Introduction to credit risk analysis

In this chapter, we will discuss basic concepts related to credit risk, such as credit rating, credit spread, 1-year and 5-year rating migration matrices, probability of default, recovery rate, and loss given default. A credit spread, the difference between a bond's yield and a benchmark yield (risk-free rate), reflects its credit risk or default risk. For example, to estimate the present value of a coupon payment in two years for an AA rated bond, the discount rate (yield) will be a risk-free yield (treasury-note yield) plus the corresponding spread. There are many tools that we could use when analyzing a company or a bond's credit worthiness. The first tool is credit rating offered by a credit rating agent, such as Moody's or Standard and Poor's. One of the apparent advantages is that a potential user would spend less time and efforts to assess a company or a bond's credit risk. The obvious disadvantage is that the credit rating is a black box for most...