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GRADUATE SCHOOL OF BUSINESS Global Risk Management: A Quantitative Guide Credit Risk Management Ren-Raw Chen

GRADUATE SCHOOL OF BUSINESS Global Risk Management: A Quantitative Guide

Credit Risk Management

Ren-Raw Chen Fordham University

SCHOOL OF BUSINESS Global Risk Management: A Quantitative Guide Credit Risk Management Ren-Raw Chen Fordham University
Types of Credit Risk
Types
of
Credit
Risk

Bankruptcy

Rating migration

Spread change

Types of Credit Risk • Bankruptcy • Rating migration • Spread change 2

2

Bankruptcy
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)

to drop in value) – Senior unsecured – 40% – Junior unsecured – 15% • Jump

3

Migration
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)

vs. BB or lower – buy and sell pressure – due to pension fund regulation •

4

Migration
Migration
Migration 5
Migration 5

5

Spreads
Spreads

Day to day risk

market risk

hedgeable

CVA

CDS

Correlation risk

Spreads • Day to day risk – market risk – hedgeable • CVA – CDS –

6

The Market
The
Market
The Market 7

7

The Market
The
Market
The Market 8

8

The Market
The
Market
The Market Source: http://viableopposition.blogspot.com/ 9

Source: http://viableopposition.blogspot.com/

The Market Source: http://viableopposition.blogspot.com/ 9

9

The Market
The
Market
Source: Federal Reserve Board
Source: Federal Reserve Board

10

The Market
The
Market
The Market 11
The Market 11

11

The Market
The
Market
The Market Source: FDIC 12
The Market Source: FDIC 12

Source: FDIC

12

The Market
The
Market
The Market 13
The Market 13

13

Model
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

1997 • structural – Black-Scholes-Merton, Geske 1977, Leland 1990 • Hybrid – Black-Cox 1976, CreditGrades 14

14

Model
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

to default • no link to spread • For spread – Black-Scholes • no link to

15

Measures of Credit Risk
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.

• = 1 – recovery • = exposure at default (note: exposure = notional) • Measures

16

Instruments to Transfer Credit Risk
Instruments
to
Transfer
Credit Risk

CDS

FTD/NTD

CDO

etc.

Instruments to Transfer Credit Risk • CDS • FTD/NTD • CDO • etc. 17

17

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)
Credit Default Swap (CDS) 18
Credit Default Swap (CDS) 18

18

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)
Credit Default Swap (CDS) 19
Credit Default Swap (CDS) 19

19

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

source BBA

Credit Default Swap (CDS) • source BBA 20
Credit Default Swap (CDS) • source BBA 20

20

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

source BBA

Credit Default Swap (CDS) • source BBA 21
Credit Default Swap (CDS) • source BBA 21

21

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)
Principal+accrued Default Seller interest-recovery occurs 0 T Spread Buyer
Principal+accrued
Default
Seller
interest-recovery
occurs
0
T
Spread
Buyer
Credit Default Swap (CDS) Principal+accrued Default Seller interest-recovery occurs 0 T Spread Buyer 22

22

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

Back-of-the-envelope formula

receive 1 - R if defaultDefault Swap (CDS) • Back-of-the-envelope formula p 1 − p pay spread (s) if survive p

p

1p

p 1 − p

pay spread (s) if surviveformula receive 1 - R if default p 1 − p p (1 ) − R

receive 1 - R if default p 1 − p pay spread (s) if survive p

p

(1

)

