Journal of Credit Risk

Michael K. Ong

Stuart Graduate School of Business, Illinois Institute

I am very pleased to complete the second issue of The Journal of Credit Risk. Reactions to our inaugural issue from both academia and the financial industry have been very positive and supportive. I would like to thank all of you for your continued support and guidance.

As I have said many times in the past, this journal is your venue for communicating results in the modeling and management of portfolio credit risk, the pricing and hedging of credit derivatives, particularly, structured credit products and securitizations. I strongly encourage you to contribute to the four different sections of the Journal. More specifically, I would like to highlight the opportunity for you to share your insights, thoughts, queries, and solutions to practical problems in the forum and solutions sections. Please use this as your forum for discussing current issues in the field.

Research Articles

In this issue, we present two full-length research papers in the main section. The first paper by Praveen Varma, “Default and Recovery Rates of Asia-Pacific Corporate Bond Issuers, 1990-2003”, provides an empirical study of the long-term corporate bond ratings in the Asia-Pacific region. Ironically, while the region had experienced explosive growth in the number of corporate issues and issuer ratings, this marks the very first analytical study of the default and recovery aspects of the region in 14 years. More importantly, despite this growth, issuers in the Asia-Pacific region historically have experienced higher average ratings and lower default rates compared to the global sample. Additionally, with the corresponding growth of speculative-grade issuers, now accounting for 20% of total issues, these issuers have higher default rates than their global counterparts, most of these defaults occurring during the Asian crisis of 1998-1999. The study also shows that overall, the recovery rates and annual credit losses for defaulted bonds in the region are comparable to those in Europe and North America.

Simple reduced form credit risk models use long run transition matrices from rating agencies to determine the probable credit risk of market securities. However, these transition matrices also reflect systematic behavior over the credit cycle. In the second paper, “Expected Loss and Fair Value over the Credit Cycle”, Daniel Philps and Solomon Peters use an empirical approach to model the probable changes in systematic risk over time and show that investment grade portfolios that are naïve to changes in levels of systematic risk can significantly underestimate expected loss. A valuation model that risk-adjusts credit spreads to the probable future levels of systematic risk is shown to outperform both the naïve approach and the Global Lehman Credit Index.

Credit Risk Forum

The Credit Risk Forum constitutes the second main section of The Journal of Credit Risk. The Forum is intended to provide rapid communication on findings and ideas about credit risk that are timely, expository, and educational in nature. We strongly encourage readers to submit short discussion articles that are specifically designed to be tutorial and highly educational in nature. The main goal of the submitted articles is to educate the masses and to bring to light a higher level of understanding to both industry and academia on issues and topics that might not normally be readily and easily accessible to either side.

We have three short discussion articles in the Credit Risk Forum section. O ne peculiarity of the credit markets is the large difference between probabilities of default calculated from historical data and probabilities of default implied from bond prices or from credit default swaps. For example, using historical data Moody's estimates that about 0.9% of companies that are initially rated A default within a seven year period while the bond market indicates that about 8.6% of these companies are expected to default in the next seven years. Why are these two estimates so different and which one should be used in practice? The first article, “Bond Prices, Default Probabilities and Risk Premiums”, by John Hull, Mirela Predescu, and Alan White provides some potential answers.

Credit investors need a measure to determine how much they are being paid to compensate them for assuming the credit risk embedded within a security. A number of such measures exist, and are commonly known as credit spreads since they attempt to measure the return of the credit asset relative to some higher credit quality benchmark. What are these commonly used credit spreads and what exactly do they measure? In the second article, “Credit Spreads Explained”, Dominic O'Kane and Saurav Sen present a variety of suggestions to these questions using fixed rate bonds, floating rate notes, and credit default swaps.

The CDS index basis, which is the difference between the market index level and the intrinsic index level implied by the underlying single-name default swap levels, is typically viewed by m arket participants as a leading indicator for the aggregate spread level. The is a market hypothesis that protection sellers prefer receiving upfront premiums and therefore are willing to offer concessions for upfront plus running contracts relative to “all running” contracts, creating an “upfront concession effect”. The final discussion article by Haiyun Zhang, “Instant Default, Upfront Concession and CDS Index Basis”, presents a contrasting view.

Problems and Solutions

The Problems and Solutions section is intended to encourage active discussion on how some of the many interesting questions and issues surrounding credit risk can be solved.

The section is intended to allow readers to post serious, practical questions or to post previously unknown and novel solutions to difficult questions.

We have two practical questions for this issue seeking solutions and discussions. The discussions will appear in the next issue.

Book Reviews

Michel Crouhy reviews the book,Measuring and Managing Credit Risk, by Arnaud de Servigny and Olivier Renault, McGraw-Hill, 2004, 466 pages, ISBN 0-07-141755-9