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December 2016

With the implementation of IFRS 9 underway, institutions want to better quantify the impact of IFRS 9 on provisions, result earnings and capital buffers. During this video webinar, we will discuss the strategic impact of IFRS 9 on earnings, capital and investment concentration.

Related Insights
Whitepaper

A Composite Capital Measure Unifying Business Decision Rules in the Face of Regulatory Requirements Under New Accounting Standards

Prudent credit risk management ensures institutions maintain sufficient capital and limit the possibility of a capital breach. With CECL and IFRS 9, the resulting trend toward greater credit earnings volatility raises uncertainty in capital supply, ultimately causing an increase in required capital. It is ever more challenging for institutions to manage their top-of-the house capital while steering their business to achieve the desired performance level. This paper introduces an approach that quantifies the additional capital buffer an institution requires, beyond the required regulatory minimum, to limit the likelihood of a capital breach. In addition, we introduce a new measure that allocates capital and recognizes an instrument's regulatory capital requirements, loss allowance, economic concentration risks, and the instrument's contribution to the uncertainty in capital supply and demand. In-line with the Composite Capital Measure introduced in Levy and Xu (2017), this extended measure includes far-reaching implications for business decisions. Using a series of case studies, we demonstrate the limitations of alternative measures and how institutions can optimize performance by allocating capital and making business decisions according to the new measure.

May 2018 Pdf Dr. Amnon Levy, Xuan Liang, Dr. Pierre Xu
Whitepaper

Measuring and Managing the Impact of IFRS 9 and CECL Requirements on Dynamics in Allowance, Earnings, and Bank Capital

Reserving for loan loss is one of the most important accounting aspects for banks. Its objective is to cover estimated losses on impaired financial instruments due to defaults and non-payment. Reserve measurement affects both the balance sheet and income statement. It impacts earnings, capital, dividends and bonuses, and attracts the attention of bank stakeholders ranging from the board of directors and regulators to equity investors. In response to the so-called “too-little, too-late” problem experienced with loan loss reserve during the Great Financial Crisis, accounting standard setters now require that banks provision against loan loss based on expected credit losses (ECL). Arguably, calculating the Expected Credit Loss Model under IFRS 9 and CECL presents a momentous accounting change for banks, with the new standards coming into effect sometime between 2018 and 2021, depending on the jurisdiction.

March 2018 Pdf Dr. Amnon LevyDr. Jing Zhang
Whitepaper

Economic Capital Model Validation: A Comparative Study

Using a long history of public firm defaults from Moody's Investor Services and Moody's Analytics, this study illustrates a validation approach for jointly testing the impact of PD and correlation upon model performance. We construct predicted default distributions using a variety of PD and correlation inputs and examine how the predicted distribution compares with the realized distribution. The comparison is done by looking at the percentile of realized defaults with respect to the predicted default distribution. We compare the performance of two typical portfolio parameterizations: (1) a through-the-cycle style parameterization using agency ratings-based long-term average default rates and Basel II correlations; and (2) a point-in-time style parameterization using public EDF credit measure, and Moody's Analytics Global Correlation Model (GCorr™). Results demonstrate that a through-the-cycle style parameterization results in a less conservative view of economic capital and substantial serial correlation in capital estimates. Results also show that when point-in-time measures are used, the tested economic capital model produces consistent and conservative economic capital estimates over time. A version of this paper appears in the Journal of Risk Model Validation, March 2013.

February 2018 Pdf Zhenya Hu, Dr. Amnon LevyDr. Jing Zhang
Interview

Regulatory Constraints: How Increased Requirements Are Evolving CPM

Amnon Levy, managing director and head of portfolio and balance sheet research at Moody's Analytics, discusses the evolving expectations of institutions for credit portfolio management, as well as how it is being altered and adapted amid greater impact from new regulatory and technological advancements.

February 2018 Pdf Dr. Amnon Levy
Article

A Composite Capital Allocation Measure Integrating Regulatory and Economic Capital, and the Impact of IFRS 9 and CECL

We propose a composite capital allocation measure integrating regulatory and economic capital. The approach builds upon the economic framework underpinning traditional RORAC-style business decision rules, allowing for an optimized risk-return tradeoff while adhering to regulatory capital constraints. The measure has a number of depictions, and it can be viewed as a weighted sum of economic and regulatory capital, as economic capital adjusted for a regulatory capital charge, or as regulatory capital adjusted for concentration risk and diversification benefits. Intuitively, when represented as economic capital adjusted for a regulatory capital charge, the adjustment can be represented as the additional top-of-the-house regulatory capital, above economic capital, allocated by each instrument's required regulatory capital. We show that the measure has ideal properties for an integrated capital measure. When regulatory capital is binding, composite capital aggregates to the institution's top-of-the-house target capitalization rate. We find the measure is higher than economic capital, but lower than regulatory capital for instruments with high credit quality, reflecting the high regulatory capital charge for this instrument class. Finally, we address how IFRS 9/CECL impacts the CCM and discuss the broader implications of the new accounting standards.