R =

p =

s

1 R

(1

)

ps s

23

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

p i : default prob; Q i : survival prob

1 - recovery = 0.6

1 - recovery = 0.6

1 - recovery = 0.6

p 1 p 1 Q 2
p
1
p
1
Q
2

1 - recovery = 0.6

- recovery = 0 . 6 p 1 p 1 Q 2 1 - recovery =
- recovery = 0 . 6 p 1 p 1 Q 2 1 - recovery =
1−p 1 1−p p 1 2 spread 1−p 3 Q spread 1 1−p 4 spread
1−p
1
1−p
p
1
2
spread
1−p
3
Q
spread
1
1−p
4
spread
6 p 1 p 1 Q 2 1 - recovery = 0.6 1−p 1 1−p p

spread

6 p 1 p 1 Q 2 1 - recovery = 0.6 1−p 1 1−p p

24

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

Quotes (Disney 12/23/2005)

term

sprd

1

9

2

13

3

20

5

33

7

47

10

61

• Quotes (Disney 12/23/2005) term sprd 1 9 2 13 3 20 5 33 7 47

25

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

1 - recovery rate = 0.6 if defaultCredit Default Swap (CDS) p 1 Q 1 = 1 − p 1 spread = 0.009

p

p 1

1

p 1

Q

1

= 1p

1

spread = 0.009 if survive1 - recovery rate = 0.6 if default p 1 Q 1 = 1 − p

default p 1 Q 1 = 1 − p 1 spread = 0.009 if survive 0.6

0.6 ×

(

1

Q

1

)

1.05

=

0.0009 × Q

1

1.05

Q

λ

1

1

=

0.9985

=

e

λ

1

= 14.99 basis points

26

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

1 - recovery =

0.6 p = 0.0015 1 p 2 Q = 0.9985 1 spread = 1−p 2
0.6
p
= 0.0015
1
p
2
Q
= 0.9985
1
spread =
1−p
2
0.0013
spread =
0.0013
Q
2
1 spread = 1−p 2 0.0013 spread = 0.0013 Q 2 1 - recovery = 0.6

1 - recovery =

0.6

0.0013

×

0.9985

1.05

+

0.0013 × Q

2

1.05

2

=

0.0015

×

0.6

0.9985

×

1

Q

2

1.05

=

p

2

Q

2

Q

1

= 0.9956

+

=

=

(1

)

p ×

2

0.6

Q

2

0.9985

Qe

1

λ

2

1.05

2

λ 1 = 28.65 basis points

27

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

smoothing

28

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)
Credit Default Swap (CDS) 29
Credit Default Swap (CDS) 29

29

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

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.

or volatility • Do not require initial investment • Credit event: bankruptcy, failure to pay, restructuring

30

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

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.

ways of settlement: cash and physical • An over-the-counter contract that provides insurance against credit risk.

31

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

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.

the protection seller pay compensation to the buyer of protection, thus insulating the buyer from a

32

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

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.

the principal. • CDS is similar to an insurance contract, providing buyers with protection against specific

33

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

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

cash outlay – access to credit risk not available in the cash market due to a

34

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

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

which offer flexibility in terms of leverage – provide important anonymity when shorting an underlying credit

35

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

KMV (Black-Scholes-Merton) method

400 350 300 250 200 150 DD 100 50 PD 0 0 4 8 12
400
350
300
250
200
150
DD
100
50
PD
0
0
4
8
12
16
20
24
28
32
36
40
44
48
52
Weeks
method 400 350 300 250 200 150 DD 100 50 PD 0 0 4 8 12

36

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

Equity is a call option (Black-Scholes)

( )

E t

=

A t N d

1

( )

(

)

e

(

rT t

)

(

KN d

2

)

Debt is a covered call

( )

D t

=

( )

A t

( )

E t

=

)

A t

( )[1

(

N d

1

)]

e

(

rT t

)

(

KN d

2

+

Recovery value

Survival value

Consistent with reduced form

A t ( )[1 ( N d 1 )] e − ( rT t − )

37

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

Multiple debts

Geske

discrete time

flexible capital structure

Leland

continuous time

steady state capital structure

• discrete time • flexible capital structure – Leland • continuous time • steady state capital

38

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

Geske

E

0

D

0,1

=

AMh h ρ e

0

1

+

,

2

+

;

(

)

(

rT t

2

)

KMh h ρ e

2

1

,

2

;

(

)

=

(

AN y

0

1

+

)

+

e

(

rT t

1

)

(

KNy

1

1

)

(

rT t

1

)

(

KNh

1

D

0,2

D

0,1

= A

=

D

0,1

0

(

(

1

+

)

