3 CreditRisk PDF

GRADUATE SCHOOL OF BUSINESS
Global Risk Management: A Quantitative Guide
Credit Risk Management

Ren-Raw Chen
Fordham University
Types of Credit Risk

Bankruptcy
Rating migration
Spread change
Bankruptcy
Equity investors
Almost nothing
Bond investors
Recovery
Secured 80~90% (due to drop in value)
Senior unsecured 40%
Junior unsecured 15%
Jump to default risk (now popular)

3
Migration
One step before bankruptcy
Rating announcements carry information
BBB or higher vs. BB or lower
buy and sell pressure
due to pension fund regulation
Large literature (details later)
Migration
Spreads
Day to day risk
market risk
hedgeable
CVA
CDS
Correlation risk
The Market
The Market
The Market
Source: http://viableopposition.blogspot.com/
The Market
Source: Federal Reserve Board
10
The Market
11
The Market
Source: FDIC
12
The Market
13
Model
For bankruptcy
accounting
Altman Z
Ohlson O
finance
reduced-form
Jarrow-Turnbull 1995, Duffie-Singleton 1997
structural
Black-Scholes-Merton, Geske 1977, Leland 1990
Hybrid
Black-Cox 1976, CreditGrades
14
Model
For migration
Markov chain
Jarrow-Lando-Turnbull
weak link to default
no link to spread
For spread
Black-Scholes
no link to default
no link to migration
15
Measures of Credit Risk

Two building blocks
PD (probability of default)
LGD (loss given default)
= 1 recovery
= exposure at default (note: exposure =
notional)
Measures
EL, UL, EAD, JTD, etc.
16
Instruments to Transfer Credit Risk
CDS
FTD/NTD
CDO
etc.
17
Credit Default Swap (CDS)
18
19

source BBA
20

source BBA
21
Seller
Principal+accrued
interest-recovery
Default
occurs
T
Spread
Buyer
22

Back-of-the-envelope formula
receive 1 - R
if default
p(1 R) = (1 p)s s
p=
1 p
s
1R
pay spread (s)

if survive
23

pi: default prob; Qi: survival prob
1 - recovery
= 0.6
1 - recovery
= 0.6
1 - recovery
= 0.6
1 - recovery
= 0.6
p1
p1
p1
1 p1
spread
Q1
p1
1 p2
spread
1 p3
spread
Q2
1 p4
spread
24

Quotes (Disney 12/23/2005)
term
1
2
3
5
7
10
sprd
9
13
20
33
47
61
25
1 - recovery rate = 0.6

if default
0.6 (1 Q1 ) 0.0009 Q1
=
1.05
1.05
Q1 = 0.9985 = e 1
p1
Q1 = 1 p1
1 = 14.99 basis points

spread = 0.009
if survive
26

1 - recovery =
0.6
p1 = 0.0015
1 - recovery =
0.6
p2
Q1 = 0.9985
spread =
0.0013
Q2
1 p2
spread =
0.0013
0.0013 0.9985 0.0013 Q2

+
1.05
1.052
=
0.0015 0.6 0.9985 (1 p2 ) 0.6
+
1.05
1.052
Q
Q2
1 p2 = 2 =
Q1
0.9985
Q2 = 0.9956 = Q1e 2
1 = 28.65 basis points
27

CDS
Term
1
2
3
4
5
Bootstrapping
Market
Risk-free Fwd.
Surv.Pr. Def.Pr.
Spread
P(t)
lambda(t) Q(t)
-dQ(t)
0.0009
0.9512
0.0015
0.9985
0.0015
0.0013
0.9048
0.0029
0.9956
0.0029
0.002
0.8607
0.0059
0.9898
0.0058
0.7788
0.0092
0.9808
0.0091
0.0033
0.7788
0.0092
0.9718
0.009
smoothing
28
29

Bilateral financial contracts
Allow the transfer of credit risk from one
party to another. Using these products,
investors may hedge themselves against
credit risk
Related to some risk or volatility
Do not require initial investment
Credit event: bankruptcy, failure to pay,
restructuring etc.
30

Two parties: protection buyer, protection
seller
Do not require either of the parties to
actually hold the reference asset
Two ways of settlement: cash and
physical
An over-the-counter contract that
provides insurance against credit risk.
31

The protection buyer pays a fixed fee or
premium, often termed as the spread
to the seller for a period of time.
When a credit event occur at some point
before the contract's maturity, the
protection seller pay compensation to
the buyer of protection, thus insulating
the buyer from a financial loss.
32

