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CDS Transparency, Liquidity and Pricing Paradigm

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					CDS Transparency, Liquidity
and Pricing Paradigm




Catherine Downhill
Mark Lindup           March 28 2011
Agenda

Counterparty Risk Workflow

CDS Spreads and Implied Ratings

Liquidity and the cost of funding

Benchmark CDS
Counterparty and liquidity risk


Mark Lindup
                                      Counterparty Risk
Management Survey
● 85 counterparty risk manager were interviewed
● 11 broad questions were asked re: Current practices and changes since
  the Lehman default
● Summary of results
          – Sell side actively hedge using derivatives buy side do-not
          – Active collateral management, same day posts, two-way, limit minding
          – Active monitoring
● For more detail see www.FitchSolutions.com




www.fitchsolutions.com                                                   March 30, 2011   3
Counterparty Risk Work Flow

                           66% of CRMs depend upon risk           Counterparty selection: >60% of
                           assessments from a centralized        CRMs deem credit risk the leading
                         Credit Risk function for an official        reason to NOT trade with an
                         risk assessment; 33% do not use a        ‘approved’ counterparty; 40% cited
                            formal credit risk assessment                      liquidity




                                                                                                  5-10 Active
                                                                                                 Counterparties




                                                       CRMs adjust limits and collateral
                                                          requirements according to
                                                           perceived likelihood of
                                                         downgrades or credit events




www.fitchsolutions.com                                                                      March 30, 2011        4
           Deutsche Bank AG – CDS
              Deutsche Bank AG                Banco Bilbao Vizcaya Argentaria SA        Banque Federative du Credit Mutuel
              Credit Agricole SA              Credit Suisse Group AG                    JPMorgan Chase & Co.
              Lloyds TSB Bank Plc             U.S. Bancorp                              Wells Fargo & Co
(bps)
 350
300
250
200
150
100
 50
  0
  Jan 10              Mar 10         Apr 10   Jun 10            Aug 10             Oct 10           Dec 10            Feb 11
           Source: Fitch Solutions

                                                                                                                               5
            CDS Implied Rating and Spreads 22 Feb 2011
                        Banco Bilbao Vizcaya Argentaria SA       Banque Federative du Credit Mutuel      Credit Agricole SA
                        Credit Suisse Group AG                   Deutsche Bank AG                        JPMorgan Chase & Co.
                        Lloyds TSB Bank Plc                      U.S. Bancorp                            Wells Fargo & Co

(bps)
350
300
250
200
150
100
  50
   0
   Jan 10               Mar 10               Apr 10                 Jun 10            Aug 10             Oct 10            Dec 10             Feb 11




(bps)
 300
                                                                                                                                       BB+
250
                                                                                                                         BBB-
200
                                                                                                           BBB
150
             A+                                A               A-                              BBB                                      252
100                           A                                                BBB+                                        188
                                              113                                                           133
 50           92                                               102                             89
                              69                                                 71
   0
        Credit Suisse    U.S. Bancorp      Banque            Deutsche         JPMorgan   Wells Fargo &     Credit      Lloyds TSB   Banco Bilbao
         Group AG                        Federative du       Bank AG         Chase & Co.      Co         Agricole SA    Bank Plc       Vizcaya
                                         Credit Mutuel                                                                              Argentaria SA

            Source: Fitch Solutions

                                                                                                                                                       6
                                           0
                                                 50
                                                       100
                                                              150
                                                                    200
                                                                          250
                                                                                300
                                                                                       350
                                                                                             bps
                              23/02/2010
                              05/03/2010
                              17/03/2010
                              29/03/2010
                              08/04/2010
                              20/04/2010




    Source: Fitch Solutions
                              30/04/2010
                              12/05/2010
                              24/05/2010
                              03/06/2010
                                                                                                   CDS 5Y (LHS)




                              15/06/2010
                              25/06/2010
                              07/07/2010
                              19/07/2010
                              29/07/2010
                              10/08/2010
                              20/08/2010
                              01/09/2010
                              13/09/2010
                                                                                                   CDS-IR (RHS)




                              23/09/2010
                              05/10/2010
                              15/10/2010
                              27/10/2010
                              08/11/2010
                              18/11/2010
                              30/11/2010
                              10/12/2010
                              22/12/2010
                                                                                                   IDR (RHS)




