Management Insights

In its complexity and its vulnerability to market volatility, the constant proportion debt obligation (CPDO) might be viewed as the poster child for the excesses of financial engineering in the credit market. This paper examines the CPDO as a case study in model risk in the rating of complex structured products. We demonstrate that the models used by Standard and Poor's (S&P) and Moody's fail in-sample specification tests even during the precrisis period and in particular understate the kurtosis of spread changes. Because stochastic volatility is the most natural explanation for the excess kurtosis, we estimate an extended version of the S&P model with stochastic volatility and find that the volatility-of-volatility is large and significant. An implication is that agency model-implied probabilities of attaining high spread levels were biased downward, which in turn biased the rating upward. We conclude with larger lessons for the rating of complex products and for modeling credit risk in general.This paper was accepted by Wei Xiong, finance.

I derive pricing kernels in which the market volatility is endogenously determined. Using the Taylor expansion series of the representative investor's marginal utility, I show that the price of market volatility risk is restricted by the investor's risk aversion and skewness preference. The risk aversion is estimated to be between two and five and is significant. The price of the market volatility is negative. Consistent with economic theory, I find that the pricing kernel decreases in the market index return and increases in market volatility. The projection of the estimated pricing kernel onto a polynomial function of the market return produces puzzling behaviors, which can be observed in the pricing kernel and absolute risk aversion functions. The inclusion of additional terms in the Taylor expansion series of the investor's marginal utility produces a pricing kernel function of market stochastic volatility, stochastic skewness, and stochastic kurtosis. The prices of risk of these moments are restricted by the investor's risk aversion, skewness preference, and kurtosis preference. The prices of risk of these moments should not be confused with the price of risk of powers of the market return, such as coskewness and cokurtosis. This paper was accepted by Wei Xiong, finance.

Derivative instruments attempt to protect a portfolio against failure events. Constant proportion portfolio insurance (CPPI) and constant proportion debt obligations (CPDO) strategies are recent innovations and have only been adopted in the credit market for the last couple of years. Since their introduction, CPPI strategies have been popular because they provide protection while at the same time they offer high yields. CPDOs were only introduced into the market in 2006 and can be considered as a variation of the CPPI with as main difference the fact that CPDOs do not provide principal protection. Both CPPI and CPDO strategies take investment positions in a risk-free bond and a risky portfolio (often one or more credit default swaps). At each step, the portfolio is rebalanced and the level of risk taken will depend on the distance between the current value of the portfolio and the necessary amount needed to full all the future obligations. In a first step the functioning of both products is studied in depth concluding with drawing some conclusions on their risky-ness. How to obtain EU publications Our priced publications are available from EU Bookshop (http://bookshop.europa.eu), where you can place an order with the sales agent of your choice. The Publications Office has a worldwide network of sales agents. You can obtain their contact details by sending a fax to (352) 29 29-42758. The mission of the JRC is to provide customer-driven scientific and technical support for the conception, development, implementation and monitoring of EU policies. As a service of the European Commission, the JRC functions as a reference centre of science and technology for the Union. Close to the policy-making process, it serves the common interest of the Member States, while being independent of special interests, whether private or national. LB -N A -2376-EN -C

In its complexity and its vulnerability to market volatility, the CPDO might be viewed as the poster child for the excesses of financial engineering in the credit market. This paper examines the CPDO as a case study in model risk in the rating of complex structured products. We demonstrate that the models used by S&P and Moody's would have assigned very low probability to the spread levels realized in the investment grade corporate credit default swap market in late 2007, even though these spread levels were comparable to those of 2002. The spread levels realized in the first quarter of 2008 would have been assigned negligibly small probabilities. Had the models put non-negligible likelihood on attaining these high spread levels, the CPDO notes could never have achieved investment grade status. We conclude with larger lessons for the rating of complex products and for modeling credit risk in general.

Constant Proportion Debt Obligations: A Post-Mortem Analysis of Rating Models

Pricing Kernels with Stochastic Skewness and Volatility Risk

We investigate the pricing of market volatility risk as a risk factor—the innovation risk and as a characteristic risk—the level risk. We find that the pricing of the country‐level (local) market volatility risk factor is not robust across 21 developed markets and that the global market volatility risk factor prices 21 developed market portfolios after controlling for global market, value, and size factors. Capturing various market information, idiosyncratic market volatility as a country‐specific characteristic risk dominates global market, value, size, and market volatility risk factors in predicting returns of market portfolios. Countries with higher investor protection and accounting standards have higher country‐specific market volatility. Market volatility is higher in these countries because corporate managers take higher risks on innovative projects that benefit economic growth.

