New Technology for Managing Credit Risk

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  • New Technology for Managing Credit Risk

    1. 1. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT STRATEGY PRMIA LONDON 18 MAY 2004
    2. 2. <ul><li>Recent market environment </li></ul><ul><li>New market-implied techniques to manage credit risk </li></ul><ul><li>Introduction to the BDP (Barra Default Probability) </li></ul><ul><li>Practical Examples </li></ul><ul><li>Questions and answers (assuming I have the answers) </li></ul>Discussion Outline
    3. 3. <ul><li>Recent market environment </li></ul><ul><li>New market-implied techniques to manage credit risk </li></ul><ul><li>Introduction to the BDP (Barra Default Probability) </li></ul><ul><li>Practical Examples </li></ul><ul><li>Questions and answers </li></ul>Discussion Outline
    4. 4. <ul><li>Equity declines drove re-allocations to fixed income </li></ul><ul><ul><li>Simultaneously government yields decreased to all time lows </li></ul></ul><ul><ul><li>Credit default rates neared all time highs </li></ul></ul><ul><ul><li>Pension fund shortfalls (Focus on ALM) </li></ul></ul><ul><li>Credit markets are increasingly complex </li></ul><ul><ul><li>Universe of assets is expanding rapidly </li></ul></ul><ul><ul><li>Spread products are becoming more complicated </li></ul></ul><ul><ul><li>Limited headcount to cover expanding number of issues </li></ul></ul>Market Forces Change the Rules of Credit Investing
    5. 5. Currently Very Few Easy Opportunities <ul><li>End of the bear credit market in 2003 </li></ul><ul><li>Spreads have tightened to extreme levels </li></ul><ul><ul><li>Lowest since 1998 </li></ul></ul><ul><li>Demand still high </li></ul><ul><ul><li>Non-traditional investors </li></ul></ul>Source: S&P
    6. 6. Outperformance Is More Demanding Than Ever <ul><li>Are we being correctly compensated? </li></ul><ul><ul><li>Risk premium close to zero </li></ul></ul><ul><li>How does a long-only investor win/outperform? </li></ul><ul><ul><li>Spreads have nowhere to go </li></ul></ul><ul><li>Move to </li></ul><ul><ul><li>Lower-quality / higher-yielding </li></ul></ul><ul><ul><li>Find names with value still </li></ul></ul><ul><li>Asset selection is key </li></ul>
    7. 7. One Default Can Negate Entire Portfolio’s Return <ul><li>Credit market is strongly asymmetric </li></ul><ul><li>Earning the spread has become extremely difficult over the past few years </li></ul><ul><li>Unprecedented market conditions with record downgrades and defaults </li></ul>Source: Lehman Brothers, 2002
    8. 8. Fundamental Analysis Alone Is Not Enough <ul><li>Judgment of experienced analysts remains essential </li></ul><ul><li>However, judgment often impaired by questionable data </li></ul><ul><ul><li>Nearly 1000 accounting re-statements in the last three years (source: SEC) </li></ul></ul><ul><ul><li>Creative accounting </li></ul></ul><ul><li>What’s required is a more efficient process to monitor, screen, and select credit-risky investments </li></ul>
    9. 9. Gaining the Advantage in Credit Investing <ul><li>To successfully manage credit, you need </li></ul><ul><li>Earlier, more accurate prediction of potential default risk </li></ul><ul><li>Models that allow for the real- world uncertainty of financial statements </li></ul><ul><li>Tools to make your credit analysis process more efficient </li></ul>
