Transcript CREDIT RISK PREMIA - National University of Singapore
CREDIT RISK PREMIA
Kian-Guan Lim
Singapore Management University Prepared for the NUS Institute of Mathematical Sciences Workshop on Computational Finance (29 – 30 Aug 2005) 1
Ideas
• Defaultable bond pricing • Recovery method • Credit spread • Intensity process • Affine structures • Default premia • Model risk 2
Reduced Form Models
• Jarrow and Turnbull (JF, 1995) Jarrow, Lando, & Turnbull (RFS, 1997) RFV (recovery of face value) at T Price of defaultable bond price under EMM Q
E t Q
e
t T r
ds
1 *
T
1 *
T
where default time * = inf {s t: firm hits default state} 3
Comparing with Structural Models (or Firm Value Models) Advantages Avoids the problem of unobservable firm variables necessary for structural model; the bankruptcy process is exogenously specified and needs not depend on firm variables Easy to handle different short rate (instantaneous spot rate) term structure models Once calibrated, easy to price related credit derivatives Disadvantage Default event is a surprise; less intuitive than the structural model 4
Assuming independence of riskfree spot rate r(s) and default time r.v. *
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JLT (1997) employs a discrete time, time-homogeneous finite state space per period Markov Chain Q to model Pr t ( *>T)
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1 , 1
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q k
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T-step transition probability Q(t,T)=Q(t,t+1).Q(t+1,t+2)….Q(T-1,T) If q ik (t,T) is ik th element of Q(t,T), then Pr t ( *>T) = 1- q ik (t,T) Q(.,.) is risk-neutral probability Advantage Using credit rating as an input as in CreditMetrics of RiskMetrics Disadvantage Misspecification of credit risk with the credit rating 6
Hazard rate model – basic idea
Pr Q
t
* s
s t
e
u du
Default arrival time is exponentially distributed with intensity Under Cox process, “doubly stochastic”
p
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*
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p
, 1
E t Q t T
du
where (u) is stochastic 7
Lando (RDR, 1998) When recovery of par only is paid at default time t< * cE t Q j 2 n 1 e t t 0 . 5 j r s h s ds E t Q t t n E t Q h s e t s r u h u du e t t r n s h s ds 8 Recovery – another formulation discrete time approximation , e r t h t E t Q t 1 h t E t Q t , T where h s is the conditional probability at time s of default within (s,s+ ) under EMM Q given no default by time s Under RMV (recovery of market value just prior to default) E t Q 1 L t E t Q t , T L is loss given default 9 , e r t e r t h t 1 h t 1 L t L t E t Q 1 t h t , E t Q T t , T For small e ( r t h t L t ) E t Q t , T Hence in continuous time E t Q e t T r ( s ) h ( s ) L ds 10 t t , T E t Q e t T R ds where R r ( s ) h ( s ) L Advantages Unlike the RMV approach to recovery, correlation between spot rate and hazard rate or even recovery/loss is straightforward Easy application as a discounting device Disadvantage Recovery is empirically closer to the RFV approach 11 Relation with earlier studies Given . After obtaining i (t,T), Per period spot rate is ln [ i (t,T+1)/ i (t,T)] -1 spread B BB A T 12 Relation to MC Under the RFM, for a firm with credit rating i Defining i (s) = - ln j k q ij (t,t+1) for s (t,t+1] we can recover a Markov Chain structure Relation to SFM Madan and Unal (RDR, 1996) Defining (s) = a 0 +a 1 M t +a 2 (A t -B t ) where M t variable is macroeconomic variable, and A t -B t are firm specific 13 for short rate r(t) – square root diffusion model of X t Duffie and Kan (MF, 1996), Pearson and Sun (JF, 1994) (t,T) = exp[a(T-t) + b(T t)’ X t ] provided r t c 0 c 1 X t where dX t uX t v dt nxn a 1 b 1 X t 0 0 a 1 b n X t dW t 14 Advantages Short rates positive Tractability u<0 for mean-reversion in some macroeconomic variables 15 Duffee (RFS, 1999) h t d 0 d 1 Y t where dY t wX t z dt nxn c 1 d 1 Y t 0 0 c 1 d n Y t dW t Then the default-adjusted rate r t +h t L can be expressed in similar form to derive price of defaultable bond 16 Comparing physical or empirical intensity process and EMM intensity process Suppose physical g t = e 0 +e 1 Y t And EMM h t = d 0 +d 1 Y t * And both follows square-root diffusion of Y t , Y t * Then h t = + g t +u t Another popular form, Berndt et.al.(WP, 2005) and KeWang et.al. (WP, 2005) is log g t = e 0 +e 1 Y t ; log h t = f 0 +f 1 Y t 17 Difference in processes g t and h t or their transforms provide a measure of default premia Can be translated into defaultable bond prices to measure the credit spread 18 Vasicek or Ornstein-Uhlenbeck with drift log h t f 0 f 1 Y t where dY t wX t z dt nxn dW t For which maximum likelihood statistical methods are readily applicable for estimating parameters and for testing the regression relationship 19 From KMV Credit Monitor Distance-to Default as proxy of default probability Implying from traded prices of derivatives Matched pairs , * from same firm and duration % default prob Q 3-10% 1-3% P Time series 20 Using statistical relationship between risk neutral and physical or empirical measure to infer from traded derivatives empirical risk measures such as VaR given a traded price at any time Using statistical relationship to estimate EMM in order to price product for market-making or to trade based on market temporary inefficiency or to mark-to-model inventory positions of instruments (assuming no arbitrage is possible even if there is no trade) 21 1. 2. 3. Wrong model or misspecified model can arise out of many possibilities Under-parameterizations in RFM e.g. and Incorrect recovery rate or mode e.g. RT, RFV, RMV, and timing of recovery at T or * BUT assuming same RFM and same recovery mode, USE ln(g t )-ln(h t ) regression on macroeconomics and other firm specific variables to test for degree of underspecifications – model risk in pricing and in VaR 22 • Credit Risk is a key area for research in applied risk and structured product industry • Model risk can be significant and is underexplored • RFM provides a regression-based framework to explore model risk implications • Same analyses can be applied to other derivatives using reduced form approach e.g. MBS, CDO 23Duffie & Singleton (RFS, 1999)
R
: default-adjusted short rate
Credit spreads
Affine Term Structure
Specification of intensity process
Credit Risk Premia
Extracting
and
*
Applications
Model Risk
Conclusion