Improving Evaluation Techniques for Credit Risky Securities

Abstract

The present value of bonds and loans is commonly calculated as a sum of contractual cash flows discounted by default-free interest rates added by an appropriate credit spread. The evidence that investors require higher nominal returns for credit risky securities is commonly invoked as the main argument in support of this approach. However, although it is widely applied in the common practice, it remains a quick-fix solution for several reasons. First, it does not properly account for the probability of collecting contractual cash flows. Second, it leads to the wrong conclusion that the present value of financial instruments remains unchanged when fluctuations of risk-free rates are perfectly balanced by opposite changes in the relevant credit spread. Third, it makes the more risky bonds appear more profitable because credit spread, when included into discount rates, inevitably leads to calculate internal rates of return inversely correlated to the borrower’s creditworthiness. This work shows how refined cash-flow mapping techniques may be used in order to design a double-leg approach which properly accounts for expected credit losses and credit survival probabilities. This approach leads to an accurate evaluation of traded bonds on the sole basis of market information. In addition, it defines complete non-arbitrage conditions and overcomes the flaws of the most common pricing models for credit risky securities.