E

0

0

ANy

+ e

(

rT t

2

(

Mh h

1

+

,

2

+

;

ρ

)

)

KMh ( , h ; ρ

2

1

2

))

e

(

rT t

1

)

K Ny

1

(

(

1

)

+

D

0,2

=

)]

,

Recovery

A

0

[1

Mh h ρ

1

+

2

+

;

(

)

,

+

e

rT ( t

1

)

KNh

1

1

(

)

e

rT ( t

2

)

+

KMh h ρ

2

1

2

;

(

1st Yr Survival

2nd Yr Survival

(

Nh

1

1 1 − ( ) e − rT ( − t 2 ) + KMh h

1

))

)

39

Credit Default Swap (CDS)
Credit
Default
Swap
(CDS)

Geske

default barrier is A <> sum of all debts:

(K 1 + D 12 )

Credit Default Swap (CDS) • Geske – default barrier is A <> sum of all debts:
Credit Default Swap (CDS) • Geske – default barrier is A <> sum of all debts:

40

First to Default (FTD)
First
to
Default
(FTD)

Joint default

First to Default (FTD) • Joint default A B 0 1 0 80% 0 80% 1
First to Default (FTD) • Joint default A B 0 1 0 80% 0 80% 1
A B 0 1 0 80% 0 80% 1 10% 10% 20% 90% 10% 100%
A
B
0
1
0
80%
0
80%
1
10%
10%
20%
90%
10%
100%

(

pA B

)

(

pA B

)

pA BpB

pB ApA



(

(

|

|

)

)

(

(

=  

)

)

=

pB ApA

(

|

)

(

)

=

(

pA

)

=

10%

or

41

First to Default (FTD)
First
to
Default
(FTD)

(

pA B

)

=

=

pB ApA

pA

)

(

(

|

)

(

)

 

=

10%

pB A =

(

|

)

pA B =

(

|

)

pA B )

(

(

pA

)

pA B )

(

(

pB

)

=

=

10%

10%

10%

20%

=

=

100%

50%

B completely depends on A

A only 50% depends on B

Default correlation = 0.6667 (highest possible)

10% 20% = = 100% 50% B completely depends on A A only 50% depends on

42

First to Default (FTD)
First
to
Default
(FTD)

(

pA B

)

=

=

pB ApA

pA

)

(

(

|

)

(

)

 

=

0%

pB A =

(

|

)

pA B =

(

|

)

pA B )

(

(

pA

)

pA B )

(

(

pB

)

=

=

0%

10%

0%

=

=

20%

A B 0 1 0 70% 10% 80% 1 20% 0% 20% 90% 10% 100%
A
B
0
1
0
70%
10%
80%
1
20%
0%
20%
90%
10%
100%

0%

0%

B opposite of A

A opposite of B

Default correlation = -0.1667 (lowest possible)

1 20% 0% 20% 90% 10% 100% 0% 0% B opposite of A A opposite of

43

First to Default (FTD)
First
to
Default
(FTD)

Default correlation reaches 1 as pA=pB

Default correlation reaches –1 as

pA+pB=1

Multi-party becomes more complex

reaches 1 as p A =p B • Default correlation reaches –1 as p A +p

44

First to Default (FTD)
First
to
Default
(FTD)

In the event of perfect dependency, i.e. p(B|A)=1, the basket valuation is:

V

=

=

1

+ r

1

+ r

1

[

pA pB pB ApA

(

(

)

)

+

(

)

(

|

)

(

1 pB

the basket valuation is: V = = 1 + r 1 + r 1 [ pA

)]

45

First to Default (FTD)
First
to
Default
(FTD)

In the event of perfectly negative dependency, i.e. p(B|A)=0, the basket valuation becomes:

V

=

=

1

+ r

1

+ r

1

1

[

[

pA pB pB ApA

(

)

+

(

)

(

|

)

(

pA pB

+

(

)

(

)]

valuation becomes: V = = 1 + r 1 + r 1 1 [ [ pA

)]

