...Volatility Estimation for Corporate Credit Rating 1009611462 LUFEI Xiaoxin 1009611301 HE Yao Abstract The market-based credit models make use of market information such as equity values to estimate a firm’s credit risk. The Merton model and the Black-Cox model are two popular models that link asset value with equity value, based on the option pricing theories. Under these models, the distance to default can be derived and thus the default probability can be mapped to as long as a large database of companies is provided. The difficulty, however, is that some parameters, including asset values and asset volatilities, which are required in calculating the distance to default, are unobservable in market. Therefore, statistical methods need to be developed in order to estimate the unobservable parameters. In this project, our focus is on using KMV method, which has been widely used in the industry, to estimate corporates’ asset values and asset volatilities. We implemented two models and did numeric study by simulation, which shows that the KMV method gives generally accurate estimates under both models. We also analyzed the model risk under different circumstances. The barrier sensitivity analysis gives the result of how sensitive the Black-Cox model is in choosing different barriers, in the relation with asset volatility and debt level. Furthermore, the models are applied to real companies with different leverage ratios, which shows that structural models are more dynamic and accurate...
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...the New Capital Accord, establishes a stepwise framework for regulatory capital allocation for credit risk, starting on what is designated as Standard Approach, in which banks must allocate capital according to regulatory rules, and finishing on what is designated as the Advanced IRB Approach, in which banks must allocate capital based on their own risk evaluation and on the committee guidelines for that evaluation. The committee defines several guidelines for the IRB Approach depending on the type of credit exposure but, technically, we can group the several lines of attach into two ways of deal with the credit portfolio, the rating approach, for the major exposures like banks, sovereigns and corporate; and the segmentation approach for retail and small business exposures. The most accepted credit risk frameworks are rating based models since, historically, the aim of the models was the bond market, the market of debt securities issued by stable corporations, banks and states. In this market, the assumption that a debt security is less risky than other debt security become the essence of the market, since debt issuers need to disclose information to lower the price of the debt security, affected by a risk premium over the interest rate. And the disclosed information includes rating agencies evaluations of financial figures, operational processes, company market risks, costumer risks, etc…. A bond issuer to be ratted at a high grade must be completely ‘undressed’ and accompanied...
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...Module name: Accounting in Context Course title: ELEMENT CW2 (LJ) Credit Risk Management Name of Supervisor: Anthony John Bray Student: Dieu Linh Cao. ID number: 12028548. Word count: 4,467 words. Date: 06/03/2013 Executive summary Every day when reading the financial newspapers or news on TV, I notice that the bad debt still has been the big problem of many economics. Bad debt increases which influences to the bank first, and then to the all of the economy. So, I want to do the research about the Credit Risk Management because in my opinion, this is the way to reduce bad debt effectively. In this report, I have researched about 3 models in Credit Risk Management: CreditMetrics, KMV, and Credit Risk Plus. In each model, I explain and analysis the case study from other document sources. Besides, I also compare and contrast the features or the use of them. In addition, critical thinking is applied in this report, when I have found the other idea, from opponent opinion to agreement. Because of the limitation of knowledge and timing, my report still has had many mistakes. Therefore, if I could do this topic again, may be in the dissertation of the master course, I will make it better, with my experience from AIC subject. Table of Contents Executive summary 2 Declaration 4 Content 5 1. CreditMetrics: 7 2. Portfolio Manager of KMV: 11 3. Credit Risk+: 14 Appendix 18 References 20 Declaration I declare that this research report...
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...option pricing model in practice There are some models to evaluate the “fair price” of the financial derivatives, like Black-Scholes-Merton Option Pricing Model(below; BSMOPM), or Binomial Option Pricing Model(below; BOPM). In the class, we have learned how those models work. But there may be a question. Does the price calculated by above models make a consistency with the market? The goals of this team project are the answering that question and reasoning the answer. Part. 1: Preparation 1) Collecting historical data We investigated the stock call options and put options of EXXON Mobil. The historical stock price daily data are for 6 months from November 16, 2011 to May 15, 2012. We assume that U.S. Treasury bill with maturity 3 month is risk-free, and use its yield to maturity as risk-free rate. Data are from Yahoo Finance. 2) Calculating preliminary statistics Using the data, the daily log return was calculated Daily log return = ln (△close pricei+1/close pricei) We assumed that the stock price follows Geometric Brownian Motion with constant mean[pic] and standard deviation[pic]. Therefore, the return of the stock was assumed to be normally distributed with mean [pic] and standard deviation [pic]. So we picked up n-days samples of stock prices and estimated the annualized volatility as follows. Next, we calculated the recent historical volatility. Here, n denotes the number of observations (business day), Si denotes the stock...
