What is discount rate
Although it is subject to wide interpretation amongst the wider academia and finance practitioners, the concept of discount rates remains tricky at the best. A discount rate is the percentage by which the value of a cash flow in a discounted cash flow (DCF) valuation, alternatively the interest rate used to find the present value of future cash flows. It is also the rate at which credit is availed from the lender of the last resort(central bank). Often the discount rate is taken as the risk free rate, which in turn is derived from the yield of 10 year treasury bonds or Gilts in the UK. One easy way of finding the discount rates in the current times could be from the other definition of it. Let me explain.
During the financial crisis the Federal reserve and the UK (bank of England) had to lend to the big banks to prevent their failure and avert an shock in the system. If we see the rates at which these funds were delivered, we can fairly estimate the current levels of discount rates. But wait a minute, what was the exact discount rate for one of the major bailouts during the financial crisis. When I googled the interest rate for Citi Bank bailout of 300 billions, the figure that showed up most consistently is 8%. It is a lot higher when compared to the 3 months treasury bill rates. Farrokh Langdana (2009)in his book states that discount rates usually follow 3 month T bill rates and suggests that there is empirical evidence for the same.
In the case of Citibank bailout it was stated by the US treasury that interest rates will be higher for initial few years and reduce progressively.
Amazing that the financial crisis changed the basis for making estimates for the discount rates for financial organisations all over the world. It made it obvious, rather transparent. So the one of the thumb rules for estimating discount rates should be just ask Citibank (or the Fed) the interest rates that they are paying (or receiving) on the bailout funds.
CREDIT risk
It is the risk of loss of the principal due to the failure of the borrower to fulfil contractual obligations. Basically the risk of the borrower going bankrupt as faced by the lender is termed as credit risk.The area of research done on Volatility, Options, Volatility skew and its linkages with risk and returns is a vast and very rich area of finance. Also preliminary analysis has made it obvious to me that these interrelations between these factors forms the crux of many financial models that exist in the markets today. It also encompasses vast areas from financial engineering, statistics, calculus and mathematics. In the coming days I am going to explore this area starting from the basics and gradually moving towards the more sophisticated concepts. One unique thing that is going to be done is the inclusion of relevant examples from the developments in the financial world.
The Beginning:
One popular approach to assessing credit risk involves Merton’s (1974) model. This
model assumes that a company has a certain amount of zero-coupon debt that will
become due at a future time T. The company defaults if the value of its assets is less than the promised debt repayment at time T. The equity of the company is a European call option on the assets of the company with maturity T and a strike price equal to the face value of the debt. The model can be used to estimate either the risk-neutral probability that the company will default or the credit spread on the debt.