46

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)
Collateral Debt Obligation (CDO) 47
Collateral Debt Obligation (CDO) 47

47

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

Waterfall

Tranche loss Senior tranche Equity tranche Mezzanine tranche Total loss K K K K 0
Tranche
loss
Senior
tranche
Equity
tranche
Mezzanine
tranche
Total
loss
K
K
K
K
0
1
2
3
• Waterfall Tranche loss Senior tranche Equity tranche Mezzanine tranche Total loss K K K K

48

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

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)

(boxed) – market-value CDO (non-boxed) • by sponsor – arbitrage CDO (active) – balance-sheet CDO (passive)

49

CDO
CDO
CDO – http://thismatter.com/money/bonds/types/cdo.htm 50

http://thismatter.com/money/bonds/types/cdo.htm

CDO – http://thismatter.com/money/bonds/types/cdo.htm 50

50

default

default Synthetic CDO CDS CDS A CDS CDS B CDS CDS POOL POOL Z $1,250 $1,250

Synthetic CDO

default Synthetic CDO CDS CDS A CDS CDS B CDS CDS POOL POOL Z $1,250 $1,250
CDS CDS A CDS CDS B CDS CDS POOL POOL Z $1,250 $1,250 million million
CDS CDS
A
CDS CDS
B
CDS CDS
POOL POOL
Z
$1,250
$1,250
million
million

51

$1,250 million $4 million $6 million WDFA LOSS 52
$1,250 million $4 million $6 million WDFA LOSS 52
$1,250 million $4 million $6 million WDFA LOSS 52

$1,250

million

$1,250 million $4 million $6 million WDFA LOSS 52
$1,250 million $4 million $6 million WDFA LOSS 52

$4 million

$6 million

WDFA

LOSS

52

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

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)

US$10 million notional – 0-3%, 3-7%, 7-10%, 10-15%, and 15-30%. – very liquid (more liquid than

53

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

Copula (how to correlate defaults)

Gaussian copula (solve the dependency problem) Key equations

ˆ ˆ x = ρW + −ρW 1 i M i p ˆ = Pr
ˆ
ˆ
x = ρW + −ρW
1
i
M
i
p ˆ
= Pr
(
x
<
K | W
if |
i
i
M
(
ρ f − K
i
= Pr W <
)
i
1 − ρ
= )
(
K
ρ f
i
N
1 − ρ
1
(
N
(ˆ p ) −
ρ f
= N
i
)
1 − ρ
− ρ − 1 ( N (ˆ p ) − ρ f = N i )
= f ) = Pr ( ρ f +
=
f
)
=
Pr
(
ρ
f
+
1 − ρ W K < ) i i
1
ρ
W K
<
)
i
i

54

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

Loss distribution

Fourier inversion Recursive algorithm

prob(rho=0.5) 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 Loss 0 3 6
prob(rho=0.5)
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
Loss
0
3
6
9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
prob(rho=0.9) 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1 Loss 0 3 6 9
prob(rho=0.9)
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
-0.1
Loss
0
3
6
9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
prob(rho=0) 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -0.02 Loss 0 3 6
prob(rho=0)
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
-0.02
Loss
0
3
6
9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -0.02 Loss 0 3 6 9 12 15

55

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

Problems with such a loss distribution

thin tranches (100 tranche CDO)

CDO^2, CDO^3,

mezzanine tranches difficult to price

a loss distribution – thin tranches (100 tranche CDO) – CDO^2, CDO^3, – mezzanine tranches difficult

56

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

Tranche loss/spread plots here

Collateral Debt Obligation (CDO) • Tranche loss/spread plots here 57
Collateral Debt Obligation (CDO) • Tranche loss/spread plots here 57

57

Collateral Debt Obligation (CDO)
Collateral
Debt
Obligation
(CDO)

A Cat analogy

Cats have nine lives (JPM)

Collateral Debt Obligation (CDO) • A Cat analogy – Cats have nine lives (JPM) 58
Collateral Debt Obligation (CDO) • A Cat analogy – Cats have nine lives (JPM) 58

