The objective of credit risk analysis is trying to measure the probability of potential failure to pay a promised amount. A credit rating reflects the credit worthiness of a firm or a bond. A firm's rating is different from its bond's rating since the latter depends on its maturity and certain features such as whether it is callable or puttable. In Chapter 5, Bond and Stock Valuation, we have learnt the concept of Yield to Maturity (YTM) or simply yield, which is correlated with credit quality. The lower its credit quality; the higher its required return, that is, a higher yield. In this chapter, we will discuss many basic concepts related to credit risk, such as credit rating, credit spread, 1-year credit rating migration matrix, probability of default, loss given default, recovery rate, and KMV model. In particular, the following topics will be covered:
Moody's, Standard and Poor's, and Fitch's credit ratings
Credit spread, one-year, and five-year migration...