    10. 10. <ul><li>Recent market environment </li></ul><ul><li>New market-implied techniques to manage credit risk </li></ul><ul><li>Introduction to the BDP (Barra Default Probability) </li></ul><ul><li>Practical Examples </li></ul><ul><li>Questions and answers </li></ul>Discussion Outline
    11. 11. Market-Implied Measures Provide Additional Insight <ul><ul><li>Market-implied measures from the: </li></ul></ul><ul><ul><li>Equity Market – Barra Default Probabilities (BDP) </li></ul></ul><ul><ul><li>Bond Market – Barra Implied Ratings (BIR) </li></ul></ul><ul><ul><li>Derivatives Market – Credit Default Swaps (CDS) </li></ul></ul><ul><ul><li>Coming soon… </li></ul></ul><ul><ul><li>Crossover – Empirical Credit Risk (ECR) Equity Risk Implied Spreads (ERIS) </li></ul></ul>
    12. 12. Equity Market – BDPs Go Beyond Traditional Models <ul><li>BDP advantages </li></ul><ul><li>Incomplete Information framework assumes fundamental data may be flawed </li></ul><ul><li>Use of Barra’s industry standard equity volatility forecast </li></ul><ul><li>Empirical study of historical leverage </li></ul>Barra’s model signals significant uptrend in default risk months earlier
    13. 13. Bond Market – BIRs Lead Agency Ratings <ul><li>Barra Implied Ratings take the bond market’s perspective on credit and match it to a best fit distribution of actual ratings </li></ul><ul><li>Barra Implied Ratings typically can lead agency ratings by as much as three months </li></ul>Barra’s measures provide earlier warning to possible downgrade
    14. 14. Derivatives Market – CDS Market a Leading Indicator <ul><li>Credit Default Swap (CDS) rates often provide leading indication of risk and value </li></ul><ul><li>CDS market is exploding: more than $4 trillion notional outstanding and most big names actively traded (source: BBA) </li></ul>Cash-CDS Basis History Merrill Lynch (5 Year USD)
    15. 15. <ul><li>Recent market environment </li></ul><ul><li>New market-implied techniques to manage credit risk </li></ul><ul><li>Introduction to the BDP (Barra Default Probability) </li></ul><ul><li>Practical Examples </li></ul><ul><li>Questions and answers </li></ul>Discussion Outline
    16. 16. Current Quantitative Default Models <ul><li>Structural or Cause-and-Effect approach (Merton) </li></ul><ul><ul><li>Default happens for a reason </li></ul></ul><ul><ul><li>Firm-specific information can be used advantageously </li></ul></ul><ul><li>Reduced form approach </li></ul><ul><ul><li>Default rates can be analysed statistically </li></ul></ul><ul><ul><li>Ad hoc, exogenously-given, default rate </li></ul></ul>
    17. 17. Merton’s Structural Model of Default <ul><li>Default occurs at debt maturity if the firm value is below the liabilities value </li></ul><ul><li>We thus need </li></ul><ul><ul><li>A model of firm value process </li></ul></ul><ul><ul><li>Estimate of default point </li></ul></ul><ul><li>Merton identified equity as being long a call option on the firm value </li></ul><ul><li>Merton identified a bond as being short a put option on the firm value </li></ul>
    18. 18. Merton’s 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. 19. Merton’s Structural Model of Default 0 D V 0 No Default Probability of Default Default T
    20. 20. Reduced Form Models <ul><li>Assume that default is totally unpredictable </li></ul><ul><ul><li>Default comes unannounced </li></ul></ul><ul><li>Based on a conditional default rate or intensity </li></ul><ul><ul><li>Exogenously given </li></ul></ul><ul><li>Fit well to market data including short credit spreads </li></ul><ul><li>Ad hoc, lack intuitive appeal </li></ul><ul><li>The picture: </li></ul>?
