THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS
THE DERIVATIVES 'ZINE^TM     November 2001

Credit Risk Management    Last revised: March 02, 2002

New, this month:

• 7/28/00 Ask Dr. Risk!: "Managing Credit Risk on a Long Term Lease" and "Predicting the Probability of Default."
• 7/28/00 Dr. Risk's Derivatives Dictionary^TM: EDF^TM, Expected Default Frequency^TM, KMV.
• 7/28/00 Dr. Risk's Links

On this page:

Ask Dr. Risk! | Books | Links | Presentations | Derivatives Dictionary^TM

Ask Dr. Risk!

Dr. Risk promises you at least a brief response to your important question, as soon as he has a free moment. A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. All questions and answers become the property of The William Margrabe Group, Inc. 7/28/00 

Managing Credit Risk on a Long Term Lease (7/28/00)

Dear Dr. Risk – I am working as treasurer/risk manager and have the following problem. My company intends to buy an dedicated asset and operate it for 15 years and supply the products to our Client under a long term (15 yr) contract, wherby Client is paying for the capital costs of the investment plus the variable cost and marging for the products. This client however has a rating of BB, which is quite low. Can you provide me with ideas on products and pricing techniques to hedge the counterparty risk for this casus. – Jan

Dear Jan – Your specific situation depends on specifics about which Dr. Risk has no information, but here are some general comments about your sort of situation. 

It sounds as though:
(a) You have made essentially a secured loan to your client (capital costs), probably fully amortizing, with a level payment, much like a residential mortgage loan. 
(b) You've bought an unsecured annuity from your client (margin).
(c) The variable cost is irrelevant, because if the client defaults, he's bankrupt and you can stop production, avoiding the variable cost. 
(d) You bear some risk related to output quantity and margin.
Initially, let's ignore the equipment as security, as well as the quantity risk. We'll touch on them, later. 

Hedging might conceivably be the prudent way to go to manage risk associated with the loan and the margin. At first glance, the actual loan payments and annuity are the sort of cash flows that you could replicate with the client's debt, and the promised loan payments and annuity are flows you could replicate with AAA debt. If so, then your ability to construct a hedge depends on your availability of hedge instruments. 

However, bankruptcy law handles lease payments, interest payments, and principal differently, and that may complicate the replication problem beyond solution. Even under the best of circumstances, appropriate instruments may not be available, and constructing the hedge is not a trivial matter. 

The equipment as security for the capital cost payments complicates the formation of the replicating portfolio. It seems clear that you will not find a perfect substitute for it in the marketplace. 

Dr. Risk cannot think of any way to hedge the quantity risk from the profit margin, without simply selling it in the market.  

You might be able to buy credit protection from a credit derivatives dealer. It would face precisely the same problems that you would face, but is likely to have greater expertise and market access, because it has been in the business. 

You could more easily buy insurance or a guarantee from an insurance company or a credit guarantor. Pricing is simple, but obscure. You describe the coverage you want, and prospective vendors name the premium. It’s not clear which actuarial model they would use, so it’s hard to duplicate the model. They diversify away the risk, so you probably couldn’t duplicate the protection by bypassing the insurer or guarantor.

If this protection is valuable, it doesn't come cheap. At some point the cure would be worse than the disease. Consequently, many suppliers in your situation just play with fire, and many get burnt. 

Please let us know if you need names of insurers, guarantors, or credit derivatives dealers. – Dr. Risk

7/28/00 Predicting the Probability of Default (7/28/00)

Dear Dr. Risk – Apart from KMV, what other models are being used  for forecasting the probability of default. Could you please throw some light on the relative performance of these models. Do you think that the credit rating agencies are doing a good job in terms of prediction of bankruptcy risk? How would you rate the rating agencies in this regard? – Amiyatosh

Dear Amiyatosh –  Dr. Risk can think of three main methods to forecast default, or compute or estimate the probability of default:
1. KMV / Geske
2. Strippring risk neutral probability of default from credit spread
3. historical relative frequency of credit rating migration 

Method 1. 
KMV has a way of taking accounting and market data about one company, producing the inputs that the Black-Scholes-Merton (1973) model requires, and then outputting the implied probability of default, N(-d2). Bob Geske has extended this to the simplest term structure of probabilities of default by using the Geske (1979) compound option pricing model. Using essentially the same data that KMV does, but refining things a bit, he produces a probability of default in the nearer period, then a conditional probability of default in the next period given no default in the first period.

Method 2. 
The second method is stripping the risk neutral probabilities of default from the price and coupon information on one name's debt issues of different maturities. Thus, given a one-year corporate bond and one-year sovereign debt in the same currency, one can make a few leaps of faith and deduce the risk-neutral probability of default during year one. Then you add the two-year corporate and sovereign to the mix and deduce the company's conditional probability of default during year two. And so on, and so on, and scooby, dooby, doo.

Method 3. 
The third main way to go is to use historical data for different credit ratings. Moody's and S&P produce and publish credit rating transition matrices. They describe the historical relative frequency of occurrences, such as "in one year  a BB bond became a AA bond 0.02% of the time." They also describe things, such as "in one year a BB bond defaulted 0.5% of the time". Of course, Dr. Risk just made up the specific numbers. If you want the real ones, get the tables from the agency.

How well do these methods perform? Dr. Risk saw Peter Crosbie's presentation on credit risk at a conference, recently. He had graphs that indicated that methods 1 and 2, using market data, showed marked deterioration in implied probability of default in advance of actual default. Dr. Risk doesn't have the impression that either of those methods was the undisputed king of early warning systems, and each has its methodological weaknesses. However, clearly, it appeared that both methods provided leading indicators of changes in credit ratings, and that is consistent with Dr. Risk's priors. – Dr. Risk  
P.S. What does your expert colleague at Cornell and my friend, Bob Jarrow, have to say about all this?

Modeling the credit risk of credit derivatives (6/28/00)

Dear Dr. Risk – How do practioners determine the amount of the exposure offset created by a long default swap, where the maturity of the default swap is less than the reference/underlying asset? I now for regulatory capital purposes there are policies set forth (eg: FSA in UK)  which outline the conditions but was interested to know want how bank's actually record the offset? – Peter

Dear Peter – In my experience, a default swap always matures when the underlying/reference note/bond matures. A total return swap may mature before the reference instrument matures.

You asked specifically about the impact of the default swap on exposure. A typical measure of exposure is replacement cost, or market value. I'd say it's probably still more common to look at exposure, deal by deal. 

In any case, a logical way to incorporate a short-dated total return swap on a long-dated note or bond into computation of credit exposure is to computer credit exposure, both before and after you add it to the portfolio of deals with the relevant counterparty. The change in exposure is simply exposure "after", minus exposure "before".  