May 2017 Pdf Dr. Amnon Levy, Dr. Pierre Xu
Whitepaper

Measuring and Managing Credit Earnings Volatility of a Loan Portfolio Under IFRS 9

IFRS 9 materially changes how institutions set aside loss allowance. With allowances flowing into earnings, the new rules can have dramatic effects on earnings volatility. In this paper, we propose general methodologies to measure and manage credit earnings volatility of a loan portfolio under IFRS 9. We walk through IFRS 9 rules and the different mechanisms that it interacts with which flow into earnings dynamics. We demonstrate that earnings will be impacted significantly by credit migration under IFRS 9. In addition, the increased sensitivity to migration will be further compounded by the impact of correlation and concentration. We propose a modeling framework that measures portfolio credit earnings volatility and discuss several metrics that can be used to better manage earnings risk.

January 2017 Pdf Dr. Amnon LevyDr. Yanping PanDr. Yashan Wang, Dr. Pierre Xu, Dr. Jing Zhang, Xuan Liang
Article

Risk Chartis IFRS 9 Market Report

International Financial Reporting Standard 9 (IFRS 9) is a high-impact symbolic, operational, IT and organisational transformation event for finance and risk. The Risk Chartis IFRS 9 Market Report focuses on the key challenges for banks implementing IFRS 9, including exclusive content from Moody's Analytics.

October 2016 Pdf Dr. Amnon Levy, Burcu Guner
Webinar-on-Demand

Modeling IFRS 9 Impairments – Tactical Implementation Approaches

Learn how Moody’s Analytics is helping institutions of all sizes address the challenges of implementing the IFRS 9 impairment model.

October 2016 WebPage Burcu Guner, Nihil Patel
Whitepaper

Managing Earnings Volatility and Uncertainty in the Supply and Demand for Regulatory Capital: The Impact of IFRS 9

This paper presents a novel modeling approach that allows for better management of the interplay between supply and demand dynamics for regulatory capital, combining an economic framework with regulatory capital and new loss recognition rules. The framework is particularly relevant in understanding the extent to which IFRS 9 can lead to more aggressive provisioning, which feeds into earnings volatility. Our approach provides guidance on how organizations can better manage their capital buffer, considering investment concentration, its impact on earnings volatility, and the relationship with regulatory capital requirements. Imperative to portfolio management, the framework recognizes the likelihood of a capital shortfall being significantly impacted by portfolio asset class, geography, industry, and name concentration, as extreme fluctuations in capital supply and demand occur more often for institutions holding more concentrated portfolios. Finally, we discuss integrated investment and strategic decision measures that account for the full spectrum of economic risks and interactions with regulatory and accounting rules, as well as instruments' contribution to earnings volatility and capital surplus dynamics.

September 2016 Pdf Dr. Amnon Levy, Dr. Pierre Xu, Dr. Jing Zhang, Andriy Protsyk
Whitepaper

Income-Adjusted Risk Contribution-based Capital Allocation

Banks commonly use Risk Contribution, or contribution to portfolio Unexpected Loss (i.e., standard deviation), as a risk allocation method. While the method has some very desirable properties, it can also produce seemingly counterintuitive dynamics, whereby high interest income-producing assets are associated with higher risk, all else being equal. This dynamic manifests from the higher interest income assets possessing higher value, leading to higher standard deviation in absolute terms. In reality, financial institutions often use interest income to offset losses, and thus, associate higher interest with lower risk. This paper introduces a new, income-adjusted form of Risk Contribution-based capital allocation, designed so that interest income offsets losses. The measure demonstrates improved properties for exposures with particularly high coupons.

August 2016 Pdf Andrew Kaplin, Dr. Amnon Levy, Mark Wells
Webinar-on-Demand

Quantitative Research Webinar Series: Modeling Uncertainty in Regulatory Capital and the Impact of IFRS 9 and CECL

Amnon Levy, Managing Director of Portfolio Research at Moody’s Analytics, discusses a novel modeling approach that allows organizations to better manage the supply and demand dynamics for regulatory capital. The approach marries an economic capital (EC) framework with (RegC) and loss accounting rules.