CDS can be viewed as a put option: if
one default event occurs, the bond can
be put back to the seller at the principal.
CDS is similar to an insurance contract,
providing buyers with protection against
specific risks.
33

CDS benefits
a short positioning vehicle not available in
the cash market
access to maturity exposures not available
in the cash market
does not require an initial cash outlay
access to credit risk not available in the
cash market due to a limited supply of the
underlying bonds
34

ability to effectively exit credit positions in
periods of low liquidity
off-balance sheet instruments which offer
flexibility in terms of leverage
provide important anonymity when shorting
an underlying credit
35

KMV (Black-Scholes-Merton) method
400
350
300
250
200
150
DD
100
50
PD
0
0
12
16
20
24
28
32
36
40
44
48
52
Weeks
36

Equity is a call option (Black-Scholes)
E (t ) = A(t )N (d1 ) e r (T t )KN (d2 )
Debt is a covered call

r (T t )
D(t ) = A(t ) E (t ) = A
(
t
)[1
N
(
d
)]
+
e
KN (d
2)
1

Recovery value Survival value
Consistent with reduced form
37

Multiple debts
Geske
discrete time
flexible capital structure
Leland
continuous time
steady state capital structure
38

Geske
E 0 = A0M (h1+ , h2+ ; ) e r (T2 t )K 2M (h1 , h2 ; ) e r (T1 t )K 1N (h1 )
D0,1 = A0N (y1+ ) + e r (T1 t )K1N (y1 )

D0,2 = A0 D0,1 E 0
= A0 (N (y1+ ) M (h1+ , h2+ ; )) e r (T1 t )K 1 (N (y1 ) N (h1 ))
+ e r (T2 t )K 2M (h1, h2 ; )
D0,1 + D0,2 = A0 [1 M (h1+ , h2+ ; )]

Recovery
r (T1 t )
r (T2 t )
+
e
K
N
(
h
)
+
e
K 2M (h1 , h2 ;
)
1
1

1st Yr Survival
2nd Yr Survival
39

Geske
default barrier is A <> sum of all debts:
(K1 + D12)
40
First to Default (FTD)

Joint default
A
0
0
1
80%
10%
90%
1
0
10%
10%
80%
20%
100%
p(A | B )p(B ) or
p(A B ) =
p(B | A)p(A)
p(A B ) = p(B | A)p(A)

= p(A)
= 10%
41
p(A B ) = p(B | A)p(A)

= p(A)
= 10%
p(A B ) 10%
p(B | A) =
=
= 100%
p(A)
10%
p(A | B ) =
p(A B ) 10%
=
= 50%
p(B )
20%
B completely depends on A
A only 50% depends on B
Default correlation = 0.6667 (highest possible)

42

A
p(A B ) = p(B | A)p(A)
= p(A)
0
1
70%
20%
90%
1
10%
0%
10%
80%
20%
100%
= 0%
p(A B )
0%
p(B | A) =
=
= 0%
p(A)
10%
B opposite of A
p(A B )
0%
=
= 0%
p(B )
20%
A opposite of B
p(A | B ) =
Default correlation = -0.1667 (lowest possible)

43

Default correlation reaches 1 as pA=pB
Default correlation reaches 1 as
pA+pB=1
Multi-party becomes more complex
44

In the event of perfect dependency, i.e.
p(B|A)=1, the basket valuation is:
1
[p(A) + p(B ) p(B | A)p(A)]
1+r
1
p(B )
=
1+r
V =
45

In the event of perfectly negative
dependency, i.e. p(B|A)=0, the basket
valuation becomes:
1
[p(A) + p(B ) p(B | A)p(A)]
1+r
1
=
[p(A) + p(B )]
1+r
V =
46
Collateral Debt Obligation (CDO)
47

Waterfall
Tranche
loss
Senior
tranche
Equity
tranche
Mezzanine
tranche
Total
loss
K0
K1
K2
K3
48

Types
cash CDO (real bonds)
synthetic CDO (CDS)
by action
cash-flow CDO (boxed)
market-value CDO (non-boxed)
by sponsor
arbitrage CDO (active)
balance-sheet CDO (passive)
49
CDO
http://thismatter.com/money/bonds/types/cdo.htm
50
default
Synthetic CDO
CDS
CDS
A
A
CDS
CDS
CDS
CDS
B
B
POOL
POOL
ZZ
$1,250
million
$1,250
million
51
$4 million
WDFA
$1,250
million
$6 million
LOSS
52

