Frontmatter-Prof Persp Page iii Thursday, July 24, 2003 10:09 AM Professional Perspectives on Fixed Income Portfolio Management Volume FRANK J FABOZZI EDITOR John Wiley & Sons, Inc Frontmatter-Prof Persp Page i Thursday, July 24, 2003 10:09 AM Professional Perspectives on Fixed Income Portfolio Management Volume Frontmatter-Prof Persp Page ii Thursday, July 24, 2003 10:09 AM THE FRANK J FABOZZI SERIES Fixed Income Securities, Second Edition by Frank J Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L Grant and James A Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E Crabbe and Frank J Fabozzi Real Options and Option-Embedded Securities by William T Moore Capital Budgeting: Theory and Practice by Pamela P Peterson and Frank J Fabozzi The Exchange-Traded Funds Manual by Gary L Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume edited by Frank J Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J P Anson The Exchange-Traded Funds Manual by Gary L Gastineau The Global Money Markets by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J Fabozzi Collateralized Debt Obligations: Structures and Analysis by Laurie S Goodman and Frank J Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J Fabozzi Investment Performance Measurement by Bruce J Feibel The Handbook of Equity Style Management edited by T Daniel Coggin and Frank J Fabozzi The Theory and Practice of Investment Management edited by Frank J Fabozzi and Harry M Markowitz Foundations of Economic Value Added: Second Edition by James L Grant Financial Management and Analysis: Second Edition by Frank J Fabozzi and Pamela P Peterson Measuring and Controlling Interest Rate and Credit Risk: Second Edition by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry Frontmatter-Prof Persp Page iii Thursday, July 24, 2003 10:09 AM Professional Perspectives on Fixed Income Portfolio Management Volume FRANK J FABOZZI EDITOR John Wiley & Sons, Inc Frontmatter-Prof Persp Page iv Thursday, July 24, 2003 10:09 AM Copyright © 2003 by Frank J Fabozzi All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201748-6011, fax 201-748-6008, e-mail: permcoordinator@wiley.com Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993, or fax 317-572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley, visit our web site at www.wiley.com ISBN: 0-471-26805-4 Printed in the United States of America 10 Frontmatter-Prof Persp Page v Thursday, July 24, 2003 10:09 AM Contents Preface Contributing Authors vii xiv FIXED INCOME ANALYSIS AND STRATEGIES Risk/Return Trade-Offs on Fixed Income Asset Classes Laurent Gauthier and Laurie Goodman Fixed Income Risk Modeling for Portfolio Managers Ludovic Breger 17 Tracking Error William Lloyd, Bharath Manium, and Mats Gustavsson 45 Consistency of Carry Strategies in Europe Antti Ilmanen and Roberto Fumagalli 77 The Euro Benchmark Yield Curve: Principal Component Analysis of Yield Curve Dynamics Lionel Martellini, Philippe Priaulet, and Stéphane Priaulet Dollar Rolling—Does It Pay? Jeffrey Ho and Laurie Goodman 103 131 CREDIT RISK AND CREDIT DERIVATIVES Valuing Corporate Credit: Quantitative Approaches versus Fundamental Analysis Sivan Mahadevan, Young-Sup Lee, David Schwartz, Stephen Dulake, and Viktor Hjort Maturity, Capital Structure, and Credit Risk: Important Relationships for Portfolio Managers Steven I Dym 141 183 v Frontmatter-Prof Persp Page vi Thursday, July 24, 2003 10:09 AM vi Contents A Unified Approach to Interest Rate Risk and Credit Risk of Cash and Derivative Instruments Steven I Dym 197 Implications of Merton Models for Corporate Bond Investors Wesley Phoa 211 Some Issues in the Asset Swap Pricing of Credit Default Swaps Moorad Choudhry 229 Exploring the Default Swap Basis Viktor Hjort 239 The Valuation of Credit Default Swaps Ren-Raw Chen, Frank J Fabozzi, and Dominic O’Kane 255 STRUCTURED PRODUCTS An Introduction to Residential ABS John N McElravey 281 Nonagency Prepayments and the Valuation of Nonagency Securities Steve Bergantino 303 The Role and Performance of Deep Mortgage Insurance in Subprime ABS Markets Anand K Bhattacharya and Jonathan Lieber 325 Some Investment Characteristics of GNMA Project Loan Securities Arthur Q Frank and James M Manzi 339 A Framework for Secondary Market CDO Valuation Sivan Mahadevan and David Schwartz 365 Understanding Commercial Real Estate CDOs Brian P Lancaster 395 Aircraft Valuation-Based Modeling of Pooled Aircraft ABS Mark A Heberle 431 Index 439 Frontmatter-Prof Persp Page vii Thursday, July 24, 2003 10:09 AM Preface he articles in volume of Professional Perspectives on Fixed Income Portfolio Management are grouped into three areas: Fixed Income Analysis and Strategies, Credit Risk and Credit Derivatives, and Structured Products T FIXED INCOME ANALYSIS AND STRATEGIES In the lead article in this volume, “Risk/Return Trade-Offs on Fixed Income Asset Classes,” Laurent Gauthier and Laurie Goodman look at the risk/ return characteristics of major fixed-income asset classes over time in order to see if one asset class consistently outperforms another on a risk-adjusted basis They first look at the Sharpe ratios for each asset class, and compare those to the duration-adjusted excess returns The authors then use principal components analysis to identify the factors that are important in determining excess returns and duration-adjusted excess returns Finally, Gauthier and Goodman examine the performance by asset classes after hedging out the market factors identified through the principal components analysis The conclusions are quite robust: Overweighting spread product pays over time Within spread products, mortgages and asset-backed securities tend to have a very favorable risk/return profile over time The next four articles focus on the European fixed-income market and European asset managers and traders In “Fixed Income Risk Modeling for Portfolio Managers,” Ludovic Breger discusses the important sources of risk in European fixed-income securities and how to build a reasonable risk model The author addresses challenges such as accommodating different benchmarks and securities, or providing a wide coverage without compromising accuracy The risk characteristics of a typical euro investment-grade corporate index are roughly halfway between the conservative and speculative ends of the risk spectrum Although European fixed-income instruments are on average less risky than their U.S dollar equivalent, this by no means implies that a sound risk management is less relevant vii Frontmatter-Prof Persp Page viii Thursday, July 24, 2003 10:09 AM viii Preface The growth in the popularity of total return management in the European fixed-income market has led portfolio managers, consultants, and pension funds to increasingly focus on ex ante tracking error to measure the risk in their portfolios relative to a market index In “Tracking Error,” William Lloyd reviews three different methodologies for calculating tracking error and the assumptions associated with them While very convenient and conceptually straightforward, he concludes that tracking error is not the best way to evaluate the relative risk in a fixed-income portfolio Instead, Lloyd advocates the use of scenario analysis as a better method of determining the risk exposures in a fixedincome portfolio Yield-seeking investment strategies are popular ways of trying to add value in active portfolio management Most carry strategies—overweighting high-yielding assets and