                              03/01/2011
                              13/01/2011
                              25/01/2011
                              04/02/2011
                              16/02/2011
                                                                                                                  BBVA CDS Spread and CDS Implied Rating 22 Feb 2011




                                                                          A
                                                                    A-
                                                                                A+
                                                                                      AA-




                                       BB+
                                                      BBB




7
                                               BBB-
                                                             BBB+
                                                                                                    8
                                              BB




                                                             23/01/2011
BBVA - CDS Implied Rating Bands 22 Feb 2011




                                                             23/12/2010
                                              BB+




                                                             23/11/2010
                                                             23/10/2010
                                              BBB-




                                                             23/09/2010
                                                             23/08/2010
                                              BBB




                                                             23/07/2010
                                                             23/06/2010
                                              AA-


                                                             23/05/2010
                                                             23/04/2010
                                              CDS 5Y




                                                                          Source: Fitch Solutions
                                                             23/03/2010
                                                             23/02/2010




                                                         0
                                                        50
                                                       400
                                                       350
                                                       300
                                                       250
                                                       200
                                                       150
                                                       100
Using Fitch Liquidity Indicators Usage

● Monitor CDS pricing quality
          – Low liquidity difficult to get a good average market price (client challenges)
          – Premium for low liquidity
          – Easy of closing out or taking a position
● Track market interest in an entity
          – Changes in liquidity can signal future events; good or bad
          – Generally market interest and hence liquidity increases in advance of an event
            and decreases when the risks are better understood
● Liquidity reserving
          – Adjust bid-offer spreads to account for liquidity




www.fitchsolutions.com                                                         March 30, 2011   9
Fitch Solutions Approach to Modeling CDS Liquidity

● Fitch solutions sought the inclusion of market derived indicators as a proxy
  for all characteristics of asset market liquidity
● Liquidity can be measured by the following factors
          – Inactivity and staleness of quotes (resilience)
          – Dispersion of mid quotes across contributors (depth)
          – Scaled bid-ask spread (tightness)
● These factors are then put into a logistic regression to produce an
  aggregated liquidity score
       Liquidity score = Function (resilience, DEPTH, tightness)
● How do we disentangle credit risk from the regression results?
          – The regression has a series of dummy variables including Fitch CDS implied
            ratings, these controls for credit risk mean the output is net of default risk
www.fitchsolutions.com                                                        March 30, 2011   10
Liquidity Scores - Counterparty banks




   Source: Fitch Solutions

                                        11
Liquidity Score data

● Reference Entity contract information
● Liquidity Score (4 – 29 lower the score the more liquid the contract)
● Global percentile ranking
● Regional percentile ranking
● Change in Global rank, daily, weekly, monthly, etc
● Change in Regional rank, daily, weekly, monthly, etc
● ICB Sector information
● Country and region information
● CDS spreads (if required)




                                                                          12
BBVA CDS Implied Ratings Bands 22 Feb 2011
          Citigroup Inc.           Lehman Brothers Holdings Inc.      Royal Bank of Scotland Plc
(Liquidy score)
      12       RBS percentile Rk = 72
                          Citigroup percentile Rk = 63                                    Citigroup
      11                                                  RBS nationalization         percentile Rk = 2
      10
                                                                                 RBS
        9                                                                   percentile Rk = 7
        8

        7
           Lehman
        6 percentile
            Rk = 8          Lehman bankruptcy                        Citigroup capital injection
        5
        Jan 07       Jun 07    Nov 07       May 08                 Oct 08         Mar 09        Sep 09



Source: Fitch Solutions
                                                                                                          13
  Egypt Liquidity and CDS Spreads

                               Egypt CDS (LHS)       Egypt liquidity (RHS)
(bps)                                                                                  (%, rank)
 500                                                                                         80
                                                                                             70
400
                                                                                             60

300                                                                                          50
                                                                                             40
200                                                                                          30
                                                                                             20
100                                                       Jan   25th   unrest starts         10
  0                                                                                         0
  Jan 10        Mar 10      Apr 10   Jun 10      Aug 10         Oct 10      Dec 10     Feb 11




  Source: Fitch Solutions
                                                                                                14
                                                                                                                                                                              15
                                         Developed Market (Sovereigns)




                                                                                                                                       01/03/2011
                                                                                                                                       01/01/2011
                                                                                                                                       01/11/2010
                                                                                                                                       01/09/2010
                                                                                                                                       01/07/2010
                          Europe




