Question 1 Needs Gradin Bond ratings are letter ratings (AAA-best) assigned to f

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Question 1 Needs Gradin Bond ratings are letter ratings (AAA-best) assigned to firms that issue debt. These ratings measure the quality of the firm from the point of view of the likelihood of repayment of the bond. Suppose you have been hired by an arbitrage house that wants to predict those bond ratings before they are published in order to buy bonds whose ratings are going to improve. Your company has collected a data set of 200 bonds with which to estimate a model. As you arrive on the job, your boss is about to buy bonds based on the OLS results of the following model: 3. -0.70+0.05 P +0.05 PV-0.02 D (029 (002 0003 F = 0.69 where Y-1 if the rating of the ith bond is AAA, 0 otherwise P- the profit rate of the firm that issued the ith bond PV- the standard deviation of P, over the last five years D,-the ratio of debt to total capitalization of the firm that issued the ith bond a) What econometric problems, if any. exist in this equation b) What suggestions would you have for a renun of this equation? c) Suppose that your boss rejects your suggestions. How would you respond? uestion 2 Needs Gradi

Explanation / Answer

a) The profit's accumulate to the shareholders. It is the interest that come to the debtholders. So interest coverage ratios that measure whether the interest is payable using the EBIT is more important. Hence the dependency on profits is a problem. The standard deviation of the profits again does not add value to the analysis as the more relevant criteria would be the interest payments as a percentage of debt. The debt to assets also does not add value here since equity has only a tertiary claim on EBIT, after the creditors and the government.

b) In a rerun, the relevant parameters should be the interest coverage ratio and the interest to debt ratio.

c) There are many alternatives available. You can quit the firm. You can escalate to more senior personnel or some ombudsman and act as a whistelblower. You can run the analysis on your own and show the results to the boss. You can do collective bargaining with some of your coworkers and demand that the management withdraw this analysis.

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