Questions about Credit Analysis

CFA Level II
#1

Hi

I have 2 questions regarding this topic.

  1. Question about value of debt - option analogy:

Kindly refer to the screenshot: http://prntscr.com/71cgy3 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: http://prntscr.com/71cwbg I thought issuer pays credit ratings should give conflict of interest between credit rating agencies and issuers. Why is it not so?

Thanks.

#2

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.