Transcript of New Technology for Managing Credit Risk
- 1. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT STRATEGY
PRMIA LONDON 18 MAY 2004
- 2.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
- Questions and answers (assuming I have the answers)
Discussion Outline
- 3.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
Discussion Outline
- 4.
- Equity declines drove re-allocations to fixed income
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- Simultaneously government yields decreased to all time
lows
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- Credit default rates neared all time highs
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- Pension fund shortfalls (Focus on ALM)
- Credit markets are increasingly complex
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- Universe of assets is expanding rapidly
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- Spread products are becoming more complicated
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- Limited headcount to cover expanding number of issues
Market Forces Change the Rules of Credit Investing
- 5. Currently Very Few Easy Opportunities
- End of the bear credit market in 2003
- Spreads have tightened to extreme levels
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- Non-traditional investors
Source: S&P
- 6. Outperformance Is More Demanding Than Ever
- Are we being correctly compensated?
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- Risk premium close to zero
- How does a long-only investor win/outperform?
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- Spreads have nowhere to go
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- Lower-quality / higher-yielding
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- Find names with value still
- 7. One Default Can Negate Entire Portfolios Return
- Credit market is strongly asymmetric
- Earning the spread has become extremely difficult over the past
few years
- Unprecedented market conditions with record downgrades and
defaults
Source: Lehman Brothers, 2002
- 8. Fundamental Analysis Alone Is Not Enough
- Judgment of experienced analysts remains essential
- However, judgment often impaired by questionable data
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- Nearly 1000 accounting re-statements in the last three years
(source: SEC)
- Whats required is a more efficient process to monitor, screen,
and select credit-risky investments
- 9. Gaining the Advantage in Credit Investing
- To successfully manage credit, you need
- Earlier, more accurate prediction of potential default
risk
- Models that allow for the real- world uncertainty of financial
statements
- Tools to make your credit analysis process more efficient
- 10.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
Discussion Outline
- 11. Market-Implied Measures Provide Additional Insight
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- Market-implied measures from the:
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- Equity Market Barra Default Probabilities (BDP)
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- Bond Market Barra Implied Ratings (BIR)
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- Derivatives Market Credit Default Swaps (CDS)
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- Crossover Empirical Credit Risk (ECR) Equity Risk Implied
Spreads (ERIS)
- 12. Equity Market BDPs Go Beyond Traditional Models
- Incomplete Information framework assumes fundamental data may
be flawed
- Use of Barras industry standard equity volatility forecast
- Empirical study of historical leverage
Barras model signals significant uptrend in default risk months
earlier
- 13. Bond Market BIRs Lead Agency Ratings
- Barra Implied Ratings take the bond markets perspective on
credit and match it to a best fit distribution of actual
ratings
- Barra Implied Ratings typically can lead agency ratings by as
much as three months
Barras measures provide earlier warning to possible downgrade
- 14. Derivatives Market CDS Market a Leading Indicator
- Credit Default Swap (CDS) rates often provide leading
indication of risk and value
- CDS market is exploding: more than $4 trillion notional
outstanding and most big names actively traded (source: BBA)
Cash-CDS Basis History Merrill Lynch (5 Year USD)
- 15.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
Discussion Outline
- 16. Current Quantitative Default Models
- Structural or Cause-and-Effect approach (Merton)
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- Default happens for a reason
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- Firm-specific information can be used advantageously
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- Default rates can be analysed statistically
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- Ad hoc, exogenously-given, default rate
- 17. Mertons Structural Model of Default
- Default occurs at debt maturity if the firm value is below the
liabilities value
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- A model of firm value process
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- Estimate of default point
- Merton identified equity as being long a call option on the
firm value
- Merton identified a bond as being short a put option on the
firm value
- 18. Mertons Structural Model of Default Payoff at maturity of
the bond Value of the Equity at maturity time T Value of the Bond
at maturity time T i.e. default free bond + short European put on V
@ K i.e. European call on V @ K
- 19. Mertons Structural Model of Default 0 D V 0 No Default
Probability of Default Default T
- 20. Reduced Form Models
- Assume that default is totally unpredictable
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- Default comes unannounced
- Based on a conditional default rate or intensity
- Fit well to market data including short credit spreads
- Ad hoc, lack intuitive appeal
?
