Moodys KMV Maual

MODELING PORTFOLIO RISK
IN PORTFOLIO MANAGER
MAY 19, 2004
3RD EDITION
CONTROLLED DOCUMENT DO NOT COPY OR DISTRIBUTE
CONTROL #: 000-INTERNAL
Authorized Recipient: Jeff Bohn, Research Dept, Moodys KMV
Date Released: June23, 2005
AUTHORS
Ashish Das
Anil Guarnaney
Amnon Levy
Jeff Bohn
Peter Crosbie
Stephen Kealhofer
CONTACTS
Ashish Das
ashish.das@mkmv.com
Amnon Levy
amnon.levy@mkmv.com
2004 Moodys KMV Company. All rights reserved.
This is a living document that we intend to keep current with the development of our credit risk measurement and
management software models. Therefore, we reserve the right to make changes to this document without notice. Your
comments and suggestions are welcome and should be directed to our Technical Publications Group via email c/o
docs@mkmv.com.
This is a highly confidential document that contains information that is the property of Moodys KMV. This document
is being provided to you under the confidentiality agreement established in writing under separate cover. This document
should NOT be shared with other employees of your business, including independent contractors, consultants or other
agents. By accepting this document, you agree to abide by these restrictions; otherwise you should immediately return the
document to Moodys KMV. Any other actions are a violation of the owners trade secret, copyright and other
proprietary rights. Any other actions are also a violation of the previously mentioned confidentiality agreement. Moodys
KMV retains all trade secret, copyright and other proprietary rights in this document. This notice shall remain affixed to
this document at all times.
Credit Monitor, EDFCalc, Private Firm Model, KMV, CreditEdge, Portfolio Manager, Portfolio Preprocessor,
GCorr, DealAnalyzer, CreditMark, the KMV logo, Moody's RiskCalc, Moody's Financial Analyst, Moody's Risk
Advisor, LossCalc, Expected Default Frequency, and EDF are trademarks of MIS Quality Management Corp.
All other trademarks are the property of their respective owners.
ACKNOWLEDGEMENTS
This document would not have been possible without the many comments and questions from all our clients. We want
to take this opportunity to thank you all and to encourage you to keep the comments and questions coming.
We would also like to thank everyone at Moodys KMV who contributed to this document, especially Navneet Arora,
Yuval Bar-or, Michele Freed, Andrew S. Kaplin, Stephanie Lee, Yim Lee, Bill Morokoff, Juan Redondo, Martha Sellers,
Chris Shayne, Glenn Sullivan, and Oldrich Vasicek.
Published by:
Moodys KMV Company
To Learn More
Please contact your Moodys KMV client representative, visit us online at www.moodyskmv.com, contact Moodys KMV
via e-mail at info@mkmv.com, or call us at:
NORTH AND SOUTH AMERICA, NEW ZEALAND AND AUSTRALIA, CALL:
1 866 321 MKMV (6568) or 415 296 9669
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FROM ASIA CALL:
813 3218 1160
TABLE OF CONTENTS
MODELING DEFAULT RISK CONTROL #: 000-INTERNAL 3
SECTION 1: INTRODUCTION
1 INTRODUCTION TO PORTFOLIO MANAGER .....................................................9
1.1 Overview and Motivation ...........................................................................................9
1.2 Methodology ...........................................................................................................10
1.2.1 Modeling Default Probability ..................................................................... 10
1.2.2 Correlation ................................................................................................. 11
1.2.3 Non-Normality of Credit returns.............................................................. 12
1.2.4 Incorporating Higher Order Effects........................................................... 13
1.3 The Portfolio Management System ........................................................................14
1.4 PM Concept Flow ....................................................................................................16
2 USING PORTFOLIO MANAGER .......................................................................17
2.1 Overview ..................................................................................................................17
2.2 Market Data ...........................................................................................................18
2.2.1 Reference Rates......................................................................................... 18
2.2.2 Zero-EDF Rates.......................................................................................... 18
2.2.3 Exchange Rates.......................................................................................... 18
2.2.4 Market Risk Premium................................................................................ 19
2.2.5 Spread Data................................................................................................ 19
2.3 Obligor Data ...........................................................................................................19
2.3.1 Expected Default Frequency...................................................................... 19
2.3.2 Country and Industry Classification .......................................................... 19
2.3.3 Obligor R2................................................................................................... 20
2.4 Exposure Data .......................................................................................................20
2.4.1 Commitment and Exposure....................................................................... 20
2.4.2 Loss Given Default ..................................................................................... 21
2.4.3 Related exposures ..................................................................................... 21
2.4.4 Aggregate Exposures................................................................................. 22
2.5 Parameters and Precision ....................................................................................22
SECTION 2: VALUATION AND RETURNS
3 INTEREST RATES AND CASH FLOWS ...............................................................27
3.1 Overview ..................................................................................................................27
3.2 Entering Zero-EDF Rates ......................................................................................30
3.3 Discount Factors ....................................................................................................31
3.4 Cash Flow Example ................................................................................................32
4 MODELING DEFAULT PROBABILITY .................................................................37
4.1 Asset Value and Volatility ......................................................................................39
4.2 Distance-to-Default (DD) Calculation ...................................................................41
4 CONTROL #: 000-INTERNAL
4.3 DD-to-EDF Value Mapping ....................................................................................42
4.4 EDF Value Interpolation .........................................................................................44
4.5 Summary ...............................................................................................................44
5 MODELING QUASI-PROBABILITY OF DEFAULT .................................................47
5.1 EDF and Quasi-EDF Values ...................................................................................48
5.1.1 Quasi EDF Details ...................................................................................... 50
5.1.2 Estimation of a Firms Correlation with the Market ................................. 53
