PDF Credit Risk : From Transaction to Portfolio Management - Ahmad Subagyo

Formed in 1992 with the support of the Bank of England, the London Stock Exchange, the Financial Services Authority, LIFFE and other leading financial organisations, the Securities Institute is the professional body for practitioners working in securities, investment management, finance and corporations, derivatives and related businesses. The convergence of the credit business and traditional fixed income credit, due in part to sound quantitative modeling, has made this a worthwhile exercise.

The credit product Introduction

Consequently, the yield for this maturity became dominated by liquidity considerations and not particularly representative of the risk-free interest rate. All non-government bonds, and indeed many government issues, are exposed to a source of risk that is the subject of the book, which is credit risk, distinct from the market risk to which they will also be exposed.

Figure 1.1 shows the components of the global debt markets. We can see that one of the main categories is the government issue

Government bonds and credit

An understanding of the return components inherent in a corporate bond will hopefully make this statement transparent. Clearly, this is not a statement about the creditworthiness of companies within the economy, but rather about the issue of the supply-demand imbalance in the government bond market.

Figure 1.3 The components of return on government and corporate issues.

Benchmarks for credit

The reason for this is that it represents a general indicator of the health of the credit market. Much of the credit industry thinks of the TED spread simply as the difference between the yield on the swap market and government bonds of comparable maturity.

Corporate bonds

It simply means that the trade value of the issue is the same as the notional value. In Figure 1.10 we show the effect of the seniority on the price of the bond.

Figure 1.7 Corporate debt by currency (May 2003). Source: Deutsche Bank.

Floating-rate notes

Simply because the payment is not contracted and will depend on the circumstances of the issuer. Beyond the reset dates there will be a rate risk equal to the duration of the next coupon date.

Figure 1.13 FRN volume by currency. Source: Deustche Bank.

Credit related instruments

One of the key factors that determine the issue price is the cap value. This is also a comparable advantage of holding a bond instead of the underlying stock.

Figure 1.15 The reverse FRN from the investor’s perspective.

Asset-backed securities

In the landscape of asset-backed securities, lending is effectively promoted by the issuing entity through the sale of the asset-backed structure to the capital markets. It is the task of the rating agencies to subsequently assess the creditworthiness of both the collective pool of receivables and the resulting structure.

Table 1.3 The balance sheet pre- and post-securitization.

International bonds

Any smaller movements will be addressed by a change in the price of the bond relative to par at issue.). The price of the bond will be supported by the general manager in harmony with the other syndicate members.

Table 1.4 A typical Eurobond deal.

Commercial paper

This is generally considered to be one of the most important factors responsible for the enormous growth of the Eurobond market. This is used by borrowers with a high credit rating and is quite similar to a money market product.

High-yield bonds

The European high yield market continues to try to overtake the US in terms of issuance and notional amounts outstanding. One of the main reasons behind the initial growth of the European market is the arrival of the euro.

Figure 1.25 Global high-yield volumes. Source: Deutsche Bank (May 2003).

Credit risk

On the one hand, we can discount the non-defaulted cash flows of the borrower at a rate that. We refer you to a good text. We are going to use the data provided in Table 1.9.

Figure 1.27 An illustration of the default process for a 10 year corporate bond.

Risk management of fixed income portfolios

The strength of the equation is that it allows the risk manager to isolate changes in the market from the nature of the instrument. The calculation of the variation in the present value due to a changing spread does not differ from the standard duration calculation, but with the spread replacing the return.

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Thus, the change in the value of the option is related to the change in the price of the underlying instrument with the option delta and gamma. This brings us to the bond's sensitivity to changes in issuer quality.

Figure 1.33 Dependence on the underlying.

Credit Metrics™

Credit Metrics™ was founded in response to the unique challenges posed by the nature of credit within a portfolio context. The philosophy can be seen as a portfolio approach, as opposed to traditional 'bottom-up' credit analysis, and as such the core of credit metrics is the assessment of changes in the value of a portfolio, which consists of potentially very diverse asset classes. , due to changes in the credit quality of the issuers.

Figure 1.37 The credit metrics route map. Source: Credit Metrics™.

Credit indices The choice of index

One of the most important quantitative applications of credit indices is to serve as a benchmark for portfolio optimization. The benchmark should therefore be used as the basis of the selection criteria for the optimizer.

Figure 1.39 Two dimensions of the credit index for the Euro denominated market.

Optimizers

As a result of investing in the hypothetical bond with a coupon equal to the corresponding term of the swap. However, this should be somewhat offset by the other main input which is the return on the bond.

Figure 1.42 The components of the roll-down return.

