstanding debt.

Standard & Poor's periodically computes median values of selected ratios for firms in several rating classes, which we present in Table 14.3. Of course, ratios must be evaluated

Collateralized Debt Obligation (CDO)

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.