underweighting low-yielding assets— are profitable in the long run, but some strategies appear more risky than others Antti Ilmanen and Robert Fumagalli in their article “Consistency of Carry Strategies in Europe” show that carry strategies are especially consistently profitable at short maturities Among various structural tilts that real-money investors can make in their portfolios, replacing short-dated government debt with safe credits seems to offer the best reward for risk They find similar patterns in all markets they examine, presenting empirical results from European and U.S swapgovernment spread markets and credit markets However, they find the results are more compelling for real-money investors than for leveraged investors because the latter need to factor in funding spreads Moreover, as Ilmanen and Fumagalli note, the consistency of outperformance found is not as robust when investors go further down the credit curve than when they only shift from governments to highest-grade credits The term structure of interest rates can take at any point in time various shapes and the key question from a risk management perspective is to understand how the term structure of interest rates evolves over time There have been several studies of the term structure for the U.S market In “The Euro Benchmark Yield Curve: Principal Component Analysis of Yield Curve Dynamics” Lionel Martellini, Philippe Priaulet, and Stéphane Priaulet present an empirical analysis of the term structure dynamics in the euro-zone They study both the zero-coupon euro interbank yield curve, and zero-coupon Treasury yield curves from five individual countries (France, Germany, Italy, Spain, and the Netherlands) Using principal components analysis, they find that three main factors typically explain more than 90% of the changes in the yield curve, whatever the country and the period under consideration These factors can be interpreted as changes in the level, the slope, and the curvature of the term structure Martellini, Priaulet, and Priaulet also find 20-Heberle-Aircraft Page 436 Wednesday, July 23, 2003 10:25 AM 436 EXHIBIT PROFESSIONAL PERSPECTIVES ON FIXED INCOME PORTFOLIO MANAGEMENT Asset Model Predicted Cash Flows Source: Wachovia Securities, Inc ■ Bad debts realized and/or provided for ■ Aircraft repossession costs Within each pooled aircraft trust, the assumed case incorporates a 4.0–7.5% revenue haircut related to these types of stresses Our valuation-based stress model incorporates this revenue stress as a part of the stress being applied to the base lease revenue stress We have taken additional revenue haircuts that are applied to the cash flows generated by our asset model for each of our stress runs Although the original model assumes net maintenance at zero, our additional revenue stresses can be assumed to cover the typical portfolio stresses as well as maintenance and additional sales, general and administrative costs When we combine (1) our stressed cash flow from lease revenue, (2) the residual value cash flows, and (3) the haircut taken for additional stresses, we get our final predicted cash flows from our model shown in Exhibit CONCLUSION In each scenario, we evaluate the effect of the stresses by using the cash flows and the portfolio valuation curve that generated the cash flows as inputs to an aircraft deal’s liability model In this way, we have analysis that is consistent with all of our views on aircraft values This methodology captures the full nonparallel nature of aircraft stresses and uses a single set of assumptions to drive both aircraft values and cash flows By running this type of analysis under a variety of different stresses a portfo- 20-Heberle-Aircraft Page 437 Wednesday, July 23, 2003 10:25 AM Aircraft Valuation-Based Modeling of Pooled Aircraft ABS 437 lio manager can develop a better understanding of the relative strengths and weaknesses of a particular securitized structure Further, by building this analysis across different deals assumptions related to individual aircraft prospects can be used to compare securities from separate deals under a similar stresses 20-Heberle-Aircraft Page 438 Wednesday, July 23, 2003 10:25 AM Index2 Page 439 Wednesday, July 23, 2003 3:40 PM Index Absolute liquidity, decline, 252 Adjustable-rate loans, 299 Adjustable-rate mortgages (ARMs), 286, 293, 298 See also Hybrid ARMs collateral, 293 Agency CMOs, 289 collateral characteristics See Nonagency collateral characteristics debentures, guidelines, 282 loan size limit, adjustment, 304 market See Nonagency market mortgage securitization market, 284 origination volume See Nonagency origination volume passthrough, 315 pools, 312 burnout, 316 prepayments See Nonagency prepayments differences See Jumbo agency prepayment differences securities, valuation See Nonagency securities turnover rates, contrast See Jumbo turnover Aircraft appraised value, depreciation, 433 Aircraft Lease Portfolio Securitization (ALPS), 431 Aircraft residual values, 435 Aircraft valuation, modeling, 432–433 Aircraft valuation-based modeling See Pooled aircraft ABS Alt-A mortgages, 304 markets, 319 Alt-A originations, 319 Alt-A prepayments credit impairment, 318 security valuation, relationship, 315–322 value, 319 Alt-A securities, issuers, 317 AMBAC, 332 American International Group, 329 Arbitrage cash flow CDO structures, 366 considerations, 28 opportunities, 267 players, 249–250 Arbitrage-free option price, 151 Arbitrage-free relationship, 241 See also Default swaps Asset swap pricing, 229–231 example, 231–232 illustration, Bloomberg (usage), 233–237 issues See Credit default swaps Asset-backed securities (ABSs), 1, 12 See also Residential ABS aircraft valuation-based modeling See Pooled aircraft ABS CDOs, contrast See Commercial real estate CDOs collateral, 281 Assets See Uncorrelated assets classes, 13, 396 categorization See Fixedincome returns risk/return trade-offs See Fixed-income asset classes expected value, 148 portfolio, 390 swaps, 207–208 spread See Par asset swap spread volatility, 146 computation, 145–146 Available funds cap, 298–300 carryforward, 300 B and C borrowers, 283, 285 Bankruptcy, 186, 259 See also Personal bankruptcies court, 210 event, 191 evidence, 150 protection (Chapter 11), 166 Barrier options, 67 Base case scenarios, 321 Base lease revenue, 434–435 Basis convention, usage, 258 risk, 199 smile, 245, 247 Basis-type trade, 230 Baskets See Synthetic baskets products, 143 Benchmark See London Interbank Offered Rate swap account See Czech benchmark account index, 47 yield curve See Euro benchmark yield curve Binomial distribution See Modeling defaults Binomial Expansion Method (Moody’s Investor Services), 369 Binomial method See Moody’s Investor Services Black-Scholes option pricing formula, 145–146 Black-Scholes-Merton (BSM) model, 266 Bond returns application See Corporate bond returns normality, 72–76 result, 75 symmetric distribution, 60 Bondholders, recovery, 158 Bonds See Longer-dated bonds basket, 99 classification, 97 convexities, 189 coupon step-ups, 243 default swap, combination, 209–210 identity, 232 insurance structures, 294 markets See European corporate bond market lag, 216 valuations, 167 maturity, 187–191 portfolio risk, 76 prices interest rate shift, factoring See Corporate bonds 439 Index2 Page 440 Wednesday, July 23, 2003 3:40 PM 440 Bonds (Cont.) less than par, 245–247 price-yield formula, usage, 187 pricing, 184–185 subordination, effect, 