                                                                                                                                       01/05/2010
                                                                                                                                       01/03/2010
                                                                                                                                       01/01/2010
                                         Emerging Market (Sovereigns)




                                                                                                                                       01/11/2009
                                                                                                                                       01/09/2009
                                                                                                                                       01/07/2009
                          Americas




                                                                                                                                       01/05/2009
                                                                                                                                       01/03/2009
Fitch Liquidity Indices




                                                                                                                                       01/01/2009
                                                                                                                                       01/11/2008
                                                                                                                                       01/09/2008




                                                                                                                                                    Source: Fitch Solutions
                                                                                                                                       01/07/2008
                                                                                                                                       01/05/2008
                          Global Index
                                                                                                                                       01/03/2008




                                         Asia
                                                                                                                                       01/01/2008




                                                                         12.5
                                                                                12
                                                                                     11.5
                                                                                            11
                                                                                                 10.5
                                                                                                        10
                                                                                                             9.5
                                                                                                                   9
                                                                                                                       8.5
                                                                                                                             8
                                                                                                                                 7.5
Liquidity Premium Model

● Extension of the current Liquidity Score model
● Liquidity Premium Model = Function[Bid-Offer, Mid Spread]
● Different fits based on credit quality using CDS implied ratings otherwise
  function fit is non-monotonic especially for lower credit quality
● Corporate, Sovereign, Financials
● BBB CDS Implied Rating
● X-axis Liquidity score
● Y-Axis absolute premium




                                                                               16
                                                                    % Liquidity Premium   




                                            0.00%
                                                    1.00%
                                                            2.00%
                                                                       3.00%
                                                                                  4.00%
                                                                                             5.00%
                                                                                                     6.00%
                                                                                                             7.00%
                               04/01/2010
                               12/01/2010
                               20/01/2010
                               28/01/2010
                               05/02/2010
                               15/02/2010
                                                                                                                                            Liquidity Premium 




                               23/02/2010




     Source: Fitch Solutions
                               03/03/2010
                               11/03/2010
                               19/03/2010
                               29/03/2010
                               06/04/2010
                               14/04/2010
                               22/04/2010
                               30/04/2010
                               10/05/2010
                               18/05/2010
                                                                                                                     Credit Agricole SA
                                                                                                                     Deutsche Bank AG




                               26/05/2010
                                                                                                                     Lloyds TSB Bank Plc




                               03/06/2010
                               11/06/2010
                               21/06/2010
                               29/06/2010
                                                                                                                     Banque Federative du Credit Mutuel




                               07/07/2010
                               15/07/2010
                               23/07/2010
                               02/08/2010
                               10/08/2010
                               18/08/2010
                               26/08/2010
                               03/09/2010
                               13/09/2010
                               21/09/2010
                               29/09/2010
                               07/10/2010
                               15/10/2010
                                                                                                                     Wells Fargo & Co




                               25/10/2010
                                                                                                                     JPMorgan Chase & Co.
                                                                                                                     Credit Suisse Group AG




                               02/11/2010
                               10/11/2010
                               18/11/2010
                               26/11/2010
                                                                                                                     Banco Bilbao Vizcaya Argentaria SA




                               06/12/2010
                               14/12/2010
                               23/12/2010
                               04/01/2011
                               12/01/2011
                               20/01/2011
17
Liquidity and Cost of Funding

● Fitch Solutions finds that the liquidity of a sovereigns CDS is highly
  correlated with the level of underlying bond yield.
● Where sovereign CDS liquidity is high, bond yields tend to fall, thus
  reducing the cost of funding for sovereigns
● Conversely bond yields increase when liquidity in the CDS market falls
● The research also demonstrates liquidity in the CDS market offers an
  indicator of the future direction of yield levels that is external to the credit
  risk factors.
● The analysis does not demonstrate causality as fundamental credit issues
  are prevalent in the movement of bond yields. However, realised
  correlations do highlight the importance of the market attaches to liquidity.
●   http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=563406

                                                                                     18
Dealing with illiquidity


Catherine Downhill
CDS in risk management

●   CDS spreads provide a valuable information when looking at risk:
    – Provides granular measure of credit risk on both cardinal and rank
      ordered scales
    – CDS spreads are a tangible value actively used in CVA and capital
      charges
    – PDs can be derived from spreads…albeit carefully!
    – CDS spreads capture risk migration, not only default and/or failure
    – When handled properly, the CDS market proved to be the most accurate
      credit signal available




