Questions about Credit Analysis


I have 2 questions regarding this topic.

  1. Question about value of debt - option analogy:

Kindly refer to the screenshot: I don’t understand the payoff when the put is in the money. When the put is in the money, we will receive K from the risk free bond. We will also deliver the assets and receive K, correct? Then shouldn’t the payoff be K+(K-A_T)? Can someone help to explain why the payoff is K-(K-A_T)?

  1. Question about conflict of interest in issuer-pay ratings:

Kindly refer to this screenshot: I thought issuer pays credit ratings should give conflict of interest between credit rating agencies and issuers. Why is it not so?


In the structural model, we assume the risky debt is equal to the risk free debt minus the value of the put option that has been shorted. The put option has a strike price of K, and depends on the value of A. The put option is in the money when A < K (hence when the company performs like crap), so it will be exerciced, and as an investor, you will get A only. When the put is out of the money, it will not be exercised and you get the K face value.

The issuers can’t have a conflict of interest, since they only have one interest: getting the best rating in order to decrease cost of debt. Agencies have one, since they want the money, as well as providing good service.