Economic and market conditions can and will affect borrower’s ability to repay an obligation and their own financial circumstances change, in many cases tied to general fluctuations in the economy. 32
Fundamentals of Financial Risk ManagementCreditMetrics This type of analysis was developed by J.P. Morgan and is called CreditMetrics™ although several other companies have established related methodologies. The CreditMetrics™ approach draws on concepts of credit risk migration, usually observed in bond ratings but have applicability to other asset types as well as portfolio diversification effects on credit risk. 33
Fundamentals of Financial Risk ManagementCredit Migration Concept 34A B DYear 1 Credit RatingA B DYear 2 Credit Rating
Fundamentals of Financial Risk ManagementCredit Risk MigrationLonger time horizons can be examined with the use of techniques such as Markov chains. Historical information collected on the 1-year ratings migration patterns of mortgage CDO tranches is used by SifiMortgage analysts. Knowing the total outstanding amount of each tranche at the beginning of each year and the amount of each tranche that moves from grade i to grade j in 1 year, a 1-year marginal mortality rate for each migration can be computed as the following:where represents the dollar value of tranche i that migrates to a rating of j in 1 year and is the total dollar value of tranche i at the beginning of the year. 35MMRij1Vij1Vi1Vij1Vi1
Fundamentals of Financial Risk ManagementCredit Risk Migration Consider a dataset as shown in the next table for A-rated CDO tranches for each year from 2000-2010. The downgrades to B are shown in the table as well as each year’s MMR. Since the MMR’s will vary over time, an average of 8.65% could be used in the CreditMetrics analysis for this particular migration outcome. Other ratings transitions could be computed in similar fashion. Once these transition probabilities have been computed a transition rate matrix can be developed as shown in a following table. Each transition rate or probability is shown in the table as representing the migration in 1 year from rating i to j. Looking at the table, it is clear that most of the time ratings remain the same over 1 year. 36
Fundamentals of Financial Risk ManagementCredit Risk Migration 37
Fundamentals of Financial Risk ManagementCredit Risk Migration 38
Fundamentals of Financial Risk ManagementCredit Risk AssessmentThere is a 95.5% chance that the A-rated CDO tranche will remain A-rated the next year. In addition, the transition probabilities for each tranche should sum to 100% across each row. The sums in each column, however, will not equal 100%.
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