- 21. Model Comparison
- Based on a model definition of default
- The default time is often (implicitly) predictable
- Hard to fit to empirical data
- Based on an exogenously given default rate
- The default time is always totally unpredictable
- Easy to fit to empirical data
Structural / Cause and Effect
- What we want: a hybrid model
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- Incorporate the best features of structural and reduced
form
Reduced Form
- 22. The Barra Default Probability (BDP) Model
- A genuine hybrid of cause-and-effect (structural) and
reduced-form models (compensator approach)
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- Based on a default time that is not predictable
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- Makes use of all publicly available liability statements and
equity market data
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- Assumes investors have incomplete information
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- Calibrates easily to short credit spreads
- 23. Barra Default Probability Model Intuition 0 V 0 T
Distribution of possible default boundary levels Paths of Asset
Value Process Expected level of default barrier Width represents
uncertainty in the default barrier level Time Asset Value
- 24. Default Barrier Scaled Beta Distribution Mean = current
debt Standard deviation, calibrated or user-configured
- 25. BDP Model Uncertainty Can Be Varied Barra Default
Probability Model Variant 1 Variant 2 Variant 3
- 26. BDP Model A Firm Becomes Distressed 9/17/2001 9/10/2001
Credit term structure steepens and short-term spreads increase
- 27. BDP Model Subtlety Healthy Firm 4/15/2002 4/10/2002 15%
drop in equity Credit term structure steepens but short-term
spreads barely move
- 28. Testing the Model ROC Curves
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- Radar Operators in WWII: Plane (or flock of birds)?
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- Medical Diagnosis: Is this persons Thyroid OK?
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- Astronomy: Is this a Planet?
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- Marketing Analysis: Will this household buy insurance?
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- Credit Risk: Will this name default ?
Non-Event Event MODEL FORECAST Event (+) Non-Event (-) True
Negative False Negative False Positive True Positive REAL
WORLD
- 29. ROC Curves Merton Comparison Merton BDP Random Method
- 30. ROC Curves First Passage Comparison First Pass BDP
- 31. ROC Curves Moodys Rating Comparison BDP Moodys Rating
- 32.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
Discussion Outline
- 33. BIR Good Complement to Agency Ratings ZOOM ZOOM
- 34. BDP Outlier Identification
- Inspecting like-credits in a new way can sometimes turn up
opportunities or threats
USD BBB Consumer Cyclicals Average BDP = 0.20% Toys R Us BDP =
4.97% Source: Barra Credit
- 35. BDP Warning of Toys R Us Downgrade?
- Bond implied ratings moved in October as well
A few days later spreads widened, and months later Toys R Us was
downgraded to below investment grade (junk) Source: Barra
Credit
- 36. BIR Mandate Restrictions
- Early warnings of Potential Downgrades can allow managers to
exit worrying names before the flood
The Bond Market was pricing in concerns back in September when the
Barra Implied Rating for Parmalat dropped to Sub-IG Source: Barra
Credit
- 37. BDP Early Warning
- The equity market was also signalling concerns for
Parmalat
The BDP moved well into HY levels before December Source: Barra
Credit Investment Grade (approximately) . .
- 38. Capital Structure Arbitrage
- Differing views from two markets on the capital structure point
out interesting opportunities
FedExs announcement of its planned acquisition of Kinkos triggered
concern implied by the equity market but not reflected in bond
spreads Source: Barra Credit
- 39. Market-Implied Measures Offer More Insight Source: Barra
Credit
- 40. Research Papers and More Info
- 41. [email_address]