August 2016 WebPage Dr. Amnon Levy
Whitepaper

Investment Decisions and Risk-Based Capital Allocation Under Stress Testing Requirements

Higher capital standards imposed by new stress testing requirements have forced organizations to address how to better manage capital to meet regulatory constraints. While maintaining higher capital levels is indeed mandatory, simply satisfying the requirement does not necessarily align with stakeholders' preferences for optimal capital deployment and investment decisions. CCAR-style stress tests are requirements that organizations must adhere to; however, these exercises likely do not reflect how stakeholders actually trade off risk and return.

May 2016 Pdf Dr. Amnon Levy, Dr. Pierre Xu
Whitepaper

Using GCorr® Macro for Multi-Period Stress Testing of Credit Portfolios

This document presents a credit portfolio stress testing method that analytically determines multi-period expected losses under various macroeconomic scenarios. The methodology utilizes Moody's Analytics Global Correlation Model (GCorr) Macro model within the credit portfolio modeling framework. GCorr Macro links the systematic credit factors from GCorr to observable macroeconomic variables. We describe the stress testing calculations and estimation of GCorr Macro parameters and present several validation exercises for portfolios from various regions of the world and of various asset classes.

April 2016 Pdf Noelle Hong, Jimmy Huang, Albert Lee, Dr. Amnon Levy, Marc Mitrovic, Libor Pospisil, Olcay Ozkanoglu
Whitepaper

Measuring Required Economic Capital and Parameterizing the Loss Reference Point

When parameterizing an Economic Capital (EC) framework, organizations must consider how losses and gains on principal and coupons/fees are recognized, if they are to ensure appropriate capitalization. The level of loss allowance and capital organizations hold must be sufficient to cover potential losses. This paper outlines how parametrization differs for accrual and securities portfolios. In addition, we relate parametrization approaches with those associated with Basel Advanced-IRB calculations. We conclude that, when measuring an organization's required economic capital buffer, the relevant loss reference point is the accounting value net of loss allowance — losses should be measured in excess of total spread. While seemingly inconsistent with the Basel A-IRB formulation, where losses are measured in excess of expected loss, the difference can be interpreted as loss allowance exactly aligning with expected loss.

March 2016 Pdf Dr. Amnon Levy, Peter Bozsoki, Thomas Tosstorff, Mark Wells
Presentation

IFRS 9 Impairment - Current ‘State of the Market' Webinar Presentation Slides

In this webinar, we provided some observations of some of the challenges and possible processes banks are considering for their IFRS 9 Impairment Implementation.

March 2016 Pdf Burcu Guner
Webinar-on-Demand

IFRS 9 Impairment - Current ‘State of the Market'

This webinar provides some observations of some of the challenges and possible processes banks are considering for their IFRS 9 Impairment Implementation.

March 2016 WebPage Burcu Guner
Whitepaper

Through-the-Cycle Correlations

In some instances, financial institutions prefer to take longer-term views when assessing the risks of their credit portfolio. While forward-looking or Point-in-Time (PIT) parameters might be more reflective of the current economic environment, their frequent updates may create fluctuations in risk measures, such as economic capital and unexpected loss, which may not be desirable in some applications. This paper outlines two approaches that financial institutions can consider to estimate Through-the-Cycle (TTC) correlation parameters. The first approach averages PIT measures across years to obtain a longer-term TTC average. The second approach calibrates a TTC correlation measure that generates a default distribution in-line with the institution's actual default distribution.

January 2016 Pdf Jimmy Huang, Dr. Amnon Levy, Libor Pospisil, Noelle Hong, Devansh Kumar Srivastava
Article

Credit Risk Management Under Regulatory Capital Constraints

This article outlines recent approaches to managing credit risk when facing regulatory capital requirements. We explore how institutions should best allocate capital and make economically-optimized investment decisions under regulatory capital constraints, such as those imposed by Basel or CCAR-style rules.

December 2015 WebPage Dr. Amnon Levy, Dr. Pierre Xu, Dr. Jing Zhang
Webinar-on-Demand

Quantifying Risk Appetite for Limit Setting

In this webinar, Moody’s Analytics will discuss practical considerations when unifying regulatory and economic capital in investment decisions and the method for measuring this unified approach.