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...Value of Money b. Concept of Zero Coupon (Discount) Bonds and Coupon Bonds. c. Bond Characteristics d. Bond Types – Fixed Rate, Floating Rate, Inverse Floater Rate, etc. e. Interest Rates – Discrete and Continuous Compounding f. Bond Pricing – using ZCYC or YTMC with discrete compounding or continuous compounding g. Difference between bond coupon rate and bond yield h. Calculating Bond Yield (YTM, CY, MMY, ZCY/Spot, Par Yield, etc.) i. Price Yield Relationship Introduction to Financial Statistics and Econometrics 1. Introduction to Financial Statistics a. Frequency distributions b. Measures of Central Tendency/Location (Mean/Mode/Median) c. Dispersion, Measures of Dispersion (Variance/SD/Quartiles/Percentiles/Ranges) and its relevance to Risk Management d. Correlations 2. Introduction to Probability Theory a. Random variables b. Probability and its uses c. Probability Rules d. Conditional Probabilities e. Probability Distributions (Single Variable) i. Continuous Time/Discreet Time; Continuous Value/ Discreet...
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... CAPM Contents Overview of CAPM 1 Advantages and Limitations 3 Breakthroughs and Setbacks 4 Works Cited 6 Overview of CAPM The CAPM was introduced by Jack Treynor , William F. Sharpe , John Lintner and Jan Mossin in 1964, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory (Fama & French, 1982). Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics. Fischer Black developed another version of CAPM, called Black CAPM or zero-beta CAPM that does not assume the existence of a riskless asset. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM (Fama & French, 1982). CAPM has become very attractive as a tool that measures risk to possible in relation to expected return, although it is still widely used for estimating the cost of capital for firms and evaluating the performance of managed portfolios. While CAPM is accepted academically, there is empirical evidence suggesting that the model is not as profound as it may have first appeared to be. CAPM’s empirical fallings arise theoretically from many over simplified assumptions made by the model. This has made it difficult to implement valid test for this model (Kristina Zucchi, 2015). For example according to the CAPM model the risk from an asset such as stock should be measured relative to a comprehensive...
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...University of Nottingham Credit Risk Management in Major British Banks By Xiuzhu Zhao 2007 A Dissertation presented in part consideration for the degree of “MA Finance and Investment” Acknowledgement I would like to express my special thanks to my supervisor Mrs. Margaret Woods, who has given me strong support and encouragement during the whole research, and I am very appreciate of the expert guidance and inspiration she brought me. I am very grateful to my parents for their love and encouragement during my whole education period. The academic suggestions my father has given help me a lot in designing the dissertation. Last but not least, I would like to thank all my friends especially those in Melton Hall. I will never forget the help they have offered, which raises my confidence in completing this dissertation. i Abstract Credit risk is always treated as the major risk inherent in a bank’s banking and trading activities. And if not well managed, this kind of risk may drag a bank into great trouble or even bankruptcy, which can be proved by various bank failure cases. For banks, managing credit risk is not a simple task since comprehensive considerations and practices are needed for identifying, measuring, controlling and minimizing credit risk. In this dissertation, the credit risk management practices of major British banks are examined through the quantitative research on all Major British Banking Group members and qualitative analysis on the four sample banks....
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...The Study Guide sets forth primary topics and subtopics under the five risk‐related disciplines covered in the FRM exam. The topics were selected by the FRM Committee as topics that risk managers who work in practice today have to master. The topics are reviewed yearly to ensure the FRM exam is kept timely and relevant. FRM Examination Approach The FRM exam is a practice‐oriented examination. Its questions are derived from a combination of theory, as set forth in the readings, and “real‐world” work experience. Candidates are expected to understand risk management concepts and approaches and how they would apply to a risk manager’s day‐to‐day activities. The FRM examination is also a comprehensive examination, testing a risk professional on a number of risk management concepts and approaches. It is very rare that a risk manager will be faced with an issue that can immediately be slotted into one category. In the real world, a risk manager must be able to identify any number of risk‐related issues and be able to deal with them effectively. Readings Questions for the FRM examination are derived from the readings listed under each topic outline. These readings were selected by the FRM Committee to assist candidates in their review of the subjects covered by the exam. It is strongly suggested that candidates review these readings in depth prior to sitting for the exam. The Financial Risk Manager Handbook, 4th edition, by Philippe Jorion (New York: Wiley & Sons...