5.1.3 Estimation of Market Parameters............................................................. 54
5.2 Summary ................................................................................................................56
6 VALUATION ......................................................................................................57
6.1 Book Value/User Input Pricing ..............................................................................58
6.2 Risk-comparable Valuation ...................................................................................58
6.2.1 RCV Example.............................................................................................. 59
6.3 Matrix Valuation .....................................................................................................65
6.3.1 Valuation Using Matrix Spreads ................................................................ 65
6.3.2 Computing the Matrix Spread.................................................................... 66
6.3.3 Matrix Value Example ................................................................................ 66
6.4 User Input Spread ..................................................................................................71
6.4.1 Computing the User Input Spread............................................................. 72
6.4.2 User Input Spread Example....................................................................... 72
6.5 Facilities Denominated in Foreign Currencies ......................................................74
7 CREDIT MIGRATION ..........................................................................................77
7.1 Distance to Default .................................................................................................77
7.2 DD Dynamics ..........................................................................................................79
7.3 Estimation of DD Distributions ..............................................................................82
7.3.1 Obligor-Specific DD Distributions ............................................................. 83
7.3.2 Adjusting the DD Distributions .................................................................. 84
7.4 Summary ................................................................................................................84
8 VALUATION AT HORIZON AND SPREADS ..........................................................87
8.1 Valuation at Horizon ..............................................................................................87
8.1.1 Value at Horizon in the Non-Default State ................................................ 87
8.1.2 Value at Horizon Given Default .................................................................. 90
8.2 Input Spreads .........................................................................................................90
8.2.1 Computed Spreads on the Exposure Editor screen.................................. 91
8.2.2 Simple Cash Spread................................................................................... 92
8.3 Output Spreads ......................................................................................................92
8.3.1 Understanding Spread to Maturity ............................................................ 93
8.3.2 Total Spread to Horizon ............................................................................. 93
8.3.3 Expected Spread and Expected Loss......................................................... 94
8.3.4 Portfolio Total Spread, Expected Spread, and Expected Loss.................. 95
8.3.5 Portfolio Value Distribution, Spreads, and Losses ................................... 96
8.4 Foreign Currency Denominated Facilities .............................................................97
9 MODELING RECOVERY ......................................................................................99
9.1 Specifying Expected Recovery Value ......................................................................99
MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 5
9.1.1 Recovery as a Percentage of Book Exposure............................................ 99
9.1.2 Recovery as a Percentage of No-Default, Value at Horizon ................... 101
9.1.3 Recovery as a Percentage of the Risk Free Value at Horizon................. 102
9.2 The Beta Distribution ...........................................................................................102
9.2.1 Parameter Assumptions for LGD ............................................................ 103
9.2.2 Choosing the k Parameter....................................................................... 103
SECTION 3: RISK MODELING
10 STAND-ALONE RISK .......................................................................................107
10.1 General case: DD Dynamics ................................................................................108
10.2 Default-No-Default Case .....................................................................................109
10.3 Some facts about exposure UL ...........................................................................111
10.4 Portfolio Unexpected Loss ..................................................................................112
11 CORRELATION ................................................................................................117
11.1 Factor ModelOverview ......................................................................................117
11.2 Factor Model - Estimation ...................................................................................119
11.2.1 Constructing Country and Industry Return Indices ................................ 119
11.2.2 Constructing the Basic Economic Factors .............................................. 121
11.2.3 Decomposing Country and Industry Risks .............................................. 122
11.2.4 Decomposing the Firm Risk .................................................................... 125
11.3 Applying the Factor Structure ..............................................................................128
11.4 Using the Factor Model to Calculate Correlations ..............................................130
11.5 Default Correlation ...............................................................................................131
11.6 Value Correlation ..................................................................................................135
11.7 MKMV Global Correlation Model .........................................................................136
12 PORTFOLIO VALUE AND LOSS DISTRIBUTIONS: THEORY ...............................139
12.1 Value Distribution .................................................................................................139
12.2 Loss Distribution ..................................................................................................143
12.2.1 Loss in Excess of Expected Loss ............................................................. 144
12.2.2 Loss in Excess of Total Spread................................................................ 145
12.3 Implications ..........................................................................................................147
13 MARGINAL RISK MEASURES ..........................................................................149
13.1 Risk Contribution .................................................................................................149
13.2 Tail Risk Contribution ..........................................................................................151
13.3 Exposure Capital ..................................................................................................154
