Financial Risk Manager Part 2
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A credit manager in the counterparty risk department of a large bank uses a simplified version of the Merton model to monitor the relative vulnerability of its largest counterparties to changes in their valuation and financial status. To assess the default risk of three specific counterparties, the manager calculates the distance to default with a one-year horizon (t=1). The counterparties are: Company P, Company Q, and Company R, all of which operate in the same industry and do not pay dividends. The relevant data for these companies is provided in the table below:
Company P Q R Market value of assets (EUR million) 100 150 250 Face value of debt (EUR million) 60 100 160 Annual volatility of asset values 10.0% 7.0% 8.0%
Assuming that the only liability for each company is a zero-coupon bond maturing in one year and using the approximation formula for the distance to default, determine the correct ranking of the counterparties from the most likely to default to the least likely to default.
A credit manager in the counterparty risk department of a large bank uses a simplified version of the Merton model to monitor the relative vulnerability of its largest counterparties to changes in their valuation and financial status. To assess the default risk of three specific counterparties, the manager calculates the distance to default with a one-year horizon (t=1). The counterparties are: Company P, Company Q, and Company R, all of which operate in the same industry and do not pay dividends. The relevant data for these companies is provided in the table below:
| Company | P | Q | R |
|---|---|---|---|
| Market value of assets (EUR million) | 100 | 150 | 250 |
| Face value of debt (EUR million) | 60 | 100 | 160 |
| Annual volatility of asset values | 10.0% | 7.0% | 8.0% |
Assuming that the only liability for each company is a zero-coupon bond maturing in one year and using the approximation formula for the distance to default, determine the correct ranking of the counterparties from the most likely to default to the least likely to default.