58

Default Prediction
Default
Prediction

Early warning signal

Quantitative rating

KMV-Moodys Altman’s Z

Olhson’s O

Prediction • Early warning signal • Quantitative rating • KMV-Moodys • Altman’s Z • Olhson’s O

59

EL and UL
EL
and
UL

Basic intuition (single name)

Default => 1 − R 1 R

p

1p

No default => 0 0

EL = p(1 R)

UL =

1 − R p 1 − p No default => 0 EL = p (1 −

p(1 p)(1 R)

UL highest when p = 0.5

1 − R p 1 − p No default => 0 EL = p (1 −

60

EL and UL
EL
and
UL

Portfolios

difficult to measure accurately

use standard deviation

EL and UL • Portfolios – difficult to measure accurately – use standard deviation 61
EL and UL • Portfolios – difficult to measure accurately – use standard deviation 61

61

EAD (exposure at default)
EAD
(exposure
at
default)

Expected recoveries from counterparties

Correlations among defaults

Similar to FTD/NTD

at default) • Expected recoveries from counterparties • Correlations among defaults • Similar to FTD/NTD 62

62

CVA
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

– CVA to the counterparty – worsening credit (DVA falls) helps NI – correlation of credit

63

CVA
CVA

An old method: exposure (call option)

Exposure Moneyness of Deal
Exposure
Moneyness of Deal
CVA • An old method: exposure (call option) Exposure Moneyness of Deal 64

64

CVA
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 B’s default

A books the trade at 6% -- true cost

IRS matches with CDS

is 200 bps • A needs to hedge for B’s default • A books the trade

65

CVA
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

is $106.2 • Complexities – correlation among counter parties – correlation between assets and counter parties

66

CVA
CVA
CVA 67
CVA 67

67

CVA
CVA

CVA - DVA

CVA • CVA - DVA 68
CVA • CVA - DVA 68

68

CVA
CVA

Wrong Way Risk (WWR)

In general, the exposure with a CP is not independent of the CP’s 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

exposure increases when the credit quality of the CP deteriorates – i.e. exposure tend to be

69

CVA
CVA

WWR

Negative correlation between PD and LDG (source: Altman)

CVA • WWR – Negative correlation between PD and LDG (source: Altman) 70
CVA • WWR – Negative correlation between PD and LDG (source: Altman) 70

70

CVA
CVA

Two types of WWR

General WWR: the CP’s 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: CP’s exposure is highly correlated with CP’s PD. (e.g. a company writing put options on its own stock, derivatives collateralized by own shares)

with CP’s PD. (e.g. a company writing put options on its own stock, derivatives collateralized by

71

CVA
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

noise from systematic correlation – Challenge of dynamic forward looking adjustment to historical calibration 72

72

CVA Sensitivity and Hedging
CVA
Sensitivity
and
Hedging

CVA Sensitivity is straight forward by definition:

CVA Sensitivity and Hedging • CVA Sensitivity is straight forward by definition: 73
CVA Sensitivity and Hedging • CVA Sensitivity is straight forward by definition: 73

73

CVA
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 desk’s 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

risk capital mitigation • Difficulty to draw clear line between hedging to limit risk and hedging

74

CVA
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.

noise: bucketed FX Vega/IR Delta/IR Vega – IR Vega and cross gamma for meaningful hedging/P&L explain.

75

Credit VaR
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)

– highly dependent on models • Difficulties to use models on banks – Case study of

76

Lehman Case Study
Lehman
Case
Study

Balance sheet (look at capital 1.6%)

as of 2002

Assets

Liabilities

Cash

2,265

Short-term Debt

123

Securities

70,881

Other Securities

50,352

Coll

Agmt 101,149

Coll ST Financing

121,844

Receivables

21,191

Payables

12,758

Real Estate

138

Long-Term Debt

7,990

 

Equity

3,152

Total 196,219 million $

Total

196,219

Estate 138 Long-Term Debt 7,990   Equity 3,152 Total 196,219 million $ Total 196,219 77

