R. Merton published a seminal paper [1] that laid the foundation for the development of structural credit risk models. In this post, we’re going to provide an example of how it can be used for managing credit risks. Within the Merton model, equity of a firm is considered a call option on its asset, and…
Read More Credit Risk Management Using Merton ModelLast year, in a post entitled Credit Derivatives-Is This Time Different we wrote about credit derivatives and their potential impact on the markets. Since then, they have started attracting more and more attention. For example, Bloomberg recently reported that collateralized loan obligations (CLO), a type of complex credit derivatives, are becoming a favorite financing vehicle…
Read More Are Collateralized Loan Obligations the New Debt Bombs?We have written many blog posts about the increase in volatility of volatility. See, for example Is Volatility of Volatility Increasing? What Caused the Increase in Volatility of Volatility? Similarly, last week Bloomberg reported, The sudden rise in volatility in February and March showed that even with strong growth fundamentals, financial markets remain vulnerable. Since…
Read More Black Swan and Volatility of VolatilityThe US equity market just reached new highs, and it broke many records. For example, Bloomberg reported that the US market had not been overbought like this in 21 years. The S&P 500 Index’s superlative start to 2018 is making a contrarian technical indicator look silly. The benchmark gauge is poised to end trading Thursday…
Read More Correlation BreakdownThe sell-off in the high yield bond Exchange Traded Funds space last month reminds us of an important risk factor: liquidity. But what exactly is liquidity risk? According to Aleksander Kocic, derivatives strategist at Deutsche Bank AG, Liquidity transforms the risk of default (the ability that the debtor may not be able to pay back…
Read More Liquidity Risk and Exchange Traded FundsValue at Risk (VaR) is an important risk measure that large financial institutions use for managing the risks and allocating capital. Wikipedia defines VaR as follows: Value at Risk (VaR) is a measure of the risk of investments. It estimates how much a set of investments might lose, given normal market conditions, in a set…
Read More Is Value at Risk a Good Risk Measure?Last Thursday witnessed, again, another dramatic increase in volatility. The volatility index VIX spiked 44 percent to 16.04%, its highest daily close for the year. As shown below, the VIX futures term structure inverted in the short end. Two days before the event, Helen Bartholomew of Reuters warned that the net short position in the…
Read More VIX Futures Leads Cash Market: Tail Wags DogIt happened again, and again. Last Thursday volatility increased sharply at around 1.30 p.m, then it came back to normal at the end of day. For now, we ignore the cause. But this event reinforced our observation: sharp volatility spikes occur more and more frequently these days. In a low volatility environment like this one,…
Read More Potential Black Swans and How to Hedge Against ThemWill this low volatility persist and can a large market decline happen in this environment? Aaron Brown recently published an article in which he pointed out that a large jump in realized volatility happens only when the VIX is above 20. …the important thing is that there aren’t big surprises at low levels of the…
Read More How Long Will Low Volatility Last?In the continuation of the “Low Volatility is Not a New Normal” theme, Adam Samson of Financial Times published another post based on the recent report by JPMorgam which suggested using VIX options for managing the risks. Risk assets, like stocks, have been rallying “for years”, sending market volatility near “record lows… While fundamentally volatility…
Read More VIX Options: Should We Buy Them When Volatility is Low?