1 © 2003 Barra, Inc. All rights reserved. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT...

1© 2003 Barra, Inc. All rights reserved.

JEAN-MARTIN AUSSANTDIRECTOR

FIXED INCOME PRODUCT STRATEGY

PRMIALONDON

18 MAY 2004


Recent market environment

New market-implied techniques to manage credit risk

Introduction to the BDP (Barra Default Probability)

Practical Examples

Questions and answers (assuming I have the answers)

Discussion OutlineDiscussion Outline





Practical Examples

Questions and answers



Equity declines drove re-allocations to fixed income

Simultaneously government yieldsdecreased to all time lows

Credit default rates neared all time highs

Pension fund shortfalls (Focus on ALM)

Credit markets are increasingly complex

Universe of assets is expanding rapidly

Spread products are becoming more complicated

Limited headcount to cover expandingnumber of issues

Market Forces Change the Rules of Credit InvestingMarket Forces Change the Rules of Credit Investing


Currently Very Few Easy OpportunitiesCurrently Very Few Easy Opportunities

End of the bear credit market in 2003

Spreads have tightened to extreme levels

Lowest since 1998

Demand still high

Non-traditional investors

Source: S&P


Outperformance Is More Demanding Than Ever Outperformance Is More Demanding Than Ever

Are we being correctly compensated? Risk premium close to zero

How does a long-only investor win/outperform? Spreads have nowhere to go

Move to Lower-quality / higher-yielding Find names with value still

Asset selection is key


One Default Can Negate Entire Portfolio’s ReturnOne Default Can Negate Entire Portfolio’s Return

Credit market is strongly asymmetric

Earning the spread has become extremely difficult over the past few years

Unprecedented market conditions with record downgrades and defaults Source: Lehman Brothers, 2002


Fundamental Analysis Alone Is Not EnoughFundamental Analysis Alone Is Not Enough

Judgment of experienced analysts remains essential

However, judgment often impaired by questionable data

Nearly 1000 accounting re-statementsin the last three years (source: SEC)

Creative accounting

What’s required is a more efficient process to monitor, screen, and select credit-risky investments


Gaining the Advantage in Credit InvestingGaining the Advantage in Credit Investing

To successfully manage credit, you need

Earlier, more accurate prediction of potential default risk

Models that allow for the real-world uncertainty of financial statements

Tools to make your credit analysis process more efficient





Practical Examples




Market-Implied Measures Provide Additional InsightMarket-Implied Measures Provide Additional Insight

Market-implied measures from the:

Equity Market – Barra Default Probabilities (BDP)

Bond Market – Barra Implied Ratings (BIR)

Derivatives Market – Credit Default Swaps (CDS)

Coming soon…

Crossover – Empirical Credit Risk (ECR)Equity Risk Implied Spreads (ERIS)


Equity Market – BDPs Go Beyond Traditional ModelsEquity Market – BDPs Go Beyond Traditional Models

BDP advantages

Incomplete Information framework assumes fundamental data may be flawed

Use of Barra’s industry standard equity volatility forecast

Empirical study of

historical leverage

Barra’s model signals significant uptrend in default risk months earlier


Bond Market – BIRs Lead Agency RatingsBond Market – BIRs Lead Agency Ratings

Barra Implied Ratings take the bond market’s perspective on credit and match it to a best fit distribution ofactual ratings

Barra ImpliedRatings typicallycan lead agency ratings by as much as three months

Barra’s measures provide earlier warning to possible downgrade


Derivatives Market – CDS Market a Leading IndicatorDerivatives Market – CDS Market a Leading Indicator

Credit Default Swap (CDS) rates often provide leading indication of risk and value

CDS market is exploding: more than $4 trillion notional outstanding andmost big names actively traded(source: BBA)

-80

-60

-40

-20

0

20

40

60

80

100

120

140

2-Jan-02 13-Mar-02 23-May-02 1-Aug-02 17-Oct-02 6-Jan-03 20-Mar-03 2-Jun-03 11-Aug-03 22-Oct-03