13.3.1 Risk Contribution based Capital .............................................................. 154
13.3.2 Tail Risk Contribution based Capital ....................................................... 157
13.3.3 Dynamics of Risk Contribution and Tail Risk Contribution based Capital.....
159
14 PORTFOLIO VALUE AND LOSS DISTRIBUTIONS: ESTIMATION ........................161
14.1 Analytical Approximation .....................................................................................162
14.2 Calculated Loss Distribution ................................................................................162
14.3 Monte Carlo Simulation ........................................................................................163
14.3.1 Sampling Obligor Asset Values at the Horizon....................................... 163
14.3.2 Exposure Value at the Horizon ................................................................ 164
14.3.3 Exposure Value in the Default State....................................................... 165
14.3.4 Exposure Value in the Non-Default State............................................... 166
14.3.5 Monte Carlo Portfolio Statistics .............................................................. 168
14.3.6 Accelerated Monte Carlo ......................................................................... 169
14.3.7 Choosing an Accelerated Distribution: Testing AMC.............................. 170
14.3.8 Technical Discussion ............................................................................... 172
14.4 Using the Three Methods .....................................................................................175
14.5 Modeling Aggregates ............................................................................................176
15 CAPITAL DISTRIBUTION .................................................................................181
16 MEASURING RETURN/RISK ............................................................................187
16.1 Sharpe Ratio .........................................................................................................187
16.2 Vasicek Ratio ........................................................................................................190
16.3 Mispricing .............................................................................................................192
16.3.1 Risk Contribution Based Mispricing or Sharpe-Mispricing .................... 192
16.3.2 Tail Risk Contribution Based Mispricing or Vasicek-Mispricing ............ 194
16.4 Required Spread ...................................................................................................195
16.5 Return on Risk Adjusted Capital ..........................................................................197
16.5.1 Risk Contribution based RORAC.............................................................. 198
16.5.2 Tail Risk Contribution based RORAC....................................................... 199
16.6 Conclusion ............................................................................................................199
17 OPTIMIZATION ................................................................................................201
17.1 Quadratic Optimization .........................................................................................202
17.2 Optimization Direction ..........................................................................................203
17.3 Trades Optimization .............................................................................................204
17.4 Portfolio Global Optimization ...............................................................................205
17.5 Aggregate Exposures ...........................................................................................205
17.6 Conclusion ............................................................................................................205
APPENDIX A UNDERSTANDING EXPOSURE PROFILE CALCULATIONS .............207
A.1 Valuation at time Zero ......................................................................................... 208
A.2 Valuation at Horizon ............................................................................................ 210
A.3 Effective Initial Value and Spreads...................................................................... 211
A.4 Measuring Risk..................................................................................................... 212
APPENDIX B SYMBOLS AND ABBREVIATIONS ..................................................215
B.1 Symbols ................................................................................................................ 215
B.2 Abbreviations........................................................................................................ 217
GLOSSARY .................................................................................................................219
INDEX ........................................................................................................................223
MODELING PORTFOLIO RISK 7 MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 7
SECTION 1
INTRODUCTION
CHAPTER 1
INTRODUCTION TO PORTFOLIO MANAGER
1.1 OVERVIEW AND MOTIVATION
Credit risk has become one of the most challenging and important areas of risk management since the early
to mid-1990s. Corporate loans have always constituted a large portion of the balance sheets for banks
around the world. The financial crises facing large economies like the U.S. and Japan in the past few
decades have focused the attention of credit market participants on quantifying and managing risk. The
remarkable growth of the credit derivatives market along with the low issuance of government debt has
resulted in a substantial flow of investors to higher yielding corporate and emerging market securities.
These trends are resulting in a heightened interest in quantitative models for modeling credit risk.
Historically, credit risk has been managed qualitatively with stringent underwriting standards, limit
enforcement, and counterparty monitoring. These approaches have proven inadequate as financial
products have become more complex. Even institutions originating standard corporate loans have suffered
from the correlated nature of distress in the economy. Many banks have failed despite the presence of rules
focused on controlling an institutions overall credit exposure. Financial institutions looking to build
portfolios with superior return-to-risk characteristics are increasingly seeking to quantify their credit risk.
