B1_2

If Z < 1.81 Default (or distressed)

1.81 <=Z <= 2.99 Gray Zone

Z > 2.99 Nondefault or safe

LGD = EAD * (1-RR) = 250 * (1-0.314) = 171.50

E(Loss) = LGD * PD = 171.50 * 0.0115 = 1.972

Reduced form models treat default risk as a random external variable

structural model view credit risk from the perspective of equity holders

positive models explore how assets should behave and

empirical models do not directly evaluate default risk 

E = 175*0.9466 - 115 * e^(-0.0325*5) * 0.8539 = 82.18

D = A - E = 175 - 82.18 = 92.82

p(4) - p(5) = e^(-0.07 *4) - e^(-0.07*5) = 5.11%

A

The five determinants of Altmans Z-score are (1) workingcapital total assets, (2) retainedearnings total assets(3) EBIT/total assets, (4) market value of equity/book valueof total liabilities, and  (5) sales / total assets

The Merton model is sensitive to both maturity and volatility with respect to credit spreads. However, the slope of the change declines as time progresses. For example, credit spreads rise rapidly as maturity initially begins to increase but the rate of change slows considerably as time progresses. This profile reflects the law of diminishing marginal utility. The reason for this shape is that as firms are able to survive longer under rising maturity lengths or volatility the marginal probability of defailt decreases

Adverse selection arises from asymmetric information that is skewed in favor of borrowers. This issue impacts the loan underwriting process and it could result in higher interest rates being charged to all borrowers. Adverse selection could leave the bank with unallocated capital as solid borrowers avoid the higher offered rates. It could also bias the loan pool in favor of low-quality borrowers. Requesting collateral or in-depth background checks on borrowers could help solve this issue. On the other hand, moral hazard is a post-loan concern in which a borrower increases the risk level for lenders after the loan has been made. This can be resolved by placing loan covenants (i.e., borrowing limits) in the loan agreement

1. Not be highly correlated with each other

2. Have an economic logic for inclusion

3. Persist over a long period

1. Macroeconomic factors

2. Fundamental, style, investment, or dynamic factors - (Momentum, size, low volatility and quality)

3. Statistical factors - (no known connection with economy or style factors)

Intercept may indicate "Alpha" which is true if:

- Variables are tradable assets

- Model includes all sources of systemic risk

- Intercept coefficient is statistically significant

--> In an informationally efficient market the intercept should have a mean value of zero.

1. Excess Return on the market Portfolio (part of Fama and French 3 factor)

2. Value Factos (high minus low value) (part of Fama and French 3 factor)

3. Size factor (small minus big( (part of fama and french 3 factor)

4. Robust minus weak (spread between firms with high versus low operating profitability)

5. Conservative minus aggressive investment in corporate assets

--> The fama and french and carhart model is the original FF 3F Model plus a Momentum Factor

1. Chance that a factor is falsely identified

2. Factors that are correlated with returns do not need to be the cause of returns

--> Single factor models like CAPM create problems for alternative managers as it assumes:

- All ivnestors invest only in the market portfolio

- Returns are normally distributed

- All investors have homogenous expectations and time horizons

1. Value premium - high book to market vs low book to market

2. Size factor

3. Momentum factor

4. Liquidity factor

5. Credit risk factor

6. Term factor

7. Implied volatility factor

8. Low volatility factor

9. Carry trade factor

10. Roll factor