What credit needs

The sudden growth in sophistication and size of the global credit markets – notably in areas such as credit default swaps (CDSs) and collateralised debt obligations (CDOs) – has been one of the great success stories of global financial markets.

Remember that, little more than five years ago, credit as an asset class was rarely referred to outside the US. Then, we talked of bonds, of loans, of asset-backed securities, of other forms of debt.

But these dramatic developments have brought their own problems – the credit market’s growing pains, if you will.

Dealing with these growing pains is an area of particular interest to Risk and its readers. And this month we look at two areas of the credit market where its finest minds, both academics and practitioners, are focusing their attention.

Our cover story looks at the difficulties of quoting implied correlation in products such as CDOs and other correlation products. In particular, some market participants claim that certain banks are wilfully misquoting the relative value of correlation products, notably mezzanine tranches of CDOs, to an unsuspecting client base that has no real means of valuing the instruments.

Using compound correlation – until recently a common approach to representing relative value in tranches of a credit-linked product – can lead to dangerous discrepancies.

As our story reveals, many institutions have started to use a base correlation approach, but even this method has its limitations as well as advantages (an important one being that it at least brings greater certainty).

But as leading academic Darrell Duffie wrote in Risk in April, uncertainty is likely to prevail until traditional copula methods are adapted to provide a new standard for the price quotation of credit products that models correlated changes in credit spreads as well as default times.

One area where the world of academia appears to have provided an answer is in the pricing of options using forward measures. Derivatives are being written on plain vanilla credit default swaps as the market’s liquidity grows. But to price an option on a CDS, you need to value a CDS contract that starts in the future (or a forward CDS). This obligation to sell protection in an underlying credit has value today, and so does the right to enter into a CDS.

However, since a credit can default at any time, even before the CDS contract begins, valuing this forward CDS poses severe technical difficulties – which means standard option pricing theory doesn’t work.

In Risk this month, leading quant Philipp Schönbucher publishes for the first time a working paper that had already provided the technical breakthrough – the theory of T-forward survival methods – but in this latest version also offers proof of the theory and empirically investigates the type of volatility structure that best describes the CDS markets. Schönbucher’s work is likely to have important implications beyond CDS options, in areas such as credit counterparty risk management.