Structured Product (Toxic or Impaired) Asset Pricing and Valuation Theoretical & Applied Modelling References BLUEPRINTS (ABBU)
Tuesday, 31 March 2009 | 
Risk - Research
This is all part of the 'Theory Forge' (or theoretical framework) which I have been initiating recently. Our publications work (we think) by explaining more fully our theoretical point of view & our specific approach to quantitative analytics in risk management and finance. The content is mostly taken from the higher level theoretical background with which we approach specific client engagements.
THE THEORY FORGE
A paper which explains how we approach the valuation of complex structured instruments (those 'products' which have become toxic, since they are so hard to value), the paper also explains what the modelling process is and the software toolsets, in terms of R packages, which we envisage as required are.
Our "blue paper") is an exposition on the latest publications about fair value / economic value of structured credit instruments, which sets out theoretical foundations to be considered by any team considering the process review and we comment on forecast assumptions, recent trends including in related markets, available here;
Structured Product (Impaired Asset) Pricing and Valuation
If one is engaged in a process to consider the fair or market or 'economic' value of Structured Products (Collateralized Debt Obligations (CDOs) etc) which is the challenge of the moment, right now; then this set of references could contribute to a lighthouse theory framework for you in beginning to establish an empirical or quantitative environment to meet this requirement. These 'structured assets' are by definition 'Level 3' in IFRS7 terms and thus the valuation philosophy of 'mark to model' must apply since no active reference market for such securities exists in anyway globally. The question is what is the optimum model? This has to be a model defined by practitioners (academic, supervisory or market participants) & in the public domain. Optimally by following one of the theoretical approaches referenced below precisely and by attempting to avoid too much fusion of aspects of preferred approaches since that way leads to "yet another CDO pricing model". We have enough already, from the so elegant they are aesthetic to the simply bonkers (or whacky for our US colleagues). Going the track of 'your special CDO pricing model' takes you further and further and further from transparency and towards a form of solipsism, if Wittgenstein's famous logic is properly understood. Since the current failure of our market-games is a function of a form of solipsism, that is not a route to take. Finally these theoretical approaches to Structured Product valuation are applicable whether the assets are regarded as impaired or not, since in large part the concept of 'impaired-ness' is a function of the lack of existing market pricing reference frameworks and thus a kind of voodoo psychology around these assets right now, driven by apocryphal assumptions of the value of underlying model variables.
Structured Product (Toxic or Impaired) Asset Pricing and Valuation Theoretical & Applied Modelling References BLUEPRINTS
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The development of securitisation statistics in Ireland
Clive A Jackson
Statistics Department, Central Bank of Ireland
Abstract
Securitisation has been used by Irish credit institutions for more than a decade, and has been an important factor in analysing developments in private sector credit. Since 2003, however, Ireland has also been a prominent location within the euro area for Special Purpose Vehicles engaging in securitisation unrelated to the domestic economy. This paper focuses on the development of statistics in Ireland within the framework of the recent ECB regulation on securitisation vehicles, including the identification of vehicles, conceptual and methodological issues encountered, initial results, and the future integration into national statistics.
very interesting
The Calculus of Structured Assets - Asymptotix Presentation
From a risk management perspective, the most important factor affecting the performance of a CDO deal is the total loss in collateral portfolio value over the life of the deal due to correlated defaults among the collateral. Each tranche can withstand a characteristic level of loss on the collateral pool before it does not receive its promised interest and principal payments. Performance is also greatly affected by the timing of the defaults, particularly for the equity tranche. Other risk factors are interest rates, maturing and prepayment rates of collateral, and recovery rates on defaulted collateral. There is also price risk, i.e. the change in value of the collateral due to changes in credit quality or interest rates, and the related issue of reinvestment risk.
Credit enhancement is the structural feature of CDOs that allows for higher quality debt (e.g.AAA) to be issued relative to the lower rated underlying collateral (average single B). Credit enhancements include, amongst others, features such as over-collateralisation and subordination. Over-collateralisation is the extent to which the par amount of collateral assets exceeds the rated liabilities, taken as a whole or for each rated tranche. Subordination refers to the structural priority of payments. Senior notes of the liability side of the transaction have a priority claim on the cash-flows and principal of the CDO. Subordinated notes/equity are entitled to the residual interest proceeds generated by the asset portfolio after the payment of expenses and debt service on the more senior obligations.
In the academic space, the shortcomings of the Discounted Cash Flow (DCF) approach to valuation are well recognised. DCF misses key elements of total return, the absence of a market value basis omits important information necessary to more fully judge performance going forward and volatility in valuation expectations, i.e. significant market value adjustments, are ignored. This means that the cash flow of the receivables for a securitised instrument, although an important fundamental aspect of the valuation process, is not the end of the process and should not be recognised as such. The next step forward in the methodological evolutionary process is some kind of Economic Valuation (ECVM) or Rate of Return (RARORM) modelling. Economic valuation presents a financial view in which all assets and liabilities are market valued (cash equivalent). ECVM considers the estimated magnitude and timing of future cash flows where economic income is the change in economic value over a period in time. Succinctly and in the language of the DCF approach, we are considering Forward Looking NPV income formulation (with and without risk adjustment). What this critique entails of course is a recommendation of the deployment of the "Reduced Form" approach to analytics is Risk Management.
This discussion may seem "up in the air" academic and irrelevant to the practical considerations of the business of securitisation but it is not. As G&J comment: "The details of the contractual cash flow waterfall are material but unobservable parameters in the true model of the securitization". From the perspective of the econometrician (in our case, the regulator), such parameters act as sources of random error that must be "integrated out" rather than ignored".
