Volume 5, No. 4, Fourth Quarter 2007
-
Practitioner's Digest
Practitioner’s Digest • Vol. 5, No. 4
The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.
-
Insight
A Brief Review of “The Basis”
Credit derivatives provide an alternative to the cash market, allowing investors to manage exposure to a wide range of entities. In a brief case study looking at several relatively volatile corporate names, we set out to describe, in general terms, the nature and behavior of the relationship of CDS, LCDS, and bonds over the very recent turbulent past.
-
Article
Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk
This paper proposes a new approach to measure, analyze, and manage sovereign risk based on the theory and practice of modern contingent claims analysis (CCA). The paper provides a new framework for adapting the CCA model to the sovereign balance sheet in a way that can help forecast credit spreads and evaluate the impact of market risks and risks transferred from other sectors. This new framework is useful for assessing vulnerability, policy analysis, sovereign credit risk analysis, and design of sovereign risk mitigation and control strategies.
Applications for investors in three areas are discussed. First, CCA provides a new framework for valuing, investing, and trading sovereign securities, including sovereign capital structure arbitrage. Second, it provides a new framework for analysis and management of sovereign wealth funds being created by many emerging market and resource rich countries. Third, the framework provides quantitative measures of sovereign risk exposures which facilitates the design of new instruments and contracts to control or transfer sovereign risk.
-
Article
What Happened to the Quants in August 2007
During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid "unwind" of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses by triggering stop/loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the long/short equity sector in a completely unrelated set of markets and instruments suggesting that systemic risk in the hedge-fund industry may have increased in recent years.
-
Article
The Pricing of Credit Default Swaps During Distress
Credit default swaps (CDS) provide the buyer with insurance against certain types of credit events by entitling him to exchange any of the bonds permitted as deliverable against their par value. Unlike bonds, whose risk spreads are assumed to be the product of default risk and loss rate, CDS are par instruments, and their spreads reflect the partial recovery of the delivered bond's face value. This paper addresses the implications of the difference between bond and CDS spreads and shows the extent to which the recovery assumption matters for determining CDS spreads. A no-arbitrage argument is applied to extract joint recovery rates from CDS and bond markets, using data from Brazil's distress in 2002-2003. Results are related to the observation that preemptive restructurings are now more common than straight defaults in sovereign bond markets and that this leads to a decoupling of CDS and bond spreads.
-
Article
Interest Rate Models Implied Volatility Function Stochastic Movements
This paper presents a one-factor and a two-factor arbitrage-free interest rate models with parsimonious implied volatility functions. The models are empirically tested on the entire swaption surface in three currencies (US dollar, Euro, and Japanese yen) over a 5-year period. They are shown to be robust in explaining the swaption values, and the implied volatility functions are shown to exhibit a three-factor movement in all three currencies. The results show that the observed swaption prices incorporate the market conditional expectations of the correlations of the key interest rates and the stochastic process of the yield curve, and the interest rate models should be calibrated to such market information to provide accurate relative valuation. Further this paper describes a modeling approach that has important implications on hedging interest rate derivatives dynamically taking the stochastic volatility risks into account.
-
Case Study
Dependable Trust
“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.
-
Book Review
Fortune's Formula
“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.
-
Book Review
Fortune's Formula
“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.