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...United States, Europe, Asia and Latin America. A total of 14 theories and models are synthesized in this work, organized in five tables with the same structure: Theories of capital structure; capital budgeting and cost of equity; asset valuation, financial behavior and international finances. Each table contains theories organized alphabetically with an indication of its germinal or current character. The description of the theory is accompanied by current examples of empirical research that updates or contradicts the theory and additional information about limitations, scope and opportunities of research. Finance Theories Taxonomy 3 Table 1 Finance Theories Taxonomy: Theories of capital structure Theory General description Current examples of the theory Other attributes Modigliani and Miller Germinal theory of corporate finance A review of the theory by Criticism against flaws of M& M theory Theory of investment proposed by Miller and Modigliani Miller himself, offers a new (Ball, 2001) (1958) argues that “the value of a firm view about the so called ‘junk 1. Market perfection. M&M assumed is independent of its capital structure” bonds’ which were considered information was complete and (Miller, 2001) undesirable and non-tradable symmetric, when it was not Dividends and capital structure are during the 60s when low-risk 2. Easy acceptance of firms with high irrelevant in the determination...
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...Function of Punishment: * According to Durkheim the function of punishment is not to remove crime but to ‘heal the wounds done to collective sentiment’. * Without Punishment – collective sentiments would lose their force and strength * Crime and punishment are both inevitable and functional. Function of Punishment: * According to Durkheim the function of punishment is not to remove crime but to ‘heal the wounds done to collective sentiment’. * Without Punishment – collective sentiments would lose their force and strength * Crime and punishment are both inevitable and functional. Crime is Inevitable: * Durkheim argued that crime in an inevitable and normal aspect of social life. * Crime is present in all types of society; indeed the crime rate is higher in more advanced, industrialized countries. * It is inevitable because not every member of society can be equally committed to the collective sentiments (shared values and beliefs). Crime is Inevitable: * Durkheim argued that crime in an inevitable and normal aspect of social life. * Crime is present in all types of society; indeed the crime rate is higher in more advanced, industrialized countries. * It is inevitable because not every member of society can be equally committed to the collective sentiments (shared values and beliefs). Crime is Functional: * Durkheim argues that it only becomes dysfunctional when it is rate is unusually low or high. ...
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...article “Credit Risk Rating at Large U.S. Banks” authors William F. Treacy and Mark S. Care say that risk ratings are the primary summary indicator of risk for banks’ individual credit exposures. They both shape and reflect the nature of credit decisions that banks make daily. The specifics of internal rating system architecture and operation differ substantially across banks. The number of grades and the risk associated with each grade vary across institutions, as do decisions about who assigns ratings and about the manner in which rating assignments are reviewed. In general, in designing rating systems, bank management must weigh numerous considerations, including cost, efficiency of information gathering, consistency of ratings produced, staff incentives, the nature of the bank’s business, and the uses to be made of internal ratings. RATINGS MIGRATION SYSTEM An Internal Ratings Migration Study by Michel Araten, Michael Jacobs Jr., Peeyush Varshney, and Claude R. Pellegrino-- This article discusses issues in evaluating banks’ internal ratings of borrowers. Ratings migration analysis entails the actuarial estimation of transition probabilities for obligor credit risk ratings, with emphasis on estimation of empirical default probabilities. Measurement of changes in borrower credit quality over time is important as obligor risk ratings are a key component of a bank’s credit capital methodology. These analyses permit banks to more accurately assess and price credit risk, as well...