As a result, there is a strong need for quantitative and coherent credit models.
Moodys KMV Portfolio Manager (PM) reflects the state of the art in the science of credit portfolio
management. PM offers a practical and coherent alternative to much of the qualitative fuzziness in existing
portfolio management approaches. Rather than measure risk as exposure-based concentration amounts,
PM focuses on the amount of economic capital needed to maintain a particular level of risk in the debt
issued by the institution holding the portfolio. In other words, the basic paradigm of the model is designed
to fit institutional risk management needs and to support the determination of aggregate capital
requirements and economic capital allocations.
The approach implemented in PM uses value-at-risk (VAR) measurements and is fully consistent with
methods employed to measure "market" risks such as currency or interest-rate risks. The quantity of
required capital is the quantity of risk in the portfolio. PM offers a complete toolkit for managing the
credit risk and return of a large-scale credit portfolio. To elaborate, PM is designed to:
produce a mark-to-model price for credit-risky exposures;
characterize the return and risk of exposures in the context of a credit portfolio, and the return and risk
of the portfolio as a whole;
compute the distribution of portfolio values at a specified horizon date and use this distribution to cal-
culate required economic capital today;
determine optimal buy/sell/hold transactions for a given set of trading or origination opportunities;
and
calculate hypothetical optimal portfolios by rearranging the weights of existing holdings.
Broadly speaking, PM has two design objectives: The first is to accurately model the values of credit
exposures and the correlations between these values. The software is designed to deal with a wide variety of
possible exposures, including funded loans, revolvers, back-up lines, letters of credit, bonds, and some
types of structured transactions, such as collateralized pools of debt obligations. The second is to produce
an actionable set of quantitative goals for portfolio management. Traditionally these goals have been
measured in terms of earnings or return on equity. Recently, the focus has shifted to Risk-Adjusted Return
on Capital (RAROC). One measure of risk reduction is portfolio-wide capital relief. In this context, the
best use of PM is to maximize return for a given level of economic capital. Hence, PM calculates a Return
on Risk-Adjusted Capital (RORAC). Moving beyond the acronyms, PM facilitates the comparison of
compensation for credit risk against the amount of capital needed to support a particular exposure. PM
also measures the return per unit of portfolio unexpected loss or the portfolio Sharpe ratio. This return-to-
risk measure provides another guide for developing portfolio strategies.
1.2 METHODOLOGY
One of the key inputs to PM is the default probability of an obligor. A brief conceptual description of this
and other aspects of PM is given below.
1.2.1 Modeling Default Probability
In the context of Moodys KMV (MKMV) model, a firm is assumed to have defaulted when it fails to
make scheduled principal or interest payments. One way to model default defined in this manner is to
assume a firm defaults when the market value of its assets (the value of its ongoing business) falls below its
liabilities payable (the default point). Traditional approaches for measuring default probability involve a
detailed examination of a companys operations to project current and future cash flows of the firm. An
assessment of the companys future cash flows has already been made by all market participants and is
reflected in the firms current market value. Both current and prospective investors perform this analysis,
and their actions set the price.
Moodys KMV uses an economic structural model to measure the probability of default or the Expected
Default Frequency (EDF) of a firm. There are three main elements that determine the EDF value for a
firm:
Value of Assets: The market value of the firms assets. This is a measure of the present value of the
future free cash flows produced by the firms assets discounted back at the appropriate discount rate.
This market value of assets reflects the firms prospects and incorporates relevant information about
the firms industry and the economy more generally.
Asset Risk: The uncertainty or the risk of the asset value. This is a measure of the firms business and
industry risk. The value of the firms assets is an estimate and, thus, is uncertain. As a result, the value
of the firms assets should always be understood in the context of the firms business or asset risk.
Leverage: The extent of the firms contractual liabilities. While the relevant measure of the firms
assets is always their market value, the book value of liabilities relative to the market value of assets is
the pertinent measure of the firms leverage, since book value of liabilities is the amount the firm must
repay.
Moodys KMV research to date has uncovered the fact that firms typically do not default when their asset
value reaches the book value of their total liabilities. While some firms certainly default at this point, many
continue to trade and service their debts. The long-term nature of some of their liabilities provides these
firms with some breathing space. We have found that the default point, the asset value at which the firm
will default, generally lies somewhere between total liabilities and short-term liabilities. The relevant net
worth of the firm for determining the firms capacity to repay its liabilities, therefore, is the market value of
the firms assets minus the firms default point.
Net worth by itself does not distinguish the propensity to default among firms. Two firms with the same
net worth will be distinguished by the volatility in their respective market values. We use this intuition in
constructing what we call distance-to-default, which is simply the net worth of a company scaled by the
standard deviation or volatility of its asset value. Thus, for a given net worth, riskier assets would produce a
lower distance-to-default. Clearly, given two firms, the one which is closer to default, i.e, the one having a
lower distance-to-default, will have a higher probability of default.
