SERVING THE QUANTITATIVE FINANCE COMMUNITY

 
User avatar
Stefano87
Topic Author
Posts: 5
Joined: November 17th, 2014, 5:10 pm

How to price a defaulted corporate bond

December 11th, 2014, 9:08 am

Dear all,I came across a defaulted corporate bond and I was wondering how to price it.1) If I stick to the idea of discounting future cashflows ... well, the company defaulted and likely there will not be foreseeable future cashflows ==> price = 0.2) The simple fact that speculative funds actually earn their livings in buying (not at zero, probably at a very discounted price but not zero) defaulted corporate bonds and try a leverage to induced debt re-structuring or the like ... and that at the end of the day (when they succeed) they result in enormous gains, in someway tells me that these instruments should value something and the "cashflow actualization" technique simple does not apply.Any idea?Which would be the best professional practice for a quant here?Best.Stefano
 
User avatar
daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

How to price a defaulted corporate bond

December 11th, 2014, 9:38 am

I think distressed debt is a highly specialised subject. I wouldn't think that discounting cashflows is the most appropriate way of valuing them. I would suggest that you look at the assets of the issuer and where the bond sits in the capital structure.
knowledge comes, wisdom lingers
 
User avatar
Stefano87
Topic Author
Posts: 5
Joined: November 17th, 2014, 5:10 pm

How to price a defaulted corporate bond

December 11th, 2014, 9:45 am

Good point.In the end it seems more likely a legal issue. It seems to me that there are so many different "human-driven" factors (expectations, psycological beliefs, court trials, bond-holders summons ...) that I even do not see room for a mathematical sensible modelling approach....maybe
 
User avatar
MHill
Posts: 488
Joined: February 26th, 2010, 11:32 pm

How to price a defaulted corporate bond

December 11th, 2014, 10:33 am

There are auctions to settle CDS defaults. Maybe you could use the results from that in some way? See:http://www.creditfixings.com/CreditEven ... ixings.jsp
 
User avatar
daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

How to price a defaulted corporate bond

December 11th, 2014, 10:41 am

you could use a form the KMV model for structural credit risk modelling. i.e. look at the defaulted debt as a call option on the assets of the firm. but again you will have to look at the asset value
knowledge comes, wisdom lingers
 
User avatar
DavidJN
Posts: 1744
Joined: July 14th, 2002, 3:00 am

How to price a defaulted corporate bond

December 12th, 2014, 5:44 pm

MHill's advice to look at the CDS market is worth pursuing. To attempt to summarize that, from a legal perspective when a bond defaults the future coupon payment obligations disappear and the par amount becomes due immediately. So a defaulted bond price should be the price of a zero coupon bond due immediately, which in other words means its expected recovery value. In practice there is a bit of time discounting involved because it takes a bit of time to get all the ducks in a row.
 
User avatar
Anthis
Posts: 4313
Joined: October 22nd, 2001, 10:06 am

How to price a defaulted corporate bond

December 13th, 2014, 5:11 am

QuoteOriginally posted by: DavidJNMHill's advice to look at the CDS market is worth pursuing. To attempt to summarize that, from a legal perspective when a bond defaults the future coupon payment obligations disappear and the par amount becomes due immediately. So a defaulted bond price should be the price of a zero coupon bond due immediately, which in other words means its expected recovery value. In practice there is a bit of time discounting involved because it takes a bit of time to get all the ducks in a row.It takes an uncertain amount of time, I might add.
 
User avatar
daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

How to price a defaulted corporate bond

December 13th, 2014, 8:04 am

QuoteOriginally posted by: AnthisQuoteOriginally posted by: DavidJNMHill's advice to look at the CDS market is worth pursuing. To attempt to summarize that, from a legal perspective when a bond defaults the future coupon payment obligations disappear and the par amount becomes due immediately. So a defaulted bond price should be the price of a zero coupon bond due immediately, which in other words means its expected recovery value. In practice there is a bit of time discounting involved because it takes a bit of time to get all the ducks in a row.It takes an uncertain amount of time, I might add.I didn't think the OP's question was to determine the "price" of the defaulted bond (as I think these trade in the market anyway even if there is no CDS settlement) but rather the "value".
knowledge comes, wisdom lingers
 
User avatar
dweeb
Posts: 142
Joined: July 11th, 2009, 8:10 pm

How to price a defaulted corporate bond

December 14th, 2014, 3:58 pm

You could use a tree to analyze the scenarios. Collector's book has the VBA code, just modify as required.
 
User avatar
dweeb
Posts: 142
Joined: July 11th, 2009, 8:10 pm

How to price a defaulted corporate bond

December 14th, 2014, 4:18 pm

QuoteOriginally posted by: daveangelyou could use a form the KMV model for structural credit risk modelling. i.e. look at the defaulted debt as a call option on the assets of the firm. but again you will have to look at the asset valueI'll throw this out there - the value of a firm's assets is largely ignored in finance. Accounting records physical assets at historic value plus depreciation on the balance sheet. Intangibles are mostly ignored. In corp finance it's the PV of future cash flows, whatever they may be. So if the firm in default is in for example tech, IP development, biotech, or has obsolete assets, what are the asset values in default??
Last edited by dweeb on December 13th, 2014, 11:00 pm, edited 1 time in total.
 
