Credit Treasury: A Credit Pricing Guide in Liquid and Non-Liquid Markets

Cover......Page 1
Half Titile......Page 2
Series page......Page 3
Titile......Page 4
Copyright......Page 5
Contents......Page 6
List of Figures......Page 11
List of Tables......Page 19
Foreword......Page 23
CHAPTER 1 Introduction......Page 26
2.2 THE MERTON STRUCTURAL DEFAULT MODEL......Page 32
2.2.1 The Mathematical Model......Page 38
2.3.1 The credit default swap5......Page 40
2.3.2 Liquid curves......Page 42
2.3.3 Non-liquid curves......Page 43
3.1 INTRODUCTION......Page 46
3.2 INTERNAL RATING AND PRICING MODELS......Page 47
3.3 INCORPORATING MARKET VIEW IN PRICING MODELS......Page 49
3.4.1 The corporate rating model......Page 55
3.4.2 The validation and improvement approach......Page 56
3.4.3 Term structure of probability of default......Page 64
3.5 TRANSITION MATRIX STATE – DEPENDENT PRICING MODEL......Page 68
3.5.1 Large corporate transition matrices......Page 69
3.5.2 Corporate transition matrices......Page 71
3.5.3 SME corporate transition matrices......Page 72
3.5.4 SME retail transition matrices......Page 73
3.6 USAGE GIVEN DEFAULT (EXPOSURE AT DEFAULT)......Page 74
3.6.1 Defining and calculating the components of EaD......Page 76
3.6.3 Calculating EaD......Page 83
3.7 LOSS GIVEN DEFAULT......Page 85
3.7.1 Structure of the basic calculation......Page 86
3.7.3 LGD estimates used in the pricing model......Page 94
3.7.4 Cure rate......Page 95
3.8.1 Credit risk capital – the global correlation factor structure......Page 100
3.8.2 Operational risk capital......Page 110
3.8.5 Net interest revenue......Page 111
3.8.7 Expected loss......Page 113
3.8.10 Profitability measurement......Page 114
3.9 PRICING OF A PRE-PAYMENT OPTION......Page 118
A1.1 Introduction......Page 121
A1.2 What we will cover......Page 123
A1.3 Section I: The current credit risk toolbox......Page 124
A1.4 Section II: Past studies and current theory of private firm default......Page 129
A1.5 Appendix 2......Page 141
A1.6 Section III: Data......Page 143
A1.7 Section IV: Univariate ratios as predictors of default: the variable selection process......Page 150
A1.8 Appendix 4A......Page 171
A1.9 Section V: Similarities and differences between public and private companies......Page 177
A1.10 Section VI: Transformations and functional form......Page 187
A1.11 Appendix 6A: Transformations of input ratios......Page 194
A1.12 Appendix 6B: RiskCalc schema......Page 196
A1.13 Section VII: Mapping to default rates and Moody’s ratings......Page 201
A1.14 Appendix 7A: Perceived risk of private vs. public firm debt......Page 210
A1.15 Section VIII: Model validation......Page 212
A1.16 Appendix 8A: Accuracy ratios and conditional entropy ratios......Page 227
A1.18 Section IX: Conclusion......Page 231
ANNEX A2 – PROXYING THE NON-LIQUID MARKET USING EQUITIES......Page 233
4.1.1 Decomposing risk in a bond......Page 237
4.1.2 Par-equivalent credit default swap spread......Page 239
4.1.3 Methodology for isolating credit risk in bonds with embedded options......Page 247
4.2.1 Understanding the difference between bonds and credit default swap spreads......Page 252
4.2.2 Trading the basis......Page 255
4.3 TRADING CREDIT CURVES......Page 261
4.3.1 Drivers of P+L in curve trades......Page 262
4.3.2 Curve trading strategies......Page 272
4.3.3 Equal-notional strategies: forwards......Page 273
4.3.4 Duration-weighted strategies......Page 279
4.3.5 Carry-neutral strategies......Page 285
4.3.6 Different ways of calculating slide......Page 287
4.3.7 Calculating breakevens......Page 290
4.3.8 The Horizon Effect......Page 292
4.3.9 Changing risky annuities over the trade horizon......Page 293
4.3.10 A worked example......Page 294
4.3.11 Horizon Effect conclusion......Page 298
4.4.1 Intuition......Page 299
4.4.2 CDS curve shape impact......Page 300
4.4.3 Recovery rate impact......Page 301
4.4.4 Assumptions at contract inception......Page 302
4.5 TRADING CDS AGAINST EQUITY PUTS......Page 303
4.5.1 Structuring a CDS/put trade......Page 304
4.5.2 Risks to the strategy......Page 308
4.5.4 Implications for put skew in the equity market......Page 310
5.1.1 Introduction......Page 311
5.1.3 Basis to theoretical......Page 312
5.1.4 Comparing on-the-run and off-the-run basis......Page 314
5.1.5 Credit events......Page 315
5.1.6 CDX and iTraxx indices......Page 317
5.2.1 Product description......Page 322
5.2.2 Basic option strategy payoff diagrams......Page 325
5.2.3 Using options to express a spread view......Page 326
5.2.5 Combining spread and volatility views......Page 327
5.2.6 Option trading strategies......Page 328
5.2.7 The practical side to trading options......Page 331
5.3.1 Defining volatility......Page 336
5.3.2 Delta-hedging......Page 337
5.3.3 The returns from delta-hedging in credit......Page 338
5.3.4 Historical analysis......Page 340
5.4.1 What is a tranche?......Page 341
5.4.2 Why are synthetic tranches traded?......Page 346
5.4.3 The mechanics of trading tranche protection......Page 348
5.4.4 The role of correlation......Page 350
5.4.5 Pricing tranches......Page 351
5.4.6 Other products......Page 353
6.1.1 Introduction to different approaches to transition matrices......Page 357
6.1.2 Present EVA backward-looking methodology......Page 360
6.1.3 Present EVA Nelson–Siegel methodology......Page 362
6.1.4 Comparison between present EVA backward-looking methodology and present EVA Nelson–Siegel methodology......Page 363
6.2 CREDIT TREASURY PROFIT & LOSS: THE ACCOUNTING FRAMEWORK......Page 366
A.3.1 Company officially rated and with liquid CDS: Enel SpA......Page 371
A.3.2 Company officially rated and with liquid CDS: Fiat SpA......Page 373
A.3.3 Large corporate without an official rating: Ferretti SpA......Page 374
A.3.4 Asset finance – pricing of implied option: ACS......Page 376
A.3.5 Lending to small business......Page 378
Notes......Page 379
Bibliography......Page 384
Index......Page 390