Said differently, the dynamics of the credit quality changes of a firm are driven by changes in the market
value of assets, book liabilities, or asset volatility. We find that changes in asset value are the primary driver
of credit quality dynamics, followed by changes in liabilities. Asset volatilities are relatively stable over time
because they reflect the fundamental economic risk of a business. Changes in asset value volatility are
generally a result of spin-offs, mergers, or acquisitions. These corporate restructurings are typically
accompanied by dramatic changes in liabilities.
In addition to knowing the default probabilities of individual exposures, portfolio management of default
risk requires measuring the correlation in the exposures changes in value.
1.2.2 Correlation
PM uses Markowitzian portfolio analysis where the total risk of a portfolio is measured by explicit
consideration of the relationships between individual risks and exposure amounts in a variance-covariance
framework. We are interested in the distribution of portfolio values over a given horizon, e.g., one year.
Each exposure has associated probabilities of credit quality changes and default over the next year. Each of
these events implies an exposure value. Because the events are not independent across exposures, we cannot
simply sum individual exposure value variances into a portfolio value variance. Thus, the portfolio value
distribution requires a model for the correlation among exposures in the portfolio.
Moodys KMV has constructed a factor model called the Global Correlation Model
TM
to explain
correlation in the underlying asset values of the obligors. These underlying asset values are part of the
economic model of default described above. These values can be used in the context of a correlation model
by determining the joint frequency of two firms market values of assets falling below their respective
liabilities. Pair-wise exposure value correlation is a function of both the asset correlation and the respective
EDF values of the two firms. This link between firm asset value and exposure value is combined with the
link between firm asset value and exposure value correlation to produce the necessary calculations for
determining the portfolios overall credit risk. The key to robust risk measurement lies in accurately
transforming asset values into exposure values with suitable valuation technology. Moodys KMV provides
one possible model called Risk Comparable Valuation (RCV) for this purpose. MKMVs factor model
isolates the systematic variation in asset values to provide the basis for calculating asset value correlation.
That is, ex ante the best estimate of future co-movement in asset values is a function of the extent to which
firms have similar systematic components driving their respective asset values.
1.2.3 Non-Normality of Credit returns
Credit portfolios are very different from equity portfolios. Credit returns are characterized by a large
likelihood of earning a small profit through interest payments and a small chance of losing a large amount
of investment. Despite the skewed nature of these return distributions, the return on a portfolio of many
uncorrelated exposures with these characteristics will still converge to a normal distribution as the number
of exposures grows large. In practice, however, credit portfolios contain correlated exposures. As a result,
credit portfolio returns are not well approximated by normal or Gaussian distributions. Figure 1.1 depicts
a typical credit portfolio value distribution and a normal density with the same mean and variance.
FIGURE 1.1 Non-normality of Actual Portfolio Value Distribution
Correlation among exposure values implies a portfolio value distribution that is highly skewed: it has a
long tail of adverse outcomes. Attempts at estimation of the portfolio value distribution using only mean
and variance literally fall short: they have the effect of ignoring the tail of the distribution-- the very worst
outcomes that are the critical focus of risk management. The purpose of economic capital is to protect
against these extreme outcomes.
Modeling credit portfolios requires careful estimation of the tail in the portfolio value distribution. Some
analytically derived value distributions provide approximations to the shape of the tail for skewed,
correlated, credit-risky securities; however, credit portfolios with a large variety of instruments will likely
require a simulation to determine the portfolio value distributions tail probabilities. Actual credit portfolio
distributions can diverge substantially from the normal distribution.
In Figure 1.2 we see that the tail of the normal distribution is approximately zero near 97.3%. The tail of
an actual credit portfolio value distribution extends several standard deviations below this value.
Intriguingly, portfolio value distributions can have similar variances but dramatically different tail sizes.
These differences in tails reflect the presence of different outliers. Since credit portfolio management is
Normal vs. Actual Portfolio Value Distribution
0
0.02
0.04
0.06
0.08
0.1
0.12
96.0% 97.0% 98.0% 99.0% 100.0% 101.0%
Portfolio Value (% of Initial Value; Mean value = 98.9%)
P
r
o
b
a
b
i
l
i
t
y

D
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s
i
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y
Portf olio Value Distribution
Normal Distribution with Identical Mean and Variance
Cri t ical Regi on
really outlier management, accurate characterization of a portfolios tail risk is an essential ingredient to
developing effective portfolio strategies.