It may make more sense to look at things in the proper portfolio setting, not deal by deal. Perhaps, consider the portfolio of all deals that should net, upon default. Also, exposure isn't the only measure of risk that one might use. Credit VaR comes to mind, although that has its drawbacks. – Dr. Risk

Pricing Credit Risk (6/28/00)

Dear Dr. Risk – We are looking for a good book on Pricing for Credit Risk and details of how and where to obtain it. – Sarie

Dear Sarie – Dr. Risk has links to books on credit derivatives at http://www.margrabe.com/CreditDerivatives.html and http://www.margrabe.com/DrRisksBookshelf.htm. Also, the Jarrow-Turnbull theory book that you'll find there covers pricing of credit derivatives at a sophisticated level. – Dr. Risk

Expected Loss on Retail Loans (6/28/00)

Dear Dr. Risk – I am interested in learn more about the probability of default, de loss given default rate, the expected loss in credit risk, particular for retail loans. Where can i find or download information about this topics? – Pablo

Dear Pablo – You could do a lot worse than looking at the resources available at http://www.margrabe.com/CreditDerivatives.html and http://www.margrabe.com/CreditRisk.html . Dr. Risk needs a more specific question to provide a more specific answer. For example, Dr. Risk doesn’t know what you mean by retail loans. You could mean real estate mortgage loans, commercial credit, etc. It’s not clear whether you are interested in theory or empirical work. If it’s theory, you can pick from several possible models that encompass elements of your question, mainly reduced form models, such as Jarrow-Turnbull and Duffie-Singleton. If it’s empirical work, the main data sources are the credit rating agencies. For individual credit, you might want to see what Fair Isaac has to say. – Dr. Risk

7/28/00 [more] (7/28/00)

Where did the CreditRisk+ Technical Document go? (5/28/00)

Dear Dr. Risk – I am a final year Finance/Maths student who is currently doing a research

As such, I would like to ask you a few questions: Firstly, would you know where I could get a copy of the CreditRisk+ Technical Document? It appears that it has been taken off the CSFP website.

I was also hoping to get your opinion on the current models and where you think improvements should be made and where the focus should lie. – Kristin

Dear Kristin – Dr. Risk checked the link from The Derivatives 'Zine to the CreditRisk+ technical document and confirmed that it was broken. Thanks for informing us. Next, Dr. Risk contacted Tom Wilde at CSFB, because he was the prime mover who innovated CreditRisk+. (GARP recently honored Tom as "Risk Manager of the Year", largely for that service to the risk management community.) Tom graciously informed us of the new location, http://www.csfb.com/creditrisk/. 

Concerning Dr. Risk's opinion on current models: Dr. Risk wouldn't want to deprive you of the opportunity to dig into the models and develop your own opinions. However, at the risk of coloring those opinions, here are some questions that Dr. Risk would try to answer while modeling credit risk. The answers to these questions will help shape a useful model:

1. Whose risk are we trying to measure? Shareholders'? Directors'? Traders'? Society's?
2. What do these people want to know about credit risk?
3. Does it make sense to differentiate credit and market risk? Does it make sense to combine them?
4. What should those people do about the risk?
5. Does the model provide any hypothetically useful answers to significant risk management questions?
6. What is the tradeoff between risk and reward, and does the model address it?
7. How good are the required data? How valuable is the model, given the available data?

– Dr. Risk

P.S. I wasn't able to open the documents that I downloaded. My old versions worked fine. Let me know if you have a similar problem.

How has the level of whatchamacallit been related to you-know in the past? (5/28/00)

Dear Dr. Risk –  what is the historic correlation pls between interest rates and credit, assuming underlying credit is investemnt grade. – roger

Dear roger – Dr. Risk is many things, but – alas – he's not a mindreader. Could you please provide a little context and explain why you want to know what you're asking? That way, Dr. Risk won't waste your time with detailed answers to questions that don't interest you. 

Let's take your question, almost word by word. 

• What do you mean by historic? Which time period? What part of the credit cycle?

• What interest rate? Interest rates in general? The yield on investment grade issues?

• What is "credit"? Credit spread? Credit quality? Credit quantity? 

Please help Dr. Risk help you. What are you trying to do? Why do you want this historical correlation? What model are you going to put it in? A credit derivatives pricing model? A credit risk management model? – Dr. Risk

Is the M&M theory of the cost of capital all wet? (4/28/00)

Dear Dr. Risk – I own shares of Kelda Group, which owns Yorkshire Water Services. It's definitely not "New Economy", and I'm pessimistic about its long-term prospects. Recently, I heard that Moody's is probably going to downgrade its bonds from A2, so its yield spreads widened. An analyst at Moody's said, "At the moment debt is cheaper than equity for water companies ..." Kelda is thinking about securitising its revenue stream to raise money.  (Aline van Duyn, "Credit reratings may hit water company bonds," Ft.com, 4/12/00) Do you agree that that's best? – Roy Poseidon 

Dear Roy – When you make a value judgment, such as what's "best", you have to first pick a set of values. In this case, stakeholders include 

• shareholders

• original bondholders

• new bondholders

• the bankruptcy bar

• Inland Revenue

Dr. Risk presumes that you would prefer to use your values, so your question is, "Do you agree that that's best for me?" or "... for original shareholders?" However, we'll have to consider the impact on other stakeholders to deduce the impact on you. 

Your question raises three of the major issues in corporate finance: 

• optimal investment 

• optimal capital structure

• optimal dividend policy

Of course, Dr. Risk will look at these from your point of view, not from some ivory tower. 

In any event, the buyers of the new bonds backed by the revenue stream should be indifferent to this scheme. If Kelda sells the bonds properly, these bondholders should pay a competitive price for their bonds. Good security, hence a high price. 

The bankruptcy bar benefits from any plan that significantly raises the probability of Kelda's financial failure, landing it in bankruptcy court. Roughly speaking, a decrease in a corporation's equity as a percentage of assets makes bankruptcy more likely. 

The Inland Revenue (the U.K.'s version of the U.S.'s IRS) is always sitting at the table, pounding the butt ends of its knife and fork against the table, demanding its piece of the pie that someone else baked. Dr. Risk doesn't know much about taxation in the U.K., hence would not care to speculate on the impact of Kelda's financing on the collections by the boys and girls at Somerset House (Inland Revenue's HQ). However, in the U.S., corporate finance decisions can significantly affect the corporate and personal tax bite out of any business operation.

You're not clear on Kelda's investment and dividend plans, hence on the destination of the funds raised. If Kelda is such an "Old Economy" investment, perhaps this is part of a scheme to disinvest and pay dividends or buy back shares. Either way, the same collateral would secure even more promises to pay, and the old bondholders would find the new bondholders in line ahead of them when it came time to seize collateral to get paid. Clearly, this would be bad for existing bondholders, neutral for the new bondholders, and good for shareholders, such as you.

