9
I could not find any such detailed documentation after some weeks of looking (not non-stop obviously). It is appallingly documented. I do understand fully what it does though so am happy to field some questions on it if you like.
In a nutshell, I can tell you it is a standard reduced-form credit model under a constant hazard rate (i.e. homogeneous Poisson ...
9
The argument about Basel is an adjunct to the central bank argument. There, a relatively price-insenstive CB either distorts credit by buying it directly (ECB, Fed wrt Agencies). Or distorts it indirectly by distorting the govvie market, pushing hitherto govvie holders into credit markets at a different price to what everyone would see without this effect. ...
7
well you can use CDS spreads to strip out implied default probabilities for default before time $T.$ These had better be increasing as a function of $T$ or you have an arbitrage opportunity.
However, there is an assumption here that there is no default risk on the CDS swap itself once you take that into account there may be a good chance of profit but no ...
6
Both 'credit risk' and 'counterparty credit risk' refer to the same type of risk, i.e. the risk that the opposite side of a contract will not honor its obligations to repay.
But 'credit risk' will be typically used in the context of traditional loans business, i.e. for practitioners 'credit risk' will be associated with lending a money to someone - here ...
6
One explanation might be purely quantitative: The spread is to compensate for the present value (cost) of a possible future default. When interest rates rise all else equal, the discounted cost of future default decreases, which translates into tighter spreads. See for instance Leland(1994b) as presented here.
As investigated in a paper from Kansas Fed ...
5
Actuarial science traditionally focuses on estimation of joint probabilities using real data where math finance is on valuation of contracts under an arbitrary distribution.
It means the first one deals with methods of estimation of future distributions (the number of accidents of a given kind, the probability of someone with a given profile to have a ...
5
You could read it like this:
The typical change in equity value is equal to the typical change in asset value, adjusted for the probability of the assets surviving.
Note that the formula is not specific to Merton models, it's also true for regular options and their underlyings. It's just that volatility of option prices isn't typically a concern in "...
5
This is indeed a markit vocabulary that spread worldwide. Both recoveries are indeed "often" equal, but there is nevertheless a huge difference between them : one is a pure quotation tool whereas the other is an average or selected market "prices" :
the assumed recovery rate is only used for a quotation purpose : to do the (quoted spread,coupon) --> upfront ...
5
You would need to provide more details for an accurate PnL attribution. However, here are some additional points to consider that might help.
When you sold protection, you effectively became long the 5Yr synthetic debt of the reference entity at a credit spread of 190bps. I assume that the reference entity and the sovereign where the company is domiciled ...
4
Well, the main intuition of the Merton model is that a company's equity can be treated as a call option on its assets, thus allowing for the application of Black-Scholes option pricing methods. Let's consider a company that has assets $A_{t}$ financed by equity $E_{t}$ and a zero-coupon debt $B_{t}$ with face value K, and maturity T. At time of maturity T, ...
4
All else being equal, buying back stock would cause a company's credit spread to widen (increase). This is because a share buyback involves shrinking the firm's assets (spending cash to buy back the stock) and shrinking equity/retained earnings, while leaving the liabilities unchanged (or increasing them in the case of a leveraged buy back). This is an ...
4
If you don't have a significant amount of losses in your portfolio to validate the model, you should be able to obtain external loss data and adjust it where necessary to better fit your organization. This is very common with operational loss models where operational losses are quite scarce.
4
It depends on how one is thinking about the hedge. One might be thinking of it as
A hedge against catastrophic risk (default of the issuer), or
A hedge against changes in (market-implied) default intensity or hazard rate
In the former case, which seems to be how you are considering it, the hedge is a static hedge, kept for up to 5 years, and insulates you ...
4
Most, but far from all, companies maintain a relatively steady debt load. When a bond matures, they fund its principal payout with a new bond.
Sometimes companies do take on more and more debt, meaning that CDS protection sold during earlier times of small debt loads becomes more valuable (and underpriced, from the point of view of the protection seller). ...
