Sample-path Large Deviations in Credit Risk

The event of large losses plays an important role in credit risk. As these large losses are typically rare, and portfolios usually consist of a large number of positions, large deviation theory is the natural tool to analyze the tail asymptotics of the probabilities involved. We first derive a sample-path large deviation principle (LDP) for the portfolio's loss process, which enables the computation of the logarithmic decay rate of the probabilities of interest. In addition, we derive exact asymptotic results for a number of specific rare-event probabilities, such as the probability of the loss process exceeding some given function

Systemic Risk and Default Clustering for Large Financial Systems

As it is known in the finance risk and macroeconomics literature, risk-sharing in large portfolios may increase the probability of creation of default clusters and of systemic risk. We review recent developments on mathematical and computational tools for the quantification of such phenomena. Limiting analysis such as law of large numbers and central limit theorems allow to approximate the distribution in large systems and study quantities such as the loss distribution in large portfolios. Large deviations analysis allow us to study the tail of the loss distribution and to identify pathways to default clustering. Sensitivity analysis allows to understand the most likely ways in which different effects, such as contagion and systematic risks, combine to lead to large default rates. Such results could give useful insights into how to optimally safeguard against such events.Comment: in Large Deviations and Asymptotic Methods in Finance, (Editors: P. Friz, J. Gatheral, A. Gulisashvili, A. Jacqier, J. Teichmann) , Springer Proceedings in Mathematics and Statistics, Vol. 110 2015

Term structure transmission of monetary policy

Under bond rate transmission of monetary policy, standard restrictions on policy responses to obtain determinate inflation need not apply. In periods of passive policy, bond rates may exhibit stable responses to inflation if future policy is anticipated to be active, or if time-varying term premiums incorporate inflation-dependent risk pricing. We derive a generalized Taylor Principle that requires a lower bound to the average anticipated path of forward rate responses to inflation. We also present a no-arbitrage term structure model with horizon-dependent policy and time-varying term premiums to explain mechanics and provide empirical results supporting these channels

Boom-Bust Cycles in Middle Income Countries: Facts and Explanation

In this paper we characterize empirically the comovements of macro variables typically observed in middle income countries, as well as the boom-bust cycle that has been observed during the last two decades. We find that many countries that have liberalized their financial markets, have witnessed the development of lending booms. Most of the time the boom gradually decelerates, but sometimes the boom ends in twin currency and banking crises and is followed by a protracted credit crunch that outlives a short-lived recession. We also find that during lending booms there is a real exchange rate appreciation, and the nontradables (N) sector grows faster than the tradables (T) sector. Meanwhile, the opposite is true in the aftermath of crisis. We argue that these comovements are generated by the interaction of two characteristics of financing typical of middle income countries: risky currency mismatch and asymmetric financing opportunities across the N and T sectors Copyright 2002, International Monetary Fund

Boom-Bust Cycles in Middle Income Countries: Facts and Explanation

In this paper we characterize empirically the comovements of macro variables typically observed in middle income countries, as well as the boom-bust cycle' that has been observed during the last two decades. We find that many countries that have liberalized their financial markets, have witnessed the development of lending booms. Most of the time the boom gradually decelerates. But sometimes the boom ends in twin currency and banking crises, and is followed by a protracted credit crunch that outlives a short-lived recession. We also find that during lending booms there is a real appreciation and the nontradables (N) sector grows faster than the tradables (T) sector. Meanwhile, the opposite is true in the aftermath of crisis. We argue that these comovements are generated by the interaction of two characteristics of financing typical of middle income countries: risky currency mismatch and asymmetric financing opportunities across the N- and T-sectors.

Simulation-Based Pricing of Convertible Bonds

We propose and empirically study a pricing model for convertible bonds based on Monte Carlo simulation. The method uses parametric representations of the early exercise decisions and consists of two stages. Pricing convertible bonds with the proposed Monte Carlo approach allows us to better capture both the dynamics of the underlying state variables and the rich set of real-world convertible bond specifications. Furthermore, using the simulation model proposed, we present an empirical pricing study of the US market, using 32 convertible bonds and 69 months of daily market prices. Our results do not confirm the evidence of previous studies that market prices of convertible bonds are on average lower than prices generated by a theoretical model. Similarly, our study is not supportive of a strong positive relationship between moneyness and mean pricing error, as argued in the literature.Convertible bonds, Pricing, American Options, Monte Carlo simulation

Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing

The turmoil in the capital markets in 1997 and 1998 has highlighted the need for systematic stress testing of banks' portfolios, including both their trading and lending books. We propose that underlying macroeconomic volatility is a key part of a useful conceptual framework for stress testing credit portfolios, and that credit migration matrices provide the specific linkages between underlying macroeconomic conditions and asset quality. Credit migration matrices, which characterize the expected changes in credit quality of obligors, are cardinal inputs to many applications, including portfolio risk assessment, modeling the term structure of credit risk premia, and pricing of credit derivatives. They are also an integral part of many of the credit portfolio models used by financial institutions. By separating the economy into two states or regimes, expansion and contraction, and conditioning the migration matrix on these states, we show that the loss distribution of credit portfolios can differ greatly, as can the concomitant level of economic capital to be assigned.Credit risk, stress testing, ratings migration, credit portfolio management

Dissecting saving dynamics: measuring wealth, precautionary, and credit effects

We argue that the U.S. personal saving rate’s long stability (1960s–1980s), subsequent steady decline (1980s–2007), and recent substantial rise (2008–2011) can be interpreted using a parsimonious ‘buffer stock’ model of consumption in the presence of labor income uncertainty and credit constraints. Saving in the model is affected by the gap between ‘target’ and actual wealth, with the target determined by credit conditions and uncertainty. An estimated structural version of the model suggests that increased credit availability accounts for most of the long-term saving decline, while fluctuations in wealth and uncertainty capture the bulk of the business-cycle variation