FIGURE 1.2 Tail of the Value Distribution
1.2.4 Incorporating Higher Order Effects
In addition to modeling mean and variance, PM takes into account successively higher order effects like
skewness and kurtosis to obtain the complete portfolio value distribution. Explicit analytical solutions are
computationally impractical for portfolios of even moderate size. Moodys KMV has developed three
methods to address higher-order effects. The first, the Analytical Approximation, uses aggregate portfolio
measures to re-calibrate the normal distribution to better approximate the tail of a typical loan portfolio
value distribution. The Analytical Approximation is calibrated to the value distribution for a typical bank
portfolio of over a thousand loans with relatively uniform weights. The calibration performs best near the
10 bp level of tail risk, or the worst one-thousandth of possible outcomes. Analytical Approximation run
time, even for large portfolios, rarely exceeds a few minutes. It should always be benchmarked against the
other two methods based on Monte Carlo simulations.
The Standard Monte Carlo simulation takes as input the individual risks of exposures in the portfolio and
the drivers of asset-value correlation among these exposures. No assumptions are made regarding the
distribution of weights or the standard deviations of the exposure values. The Monte Carlo Simulation
draws a state of the world under the factor model (a return for each country and industry and some other
macroeconomic factors), draws a default or credit quality change outcome (a return on the market value of
assets) for each obligor in the portfolio, and then computes a portfolio value by summing individual
exposure values. The realized portfolio value is tabulated in a frequency distribution, and the process is
repeated until the desired level of resolution is obtained. The Monte Carlo simulation does not explicitly
assume any particular functional form for the portfolio value distribution; assumptions are made on the
asset distribution for the underlying obligors. We expect that, with a sufficient number of trials, the
Critical Region
0
0.005
0.01
0.015
0.02
96.5% 97.0% 97.5% 98.0% 98.5%
Portfolio Value (%of Initial Value)
Portfolio ValueDistribution
Normal DistributionwithIdentical MeanandVariance
P
r
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a
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D
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simulation will converge to the true portfolio value distribution. The only disadvantage of the Monte
Carlo method is computation time.
There is also an option of Accelerated Monte Carlo (AMC) available in PM. This approach is based on
the Importance Sampling method which samples more frequently from the tail region, thereby reducing
the number of runs needed for a given resolution of capital in the tail. Although AMC produces results
that are statistically equivalent to standard Monte Carlo simulation, it is generally about an order of
magnitude faster.
1.3 THE PORTFOLIO MANAGEMENT SYSTEM
PM is part of a Portfolio Management System supported by several databases. The Portfolio Management
System is typically a PC or workstation-based relational database. The database tasks are straightforward
and require only basic database management skills. The Portfolio Management System is site-specific. Its
most important function is the collection of data from the commercial loan system and other systems of
record in the case of a bank, or as a repository for portfolio information in the case of a fund or insurance
company. The database supplies the basic input data files to the Moodys KMV Portfolio Preprocessor.
The Preprocessor is a database application included with PM. It combines the financial institutions
exposure data with MKMVs EDF and correlation data. It also performs audit and test functions that warn
the user of erroneous or inconsistent data. The Preprocessor allows the user to specify a number of options
used in the preparation of the portfolio input data. These options include the determination of exposure
amounts for undrawn commitments, specification of valuation methods for mark-to-model calculations,
and preset values for missing data. The Preprocessor output files are PM input files. PM itself provides
output in the form of reports, graphs, and data tables. These reports and graphs are often supplemented by
a set of custom reports and graphs that combine output from PM and the user's Portfolio Management
System.
The details of the non-MKMV components differ across users, but the basic design of most sites follows
that in Figure 1.3.
FIGURE 1.3 The Portfolio Management System
MKMVs PM supplies and maintains the components enclosed by the dotted line. Note that MKMVs
PM also includes a Portfolio Viewer that can be used to develop portfolio management reports. This
component embeds a multi-dimensional reporting tool based on OLAP (on-line analytical processing)
technology. Some clients, however, choose to develop their own reporting systems for presenting the
output of their portfolio calculations.
Moodys KMV provides data on asset correlations, EDFs, and recovery. The Moodys KMV Private Firm
Model (PFM) and RiskCalc calculate EDF values for firms not covered by MKMV databases for public
companies. PFM can also be used to generate correlation inputs for Portfolio Manager. PFM, however,
requires the maintenance of a database of financial statement information on obligors. This is provided by
Moodys KMV MFA and MRA. Meanwhile, Moodys KMV LossCalc provides dynamic estimates of
recovery.
While Moodys KMV recommends using market-based data for populating PM, the underlying portfolio
model is not restricted to using MKMV data for default probabilities and measures of systematic risk
(referred to as R
2
). In the case of securities issued by firms not covered in MKMV databases, the user will
need to calculate these inputs separately. Even in cases where MKMV data is available, the user may decide
to override this data at the preprocessing stage and use different data. MKMVs software accommodates
the entry and management of non-MKMV data. As with any financial model, the better the data input,
the better the data output. MKMVs extensive research in the area of credit risk demonstrates the
superiority of market-based measures of default risk and correlation.
