1. JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT STRATEGY PRMIA LONDON 18 MAY 2004

2.

• Recent market environment

• New market-implied techniques to manage credit risk

• Introduction to the BDP (Barra Default Probability)

• Practical Examples

• Questions and answers (assuming I have the answers)

Discussion Outline

3.

• Recent market environment

• New market-implied techniques to manage credit risk

• Introduction to the BDP (Barra Default Probability)

• Practical Examples

• Questions and answers

Discussion Outline

4.

• Equity declines drove re-allocations to fixed income

• • Simultaneously government yields decreased to all time lows

• • Credit default rates neared all time highs

• • Pension fund shortfalls (Focus on ALM)

• Credit markets are increasingly complex

• • Universe of assets is expanding rapidly

• • Spread products are becoming more complicated

• • Limited headcount to cover expanding number of issues

Market Forces Change the Rules of Credit Investing

5. Currently Very Few Easy Opportunities

• End of the bear credit market in 2003

• Spreads have tightened to extreme levels

• • Lowest since 1998

• Demand still high

• • Non-traditional investors

Source: S&P

6. Outperformance Is More Demanding Than Ever

• Are we being correctly compensated?

• • Risk premium close to zero

• How does a long-only investor win/outperform?

• • Spreads have nowhere to go

• Move to

• • Lower-quality / higher-yielding

• • Find names with value still

• Asset selection is key

7. One Default Can Negate Entire Portfolios Return

• Credit market is strongly asymmetric

• Earning the spread has become extremely difficult over the past few years

• Unprecedented market conditions with record downgrades and defaults

Source: Lehman Brothers, 2002

8. Fundamental Analysis Alone Is Not Enough

• Judgment of experienced analysts remains essential

• However, judgment often impaired by questionable data

• • Nearly 1000 accounting re-statements in the last three years (source: SEC)

• • Creative accounting

• Whats required is a more efficient process to monitor, screen, and select credit-risky investments

9. Gaining the Advantage in Credit Investing

• To successfully manage credit, you need

• Earlier, more accurate prediction of potential default risk

• Models that allow for the real- world uncertainty of financial statements

• Tools to make your credit analysis process more efficient

10.

• Recent market environment

• New market-implied techniques to manage credit risk

• Introduction to the BDP (Barra Default Probability)

• Practical Examples

• Questions and answers

Discussion Outline

11. Market-Implied Measures Provide Additional Insight

• • Market-implied measures from the:

• • Equity Market Barra Default Probabilities (BDP)

• • Bond Market Barra Implied Ratings (BIR)

• • Derivatives Market Credit Default Swaps (CDS)

• • Coming soon

• • Crossover Empirical Credit Risk (ECR) Equity Risk Implied Spreads (ERIS)

12. Equity Market BDPs Go Beyond Traditional Models

• BDP advantages

• Incomplete Information framework assumes fundamental data may be flawed

• Use of Barras industry standard equity volatility forecast

• Empirical study of historical leverage

Barras model signals significant uptrend in default risk months earlier

13. Bond Market BIRs Lead Agency Ratings

• Barra Implied Ratings take the bond markets perspective on credit and match it to a best fit distribution of actual ratings

• Barra Implied Ratings typically can lead agency ratings by as much as three months

Barras measures provide earlier warning to possible downgrade

14. Derivatives Market CDS Market a Leading Indicator

• Credit Default Swap (CDS) rates often provide leading indication of risk and value

• CDS market is exploding: more than $4 trillion notional outstanding and most big names actively traded (source: BBA)

Cash-CDS Basis History Merrill Lynch (5 Year USD)

15.

• Recent market environment

• New market-implied techniques to manage credit risk

• Introduction to the BDP (Barra Default Probability)

• Practical Examples

• Questions and answers

Discussion Outline

16. Current Quantitative Default Models

• Structural or Cause-and-Effect approach (Merton)

• • Default happens for a reason

• • Firm-specific information can be used advantageously

• Reduced form approach

• • Default rates can be analysed statistically

• • Ad hoc, exogenously-given, default rate

17. Mertons Structural Model of Default

• Default occurs at debt maturity if the firm value is below the liabilities value

• We thus need

• • A model of firm value process

• • Estimate of default point

• Merton identified equity as being long a call option on the firm value

• Merton identified a bond as being short a put option on the firm value

18. Mertons Structural Model of Default Payoff at maturity of the bond Value of the Equity at maturity time T Value of the Bond at maturity time T i.e. default free bond + short European put on V @ K i.e. European call on V @ K

19. Mertons Structural Model of Default 0 D V 0 No Default Probability of Default Default T

20. Reduced Form Models

• Assume that default is totally unpredictable

• • Default comes unannounced

• Based on a conditional default rate or intensity

• • Exogenously given

• Fit well to market data including short credit spreads

• Ad hoc, lack intuitive appeal

• The picture:

?

