Cutting Edge

Analysing counterparty risk

In an attempt to improve on existing regulatory approaches to derivatives counterparty creditrisk, Eduardo Canabarro, Evan Picoult and Tom Wilde present a new method based on expectedpositive exposure (EPE). Using a one-factor conditional independence…

VAR: history or simulation?

Greg Lambadiaris, Louiza Papadopoulou, George Skiadopoulos and Yiannis Zoulis assess theperformance of historical and Monte Carlo simulation in calculating VAR, using data from theGreek stock and bond market. They find that while historical simulation…

Ultimate recoveries

Measuring recovery using the ultimate rate observed at emergence from bankruptcy may be conceptually desirable, but modelling it is difficult. Craig Friedman and Sven Sandow tackle the problem by maximising the creditor’s utility function, constructed…

A false sense of security

Credit portfolio models often assume that recovery rates are independent of defaultprobabilities. Here, Jon Frye presents empirical evidence showing that such assumptions arewrong. Using US historical default data, he shows that not only are recovery…

Unexpected recovery risk

For credit portfolio managers, the priority is to properly incorporate recovery rates into existing models. Here, Michael Pykhtin improves upon earlier approaches, allowing recovery rates to depend on the idiosyncratic part of a borrower’s asset return,…

Questions of error

Consider the following two, difficult, questions. How should a financial institution allocate capital to different businesses? How should a financial institution be valued? The first question is a subject for the senior management of an institution. But…

Market-implied ratings

There has been much debate over the respective merits of credit ratings and market-based indicators. Ludovic Breger, Lisa Goldberg and Oren Cheyette present a new approach that tries to incorporate the benefits of both approaches. Starting with agency…

Overcoming the hurdle

How should capital be allocated to different business lines in a financial institution? Thomas Wilson explores this question from an investor’s perspective by constructing a statistical model that measures the risk of individual business types. The…

Correlation evidence

Like ratings, default correlation is an area of fierce industry debate. But any fundamental, long-term investor searching for fair value in credit correlation will want to understand what the historical data actually says. Here, Arnaud de Servigny and…

I will survive

Jon Gregory and Jean-Paul Laurent apply an analytical conditional dependence framework to the valuation of default baskets and synthetic CDO tranches, matching Monte Carlo results for pricing and showing significant improvement in the calculation of…

Bidding principles

Robert Almgren and Neil Chriss show how principal bid programme trades can be priced and evaluated as part of a trading business. By annualising the price impacts and variances of such trades, they construct an information ratio measure that can be used…

Credit barrier models

Claudio Albanese, Giuseppe Campolieti, Oliver Chen and Andrei Zavidonov construct an analytic credit barrier model driven by credit ratings, constrained to fit the term structure of credit spreads

Black smirks

Fei Zhou presents a simple stochastic volatility extension of the Black interest rate option pricing model widely used by traders. Using a perturbative expansion in volatility of volatility, he derives modified Black formulas that correctly fit the…

Real option valuation and equity markets

Many non-financial assets can be viewed as ‘real options’ linked to some underlying variable such as a commodity price. Here, Thomas Dawson and Jennifer Considine show that the stock price of a well-known electricity generating company is significantly…

The road to partition

Applying the ensemble approach developed in these pages last month, Kevin Thompson and Roland Ordovas calculate risk contributions and show how to measure higher-order default dependence using the method of partitions. The results provide tools allowing…

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