77

Lehman Case Study
Lehman
Case
Study

2006 (capital 3.8%)

Cash and Short Term Investments $ 12,078.00 Accounts Payable $ 43,912.00 Accounts Receivable - Trade,
Cash and Short Term Investments
$
12,078.00
Accounts Payable
$ 43,912.00
Accounts Receivable - Trade, Net
$
25,919.00
Accrued Expenses
$ 14,697.00
Receivables - Other
-
Notes Payable/Short Term Debt
$ 16,596.00
Total Receivables, Net
$
27,971.00
Current Port. of LT Debt/Capital Leases
$ 12,878.00
Total Inventory
-
Other Current liabilities, Total
-
Prepaid Expenses
-
Total Current Liabilities
-
Other Current Assets, Total
-
Long Term Debt
$
81,178.00
Total Current Assets
Capital Lease Obligations
-
Property/Plant/Equipment, Total - Gross
$
5,194.00
Total Long Term Debt
$
81,178.00
Accumulated Depreciation, Total
$
(1,925.00)
Total Debt
$110,652.00
Goodwill, Net
$
2,417.00
Deferred Income Tax
-
Intangibles, Net
$
945.00
Minority Interest
-
Long Term Investments
$
451,752.00
Other Liabilities, Total
$315,093.00
Other Long Term Assets, Total
-
Total Liabilities
$484,354.00
Redeemable Preferred Stock, Total
-
Preferred Stock - Non Redeemable, Net
$
1,095.00
Common Stock, Total
$
61.00
Additional Paid-In Capital
$
8,727.00
Retained Earnings (Accumulated Deficit)
$
15,857.00
Treasury Stock - Common
$
(4,822.00)
Other Equity, Total
$
(1,727.00)
Total Equity
$
19,191.00
Total Assets
$
503,545.00
Total Liabilities & Shareholders' Equity
$ 503,545.00
78
Lehman Case Study
Lehman
Case
Study

Liability term structure

Aug.2008 Jun.2008 Apr.2008 Feb.2008 Dec.2007 30000.00 25000.00 20000.00 15000.00 10000.00 5000.00 0.00 2008
Aug.2008
Jun.2008
Apr.2008
Feb.2008
Dec.2007
30000.00
25000.00
20000.00
15000.00
10000.00
5000.00
0.00
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
2028
2030
2032
2034
2036

79

Lehman Case Study
Lehman
Case
Study

Time line of events

80
80
Lehman Case Study
Lehman
Case
Study

Assets

&

Liabs

Lehman Case Study • Assets & Liabs 81
Lehman Case Study • Assets & Liabs 81

81

Lehman Case Study
Lehman
Case
Study
Lehman Case Study 82
Lehman Case Study 82
Lehman Case Study 82

82

Lehman Case Study
Lehman
Case
Study

PD curves

Lehman Case Study • PD curves 83
Lehman Case Study • PD curves 83

83

Lehman Case Study
Lehman
Case
Study

PD over time

Lehman Case Study • PD over time 84
Lehman Case Study • PD over time 84

84

Lehman Case Study
Lehman
Case
Study

Equity value

Lehman Case Study • Equity value 85
Lehman Case Study • Equity value 85

85

Lehman Case Study
Lehman
Case
Study

Liquid

Semi

Illiquid

Lehman Case Study • Liquid • Semi • Illiquid 86
Lehman Case Study • Liquid • Semi • Illiquid 86

86

Lehman Case Study
Lehman
Case
Study
Lehman Case Study 87
Lehman Case Study 87

87

Lehman Case Study
Lehman
Case
Study
Lehman Case Study 88
Lehman Case Study 88

88

Lehman Case Study
Lehman
Case
Study
Lehman Case Study 89
Lehman Case Study 89

89

Lehman Case Study
Lehman
Case
Study
Lehman Case Study 90
Lehman Case Study 90

90

Conclusion
Conclusion

Next topic: Liquidity

THANK YOU

Conclusion • Next topic: Liquidity THANK YOU 91

91