We should note the Gordy critique of the accounting approach to securitisation transactions - it is not necessarily specific to securitisation transactions; it is an instance of a current general view to move the analysis and quantification of capital form an accounting basis to an econometric one, where uncertainty and error are acceptable parts of the process. Essentially the accounting certainty is a chimera. This reflects a key critique of Structural Models in general which developed in the mid-90s as the RF approach evolved, namely that Structural Models (Merton) which rely on quantification of the firms assets and (in particular) liabilities in a precise manner are seriously "punctured" or appear flawed when we introduce the assumption that accounting information is uncertain.
Risk quantification means' the dollar, pound, euro or Swiss franc value of the total risk of that exposure or position or pool of exposures. By thinking of risk in this way we can think of the process of risk quantification as applicable both off and on balance sheet; that is whether off or on balance sheet we can use the same techniques and similar data to quantify risk (and more precisely we should see a feedback loop between the two domains). Further one can consider an originated loan exposure as only different in degree to a risk position in a market for traded securities and finally by considering risk in terms of a dollar value the immediacy of the relationship between risk and capital is embedded in the process of quantifying risk in an applied manner.
We can isolate Structured Products as the cause or source of the CC or more precisely the failure to comprehensively compute the risk capital in those instruments as the real source of the CC. But these products cannot be abandoned entirely since that would send the banking industry and the wider economy back to a prehistoric wilderness like the science fiction novel cliché of a quasi prehistoric world existing post a devastating event of pestilence or war! We as citizens are systemically dependent upon the fantastic innovations in financial technology of the past decades, now these technologies must be re-implemented and managed with appropriate concern for the risk levels they expose us to and thus computation of risk capital in an holistic and comprehensive manner is the key to our recovery from this crisis episode.
A holistic view by the board of the bank of the trend positions in BOTH capital and liquidity as shall be argued later in this paper, is the key to competent governance and sound management of a financial institution.This presentation is an exposition of the process issues and challenges in evaluation the Price or underlying Financial Risk of a Structured Asset.
Download the paper here!
VALUING TOXIC ASSETS: AN ANALYSIS OF CDO Equity
Francis A. Longstaff, UCLA Anderson School , and NBER
Brett Myers, Krannert School of Management, Purdue University, and Research Affiliates, LLC
This paper studies this issue from a novel perspective by contrasting the valuation of CDO equity with that of bank stocks. This is possible because both CDO equity and bank stock represent levered first-loss residual claims on an underlying portfolio of debt. There are strong similarities in the two types of equity investments. Using an extensive data set of CDX index tranche prices, we find that the discount rates applied by the market to bank and CDO equity are very comparable. In addition, a single factor explains more than 64 percent of the variation in bank and CDO equity returns. Although banks are presumably active creditportfolio managers, we find that bank alphas are significantly negative during the sample period and comparable in magnitude to those of more-passively-managed CDO equity. Both banks and CDO equity display significant sensitivity to "shadow banking" factors such as counterparty credit risk, the availability of collateralized financing for debt securities, and the liquidity of the derivatives market. A key implication is that we may be able to value "toxic" assets using readily-available stock market information.
LINK
Market Pricing of Exotic Structured Products
Market Pricing of Exotic Structured Products: The Case of Multi-Asset Barrier Reverse Convertibles in Switzerland
Martin Wallmeier
University of Fribourg (Switzerland) - Faculty of Economics and Social Science
Martin Diethelm
University of Fribourg (Switzerland) - Chair of Finance
April 2008
Abstract:
The market for structured financial products in Switzerland is considered the largest in the world. Its most successful products are multi-asset reverse convertibles with knock-in barriers. We analyze whether these complex instruments are fairly priced. Using a numerical, tree-based valuation method, we obtain an average overpricing of at least 3.4% for 468 certificates outstanding in April 2007. This premium on the entire product corresponds to a price discount of 29% on its embedded short put. The overpricing is positively related to the coupon level, indicating that investors tend to overweight the sure coupon and underestimate the risk involved. This behavioral bias appears to be important in explaining the success of the product.
LINK to SSRN page
Direct Link
(The) Structured Products Handbook (OeNB)
Structured capital market products - including ever-new ones - have become increasingly complex in recent years. For market participants to be able to evaluate and control the risks involved, they must be
well-grounded in the intricacies of these innovative instruments as well as in adequate valuation techniques.
This publication is meant to provide all interested market participants with a reference work about the valuation and replication of the structured bond products most widely traded in Austria. A partner institution of the Austrian credit institutions, the OeNB offers this service to all market players to ensure transparency.
The first part of the handbook deals with structured bonds whose payoff properties depend on interest rate movements, and the following two parts focus on products whose payoff characteristics are shaped by equity prices and foreign exchange rates.
The replication techniques presented in this handbook are meant to serve as exemplary approaches, e.g. to reporting the Austrian interest rate risk statistics or computing the regulatory capital requirement.
This ensures increased transparency and objectivity during audits. Ultimately, the Oesterreichische Nationalbank aims to strengthen the confidence in the Austrian financial marketplace and to contribute in particular in the light of Basel II to its stability and competitiveness.
LINK
CDO Pricing with Copulae
by Barbara Choros, Wolfgang Härdle & Ostap Okhrin
ABSTRACT
Modeling the portfolio credit risk is one of the crucial issues of the last years in the financial problems. We propose the valuation model of Collateralized Debt Obligations based on a one- and two-parameter copula and default intensities estimated from market data. The presented method is used to reproduce the spreads of the iTraxx Europe tranches. The two-parameter model incorporates the fact that the risky assets of the CDO pool are chosen from six different industry sectors. The dependency among the assets from the same group is described with the higher value of the copula parameter, otherwise the lower value of the parameter is ascribed. Our approach outperforms the standard market pricing procedure based on the Gaussian distribution.
LINK