November 2015 WebPage Dr. Amnon Levy
Webinar-on-Demand

IFRS 9 Impairment Webinar Series – Key Elements & Challenges Ahead

This webinar discusses the challenges of IFRS 9 Impairment calculation and provides market insights for overcoming these challenges.

September 2015 WebPage Burcu Guner
Whitepaper

Practical Considerations When Unifying Regulatory and Economic Capital in Investment Decisions

The degree to which an organization's regulatory capital is constraining impacts an investment's appeal. The more constraint on the organization, the more heavily an instrument's regulatory capital weighs down the investment's appeal, with investments assigned higher regulatory capital impacted more. This paper explores a method for measuring the extent to which an organization's regulatory capital binds and calibrates the model introduced by Levy, Kaplin, Meng, and Zhang (2012), which unifies regulatory and economic capital in investment decisions. We then examine the impact of the regulatory capital requirement on investment decisions based on the calibrated model. We find that the rank order of exposures' risk-return tradeoff in our sample portfolio changes substantially when taking into account the regulatory capital constraint.

August 2015 Pdf Dr. Pierre Xu, Dr. Amnon Levy, Qiang Meng, Andrew Kaplin
Whitepaper

Quantifying Risk Appetite in Limit Setting

In this paper, we explore leveraging an organization's economic capital framework to quantify the RAS via risk- and macro scenario-based limits.

June 2015 Pdf Andrew Kaplin, Dr. Amnon Levy, Qiang Meng, Libor Pospisil
Webinar-on-Demand

Unifying Regulatory and Economic Capital for Investment Decisions

In this webinar, Moody’s Analytics will discuss practical considerations when unifying regulatory and economic capital in investment decisions and the method for measuring this unified approach.

May 2015 WebPage Dr. Amnon Levy
Webinar-on-Demand

Stress Testing Model Validation

This 30-min webinar discusses review of the stress testing model validation process, identifing common analytic and data gaps and discussing best practices in documentation and governance of model validation.

September 2014 WebPage Burcu Guner
Whitepaper

Quantitative PPNR Modeling

This paper discusses various quantitative approaches for linking macroeconomic scenarios with PPNR items. Given the broad range of PPNR categories, each item requires special consideration when developing a modeling approach. Modeling approaches range in granularity and depend upon the availability and quality of historical data, statistical properties of the line item, business use and application, and model consistency across balance sheet and income statement items.

January 2014 Pdf Dr. Amnon Levy
Webinar-on-Demand

Stress Testing Webinar Series: Macroeconomic Conditional Pre-provision Net Revenue (PPNR) Forecasting

This webinar discusses the primary challenges confronting banks when forecasting macroeconomic conditional pre-provision net revenue (PPNR), best practices for forecasting macroeconomic conditional PPNR, and the tools and techniques used by Moody’s Analytics to address the challenges.

October 2013 WebPage Thomas Day, Dr. Amnon Levy, Robert Wyle
Presentation

Integrating Economic Capital, Regulatory Capital and Regulatory Stress Testing

Amnon Levy, Managing Director and Head of Portfolio Research at Moody's Analytics, shares solutions to integrating the three kinds of stress testing variables for strategic decision making.

October 2013 Pdf Dr. Amnon Levy
Webinar-on-Demand

A New Approach to Accounting for Regulatory and Economic Capital

Learn about Moody's Analytics Portfolio Research methodology and findings of the new unified measures, which allow institutions to rank-order their portfolios and potential deals in a way that accounts for both economic risks and regulatory changes.

August 2013 WebPage Dr. Amnon Levy
Presentation

A New Approach to Accounting for Regulatory and Economic Capital

In this presentation, which accompanies a recorded Moody's Analytics webinar of the same title, Dr. Amnon Levy discusses Portfolio Research methodology and findings of the new unified measures (RORAC and EVA™) which allow institutions to rank-order their portfolios and potential deals in a way that accounts for both economic risks and regulatory changes.

August 2013 Pdf Dr. Amnon Levy
Whitepaper

A Unified Approach to Accounting for Regulatory and Economic Capital

In this paper, we introduce two new measures that incorporate both RegC and EC: return on risk-adjusted capital (RORAC) and economic value added (EVA™). These measures allow institutions to rank-order their portfolios and potential deals in a way that accounts for economic risk and regulatory charges.

