Abstract
Corporate credit ratings remove the information asymmetry between lenders and borrowers to find an equilibrium price. Structured finance ratings, however, are informationally insufficient because the systematic risk of equally rated assets can vary substantially. As I demonstrate in a Monte Carlo analysis, highly-rated structured finance bonds can exhibit far higher non-linear systematic risks than lowly-rated corporate bonds. I value credit instruments under a four-moment CAPM, between and within some markets there is no one-to-one relation between expected loss (rating) and credit spread (pricing). The linear CAPM beta is insufficient, buyers and sellers need also the same information on non-linear risk to have an equilibrium.
Highlights
The expected loss of a credit instrument comprises an assessment of default probability as well as loss expectation in the event of a credit default
I will show in an empirical application that the huge losses at the trading desks of two Wall Street titans, namely Morgan Stanley and UBS, were basically realized with a capital asset pricing model (CAPM) beta of zero but with considerable non-linear systematic risk
To demonstrate the often non-monotone relation between rating and systematic risk of various credit instruments, I create a stylized market with underlying digital bonds, i.e., bonds which can be synthetically replicated by digital default swaps
Summary
The expected loss of a credit instrument comprises an assessment of default probability as well as loss expectation in the event of a credit default. I derive a four-moment CAPM under standard risk aversion to characterize the quality of a credit instrument by four fundamental real-world factors (i.e., three systematic risk factors in addition to the rating factor) to provide an elementary relation between risk and price. I will show in an empirical application that the huge losses at the trading desks of two Wall Street titans, namely Morgan Stanley and UBS, were basically realized with a CAPM beta of zero but with considerable non-linear systematic risk These “hedged” structured finance portfolios had no covariation with the market and were no economic assets (β > 0) in the sense of Coval et al (2009a) but no actuarial claims whose risk could be diversified away in large portfolios.
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