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...Finance 341 Risk Management and Insurance Fall 2014 - Niehaus Overview This is a foundational course that focuses on the economics of risk, decision making under uncertainty (including behavioral biases), methods for managing risk, markets for transferring risk (e.g., insurance markets and derivative markets), and public policy issues related to risk. Specific topics include risk measurement, diversification, moral hazard, adverse selection, insurance pricing, the role of capital in ensuring performance, biases affecting decisions, safety regulation, longevity risk, systemic risk, natural catastrophe risk, and cyber risk. In addition to learning about risk, the course is designed to improve your analytical thinking and problem solving skills. Class Tuesday: 4:25-5:40 Thursday: 4:25-5:40 Office Hours: Room 457H Tuesday: 2:30-4:00 Thursday: 2:30-4:00 Or stop by my office Or make an appointment Expectations I expect students to spend a considerable amount of time outside of class reading the required materials, working on problems, and studying for exams. Expect to spend 6-9 hours outside of class each week. My strong recommendation is not to get behind. If you have questions, do not hesitate to ask either in class, outside of class, or in question and answer sessions which typically are held on Friday afternoons. Grading Homework (problems and writing assignments) 20% 1st exam (Sept. 18) 20% 2nd exam (Oct. 28)...
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...Economics’ Approach to Financial Planning by Laurence J. Kotlikoff, Ph.D. |Executive Summary | |Economists long have shown that when it comes to consuming lifetime economic resources, households seek to neither splurge nor hoard, but | |rather to achieve a smooth living standard over time. Consumption smoothing not only underlies the economics approach to spending and | |saving, it is central to the field’s analysis of insurance decisions and portfolio choice. | |Smoothing a household's living standard requires using a sophisticated mathematical technique called dynamic programming to solve a number | |of difficult and interconnected problems. Advances in dynamic programming coupled with today's computers are permitting economists to move | |from describing financial problems to prescribing financial solutions. | |Conventional planning’s targeted liability approach has some surface similarities to consumption smoothing. But the method used to find | |retirement- and survivor-spending targets is virtually guaranteed to disrupt, rather than smooth, a household’s living standard as it ages.| |Moreover, even very small targeting mistakes will suffice to produce major consumption disruption for the simple reason that the wrong...
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...REVISITING MARKET EFFICIENCY: THE STOCK MARKET AS A COMPLEX ADAPTIVE SYSTEM by Michael J. Mauboussin, Credit Suisse First Boston t is time to shift the emphasis of the debate about market efficiency. Most academics and practitioners agree that markets are efficient by a reasonable operational criterion: there is no systematic way to exploit opportunities for superior gains. But we need to reorient the discussion to how this operational efficiency arises. The crux of the debate boils down to whether we should consider investors to be rational, well informed, and homogeneous—the backbone of standard capital markets theory—or potentially irrational, operating with incomplete information, and relying on varying decision rules. The latter characteristics are part and parcel of a relatively newly articulated phenomenon that researchers at the Santa Fe Institute and elsewhere call complex adaptive systems. Why should corporate managers care about how market efficiency arises? In truth, executives can make many corporate finance decisions independent of the means of market efficiency. But if complex adaptive systems do a better job explaining how markets work, there are critical implications for areas such as risk management and investor communications. I Take, for example, the earnings expectations game.1 In a complex adaptive system, the sum is greater than the parts. So it is not possible to understand the stock market by paying attention to individual analysts. Managers...
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...known as Modern Portfolio Theory was first developed by Harry Markowitz. He had introduced the theory in his paper ‘Portfolio Selection’ which was published in the Journal of Finance in 1952. In 1990, he along with Merton Miller and William Sharpe won the Nobel Prize in Economic Sciences for the Theory. The theory suggests a hypothesis on the basis of which, expected return on a portfolio for a given amount of portfolio risk is attempted to be maximized or alternately the risk on a given level of expected return is attempted to be minimized. This is done so by choosing the quantities of various securities cautiously taking mainly into consideration the way in which the price of each security changes in comparison to that of every other security in the portfolio, rather than choosing securities individually. In other words, the theory uses mathematical models to construct an ideal portfolio for an investor that gives maximum return depending on his risk appetite by taking into consideration the relationship between risk and return. According to the theory, each security has its own risks and that a portfolio of diverse securities shall be of lower risk than a single security portfolio. Simply put, the theory emphasizes on the importance of diversifying to reduce risk. Early on, investors stressed on individually picking high yielding stocks to earn maximum profits. So if one particular industry was offering good returns; an investor would have landed up picking all stocks of his...
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