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Bankruptcy
Equity investors
Almost nothing
Bond investors
Recovery
Secured 80~90% (due to drop in value)
Senior unsecured 40%
Junior unsecured 15%
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
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
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
EL, UL, EAD, JTD, etc.
16
CDS
FTD/NTD
CDO
etc.
17
18
19
20
21
Seller
Principal+accrued
interest-recovery
Default
occurs
T
Spread
Buyer
22
p(1 R) = (1 p)s s
p=
1 p
s
1R
23
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
sprd
9
13
20
33
47
61
25
0.6 (1 Q1 ) 0.0009 Q1
=
1.05
1.05
Q1 = 0.9985 = e 1
p1
Q1 = 1 p1
26
1 - recovery =
0.6
p2
Q1 = 0.9985
spread =
0.0013
Q2
1 p2
spread =
0.0013
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
33
35
DD
100
50
PD
0
0
12
16
20
24
28
32
36
40
44
48
52
Weeks
36
N
(
d
)]
+
e
KN (d
2)
1
Recovery value Survival value
37
Leland
continuous time
steady state capital structure
38
1st Yr Survival
2nd Yr Survival
39
40
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(A B ) 10%
=
= 50%
p(B )
20%
B completely depends on A
A only 50% depends on B
= 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 ) =
44
V =
45
V =
46
47
Equity
tranche
Mezzanine
tranche
Total
loss
K0
K1
K2
K3
48
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
53
(
=N(
Wi <
= Pr
Ki f
=N
f Ki
1
N 1 ( pi ) f
1
)
54
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
56
57
58
Default Prediction
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
EL and UL
Portfolios
difficult to measure accurately
use standard deviation
61
62
CVA
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
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
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
76
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
$
$
$
-
Total Assets
$
$
$
$
$
-
$ 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
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
80
81
82
83
84
85
86
87
88
89
90
Conclusion
Next topic: Liquidity
THANK YOU
91