Perhaps, Kelda plans to invest the funds in new plant and equipment, including prudent repairs on the old. Again, the new bondholders would be indifferent. The old bondholders would lose some collateral, but would gain a claim on new assets. Dr. Risk can't be sure of the overall impact on the shareholders and the old bondholders. The key issue is the probability distribution of asset value at the time the debt matures. If asset value exceeds debt, then the corporation will pay the bondholders in full. Otherwise, the corporation may default. A purchase of additional assets should tend to shift the probability distribution of future asset value to the right, which would be good for the bondholders. However, the investment might also affect the variability, which could be good or bad for the bondholders. Increased variability works against the bondholders, because it increases the value of the shareholders' (put) option to default. Increased variability could result from investment in a highly risky asset. Investment in an asset with negative correlation with the original assets decreases the variability of asset value. If that risky, future asset value will likely exceed (fall short of) the debt's face value, then decreased variability makes the bonds more (less) valuable, and increased variability makes the bonds less (more) valuable. – Dr. Risk

Waiter, would you recommend the Wiener ... or the Poisson? (4/28/00)

Dear Dr. Risk – I am familiar with the properties of Wiener Processes, but I would like to have a good reference (either book or article) explaining the basics of Poisson Processes. I need to do some Monte Carlo modelling of Jump-Diffusion processes, and I want to make sure I get the step size right to ensure I only get one jump (at most) per period. – Dr. B.

Dear Dr. B. – Dr. Risk has three suggestions, all on Dr. Risk's Bookshelf and through Amazon.com: 

1. They say nobody ever forgets his first time. For Dr. Risk, the first time he looked at Poisson's Theorem, the Poisson distribution, and Poisson processes was in Boris Gnedenko, The Theory of Probability (B.D. Seckler's translation of the fourth Russian edition. I found his discussions sometimes concrete, sometimes abstract, and always clear. You can now find Igor Ushakov's translation of the sixth Russian edition at Amazon.com .

2. Howard M. Taylor and Samuel Karlin, An Introduction to Stochastic Modeling. The explanations are also clear and thorough, and it's about stochastic modeling, which seems to be what you want.

3. A more theoretical book is Reza Iranpour and Paul Chacon, Basic Stochastic Processes; The Mark Kac Lectures. The book is based on the lectures at USC in 1982-1983 of Kac, one of the greats in probability theory. Sadly, this title is out of print, but Amazon will search used bookstores for a copy.

Dr. Risk hopes one of those books is what you want. – Dr. Risk

Risk vs. Reward in the "Full Monte" for Credit Metrics (10/28/98)

Dear Dr. Risk – i have [a] question ... concerned to risk-return-analysis Situation: If i use CreditMetrics (full mark-to-market version), the expected return of one exposure can be calculated as

 [(mean value - current value)/current value] - cost of funding

 Afterwards i can compare this return with the risk contribution of the exposure to the portfolio. The result is a relative ratio

My question: If i use CreditMetrics in a reduced form, that means i only consider default or non default (like CR+), i get a portfolio distribution of (potential) losses. I can analogous calculate the risk contribution for each exposure. What a measure for the expected return of each exposure should be chosen? – Mike

Dear Mike – In all seriousness, Dr. Risk's answer depends on his best guess of what you're really trying to accomplish, which you didn't state and which isn't obvious to Dr. Risk. Dr. Risk guesses that you want to develop a methodology  for making credit decisions by a sort of marginal analysis. You want to accept the loans that have a high ratio of reward to risk, reject the loans that have a low ratio of reward to risk, and find the dividing line between the acceptable and unacceptable loans. In order to do this, you clearly need a measure of reward and a measure of risk. You've adopted the marginal contribution to credit exposure, as CreditMetrics computes it, as the measure of risk. For CreditMetrics "Full Monte" Carlo simulation of mark-to-market, you're willing to use the excess of an asset's expected rate of return over cost of funding as a measure of reward. You want to know what measure to use when you are considering only losses. 

Dr. Risk could easily and truthfully answer, "The same measure of expected excess return over cost of funding will be just as valid in the 'reduced form' case as it was in the 'Full Monte' case." Unfortunately, that would be both true and misleading. The basic approach you want to take has the important and sometimes over-riding advantage of producing a decision rule, but the disadvantage of being "ad hoc" and even questionable. In academic terms, it doesn't have a firm theoretical foundation. In layman's terms, it doesn't really make sense. 

I see a basic similarity between what you want to do and what Harry Markowitz did  with portfolio theory – you want to pick the optimal spot on the tradeoff between reward and risk. So you're off to a good start. Your choice for reward is the same as Markowitz's. 

Your problems start when you pick a measure of risk (VaR) that Dr. Risk cannot imagine figuring directly into the decision maker's utility function. Markowitz chose variance as his measure of risk and Tobin justified it two ways, each sufficient by itself: (1) if the asset price distributions are normal, then variance is the natural and only measure of risk, (2) if the investor has a quadratic utility function, then you needn't go beyond variance to analyze risk. VaR as a rational measure of risk? Questionable, at best. (If you can come up with some sort of reasonable and rational argument for that, please call Dr. Risk at any hour of the day or night. This will be momentous news.) 

If your measure of risk is questionable, then your results will be questionable, regardless of your measure of expected return. I would suggest going back to first principles, figuring out how your decision maker makes decisions (e.g., expectation of quadratic utility of wealth) and/or how does the world  work (e.g., normal distribution of returns) and deduce your measures of reward and risk from there. Please, next time, bring Dr. Risk into the problem closer to the start, rather than at the end of seems to be a blind alley. – Dr. Risk

How safe are dollar deposits in various banks around the world? (9/28/98)

Dear Dr. Risk – I would like to know wich are the risk of the dollar deposits in:

 1- A International [i.e., foreign] Banking Facilty in the US
 2- In a us bank branch in London
 3- In a us bank in Hong Kong
 4- In a Mexican Bank in Mexico

– Rene

Dear Tommaso – While I'm asking some experts on this topic, please answer me this: Why do you care? Idle curiosity? – Dr. Risk

Dear Dr. Risk – I work for the Central Bank of my country, which have recently been upgraded in his credit rating and is seeking markets to invest. Also is a good subject to give in my class of International Banking and a good example for my students in the usage of the internet as a research tool. – Tommaso

Dear Rene – You closed off discussion of the thorny issue of devaluation by denominating all the accounts in dollars. Good move.

I spoke with a Wall Street professional ("Señor Wall Street") and a source closer than I to Alan Greenspan ("Deep Vault") The key issues that came up were (a) the sanctity of property rights, (b) the banking culture , (c) capital requirements, and (d) other regulations. Obviously, an "International Banking Facility" might be a bank of the U.S., U.K., Japan, etc. (you get the picture), or Mexico, Nigeria, etc. (you get the picture). So let's divide that into 

1a - A British Banking Facility in the U.S. 
1b - A Mexican Banking Facility in the U.S. 

All other things being equal, I would say that you put 2, 3, and 4 in the right order. The British Banking Facility in the U.S. would be right up there with the U.S. bank branch in London, maybe a little ahead or behind. I'm not sophisticated enough to know for sure which is better, and maybe nobody is. The point is that U.S. and U.K. banks are – with all their imperfections – relatively reliable wonders of the modern world, and we're fortunate to have them. Hallelujah! (Senior Wall Street thinks I'm too sanguine about prospects for U.S. banks during a recession with loan defaults and praises Swiss bank accounts, backed with gold reserves.) 

