IBM RegTech Innovations

On credit-augmented market risk analysis

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Many investors appreciate occasional bond rallies throughout their financial year. They may not all welcome the ongoing presence of low long interest rates as much (see Fig. 1). In such markets, low coupons and yields offered by top issuers may not be well suited to the refinancing of liabilities.

Fig. 1 – Evolution of 10Y Gov’t bond yields (OECD Data)

Exploring the credit spectrum

For fund managers and asset allocation sponsors, the investment answer often lays in the exploration of the credit quality spectrum. Using a blend of quantitative and fundamental approaches, these investors have on-boarded more corporate debt instruments. Thus, they benefit from higher coupons than government bond instruments, and receive welcome yield enhancements to improve upon expected performance.

For many fund managers, these broader investment types may only marginally impact short term risk indicators. Their key measures are often based on gross market exposures for leverage, sector limits for diversification, and market risk ratios; for example, these ratios can be based on volatility estimates, tracking errors or short term Value-at-Risk figures. For longer term investors and core sponsors, the picture is somewhat different. Exposed to economic capital management frameworks, on-boarding spread sensitive instruments requires them to monitor more than market risks. As pension funds and insurance firms seek to improve their financial performances, they need to also better integrate all risks. In such ERM context, further enhancing their credit risk monitoring capabilities matters.

Taking an integrated view on market and credit risks

As one expects, obligor defaults and portfolio contagion effects can have an adverse impact on these investors’ high-quintile risk ratios. When these long-term ‘risk takers’ project positions into a distant future for ALM, integration of market and credit risks shall matter even more. For many corporate issuances, bond defaults may well materialize at time points beyond the traditional fund managers’ horizons. For ALM managers, looking beyond a 3-year horizon, these credit events will appear in large volume simulation outputs. Rating migrations and eventual defaults will impact their expected cash-flows, simulated surplus and their related economic capital projections.

Adding rating transition effects and possible obligor defaults shall have multiple impacts on market risk-only simulations. On the one hand, it shall lower mean returns, and decrease the skewness of market-only simulated return distributions of bonds. In most cases, it shall push these skewness indicators well into negative value territories, especially for high yield bonds. The detailed impact will depend, amongst other factors, on single-name exposure limits and chosen recovery rates. On the other hand, integrating credit risks may also increase the kurtosis of the original return distribution. The more contagious simulated credit events are across obligors, the higher the expected tail risk measure impact shall be.

What-if?

In the current interest rate environment, the pension funds and insurance firms’ appetite for credit-augmented market risk analysis is understandable. For these financial institutions though, the challenges go beyond taking a regular picture of their combined market and credit risks. Using their modernized data infrastructures, most organizations shall now further tie their ERM risk results with daily decision-making processes. This is no easy task at all. How can risk managers, treasury and ALM teams consistently act upon insights they can gain from integrated market and credit risk analysis? Leveraging daily data feeds, credit-enriched risk management solutions shall allow these teams to run advanced market scenarios at position level. Users of these platforms shall also be able to simulate single-name hedges, and test their broader overlay plans too. With some short interest rates up, do more investors now prepare for times when market and credit risk indicators deviate from the current paths?

Functional Leader, Buy-side and Insurance – Risk Analytics, Customer Solutions Group, Watson FSS

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