Time

Sp

read

(b

p)

Cash-CDS basis 5 Year CDS rate 5 Year CM Asset Swap Spread

Cash-CDS Basis HistoryMerrill Lynch (5 Year USD)





Practical Examples




Current Quantitative Default ModelsCurrent Quantitative Default Models

Structural or Cause-and-Effect approach (Merton)

Default happens for a reason

Firm-specific information canbe used advantageously

Reduced form approach

Default rates can be analysed statistically

Ad hoc, exogenously-given, default rate


Merton’s Structural Model of DefaultMerton’s Structural Model of Default

Default occurs at debt maturity if the firm valueis below the liabilities value

We thus need

A model of firm value process

Estimate of default point

Merton identified equity as being long a call option on the firm value

Merton identified a bond as being short a put option on the firm value


Payoff at maturity of the bond

Value of the Equity at maturity time T

Value of the Bond at maturity time T

i.e. default free bond + short European put on V @ K


i.e. European call on V @ K



0

D

V0

No Default

Probability of Default

Default

T


Reduced Form ModelsReduced Form Models

Assume that default is totally unpredictable

Default comes unannounced

Based on a conditional default rate or intensity

Exogenously given

Fit well to market data including short credit spreads

Ad hoc, lack intuitive appeal

The picture: ?


Model ComparisonModel Comparison

Based on a model definition of default

Intuitive, appealing

The default time is often (implicitly) predictable

Hard to fit to empirical data

Based on an exogenously given default rate

Ad hoc

The default time is always totally unpredictable

Easy to fit to empirical data

Structural / Cause and Effect

What we want: a hybrid model

Incorporate the best features of structural and reduced form

Avoid their pitfalls

Reduced Form


The Barra Default Probability (BDP) ModelThe Barra Default Probability (BDP) Model

A genuine hybrid of cause-and-effect (structural) and reduced-form models (compensator approach)

Based on a default time that is not predictable

Makes use of all publicly available liabilitystatements and equity market data

Assumes investors have incomplete information

Calibrates easily to short credit spreads

Intuitive and appealing


Barra Default Probability Model – IntuitionBarra Default Probability Model – Intuition

0

V0

T

Distribution of possible default boundary levels

Paths of Asset Value Process

Expected level of default barrier

Width represents ‘uncertainty’ in the default barrier level

Time

Ass

et V

alu

e


Default Barrier – Scaled Beta DistributionDefault Barrier – Scaled Beta Distribution

Mean = current debt

Standard deviation, calibrated or user-configured


BDP Model – Uncertainty Can Be VariedBDP Model – Uncertainty Can Be Varied

IBM One Year Default Probabilities

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

4/19/2001 9/16/2001 2/13/2002 7/13/2002 12/10/2002 5/9/2003

Pe

rce

nt

Barra Default Probability Model

Variant 1

Variant 2

Variant 3


BDP Model – A Firm Becomes DistressedBDP Model – A Firm Becomes Distressed

United Airlines Term Structures of Credit Spreads

0

50

100

150

200

250

300

350

400

0 0.2 0.4 0.6 0.8 1 1.2

Maturity (years)

Ba

sis

Po

ints 9/17/2001

9/10/2001

Credit term structure steepens and short-term spreads increase


BDP Model Subtlety – Healthy FirmBDP Model Subtlety – Healthy Firm

General Electric Term Structures of Spreads

0

5

10

15

20

25

30

0 0.2 0.4 0.6 0.8 1 1.2

Maturity (years)

Sp

rea

d (

ba

sis

po

ints

)

4/15/2002

4/10/2002

15% drop in equityCredit term structure steepens but short-term spreads barely move


MODEL FORECAST

Event (+)

Non-Event (-)

REAL WORLDEvent Non-Event

True Positive False Positive

False Negative True Negative

Testing the Model – ROC CurvesTesting the Model – ROC Curves

Radar Operators in WWII: Plane (or flock of birds)?