The Mexican Banking Facility in the U.S. would go between the U.S. bank in Hong Kong and the Mexican Bank in Mexico. Putting money in a Mexican bank has been a little like drinking Mexican water. Mexican banks in Mexico have a long record of ... uh, not being Swiss banks, and there is only so much that U.S. regulation can do to counter that. Think of U.S. regulation of a Mexican bank's U.S. branch as akin to an iodine tablet dissolving in a canteen of Mexican water. In theory, the iodine should purify the water, but would you really drink it, if you could drink New York City tap water, instead? Would you really put your money in a Mexican bank in New York, if you could put it in a New York city branch of a U.S. bank? The Hong Kong branch of CitiBank isn't quite as secure as a New York branch. However, the Communist Chinese have not yet proven that they are going to loot Hong Kong, and there is reason to hope that they may never do it: people aren't papering their walls with Hong Kong stock certificates. So, I'll give the U.S. bank in Hong Kong the benefit of some doubt. 

Here are comments from the experts: 

I. Señor Wall Street is a Mexican national who works on Wall Street. He rated the credit quality, as follows:

1. (best) US bank in US
2. Mexican bank in US
3. US bank in Mexico
4. Mexican bank in Mexico. 

As you can see, I didn't ask him your question, precisely. 

His argument is that US banks follow US practices and have US regulation. The foreign banks may have some freedom from US regulations and personnel certainly have bad habits from their hometown banking practices. Any money in Mexico is up for grabs! The US bank in Mexico has to fear some US regulation and scrutiny, which keeps it in line, and it has some protection, because the Mexican banditos don't want to anger the US without good reason. The Mexican bank in Mexico appears to have laws and rules to obey; however, the politically powerful can change them on a moment's notice, to confiscate some or all of deposits, capital, and equity.

As he explained, "In Mexico, in 1982 they nationalized banks, froze the accounts, and converted the dollar accounts into pesos at a confiscatory exchange rate. They didn't touch CitiBank, which was then mainly in the private banking business and had only accounts of prominent Mexicans. Carlos Salinas was President of Mexico. His brother, Raul, got 10% of every nationalization, hence his nickname, 'Mr. Ten Percent' ". (For a perspective on the dark side of the Mexican economy, look at http://www.cs.unb.ca/~alopez-o/politics/interoppenheimer.html.) 

II: Deep Vault spoke with me on the condition that I would not identify him or her. I can assure you that what he says is not an official position of the Federal Reserve Board, any Federal Reserve Bank, or anybody in the federal government. It's one person's opinion – in my estimation a very bright person's opinion – and for all I know he wasn't taking his medication. (However, for all I know he wasn't on any medication.) According to Deep Vault, "As it turns out, the question of supervisory control of foreign banking entities is a very sensitive issue. Historically (10+ years ago), branches and agencies of foreign banks were subject to significantly fewer restrictions that US banks, e.g. branching across state lines was not prohibited.  It is my understanding that US bankers were behind much of the most recent legislation regarding acceptable/unacceptable behavior by foreign bank branches and agencies.

"Let me now answer the questions addressed to Dr. Risk ... These are quite simple.  I believe the questions are asking about the riskiness of deposits in particular institutions.  This is a function of where the capital backing the deposits is located.  If the institution is a US bank, regardless of its location, at a minimum, it is subject to US regulations (Fed, OCC, FDIC, OTS, and/or state regulators); in particular, capital requirements.  Additionally, if the branch of the US bank is located outside of the US, it will be subject to local regs as well.  I cannot speak to the efficacy of these regs.  In some countries, they may be essentially nonexistent; in others, they may be onerous.  An International Banking Facility is not a legal entity; it has to do with off-shore banking.  I am not very familiar with these.  Deposits in US banks have US risk, regardless of where the deposits are located.  That is, the capital backing the deposits is in the US and is subject to US regulations.  If the deposits are in a Mexican bank, regardless of where the deposits are (Mexico or the US), these deposits are backed by capital in Mexico.  That capital is not subject to US regulatory authority.  US regulatory authorities only have authority over branches and agencies located in the US.

"Does all of that make sense?  In short, authorities in a country only have control over capital located in that country.  Foreign entities may be allowed to do business in that country, but there is no authority over the capital (its measurement, adequacy, etc.) that is located in the home country.   For that reason, if you deposit money in a branch of a foreign bank located in the US, you still bear the risk that the bank may be inadequately regulated in its home country.  It may go bankrupt and the US will have no control or authority over that resolution process.

"As to your additional questions ... General Information ... The specific answers to all these queries are in the Federal Reserve's Regulation K, which details the treatment of US branches of foreign banks and foreign branches of US banks. Before 1978, there was basically no federal oversight of US branches of foreign banks.  Each state established its own controls.  There was not coordinated oversight.  The International Banking Act of 1978 established federal oversight.  In 1991, the Foreign Bank Supervisory Enhancement Act was also passed. As it stands, a foreign bank must apply to the Federal Reserve.  We oversee supervision in the US.  The foreign bank may still be chartered as either a state or federal branch, which will affect which regulator oversees specific functions.

"Historically, the foreign bank could choose to be either insured or uninsured (that is the deposits).  Since 1991, all new insured branches must be capitalized here. When a branch is established, their license will specify exactly what types of activities it can engage in. Branches can be established as either retail or wholesale ($100,000 or greater per deposit).  Wholesale branches are established in large part to service high-net worth clients back in the bank's home country, i.e. to offer the safety of dollar-denominated deposits. There may also be restrictions on the source of deposits.  Some branches may only accept deposits from non-US residents. Again, all of this is spelled out in great detail in Regulation K.

"Who regulates...It depends on how the foreign branch is chartered and what services they provide.  It could be as many as five different regulators. There is a chart/matrix that shows which regulator is responsible for which function in which banks/branches.  It is huge.  I don't know know anyone who has memorized the entire thing.  It's ugly.

"Deposit structure...It depends on the type of license that the branch has as I indicated above.  Some branches may be restricted to a single type of deposit.  Others may be able to accept numerous types.  Again, Reg K.

"London and H.K...Host countries have jurisdiction.  You would have to get information from them about any specific rules and regs that apply to foreign branches in their countries.

"BIS requirements apply to countries that have adopted them.  In many instances though, specific requirements are left to the discretion of each country.  Additionally, many countries have different definitions of capital, i.e. is preferred stock Tier 1 or Tier 2 capital.  I don't want to get off on capital arbitrage, but I would imagine that certain forms of arbitrage are restricted in some countries and are all but encouraged in other countries.  This is a topic for another discussion.

"Mexico is an OECD country.  Interestingly, just before the crash in 1994, they were admitted to the OECD.  Instantaneously, loans to government entities in Mexico had no capital requirements (per the Basle Accord) as they were deemed riskless.  We all know what happened.  This exemplifies one of the many problems with the Accord's statutory limits; they are arbitrary.