21. Model Comparison

• Based on a model definition of default

• Intuitive, appealing

• The default time is often (implicitly) predictable

• Hard to fit to empirical data

• Based on an exogenously given default rate

• Ad hoc

• The default time is always totally unpredictable

• Easy to fit to empirical data

Structural / Cause and Effect

• What we want: a hybrid model

• • Incorporate the best features of structural and reduced form

• • Avoid their pitfalls

Reduced Form

22. The Barra Default Probability (BDP) Model

• A genuine hybrid of cause-and-effect (structural) and reduced-form models (compensator approach)

• • Based on a default time that is not predictable

• • Makes use of all publicly available liability statements and equity market data

• • Assumes investors have incomplete information

• • Calibrates easily to short credit spreads

• • Intuitive and appealing

23. Barra Default Probability Model Intuition 0 V 0 T Distribution of possible default boundary levels Paths of Asset Value Process Expected level of default barrier Width represents uncertainty in the default barrier level Time Asset Value

24. Default Barrier Scaled Beta Distribution Mean = current debt Standard deviation, calibrated or user-configured

25. BDP Model Uncertainty Can Be Varied Barra Default Probability Model Variant 1 Variant 2 Variant 3

26. BDP Model A Firm Becomes Distressed 9/17/2001 9/10/2001 Credit term structure steepens and short-term spreads increase

27. BDP Model Subtlety Healthy Firm 4/15/2002 4/10/2002 15% drop in equity Credit term structure steepens but short-term spreads barely move

28. Testing the Model ROC Curves

• • • Radar Operators in WWII: Plane (or flock of birds)?

• • • Medical Diagnosis: Is this persons Thyroid OK?

• • • Astronomy: Is this a Planet?

• • • Marketing Analysis: Will this household buy insurance?

• • • Credit Risk: Will this name default ?

Non-Event Event MODEL FORECAST Event (+) Non-Event (-) True Negative False Negative False Positive True Positive REAL WORLD

29. ROC Curves Merton Comparison Merton BDP Random Method

30. ROC Curves First Passage Comparison First Pass BDP

31. ROC Curves Moodys Rating Comparison BDP Moodys Rating

32.

• Recent market environment

• New market-implied techniques to manage credit risk

• Introduction to the BDP (Barra Default Probability)

• Practical Examples

• Questions and answers

Discussion Outline

33. BIR Good Complement to Agency Ratings ZOOM ZOOM

34. BDP Outlier Identification

• Inspecting like-credits in a new way can sometimes turn up opportunities or threats

USD BBB Consumer Cyclicals Average BDP = 0.20% Toys R Us BDP = 4.97% Source: Barra Credit

35. BDP Warning of Toys R Us Downgrade?

• Bond implied ratings moved in October as well

A few days later spreads widened, and months later Toys R Us was downgraded to below investment grade (junk) Source: Barra Credit

36. BIR Mandate Restrictions

• Early warnings of Potential Downgrades can allow managers to exit worrying names before the flood

The Bond Market was pricing in concerns back in September when the Barra Implied Rating for Parmalat dropped to Sub-IG Source: Barra Credit

37. BDP Early Warning

• The equity market was also signalling concerns for Parmalat

The BDP moved well into HY levels before December Source: Barra Credit Investment Grade (approximately) . .

38. Capital Structure Arbitrage

• Differing views from two markets on the capital structure point out interesting opportunities

FedExs announcement of its planned acquisition of Kinkos triggered concern implied by the equity market but not reflected in bond spreads Source: Barra Credit

39. Market-Implied Measures Offer More Insight Source: Barra Credit

40. Research Papers and More Info

• www.barra.com

• Datasheets

• Flash Demos

• Research Papers

• Practitioner Papers

• Conference Attendance

41. [email_address]