CDX
a CDX CDO is a CDO with 125 credit default
swaps (8% each) with US$10 million
notional
0-3%, 3-7%, 7-10%, 10-15%, and 15-30%.
very liquid (more liquid than single name
CDS)
53

Copula (how to correlate defaults)
Gaussian copula (solve the dependency
problem)
Key equations
x i = WM + 1 Wi
(x < K | W = f ) = Pr
( f + 1 W < K )
pi|f = Pr
i
i
M
i
i
(
=N(
Wi <
= Pr
Ki f
=N
f Ki
1
N 1 ( pi ) f
1
)
54

Loss distribution
Fourier inversion
Recursive algorithm
prob(rho=0.9)
0.7
0.6
0.5
0.4
0.3
0.2
0.1
36
39
42
45
48
51
54
57
60
36
39
42
45
48
51
54
57
60
33
30
27
24
21
18
15
12
0
-0.1
Loss
prob(rho=0.5)
prob(rho=0)
0.16
0.14
0.12
0.1
0.08
0.06
0.04
Loss
33
30
27
24
21
18
15
12
-0.02
60
57
54
51
48
45
42
39
36
33
30
27
24
21
18
15
12
0.02
0
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
Loss
55

Problems with such a loss distribution
thin tranches (100 tranche CDO)
CDO^2, CDO^3, ...
mezzanine tranches difficult to price
56

Tranche loss/spread plots here
57

A Cat analogy
Cats have nine lives (JPM)
58
Default Prediction
Early warning signal

Quantitative rating
KMV-Moodys
Altmans Z
Olhsons O
59
EL and UL
Basic intuition (single name)
Default => 1 R
EL = p(1 R)
UL = p(1 p)(1 R)
1 p
No default => 0
UL highest when p = 0.5

60
EL and UL
Portfolios
difficult to measure accurately
use standard deviation
61
EAD (exposure at default)

Expected recoveries from counterparties
Correlations among defaults
Similar to FTD/NTD
62
CVA
Became important after the crisis

quantifies counterparty risk
trading desk (transfer pricing)
DVA CVA to the counterparty
worsening credit (DVA falls) helps NI
correlation of credit and other products
63
CVA
An old method: exposure (call option)
Exposure
Moneyness of Deal
64
CVA
Valuation
= CDS protection value
An example (IRS)
A pays fixed 4%
B is BBB rated; CDS spread is 200 bps
A needs to hedge for Bs default
A books the trade at 6% -- true cost
IRS matches with CDS
65
CVA
A different example (bond)
A buys a Treasury bond from B ($100 face)
B CDS spread is 200 basis points
PV 5 years of 200 bps is, say 6.2% ($6.2)
cost to A is $106.2
Complexities
correlation among counter parties
correlation between assets and counter
parties
66
CVA
67
CVA
CVA - DVA
68
CVA
Wrong Way Risk (WWR)
In general, the exposure with a CP is not
independent of the CPs credit quality
Wrong Way Risk is cases where the
exposure increases when the credit quality
of the CP deteriorates i.e. exposure tend
to be high when PDs are high
69
CVA
WWR
Negative correlation between PD and LDG
(source: Altman)
70
CVA
Two types of WWR
General WWR: the CPs credit quality is for
correlated with macroeconomic factors which also
affect the value of the derivatives (e.g. correlation
between declining corporate credit quality and high
(or low) interest rates causing higher exposures
Specific WWR: CPs exposure is highly correlated
with CPs PD. (e.g. a company writing put options
on its own stock, derivatives collateralized by own
shares)
71
CVA
WWR quantification is still an open
challenge other than the self referencing
specific WWR due to:
Difficulty to separate statistical noise from
systematic correlation
Challenge of dynamic forward looking
adjustment to historical calibration
72
CVA Sensitivity and Hedging

CVA Sensitivity is straight forward by
definition:
73
CVA
Meaningful hedging and P&L explain: a
long way to go
Common hedges on the street
Counterparty credit spread delta, FX delta, IR
delta, FX vega
In progress and outstanding

IR Vega, FX/IR Gamma, Cross Gamma - WWR
Additional note
CVA hedging and P&L explain gap, Debt/Liability DVA management
Direction of CVA desks roles and performance factors real PnL, VaR capital
mitigation, counterparty risk capital mitigation
Difficulty to draw clear line between hedging to limit risk and hedging for profit
74
CVA
Practical challenges
Path dependent impact: early exercise,
Barrier, Bermudan
Recalibration noise: bucketed FX Vega/IR
Delta/IR Vega
IR Vega and cross gamma for meaningful
hedging/P&L explain.
75
Credit VaR
Skewed loss distribution
Term structure of CVaR (Basel II)
no more Gaussian, no more scalability
highly dependent on models
Difficulties to use models on banks