186 ratings, 232 relative price responses, 193 risk, 220 premium, 87 spread, scatter plot, 222 Borrower See Prime borrowers; Subprime borrowers credit quality, 291 mortgage rate, 305 motivations See Commercial real estate CDOs B-piece, 396 buyers, 396 Break-even calculations, 88 Break-even cushions, 78, 82, 83 Break-even spread, 78, 81 average, widening, 97 cushions term structure, 85 widening, 91 Broad Investment Grade (BIG) Index (SSB), 2–3, 95 Burnout See Agency; Jumbos effect, 286 Business risk, 156 Butterfly component, 22, 43 factors, 37, 41 shapes, 43 Buy-side credit analysts, 156 Calendar convention, usage, 258 Calendar effects, 138 Callable agencies, 12 performance, Callable corporates, 13 See also Noncallable corporates Callable instruments, 11–13 Cap volatility, 8–11 significance, 12 Capital gains, 78, 91, 206 determination, 82 losses, 79, 81 determination, 82 markets, 165 reinvestment, 392 structural changes, 157–158 Capital structure, 183, 421 See also Firm change, motivation, 156 complexity, 184 dynamics, 225–228 subordinate position, 398 upgrading, 186 Carry components, 90 trade See Long-end carry trade Carry strategies, 94 Index consistency See European swap market (Europe), consistency, 77 interpretations, 100–102 Carry trades consistency See Short/long maturities forecasting model, 87 past outperformance, quantification, 85–86, 91–95 Carryforward See Available funds cap mechanism, 300 Cash assets, shorting difficulty, 250–251 Cash bonds borrowing rate, 232 credit risk, inclusion, 200–202 credit risk, nonexistence, 198–199 purchase, 232 Cash flow See Risk-free cash flows; Riskless cash flows approach, comparable yield (usage), 383–384 CDO, 401 discounting, 386 reasons See Equity diversion trigger, 425 methodology, 368, 382–389 modeling See Expected cash flows models, 434 projection See Defaultadjusted cash flows valuation See Rated CDO notes waterfall, 389 See also Collateralized debt obligation Cash instruments, 206–207 credit risk, unified approach, 197 interest rate risk, unified approach, 197 Cash market, 210 FRN, 230 reference assets, 231 shorting, 243 Cash settlement, 256, 257 Cheapest-to-deliver issues, 249 See also Futures contracts Cheapest-to-deliver option, 242–244, 252 Clean-up call, 300 option, 300 Collateral characteristics, 317, 367 See also Nonagency collateral characteristics uniformity, 307 composition, 304 generalizing, 370–371 pool, 291, 299, 392 repo, 96 type, 368 value, decline, 380 Collateralized debt obligation (CDO), 177 See also Cash flow; Investment grade synthetic CDOs; Static pool CDO age, 378 assets, 377 cash flow waterfall, 373 collateral, 370, 406 contrast See Commercial real estate CDOs equity, 382 option value See Distressed CDO notes/equity yield, 385 investment opportunities, 366 investment-grade tranches, 398 liabilities, 377–378 market, 381 notes, 365–367, 378, 384 cash flow valuation See Rated CDO notes option value See Distressed CDO notes/equity purchasers, characteristics See Real estate CDOs structures See Arbitrage understanding See Commercial real estate CDOs valuation, 387 framework, 366–368 See also Secondary market CDO valuation Collateralized debt obligation (CDO) tranches, 365– 369, 387 expected loss computation, 373–374 pricing, 389 valuation, 383 Collateralized mortgage obligations (CMOs), 281–282 See also Nonagency CMOs activity, 137 production, 137–138 Combined LTV (CLTV), 291 Commercial mortgage defaults, 415 Commercial mortgage-backed securities (CMBSs), 408 See also Investmentgrade CMBS contrast See Commercial real estate CDOs correlation, levels, 406 market, 411 portfolio, 401 prepayment protection, 417 recovery rates, 411 tranches, 410 transactions, 399 Commercial real estate (CRE) CDOs ABS CDOs, contrast, 417 borrower motivations, 398–403 Index2 Page 441 Wednesday, July 23, 2003 3:40 PM 441 Index Commercial real estate (Cont.) CMBSs, contrast, 411–415 corporate CDOs, contrast, 411 definition, 396–398 discrimination methodology, 419–422 high-yield corporate CDOs, contrast, 410–411 market, history, 395–396 penalization, 406–410 protection, historic context, 417–419 quality, 422 sector, performance, 423–425 trading process, 415, 422–423 tranches, 422 understanding, 395 Commercial real estate (CRE) loss severity rates, 411 Common factors, 53 Conditional mean exceedance, 224 Conforming mortgages, 282 rates, 305 Constant maturity (CM) spread, 80, 90 changes, 82 swap-gilt spreads, 92 Convergence, speed, 68 Convertible bonds, 249–250 Convexity See Bonds differences, 241 Copula functions, 179 Corporate bonds, 5, 29, 68, 249 See also Eurodenominated corporate bond; Euro-dominated corporate bond; Noninvestment grade corporate bonds; Short-dated corporate bonds coupon step-ups, 245 defaults See U.S corporate bond defaults investors, Merton models (implications), 211 prices, interest rate shift (factoring), 190 purchase, 205 returns, application, 73–74 sensitivity, 189 spreads changes, volatility, 97 connection See Equity drivers, 155 Corporate carry trades consistency See Short/long maturities outperformance, consistency, 97–100 Corporate CDOs, contrast See Commercial real estate CDOs Corporate credit fundamental approach, historical analysis, 166–175 products, 401 quantitative approach fundamental analysis, contrast, 141 historical analysis, 166–175 spreads See Euro corporate credit spreads structural models, 143–152 valuation, 141, 175–177 fundamental approaches, 156–166 quantitative approaches, 142–155 Corporate spreads, factor model, 143 Corporate-specific factor, 10 Counterparty credit exposure, diversification, 331 Counterparty risk, 200, 247–248 degree, 248 Coupon-adjusted swap (CAS) spread, 80 See also German Bundesobligationen Coupons, 201 bond See Fixed coupon bond; Par fixed coupon bond collateral, 135 dates, default occurrence, 148 mortgage, 133 See also Current coupon mortgage payments, 198 rates, 315 step-ups, 241, 252 See also Bonds; Corporate bonds Covariances blocks, 37 clusters, 40 construction, 19–20 forecasts, 35 matrix, 57, 64 See also KR covariance matrix method See Full covariance method model See Variance-covariance model Cox-Ingersoll-Ross model, 66– 67, 154 CPR, 286–288, 308, 316 history, 361 pricing assumption, 354 rate, 311–313, 321, 351–353 Credit analysts See Buy-side credit analysts; Sell-side credit analysts forecasts, 150 curing effect, 287 curve, 247 derivative See Pure credit derivative; Simple credit derivative inclusion, 187 market, 142 enhancement, 332–334 exposures, 229 impairment See Alt-A prepayments market See Euro credit markets portfolio products (valuation), quantitative approaches, 175–181 protection, purchase, 249, 250 quality, 319–321 See also Mortgages deterioration, 243, 252 measurement, SATO usage, 317–318 ratings, 50, 143 upgrades/downgrades, 381 relative pricing, 155 spread See Euro corporate credit spreads factors, 26–29, 37 widening, 142 structured synthetic bid, 251 systematic overweighting, 78 usage See Reference view, 68 Credit analysis key aspects, 290–293 principles, 156–157 Credit default basis, 232 Credit default swaps (CDSs), 190, 222 See also Up-front CDS asset swap pricing, issues, 229 attraction, 264 basis, 224 baskets, 67 developments, 276–278 markets, 224 premium, 265 pricing, 268 model See JP Morgan static replication, usage, 262–266 risk, 272–274 sensitivities, 272–274 spread, 256, 270, 274 term structures, 257 unwinding, practicalities, 275–276 valuation, 255, 269–272 Credit events, 259–262 See