"Hong Kong...I don't believe it is OECD, especially now that it is back with China.

"Deposits risk in specific institutions...and you want a simple answer...It depends on credit risk and transfer risk specific to that institution.

"Recommended readings/follow-up if you're really interested...
1. Regulation K (I have been told that it is actually very well-written; i.e., not your typical fed speak. ["Well-written" is a relative term and highly subjective, as a comparison of  Reg K with the writings of P.J. O'Rourke shows.]
2. The Fed recently (April 12, 1999) approved the establishment of a US branch of Banco de Credito e Inversiones S.A. (from Chile).  You might check the Fed's website (www.federalreserve.gov) to see if the Press Release is there.  I believe it will be.  It briefly explains the process that the Fed went through in approving the branch license.  Further, it defines the scope of the bank's allowed activities in the US.  In addition, it states that 'The Board [of Governors] generally also must determine that the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country supervisor.'  Also, 'Chile's risk-based capital standards conform to those established by the Basle Capital Accord.'
3. Economist article in Jan. 30th issue.  Go to The Economist's website and/or consult your library.  In the January 30th issue, there is a special pull out section entitled "A Survey of Global Finance," where you will find a discussion of many of the above issues. Specifically, see p. 8 of the survey for a discussion about how international investors poured $500 billion in short-term capital into Asian economies with known deficiencies in capital, financial accountability. See p. 11 about the Federal Reserve and the foreign branch approval process.
4. Contact Public Affairs at any Fed as they will have some officially prepared responses to many of the above questions.  I have been told that this is a particularly sensitive area.  We (the Fed) must be very careful what we say with respect to foreign bank supervision.

"In closing... Well, just imagine what the response would have been if I had truly researched the topic.  Actually, I found the questions were very interesting.  In fact, they were more interesting that what ever it was I was working on last week, so they got priority." 

 – Dr. Risk

International Ratings (7/28/99)

Dear Dr. Risk – How are derivative instruments rated internationally by rating agencies like S&P? What are the rating criteria and methodologies for rating these instruments? How are international corporate bond issues rated by international credit rating agencies? What are the methodologies and criteria used for rating these instruments? – Roy

Dear Roy – These are good questions, too good for good off-the-cuff answers. The quick answer is that to the rating agencies obviously have proprietary methodologies, but the methodologies aren't obvious to outsiders, and they differ both across rating agencies and over time for a given agency. If I look deeper into this, I'll update your answer. Meanwhile, use my links to the web sites for the rating agencies, such as Duff & Phelps, Fitch IBCA, Moody's, and S&P. 

Your mention of the word, "internationally", is crucial. International standards for accounting and other information are generally not as high as those in the U.S. Sometimes, the "standards" could qualify for the "Derivative Humor" page, except that the jokes are in bad taste. – Dr. Risk

Dissertation Topic: Credit Risk management of commercial loan portfolio (7/14/99)

Dear Dr. Risk – I am a financial economics student at the Amsterdam University. Currently I am working at a thesis about managing credit risk of commercial bank loan portfolio's and I am concentrating on the application of modern portfolio theory in managing risk and return of loan portfolio's. Although this is a very exciting subject with lots of different aspects, it is also very complex.

I have read a lot of articles and papers that deal with the issue (including the CreditMetrics and CreditRisk+ technical documents) and they all provided me with really interesting insights of how credit risk in commercial loan portfolios could be managed. Yet all authors seem to conclude that there is still a lot of work and researching that needs to be done in this field. Although this suggests that there are many opportunities for exciting research, I am somehow finding it difficult to focus on an aspect which would be value adding to the already existing literature on this subject. Maybe You could give me a few tips about what would be an interesting aspect to focus on. – Chris

Dear Chris – Sometimes, the world of credit risk management seems to have more in common with religion than with science. We have several "approaches" to credit risk measurement, which Anthony Saunders surveys in his new book, Credit Risk Measurement. You might think of these as analogous to the world's major religions. In this context, the BIS approach is an state religion, an "established church", such as England's Anglican Church. It's also something like voodoo, given its lack of sophistication. (In all fairness, the folks at BIS are not stupid – far from it. They realize the need to enter the 20th century, and they are looking for a better way to go.)

Few scientists have tried to find testable hypothesis in the approaches, few have tried to compare the approaches, and no one has provided the evidence to reject any of the approaches. (However, Bob Geske of UCLA and MKIRisk is doing promising research about the market's ability to predict the probability of default.) A dissertation that did any of these things would be a great contribution to the literature. I don't know whether the problem is one of empty theories, missing data, or just the lack of a recent financial crisis that would allow us to separate good theory from bad.

We don't have good data. The ratings agencies, such as Fitch, Moody's, Standard & Poor's, etc. have been working in this area for years and collected a great deal of data. However, we still don't have reliable data on things we would like, such as default rates, recovery rates, or default correlations. Banks have been making loans for decades, but useful data on credit losses haven't surfaced. Perhaps a bank would let you analyze its credit data. – Dr. Risk

Pricing credit risk (1/28/99)

Question: Dear Dr. Risk – I am a part-time PhD student and my thesis is about interest rate swaps and credit risk in banking industry. I would be grateful if you could give me some ideas and the current issues in this area and also it would provide economic value to the banking industry. I have read in fact alot of the journal articles related to this area, but I find that I got nowhere in the notations and find that some of the articles are too hard to fully understand. Any advice for me from an experienced Dr. like you? Your prompt reply would be much appreciated. Warmest regards from Downunder – Vic

Answer: Dear Vic – The intersection of interest rate swaps and credit risk is a busy corner. You're dissertation should focus on a minuscule portion of the action there, and the same is true of my answer. Since you mention the tricky notation, I'll guess that you are talking about pricing credit risk for bonds and swaps. That's my focus.

The literature and industry have three ways of pricing credit risk.

1. Static replication, used to price credit default swaps and total return swaps, is the most useful way for pricing credit derivatives, but only for some products. Buying protection via a credit default swap is equivalent to shorting the related floating rate note (FRN) and buying the corresponding AAA FRN. The related FRN has the same maturity, issuer, credit rating, seniority in bankruptcy, etc. The corresponding FRN is identical, but has a AAA issuer. The payoff on this portfolio equals a payment stream equal to the excess of the FRN coupon over the AAA FRN coupon, plus a contingent payment equal to the loss on the FRN upon default. In equilibrium, the value of the credit default swap should equal the value of the replicating portfolio.

2. The structural approach to credit default looks at a credit risky bond or swap as a credit riskless bond or swap, minus an option to exchange the bond or swap for the debtor's portfolio in bankruptcy. The approach is on sound theoretical footing, practical for a firm with a trivial capital structure, but questionable for a firm with a complex capital structure. The classic Black-Scholes (1973) paper and Merton's paper on risky debt are the inspiration for this literature.