KMV model

The arrow in the figure has a length equal to the product of the asset level, the asset's volatility and the distance to default. We can find an expression for the asset value and the distance to default that satisfies both of these conditions; we also require total assets to be composed of equity plus average recovered debt.

Figure 1.44 Structural model schematic chart. Source: Credit Grades.

Rating agencies

AAA AAA The capacity of the obligor to fulfill its financial commitment on the obligation is extremely strong. Adverse circumstances are more likely to lead to a weakening of the debtor's capacity to meet his financial commitment on the obligation.

Table 1.25 The comparative long-term investment grade ratings.

What is loan portfolio management?

However, something of a revolution is gradually transforming this environment, challenging many of the hitherto standard market practices. Perhaps the most notable development, however, is the growth of the market for credit derivatives as a viable medium for transferring the risk associated with the loan.

The loan market Syndicated market

Apart from the syndicated market, there are many reasons for the dominance of the traditional loan. The long-term development of the high-yield bond market in Europe is likely to contribute to the erosion of the loan market as a funding area.

Figure 2.1 shows a comparison between issuance, you can see that loans are preferential to bonds as a source of finance

Definitions

More than a decade ago, the US loan market was based on relationships, while it is still an important driver of the market structure, a number of developments have occurred that have caused some convergence between the loan and bond markets. Start at A and usually end at D. The normal arrangement is for the B–D loans to be sold to institutional clients while the shorter date is.

Relative value analysis

The activity will also include leveraged funds, which execute 'arbitrage'. strategies between credit and bond markets. You can see that many of the terms in the credit market have been carried over from the bond markets without actually being applicable.).

Term sheet of a loan

This is especially important when issuing a loan because its price will be quite close to the value at which the bond is trading on the secondary market, although of course there are usually exceptions. You should note that loans are always priced at face value and that the spread at origination is set so that the market value of the trade is equal to the hypothetical amount of the loan.

The syndication process

We calculate the all-in return, which reflects the total costs from the borrower's perspective. This is divided by the average term of the loan, creating a spread of 14.91 basis points.

Table 2.1 The term sheet of a syndicated loan.

Pricing within a commercial bank

For example, the precipium will be deducted from the total fee and the remainder will be divided by the notional credit to determine the relevant yield for the arranger and lead managers. FTP can be considered as the adjustment of the trading margin in order to equalize the accounting margin.

Figure 2.4 The FTP mechanism.

Loan ratings

The subsequent step involves the prioritization of the loan payment within the capital structure. Surprisingly, the extent of the covenant will typically not have a large impact on the loan assessment.

Table 2.5 Loan ratings (investment grade).

Risk management

In addition, a portion of the loan will likely have been repaid, resulting in better asset-loan value coverage. Figure 2.5 shows that the different activities of the bank entail very different risks.

Figure 2.5 Origin of risks banking and market portfolios.

Approaches to management Goals of portfolio management

Consequently, the job of the loan portfolio manager can be translated into one of concentration management. It is effectively a graph of the probability of the portfolio defaulting, which is very sensitive to the amount of 'concentration' or correlation within the portfolio.

Figure 2.7 shows the amount of economic capital required within a loan portfolio to maintain a category of rating

Economic vs. regulatory capital

As we pass the average loss we move into 'unexpected territory', the implications for management are that losses in this region must be met by capital. The actual real world is described by the distribution along with the human decision about the location of the vertical lines.

Figure 2.9 Target prices of credit risk.

Loan case studies

We need to complete the analysis by valuing the loan for each of the states. We then repeat the analysis for the AA and then collect the revaluation in each of the states in Table 2.14.

Figure 2.11 The possible states for a two loan portfolio.

Concentration management

Economic capital is proportional to the average rating of collateral in the entire portfolio. The product of the exposure required to make the same contribution to risk and the sensitivity of the spread is a good benchmark;

Hedging techniques Securitization

This will be achieved when most of the incoming loan proceeds are distributed as fully as possible. In Section 4.11 we go into the 'profile' and consider the assets that make up the offering in light of the investor base.

Figure 2.18 shows the resulting securities. If you look at the profile, you will observe that the asset redemption and interest schedule match the pay-off profile of the underlying loans

Central themes Expected loss

This means that the worst case is not just the sum of the individual worst cases. The probability of bankruptcy is determined by the probability that the company's assets will be covered by its debts. The likelihood of this can be inferred from the volatility of the share price.

Table 2.15 Potential lending opportunities.

Introduction

Credit derivatives now provide the ability to manage credit exposure separately from the other characteristics of the bond. An important aspect of this process is a resulting efficiency gain due to the process of market completion due to the separation of credit risk from other risks.

