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3 Step #2: Valuation 27 1. Obtain the forward zero curves for each rating category. These forward curves are stated as of the risk horizon and go to the maturity of the bond. 2. Using these zero curves, revalue the bond's remaining cash flows at the risk horizon for each rating category. Let us illustrate the above steps with the help of our BBB bond example. Recall that this bond has a five-year maturity, and pays annual coupons at the rate of 6%. Assume that the forward zero curves for each rating category has been given to us.
Finally, we combine these variances with the variances for individual assets and arrive at a portfolio standard deviation. The details of this calculation are discussed in Chapter 9 and Appendix A. After having calculated the portfolio standard distribution, we next calculate a second measure of credit risk, that is, the percentile level. Assume that we are interested in calculating the 1st percentile level. Again, we point out that there is no fixed rule to prefer any given percentile level over another.
Recall that our example bond pays an annual coupon at the rate of 6%. Therefore, assuming a face value of $100, the bond pays $6 each at the end of the next four years. At the end of the fifth year, the bond pays a cash flow of face value plus coupon, which equals $106 in this case. Now, let us calculate the value V of the bond at the end of one year assuming that the bond upgrades to single-A. 3. To calculate the value of the bond in a rating category other than single-A, we would substitute the appropriate zero rates from the table.