Borrower
Data
Moodys KMV
Data
Portfolio Manager Database
Exposure
Data
Moodys KMV
Preprocessor
Moodys KMV
Portfolio Manager
Portfolio Manager
Reports
1.4 PM CONCEPT FLOW
The following diagram provides a schematic of Portfolio Manager as well as DealAnalyzer. DealAnalyzer
is a calculation engine that helps price and structure deals in the context of a portfolio that has been
previously analyzed in Portfolio Manager. It allows loan origination to be aligned with portfolio
management.
FIGURE 1.4 PM Concept Flowchart
Risk Calc CM/CE LosCalc
As-of Date
Valuation
EDF
Industry
Weights
Gcorr
R squareds
Country
Weights
Empirical Credit
Migration
Portfolio
Manager
Horizon Value
Distribution
LGD
CreditMark
Obligor Info and
Facility Terms
Trades
Optimizer
Global
Optimizer
Deal
Analyzer
Portfolio
Tracker
Interest
Rates
Exchange
Rates
Valuation
Spreads
Market Risk
Parameters
Environment
Risk and Return
Calculations
CHAPTER 2
USING PORTFOLIO MANAGER
2.1 OVERVIEW
Using Moodys KMVs Portfolio Manager (PM) requires integration of general economic or market data,
company or obligor data, and facility or exposure data. These three main categories of data are explained
below.
Market data characterizes the general economic environment. This data includes the default-risk-free
term structure of interest rates, exchange rates, and the prevailing market price of risk or credit spreads
embedding the markets risk premium. This information is primarily used for valuation. The user must
update this information.
Obligor data identifies and characterizes obligors rather than specific exposures. This data includes the
EDF, country in which the obligor does business, industry classification, and proportion of systematic
risk (R
2
).
Moodys KMV supplies this data for firms covered by MKMV in Credit Monitor (the MKMV
databases can be overwritten by the user). For firms without publicly traded equity, users can obtain
values from the MKMV Private Firm Model if financial statement data is available. Obligor data
may also be input directly based upon typical values computed by either the user or MKMV.
Exposure data characterizes individual exposures. This data includes the commitment amount, matu-
rity date, currency, drawn amount, fees and spreads, recovery rate, and a currency exposure factor. PM
also accepts information about special relationships between exposures such as guarantees between a
parent and its subsidiaries. The user must select a valuation method for each exposure. For example,
note that pricing using a spread matrix (see, Chapter 7) requires an internal rating for the exposure.
The user must provide this information.
PM requires current portfolio data for each exposure. However, large, relatively homogeneous asset
groups, such as credit card accounts or small business loans, can be entered as one or more aggregates
based upon the characteristics of a typical asset for the group.
There is no fixed upper bound on the number of input records.
A more detailed description of PM input data is provided in the book, Portfolio Manager User Guide:
Preprocessor.
2.2 MARKET DATA
PM requires some data on the general economic environment. Users should be careful to update this data
regularly since it affects all exposures in the portfolio. Moodys KMV does not regularly update this general
economic data.
2.2.1 Reference Rates
PM focuses analysis on the spread of an exposure. In order to construct the expected cash flows for an
exposure, PM requires the input of a reference rate term structure. This term structure of reference rates
reflects the markets best guess of prevailing interest rates in the future. Typical reference rates are reserve
currency sovereign rates such as the U.S. Treasury term structure. Another common reference rate is
LIBOR which is reflected in the term structure of U.S. dollar swap yields. Users must match the
appropriate reference rate with the spread or fee input for each exposure so that the cash flows are
appropriately constructed. The reference rate is entered in the Set Environment Parameters screen within
the PM application.
2.2.2 Zero-EDF Rates
Since PM is concerned with the modeling of credit risk, it requires the default risk-free or credit risk-free
rate for the purposes of discounting cash flows. This credit risk-free rate should reflect the borrowing rate
for a corporation without any default risk. In the context of Moodys KMV models, this credit-risk-free
firm would have an EDF of zero. We can alternatively call the credit-risk-free rate the zero-EDF rate.
PM allows the user to adjust the reference rate to produce a zero-EDF rate. The Set Environment
Parameters screen includes a field for this adjustment. In this way, one term structure can be used for
constructing cash flows consistent with the terms of the exposure and another term structure can be used
for discounting. In general, the zero-EDF rate will lie between the reserve-currency sovereign curve and the
swap rate (see Chapter 3). Thus, if the U.S. Treasury rate is entered as the Reference rate a positive
adjustment should be made to obtain the zero-EDF rate.
2.2.3 Exchange Rates
PM reports aggregate results in terms of one currency specified by the user as the reference currency.
