Chapter 24: Credit Risk & Corporate Debt Valuation

Credit Risk & Corporate Debt Valuation clarifies the critical distinction between promised yields and expected yields, explaining that the yield spread on corporate bonds acts as compensation for the risk that the issuer may fail to repay principal or interest. This spread is conceptually linked to the cost of insurance against default, illustrated through the mechanics of Credit Default Swaps (CDS), where investors pay premiums to protect against credit events. The chapter utilizes option pricing theory to model the decision to default, characterizing corporate equity as a call option on the firm's assets and the limited liability of shareholders as a put option on those assets. This structural framework, often associated with the Merton model, allows students to calculate the value of risky debt by subtracting the value of the default put option from the value of a risk-free bond. Key variables influencing this valuation include the volatility of the company's assets, the risk-free interest rate, and the time to maturity. Beyond theoretical pricing, the text details practical tools for credit assessment, including the role of bond rating agencies like Moodys and Standard and Poors in classifying debt as investment-grade or high-yield junk bonds. Additionally, it explores statistical methods for predicting corporate failure, such as Altmans Z-score, which combines various accounting ratios into a single predictor of bankruptcy, and discusses how market prices can be used to derive risk-neutral probabilities of default.