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Iaqf Competition Paper
Iaqf Competition Paper
Where S
t
is the spread at time t, is the hedge ratio, and q
t
and p
t
are the prices for Q and P
respectively at time t.
As for the computation of hedge ratio, we employ the Total Least Square (TLS) model as the
results from this algorithm is reasonably symmetrical compared to others.
\Here we suppose the regression model is as follows:
Y=
0
+
1
X
Instead of minimizing the sum of vertical distances between the regression line and actual data
points, we attempt to minimize the sum of perpendicular distances R
i
, which we can write as:
Where we have identified the slop
1
=tan
So we need to solve the equation
Minimize: R(
1
,
0
)=
For the TLS solution:
Where
]
Initially, the returns on the unhedged and the hedged portfolios are calculated as:
R
u
=S
t
-S
t-1
And R
h
= (S
t
-S
t-1
) h*(F
t
F
t-1
)
Where R
u
and R
h
are returns on the unhedged portfolio and the hedged portfolio, respectively. F
t
and S
t
are logged price of CDS and hedge instruments at time period t, and h*is the optimal
hedge ratio.
Besides, the variances of the unhedged and hedged portfolios are calculated as:
Var(U)=
And Var(H) =
Where Var(U) and Var(H) represent variance of unhedged and hedged portfolios,
s
and
f
are
standard deviations of the CDS and hedge instruments, respectively. s,f represents the
covariance of the two serials. The effectiveness of hedging can be measured by the percentage of
decrease in variance of the hedged portfolio relative to the unhedged portfolio. The decrease of
variance can be computed as:
(Var(U) Var(H))/Var(U)
Thus we can check the hedge effectiveness by looking at the returns and variance over in-sample
and out-of-sample hedge period of 5, 10, 20 days.
We use the price data of Markit CDX North American Investment Grade Index and iShares Core
S&P 500 ETF (IVV) from 3/20/2009 to 28/10/2013 to calculate the hedge ratio.
Through our regression, we get the hedge ratio -0.1779, which means 0.1779 shares of IVV
should be sold for every CDS written.
To judge the hedge effectiveness, firstly we use next 5 days out-of-sample data to calculate the
returns of hedged portfolio and unhedged portfolio respectively.
From the table above, we can see that the return of the hedged portfolio is higher than the
unhedged portfolio.
We also check the variance reduction of the hedged portfolio and found that the hedge ration
from TLS provides approximately 90.87345% variance reduction, which indicates that the hedge
provided by the S&P 500 ETF is effective.
Part III. Reserve for writers and buyers
In our model, we attempt to account in factors that were revealed to be devastating if ignored
during the financial crisis, including the significant disruption in the market and the credit
downgrade of the CDS writer. What we consider here is the reserves for a CDS written on non-
truncated RMBS, and we abandon any external rating-based approach due to the failure of credit
rating agencies to precipitate the collapse of housing market in the financial crisis as well as
regulatory concern.
Once a CDS contract is set, we are able to extrapolate the default probability of the underlying
assets from the credit spread with a no arbitrage approach. Suppose the probability of a default
happening at maturity T is p, risk free rate is r, credit premium provisioned in the contract is s
and the premium is paid every T/K period of time, recovery rate given default is R.
The premium leg is
The protection leg is
By setting Premium leg = Protection leg, we can get
which is the average default rate of a single loan in the underlying pool.
According to the Gaussian Copula Model (Vasicek. 1987) we can simply assume that correlation
between any pair mortgage loans in the MBS is . We then set the confidence level as X, which
is usually 99% or 99.9%, and the percentage of loss as , then
(
)
For the seller of CDS, it should also hold reserves cover the potential collateral call from its
counterparty once it is downgraded. As credit rating is abandoned in our model, we assume that
in the CDS contract, the seller is required to post a certain amount of collateral (C) if its leverage
ratio increases to a certain level, that is, the total asset of the seller falls below its total liability
multiplied by a constant, a. We can derive this probability using Mertons model proposed in
1973. According to Merton,
and the probability of asset falling below a certain percentage of liability can be represented as
, where
is
In the formula, A is the assets of the seller, L is the liability, and is the maturity of the contract.
Thus, the reserve of the seller, assuming no initial margin posted, can be computed as follows:
Where N is the notional amount of the contract and
.
On the other hand, the buyer of CDS should also hold some reserves to protect itself from the
sellers default. Here we assume that the seller establishes a special purpose vehicle (SPV) which
specializes in transacting in CDS. We also assume that the SPV takes all of the available liquid
assets of the seller, which is the proportion of liquid assets that is still left after all liquid
liabilities are paid off, and the liability side of the SPV is the credit VaR computed above. Since
the seller is regarded as default if it cannot liquidate its assets to post additional collateral, we can
use Merton Model here for the SPV, and the default probability of the SPV, also the seller, is
represented as
, where
is:
The default rate associates the default probability of the protection seller to the extent of loss of
the underlying assets of the CDS. Thus the reserve for the buyer is
Part IV. Capital Requirements
When AIG-FPs positions in CDS contracts were made public, it shocked the world with the
leverage it had built up, as this relatively little subsidiary of AIG, entered into $562 billion of
CDS contracts, which in notional amount was more than half of total assets of AIG. That
prompted regulators to realize the fact that off-balance-sheet transactions, especially credit
derivatives had soared to an unprecedented and even uncontrollable level, and the importance of
enforcing tougher regulations on these transactions cannot be stressed more. Moreover, among
all the CDS written by AIG-FP, more than 70%, or $379 billion was written for European
financial institutions for the purpose of regulatory capital relieve other than risk mitigation,
adding to the volume, and also volatility of CDS market, hence nudged regulators to establish
stricter capital requirement for these instruments to rein in such kind of activities.
In response to the shortcomings of previous regulatory framework, the Basel Committee for
Banking Supervision (BCBS) revised Basel II Rules and released a new framework, known as
Basel III, in order to strengthen the resilience of banking system by increasing the amount,
quality and coverage of capital in 2010. Basel III establishes a set of firm-wide capital
requirements including 4.5% of Common Equity Tier 1, 6% of Tier 1 Capital, 8% of Total
Capital, 2.5% of capital conservation buffer and a countercyclical buffer ranging from 0 to 2.5%,
relative to risk-weighted assets.
As for CDS, determining the credit capital charge is much more complex. Under an internal
ratings-based approach (IRB), the critical part of this process is to determine a stressed
counterparty credit exposure simulated with data in significantly stressed scenarios, which entails
a downgrade of the credit rating of the institution, partial loss of the access to unsecured funding,
significant increase in the secured funding haircuts, and increases in collateral calls concerning
the derivatives contracts. No that a precedent exists, data during the 07-09 financial crisis can
also be employed. After simulation, the value corresponding to a tail event, say a confidence
level of 99.9% is selected to represent the credit exposure for the computation of capital charge.
In addition to the capital charges for counterparty credit risk, Basel III also a capital charge to
cover the risk of mark-to-market losses on the expected counterparty risk, known as credit value
adjustments (CVA) to OTC derivatives which would provide institutions with some liquidity
relieve during financial distress, while the transactions with a central counterparty (CCP) are
exempted from this provision.
Hence, according to arguments above and pursuant to real world rules completed by Basel
Committee, we can derive the following formula for the computation of capital requirements:
Where
is the credit risk charge for ith CDS contract, 10.5% is the minimum capital level
plus conservation buffer, 2.5% represents the maximum countercyclical buffer.
is a unit
variable ranging from 0 to 1 which equals 1 in periods of excessive credit growth and equals 0 in
periods of credit crunch.