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 Moody’s Analytics UCBM, Roma 9 th and 10 th February 2012 Scuola San Giovanni Evangelista 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 1
Agenda «Credit Risk Reshaped Equity Market» 1. EDF MODEL RELIABILITY 2. CREDIT RISK PRICING AS BOND AND STOCK SELECTOR 3. BACKTESTING PORTFOLIO PERFORMANCE 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 2
Agenda «Credit Risk Reshaped Equity Market» 1. EDF MODEL RELIABILITY 2. CREDIT RISK PRICING AS BOND AND STOCK SELECTOR 3. BACKTESTING PORTFOLIO PERFORMANCE 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 3
Moody’s Analytics’ Public Expected Default Frequency (EDF) Model 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 Distribution of Asset Value at Horizon Asset Return follows Geometric Brownian Motion Process Asset Volatility (σ) Expected Asset Value Asset Value as of today Distance-to-Default (DD) = The number of Standard Deviations Asset Value is away from Default Point Default Point EDF Today 1 Year 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 4
Rank Order Power: North American Corporate Firms EDF credit measures have exhibited a high degree of predictive accuracy relative to other risk measures, such as Z scores. Both relative and absolute performance held up well during the financial crisis. 2001-2007 2008-2010 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 5
Rank Order Power: European Corporate Firms The conclusion is broadly the same for European corporate firms, although absolute power was somewhat lower during the financial crisis. 2001-2007 2008-2010 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 6
Rank Order Power: Global Financial Firms 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 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 7
Early Warning Power: European Corporates The same is true for European corporate firms. 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 8
Agenda «Credit Risk Reshaped Equity Market» 1. EDF MODEL RELIABILITY 2. CREDIT RISK PRICING AS BOND AND STOCK SELECTOR 3. BACKTESTING PORTFOLIO PERFORMANCE 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 9
Moody’s Analytics’ Corporate Bond Valuation Framework Moody’s Analytics’ valuation framework: built upon risk-neutral valuation methodology Spread = (PD x LGD) + Market Price of Risk Provides a level play field between bond credit spread and default probability (EDF/PDs) Moody’s Analytics’ Fair Bond Market Spreads Value Spread 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 10
EDF-Implied Fair Value Spread: FVS Linking bond and equity markets through EDFs: » EDFs (Equity-based PD measure) implies FVS EDF: Default Risk Expected Recovery Value Market Risk Premium Fair Value Spreads Term Percentage of Systematic Risk 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 11
Financial Models: CDS Spreads Use factor analysis for forecasting CDS spreads : Global Non-Financial Corporates for Moody’s rating buckets (Aaa, Aa, A, Baa, Ba, B, Caa) 100 400 5000 AAA_NFC AA_NFC 90 4500 350 A_NFC BAA_NFC 80 4000 % of explained variance 300 BA_NFC B_NFC 3500 70 CAA_NFC 250 3000 60 200 2500 50 2000 40 150 1500 30 100 1000 20 50 500 10 0 0 0 2005 2006 2007 2008 2009 2010 PC1 PC2 PC3 PC4 PC5 PC6 PC7 Source: Moody’s Analytics, Capital Market Research Group 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 12
Credit Risk Pricing as Name Picking OAS II Hypoth. I Hypoth. FVS A) Fixed Equity Income …but… A > B A > B FVS OAS B) 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 13
Agenda «Credit Risk Reshaped Equity Market» 1. EDF MODEL RELIABILITY 2. CREDIT RISK PRICING AS BOND AND STOCK SELECTOR 3. BACKTESTING PORTFOLIO PERFORMANCE 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 14
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) 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 15
Generating Portfolio Outperformance with Fair Value Spreads Bonds with OAS > FVS are Good Defensive Investments During Sell-offs (Avg. Spreads in bp) 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 16
Generating Portfolio Outperformance with Fair Value Spreads FVS-Based Portfolio: 82% Bond Price Up 18% Bond Price Down Excluded Portfolio: 43% Bond Price Up 57% Bond Price Down 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 17
Measuring Portfolio Performance Performance of the FVS portfolio vs. the iTraxx cash index 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 18
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) 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 19
Generating Portfolio Outperformance with Fair Value Spreads Bonds with OAS > FVS are Good Defensive Investments) 1.20 1.00 0.80 Excluded 0.60 OAS-FVS 0.40 0.20 - 2/28/2008 2/28/2009 2/28/2010 2/28/2011 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 20
Generating Portfolio Outperformance with Fair Value Spreads 40% over performance 1.20 1.00 0.80 Excluded 0.60 OAS-FVS delta 0.40 0.20 - 2/28/2008 2/28/2009 2/28/2010 2/28/2011 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 21
Generating Portfolio Outperformance with Fair Value Spreads FVS-Based Portfolio: 53% Equity Price Up 47% Equity Price Down Excluded Portfolio: 19% Equity Price Up 81% Equity Price Down 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 22
Conclusions 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… 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 23
Conclusions …Credit Risk Reshaped Equity Market! Thanks Gianluca Oricchio g.oricchio@unicampus.it 7° QUANTITATIVE ASSET & RISK Management Workshop 2012 24
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