                                                                            20
The Credit Default Swap Universe
    What about CDS spreads for entities where there is no
    readily available market information?
●   Demand for CDS spreads on a broader universe of names has been increasing
    as there use in risk management expands as well the need for accurate
    valuations on CDS positions for these less liquid CDS


●   This demand is leading to the development of benchmarked spreads to assist
    particularly in CVA and risk management


●   Benchmarked spreads can be validated against and calibrated to a large current
    and historical data universe…many times larger than observed bank defaults
Benchmarking CDS Entities

● An indicative price for a less liquid CDS, derived from entities/instruments
  where market prices is readily available.
    – Pricing illiquidity entities – today’s liquid entity = tomorrow’s illiquid entity
    – Additional Basel III requirement
● Common CDS Benchmarking Methodologies
    – Rating, Region, Sector
    – Bond - Bond basis
    – Equity probability of default type model
    – Derived Data
    – Hybrid models




                                                                                          23
Benchmarking Methodologies

 ● Rating, Region, Sector
 –   Group together entities with CDS curves by Rating, Region and Sector and
     aggregate the group as a proxy for entities without CDS spreads within the same
     grouping
 ● Bond – Basis
 –   Find an appropriate bond for an Entity, find its spread over the risk-free rate and
     this approximates for the CDS spread, more advance version adjust for CDS-Bond
     basis and maturity mismatches.
 ● Equity probability of default type model
 –   Group similar probabilities to create Equity implied ratings; use the Equity implied
     ratings instead of agency rating in the first approach above




                                                                                            24
Benchmarking Methodologies (continued

● Derived data
          – Have a good CDS curve but need a curve for the same entity but with different
            attributes, adjusting good curve for ; Debt subornation level, Currency,
            restructuring differences.
● Hybrid models
          – Combining the other methodologies above. to group and aggregate CDS
            curves which can then be used as proxies to entities without CDS curves but
            having the same characteristics.
          –      Enhancements include using the bond and CDS bonds basis as a cap and
                floor




www.fitchsolutions.com                                                     March 30, 2011   25
Which CDS benchmarking methodology do think is
best?

1. Rating, Region, Sector
2. Bond - Bond basis
3. Equity probability of default type model
4. Hybrid models of above models
5. Other
6. None work to your satisfaction
          Benchmarking Accuracy – Breakdown by Rating, Sector, Region,
          Currency, Restructuring (11 March 2011)


                          %Ind             %SupSec           %Sec         %SubSec

                100%
                 90%
% of Universe




                 80%
                 70%
                 60%
                 50%
                 40%
                 30%
                 20%
                 10%
                  0%
                        0%       <10% <20% <30% <40% <50% <60% <70% <80% <90% <100% <500%

                                                   % Deviation
       Source: Fitch Solutions

                                                                                            27
                 Indices – Global Consumer Goods

                    Consumer Goods                      Autos             Food & Breverage             Personal & HH Goods


                 500
                 450
                 400
CDS Spread bps




                 350
                 300
                 250
                 200
                 150
                 100
                  50
                   0
                       01/07/09



                                  01/09/09



                                             01/11/09



                                                         01/01/10


                                                                    01/03/10



                                                                               01/05/10



                                                                                          01/07/10



                                                                                                     01/09/10



                                                                                                                01/11/10



                                                                                                                           01/01/11
             Source: Fitch Solutions

                                                                                                                                      28
      Indices – Global Financials

           Financials                         Banks                       Insurance                    Financial Services

800
700
600
500
400
300
200
100
  0
      01/07/2009


                    01/09/2009


                                 01/11/2009


                                                01/01/2010


                                                             01/03/2010


                                                                             01/05/2010


                                                                                          01/07/2010


                                                                                                         01/09/2010


                                                                                                                      01/11/2010


                                                                                                                                   01/01/2011
      Source: Fitch Solutions

                                                                                                                                                29
A Counterparty Risk Manager Requires Timely and
Accurate Data to Meet 3 Key Needs




                                                  30
Fitch Solutions Client Best Practices:
Counterparty Credit Risk Monitoring




                                         31
Fitch Solutions           New York                    London
www.fitchsolutions.com    One State Street Plaza      30 North Colonnade
                          New York, NY 10004          Canary Wharf
                          +1 212 908 0500             London E14 5GN
                          +1 800 75 FITCH             +44 20 3530 1000




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