also Soft credit event number, 32 occurrence, 263 Credit impaired security, 397 Credit risk, 68, 183, 187–191, 199 amount See Cash bonds disaggregation, 156–157 factor, 210 present value, 204 structural models, 214–215 unified approach See Cash instruments; Derivative instruments Index2 Page 442 Wednesday, July 23, 2003 3:40 PM 442 Credit specific factor, CreditGrades (RiskMetrics), 141, 150, 215 CreditMetrics, 31 Credit-specific EDF, 391 Credit-spread factors, 55 Creditworthiness, 165, 332 CREST Clarendon Street 20021, 395, 401–405, 420 CRIIMI MAE, 396 Cross-collateralization See Mortgage insurance Cross-country trading, 78 Cross-market terms, computation, 37 Cubic B-splines method, 108 Cumulative defaults production year, 356–359 rates, 408 Cumulative net loss test, 296 trigger, 297 Currency exchange rates, 19 factors, 37 risk, 32–35 hedging, 39 Currency-hedged assets, 78 Current coupon mortgage, 132–133 Curvature effect, 116 Curvature factor, 119 Cushion curves, 90 CUSP Model (CSFB), 215, 217 Czech benchmark account, 24 Debt See European debt fixed allocation, 225 inclusion See Real estate investment trusts instrument, 184 levels, adjustment, 148 service payments, stream, 226 Debt/assets ratio, 149 Debt-holders, recovery value, 185 Debt-to-income (DTI), 315 ratios, 292 Deep mortgage insurance (MI), 298 mechanics, 326–328 role/performance See Subprime ABS structures, 333–334 Deep mortgage insuranceinsured structures, 337 Default, 206 barriers, 180 cumulative probability, 373 distributions See Nonbinomial default distributions event, 240 forward probability, 152 occurrence, 148, 206 See also Coupons; Maturities protection, seller, 245 rate See Gross default rate Index risk, 200 estimation, 216 spread, prediction ability, 170–172 threshold, 148, 224 See also Implied default timing, modeling, 387 Default correlation, 151, 390–392 See also Protection seller importance, 177–179 inferring, 179–180 measurement, difficulty, 217 modeling, 387–388 usage, 180–181 Default probabilities, 68, 179 computation, 147–148 determination, 142 forward curve, 266 modeling, 387–388 recovery rates, discrepancies, 224 Default swap basis, 265 See also Credit default swaps arbitrage-free relationship, 240–241 exploration, 239 fundamental factors, 241–248 practice, 252–253 technical factors, 248–252 Default swaps, 208–209, 256– 259 See also Digital default swap; Sovereignlinked default swap buyer, exposure, 232 high-beta nature, 243 payout requirements, 232 premiums, 251 zero flooring, 245 pricing models, implementation, 262 Default-adjusted cash flows, projection, 385–386 Default-based pricing models, 155 Defaulted security, 397 Default-free bonds, 66 Deleveraging, 419 Deliquency, 296–298 rates, 318 test, 296 trigger event, 297 Delivery option, 252 valuation, 260 Depreciation, 350–351 Derivative contract See Overthe-counter derivative contract Derivative instruments credit risk, unified approach, 197 interest rate risk, unified approach, 197 Digital default swap, 274 Discount margin, approach, 204 Distress See Financial distress probability, 220–222 Distressed CDO notes/equity, option value, 389–390 Distressed credits, 278 Distribution See Multivariate normal distribution; Returns Diversification, benefit, 406 Diversity score, 251, 370–371, 390, 406–408 robustness, 425 Documentation loans, 305 Dollar rolling, 131–132 results, 134–135 TBAs, 131, 137, 139 Dollar rolls, 137–138 See also Coupon-based dollar roll strategies, 133–135 performance, 134 Dollar rolls, advantages, 132 Domestic government bond returns, 42 Downgrades, 216, 411 See also Moody’s Investor Services D-Score (Moody’s Investor Services), 405–410, 425–426 importance, 408 understanding, 405–406 Duration, 47 contribution, 50 directionality, measurement, drift, 47 extensions, 87 historical view, 47–51 Duration-adjusted excess returns, 4–6 calculation, Duration-adjusted returns, 10 Duration-based model, 24 Duration-equivalent portfolio See On-the-run Treasuries Duration-matched Treasuries, 96 Dwarfs, 134 Dwelling type, 291 EBITDA, 143 Economic conditions change, 148 jumbo turnover, relationship, 312–315 Effective durations, 2, EGBI, financial issues, 97 Embedded options, 18 Emerging market (EM) algorithm, 35 comparison, 41–42 spread, 37 factors, 29–31, 37 Emerging Markets Bond Index Global (EMBIG) (JP Morgan), 30 Enron, 71 Equity See First-loss equity Index2 Page 443 Wednesday, July 23, 2003 3:40 PM 443 Index Equity (Cont.) cash flow, discounting reasons, 384–385 fixed allocation, 225 holders, payoff diagram, 144 markets, 150 corporate bond spreads, connection, 211 valuations, 167 model, market value, 191 option, 157–158 See also Over-the-counter equity options valuation, 293 value See Distressed CDO notes/equity prices, 151 valuation, 377, 392 volatility, 143, 146 usage See KMV Corporation Equity risk premium (ERP), 159 ERISA-eligible funds, 398 Euribor futures contracts, 111 rates, maturities, 108, 110 swap yields, 111 Euro benchmark yield curve, 103 data, 108–112 Euro Corporate Credit Index (MSCI), 161 Euro corporate credit spreads, 95–97 Euro credit markets, 49, 97 Euro interbank yield curve, 112, 113 derivation, 110–112 PCA (European zone), 112–119 Euro investment grade corporate index, 42 Euro spread factors, 37 Euro-denominated corporate bond, 25 European bond market, 27 European corporate bond market, 142 European currencies, volatilities, 33 European Monetary Union (EMU), 77 EMU Corporate Large Cap (Merrill Lynch), 38–39 EMU interest rate factors, construction, 23 markets, 80 European swap market carry strategies, consistency, 80–88 interpretations/implications, 86–88 historical experience, 80–85 spread curve (mid-2001), 80–85 European-denominated fixed income instruments, 41 Event See Credit events; Default determination date, 258 distribution, 368 risk, 411 Ex ante tracking error, 51–53, 56, 58 Ex post tracking error, 51–53, 56 Excess returns See Durationadjusted excess returns; Hedged excess returns capturing, 10–14 determination, volatility, 135 Exchange rates, usage, 33 Exotic derivatives, 67 Expected cash flows, modeling, 434–435 Expected default frequency (EDF), 150 See also Credit-specific EDF; KMV Corporation Expected earnings, 191 Expected recovery rate, 153, 224 Exponential distribution, 388 Exponentially Weighted VcV Matrix, 58 Exposure vector, 52 difference, 56 External currencies, shortage, 29 External debt, 30 risk, 29 Extreme events, 62 Factors See Common factors; Credit spread factors; Currency; Explanation power; Principal factors; Swaps correlation, 39, 117–119, 127–129 models, 59, 155 See also Corporate spreads historical study See Statistical factor model study, 169 returns, 43 shapes, 42–43 volatilities, 39 Fair market spreads, computation, 146–147 Fair market value, 142 Fat tails, 58, 177, 392 Federal Housing Administration (FHA), 339 FHA-financed nursing homes, 358, 363 FHA-insured passthrough participations, 340 insurance, 339 override See Lockout project loans, 340, 355 insurance programs, sections (listing), 341–344 regulations, 355 underwriting standards, 359 Federal National Mortgage Association (FNMA), 132–134 coupon, rolling, 134 pools, 288 Feedback loops, 225–228 FICO characteristic, 317 experience See Subprime market reduction, 305 scores, 285, 315, 336 Financial distress, 149 Financial prices, behavior, 67 Financial securities, contribution, 40 Financial status, evaluation, 165 First lien mortgages, 282 First-loss equity, 401 Fixed coupon bond, 206 Fixed-income