Credit Derivatives & the Management of Risk: Including Models for Credit Risk

by Chorafas, Dimitris N. (Author)

• ISBN13: 9780735201040
• ISBN10: 0735201048
• Format: Hardcover
• Copyright: 1999-09-01
• Publisher: Penguin Group USA

Summary

Credit derivatives are revolutionizing the world of investment. But without a firm understanding of their mechanics and their bottom-line impact, these hot financial instruments can bring devastating losses. An international authority on risk management, Dr. Dimitris N. Chorafas draws on his own experience and the insights of seventy-six senior executives at forty-six organizations worldwide to introduce readers to the market for credit derivatives; the instruments that make trading in credit derivatives possible; the models that are applicable to the management of credit risk, and; the information needed by senior management to ensure credit derivatives don't turn into junk bonds. The book contains many firsts: the perspectives opened by new financial instruments; new markets for selling credit derivatives; the coming derivatives of catastrophe insurance and hurricane events; the best currently available credit risk models, and; a discussion of the work done by "rocket scientists, " and the aftermath with Long Term Capital Management (LTCM) Dr. Chorafas empowers anyone who works with derivatives to get the best possible performance, and, at the same time, alerts them to their shortcomings and dangers.

Author Biography

Dr. Dimitris N. Chorafas is an international consultant for management, finance, and technology. His clients include major banks throughout Europe, as well as multinational corporations such as General Electric and Honeywell. A Fulbright Scholar who did his postgraduate studies at UCLA and received his doctorate at the Sorbonne, he has taught at Catholic University, Washington State University, and four other American universities, plus the University of Alberta, the Technical University of Karlsruhe, and the University of Geneva. He has also lectured on finance and technology all around the world. Dr. Chorafas is the author of 115 books, and his work has been translated into 16 languages. John B. Caouette is Vice Chairman of MBIA Insurance Corporation, responsible for MBIA's international insurance business and new business development. Mr. Caouette was previously President of the Structured Finance Division of MBIA Insurance Corporation. He was formerly Chairman and CEO of Capital Markets Assurance Corporation. Mr. Caouette is the author (with E.I. Altman and Paul Narayanan) of Managing Credit Risk: The Next Great Financial Challange.