August 2013 Pdf Dr. Amnon Levy, Andrew Kaplin, Qiang Meng, Dr. Jing Zhang
Whitepaper

An Overview of Modeling Credit Portfolios

This document provides a high-level overview of the modeling methodologies implemented in Moody's Analytics RiskFrontier™. To address the challenges faced by credit risk or credit portfolio managers, RiskFrontier models a credit investment's value at the analysis date, its value distribution at some investment horizon, as well as the portfolio-referent risk of every instrument in the portfolio. The approach is designed to explicitly analyze a wide range of credit investments and contingencies, including term loans with prepayment options and grid pricing, dynamic utilization in revolving lines of credit, bonds with put and call options, equities, credit default swaps, retail instruments, commercial real estate loans, and structured instruments.

June 2013 Pdf Dr. Amnon Levy
Whitepaper

Applications of GCorr™ Macro: Risk Integration, Stress Testing, and Reverse Stress Testing

This research develops an approach to expand the Moody's Analytics Global Correlation Model (GCorr) to include macroeconomic variables. Within the context of this document, macroeconomic variables can include financial market variables, economic activity variables, and other risk factors. The expanded correlation model, known as GCorr Macro, lends itself to several functions that facilitate a cohesive and holistic risk management practice.

April 2013 Pdf Mariano Lanfranconi, Libor Pospisil, Andrew Kaplin, Dr. Amnon LevyNihil Patel
Whitepaper

A Unified Decision Measure Incorporating Both Regulatory Capital and Economic Capital

Required economic capital (EC) and regulatory capital (RegC) are two measures frequently used in loan origination and other decisions related to portfolio construction. EC accounts for economic risks such as diversification and concentration effects. When used in measures such as return on risk-adjusted capital (RORAC) or Economic Value Added (EVA™), EC can provide useful insights that allow institutions to optimize risk-return profiles, facilitate strategic planning and limit setting, as well as quantify risk appetite. Meanwhile, when RegC is binding, an institution faces a tangible cost, in that additional capital is needed for new investments that face a positive risk weight. Given these observations, both EC and RegC should influence decision making. After all, a deal with lower RegC but the same EC is favorable, and a deal with lower EC but the same RegC is favorable. In this paper, we formalize RORAC and EVA measures that incorporate both RegC and EC. The new measures allow institutions to rank-order their portfolios and potential deals in a way that accounts for economic risks and regulatory charges.

January 2013 Pdf Dr. Amnon Levy, Andrew Kaplin, Qiang Meng, Dr. Jing Zhang
Webinar-on-Demand

New Risk Management Techniques that Improve Strategic Planning

New Risk Management Techniques that Improve Strategic Planning

October 2012 WebPage Dr. Amnon Levy, Randy Miller
Presentation

Moody's Analytics RPC Presentation: Levy Wang on Assessing and Pricing Liquidity Risk

Moody's Analytics RPC Presentation: Levy Wang on Assessing and Pricing Liquidity Risk

January 2011 Pdf Dr. Amnon LevyDr. Yashan Wang
Presentation

Bulletproofing an Index-Benchmarked Portfolio

Portfolio management problem: Benchmarking portfolio to an index is a common problem. A common approach is to track an index with a smaller number of positions in order to minimize transaction costs. Traditionally, more focus has been on the return; Second-moment-based risk measures such as Unexpected Loss (Standard Deviation) are also used; Less consideration is given to higher-moment, e.g., Tail Risk measures, that are important for credit portfolios.

November 2010 Pdf Dr. Amnon Levy
Whitepaper

Analyzing the Impact of Credit Migration in a Portfolio Setting

(A version of this has been published in the Journal of Banking & Finance, 2011, vol. 35, issue 12, pages 3145-3157) Credit migration is an essential component of credit portfolio modeling. In this paper, we outline a framework for gauging the effects of credit migration on portfolio risk measurements.

September 2010 Pdf Yaakov Tsaig, Dr. Amnon LevyDr. Yashan Wang
Whitepaper

Navigating Through Crisis: Validating RiskFrontier® Using Portfolio Selection

Assessing credit risk and ensuring the effectiveness and reliability of credit models are critically important to many risk managers and portfolio managers, especially during financial crises. This validation study examines the measurement accuracy of the portfolio credit risk models employed in Moody's Analytics RiskFrontier.

April 2010 Pdf Zhenya Hu, Dr. Amnon LevyDr. Jing Zhang
Whitepaper

Implications of PD-LGD Correlation in a Portfolio Setting

This paper discusses the implications of the Moody's Analytics PD-LGD correlation model on portfolio analysis. We provide numerical results to illustrate the impacts of PD-LGD correlation on risk and return measures of credit portfolios.

