Authors: Marcelo Labre and Bertrand Le Nézet
Trading books of most financial institutions contain significant exposure to illiquid defaultable instruments that are subject to mark-tomarket accounting. Due to unavailability of regular market quotes of credit spreads for such instruments, one must make use of proxies for valuation and to manage risks. Credit curve proxies are typically arbitrary, resulting in inaccurate risk management and high valuation uncertainties. In addition, a typical bias toward over-conservativeness results in higher regulatory capital calculation. We propose an approach for the construction of generic credit curves that establishes consistency with the default risk of the wider credit market, implicitly solving the various problems with arbitrary proxies. The approach consists in adopting the universe of credit rated issuers with visible market quotes of CDS spreads to form the underlying portfolio of an imaginary synthetic Collateralized Debt Obligation (CDO), in which credit ratings are associated with specific tranches or subordinations. AAA-rated spreads constitute the portfolio loss risk of a super senior tranche while CCC-rated spreads are aligned with equity (first-loss) tranche losses, with all other ratings forming the mezzanine subordinations. Vasicek’s portfolio loss distribution is used to imply the loss distribution of the portfolio, allowing for the construction of generic credit spreads for all desired maturities, credit subordinations, currencies, sectors and ratings.
Keywords:Credit curves, Credit Default Swaps, Collateralized Debt Obligation, Vasicek portfolio loss distribution