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Abstract:
This paper examines the different factors that have contributed to the subprime mortgage credit crisis: the search for yield enhancement, agency problems, lax underwriting standards, failure by the rating agencies to identify a changing environment, poor risk management by financial institutions, lack of transparency, the limitation of extant valuation models and the failure of regulators to understand the implications of the changing environment for the financial system. The paper addresses the different issues and offers suggestions on how to move forward.

Subprime mortgages, SIVs, monolines, transparency, valuation

Abstract:
The paper examines three equity-based structural models to study the nonlinear relationship between equity and credit default swap (CDS) prices. These models differ in the specification of the default barrier. With cross-firm CDS premia and equity information, we are able to estimate and compare the three models. We find that the stochastic barrier model performs better than the constant and uncertain barrier models in terms of both in-sample fit and out-of-sample forecasting of CDS premia. In addition, we demonstrate a linkage between the default barrier, jump intensity, and barrier volatility estimated from our models and firm-specific variables related to default risk, such as credit ratings, equity volatility, and leverage ratios.

credit default swaps, default risk, structural models, jump

Abstract:
Recent court decisions, starting with the State Street decision in 1998, allow business methods to be patentable and now give financial institutions the option to seek patent protection for financial innovations. We develop a dynamic model that incorporates salient aspects of the adoption and dissemination of financial innovations. We find, somewhat surprisingly, that patent protection may be detrimental to long-term profits because of embedded real options for further innovations and market expansion that are especially important for financial firms. Moreover, a strategy of patenting and then licensing may not be effective because of expertise-related constraints of the licensees. Our framework helps understand the success of a wide class of innovations including swaps, credit derivatives, and pricing algorithms; it also helps financial institutions decide whether it is optimal to exercise the patentability and licensing option.

Business Methods, Financial Innovations, Patents, Licenses, Real Options

Abstract:
In this paper we model the expected loss over multi-year horizons. Investors usually have only incomplete information about the true state of a firm. To model this form of unobservable heterogeneity, we introduce a latent non-negative random variable into the model specification of the probability of default and the recovery rate. To estimate the expected loss over arbitrary horizons, we estimate the coefficients for the stochastic processes describing the covariates for the probability of default for each obligor and the loss given default. We provide an analysis of both in and out of sample performance of our estimates of the probability of default and the loss given default.

Default, Bankruptcy, Recovery Rate, Frailty, Unobservable Heterogeneity

Abstract:
Recent court decisions, starting with the State Street decision in 1998, allow business methods to be patentable and now give financial institutions the option to seek patent protection for financial innovations. This new patentability paradigm and the heterogeneity of characteristics associated with financial innovations, poses an immediate decision problem for senior management: what to patent. We present a parsimonious decision framework that answers this question. We show that for innovations with certain characteristics, it is optimal not to patent, even if the option of patenting and licensing is available. Our model emphasizes the role of embedded real options that arise from certain types of financial innovations. The model provides an explanation of observed patenting behavior of financial institutions and the success of a wide class of innovations, including swaps, credit derivatives, and pricing algorithms.

Business Methods, Financial Innovations, Patents, Licenses, Real Options

Abstract:
We describe a methodology for deriving the upper and lower profit and loss (P&L) bounds in the presence of counterparty risk that does not rely on either structural or reduced-form credit models. The methodology provides practitioners and regulators with a practical tool to estimate the impact on P&L of the two facets of counterparty risk: failure to perform and mark-to-market exposure. We show that for many applications, the bounds are tight and the creditworthiness of counterparties can have a major impact on the P&L.

upper and lower loss, P&L, counterparty risk, structural credit models, reduced-form credit models, mark-to-market exposure

Abstract:
This paper provides an analytical and practical framework, consistent with maximizing the wealth of existing shareholders, to address the following questions:

What are the costs associated with economic capital?

What is the tradeoff between the probability of default and the costs of economic capital?

How do we take into account the time profile of economic capital when assessing the performance of a business?

What is the appropriate measure of profitability, keeping the probability of default constant?

It is shown that the capital budgeting decision depends not only on the covariance of the return of a project with the market portfolio, but also on the covariance with the bank's existing assets. This dependency arises from the simple fact that the economic capital is not additive.

Abstract:
This paper provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a "spot exchange rate". Arbitrage free valuation techniques are then employed. This methodology can be applied to corporate debt and OTC derivatives, such as swaps and caps.

Abstract:
A European interest rate digital call (put) option pays one dollar at maturity if the prespecified reference interest rate is above (below) the strike level, and zero otherwise. A European range digital option pays one dollar if the prespecified reference interest rate lies within a specified range at maturity, and zero otherwise.A range note is a form of floating-rate note. The payment at the end of each period is defined to equal the number of days the reference interest rate lies within a specified range times an interest rate specified at the start of each period.Taking the initial term structure to be exogenous, closed-form solutions are derived for European interest rate digital options, digital range options, and range notes.

Abstract:
Taking the term structure of Treasury securities and Eurodollar rates as exogenous, this paper provides an integrated approach to the pricing and hedging of LIBOR derivatives. Our approach allows the spread between Eurodollar and Treasury rates to reflect both the credit risk in holding Eurodollar deposits and a convenience yield from holding Treasury securities. This integrated approach includes the models of Babbs [1991], Grinblatt [1994], and Jarrow and Turnbull [1995] as special cases.

Abstract:
This paper provides a Markov model for the term structure of credit risk spreads. The model is based on Jarrow and Turnbull (1995) with the bankruptcy process following a discrete state space Markov chain in credit ratings. The parameters of this process are easily estimated using observable data. This model is useful for pricing and hedging corporate debt with imbedded options, for pricing and hedging OTC derivatives with counterparty risk, for pricing and hedging (foreign) government bonds subject to default risk (e.g., municipal bonds), for pricing and hedging credit derivatives, and for risk management.

Abstract:
This paper provides a Markov Model for the term structure of credit risk spreads. The model is based on Jarrow and Turnbull (1995) with the bankruptcy process following a discrete state space Markov chain in credit ratings. The parameters of this process are easily estimated using observable data. This model is useful for pricing and hedging corporate debt with imbedded options, for pricing and hedging OTC derivatives with counterparty risk, for pricing and hedging (foreign) government bonds subject to default risk (e.g. municipal bonds), for pricing and hedging credit derivatives, and for risk management.