3. The reduced form approach multiplies the states of the world, beyond the usual ones with interest rate derivatives, to include states where the debtor defaults. The risk neutral probability of default and the recovery rate in default are important variables here. The approach is theoretically correct, but has a few practical problems. The recovery rates, after default, are hard to come by. Deducing the risk neutral probability of default depends on knowing the recovery rates, having a rich set of debt instruments for the debtor, and assuming that default and the level of riskless rates is independent. Jarrow and Turnbull are apparently the originators of this line of thinking. Many others have pursued this line of research.

Unfortunately, I would say that approaches 2 and 3 are "not ready for prime time". One is hard pressed to come up with the required information on the debtor's portfolio to complete the structural model. One has to make assumptions about the recovery rate and often about the risk neutral probability of default. I'm not going to bet my money on either of these models at this time. However, one may not have the data need to make approach 1 work, either. Making markets in credit derivatives is not for wimps or firms with weak sales forces.

Complicated notation is a necessary evil in the world of credit derivatives, particularly for reduced form models. Some authors seem impelled to use needlessly complicated notation, but sometimes the complications are required. In either event, you just have to learn to love time and state subscripts. Best wishes. – Dr. Risk

Market skepticism about agency credit quality? (11/28/98)

Question: My question has to do with the widening of the spread between 10 year treasuries and mortgage rates. For as long as I can remember it has been 80/120 bases points over the 10 yr. T/B for a 30 year mortgage. A recent article in the NY Times said the spread has widened to over 200 B/P. If using either Fannie or Freddie as the issuer of the MBS with the implied guarantee of the US government how has the market assigned what appears to be a very high risk factor to this type of investment. [Today is 10/22/98.] I notice that the last question up-date was 9/28/98 so if you e-mail back a answer it would be appreciated. – Paul

Answer: I won't address your facts. I'll assume they are correct and try to explain how that could be consistent with rationality in the market. It's not clear that credit risk is the issue. I'll agree that Fannies and Freddies have little of that, although they don't have federal government guarantees, as far as I know, except for Fannie's limited "backstop authority".

The main issue here is the value of the borrower's prepayment option inherent in each loan that Fannie or Freddie buys. The more valuable that option, the more the borrower will pay for it. The borrower pays more by paying a larger coupon for a loan priced at par. The larger coupon leads to a larger yield to maturity and spread over the ten-year Treasury. Apparently, right now, that option is extremely valuable, which I don't find particularly amazing in this relatively uncertain world. See what has happened to volatilities in the Treasury bond market. I haven't looked, but would guess that they have risen.

Maybe the following illustration will be useful. If you buy the ten-year, noncallable Treasury, trading at par, then your coupon and yield to maturity will be a specific number, say 5% for ten years. (I'm making this up. I don't know the real number and don't really care. If you don't like 5%, use another number and make the appropriate changes, elsewhere.) If you had bought the ten-year, callable Treasury, trading at par, and its coupon were also five percent, then three things could happen:
(a) rates could rise and you would take an immediate capital loss, then receive your five percent, until maturity
(b) rates could remain the same and you'd collect your coupon to maturity with no regrets
(c) rates could fall and the Treasury would exercise its call option and take your notes back, forcing you to reinvest at a lower coupon.
For the Treasury, it's a "heads, I win, and tails, the lender loses" situation. The ten-year, noncallable Treasury with a coupon of 5% would be a poor investment for you, but a great funding coup for the the Treasury. The Treasury would be happy to pay a higher coupon, in exchange for that call option, and you'd be a fool not to demand it.

Similarly, the 30-year mortgage contains an embedded prepayment (American call) option. The lender demands a high coupon to pay for selling that option, and the borrower is willing to pay for the option that way. When the mortgage spread over the 10-year Treasury rises, it could be because of declining credit quality or because of increased time value for the embedded call option. – Dr. Risk

Credit risk (7/28/98; revised 11/28/98)

Question: Dear Dr. Risk – I research a litterature survey of the credit risk: How is credit risk measured? – Stephane

Answer: Dear Stephane – The short answer is, very badly.
1. The classic approach is that of "fractional exposure", which is a forecast of potential market value of a position – if positive. In its primitive form, this doesn't encompass correlation among credit risks.
2. The state of the art model seems to be along the lines of VaR, but with more mathematics, combining diffusion and Markov matrices. JP Morgan's CreditMetrics takes this approach. Currently, their model assumes that the forward curve is constant, to isolate credit deterioration from market risk. However, most credit deterioration comes from unfavorable market moves.
3. An actuarial approach, which starts by modeling default as a Poisson process, has its fans. CSFP's CreditRisk+ takes this tack. I suggest that they rethink their model of correlation among defaults.
4. Default rates rise (fall) during a recession (boom). In principal, one might forecast the business cycle to gain insight into default rates. Tom Wilson of McKinsey is pursuing this idea. Unfortunately, decades of research have taught us only that the stock market predicts the business cycle as well as everything else combined, so I think that Wilson's explorations will lead to dry holes.
5. Default is ordinarily a rational decision, where equity holders decide not to exercise the option to keep a firm alive. KMV has built an empire on this idea. The problem is quantifying the underlying asset's value and volatility, as well as the appropriate "strike" price.
Just about everything I've seen is highly suspect – not the mathematical reasoning, only the assumptions from which it derives. The problem is that much of the data you need to calibrate the models is not observable. I hope to write more on the topic later this summer or early in the fall, and I'll be offering courses on managing credit risk with credit derivatives in New York, Geneva, and London. Meanwhile, look at the books on credit risk, mentioned above. – Dr. Risk

Links Links related to credit risk are below. Links related to other financial topics are here.

Emerging Markets

• The Asian Crisis: Chronology and Other Episodes. 
• Central Europe Online. 
• Chronology of the Asian Currency Crisis and its Global Contagion. 
• Emerging Markets Companion. 
• Inside China Today. 
• The Russia Journal.

Methodologies

• BIS. Four papers guiding banks on credit risk management, plus other information.
• CreditMetrics. The RiskMetrics Group's free documentation of their methodology and data. "Four-fifteen" software for sale.
• CreditRisk+. CSFP's free technical documentation of their methodology in Acrobat (.pdf) format.
• Fair, Isaac. Credit scoring 
• Federal Reserve Bank of Chicago. Final Basle Committee Paper on Internal Controls
• Federal Reserve Bank of Chicago. Final Report on Internal Credit Risk Models.
• Federal Reserve Board of Governors. Credit Risk Models at Major U.S. Banking Institutions: Current State of the Art and Implications for Assessments of Capital Adequacy.
• Federal Reserve Board of Governors. Sound Credit Risk Management and the Use of Internal Credit Risk Ratings at Large Banking Organizations.
• FSA and Bank of England. Conference on credit risk.
• Gordy, Michael B.. "A Comparative Anatomy of Credit Risk Models", namely, JP Morgan's RiskMetrics vs. CSFP's CreditRisk+.
• Kamakura. Credit risk modeling. Site under construction.
• K.M.V. Corp. Technical papers in Acrobat (.pdf) format. Credit risk links. EDF^TM in action.
• Loan Pricing Corp. 
• Meridien research. Credit risk consulting. Reports are available to qualifying persons.
•  Skora, Richard. Lots of articles. 
• SSRN. "Bank Capital Requirements and Managerial Self-Interest".
• Turnbull, Stuart. "The Intersection of Market and Credit Risk."