asset classes, 10–11 performance, risk/return trade-offs/characteristics, Fixed-income instruments See Euro-denominated fixed income instruments Fixed-income returns, asset class categorization, 6–10 Fixed-income risk modeling See Portfolio managers Fixed-rate payer, 207 Floating rate notes (FRNs), 202–205 See also Cash market appearance, 207 default, 208 floating-for-fixed swap, combination, 208 Floating rate residential ABS, 298 transaction, 300 Floating-for-fixed swap, combination See Floating rate notes Floating-rate coupon, 230 Floating-rate international buyers, 403 Forward default probability, 279 Forward-looking analyses, 46 Forward-looking valuation model, 433 Free cash flow generation, 172 changes, 167 relationship See Relative value sector relationships, 174 trends, 173 Front-end carry trades, 101 Front-end spreads, 82 Full covariance method (FCM), 51–53 Fundamental factors See Default swap basis negative basis, 247–248 positive basis, 241–247 Index2 Page 444 Wednesday, July 23, 2003 3:40 PM 444 Funding risk, 252 Funding spread, 81, 97 Futures contracts, cheapest-todeliver issues, 199 GE Capital Mortgage, 329 General Auto-Regressive Conditional Heteroskedastic (GARCH) estimate, usage, 220 models, 33 volatilities, 35 Geographic concentrations, 292 Geometric Brownian motion, 65–66 German Bundesobligationen (Bobls) CAS spread, 80 liquidity, 85 reverse asset position See Swap-Bobl reverse asset position spread curve See Swap-Bobl spread curve swap spreads, 80 German shift volatility, 33 G-Force 2002-1, 421 Global integration, 35–38 Global portfolio, 107 GMAC, 399, 401 Gold standard, usage, 213 Government bond returns See Domestic government bond returns Government National Mortgage Association (GNMA), 132–134 prepayment tapes, 355 Project Loan Default Curve (GN PLD), 356–359, 363–364 underwriting changes, 359 Government National Mortgage Association (GNMA) multifamily pools, 340 default behavior, 354–356 investment characteristics, 363–364 prepayment behavior, 345–354 Government National Mortgage Association (GNMA) project loan default curve, 356–359 prepayments, breakdown, 359–361 securities, 340–344 investment characteristics, 339 Government-sponsored enterprises (GSEs), 4, 304 Gross default rate (GDR), 420 Hard penalties, 319 Hazard rate, 152–154 Index Health care loans, refinancing history, 361–363 Hedge ratios, 187–191 Hedged excess returns, 14 Hedging instruments, 107 High-beta, 239 character, 253 market, 253–254 Highest-grade assets, 100 High-grade corporate bonds, short-horizon spread returns, 18 High-grade debt, spread curve slope, 99 High-yield bonds, 27, 422 High-yield CBO, 411 sector, 424 High-yield corporate CDOs, 410 bonds, 409 contrast See Commercial real estate CDOs High-yield instruments, 31 Historical equity volatilities, usage See KMV Corporation Historical simulation, 60–64 advantages, 62 disadvantages, 63 Home equity lines of credit (HELOCs), 282 Home equity loans (HELs), 283, 289, 326 sector, 330 structures, MI inclusion/noninclusion, 332–334 Home equity prepayment (HEP), 286 Housing turnover, lock-in (dampening effect), 313 Hybrid ARMs, 293, 299 IBoxx Euro Corporate Nonfinancial Index, 52 IBoxx indices, 45, 47 Idealized Cumulative Default Rate (ICDR) (Moody’s Investor Services), 369, 374, 399, 420 matrix, 406, 409 Illiquidity problems, 97 Implied default probability mappings, 374 threshold, 180 Incomplete return series, usage, 35 Index composition, identification, 68 Index prices, 97 Index returns, 99 Index-based investors, 132 Inflation Protected Bonds (IPBs), 21 IPB-specific interest rate factors, 21–22 Information asymmetry, reduction, 163–165 Information ratio, 85, 92 See also Funds usage, 96 Instantaneous drift, 66 Instantaneous shocks, 68 Instantaneous volatility, 66 Interbank yield curve See Euro interbank yield curve PCA, 113–115 Interest coverage (IC) tests, 416–417 trigger, 417 Interest curve scenarios, number (selection), 68 Interest rate See Domestic interest rates; Foreign interest rates; Market; Maturities; Risk-free interest rate changes, 202 curves, PCA, 122 decline, derivatives See Pure interest rate dynamics, 66–67 environment, stability, 190 factors See Inflation Protected Bonds; Pure interest rate; Sovereign-based interest rate factors construction See European Monetary Union model, selection, 154 movements, 185 one-factor model, 66 process, 67 returns, computation, 42 shift, factoring See Corporate bonds term structure, 103–104 variations, time series, 104 Interest rate risk, 20–31 hedging, 39 PCA model, usage, 107–108 unified approach See Cash instruments; Derivative instruments Interest-only (I/O) securities, 359 Interest-only (I/O) strip, 299 Internal debt, risk, 29 International Swap and Derivatives Association (ISDA) 2003, 259 Credit Derivatives Definitions, 243 credit event definitions, 259, 262 documentation, 260 Mod-Mod-Re, 261 old definitions, (Old-Re), 261 restructuring definition, 242 Internet bubble, 151 Intex Solutions, 421 Investment grade corporate bond, 366 Index2 Page 445 Wednesday, July 23, 2003 3:40 PM 445 Index Investment grade corporate index See Euro investment grade corporate index Investment grade synthetic CDOs, 251 Investment grade-backed CDO, 424 Investment-grade CMBS, 417 collateral, 418–419 Investment-grade equity REITs, 416 Investment-grade REITs, 416 Investment-grade tranches See Collateralized debt obligation Irish Stock Exchange Limited, 398 IRR, 390 Issuer defaults, 226 Iterative procedure, 146 usage, 149 Ito’s lemma, 146 JP Morgan See Emerging Markets Bond Index Global; GBI Broad Index credit default swap pricing model, 237 Jumbo agency prepayment differences, 308–311 Jumbo mortgage rates, 305 Jumbo Pfandbriefe, 80 Jumbo prepayments increase, 310 security valuation, 307–315 Jumbo relos, 304 prepayments, security valuation, 322–323 valuation, 322–323 Jumbo securities, valuation, 313–315 Jumbo turnover rates, agency turnover rates (contrast), 313 relationship See Economic conditions Jumbos, 304 See also Weighted average coupon collateral, relative callability, 315 lock-in, 312 pools, burnout, 316 refinancing behavior, 307 turnover rates, 312 KMV Corporation, 141, 150, 215 approach, 391 default predictions, 169 EDF, 166–169 report, 152 usefulness See Relative value historical equity volatilities, usage, 217 LLC, 391 model, usage, 225, 228 KR covariance matrix, 43 Kurtosis See Leptokurtosis calculation, 75 Legacy factors, 23 Legacy market See Euro legacy markets idiosyncrasies, 23 Lehman Brothers See Nonagency prepayments Leverage, 143 model See Target leverage model Leveraged investors, 78 Leveraged-loan CDOs, 422 LIBID, 231 LIBOR See London Interbank Offered Rate Lien mortgages See First lien mortgages; Second lien mortgages status, 291–292 Liquidation costs, 185 Liquidity, 366, 411 See also Relative liquidity decline See Absolute liquidity growth, 20–21 LoanPerformance data, 335, 337 loan-level data, 304 Loans See Restructured loans aggregators, 317 documentation, 292–293 foreclosure, 418 identification, 355 origination, 415 purpose, 292 size, 292, 321 prepayment penalties, 318– 321 type, 293 Loan-to-value (LTV) See Combined LTV characteristic, 317 equilibrium, 431 level, 298 mortgage loans, 282 ratio, 291, 292 reduction, 315 Lock-in dampening effect See Housing turnover profile, 315 Lockout, 296 See also 36-month lockout form, 417 patterns, 345 period, FHA override, 354 provisions, overriding, 345 Lognormal model, 154 London Interbank Offered Rate (LIBOR), 3, 422 See also Zero-coupon LIBOR benchmarks, 42 borrowing rate, difference, 232 contract (3-month), 111 cost, 240 effect, 205 funding cost, 247 relationship, 247 increase, 299 LIBOR-GC repo spread, 88 LIBOR-GC spreads, 87, 90, 91 deducting, 92 LIBOR-repo, 81 payment, 207, 230 London Interbank Offered Rate (LIBOR) swap benchmarks, 42 curve, 20–21, 25 key rate returns, 43 Long swap-gilt spreads, withinsample widening, 92 Long-end carry trade, 95 Longer-dated deliverable, 260 Longer-dated nongilts, 48 Long-Term Capital Management, 283 Long-term debt, 151 Long-term performance record, 139 Losses calculation, 418 coverage requirements, 290–291 severity, 336–337 Management evaluation, 165 fees, 368 option, framework (development), 158–160 Market correlations, 63 frictions, 110 idiosyncrasies, 19 See also Legacy market idiosyncrasies interest rates, 210 participants, 163, 197, 247, 418 segmentation, 109 Market value See Equity changes categorization, 380–381 role, 378–380 methodology, 368, 377–382 usage See Structural change indicator Market-adjusted ratings, usage, 27 Market-dependent factors, 37 Market-implied default probabilities, 167 rates, 172 Market-implied rates, 171 Market-lagging approach, 165 Market-wide common factors, 18 Mark-to-market (MTM), 270–273 basis, 251 effect, 241 fluctuations, 181 Index2 Page 446 Wednesday, July 23, 2003 3:40 PM 446 Mark-to-market (Cont.) value, 274–275 vehicle See Nonmark-to-market vehicle Maturities, 183, 189 assets, 81 carry/roll components, 81 default, occurrence, 148 factors, 123 interest rates, 104 volatility, 82 MBA Refi Index, 137 MBIA, 332 Medium-term segment, 115, 116 Merton, Robert C., 145, 147, 214, 266 framework, 158 model See Black-ScholesMerton model original structural model, 145–148 extension, 148–149 structural approach, commercial implementation, 150 Merton, Robert C., models empirical results, 217–225 implications See Corporate bonds overview/uses/caveats, 214–217 Mezzanine CRE CDOs, 415 Mezzanine notes, 381 MFS Investment Management, 401, 403 Modeling defaults (binomial distribution), 371–373 Modified Restructuring (ModR/ ModRe), 243 Modified-Modified Restructuring (Mod-Mod-Re), 243 See also International Swap and Derivatives Association Moment-matching, 370 Money market tranche, 421 Mono-line insurance adjustments, 330–332 companies, ratings differential, 331 contrast See Mortgage insurance coverage, depth, 330 exclusions, 330–331 selection, 333 Mono-line wrap structure, 332 Monte Carlo simulation, 51, 62, 64–68 advantages, 67 calculation framework, 64–65 disadvantages, 67–68 models, examples, 65–67 Monthly tracking error, 135 Moody’s Investor Services, 242, 336, 369, 411 See also Binomial Expansion Index Method; Idealized Cumulative Default Rate; Watch List; Weighted average rating factor Corporate Default Index, 423–424 credit rating, inferring, 374 databases, 274–275 Double Binominal Method, 389 downgrades, 221 historical data, 174 Rating Factor Table, 426 recovery rate, 425 Morgan Stanley, 156 Mortgage Guarantee Insurance Corporation (MGIC), 329, 333 Mortgage insurance (MI), 325– 326 See also Deep mortgage insurance adjustments, 330–331 coverage, depth, 330 cross-collateralization, 326 exclusions, 330–331 inclusion/noninclusion See HEL structures markets, exposure, 331–332 MI-backed HEL deals, senior classes, 331 mono-line insurance, contrast, 330–332 performance, 334–337 providers, 329, 332, 337 ratings differential, 331 Mortgage-backed securities (MBSs), 1, 12, 282 See also Nonagency MBSs performance, prepayment risk, exposure, 18 valuation, 313 Mortgage-related market, development, 282–283 Mortgages See Prepaid mortgage default, 345 indices, 138 loans See Loan-to-value markets, 282 See also Alt-A mortgages; Single-family mortgage market pool, credit quality, 305 portfolio, rate-of-return, 138 rates, 305 See also Borrower; Conforming mortgages; Jumbo mortgage rates refinancing, 305 seasoning, 292 MSCI See Euro Corporate Credit Index index, 253 Multifactor model (MFM), 53–59 example See Sterling multifactor model Multifamily pools default behavior See Government National Mortgage Association prepayment behavior See Government National Mortgage Association Multivariate normal distribution, 47 National Housing Act of 1934, 339 Net loss test See Cumulative net loss trigger, 296–298 See also Cumulative net loss No-arbitrage condition, 231 No-arbitrage hypothesis, 109 Nonagency CMOs, 304 Nonagency collateral characteristics, 305–307 Nonagency market, 303–304 Nonagency MBSs, 304 Nonagency origination volume, 304 Nonagency prepayments, 303 model (Lehman Brothers), 307 Nonagency securities, valuation, 303 Nonbinomial default distributions, 390–392 Noncallable agencies, debentures, Noncallable corporates, 13 Nondomestic sovereign bond, 27 Noninvestment grade corporate bonds, 367 Nonmark-to-market financing, 398 Nonmark-to-market vehicle, 396, 401 Nonnegligible trading costs, 97 Non-penalty pool, 322 No-restructuring (No-Re) contract, 261 Obligation acceleration/default, 259 Observation periods, 61–62 Occupancy status, 291 Off-balance-sheet vehicles, 397 Offering memorandum (OM), 432, 434–435 Office of Federal Housing Enterprise Oversight (OFHEO), 326 Off-market derivatives, 199 OFHEO See Office of Federal Housing Enterprise Oversight Old Republic, 329 On-the-run Treasuries, durationequivalent portfolio, Operating environment, industry analysis, 160–161 Opportunity cost, 249, 312 Index2 Page 447 Wednesday, July 23, 2003 3:40 PM 447 Index Option value See Distressed CDO notes/equity Option-adjusted spread (OAS), 321 models, OAS-based models, valuation statistics, 319 Optionality factor, Origination, 319, 351 See also Alt-A originations; Federal National Mortgage Association costs, 305, 307 fixed costs, 308 volume See Nonagency origination volume Originator-level documentation coding systems, 317 Overcollateralization (OC), 290, 334 benefits, 416–417 trigger, 417 Over-the-counter (OTC) derivative contract, 275 Over-the-counter (OTC) equity options, 249–250 Par asset swap spread, 262 Par fixed coupon bond, 207 Par loss, 374 Par-floater, 241 Pari passu ranked assets, 242, 253 Pari passu requirement, 257 Par-par asset swap, purchase, 240 Path-dependent instruments, 67 Pay-floating interest rate swap, 88 Penalties See Hard penalties; Soft penalties provision, overriding, 345 Per period default probabilities, 268 Percentage profit/losses, differences (calculation), 61 Performance figures, range identification, 69 Performance risk, 200 Perpetual security, 47 Personal bankruptcies, 285 Pfandbrief See Jumbo Pfandbriefe hotspot, 40 Physical assets See End-of-year physical assets ROR, 193 Physical settlement, 256, 257 mechanics, 258–259 notice, 258 Plain vanilla coupon-paying Treasury bond, 198 PMI Mortgage Insurance, 329 Poisson distribution, 279 Poisson process, usage, 269 Pooled aircraft ABS, aircraft valuation-based modeling, 431 Pooled aircraft trust, 436 Portfolio See Global portfolio management, 17 performance, 59 products, valuation See Tranched portfolio products quantitative approaches See Credit risk, 67 WARF, 373 Portfolio managers fixed-income risk modeling, 17 usage, 38–41 relationships, 183 Premium leg, 256 payment, 269 zero flooring See Default swaps Prepaid mortgage, 315 Prepayment assumption, 393 behavior See Government National Mortgage Association multifamily pools breakdown See Government National Mortgage Association project loan differences See Jumbo agency prepayment