February 2010 Pdf Qiang Meng, Dr. Amnon Levy, Andrew Kaplin, Dr. Yashan Wang, Zhenya Hu
Whitepaper

Risk Integration: New Top-down Approaches and Correlation Calibration

While the sophistication and adoption of the data, models, and software systems for individual risk types has become more widespread, the tools for consistently measuring integrated risk lag. Typically, individual risk components are aggregated in ways ranging from simple summation to employing copula methods that describe the relationship between risk types. While useful, these “top-down” approaches are limited in their ability to describe the interactive effects of various risk factors that drive loss.

January 2010 Pdf Nan Chen, Andrew Kaplin, Dr. Amnon LevyDr. Yashan Wang
Whitepaper

Understanding Asset Correlation Dynamics for Stress Testing

Understanding how the components of asset correlation change through time will allow us to investigate how asset correlation dynamics behave during periods of economic stress. Although the time-varying correlation of equity returns has been extensively researched, we have found few studies on the dynamics of asset correlation over time. In this paper, we explore how both R-squared values and systematic factor correlations change through time. We show that R-squared values are more volatile than the systematic factor correlations. We also study the relationship between changes in R-squared and changes in factor variance, as well as the relationship between changes in factor correlation and changes in factor variance.

July 2009 Pdf Qibin Cai, Dr. Amnon LevyNihil Patel
Whitepaper

An Overview of Modeling Credit Portfolios

This document provides a high-level overview of the modeling methodologies implemented in Moody's KMV RiskFrontier®. To address the challenges faced by credit risk or credit portfolio managers, RiskFrontier models a credit investment's value at the analysis date, its value distribution at some investment horizon, as well as the portfolio-referent risk of every instrument in the portfolio. The approach is designed to explicitly analyze a wide range of credit investments and contingencies, including term loans with prepayment options and grid pricing, dynamic utilization in revolving lines of credit, bonds with put and call options, equities, credit default swaps, retail instruments, commercial real estate loans, and structured instruments.

December 2008 Pdf Dr. Amnon Levy
Whitepaper

Modeling Correlation of Structured Instruments in a Portfolio Setting

Traditional approaches to modeling economic capital, credit-VaR, or structured instruments whose underlying collateral is comprised of structured instruments treat structured instruments as a single-name credit instrument i.e., a loan-equivalent). While tractable, the loan-equivalent approach requires appropriate parameterization to achieve a reasonable description of the cross correlation between the structured instrument and the rest of the portfolio. This article provides an overview of how one can calibrate loan-equivalent correlation parameters. Results from taking the approach to the data suggest that structured instruments have far higher correlation parameters than single-name instruments.

November 2008 Pdf Tomer Yahalom, Dr. Amnon Levy, Andrew Kaplin
Whitepaper

Using Asset Values and Asset Returns for Estimating Correlations

In the Moody's KMV Vasicek-Kealhofer (VK) model, asset values and asset returns are calculated separately. Moody's KMV GCorr™ uses weekly asset returns directly from the VK model to calculate asset correlations. As an alternative, asset returns estimated from monthly asset values from Credit Monitor® can be used to estimate asset correlations. This study shows that the asset returns backed out from asset values are vulnerable to capital structure changes and other corporate activities, especially for financial firms. The frequent capital structure changes in financial firms make their correlations from asset values much smaller than the correlations from VK asset returns. Moreover, it is demonstrated that confidence intervals for correlation estimates from three years of monthly returns are much wider than correlation estimates from three years of weekly VK asset returns.

September 2007 Pdf Brian Dvorak, Fanlin Zhu, Dr. Jing ZhangDr. Amnon Levy
Whitepaper

Incorporating Systemic Risk In Recovery: Theory and Evidence

This paper proposes a theoretical framework to account for systematic risk in recovery and to address the correlation between the firm's underlying asset process and recovery. Under the proposed framework, the expected value in default under the risk neutral measure can be expressed as a linear function of the expected value under the physical measure. This allows for a simple mapping between expected recovery observed in the data and a measure that can be applied when using risk neutral valuation methods. When calibrating the model to parameters observed in the data, the risk neutral adjustment results in spreads that are 14% higher for a typical bond, and over 30% higher in some cases. When validating against market data, the evidence suggests that market spreads reflect systematic risk in recovery. We found that approximately 80% of our sample was estimated with a lower absolute error when using the risk neutral adjustment to compute model implied spreads.

April 2007 Pdf Dr. Amnon Levy, Zhenya Hu