Project Finance

• Perkins Coie LLP. Legal advice for independent power, transport, mining, and telecommunications projects.
• Thomson Finance. "Searching the globe for projects of merit" requiring more than $5 million. 

Ratings Agencies

• Clifford G. Dow. “An Explanation of 'Junk' Bond Ratings." 
• Duff & Phelps Credit Rating Agency. One of the major credit rating agencies.
• Fitch IBCA. One of the major credit rating agencies.
• Moody’s Investors Services. One of the major credit rating agencies.
• Standard & Poor's. Standard & Poor's Credit Ratings.
• Standard & Poor’s. One of the major credit rating agencies.

Regulation

• FDIC. "Summary of the Basel Committee's Consultative Document: 'A New Capital Adequacy Framework'."
• Bank for International Settlements (BIS). Basel Committee [on Banking Supervision]. "A NEW CAPITAL ADEQUACY FRAMEWORK - Executive Summary."
• BIS. Basel Committee. "A NEW CAPITAL ADEQUACY FRAMEWORK."
• BIS. Assorted publications.

Other

• Asset Forfeiture Collection Agency. If you're a creditor who needs help collecting, get help here. 
• Debt Collection Fast Facts. If you're on the receiving end of debt collection efforts, get advice here. 
• eCredit.com. Make credit decisions, collect after bad decisions, and finance equipment online.
• C-Bass.com. "Credit-based asset servicing and securitization."
• eReorg.com. Trading loans and distressed debt.
• GeoCities. Credit Risk Resources.
• Institute of Credit Management. The largest professional credit management organisation in Europe. 
• NetExposure. Special issue devoted to credit risk.
• Partnoy, Frank. "The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies."
• RiskCenter.com. An on-line source of news about risk.
• Jim Rosenthal and Juan Ocampo. Securitization of Credit. John Wiley & Sons, U.S., 1988. 
• Term Sheets for Local Currency Debt.
• Warburg Dillon Read. "European Credit Indices." 
• PETER A. WUFFLI AND DAVID A. HUNT. Fixing the credit problem. (The McKinsey Quarterly, 1993 Number 2, pp. 93—106.) A practical guide to rethinking the organization and management of a bank’s credit processes. 

Derivatives Dictionary^TM  Terms and definitions relating to credit risk are below. The main Derivatives Dictionary^TM is here. 

Here we have only terms relating to credit risk. Find the entire Derivatives Dictionary^TM at www.margrabe.com/Dictionary.html. 

AAA, Aaa

Definition: The highest credit rating that Fitch IBCA, Moody's, and Standard & Poor's issues to fixed income securities, particularly long term securities, such as notes and preferred shares. For example, Fitch IBCA writes, "Bonds and preferred stock considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal, which is unlikely to be affected by reasonably foreseeable events."
Example: An extremely sound public corporation might issue AAA 10-year notes.
Application: Investors look to debt ratings to tell them how great is the probability of getting the promised return on investment. The highest credit ratings indicate that the debt is "investment grade" (q.v.).
Comment: Other ratings on securities not in default are combinations of A's, B's, C's, 1's, 2's, and 3's.

adverse selection

Business: The problem of doing business with people and firms who get the most from you and give you the least. 
Credit risk: The problem of doing business with relatively many borrowers who have lower credit quality. This ordinarily results from offering credit on excessively attractive terms to borrowers with lower credit quality, but not sufficiently attractive terms to borrowers with higher credit quality. This problem can arise when the lender's credit rating granularity (q.v.) is courser than his competition's.  

Basel Committee

The Basel Committee on Banking Supervision. A committee of the Bank for International Settlements (BIS). It's focus is on the health of commercial banks involved in international finance.  

Bank for International Settlements (BIS) 

The major international organization for central banks, created at the Hague Conference in January 1930. Its owners are central banks, mainly from the developed world, but increasingly from Asian and Africa. The BIS holds deposits of some 120 national central banks. It's mission has been to facilitate international money flows. 

Capital Accord 

The Basle Committee's (q.v.) July 1988 Capital Accord is the "constitution" of central bank regulation of of commercial bank capital. 

credit rating granularity

Definition: The number of distinct credit ratings in a ratings system. 
Comment: The minimum granularity is two ratings – good and bad, essentially. Some banks use little more than those categories, essentially. The current record holder for finest granularity is Moody's RiskScore™, with 901 grades from 1.00 to 10.00.   

Derivative Products Company (DPC)

A subsidiary that exists solely as a secure home for some of its parent’s financial transactions, contracts, and derivative products. The DPC’s credit rating typically exceeds the parent’s, because the parent infuses it with a large amount of capital, compared to the credit exposure that that DPC counterparties have to it. In case the parent is insolvent or bankrupt, the DPC might either continue (continuation structure, q.v.) or terminate (termination structure, q.v.).

documentation basis risk

Definition: The risk that the documentation of two apparently identical contracts will differ significantly on details, thus destroying what a hedger thought was a perfect hedge.
Example: A GKO repo and a total return swap are two financing transactions that might differ in details, such as settlement period or term to maturity.  (Marlisa Vinciguerra (Lehman Brothers), at the GARP 2000 1st Annual Risk Management Convention.)  

documentation risk

The risk that counterparties will change their minds after they agree on telephone, but before they sign the papers. (Marlisa Vinciguerra (Lehman Brothers), at the GARP 2000 1st Annual Risk Management Convention.)  

DPC

Derivative Products Company (q.v.).

EDF^TM

Definition: The acronym for Expected Default Frequency^TM (q.v.). 

Expected Default Frequency^TM (EDF^TM)

Definition: The probability of default during the coming year or years, according to the KMV (q.v.) methodology. Essentially, the risk neutral probability of the shares -- as options on the underlying assets -- ending up out of the money. Obtained by combining some proprietary data and assumptions with the Nobel-Prize-winning Black-Scholes-Merton (1973) option pricing model. 

