Question

Elaborate on default risk of a firm.

That is, a) talk about the definition the ratings and the factors which go into the ratings.

b) How do ratings and yields to maturity relate?

c) How does time and bankruptcy risk relate?

d)How is default risk different from systematic risk?

Answer 1

Rating : a measurement of how good or popular someone or something is

1. Payment History: 35%

There’s one key question lenders have on their minds when they give someone money: “Will I get it back?”

The most important component of your credit score looks at whether you can be trusted to repay funds that are lent to you. This component of your score considers the following factors:

• Have you paid your bills on time for each account on your credit report? Paying late has a negative effect on your score.
• If you've paid late, how late were you – 30 days, 60 days or 90+ days? The later you are, the worse it is for your score.
• Have any of your accounts gone to collections? This is a red flag to potential lenders that you might not pay them back.
• Do you have any charge offs, debt settlements, bankruptcies, foreclosures, law suits, wage garnishments or attachments, liens or public judgments against you? These items of public record constitute the most dangerous marks to have on your credit report from a lender's perspective.
• The time since the last negative event and the frequency of missed payments affect the credit score deduction. For example, someone who missed several credit card payments five years ago will be seen as less of a risk than a person who missed one big payment this year.

2. Amounts Owed: 30%

So you might make all your payments on time, but what if you’re about to reach a breaking point?

FICO scoring considers your credit utilization ratio, which measures how much debt you have compared to your available credit limits. This second-most important component looks at the following factors:

• How much of your total available credit have you used? Don’t assume you have to have a $0 balance on your accounts to score high marks here. Less is better, but owing a little bit can be better than owing nothing at all because lenders want to see that if you borrow money, you are responsible and financially stable enough to pay it back.
• How much do you owe on specific types of accounts, such as a mortgage, auto loans, credit cards and installment accounts? Credit scoring software likes to see that you have a mix of different types of credit and that you manage them all responsibly.
• How much do you owe in total, and how much do you owe compared to the original amount on installment accounts? Again, less is better. For example, someone who has a balance of $50 on a credit card with a $500 limit will seem more responsible than someone who owes $8,000 on a credit card with a $10,000 limit.

3. Length of Credit History: 15%

Your credit score also takes into account how long you have been using credit. For how many years have you had obligations? How old is your oldest account, and what is the average age of all your accounts?

A long credit history is helpful (if it's not marred by late payments and other negative items), but a short history can be fine, too, as long as you've made your payments on time and don't owe too much.

This is why personal finance experts always recommend leaving credit card accounts open, even if you don’t use them anymore. The account’s age by itself will help boost your score. Close your oldest account and you could see your overall score decline.

4. New Credit: 10%

Your FICO score considers how many new accounts you have. It looks at how many new accounts you have applied for recently and when the last time you opened a new account was.

Whenever you apply for a new line of credit, lenders typically do a hard inquiry (also called a hard pull), which is the process of checking your credit information during the underwriting procedure; this is different from a soft inquiry, such as when you retrieve your own credit information. (For details, read "Credit Score: Hard Versus. Soft Inquiry.")

Hard pulls can cause a small, temporary decline in your credit score. Why? The score assumes that if you've opened several new accounts recently (and the percentage of new accounts relative to the total number, you could be a greater credit risk; people tend to do so when they are experiencing cash flow problems or planning to take on lots of new debt.

For example, when you apply for a mortgage, the lender will look at your total existing monthly debt obligations as part of determining how much mortgage you can afford. If you have recently opened several new credit card accounts, this might indicate that you are planning to go on a spending spree in the near future, meaning that you might not be able to afford the monthly mortgage payment the lender has estimated you are capable of making. Lenders can't determine what to lend you based on something you might do, but they can use your credit score to gauge how much of a credit risk you might be.

FICO scores only take into account your history of hard inquiries and new lines of credit for the past 12 months, so try to minimize how many times you apply for and open new lines of credit within a year. However, rate-shopping and multiple inquiries related to auto and mortgage lenders will generally only be counted as a single inquiry, since the assumption is that consumers are rate-shopping – not planning to buy multiple cars or homes. Even so, keeping the search under 30 days can help you avoid dings to your score.

5. Types of Credit in Use: 10%

The final thing the FICO formula considers in determining your credit score is whether you have a mix of different types of credit, such as credit cards, store accounts, installment loans and mortgages. It also looks at how many total accounts you have. Since this is a small component of your score, don't worry if you don't have accounts in each of these categories, and don't open new accounts just to increase your mix of credit types