    21. 21. Model Comparison <ul><li>Based on a model definition of default </li></ul><ul><li>Intuitive, appealing </li></ul><ul><li>The default time is often (implicitly) predictable </li></ul><ul><li>Hard to fit to empirical data </li></ul><ul><li>Based on an exogenously given default rate </li></ul><ul><li>Ad hoc </li></ul><ul><li>The default time is always totally unpredictable </li></ul><ul><li>Easy to fit to empirical data </li></ul>Structural / Cause and Effect <ul><li>What we want: a hybrid model </li></ul><ul><ul><li>Incorporate the best features of structural and reduced form </li></ul></ul><ul><ul><li>Avoid their pitfalls </li></ul></ul>Reduced Form
    22. 22. The Barra Default Probability (BDP) Model <ul><li>A genuine hybrid of cause-and-effect (structural) and reduced-form models (compensator approach) </li></ul><ul><ul><li>Based on a default time that is not predictable </li></ul></ul><ul><ul><li>Makes use of all publicly available liability statements and equity market data </li></ul></ul><ul><ul><li>Assumes investors have incomplete information </li></ul></ul><ul><ul><li>Calibrates easily to short credit spreads </li></ul></ul><ul><ul><li>Intuitive and appealing </li></ul></ul>
    23. 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. 24. Default Barrier – Scaled Beta Distribution Mean = current debt Standard deviation, calibrated or user-configured
    25. 25. BDP Model – Uncertainty Can Be Varied Barra Default Probability Model Variant 1 Variant 2 Variant 3
    26. 26. BDP Model – A Firm Becomes Distressed 9/17/2001 9/10/2001 Credit term structure steepens and short-term spreads increase
    27. 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. 28. Testing the Model – ROC Curves <ul><ul><ul><li>Radar Operators in WWII: Plane (or flock of birds)? </li></ul></ul></ul><ul><ul><ul><li>Medical Diagnosis: Is this person’s Thyroid OK? </li></ul></ul></ul><ul><ul><ul><li>Astronomy: Is this a Planet? </li></ul></ul></ul><ul><ul><ul><li>Marketing Analysis: Will this household buy insurance? </li></ul></ul></ul><ul><ul><ul><li>Credit Risk: Will this name default ? </li></ul></ul></ul>Non-Event Event MODEL FORECAST Event (+) Non-Event (-) True Negative False Negative False Positive True Positive REAL WORLD
    29. 29. ROC Curves – Merton Comparison Merton BDP Random Method
    30. 30. ROC Curves – First Passage Comparison First Pass BDP
    31. 31. ROC Curves – Moody’s Rating Comparison BDP Moody’s Rating
    32. 32. <ul><li>Recent market environment </li></ul><ul><li>New market-implied techniques to manage credit risk </li></ul><ul><li>Introduction to the BDP (Barra Default Probability) </li></ul><ul><li>Practical Examples </li></ul><ul><li>Questions and answers </li></ul>Discussion Outline
    33. 33. BIR – Good Complement to Agency Ratings ZOOM ZOOM
    34. 34. BDP – Outlier Identification <ul><li>Inspecting ‘like-credits’ in a new way can sometimes turn up opportunities or threats </li></ul>USD BBB Consumer Cyclicals Average BDP = 0.20% Toys ‘R’ Us BDP = 4.97% Source: Barra Credit
    35. 35. BDP – Warning of Toys R Us’ Downgrade? <ul><li>Bond implied ratings moved in October as well </li></ul>A few days later spreads widened, and months later Toys R Us was downgraded to below investment grade (junk) Source: Barra Credit
    36. 36. BIR – Mandate Restrictions <ul><li>Early warnings of Potential Downgrades can allow managers to exit worrying names before the flood </li></ul>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. 37. BDP – Early Warning <ul><li>The equity market was also signalling concerns for Parmalat </li></ul>The BDP moved well into HY levels before December Source: Barra Credit Investment Grade (approximately) . .
    38. 38. Capital Structure Arbitrage <ul><li>Differing views from two markets on the capital structure point out interesting opportunities </li></ul>FedEx’s announcement of its planned acquisition of Kinko’s triggered concern implied by the equity market but not reflected in bond spreads Source: Barra Credit
    39. 39. Market-Implied Measures Offer More Insight Source: Barra Credit
    40. 40. Research Papers and More Info <ul><li>www.barra.com </li></ul><ul><li>Datasheets </li></ul><ul><li>Flash Demos </li></ul><ul><li>Research Papers </li></ul><ul><li>Practitioner Papers </li></ul><ul><li>Conference Attendance </li></ul>
    41. 41. [email_address]

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