Market Spreads vs Modelled Spreads in Fixed Income and Equity - - PowerPoint PPT Presentation

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Market Spreads vs Modelled Spreads in Fixed Income and Equity - - PowerPoint PPT Presentation

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7 th Annual QUANTITATIVE ASSET & RISK Management Workshop 2012 Venice - Italy Market Spreads vs Modelled Spreads in Fixed Income and Equity Markets Prof. Gianluca Oricchio Senior Partner Moodys Analytics UCBM, Roma 9 th and 10 th

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

7th Annual QUANTITATIVE ASSET & RISK Management Workshop 2012 Venice - Italy

9th and 10th February 2012 Scuola San Giovanni Evangelista

Market Spreads vs Modelled Spreads in Fixed Income and Equity Markets

  • Prof. Gianluca Oricchio

Senior Partner Moody’s Analytics UCBM, Roma

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Agenda

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«Credit Risk Reshaped Equity Market»

  • 1. EDF MODEL RELIABILITY
  • 2. CREDIT RISK PRICING AS BOND AND STOCK

SELECTOR

  • 3. BACKTESTING PORTFOLIO PERFORMANCE
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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Agenda

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«Credit Risk Reshaped Equity Market»

  • 1. EDF MODEL RELIABILITY
  • 2. CREDIT RISK PRICING AS BOND AND STOCK

SELECTOR

  • 3. BACKTESTING PORTFOLIO PERFORMANCE
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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Moody’s Analytics’ Public Expected Default Frequency (EDF) Model

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Measure of default probability built upon the Vasicek-Kealhofer structural model Precise credit risk metrics based on real-time equity market information and public financial statements De facto standard, widely used by banks, asset managers, and corporate treasuries in credit risk management and credit valuation

1 Year

Asset Return follows Geometric Brownian Motion Process Asset Volatility (σ)

Default Point

Expected Asset Value

Today

Distribution of Asset Value at Horizon

EDF

Distance-to-Default (DD) = The number of Standard Deviations Asset Value is away from Default Point Asset Value as

  • f today
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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Rank Order Power: North American Corporate Firms

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EDF credit measures have exhibited a high degree of predictive accuracy relative to

  • ther risk measures, such as Z scores.

Both relative and absolute performance held up well during the financial crisis. 2001-2007 2008-2010

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Rank Order Power: European Corporate Firms

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The conclusion is broadly the same for European corporate firms, although absolute power was somewhat lower during the financial crisis. 2001-2007 2008-2010

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Rank Order Power: Global Financial Firms

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Despite the suddenness and severity of the crisis for global financial firms, rank order power was maintained in the 2008-2010 time period. 2001-2007 2008-2010

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Early Warning Power: European Corporates

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The same is true for European corporate firms.

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Agenda

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«Credit Risk Reshaped Equity Market»

  • 1. EDF MODEL RELIABILITY
  • 2. CREDIT RISK PRICING AS BOND AND STOCK

SELECTOR

  • 3. BACKTESTING PORTFOLIO PERFORMANCE
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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Moody’s Analytics’ Corporate Bond Valuation Framework

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Moody’s Analytics’ valuation framework: built upon risk-neutral valuation methodology Bond Market Spreads Moody’s Analytics’ Fair Value Spread Provides a level play field between bond credit spread and default probability (EDF/PDs)

Spread = (PD x LGD) + Market Price of Risk

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

EDF-Implied Fair Value Spread: FVS

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Percentage of Systematic Risk Term Market Risk Premium Expected Recovery Value EDF: Default Risk

Fair Value Spreads

Linking bond and equity markets through EDFs:

» EDFs (Equity-based PD measure) implies FVS

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Financial Models: CDS Spreads

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Use factor analysis for forecasting CDS spreads: Global Non-Financial Corporates for Moody’s rating buckets (Aaa, Aa, A, Baa, Ba, B, Caa)

500 1000 1500 2000 2500 3000 3500 4000 4500 5000 50 100 150 200 250 300 350 400 2005 2006 2007 2008 2009 2010 AAA_NFC AA_NFC A_NFC BAA_NFC BA_NFC B_NFC CAA_NFC

Source: Moody’s Analytics, Capital Market Research Group 10 20 30 40 50 60 70 80 90 100 PC1 PC2 PC3 PC4 PC5 PC6 PC7

% of explained variance

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Credit Risk Pricing as Name Picking

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OAS OAS FVS FVS I Hypoth. Fixed Income A > B II Hypoth. Equity A > B

A) B)

…but…

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Agenda

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«Credit Risk Reshaped Equity Market»

  • 1. EDF MODEL RELIABILITY
  • 2. CREDIT RISK PRICING AS BOND AND STOCK

SELECTOR

  • 3. BACKTESTING PORTFOLIO PERFORMANCE
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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Series 15 Index: Bond Selection

 OAS - Fair Value Spread determination

Two Fixed Income portfolios:

 FVS-based Portfolio: Highest OAS-FVS (56 names)

 versus

 Excluded Portfolio: Lowest OAS-FVS (60 names)

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Generating Portfolio Outperformance with Fair Value Spreads

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Bonds with OAS > FVS are Good Defensive Investments During Sell-offs (Avg. Spreads in bp)

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Generating Portfolio Outperformance with Fair Value Spreads

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FVS-Based Portfolio: 82% Bond Price Up 18% Bond Price Down Excluded Portfolio: 43% Bond Price Up 57% Bond Price Down

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Measuring Portfolio Performance

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Performance of the FVS portfolio vs. the iTraxx cash index

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Series 15 Index: Equity Selection

 OAS - Fair Value Spread determination

Two Equity portfolios:

 FVS-based Portfolio: Highest OAS-FVS (56 names)

 versus

 Excluded Portfolio: Lowest OAS-FVS (60 names)

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Generating Portfolio Outperformance with Fair Value Spreads

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Bonds with OAS > FVS are Good Defensive Investments)

  • 0.20

0.40 0.60 0.80 1.00 1.20 2/28/2008 2/28/2009 2/28/2010 2/28/2011 Excluded OAS-FVS

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Generating Portfolio Outperformance with Fair Value Spreads

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40% over performance

  • 0.20

0.40 0.60 0.80 1.00 1.20 2/28/2008 2/28/2009 2/28/2010 2/28/2011 Excluded OAS-FVS delta

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Generating Portfolio Outperformance with Fair Value Spreads

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FVS-Based Portfolio: 53% Equity Price Up 47% Equity Price Down Excluded Portfolio: 19% Equity Price Up 81% Equity Price Down

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Conclusions

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1) A Reliable Credit Risk Model is the premise for a Credit Risk Pricing Valuation… 2)…Credit Risk Pricing is key in Bond Portfolio Selection… 3)…Credit Risk Pricing is key in Equity Portfolio Selection…

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7° QUANTITATIVE ASSET & RISK Management Workshop 2012

Conclusions

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…Credit Risk Reshaped Equity Market! Thanks Gianluca Oricchio g.oricchio@unicampus.it