differences history, 348, 351 penalties, 305, 319–322, 417 See also Loans usage, 287 performance, 304 protection, 345, 417 See also Commercial mortgagebacked securities risk, 367 exposure See Asset-backed securities; Mortgagebacked securities security valuation See Jumbo prepayments; Jumbo relos relationship See Alt-A prepayments speeds, 285–289 Prepay-penalty collateral, 321 Pricing differentials, 232–233 errors, 54 issues See Credit default swaps models, implementation See Default swaps Prime borrowers, 282 Principal payment See Unscheduled principal payments return, 198 Principal component analysis (PCA), 42–43 See also Interbank yield curve; Interest rate; Yield curve European zone See Euro interbank yield curve; U.S Treasury yield curve model, 104–108 usage See Interest rate risk Principal factors, 53 Private label mortgages, 282 Probability mappings See Implied default Probability-weighted loss, 373 Production refinancing, 353 Profit & loss (P&L), 276 Profits/interest rates, macroeconomic correlation, 191 Project loan insurance programs See Federal Housing Administration securities, investment characteristics See Government National Mortgage Association project loan Protection See Prepayment buyer, 258, 260 leg, 277 purchase, 263 seller, 209, 248 See also Default quotes, 277 reference entity, default correlation, 248 PSA, 286 Pull-to-par, 64, 65 Pure credit derivative, 206 Pure interest rate derivatives, 199–200 factor, 208 Qualified SPV (QSPV), 396–397 Radian Guaranty, Inc., 329 Rated CDO notes, cash flow valuation, 382–383 Rate-lock, 350–351 Rate-of-return (ROR), 185 money managers, 3–4 outcomes, 190 expansion, 191–193 possibilities, 186 shocks, 195 Ratings See Sectors/ratings agencies, approaches, 163–166 change, 165–166 agencies, consistency, 174–175 assessment, 165 transitions, prediction, 216 Real estate CDOs, purchasers (characteristics), 403–405 Real estate cycle, 415 vintage, 415 Real estate investment trusts (REITs), 408 See also Investment-grade equity REITs; Investment-grade REITs asset portfolios, 416 bonds, 398 cash flows, 406 collateral, 401 Index2 Page 448 Wednesday, July 23, 2003 3:40 PM 448 Real estate investment trusts (Cont.) debt, 396, 399, 415 inclusion, advantages/disadvantage, 415–416 payments, 398 Real-money investors, 81, 90, 92 perspective, 97 Recovery rates, 148 See also Expected recovery rate assumption, calculation, 274– 275 discrepancies See Default Recovery vectors, inclusion, 433 Reduced form models, 143, 152–154 advantages/disadvantages, 154 risk-neutral pricing, usage, 267 name, 266 Reference credit, usage, 232 entity, 256 default correlation See Protection seller issuer, 255 obligation, 255 Refinancing See Mortgages; Production refinancing (1993) wave, 309 history See Apartment complexes; Health care loans loan size, effect, 319 motivations, 287 profile, 315 Relative value consequences, 289–290 determination, 161 free cash flow, relationship, 172–174 KMV EDFs, usefulness, 168–172 opportunities, identification, 216 Relo prepayments, security valuation See Jumbo relos REMICs, 345 investment characteristics, 363–364 pricing, 357–359 tranches, 359, 362 Rental revenue, loss, 435 Repo See Collateral advantages, 85 Republic Mortgage Insurance Corporation, 329 Repudiation/moratorium, 259 Rerating methodologies, 367–377 Reserve accounts, 334 Residential ABS, 282, 283, 285 See also Floating rate residential ABS credit support, 290 introduction, 281 product, 289 structural considerations, 293–300 transactions, 294 Index Residual value See Aircraft residual values cash flow, 436 Residuals, 114, 377 See also Rich-cheap residuals Restructured loans, 418 Restructuring, controversy, 259–262 Returns See Multivariate normal returns data, normal distribution, 46–47 variation, Revenue See Base lease revenue haircuts, 435–436 stream, 225 Reward-to-risk, 95 Reward-to-volatility ratios, 99 Rich-cheap residuals, 168 Risk analysis, 36 clusters, identification, 41 excess, 45 exposure, types, 333 factors, 108 management, 42, 142 group, asset type split, 404 model, 35 modeling/understanding framework, 18–20 nominal amount, 87 premiums, 167 See also Bonds profile, change, 252 underestimation, 63 understanding, 17 Risk-adjusted returns, 137 Risk-based loan pricing, 227–228 Risk-free cash flows, 201 RiskMetrics See CreditGrades Risk-neutral default probabilities, 267 Risk-neutral pricing, 185 usage See Reduced form Risk-neutral probabilities, 150 Risk/return measures, Risk/return trade-offs See Assets; Fixed-income asset classes Rolldown components, 90 gains, presence, 85 spread changes, 99 Rolling CDS contract, 276–277 Rolling yield advantage, 81 Rotation factor, 119 Russian debt crisis, 395–396 Salomon Smith Barney (SSB) See Broad Investment Grade data, Yield Book, research report, 78 Sampling variation, 65 Scenario analysis, 68–71 conducting, 165 method, 69 Scholes, Myron, 266 model See Black-ScholesMerton model Seasonal effect, 138 Seasoned collateral, 138 Seasoning See Mortgages curves See Non-Cal seasoning curves effect, 291 Second lien mortgages, 282 Second priority notes, 381 Secondary market CDO valuation framework, 365 methodologies, 367–368 Sector-by-rating credit factors, construction, 32 Sector-by-rating spreads, 39 Sectors groupings, 163 ratings, 49–51 contrast, 161–163 weightings, 49–50 Selection bias, 336 Self-financing constraint, 108 Self-funded position, absolute P/L, 92 Self-funded trade, Sharpe ratio, 99 Sell-side credit analysts, 156 Senior bondholders, 295 Senior/subordinate structures, 294–295 Senior/subordinated structure, 332–333 Servicing fee, 298 Settlement conventions, 19 Severity calculations, usage, 418 Sharpe ratios, 2–4, 78 See also Self-funded trade usage, 92 Shift component, 22, 43 factors, 37, 41 shapes, 43 Shifting interest, 295–298 structure, 295 Shocks, responses, 193–195 Short/long maturities, corporate carry trades (consistency), 95–100 Short-term interest rates, 67 movements, simulation, 67 Short-term uncovered interest parity, 67 Simulation See Cash flow simulation models, 367 Single-family A quality mortgage default patterns, 355 Single-family MBS, 363 Single-family mortgage market, 348 Single-name credit default swap, pricing, 266–276 Skewed distribution, 391, 392 Index2 Page 449 Wednesday, July 23, 2003 3:40 PM 449 Index Skewness, calculation, 75 Small price movements, 65–66 Soft credit event, 242 Soft penalties, 319 Sovereign benchmarks, 42 Sovereign governments, taxes (raising), 29 Sovereign issuer, 30, 154 Sovereign-based interest rate factors, 21 Sovereign-linked default swaps, 258 Special-purpose vehicle (SPV), 396 See also Qualified SPV guidelines, 397 Specific risk, 31–32 Speculative-grade issuers, 175 Spread See Credit default swaps; Sector-by-rating spreads advantage, 87 change See Constant maturity; Rolldown; Yield prediction, 168 curve See Swap-Bobl spread curve rolldown, 85 slope See High-grade debt determination, 161 distribution, 63 excess, 100–101, 290 factor, 23–24 See also Credit; Emerging market; Euro spread factors; Swap spread position See Swap spread prediction ability See Default risk, 24–31 modeling, 26 volatility, 95, 100–101 SSSB EuroBIG index, 95 relative value curve, 97 Stale-price problems, 97 Standard & Poor’s (S&P), 32, 326 See also Core Earnings databases, 274–275 rating actions, 221 rating transition matrix, 101 Rules-Based Credit Classifications, 284 S&P 500, 8–11, 166 Structured Finance Ratings Group, 284 targets See CreditWatch listings Static