Figure 3.1 Credit derivative volumes 1997–2002. Source: Credit Trade.

Why use credit derivatives?

The protection buyer is a seller of credit exposure and the protection seller is a buyer of credit risk. A bilateral financial contract in which the buyer pays a premium in exchange for a payment contingent upon the occurrence of a credit event.

Definition of a credit event

The attractiveness of this arrangement will depend on the cost of the balance sheet, which depends on the way the institution is financed. So if we consider a corporate bond where the owner needs protection, then it would be the seller of the credit exposure as it would be immune to any deterioration of the issuer because it is a long basis.

Credit default swap

The premium payable is a function of the perceived creditworthiness of the reference and as such can be hedged prior to maturity. The final payment will be the difference between par and the recoverable amount of the asset.

Table 3.2 shows some typical features associated with a default swap contract, the terms will be available in the so-called ‘term sheet’ which sets out the details of the trade to provide transparency.

Total return swap

In the event of non-payment before the TROR due date, the contract shall cease to be valid and the recipient shall pay compensation to the payer. In addition, there is no pre-agreed price for the reference asset at maturity.

Table 3.3 shows the typical features associated with a TROR, this is the so-called ‘term sheet’ which lays out the details of the trade for reasons of transparency.

Securitization overview

An important development in the market has been the beginning of CDO classification for investments. Collateral screening is one of the critical ingredients to the success of a managed CDO.

Figure 3.7 shows a typical breakdown by asset category.

Dynamic credit swaps

However, taking the present value of the swap is not sufficient to assess the counterparty risk because we must also consider the potential value of the swap in the future. It is possible to take out a dynamic credit swap, where the nominal protection is linked to the market value of the reference swap.

Figure 3.12 The currency swap.

Credit options

This is shown in the diagram above where losses are insured at 60 million. Credit options are very attractive to institutional investors as a source of yield enhancement, creating exposure to credit where the bond is not available - the investor is short of credit collecting income in exchange for the risk of losing the asset in the future (in the event of a call).

Figure 3.14 The cash flows of an asset swap.

Credit linked note

Other users of credit options are banks and traders seeking to hedge their marked-to-market exposure to changes in credit spreads.

First to default

The return the investor receives on the first-to-default spread will be somewhere between the spread of the worst individual credit and the sum of the spreads of all. The first-to-default spread is the same as the worst case where the correlation equals 100 percent.

Figure 3.18 The yields on three companies (% vs. Time).

The default swap basis

But is concerned about the credit in the short term, and therefore takes out protection on the mortgage. The effectiveness of the hedge therefore depends on the underlying interest rate environment, together with the perceived credit risk of the issuer providing the bond.

Figure 3.20 The risk free basis trade. Source: Lehman.

Pricing

Consider the case of a bank that buys credit insurance from another bank for the underlying loan. In fact, the bank is no longer exposed only to this original transaction, but also to the counterparty of the derivative financial instrument.

Table 3.9 Jointly supported ratings 1997.

Source of pricing

Before reviewing the literature, the reader should be aware that there are two common definitions of default used; the first is the ratio of names that are standard divided by the remainder. You will come across the terms marginal defaults and cumulative; the marginal default is simply the default relevant to any 1-year and the cumulative is the sum of the marginals.

Table 3.10 Marginal default rates.

Pricing examples

An approximation made is that the 3-month rate equals the 6-month rate, and at all intermediate sampling points. In Figure 3.23 we have illustrated the steps required to determine the 6-month hazard rate; consisting of first setting the premium leg, there will be two payments conditional on the debtor surviving.

Regulatory environment Regulatory capital

The national debt of OECD member countries will receive a risk weight of 0 percent (this means that the bank does not need to reserve capital for these assets). This includes the case of Turkey, which is a member of the OECD and therefore has a risk weight of 0 percent.

Terminology

In addition, the demerger of National Power raised questions about the location of the reference entity and post-merger liabilities. If the parent ceases to exist, the entity that takes majority ownership becomes the subject of the new contract.

Asset-backed securities Market review

The arrangement is beneficial to a number of independent parties, including the investor and the original owner of the assets. A key characteristic of the SPV is 'bankruptcy remoteness'; this is achieved in part by economically removing the assets from the service business.

Figure 4.1 shows a simplified arrangement typical of most secur- secur-itizations. The servicer represents the pools of assets and sometimes is responsible for the administrative aspects to their operation

Mortgage-backed securities

The cash received by the vehicle (no difference between interest and principal) is transferred directly to the underlying securities. If prepayments occur faster than expected, the excess is diverted to other tranches.

Table 4.1 Issuance of MBSs ($ billion).

Auto- and loan-backed securities