User avatar
Traden4Alpha
Posts: 23951
Joined: September 20th, 2002, 8:30 pm

How to price a defaulted corporate bond

December 14th, 2014, 4:37 pm

QuoteOriginally posted by: dweebQuoteOriginally posted by: daveangelyou could use a form the KMV model for structural credit risk modelling. i.e. look at the defaulted debt as a call option on the assets of the firm. but again you will have to look at the asset valueI'll throw this out there - the value of a firm's assets is largely ignored in finance. Accounting records physical assets at historic value plus depreciation on the balance sheet. Intangibles are mostly ignored. In corp finance it's the PV of future cash flows, whatever they may be. So if the firm in default is in for example tech, IP development, biotech, or has obsolete assets, what are the asset values in default??Excellent point! Most of the valuation of a firm's equity and probability of default comes from the income statement. But the recovery value is a strong function of the balance sheet.Properly pricing defaulted debt also depends on the type of default. In the US, at least, the difference between Chapter 11 bankruptcy (restructuring) and Chapter 7 bankruptcy (liquidation) would lead to two very different pricing models because the first may involve debt-to-equity conversion and income statement issues around future cash flows to partially repay old debt while the second type involves liquidation of assets.
 
User avatar
daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

How to price a defaulted corporate bond

December 14th, 2014, 7:06 pm

QuoteOriginally posted by: dweebQuoteOriginally posted by: daveangelyou could use a form the KMV model for structural credit risk modelling. i.e. look at the defaulted debt as a call option on the assets of the firm. but again you will have to look at the asset valueI'll throw this out there - the value of a firm's assets is largely ignored in finance. Accounting records physical assets at historic value plus depreciation on the balance sheet. Intangibles are mostly ignored. In corp finance it's the PV of future cash flows, whatever they may be. So if the firm in default is in for example tech, IP development, biotech, or has obsolete assets, what are the asset values in default??low or zero.. I see no ambiguity. future cash flows don't come from thin air. they come from assets.
knowledge comes, wisdom lingers
 
User avatar
Traden4Alpha
Posts: 23951
Joined: September 20th, 2002, 8:30 pm

How to price a defaulted corporate bond

December 14th, 2014, 7:28 pm

QuoteOriginally posted by: daveangelQuoteOriginally posted by: dweebQuoteOriginally posted by: daveangelyou could use a form the KMV model for structural credit risk modelling. i.e. look at the defaulted debt as a call option on the assets of the firm. but again you will have to look at the asset valueI'll throw this out there - the value of a firm's assets is largely ignored in finance. Accounting records physical assets at historic value plus depreciation on the balance sheet. Intangibles are mostly ignored. In corp finance it's the PV of future cash flows, whatever they may be. So if the firm in default is in for example tech, IP development, biotech, or has obsolete assets, what are the asset values in default??low or zero.. I see no ambiguity. future cash flows don't come from thin air. they come from assets.But sometimes those assets are so intangible that they aren't even listed as intangibles on the company's balance sheet. To the extent that a company's brand, business processes, and relationships with suppliers, employees, and customers enable the company to produce a future cash flows, who needs assets?
 
User avatar
Stefano87
Topic Author
Posts: 5
Joined: November 17th, 2014, 5:10 pm

How to price a defaulted corporate bond

December 15th, 2014, 8:15 am

QuoteOriginally posted by: Traden4AlphaQuoteOriginally posted by: daveangelQuoteOriginally posted by: dweebQuoteOriginally posted by: daveangelyou could use a form the KMV model for structural credit risk modelling. i.e. look at the defaulted debt as a call option on the assets of the firm. but again you will have to look at the asset valueI'll throw this out there - the value of a firm's assets is largely ignored in finance. Accounting records physical assets at historic value plus depreciation on the balance sheet. Intangibles are mostly ignored. In corp finance it's the PV of future cash flows, whatever they may be. So if the firm in default is in for example tech, IP development, biotech, or has obsolete assets, what are the asset values in default??low or zero.. I see no ambiguity. future cash flows don't come from thin air. they come from assets.But sometimes those assets are so intangible that they aren't even listed as intangibles on the company's balance sheet. To the extent that a company's brand, business processes, and relationships with suppliers, employees, and customers enable the company to produce a future cash flows, who needs assets?Yes, I see your point. Anyway I shall consider that there are kind of two different scenarios: in business and out-of-business; let's say. In the first case everything is going well, coupon payments are actually paid and the like. In the second scenario you are either restructuring or liquidating.I would say that "hard assets" that you can sell in order to pay your debts should be considered in both cases, but probably while in business they likely should add to the credit trustworthyness of the firm (enhancing their credit rating...), in the second case they are the only things to generate those future cashflows deemed to re-pay old debts.Personally I like what was pointed out before (at some point):QuoteExcellent point! Most of the valuation of a firm's equity and probability of default comes from the income statement. But the recovery value is a strong function of the balance sheet.Properly pricing defaulted debt also depends on the type of default. In the US, at least, the difference between Chapter 11 bankruptcy (restructuring) and Chapter 7 bankruptcy (liquidation) would lead to two very different pricing models because the first may involve debt-to-equity conversion and income statement issues around future cash flows to partially repay old debt while the second type involves liquidation of assets.I shall dig further in the type of models one can put together in these two cases. More than a CDS in default, I would consider the defaulting mechanics more similar to a CDO's tranche but at random (first exit?) times.
 
User avatar
Samsaveel
Posts: 435
Joined: April 20th, 2008, 5:47 am

How to price a defaulted corporate bond

December 17th, 2014, 5:00 am

There is no mathematical models ,or some stochastic process that will give you the answer you are looking or if the bond defaulted then everything is in the realm of Solvency law and Investment law.
ABOUT WILMOTT

PW by JB

Wilmott.com has been "Serving the Quantitative Finance Community" since 2001. Continued...


Twitter LinkedIn Instagram

JOBS BOARD

JOBS BOARD

Looking for a quant job, risk, algo trading,...? Browse jobs here...


GZIP: On