4
Regarding the terminology, there is no relation between CDS spread and bid/ask spread. The term spread in this sense refers to the related difference (spread) of the effective (credit risky) interest rate and the "risk free" rate (also see "credit spread").
4
For clarity, I'll use two expressions, "liquidity premium" and "illiquidity premium":
"Liquidity premium" arises when investors value the liquidity profile of an instrument so much that they are willing to pay for the enhanced liquidity, thus pushing the price of the instrument above fair value (and its yield below fair value).
"Illiquidity premium" arises ...
4
Assume, for a moment, that all of the math behind modern portfolio theory is incorrect. See, for example, this video on deriving the distribution of returns. Without the normality assumption, indexing and methodologies like the Basel accords are not neutral.
The Gaussian distribution is the result of a convergent process over time. The system has to have ...
4
CVA stands for Credit Valuation Adjustment and should be applied to derivatives and not bond portfolios.
The reason is that unlike derivatives, a bond has the counterparty credit quality implicitly priced. Consider two bonds with exactly the same features (coupon, maturity, etc) but issued by a different entity. Most likely, the bonds will have different ...
4
Let me add that in my experience, floating-rate bonds are less liquid than fixed coupon bonds, particularly in emerging markets and also particularly for corporates. As user42108 pointed out, it might not be possible to borrow the floating rate bond (so that you cannot short the asset swap).
Also, if the bid-ask spread on the floating rate bond is large (...
3
The classical connection is the http://en.m.wikipedia.org/wiki/Esscher_transform developed for actuaries in 1932 which essentially transforms the objective probability measure into the risk neutral one used in quant finance.
3
I do not know the regulatory rules for this case, but methodologically you could take another similar dataset "peer data" and then check how correctly your model predicts the losses of this dataset.
3
As I see it, the term $\Pi_B(t, T)$ is the value of the derivatives already owned by the bank. So, it's not some price they need to pay but an asset on the balance sheet. This increase in asset value leads to a profit.
Balance sheet Example
Imagine the balance sheet of OTC Subsidiary with rating A:
Assets | Liabilities
-----------------...
3
Here are some practical tips for selecting stochastic processes for spread curves, for example, in Monte Carlo simulation.
Typically you formulate a joint stochastic model for yields at key maturities due to data limitations.
The corporate yield curves generally maintain order with the AAA yield below AA yield, AA yield below A yield, etc. If, for ...
3
The equation stated in the question is not at the core of Merton's credit model, (Not saying you claimed it is) but is a simple device in helping to solve the system of linear equations.
The equation given simply establishes a relationship between the volatility of equity and the volatility of the assets and it follows from the application of Black Scholes ...
3
Here is another Credit Default Swap database which is rather extensive, daily spreads of roughly 700 entities starting in 2006.
3
One way to approach this is to use a structural credit model which links the price of debt and equity.
To start with, you may wish to consider the JP Morgan / Deutsche Bank Credit Grades model which came out in 2002. In those days, the growing CDS market made it possible for hedge funds to short credit and to play any perceived mispricing of debt-equity ...
3
A methodology for estimating rating/ region/ sector proxies for ACVA calculations can be found here: http://www.nomura.com/resources/europe/pdfs/cva-cross-section.pdf
Please let me know if you need anything to be clarified (caveat: I am one of the authors). The methodology assigns a CDS mark to counterparties that either have no CDS marks, or their marks are ...
3
Your reference says "This method derives implied CDS spreads
for unobservable issuers through the interpolation or extrapolation of observable CDS. It is a factor model that constructs CDS spread surface as a function of credit rating and maturity."
So this is for issuers which do not have any CDS contracts priced (there are no CDS spreads to bootstrap). I'...
3
There are quite a few methods to calculate default probabilities from CDS data. Simply you start at the shortest tenor, assume constant hazard rate. Then for the next tenor, you assume the previous hazard rate is still valid till the previous tenor, and the hazard rate between the previous tenor and new tenor is calibrated so that CDS PV matches the market ...
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