Table of Contents

Foreword	xiii
John B. Caouette
Preface	xvii
Acknowledgments	xxi
PART ONE UNDERSTANDING THE MANAGERIAL BASIS AND CONSEQUENCES OF CREDIT DERIVATIVES
Credit Derivatives and their Impact on the Financial Industry	3	(28)
Introduction	3	(1)
Bankers and Analysts Take a Careful Look at Credit Derivatives	4	(5)
Credit Derivatives and the Concept of Credit Volatility	9	(5)
A Credit Derivatives Deal: A Simple Example	14	(3)
What Can Be Learned from Other Experiences in Securitization?	17	(3)
Are Credit Derivatives Lowering the Quality of a Bank's Portfolio?	20	(2)
Credit Derivatives Are Essentially Debit Derivatives	22	(4)
Factors That May Impact Market Growth	26	(5)
Assets, LIabilities, the Trading Book, and the Banking Book	31	(22)
Introduction	31	(1)
The Market's Switch from Assets to Liabilities	32	(4)
Extreme Events in Credit Risk: The Case of Long-Term Capital Management	36	(4)
Defaults That Followed the Globalization of Trades in Liabilities	40	(4)
Credit Derivatives, Banking Book, and Trading Book	44	(2)
Fixed-Rate/Floating-Rate Swaps between Banking Book and Trading Book	46	(3)
The Evolution toward More Sophisticated Bookkeeping Methods	49	(4)
Information Requirements for Issuers and Users of Credit Derivatives	53	(18)
Introduction	53	(1)
Concentration and Leverage with Credit Derivatives	54	(4)
Investors, Lenders, and the Responsibilities of Senior Management	58	(4)
Information Requirements with Credit Derivatives	62	(2)
What Can We Learn from Single-Transaction Management?	64	(3)
Internal Controls and Credit Derivatives	67	(4)
Credit Derivatives, Transparency, and Collateralization	71	(18)
Introduction	71	(2)
The Difficulty of Obtaining Fair Value Estimates	73	(3)
Securitized Balance Sheets, Event Risk, and Structural Shock	76	(3)
Derivatives Trades and the Use of Collateral	79	(2)
Lessons to Be Learned from Collateralizations of the 1920s	81	(3)
Credit Derivatives, Risk Premiums, and Long-Term Loans	84	(5)
Fund Managers and Credit Derivatives Markets	89	(22)
Introduction	89	(1)
Institutional Investors, New Money, and Hedge Funds	90	(4)
Retirement Plans, 401 (k)s, and Pension Funds	94	(2)
Is There a Credit Derivatives Market among Portfolio Managers?	96	(2)
New Business Opportunity: Marketing Credit Derivatives to Private Bankers	98	(2)
Taking Stock of Four Types of Risk and Managing Them	100	(2)
Could Credit Derivatives Become Another Exercise in Junk Bonds?	102	(3)
The Flight to Quality will Have Far-Reaching Consequences	105	(6)
PART TWO CREDIT DERIVATIVES INSTRUMENTS AND THEIR UNDERLIERS
Asset Swaps, Total Return Swaps, and Default Swaps	111	(20)
Introduction	111	(1)
Asset Swaps	112	(4)
Total Return Swaps	116	(2)
Total Return Swaps, Market Anomalies, and LTCM	118	(2)
Variants of Total Return Swaps	120	(2)
Default Swaps	122	(3)
Can Default Swaps Be Extended to Cover Country Meltdown?	125	(3)
Position Risk and Default Risk	128	(3)
Credit-Linked Instruments, Structured Notes, and Credit-Enhanced Ventures	131	(16)
Introduction	131	(1)
Credit-Linked Notes	132	(2)
Structured Notes and Inverse Floaters	134	(2)
Structured Bonds	136	(2)
Repurchase Agreements	138	(1)
Risks Associated with Repos	139	(2)
Credit-Enhanced Ventures and Structured Investment Vehicles	141	(3)
Critical Questions with CEVs and SIVs	144	(3)
Credit Spreads, Credit Options, and Debt Options	147	(16)
Introduction	147	(1)
Credit Risk Is on the Rise	148	(4)
Credit Spreads and Credit Options	152	(3)
Debt Options	155	(2)
Risks with Debt Options	157	(2)
STRIPS	159	(1)
Termination Options and Risk Control	160	(3)
Credit Derivatives and Catastrophe Insurance	163	(20)
Introduction	163	(1)
Insured and Uninsured Losses from Natural and Man-Made Catastrophes	164	(4)
Toward a Securitization of Insured Catastrophes	168	(4)
What's the Future of a Catastrophe Risk Exchange?	172	(3)
Contrarian Opinions to the Securitization of Catastrophe Insurance	175	(3)
Bankers, Treasurers, and Investors Must Always Be Concerned about Diversification	178	(5)
New Derivatives Instruments, Hedging Policies, and Credit Rating Agencies	183	(18)
Introduction	183	(1)
The Sense of Weather Derivatives	184	(2)
Risks Associated with Hurricane Derivatives	186	(3)
What's the Use of Energy Derivatives?	189	(2)
New Product Development Favors Credit Derivatives	191	(4)
The Role Trade Associations and Rating Agencies Play in Credit Risks	195	(6)
PART THREE MODELS FOR THE EVALUATION AND MANAGEMENT OF CREDIT RISK
The Art of Modeling Credit Risk and its Analytics	201	(18)
Introduction	201	(2)
Accounting for Reserves	203	(2)
The Art Credit Departments Have Been Using	205	(4)
Measuring Loan Losses on a Statistical Basis	209	(3)
Actuarial Credit Risk Accounting (ACRA)	212	(3)
Event Risk, Expected Losses, and Unexpected Losses	215	(4)
Building Improved Versions of Acra and Other Credit Models	219	(20)
Introduction	219	(1)
Using Accurate Distributions for Credit Risk	220	(4)
Operating Characteristics Curves, Chi-Square, and Degrees of Freedom	224	(4)
The Need to Integrate Credit Risk and Market Risk by Important Client	228	(2)
Employing Fermi's Concept to Calculate the Bank's Exposure	230	(3)
An Order-of-Magnitude Calculation of Derivatives Risk	233	(6)
Risk Metrics, Credit Metrics, and Credit Risk+	239	(18)
Introduction	239	(1)
Risk Metrics and the Quality of Risk Management	240	(2)
The Need for a Methodology to Improve Obtained Results	242	(5)
What Credit Metrics Could Offer to Senior Management	247	(3)
Credit Metrics and Default Thresholds	250	(3)
Credit Risk+ and Its Comparison to Credit Metrics	253	(4)
Risk Adjusted Return on Capital, Credit Portfolio View, and the Loan Analysis System	257	(18)
Introduction	257	(1)
Management Discipline and the Modeling of Credit Risk	258	(3)
Tactical and Strategic Impact of Risk-Adjusted Return on Capital (RAROC)	261	(2)
RAROC and Capital at Risk	263	(3)
Credit Portfolio View	266	(2)
The Loan Analysis System (LAS)	268	(3)
Why Analytical Systems Serve Senior Management	271	(4)
Value at Risk	275	(18)
Introduction	275	(1)
A Bird's-Eye View of Value at Risk	276	(4)
Satisfying Regulatory and Managerial Requirements	280	(3)
Applications Examples Using Value at Risk	283	(2)
Challenges with the Test of Hypotheses Used in the Model	285	(2)
Is the VAR Output Comparable from Bank to Bank?	287	(6)
Rocket Scientists	293	(16)
Introduction	293	(1)
The Use of Rocket Science in Banking	294	(2)
What the Rocket Scientists Do	296	(3)
Adding Value to Models Already in Use: ACRA and Credit Metrics	299	(4)
Who Decides on the Work Rocket Scientists Do?	303	(3)
Rocket Scientists, a Strategic Plan, and the Board	306	(3)
Index	309