Practical Applications from the Experts - June 2010

categories: Product Documentation, general

Credit Spread: Modeling and Risk

In RiskMetrics multi-asset class risk system, the modeling of credit risk for credit-sensitive securities via the Hull-White bridge allows more granular decomposition of VaR risk and OAS. For credit-sensitive instruments such as cash bonds, CDS, convertible bonds, and CDS options, the Hull-White bridge can be leveraged to extract issuer credit risk information from CDS spreads, bond spreads, and equity data via Credit Grades. With these issuer-risk related time series driving the credit component of the modeling of these securities, VaR can be broken out by risk types. One of the VaR break-out is the Issuer-Specific VaR, which represents the VaR risk associated with the credit component of the names in the book.

Looking at positions 3 and 4 in the following table, where credit modeling for the same fixed rate ArcelorMittal bond has been enabled to pick up the issuer risk of this name in the modeling, VaR risk break-out illustrates how credit modeling allows a more granular VaR decomposition into market vs issuer specific credit component.

Click for larger view

As a further refinement to the modeling, price calibration provides additional risk content in the analysis. Looking at positions 2 and 4 in the following table, where calibration of the analytical model to the issue’s price has been enabled, this particular issue’s idiosyncratic OAS as implied through the issue’s price can be obtained. Thus in sum, credit modeling with issuer risk in conjunction with issue’s price calibration leads to the most robust set of risk content for analysis.

Click for larger view

Taking this to a live example set, the power of credit modeling can be seen in a set of Alcoa bonds with maturities ranging from 2013 to 2022 and issuer credit risk modeled from the CDS term structure via the Hull-White bridge. Taking a look at the CDS term structure of Alcoa, one would note readily that issuer credit spread widens as the tenor increases but levels off at around 10 years out.

This particular “saturation” nature of Alcoa’s issuer credit is reflected in the Issuer OAS of this set of bonds with maturities covering the tenors in the CDS term structure. The Issuer OAS of the 2018 maturing issue is 309bp, while the Issuer OAS of the 2022 maturing issue only sees an incremental increase of not even 2bp in Issuer OAS, bring it to 310.5bp.

Click for larger view

Download file