Case study of Lehman (CCIS 2014)
76
Lehman Case Study

Balance sheet (look at capital 1.6%)
as of 2002
Assets
Cash
Securities
Coll
Agmt
Receivables
Real Estate
Liabilities
2,265
70,881
101,149
21,191
138
Total 196,219
million $
Short-term Debt
Other Securities
Coll ST Financing
Payables
Long-Term Debt
Equity
Total
123
50,352
121,844
12,758
7,990
3,152
196,219
77
Lehman Case Study

2006 (capital 3.8%)
Cash and Short Term Investments
Accounts Receivable - Trade, Net
Receivables - Other
Total Receivables, Net
Total Inventory
Prepaid Expenses
Other Current Assets, Total
Total Current Assets
Property/Plant/Equipment, Total - Gross
Accumulated Depreciation, Total
Goodwill, Net
Intangibles, Net
Long Term Investments
Other Long Term Assets, Total
$
$
$
-
Total Assets
$
$
$
$
$
-
12,078.00 Accounts Payable

25,919.00 Accrued Expenses
Notes Payable/Short Term Debt
27,971.00 Current Port. of LT Debt/Capital Leases
Other Current liabilities, Total
Total Current Liabilities
Long Term Debt
Capital Lease Obligations
5,194.00 Total Long Term Debt
(1,925.00) Total Debt
2,417.00 Deferred Income Tax
945.00 Minority Interest
451,752.00 Other Liabilities, Total
Total Liabilities
Redeemable Preferred Stock, Total
Preferred Stock - Non Redeemable, Net
Common Stock, Total
Additional Paid-In Capital
Retained Earnings (Accumulated Deficit)
Treasury Stock - Common
Other Equity, Total
Total Equity
503,545.00 Total Liabilities & Shareholders' Equity
$ 43,912.00
$ 14,697.00
$ 16,596.00
$ 12,878.00
$ 81,178.00
$ 81,178.00
$ 110,652.00
$ 315,093.00
$ 484,354.00
$ 1,095.00
$
61.00
$ 8,727.00
$ 15,857.00
$ (4,822.00)
$ (1,727.00)
$ 19,191.00
$ 503,545.00
78
Lehman Case Study

Liability term structure
30000.00
25000.00
20000.00
15000.00
10000.00
5000.00
00
2036
.2
00
2034
08
2032
2030
08
2028
2026
2022
2020
2024
00
20
0
.2
.2
ec
D
b
Fe
pr
A
n.
.2
Ju
ug
A
2018
2016
2014
2012
2010
2008
0.00
79
Lehman Case Study

Time line of events
80
Lehman Case Study

Assets
&
Liabs
81
Lehman Case Study
82
Lehman Case Study

PD
curves
83
Lehman Case Study

PD over time
84
Lehman Case Study

Equity value
85
Lehman Case Study

Liquid
Semi
Illiquid
86
Lehman Case Study
87
Lehman Case Study
88
Lehman Case Study
89
Lehman Case Study
90
Conclusion
Next topic: Liquidity
THANK YOU
91

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GRADUATE SCHOOL OF BUSINESS

Global Risk Management: A Quantitative Guide

Credit Risk Management

Types of Credit Risk

Jump to default risk (now popular)

Large literature (details later)

Source: Federal Reserve Board

Measures of Credit Risk

Instruments to Transfer Credit Risk

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

pay spread (s)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

1 - recovery rate = 0.6

1 = 14.99 basis points

Credit Default Swap (CDS)

0.0013 0.9985 0.0013 Q2

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Credit Default Swap (CDS)

Debt is a covered call

Consistent with reduced form

Credit Default Swap (CDS)

Credit Default Swap (CDS)

D0,1 = A0N (y1+ ) + e r (T1 t )K1N (y1 )

Credit Default Swap (CDS)

First to Default (FTD)

p(A B ) = p(B | A)p(A)

First to Default (FTD)

p(A B ) = p(B | A)p(A)

Default correlation = 0.6667 (highest possible)

First to Default (FTD)

p(A B ) = p(B | A)p(A)

Default correlation = -0.1667 (lowest possible)

First to Default (FTD)

First to Default (FTD)

First to Default (FTD)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Collateral Debt Obligation (CDO)

Early warning signal

UL highest when p = 0.5

EAD (exposure at default)