Tomorrow’s review session and various other study hints for the final exam in Finance 4335

I plan to devote tomorrow’s Finance 4335 class meeting to a review session for the final exam. If time permits, be sure to look over the Final Review and Summary of Finance 4335 lecture note prior to the start of class tomorrow.  This document summarizes virtually all the topics we covered this semester in Finance 4335. I designed this document to serve as a study guide to help you prepare for the final exam.

Here are some other helpful study hints to consider:

Fall 2020 Course Evaluations for Finance 4335

At Baylor, all of your professors undergo annual evaluations concerning the quality of teaching, research, and service.  By completing teacher evaluations, you contribute importantly by providing the University with information that may affect not only faculty compensation and promotion/tenure decisions but also provide faculty with useful information concerning ways to improve teaching. Therefore, I encourage you to complete your Fall 2020 Course Evaluations for Finance 4335 along with all of your other courses!

The window for completing your Finance 4335 Course Evaluation closes on Thursday, December 3 at 10 am. I would be most grateful for your participation in this formal evaluation of the quality of my teaching performance in Finance 4335 during the Fall 2020 semester.

On the economics of financial guarantees

In the Credit Risk lecture note and in Problem Set 9, we study how credit enhancement of risky debt works. Examples of credit enhancement in the real world include federal deposit insurance, federally guaranteed student loans, public and private bond insurance, pension insurance, mortgage insurance, government loan guarantees, etc.; the list goes on.

Most credit enhancement schemes work in the following fashion. Creditors loan money to “risky” borrowers who own risky assets worth $V(F) today (at date t = 0).  Borrowers are risky in the sense that at date T, they will default (in whole or in part) if $F < $B.  The shortfall suffered by creditors resembles a put option with date T payoff of –Max[0, BF]. Therefore, without credit enhancement, the value of risky debt today (at t = 0) is

V(D) = B{e^{ - rT}} - V(Max[0,B - F]).

However, when credit risk is intermediated by a guarantor (e.g., an insurance company or government agency), credit risk is transferred to the guarantor who receives an upfront “premium” worth V(Max[0,B - F]) at t=0 in exchange for having to cover a shortfall of Max[0,B - F] which may occur at date T. If all credit risk is transferred to the guarantor, then from the creditors’ perspective it is as if the borrowers have issued riskless debt. Therefore, creditors charge borrowers the riskless rate of interest and receive the promised payback from two sources: 1) borrowers pay D = B - Max[0,B - F], and 2) the guarantor pays Max[0,B - F].  Therefore, creditors get paid back B - Max[0,B - F] + Max[0,B - F] = B.

 

Credit risk Q&A with a Finance 4335 student

Yesterday afternoon, I received the following email from a Finance 4335 student about credit risk:

Date: Friday, November 20, 2020 at 3:40 PM
To: James Garven <James_Garven@baylor.edu>
Subject: Question for Problem Set 9

Doctor Garven,

I just have a question for part 3 of the problem set 9 which is due next Tuesday. I’m confused as to why the fair premium of the insurance corresponds to dollar value of the limited liability put option. And if the firm purchases the insurance, will its credit risk premium decline to 0?

Here’s my answer:

Perhaps I should more clearly define “fair” premium. In this setting the “fair” insurance premium corresponds to the premium paid by the firm such that it is indifferent between buying and not buying credit insurance.

Consider the following numerical example. Suppose the riskless rate of interest is zero, and a firm promises to pay $100 one year from now. Then the yield to maturity of the debt is also zero, and the present value is $100. Next, suppose an otherwise identical and uninsured firm issues debt with a promised repayment of $100, but it has a high probability of default so the current market value of the debt is only $80; in this latter case, the yield to maturity and the credit risk premium are the same, since YTM = r + credit risk premium and r = 0. Thus, YTM = credit risk premium = 25% (here I am assuming annual compounding for the sake of simplicity, so FV = PV(1+YTM) ==>100 = 80(1.25)). Now, suppose this uninsured firm changes its mind and purchases full insurance coverage for the “fair” premium of $20 (which corresponds to the value of the limited liability put option). Since the insured firm’s debt is no longer risky to investors, investors currently value the firm’s debt issue at its par value of $100, which implies that the credit risk premium falls to 0. However, from the standpoint of the firm, it can only expect to net $80 from its bond issue, irrespective of whether it purchases credit insurance, so it is indifferent between buying and not buying credit insurance.

In the real world, credit risk enhancement is a viable financial services business because so-called “prudent-person” rules often severely limit the marketability of sub-investment grade credit to institutional investors. Thus, credit enhancement to investment grade can add more value for firms, NGO’s, and government organizations by substantially expanding the market for potential investors in such credit issues.