New Technology for Managing Credit Risk
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1 © 2003 Barra, Inc. All rights reserved. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT STRATEGY PRMIA LONDON 18 MAY 2004
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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)
- Practical Examples
- Questions and answers (assuming I have the answers)
- 3.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
- Practical Examples
- Questions and answers
- 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
- 5. Currently Very Few Easy Opportunities
- End of the bear credit market in 2003
- Spreads have tightened to extreme levels
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- Lowest since 1998
- Demand still high
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- Non-traditional investors
- 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
- Move to
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- Lower-quality / higher-yielding
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- Find names with value still
- Asset selection is key
- 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
- 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)
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- Creative accounting
- 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)
- Practical Examples
- Questions and answers
- 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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- Coming soon
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- Crossover Empirical Credit Risk (ECR) Equity Risk Implied Spreads (ERIS)
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- 12. Equity Market BDPs Go Beyond Traditional Models
- BDP advantages
- Incomplete Information framework assumes fundamental data may be flawed
- Use of Barras industry standard equity volatility forecast
- Empirical study of historical leverage
- 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
- 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)
- 15.
- Recent market environment
- New market-implied techniques to manage credit risk
- Introduction to the BDP (Barra Default Probability)
- Practical Examples
- Questions and answers
- 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
- Reduced form approach
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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
- We thus need
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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
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- Exogenously given
- Fit well to market data including short credit spreads
- Ad hoc, lack intuitive appeal
- The picture:
- 21. Model Comparison
- Based on a model definition of default
- Intuitive, appealing
- The default time is often (implicitly) predictable
- Hard to fit to empirical data
- Based on an exogenously given default rate
- Ad hoc
- The default time is always totally unpredictable
- Easy to fit to empirical data
- What we want: a hybrid model
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- Incorporate the best features of structural and reduced form
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- Avoid their pitfalls
- 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
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- Intuitive and appealing
- 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 ?
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- 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)
- Practical Examples
- Questions and answers
- 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
- 35. BDP Warning of Toys R Us Downgrade?
- Bond implied ratings moved in October as well
- 36. BIR Mandate Restrictions
- Early warnings of Potential Downgrades can allow managers to exit worrying names before the flood
- 37. BDP Early Warning
- The equity market was also signalling concerns for Parmalat
- 38. Capital Structure Arbitrage
- Differing views from two markets on the capital structure point out interesting opportunities
- 39. Market-Implied Measures Offer More Insight Source: Barra Credit
- 40. Research Papers and More Info
- www.barra.com
- Datasheets
- Flash Demos
- Research Papers
- Practitioner Papers
- Conference Attendance
- 41. [email_address]