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Donald van Deventer
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Donald R. van Deventer founded the Kamakura Corporation in April, 1990 and is currently Chairman and Chief Executive Officer. Dr. van Deventer's emphasis at Kamakura Corporation is enterprise wide risk management and modern credit risk technology. The second edition of his newest book, Advanced... More
My company:
Kamakura Corporation
My blog:
Donald R. van Deventer's Kamakura Blog
My book:
Advanced Financial Risk Management, 2nd Edition 2013
  • RadioShack 1 Year Default Probability 4.75%, Up 0.61% Today 6 comments
    Feb 6, 2014 11:10 AM | about stocks: RSH, XRT, RTH

    (click to enlarge)

    475rsh61

    The blue line is the firm's one year default probability. The yellow line is the annualized one month default probability.

    Background on the Default Probability Models Used

    The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model ( abbreviated KDP-jc5) makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. KRIS covers 35,000 firms in 56 countries, updated daily. Free trials are available at Info@Kamakuraco.com. An overview of the full suite of Kamakura default probability models is available here.

    General Background on Reduced Form Models

    For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Themes: consumer goods, services Stocks: RSH, XRT, RTH
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Comments (6)
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  • june1234
    , contributor
    Comments (2499) | Send Message
     
    No wonder with nobody in their stores they now have come up with the $4M they spent on a 30 sec. super blowout ad.
    7 Feb, 05:19 AM Reply Like
  • Donald van Deventer
    , contributor
    Comments (1009) | Send Message
     
    Author’s reply » It's a tough businesss and that's an interesting bet on their part.
    7 Feb, 11:02 AM Reply Like
  • billddrummer
    , contributor
    Comments (1672) | Send Message
     
    Thank you for tracking this company.

     

    Looking back in your history, it appears that RSH's 1-year default probability has steadily risen from 1.50% in June 2013 to the level seen today.

     

    At what point does the 1-year default probability become a 'tipping point' statistic which the company cannot recover from?

     

    I welcome your thoughts, and have tremendous respect for your resources, accomplishments, and sagacity.
    9 Feb, 01:09 PM Reply Like
  • Donald van Deventer
    , contributor
    Comments (1009) | Send Message
     
    Author’s reply » Thanks for the kind words, Bill. In one of our blogs we pointed out that "what goes up can come down and what goes down can go up"--whether it's the temperature or a default probability. The best use of default probabilities is this--RSH's default probability is X% at a one year time horizon, which means the probability of bankruptcy in one year or less is X% (i.e. probability stock price goes to zero). The models are never perfect but right now this is the best available estimate. In the instablog comments, we give two key references: Campbell, HIlscher and Szilagyi (2008, 2011) in two big studies confirmed that investors are not properly rewarded for default risk. So my advice would be this--focus on firms (currently about 95% of all public firms) with short term default risk under 1%. If someone crosses the 1% line, they can return to the "safety zone" under 1%, but it's worrisome. Right now bond holders of JC Penney don't even get a credit spread as high as the default probability, so they're definitely not being rewarded for taking the risk. Personally, if you have good execution, I'd get out of anything that has a 1 year default probability over 3%. Beyond that, it gets tough to get out at a good price and you don't get compensated for the risk if you stay in. Sorry for the messy advice, but it's a messy world.
    9 Feb, 03:42 PM Reply Like
  • billddrummer
    , contributor
    Comments (1672) | Send Message
     
    Thank you for clarifying the relationship between default risk and investment attractiveness.

     

    Based on the references you have cited, it becomes an exercise in assessing current yields in relation to the default risk.

     

    As you rightly point out, JCP bondholders are not being compensated for default risk, which would compel a prudent investor to get out as soon as possible, notwithstanding the performance metrics of the company.
    In fact, one wonders if there is enough upside potential for either company to allow either JCP or RSH to reduce their default probabilities below the 3% threshold, much less the 1% line, which provides a compelling demarcation between lower- and higher-risk bond investments.

     

    My investments are miniscule, and centered in stocks, not debt securities. But I continue to learn about the investment climate created when underperformance meets weak prospects.

     

    The corporate landscape is littered with the carcasses of companies that failed to adapt to systemic operational change.

     

    Thank you again for providing a most enlightening view into the default risk probability model.
    10 Feb, 01:10 AM Reply Like
  • Donald van Deventer
    , contributor
    Comments (1009) | Send Message
     
    Author’s reply » And thanks for the kind words. We'll be throwing around "default-adjusted dividend yields" before long for exactly those reasons. Meanwhile, keep banging on those drums 8-)
    10 Feb, 10:46 AM Reply Like
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