KMV

Definition: The acronym for Kealhofer, McQuown, & Vasicek, the originators of the KMV methodology, including Expected Default Frequency^TM (q.v.). 

expected loss

Definition: The probability of default x exposure x expected loss rate given default.  
Comment: Easy to say and write. Just try to estimate them. One way to estimate probability of default is from historical frequency of default., a characteristic of the borrower or issuer. Historical recovery rates after default indicate prospective expected loss rates, which are characteristic of the type of issue. 

external risk grading system

Definition: A third party's system for rating credit quality, such as that of Duff & Phelps, Fitch IBCA, Moody's, or S&P.

investment grade

Definition: Having credit quality consider not speculative. In the Fitch IBCA scale, investment grade means from AAA down to BBB.
Example: An investor who did not want to take place a bet on credit quality would want to stick to investment grade securities, and perhaps those with highest ratings, such as AAA (q.v.).
Application: Fiduciaries find the expression particularly useful, because investing only in investment grade securities reduces the probability of a lawsuit from the beneficiaries of trusts, etc.
Comment: The meaning of investment grade is vague and subjective. One persons investment grade instrument might be another's speculative one. Even an investment grade security has a positive probability of default, small though it may be.

GKOs

Russian government Treasury bills.

Group of Ten (G10)

Eleven (!) industrial countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States) which "consult and co-operate on economic, monetary and financial matters."

highly levered institution (HLI)

A financial institution with a high ratio of borrowing to assets and a consequently low ratio of equity to assets. The classic example is a hedge fund, and Long Term Capital Management (circa 1988) certainly fit the definition. However, commercial banks and investment banks tend to be highly levered, compared to most other types of companies. 

internal risk grading system

A lender's credit rating system, as opposed to the system that a third party, such as Duff & Phelps, Moody's, or S&P uses.   

KKR terms

Favorable terms in leveraged loan agreements for buyout firm Kohlberg Kravis Roberts & Co., namely, (a) only stock as collateral, rather than specific assets and (b) a lower rate of interest on KKR debt than for similar, non-KKR debt. Recent buyers of KKR unsecured loans have taken hits – loans for the now-bankrupt Bruno’s are trading at 58% of face value. Consequently, the banking syndicate (Deutsche Bank AG, Citigroup Inc., and J.P. Morgan & Co.) is still holding most of the $616 million syndicated loan it arranged for KKR’s Alliance Imaging Inc. (Paul M. Sherer, “Loan Investors Balk at ‘KKR Terms’ for Deal, Wall Street Journal, 12/2/99.)

London Club

A group of commercial banks that joined together to negotiate the restructuring of their claims against a sovereign debtor, such as Russia. Cf. Paris Club.

OFZs

Russian government Treasury bonds.

OVZs

Long term, hard currency bonds that the Russian Ministry of Finance issued. Known as "Taiga" bonds or "MinFins".

Paris Club

A group of government lenders that joined together to negotiate the restructuring of their claims against a particular sovereign debtor. Cf. London Club.

RAROC

Risk-Adjusted Return On Capital. A family of methods for adjusting the realized rate of return on capital for some measure of risk. The academic world's Nobel Prize winning theory says that the adjustment should be for "systematic", "market", or "beta" risk. The banking world's practice is to adjust for  "variance" or "volatility" risk.

stress test

A simulation of what might happen under extreme market conditions, such as an extreme move in the forward curve, market volatility grid, or correlation matrix. 

termination structure

A design for a DPC (q.v.) that liquidates when the related name defaults. Cf. continuation structure.

Vnesh, Vnesheconombank

A "state-owned financial institution whose primary role is to hold the US$33 billion international debt obligations of the former Soviet Union." ("BANK OF AMERICA CONFIRMED AS AGENT FOR US$24 BILLION RESTRUCTURED RUSSIAN DEBT," http://www.bankamerica.com/batoday/news227.html)

Derivatives Digest^TM

8/28/00 The Fragile Middle Class, by Teresa A. Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook. New Haven: Yale, 2000. (Reviewed in the New York Times (2000 August 24) by David Frum.

In 1996 personal bankruptcies in the U.S. surpassed one million for the first year in history. Bankruptcies are five times as frequent as they were in 1979. They increased faster during the boom years after 1994 than they did during the recession years of 1981-1982. In 1980 the bankruptcy rate in the U.S. was 130, compared to Canada's 85 and the U.K.'s 8.

Why do we see so much bankruptcy in the U.S. now, compared to the past? Why so much bankruptcy in the U.S., compared to abroad? Here are some possible reasons, in no particular order:

• The U.S. bankruptcy law became much more liberal in 1978.
• The U.S. economy is more turbulent, throwing people out of work.
• Divorce and bankruptcy often go together, particularly for women.
• The U.K. has a better social net and credit is less available.

The U.S. has a high rates of bankruptcy and divorce. Why?

• In the U.S. it's easy to borrow, with lenders almost throwing themselves at anyone over the age of 18. Borrowers are likely to find themselves on hard times, because the it's easy to fire workers and competition among businesses is intense. Borrowers who find themselves over their heads can easily go bankrupt, because of the easy 1978 Act. 
• In the U.S. it's easy to marry. Married couples are likely to find their marriages stressed, because extramarital sexual partners are readily available to men and women, and because woman can often find jobs that support them better than available men can. Married persons who want out of marriage can divorce easily, because of American divorce laws -- they don't even have to claim that their partners did anything wrong. 

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Books

Saunders, Credit Risk Measurement (7/28/99)

Dear Dr. Risk – This week I found out about a new book on credit risk measurement due to be published in June/July called "Credit Risk Measurement; New approaches to value at risk and other paradigms", by Anthony Saunders (see also the picture of the book-cover below). Maybe you heard/read about this book as well. I am very interested in your opinion, is it worth buying? – Chris

Dear Chris – I saw this book when I was browsing in the McGraw-Hill Bookstore, last week. It looked like a good survey of methods for credit risk measurement, with separate chapters on the KMV, CreditMetrics, McKinsey macro, KPMG, and CSFP approaches. So I bought it and think it was a good purchase. It's moderately technical. It may overwhelm away the less quantitative. It provides the basics for system developers, but at some point they will want more technical details, some of which are on web sites for which links appear on this page. – Dr. Risk

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Presentations

Other Coming Conferences and Presentations

William Margrabe's Past Credit Derivatives Presentations

COURSE OUTLINE for "Managing Credit Risk with Credit Derivatives."

Day One – Credit Risk Measurement and Management
Morning Session – Overview
What is Credit Risk?
Why is Credit Risk Important?
How can we measure Credit Risk?
How can we manage Credit Risk?
Afternoon Session – Models
Modeling credit exposure
RiskMetrics Group’s CreditMetrics^TM
CSFP’s CreditRisk+
KMV’s expected default frequency
Tom Wilson's (McKinsey) macro approach to probability of default

Day Two – Credit Derivatives
Morning Session – Overview
What are the main Credit Derivatives structures?
Total return swaps, credit default swaps, and structured notes
Credit spread derivatives
First-to-fail, tranched, and other basket derivatives
Exotic credit derivatives
How do Credit Derivatives work?
How can we can apply Credit Derivatives?
Afternoon Session – Models
Arbitrage pricing of credit derivatives
Correlation of credit risks
Deriving risk neutral probability of default from riskless and risky term structures
The "structural" or "contingent claim" approach to pricing credit derivatives
The Black-Scholes-Merton model
The "reduced form approach" to pricing credit derivatives
The Jarrow-Turnbull (1995) model

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