Garcia João - The Art of Credit Derivatives: Demystifying the Black Swan

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Table of Contents

Table of Figures

List of Tables

About the Authors

Joo Garcia is the Head of the Credit Modeling team at the Treasury and Financial Markets of Dexia Group in Brussels. His current interests include credit derivatives, structured products, correlation mapping of credit portfolios in indices, developing strategies and trading signals for credit derivatives indices and pricing distressed assets. Before that he worked for four years on the construction of a grid system for strategic credit portfolio management of the whole Dexia Group. He has experience in methodologies to rate and price cash flow CDOs. He also worked on the allocation of credit economic capital and the pricing of exotic interest rate derivatives. He is an Electronic Eng. from Instituto Tecnolgico de Aeronutica (ITA, Brazil), with an MSc in Physics (UFPe, Brazil) and a PhD in Physics (UA, Belgium).

Serge Goossens is a Senior Quantitative Analyst working in the Front Office of Dexia Bank Belgium. He has vast experience with credit derivative instruments, both rating and pricing for hedging and trading. He has also focused on mark to model of hard to value distressed assets and on restructuring the capital structure of large portfolios. From his previous positions he has extensive expertise in parallel large-scale numerical simulation of complex systems, ranging from computational fluid dynamics to electronics. Serge holds an MSc in Engineering and a PhD from the Faculty of Engineering of the K.U. Leuven, and a Master of Financial and Actuarial Engineering degree obtained from the Leuven School of Business and Economics. He has published a number of papers and presented at conferences worldwide.

Acknowledgements

Choose a job you love, and you will never have to work a day in your life.

Confucius

This work could not have been realized without the direct and indirect support of several people. First of all we thank Mathijs Dreesen for his numerous valuable contributions. On the trading side we would like to express our gratitude to Claude Njikam. We are grateful to Igor Toder for many fruitful conversations and for bringing up the credit valuation adjustment for protection bought from a non-collateralized counterparty. His initial work on this problem really got us off to a flying start.

Special thanks go to Pete Baker and the publishing staff at John Wiley and Sons Ltd.

Joo would like to express his deepest gratitude to Marijke for neverending love and support and dedicate this book to her, Ilya, Hendrik and Elliot.

Finally, Serge would like to reserve his biggest thanks for Katrien and dedicate this book to her and to Elise, Wout and Klara.

Joo Garcia

Serge Goossens

Preface

Technology has no respect for tradition.

Peter Lee

Some people say that this book has been written during unusual market conditions. Securitization activity was designed to bring liquidity for the collateral in the portfolio. Investing in securitization instruments is a diversification and it reduces idiosyncratic risk. Combined with credit derivatives, securitization led to increased leverage in financial institutions. The high leverage levels affected liquidity, bringing the financial system to the brink of collapse.

Innovation plays a crucial role in society and leverage allows economic activity to be speeded up. However, all leveraged positions need to be carefully managed, as can be seen by the dramatic events that followed the summer of 2007. Standardized credit indices are the instruments to foster the securitization business model, playing a central role in the pricing discovery. Transparency in the pricing algorithms and the underlying parameters is key to the activity.

Our main objective in this book is to present the framework to manage this leverage. Many quantitative analysts and market practitioners have contributed to the development of the toolkit for credit derivatives described here. Despite their enormous contribution, many of them have faced hard times during the dramatic market correction that began in 2007. The quotes at the begining of each chapter have been selected to honour their work.

Nowadays, the metaphor of the black swan is sometimes used to describe the credit crunch. It is the fruit of the imagination of Taleb (2007). The underlying idea is that the credit crunch was highly improbable and constituted an extreme event. However, highly improbable under the Gaussian distribution does not mean unlikely under other distributions. Moreover, improbable does not mean undetectable. Physicists doing quantitative trading in the foreign exchange and equity markets have been using ideas inspired by the work of Mandelbrot for quite some time. We did so in September 2002 for credit portfolio management and in March 2007 for CPDOs.

Instead of assuming that a process is Brownian motion-driven, one should first get an in-depth understanding of the underlying dynamics. In this book, we show that the ones who had a sufficiently long memory have seen that the alleged black swan is in fact white. Seek and ye shall find!

For other titles in the Wiley Finance series please see www.wiley.com/finance

Introduction

If you put the federal government in charge of the Sahara Desert, in five years thered be a shortage of sand.

Milton Friedman

The credit derivatives market surged from USD 200 billion in 1997 to an astonishing USD 55 trillion in 2008. The largest growth happened in 2006 and 2007. When associated with the securitization process, the CDS asset class was in the driving seat of the enormous economic and consumption expansion that took place in the world economy in the post-internet bubble years.

A proper and detailed introduction to credit derivatives can be found in many books already on the market. For an overview of the credit derivatives market, the available instruments, their valuation and trading strategies we refer to the JP Morgan Credit Derivatives Handbook (JP Morgan, 2006) and to the Morgan Stanley Structured Credit Insights books (Morgan Stanley, 2007a; 2007b). For an introduction to stochastic calculus for finance we refer to Shreve (2004a; 2004b), and to Bingham and Kiesel (2004). For an introduction to credit risk modeling we refer to Bluhm et al. (2003). We refer to Schnbucher (2003) and OKane (2008) for credit derivatives pricing. A classic work on options, futures and other derivatives is the book by Hull (2003). For an overview of the bond market we refer to Fabozzi (2004).

This book complements the above references in many respects. First, we focus on the standardized credit indices. Second, we try not to focus only on the instrument and the models but also on the market developments, attempting to adopt a very critical view when using a model. Third, we show models to price instruments, both standardized credit indices and bespoke tranches. Fourth, we show models for portfolio management purposes of bespoke credit portfolios. Fifth, we position the securitization business model as key to the world economy and we describe the processes underlying the activity that need to be well understood. Sixth, we propose a framework to be put in place in financial institutions in order to manage the activity.

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