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Q7
.a. the basis of using market-based premiums analysis is Capital Asset Pricing Model, CAPM refers to the expected return of assets has positive correlation with beta value as ra =rf +beta*(rm-rf); where rm-rf represents market premium.
b. because there are issues with the analysis, firstly, it is difficult to find the rated and traded bond which matches the characteristics of the credit risk that the credit analyst is interested in; secondly there are other elements which influences the premium as the liquidity of bond can affect the observed repayment probability.
c.
market-based risk premiums analysis considers the risk premium of a reated corporated bond with risk free rate to infer the expected probability of default. P*(1+r)=1+I, where the probability of repayment equals to (1+i)/(1+r) where I is risk free rate, r is bond rate. For hybrid system, it combines elements of different approaches to credit risk to overcome different model’s weaknesses. Hybrid systems generates from a number of sources including option theory, insurance for lenders to apply in order to obtain promising loan evaluation.