New Economics Papers
on Financial Markets
Issue of 2007‒06‒18
six papers chosen by

  1. An assessment of Basel II procyclicality in mortgage portfolios By Jesús Saurina; Carlos Trucharte
  2. Arbitrage with fixed costs and interest rate models By Clotilde Napp; Elyès Jouini
  3. Hedging Effectiveness under Conditions of Asymmetry By Cotter, John; Hanly, James
  4. An empirical evaluation of structural credit risk models By Nikola A. Tarashev
  5. The price impact of rating announcements: which announcements matter? By Marian Micu; Eli M Remolona; Philip D. Wooldridge
  6. The pricing of portfolio credit risk By Nikola A. Tarashev; Haibin Zhu

  1. By: Jesús Saurina (Banco de España); Carlos Trucharte (Banco de España)
    Abstract: In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register, a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs: point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one of the most important banks’ portfolios.
    Keywords: procyclicality, basel ii, rating systems, mortgages
    JEL: E32 G18 G21
    Date: 2007–05
  2. By: Clotilde Napp (DRM - Dauphine Recherches en Management - [CNRS : UMR7088] - [Université Paris Dauphine - Paris IX], CREST - Centre de Recherche en Économie et Statistique - [INSEE] - [ École Nationale de la Statistique et de l'Administration Économique]); Elyès Jouini (CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - [CNRS : UMR7534] - [Université Paris Dauphine - Paris IX])
    Abstract: We study securities market models with fixed costs. We first characterize the absence of arbitrage opportunities and provide fair pricing rules. We then apply these results to extend some popular interest rate and option pricing models that present arbitrage opportunities in the absence of fixed costs. In particular, we prove that the quite striking result obtained by Dybvig, Ingersoll, and Ross (1996), which asserts that under the assumption of absence of arbitrage long zero-coupon rates can never fall, is no longer true in models with fixed costs, even arbitrarily small fixed costs. For instance, models in which the long-term rate follows a diffusion process are arbitrage-free in the presence of fixed costs (including arbitrarily small fixed costs). We also rationalize models with partially absorbing or reflecting barriers on the price processes. We propose a version of the Cox, Ingersoll, and Ross (1985) model which, consistent with Longstaff (1992), produces yield curves with realistic humps, but does not assume an absorbing barrier for the short-term rate. This is made possible by the presence of (even arbitrarily small) fixed costs.
    Keywords: interest rates; pricing; fixed costs; arbitrage
    Date: 2007–06–06
  3. By: Cotter, John; Hanly, James
    Abstract: We examine whether hedging effectiveness is affected by asymmetry in the return distribution by applying tail specific metrics to compare the hedging effectiveness of short and long hedgers using Oil futures contracts. The metrics used include Lower Partial Moments (LPM), Value at Risk (VaR) and Conditional Value at Risk (CVAR). Comparisons are applied to a number of hedging strategies including OLS and both Symmetric and Asymmetric GARCH models. Our findings show that asymmetry reduces in-sample hedging performance and that there are significant differences in hedging performance between short and long hedgers. Thus, tail specific performance metrics should be applied in evaluating hedging effectiveness. We also find that the Ordinary Least Squares (OLS) model provides consistently good performance across different measures of hedging effectiveness and estimation methods irrespective of the characteristics of the underlying distribution.
    Keywords: Hedging Performance; Asymmetry; Downside Risk; Value at Risk, Conditional Value at Risk. JEL classification: G10, G12, G15. ____________________________________________________________________ John Cotter, Director of Centre for Financial Markets, Department of Banking and Finance, University College Dublin, Blackrock, Co. Dublin, Ireland, tel 353 1 716 8900, e-mail Jim Hanly, School of Accounting and Finance, Dublin Institute of Technology, tel 353 1 402 3180, e-mail The authors would like to thank the participants at the Global Finance Annual Conference for their constructive comments.
    JEL: G15 G13
    Date: 2007
  4. By: Nikola A. Tarashev
    Abstract: This paper evaluates empirically the performance of six structural credit risk models by comparing the probabilities of default (PDs) they deliver to ex post default rates. In contrast to previous studies pursuing similar objectives, the paper employs firm-level data and finds that theory-based PDs tend to match closely the actual level of credit risk and to account for its time path. At the same time, nonmodelled macro variables from the financial and real sides of the economy help to substantially improve the forecasts of default rates. The finding suggests that theory-based PDs fail to fully reflect the dependence of credit risk on the business and credit cycles. Most of the upbeat conclusions regarding the performance of the PDs are due to models with endogenous default. For their part, frameworks that assume exogenous default tend to underpredict credit risk. Three borrower characteristics influence materially the predictions of the models: the leverage ratio; the default recovery rate; and the risk-free rate of return.
    Keywords: Basel II, Probability of default, Credit risk models, Macroeconomic factors of credit risk
    JEL: C52 G1 G3
    Date: 2005–07
  5. By: Marian Micu (Barclays - San Francisco, Ca Office); Eli M Remolona; Philip D. Wooldridge
    Abstract: Credit rating agencies make multiple announcements, some of which are intended to reflect the latest information available about a firm and others of which are intended to provide a stable signal of credit quality. Using data on CDS spreads, we examine which of these different types of rating announcements contains pricingrelevant information. We find that all types, including changes in outlook, have a significant impact on CDS spreads. Even rating announcements preceded by similar announcements have an impact. The price impact is greatest for firms with split ratings, smallcap firms and firms rated near the threshold of investment grade.
    Keywords: credit default swaps, credit ratings, event study, market reaction
    JEL: G14
    Date: 2006–06
  6. By: Nikola A. Tarashev; Haibin Zhu
    Abstract: Equity and credit-default-swap (CDS) markets are in disagreement as to the extent to which asset returns co-move across firms. This suggests market segmentation and casts ambiguity about the asset-return correlations underpinning observed prices of portfolio credit risk. The ambiguity could be eliminated by – currently unavailable – data that reveal the market valuation of low-probability/large-impact events. At present, judicious assumptions about this valuation can be used to reconcile observed prices with asset-return correlations implied by either equity or CDS markets. These conclusions are based on an analysis of tranche spreads of a popular CDS index, which incorporate a rather small premium for correlation risk.
    Keywords: CDS index tranche, joint distribution of asset returns, correlation risk premium, copula
    JEL: C15 G13
    Date: 2006–09

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