Journal of Credit Risk

Michael K. Ong

Stuart Graduate School of Business

I welcome you to the third issue of The Journal of Credit Risk. The journal continues to receive very positive reactions from the public. I would like to thank all of you for your continued support and guidance. I must reiterate that 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. Please continue 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 Problems and Solutions sections. Please use these to discuss current issues in the field.

Research Articles

There are two full-length research papers in the main section. The first, by Pierre Tychon and Vincent Vannetelbosch, entitled “A model of corporate bond pricing with liquidity and marketability risk”, proposes a corporate bond valuation model that takes into account both the risk of early default and the risk generated by lack of liquidity and marketability.

The liquidity–marketability risk has been shown to be function of the heterogeneity of investors’ valuations, the average belief about the bankruptcy cost and the bargaining power of the bond-holder. Using the proposed model, the authors also show that the liquidity premium can be important in the total risk premium observed. They further establish a relationship between credit risk and liquidity risk by formalizing the effects of the decreasing liquidity of a corporate debt issue with its age. Finally, their analysis also suggests that the dispersion of quotes and the diversification of investors and their respective bargaining powers are important factors in the resulting liquidity premium.

Rating collateralized debt obligations (CDOs), which are based on tranched pools of credit risk exposures, not only requires attributing a probability of default to each obligor within the portfolio, it also involves assumptions concerning recovery rates and correlated defaults of pool assets, thus combining credit risk assessments of individual collateral assets with estimates about default correlations and other modeling assumptions. In the second paper, “CDO rating methodology: some thoughts on model risk and its implications”, Ingo Fender and John Kiff compare the well-known binomial expansion technique (BET) with an alternative methodology based on Monte Carlo simulation. They highlight the potential importance of correlation assumptions for the ratings of senior CDO tranches and explore what differences in methodologies across rating agencies may mean for senior tranche rating outcomes. They point out the potential for “model risk” taken by investors when acquiring CDO tranches, and whether and under what conditions methodological differences may generate incentives for issuers to do selective ratings shopping.

Credit Risk Forum

We have three short discussion articles in the Credit Risk Forum section. Recovery swaps are the most recent innovation in the credit derivatives market. In this contract, two counterparties agree to exchange the realized recovery vs. the preset recovery value (recovery swap rate) in case of default, with no other payments being made in any other scenario.

They allow investors to eliminate the uncertainty of the future recovery payment which is present in the conventional (ie, floating recovery) CDS, whose protection payment in case of default depends on the post-default price of the reference obligation. Given the large uncertainty about recovery rates and their importance for the calibration of most credit derivative models Arthur Berd, in his article “Recovery swaps”, shows how the introduction of this contract impacts the practice of credit derivatives modeling. He also shows how the “credit triangle” relationship appears in the presence of traded recovery swaps and how investors should price this product and evaluate its relative value.

In synthetic CDO markets many market participants price tranches using base correlations as implied from tranches on standard indices such as I-Traxx and I-Boxx. For hedging purposes, it is of interest to consider how the base correlation curve will move with changes in default spreads, but so far few empirical data are available. In their article “CDO pricing with factor models: survey and comments”, Leif Andersen and Jakob Sidenius explain the concept of CDO “deltas” in the presence of a base correlation skew.

For the purpose of computing hedge ratios and determining the effective leverage of a CDO tranche, it is necessary to consider how the correlation skew moves as a function of spreads. For many models of the correlation skew, the authors argue that hedge and leverage ratios are non-unique and that movements of the correlation skew with spreads depend on details of the changes in idiosyncratic and systemic factors that caused the spreads to move.

In last forum article, “Better ingredients”, Christopher Finger and Robert Stamicar follow up on the recent paper by Hull, Nelken and White (2005) which establishes that a variant of the Merton model of credit calibrated to equity options can differentiate credit quality in cross-sections. The performance of this model is better than a similar model calibrated instead to historical equity volatility. Beyond differentiating credit spreads across different names, the authors question whether equity option data can aid in tracking the specific spread levels for individual names. In addition, they raise the question of whether information in the option skew can be used to improve on fundamental approaches to assessing the leverage for individual firms.

Problems and Solutions

The Problems and Solutions section is intended to encourage active discussion of 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 in this issue seeking solutions and discussions. The discussions will appear in the next issue.

Book Reviews

Greg Gupton reviews the book "An Introduction to Credit Risk Modeling" by Christian Bluhm, Ludger Overbeck and Christoph Wagner published by Chapman & Hall/CRC in 2002.