Download presentation

Presentation is loading. Please wait.

Published byNina Leggett Modified over 3 years ago

1
July 30, 2003 Bill Pauling, CFA Integrated Credit and Equity Risk Modeling Enterprise Risk Management Symposium

2
2 Overview n Rationale for integrating credit and equity risk n Possible approaches to integrating credit and equity risk n Cholesky decomposition n Transfer functions n Conclusions

3
3 Rationale for Integrating Credit and Equity Risk n Merton (1974) viewed corporate debt as a risk-free bond plus a short put option on the firms equity n Hence, the value of a firms debt and equity are fundamentally linked n Mertons model forms the basis of many models commonly used today, including Moodys KMV

4
4 Credit and Equity Markets are Connected

5
5 36-Month Rolling Correlations to Equity

6
6 120-Month Rolling Correlations to Equity

7
7 Historical Correlations n Over the long-term, the correlation between risky debt and equity is higher than the correlation between government debt and equity n The correlation between risky bonds and equity appears to be more stable that the correlation between government bonds and equity

8
8 Cholesky Decomposion n Method for transforming uncorrelated normal random variables into correlated normal random variables n Formula for correlating 2 random variables (i.e. 2x2 matrix) n where, ε a and ε b are normally distributed random numbers ρ is the correlation between variables a and b error b is a correlated random variable with unit variance n Can be used to correlate larger matrices n Can also be used with a covariance matrix

9
9 Cholesky Decomposition - Example n Given: n Random term used to produce the equity market return, Δy~N(0,1) n Credit spread model: n Correlate Δz in credit spread model to Δy in equity model n Revised credit spread model:

10
10 Transfer Functions n Useful when two series are believed to be correlated or co-integrated n Transfer functions are often used in structured economic models to link the economic factors n Transfer functions can also be used when random terms may not normally distributed (e.g. jump diffusion models)

11
11 Transfer Functions - Example n Given n The periodic equity return r t, and its long-term average return rbar from jump diffusion equity model n Credit spread model:

12
12 Transfer Functions - Example n Incorporate the difference between r and rbar in credit spread model to reflect the correlation between the series n Revised credit spread model: n Revised credit spread model now is correlated to equity model n The jump diffusion process in the equity model is transferred to the credit spread model n Equity market crashes will be associated with rather large increases in credit spreads n Negative skewness in equity returns will also be transferred to the credit spread model as positive skewness due to the negative sign of the beta term

13
13 Conclusions n Credit and equity risk should be modeled in an integrated fashion n Cholesky decomposition can be used to reflect the correlation between the random terms in credit and equity models n Transfer functions can be used to integrate credit and equity models

14
14 References n Bevan, Andrew and Garzarelli, Franco, Corporate Bond Spreads and the Business Cycle: Introducing the GS-SPREAD, The Journal of Fixed Income, March 2000. n Dynkin, L., Lindener, P., Phelps, B. and Wu, W., Equity Market Impact on Corporate Bond Excess Returns, Lehman Brothers Portfolio Strategies, May 7, 2001. n Kealhofer, Stephen, Quantifying Credit Risk I: Default Prediction, Financial Analysts Journal, January/February 2003. n Kealhofer, Stephen, Quantifying Credit Risk II: Debt Valuation, Financial Analysts Journal, May/June 2003. n Merton, Robert, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, Vol. 29, no. 2, May 1974.

Similar presentations

OK

STRATEGIC FINANCIAL MANAGEMENT Hurdle Rate: The Basics of Risk II KHURAM RAZA.

STRATEGIC FINANCIAL MANAGEMENT Hurdle Rate: The Basics of Risk II KHURAM RAZA.

© 2017 SlidePlayer.com Inc.

All rights reserved.

Ads by Google

Ppt on forest degradation in india Seeley's anatomy and physiology ppt on cells Ppt on 21st century skills for teachers Ppt on endangered and endemic species in india Ppt on surface area and volume for class 10th Ppt on eisenmenger syndrome and pulmonary Ppt on pi in maths what does the range Ppt on number system for class 9th download Ppt on temples of south india Ppt on earth hour chicago