ING-Barings Adds Repo, Credit Spreads To Market VaR

LONDON--ING-Barings is attempting to fend off the credit risks associated with emerging market trading by incorporating tools for analyzing repo spread risks and credit spread risks into the firm's market risk valuation process for credit default swaps. The novel move could prove revolutionary, in not only introducing repo rates as one factor in predicting counterparty default, but also in establishing a foundation for integrating credit and market risks.

Both components are part of New York-based Summit System's new credit derivatives module version 2.6e3, which is currently being implemented at INGBarings. The module was engineered based on finance and economic input from both ING-Barings and the European Bank for Reconstruction and Development (EBRD).

Repo spreads entered the picture, according to Summit Systems' analysts, based on the knowledge that two identical bonds can have the same price, but different credit risks if their repo spreads are different. In some cases the spreads can reach several hundred basis points, which could significantly impact the default density fitted from the risky bonds.

Taking the analysis further, some industry analysts have suggested that the same repo spreads, combined with additional information generated from the credit swap valuations, might have added the insights required for risk managers to foresee such credit events as the devaluation of the Russian ruble.

A repo trade, more formally known as a repurchase agreement, is a financing arrangement in which a dealer sells a security to a lender and agrees to repurchase them at an agreed date and price. The lender holds the security as collateral in the case that the trader defaults on their obligation to repay the loan. Repos have been growing in popularity over the last several years because they provide short-term cash to dealers and typically low-risk return to lenders.

Risk experts, however, contend that repo lenders, who have traditionally set rates based on supply and demand, are now integrating into the repo rates the risks of default by the borrower and a decline in the value of the collateral. They say this development may have created correlations between repo spreads and certain credit events.

While ING-Barings officials do not acknowledge the validity of any theory that directly correlates repo rates with credit events, they do highlight the importance of incorporating repo spreads in the valuation of credit default swaps.

"The repo rate is an important parameter in pricing credit default swaps," says Cecilia Reyes, director of quantitative risk management at ING-Barings. "We make sure that no arbitrage exists between the valuations of default swaps, spot prices of the bonds and the costs of repoing these bonds. Taking the bond's repo curve into account in the pricing is not so much an issue of 'technology,' but more of financial analytics."

Perhaps even more important is ING Barings' strategy of including credit spreads, a proven predictor of default, as a market risk factor, when most financial institutions keep credit risk factors and market risk factors separate. Credit spreads are added to interest rates and foreign exchange rates in the list of market risk factors that is used in the firm's Value at Risk (VaR) analysis of credit risky bond trading positions, according to Reyes.

"At ING Barings, we measure credit spread risk as part of our VaR analysis by treating it as a market risk factor. If you do not recognize the existence of credit spreads, especially in bonds trading at wide credit spreads, your interest rate risk will also be mis-estimated," notes Reyes. "Obviously, if you have a position in a credit risky bond, the wider the credit spread, the lower its sensitivity per basis-point move in the interest rates. If one applies the volatility of default-free interest rates to these sensitivities, then potentially the VaR will be underestimated. The missing risk is from credit spread volatilities."

Another step in ING-Barings' risk management evolution, then, is to integrate credit spread risk into a VaR calculation that could be applied consistently across all credit risky bonds and credit derivatives. The firm will accomplish this goal, Reyes says, by applying the current practise utilized by the firm's Trading Risk Management division, as well as implementing Summit's next module version 2.6e4, which will include credit spreads as a risk factor in credit risk bonds and credit default swaps for VaR.

ING-Baring's Trade Risk Management division incorporates credit spread risk in VaR by allocating each bond to various categories of credit riskiness in a manner similar to that used by credit ratings agencies. Each credit rating category is then assigned a volatility of credit spreads. Next, the risk manager estimates the correlation matrix of changes of credit spreads in the various categories. The resulting volatilities and correlation matrix are then input into the VaR calculation engine. As a result, credit VaR is measured and managed solely on the basis of credit spread movements.

Another advantage is that by running separate VaR calculations for credit spread risk and interest rate risks, ING-Barings officials are not only able to identify and hedge those risks, but also impose limits on traders based on those risks. "In high yield bond trading, there are separate limits for interest rate risk and credit spread risks, and therefore, it is important to measure credit spread risk explicitly," Reyes adds.

As a result, ING-Barings will have constructed the integrated risk management system called for by many financial institutions and regulators: a firm-wide method of integrating credit and market risks into one assessment unit. The framework permits the proper application of credit limits and hedging strategies. The strategy also allows risk managers and business managers to allocate capital to business lines that are generating optimal risk-based returns.

In general, ING-Barings will use the credit derivatives module to book, mark-to-market and manage the risks associated with trading most credit derivative products, such as default swaps, and securities, such as credit-linked notes, which are basically just bonds with embedded default swaps, says Reyes. The development of Summit's credit derivatives module, she adds, had been divided into two phases, with the first phase covering default swaps, credit linked notes, and binding and non-binding forward contracts on bonds. The second phase involved constructing total return swaps capabilities.

One reason ING-Barings chose to work with Summit is that the financial institution has been using the risk vendor's trading and risk management system globally for a wide array of fixed income instruments for a number of years, says Reyes. Sybase replication technology, Reyes says, is used to replicate globally trades and risk strategies implemented in Summit at ING-Barings' main hubs such as London/Amsterdam, New York, Hong Kong and Tokyo and major centers such as Sao Paulo, Buenos Aires, Moscow and Manila.