Credit risk management

1. Managing Credit Risk Under The Basel III Framework 101
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Corporate Credit Analysis
8
KEY CONCEPTS
• Black-Scholes option valuation model
• Merton’s corporate default model
• Financial ratios
• Altman’s Z-score
8 Corporate credit analysis
8.1 Internal credit assessment
Chapter 7 introduced the idea of leveraging on a credit rating issued by credit rating
agencies to assess the credit quality of corporations. There, the credit quality of a
corporation was assumed to have been reflected fairly by its credit rating. The exact
methodology adopted by a credit rating agency in conducting the credit assessment is
behind the scenes and remains a trade secret.
However, many corporations do not invite credit rating agencies to assess their credit
quality for various reasons. For example, a corporation in national security business may
have a strong hesitation to disclose its information to an external party. In addition,
banking regulations demand that a bank put in place appropriate procedures to ensure the
adequacy of credit assessment results provided by a third party. As such, there is a need
for a lender to develop its own techniques to facilitate the credit analysis on a corporation
regardless of whether the corporation is assigned with a credit rating.
Traditional corporate credit analysis covers:
• the macro analysis on the risks of: (i) the country where a corporation resides; and (ii)
the industry to which a corporation belongs;
• the qualitative analysis on management, business and operation of a corporation;
• the quantitative analysis of financial statements that exhibit directly the financial
healthiness of a corporation; and
• the projection of cash flows of a corporation in the near future.
This comprehensive framework is conceptually sound since major direct and indirect
factors that may impact the credit quality of a corporation are examined. The credit
assessment results are well ascertained by sufficient reasoning. Nevertheless, the success
of this comprehensive framework is at a huge cost for covering many dimensions.
Regular assessment to retrieve the up-to-date credit quality of a corporation becomes time
consuming and expensive. Moreover, the interpretation of qualitative information is
subject to experience and certain subjective views of a credit analyst. Thus the
assessment results may be prone to inconsistency among credit analysts.

2. 102 Managing Credit Risk Under The Basel III Framework
Copyright 2018 CapitaLogic Limited
Modern financial economists take an alternative approach to identify a few observable
and quantifiable factors that explain directly the credit quality of a corporation and derive
a mathematical relationship between the credit quality of a corporation and these
explanatory variables. The most representative academic works include Merton’s
corporate default model and Altman’s family of Z-scores.
8.2 Black-Scholes option valuation model
In this section, the theory of option valuation is introduced since Merton’s corporate
default model essentially rides on this theory.
A call option is a financial contract between an acquirer and a writer. The acquirer of a
call option has the right but not the obligation to buy the underlying equity from the
writer at a strike price K at maturity T. The writer of a call option, in turn, is obligated to
sell the underlying equity to the acquirer at the strike price K upon the acquirer’s request
at maturity T. The acquirer of a call option is benefited if, at maturity, the market price
of underlying equity ST is above the strike price so that he can buy the underlying equity
at a cost lower than the market price.
Mathematically, the payoff of a call option with strike price K at maturity T is expressed
as:
[ ] [ ]Payoff Call = Max Equity price at maturity - Strike price, 0
Figure 8.1 Payoff of a call option
In order to acquire a call option that will provide a monetary benefit, the acquirer must
pay a premium to the option writer who is obligated to deliver the monetary benefit at
maturity. To determine the fair value of this premium, which is essentially the value of a
call option, a methodology is required. This triggers a large amount of researches on
option valuation.