Credit Default Swap Spreads and U.S. Financial Market: Investigating Some Dependence Structure

Under Basel II framework, credit risk assessment is of high significance in the light of correlation risk. Correlation risk is often envisioned along with business conditions and financial market’s impact. We employ copula methodology to identify the dependence structures that may exist between market risk fundamentals and credit risk fundamentals. Considering credit derivative spreads as credit risk fundamentals and market data as market risk determinants, we describe and quantify the asymmetric link prevailing between credit risk and market risk. Credit risk is negatively linked with market price risk whereas it becomes positively linked with market volatility risk. Such patterns give rise to interesting asymmetric dependence structures between both risk sources. We are then able to balance reliably market price risk with market volatility feedback, the market trend supporting a common correlation between securities. In the light of the previous trade-off, we propose also a simple credit risk management rule.

Time variations of market volatility considerably affect investments risk evaluation and prediction of future returns. They are presented as a source of systemic risk to which is added a risk related to stocks’ sensitivity to volatility shocks. Analysis of the relationship between stocks volatility and market volatility allows for determining whether stocks’ sensitivities to volatility shocks may estimate market’s future risk price. Volatility shocks are defined in terms of volatility risk hedging factors, when market volatility risk price is high and for stocks that are positively correlated to these hedging factors, the value of returns is expected to be low. Idiosyncratic volatility is on the other hand a variable omitted from volatility total risk. If market volatility risk is a missing component of systematic risk, standard models should mis-price portfolios sorted by idiosyncratic volatility because these models do not include factor loadings measuring exposure to market volatility risk.

We find clustering, predictability, strong persistence and asymmetry in the conditional volatilities of national, regional and world real estate security markets. The world real estate security market volatility has a positive impact on the time‐varying real estate security market betas of Asia‐Pacific, Hong Kong, Singapore and Malaysia, and a negative impact on the real estate security market betas of Europe and the UK. The extra country–specific market volatility and global market volatility during the Asian financial crisis period impose a larger size influence than the volatility during total period in some markets. In addition, our results appear to favor the time‐varying beta estimates relative to the world real estate security market index over the world stock market index. The implications for international investors and global portfolio managers is that failing to understand the complex dynamics of real estate security market return, volatility and systematic risk relative to the world markets may make it less possible to ascertain the true potential of international real estate diversification that includes Asia‐Pacific securitized real estate.

Are Investors Compensated for Bearing Market Volatility in a Country?

In this paper we use a survey of 281 Czech, Hungarian and Polish newly‐established small private firms in order to shed some light on the constraints these firms face in the credit market. The results of our survey show that imperfections in capital markets in Central European economies do not seem to actually inhibit the growth of new private firms. Credit markets do exist for de novo private firms in the three Central European transition economies studied, and they provide quite a large amount of financing from an early stage of the existence of firms. Financial intermediation works reasonably well as far as de novo private firms are concerned: loss‐making de novo firms have a lower probability of getting credit than profitable ones. Banks protect themselves against the risk of a deteriorating pool of borrowers by requiring collateral for their loans. We do not find convincing evidence concerning the existence of adverse selection. Loss‐making firms are not ready to pay higher interest rates than profitable firms and are not more likely to ask for credit than profitable firms.

Bank Lending Standards and Access to Lines of Credit

This paper examines how changes in bank lending standards are related to the availability of bank lines of credit for private and comparable public firms. Overall, we find that access to lines of credit is more contingent on bank lending standards for private than for public firms. The impact of bank lending standards is however asymmetric: while private firms are less likely than public firms to gain access to new lines when credit market conditions are tight, we find no difference between public and private firms in terms of their use or retention of pre‐existing lines. We also find that private firms without lines of credit use more trade credit when bank lending standards are tight, which is suggestive of a supply effect. Overall, the evidence suggests that “credit crunches” are likely to have a disproportionate impact on private firms. However, pre‐existing banking relationships appear to mitigate the impact of these contractions on private firms.