loan pricing, 227 Static pool, 396 CDO, 396 Static portfolio/index, 46 Static replication, usage See Credit default swaps Statistical factor model, 166 historical study, 167–168 Step-down clauses, 245 Stepdown date, 295 Step-up coupon, 300 Sterling Bond Index, 73 Sterling factors, 28–29 Sterling global credit factors, 36 Sterling market, 36, 47–50 Sterling multifactor model, example, 55–58 Sterling-denominated corporate bond, 25 Stochastic process, 64, 67 Strategy risk, 157 Stress tests See User-defined assumptions Structural change indicator, market value (usage), 381–382 Structural credit risk model, 226 Structural models, 143, 224 See also Corporate credit; Credit risk; Merton advantages, 150–151 disadvantages, 151–152 Structural subordination, 415 Structural-based models, usage, 267 Structured credit products, 401 Structured synthetic bid See Credit Stub problem, 276–277 Subordinate tranches, 380 Subordinated A note, 415 Subordinated B note, 415 Subordinated tranches, 334 Subordination, 290 interest, 295–298 Subordination, effect See Bonds Subprime ABS deals, 333 markets, deep mortgage insurance (role/performance), 325 Subprime borrowers, 282 characteristics, 284–285 refinancing, 283 Subprime loans, 336 Subprime market, FICO experience, 337 Subprime mortgage pools, 288, 292–293 Surety fee, 299 Survival probability, 267–270, 278 Swap spread, 14 See also Bondspecific swap spreads; German Bundesobligationen; Par asset swap spread constant-maturity series, creation, 80 factors, 25–26, 37 position, 81 volatilities, 25 Swap-Bobl reverse asset position, 82 Swap-Bobl spread curve, 85 Swap-gilt curve, 90 Swap-gilt spreads, 89 See also Constant maturity Swap-related credit products, 80 Swaps See Asset swaps basis See Credit default swaps; Default swap basis benchmarks, 42 combination See Bonds; Floating rate notes curves, 80 See also London Interbank Offered Rate transparency, 20–21 factor model, 41 fixed payment, 200 gilt spreads See U.K swapgilt spreads market, carry strategies (consistency) See European swap market pricing See Asset swap pricing yields See Euribor Swiss francs-denominated bonds, 32 Synthetic baskets, 177, 252 Synthetic CDOs See Investment grade synthetic CDOs Systematic passive overweighting, 87 Systematic risk, 41 Target leverage model, 149, 152 Tax effects, 110 Tax Reform Act of 1986, 350, 353 Tax shelter, 350 TBAs See Dollar rolling contract, 134 portfolio, 131 position, 134 settlement, 131 Technical factors See Default swap basis negative basis, 251–252 new issues, 249–250 positive spread, 248–251 TED spreads, 87 Telecom assets, contribution, 40 bubble, 151 Term structures See Break-even spread; Interest rate computation, 42 risk, 22 shift, 43 Terminal value, usage, 191 Time-decay constant, 20 Total Return Index, 73 Tracking error, 45, 92, 135–137 See also Ex ante tracking error; Ex post tracking error; Monthly tracking error calculations, 46–47, 51, 60 estimate, 51, 67 fundamentals, 46–47 increase, 85 measures, implications, 76 model, 59 Index2 Page 450 Wednesday, July 23, 2003 3:40 PM 450 Tracking error (Cont.) prediction capability, 72 procedures, 51 Trading costs See Nonnegligible trading costs increase, justification, 88 Tranche See Money market tranche expected loss, computation See Collateralized debt obligation tranches loss function, 373 rating sensitivity, 374–377 valuation See Collateralized debt obligation tranches Tranched portfolio products, valuation, 180 Transaction expenses, 298–299 Transition probabilities, 32 Trepp, 421 Triad Guaranty Insurance Corporation, 329 Triggers See Net loss triggers events, 397 Trustee fee, 299 Turnover, 311–312 lock-in, dampening effect See Housing turnover rates, 313 See also Jumbos rates, contrast See Jumbo turnover relationship See Economic conditions Twist component, 22, 43 factors, 37, 41 shapes, 43 U.K swap-gilt spreads, 88–95 historical experience, 88–91 spread curve (mid-2001), 88–91 Uncorrelated assets, 370 Underwriting changes See Government National Mortgage Association criteria, 282 fees, 305 standards See Federal Housing Administration United Guaranty Corporation, 329 Unscheduled principal payments, 315 Up-front CDS, 277–278 Up-front costs, 278 U.S corporate bond defaults, 274–275 U.S swap-government spread markets, 78 U.S Treasury bond market prices, 108 defeasance, 417 notes, 191 prices, outsized movements, 190 Index securities See Benchmark yield curve derivation, 108–110 PCA (European zone), 112–119 yields, User-defined assumptions, stress tests, 68 Valuation See Credit default swaps; Equity; Firm valuation; Secondary market CDO valuation approaches See Corporate credit framework See Collateralized debt obligation methodologies extensions, 389–392 summarization, 392–393 quantitative approaches See Credit Value at Risk (VaR) See Confidence level computation, 142 definition, 60–61 estimation, 64–66 historical simulation, 51 methodology, developments, 63 Variables, orthogonalization, 13 Variance-covariance matrix, 54, 56 Variance-covariance method advantages, 59 disadvantages, 60 Variance-covariance model, 51– 60, 62 building/testing, 52–53 Variance-reduced variables, 105 Vasicek-Kealhofer (VK) model, 150 Vintage See Real estate cycle component, 415 Volatility, 22, 28, 63–64, 92 See also Euro currencies; General Auto-Regressive Conditional Heteroskedastic computation See Assets peak, 63 Wachovia Securities, Inc., 403, 417 Watch List (Moody’s Investor Services), 165 Weighted average cost of capital (WACC), 159–160 Weighted average coupon (WAC), 313, 323, 335–336 See also Alt-A WAC jumbos, 309, 322 rate, 316 Weighted average life (WAL), 409 Weighted average maturity (WAM), 335–336 Weighted average rating factor (WARF) (Moody’s Inves- tor Services), 371, 406– 410, 426–429 See also Portfolio amount, 399, 405, 420 changes, 374 forecast, 382 importance, 408 increase, 404 migration, 424–425 reduction, 426–427 understanding, 405–406 usage, 409 What-if analysis, 68 World Trade Center disaster, 411 WorldCom, 71 Wrap structure See Mono-line wrap structure Yield advantage See Rolling yield advantage maintenance agreements, 417 shift, 193 spread evolution, 95 variation, 78 usage See Cash flow Yield curve change, 61, 107 derivation See European interbank yield curve; U.S Treasury dynamics, principal component analysis, 103, 122 environment, 362 movement, 53–54 nonparallel shifts, occurrence, 104, 184 short-term segment, 113 Z-bonds See Cash flow Z-bonds accretions, 362 Zero funding spread, 88 Zero-coupon bond See Riskfree zero-coupon bond face value, 157–158 implied spread, 146–147 one year, 145 Zero-coupon corporate bond, 144 Zero-coupon euro interbank yield curve, 104 computation, 110–111 Zero-coupon LIBOR, 385–386 Zero-coupon rates, 107, 109, 111–112 sensitivities, 119–120 usage, 119 Zero-coupon Treasury yield curves, 104 Zero-coupon yield curves, 108, 111 spread, 105 ... variation) 1-Gauthier/Goodman Page 10 Thursday, July 24, 2003 10 :44 AM 10 EXHIBIT PROFESSIONAL PERSPECTIVES ON FIXED INCOME PORTFOLIO MANAGEMENT Relationship—Swap Spreads versus Duration-Adjusted... Choudhry Frontmatter-Prof Persp Page iii Thursday, July 24, 2003 10:09 AM Professional Perspectives on Fixed Income Portfolio Management Volume FRANK J FABOZZI EDITOR John Wiley & Sons, Inc Frontmatter-Prof... Mark A Heberle 43 1 Index 43 9 Frontmatter-Prof Persp Page vii Thursday, July 24, 2003 10:09 AM Preface he articles in volume of Professional Perspectives on Fixed Income Portfolio Management are