Credit risk models enhance link between credit and equity prices, say BIS

The growing use of credit risk models is helping to strengthen the link between credit and equity prices, said the Bank for International Settlements (BIS).

The integration of the credit and equity markets in the past year has improved the “price discovery process by facilitating the adjustment of prices in different financial markets to new information”, the BIS said in its annual report published on Monday.

“Linkages between markets were also strengthened by the development of markets for the transfer of credit risk, especially credit derivatives markets,” the report said. “Prior to the introduction of credit derivatives, the credit markets were among the least liquid of financial markets.”

While market participants have typically used equity volatility as the key variable for estimating asset volatility, credit risk management models provide another channel for feedback from equity to credit markets. “Such feedback effects were especially pronounced in mid-2002 because of the increased presence of hedge funds in credit markets. As institutional investors reached to higher quality credits, the investment strategies and risk management practices of hedge funds came to have a larger influence in the vacated market segments,” the BIS said.

In contrast to institutional investors, hedge funds rely less on credit ratings as measures of creditworthiness and more on credit risk pricing models, the BIS noted.

At the end of September 2002, the total credit derivatives positions were: $614 billion in credit default swaps; $390.6 billion in portfolio products; $17.4 billion in credit-linked notes; and total return swaps of $48.6 billion.

The BIS is an international organisation that fosters co-operation among central banks and other agencies in the pursuit of monetary and financial stability.