Risk Measurement and Management

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Risk Measurement and Management

• Week 12 November 9, 2006

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(No Transcript)
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Cash Flows in Credit Default Swap
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Expected Cost of Default

• Exposure
• Probability of default
• Estimated based on option pricing
• KMV approach
• Use of Moodys historical data
• Probability of default each period
• Payment of fee in case of non-default

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CEU using KMV (Simplified)

• CEU 2002 (billions) Market value of long-term
  debt 4.1 Book value of current
  liabilities 2.0 Total value of
  liabilities 6.1 Market value of equity
  6.8 Market value of assets
  12.9 Estimated standard deviation of change
  in market value 54
• Market value ? standard deviation of percent
  change 7.0 billion

Derived from LEAPs table
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Default Point

• Estimated default point assumed to midway between
  book value of current liabilities and long-term
  debt
• Book value of CEU long-term debt is 5.0 billion
  and current liabilities 2 billion
• Default point estimated to be 6.0 billion
• We do not have KMV estimates based on historical
  data to fine-tune this estimate of default

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Estimated Distance to Default
Market value to default point 6.9
12.9
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2.0
TMV
CLLTD
CL
Default point (estimated as midpoint) 6
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Simplified KMV Approach
Freqency
Probability of Default 16.2
.985?
Value
12.9 Billion
6 Billion
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More Likely Alternative

• Moodys two-year default rate for B2 rated bonds
  is .137
• At the end of two years, .863 or 86.3 of the
  bonds have not defaulted
• As an estimate of the six-month default rate, we
  can use

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Default Swap Pricing

• Present value of expected fees (paid if no
  default) present value of expected losses in
  case of default
• Risk-free rate appropriate assuming
  risk-neutrality (generally assumed in derivative
  pricing)
• Solution sensitive to all estimates

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Estimates Expected Cash Flows
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Calculation of Fee

• Present value of default payments equal to
  present value of fees
• Fee therefore (under these assumptions) is
  314,850 every six months
• Net return to Charles Bank on loan is 9.8 on 50
  million minus 619,700 per year, equivalent to
  an annual rate of 8.54

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FAB and CEU Credit Risk

• What are choices?
• Retain risk
• Portfolio implications
• Why not enter a swap arrangement with the hedge
  funds or lower-rated bank?
• What would be characteristics in terms of cash
  flows and risk of a credit-linked note?

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For Next Classes

• Start research in order to have good questions
  for our visits to San Francisco financial firms
• We will discuss Chapters 23 and 24 on November 16
  and the Basel II case
• There is no class Thanksgiving week, our last
  class is November 30