Credit Spread Widening Risk in Portfolios: Pricing Techniques and Sensitivity Measures
6 Pages Posted: 31 Jan 2008 Last revised: 2 Apr 2011
Date Written: December 20, 2007
Nowadays, contrarily to what was happening just a few years ago, credit risk soaks the majority of securities allocated in the banks’ trading portfolios. The development of securitisation techniques and the parallel refinement of pricing models allowed the transfer of this risk in new forms, more digestible even for the most cautious investors.
After the understandable initial suspicion towards the innovation, corporate bonds, asset backed securities and credit linked notes have gradually populated new portfolios, introducing a considerable component of income, but, at the same time, exposing the related fair values to the risk of credit spread fluctuations.
It is possible that some risk management system cannot fully capture the risk of devaluation of credit risky instruments that not always arises from real changes in the solvency conditions of the borrowers, but, more frequently, is due to the changes in risk perception for investors.
Indeed, behavioural mechanisms (e.g., flight to quality) may be triggered by isolated events (e.g., some important downgrade or profit warning) producing, at least in the short term, a general spread widening resulting in losses for all credit risky securities.
Treating this risk class as internal to interest-rate risk often leads to fair value inaccuracy and under-evaluation of value-at-risk. This is true for every financial instrument, but is more evident for floating rate notes that, while show a low interest rate risk, often imply high credit spread sensitivities.
Therefore, starting from the typical pricing models for plain vanilla bonds, we explore the possibility of improving the current pricing techniques in order to isolate spread risk and the mere interest-rate risk.
Keywords: spread risk, spread widening, interest rate risk, fair value, discounted cash flow, floater, floating rate note, value at risk
JEL Classification: B23, C51, C52, G12
Suggested Citation: Suggested Citation