Medical Diagnosis: Is this person’s Thyroid OK?

Astronomy: Is this a Planet?

Marketing Analysis: Will this household buy insurance?

Credit Risk: Will this name default?


ROC Curves – Merton ComparisonROC Curves – Merton Comparison

ROC Curves for 1999-2002

0.00.10.20.30.40.50.60.70.80.91.0

0.0 0.2 0.4 0.6 0.8 1.0

False positives

Tru

e p

os

itiv

es

Merton

BDP

Random Method


ROC Curves – First Passage ComparisonROC Curves – First Passage Comparison


0.00.10.20.30.40.50.60.70.80.91.0

0.0 0.2 0.4 0.6 0.8 1.0

False positives

Tru

e p

os

itiv

es First Pass

BDP


ROC Curves – Moody’s Rating ComparisonROC Curves – Moody’s Rating Comparison


0.00.10.20.30.40.50.60.70.80.91.0

0.0 0.2 0.4 0.6 0.8 1.0False positives

Tru

e p

os

itiv

es

BDP

Moody’s Rating





Practical Examples




BIR – Good Complement to Agency RatingsBIR – Good Complement to Agency Ratings

ZOOM

ZOOM


BDP – Outlier IdentificationBDP – Outlier Identification

Inspecting ‘like-credits’ in a new way can sometimes turn up opportunities or threats

USD BBB Consumer Cyclicals Average BDP = 0.20%Toys ‘R’ Us BDP = 4.97%

Source: Barra Credit


BDP – Warning of Toys R Us’ Downgrade?BDP – Warning of Toys R Us’ Downgrade?

Bond implied ratings moved in October as well

A few days later spreads widened, and months later Toys R Uswas downgraded to below investment grade (junk)



BIR – Mandate RestrictionsBIR – Mandate Restrictions

Early warnings of Potential Downgrades can allowmanagers to exit worrying names before the flood

The Bond Market was pricing in concerns back in Septemberwhen the Barra Implied Rating for Parmalat dropped to Sub-IG



BDP – Early WarningBDP – Early Warning

The equity market was also signalling concerns for Parmalat

The BDP moved well into HY levels before December

Parmalat - 1-Year Barra Default Probabilities

0

2

4

6

8

10

9/1/03 10/1/03 11/1/03 12/1/03Time

1-Y

ea

r B

DP

€ 0

€ 500,000,000

€ 1,000,000,000

€ 1,500,000,000

€ 2,000,000,000

€ 2,500,000,000

€ 3,000,000,000

Eq

uit

y M

ark

et

Ca

p

Barra Default Probability - 1 Year Equity Market Cap


Investment Grade (approximately)..


Capital Structure ArbitrageCapital Structure Arbitrage

Differing views from two markets on the capitalstructure point out interesting opportunities

FedEx’s announcement of its planned acquisitionof Kinko’s triggered concern implied by the equity

market but not reflected in bond spreads



Market-Implied Measures Offer More InsightMarket-Implied Measures Offer More Insight

Parmalat - 1-Year Barra Default Probabilities

0

2

4

6

8

10

9/1/03 10/1/03 11/1/03 12/1/03Time

1-Y

ea

r B

DP

€ 0

€ 500,000,000

€ 1,000,000,000

€ 1,500,000,000

€ 2,000,000,000

€ 2,500,000,000

€ 3,000,000,000

Eq

uit

y M

ark

et

Ca

p

Barra Default Probability - 1 Year Equity Market Cap



Research Papers and More InfoResearch Papers and More Info

www.barra.com

Datasheets

Flash Demos

Research Papers

Practitioner Papers

Conference Attendance


[email protected]

1 © 2003 Barra, Inc. All rights reserved. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT...

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Transcript of 1 © 2003 Barra, Inc. All rights reserved. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT...