Risk, credit

Economists also consider risk as multidimensional (Dahl etal, 1993). They have coined names for a variety of risks. Some of these, applied mostly to stocks, bonds, and other purely financial instruments, are market risk (related to the CAPM model and the above described parameter beta ), volatility risk (applied to options, primarily), currency risk, credit risk, liquidity risk, residual risk, inventory risk, etc. 

A bond s swap spread is a measure of the credit risk of a bond relative to the interest-rate swap market. Because the swap is traded by banks, or interbank market, the credit risk of the bond over the interest-rate swap is given by its spread over the IRS. In essence, then the IRS represents the credit risk of the interbank market. If an issuer has a credit rating superior to that of the interbank market, the spread will be below the IRS level rather than above it. 

In an asset-swap contract, the investor assumes the credit risk of the bond. In case the bond defaults, the investor will continue to pay the swap, without... 

However, a critical issue on this spread measure is how the asset swap has been stmctured. ASW measure works very well when bond prices trade at or near to par. Most corporate bonds trade with price away from the par (as in this case), thus making the ASW an inaccurate spread measure. If the bond trades at premium, the ASW spread will overestimate the level of credit risk conversely, if the bond trades at discount the ASW spread will underestimate the level of credit risk. Therefore, in the case of HERIM and TKAAV, the ASW spread overestimates the credit risk associated with the bonds because both trade significantly at premium. 

The Bloomberg ASW screen shows the Z-spread. It is 46.1 for HERIM and 45.9 for TKAAV. The Z-spread provides hence a better measure of spread, although giving a similar result in terms of investor s decision. However, being a constant measure, it does not consider the timing of default In fact, each cash flow has a different level of credit risk. To overcome this hmitatirHi, the Z-spread spread could be adjusted by introducing a probability of default for each cash flow. This other spread is referred to adjusted Z-spread or C-spread. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

Erom Eigure 1.7 we conclude that, if we assume the credit risk is virtually identical (from a rating agency and tenor perspective), the bond with the highest ASW spread will be the one we select. 

The yield of a benchmark government bond depends on expected inflation rate, currency rate, economic growth, monetary and fiscal policy. Conversely, the spread of a corporate bond is influenced by the credit risk of the issuer, taxation and market liquidity. Moreover, the yield spread depends on other factors such as ... 

G-spread It is the yield spread over the govermnent bond curve. This spread takes into account the credit risk, liquidity risk and other risks that affect corporate bonds ... 

Merton s model is one of the most important models of credit risk. Merton (1974) and Black and Scholes (1973) proposed a model to assess the credit risk recalling the concept of capital structure, according to Modigliani and Miller s theorem (1958, 1963). According to the Black and Scholes s assumptions, at basis of the model the critical ones are two ... 

Like Black and Cox s work, the authors find spreads similar to the market spreads. Moreover, they find a correlation between credit spread and interest rate. In fact, they illustrate that firms with similar default risk can have a different credit spread according to the industry. The evidence is that a different correlation between industry and economic environment affects the yield spread on corporate bonds. Then, the duration of a corporate bond changes following its credit risk. For high-yield bonds, the interest-rate sensitivity increases as the time to maturity decreases. 

In order to solve the probability of default, reduced-form models adopt a different approach. They are mainly based on debt prices rather than equity prices. In fact, they do not take into account the fundamentals of the firm and the default event is determined as an exogenous process without considering the underlying asset movements. In addition, the models are mainly based oti X t), that is the default intensity as a function of time. In particular, these models use the decomposition of the risky rate (risk-free rate and risk premium) in order to determine the default probabilities, recovery rates and debt values. Although structural models have the advantage to foUow a reliable measure of credit risk, that is the firm value, reduced-form approach overcomes the Umitatimi in which the balance sheet is not the unique indicator of the default prediction. 

Fons (1994) studied the term structure of credit risk based on the historical default probabilities, ratings and recovery rates. In fact, he proposes a bond pricing model in which the value depends on the probability of default and average recovery rate. The model presented is based on the following assumptions ... 

Jarrow and Turnbull (1995) developed the first one intensity-based approach for valuing debt involving credit risk. The model is based on three main assumptions ... 

Fons, J.S., 1994. Using default rates to model the term structure of credit risk. Financ. Anal. J. 

Hull, M., Nelken, 1., White, A., 2004. Merton s model, credit risk, and volatility skews. J. Credit Risk 1 (1), 3-28. 

Jarrow, R.A., Turnbull, S.M., 1995. Pricing derivates on financial securities subject to credit risk. J. Financ. 50 (1), 53-85. 

Saunders, A., Allen, L., 2002. Credit Risk Measurement New Approaches to Value at Risk and Other Paradigms, second ed. John Wiley Sons, New York. 

Trueck, S., Rachev, S.T., 2008. Rating Based Modeling of Credit Risk Theory and Application of Migration Matrices. Acadranic Press. 

Credit risk Fixed and floating-rate bonds are both subject to changes of credit risk. 

Consider also that because the OAS is applied over the risk-free yield curve, it includes the credit risk and liquidity risk between defaultable and default-free bonds. Figure 11.3 shows an example of the OAS Bloomberg screen for Mittel s callable bond. 

Risk can thought of as the possibility of unpleasant surprise. Fixed-income securities expose the investor to one or more of the following types of risk (1) interest rate risk (2) credit risk (3) call and prepayment risk (4) exchange rate risk (5) liquidity risk and (6) inflation or purchasing power risk. 

There are two main types of credit risk that a bond portfolio or position is exposed to. They are credit default risk and credit spread risk. Credit default risk is defined as the risk that the issuer will be unable to make timely payments of interest and principal. Typically, investors rely on the ratings agencies—Fitch Ratings, Moody s Investors Service, Inc., and Standard 8c Poor s Corporation—who publish their opinions in the form of ratings. 

A Z-spread can be calculated relative to any benchmark spot rate curve in the same manner. The question arises what does the Z-spread mean when the benchmark is not the euro benchmark spot rate curve (i.e., default-free spot rate curve) This is especially true in Europe where swaps curves are commonly used as a benchmark for pricing. When the government spot rate curve is the benchmark, we indicated that the Z-spread for nongovernment issues captured credit risk, liquidity risk, and any option risks. When the benchmark is the spot rate curve for the issuer, for example, the Z-spread reflects the spread attributable to the issue s liquidity risk and any option risks. Accordingly, when a Z-spread is cited, it must be cited relative to some benchmark spot rate curve. This is essential because it indicates the credit and sector risks that are being considered when the Z-spread is calculated. Vendors of analytical systems such Bloomberg commonly allow the user to select a benchmark. 

However, these legal provisions do not completely isolate the credit-worthiness of the SCF from external factors, but only limit the extent to which credit risk contamination may occur. For this reason Moody s, when granting ratings, begin their analysis by assessing the creditworthiness of the SCF itself. They achieve this by principally analyzing ... 

On a hold-to-maturity basis, as we ve said, inflation-linked government bonds provide as close an approximation to a guaranteed real return as is currently available. If we can assume the government is credit risk-free, then there remain only two modest reasons for us to couch the above statement with the cautionary nse of the word approximation. There will inevitably always be a small conpon reinvestment risk and also a small degree of real value uncertainty becanse of the indexation lag. 

Greater control by settlement banks over the credit risks run on their customers (by means of a debit-capped payment mechanism). 

They receive a higher yield on their cash in order to compensate them for the higher credit risk involved. 

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