Individual exposures, however, may be entered in the currency in which they are denominated. If a firm
does business in multiple countries, PM requires the exchange rates back to the reference currency for all
relevant currencies represented in the portfolio. The exchange rates, along with the country and currency
names are entered as number of currency units per reference currency unit within the Set Environment
Parameters screen. One can even construct dummy currencies.
For example, a user may find the portfolio contains exposures with spreads over multiple reference rates in
the same currency (e.g. some exposures pay spreads over U.S. Treasuries while other exposures pay spreads
over LIBOR). Rather than manually adjusting the input spreads to account for the differences in reference
rates, the user may choose to create a dummy currency for the LIBOR reference curve. Using this method,
the portfolio has two U.S. dollar reference curves and each curve can be applied to the appropriate
exposures. Note that PM is not modeling explicitly the effect of exchange rates on the portfolios risk.
Nonetheless, these effects may be reflected implicitly in the characterization of the default probabilities for
each individual exposure.
2.2.4 Market Risk Premium
Valuing a risky cash flow requires one to know the risk associated with the cash flow as well as the
aggregate risk premium associated with a unit of risk. The required return over and above the risk-free rate
for holding a unit of risk at the aggregate level is called the market risk premium. It is also called the
market Sharpe ratio. On average, the higher the market Sharpe ratio, the higher the required return for any
level of systematic risk in an exposure. Research performed at Moodys KMV on the risk premium
implicit in credit spreads for U.S. corporate bonds reveals that the market Sharpe Ratio parameter is
relatively stable over time and typically around 0.4 (see Chapter 5). Note that this is the risk premium
associated with the market value of firm assets and not the value of the firms equity. The risk premium for
equities fluctuates more than that for assets because of the dynamic nature of firm leverage. The market
Sharpe Ratio can be entered in the Risk Comparable Value tab under Set Valuation Spreads in PM.
2.2.5 Spread Data
The market risk premium must be estimated from credit spreads determined by market participants
demand for compensation. The level of this premium is a function of investors risk aversion. As explained
above, Moodys KMV has completed research on a large sample of U.S. corporate bonds to determine the
implicit market price of risk. Users may choose to enter the market price of risk directly or enter prevailing
credit spreads and estimate the market price of risk from these spreads and assumptions regarding expected
recovery rates in the event of default. The spread data can be entered in the Spread Matrix tab under Set
Valuation Spreads in PM. Given the difficulty in finding quality credit spread data, users typically enter the
market price of risk directly. Note that if the portfolio requires matrix valuation (see Chapter 7) based on
internal ratings, the credit spread data will still need to be entered.
2.3 OBLIGOR DATA
PM provides obligor data such as EDF values, asset volatility, country, and industry classification for
publicly traded firms. The user can also choose to enter different data for these companies. All other
obligor data should be input by the user.
2.3.1 Expected Default Frequency
The term structure of Expected Default Frequency (EDF) values is among the most important obligor
data. EDF values for one year through five years are entered in the Exposure Input tab. EDF values for less
than one year and more than five years are appropriately interpolated or extrapolated (see Chapter 4).
2.3.2 Country and Industry Classification
In order to account for the correlations among various exposure values, PM requires classification of the
countries and industries within which the obligor does business. Traditionally, industry and country are
used as rough guides to improving portfolio diversification. PM makes use of these classifications to
construct a custom market index for the obligor to determine how it is impacted by changes in systematic
risk factors in the economy. Using these relationships, PM calculates correlations across exposure values.
For firms in the Moodys KMV database, industry classification is determined by the percentage of sales
(percentage of assets for financial firms) across 61 different MKMV industries. While PM allows multiple
country classifications for an individual obligor, MKMVs data provides only the country of incorporation
due to a lack of readily available country-level data. For obligors not covered by Moodys KMV models,
users will need to determine these classifications. Country and industry classifications are entered under
the Group tab in the Exposure Input.
2.3.3 Obligor R
2
The overall business risk of an obligor can be decomposed into systematic risk and obligor-specific risk (see
Chapter 11). R
2
is a measure of the systematic risk. R
2
is bounded between zero and one. The systematic
portion of obligor risk is assumed to drive the correlation among the market value of the firms represented
in the portfolio. Two obligors with very little common systematic risk are likely to exhibit low correlation
in the movement of their market values. That is, all else equal, the higher the R
2
of an obligor, the higher
the correlation it will tend to have with other obligors. Moodys KMV research demonstrates that the
reasonable range for R
2
for corporates is 0.10 to 0.65.
Obligor R
2
is entered under the Group tab in the Exposure Input screen.
2.4 EXPOSURE DATA
PM requires data at the facility or, in other words, at the exposure level. This data is essential to calculating
the expected cash flows associated with the exposure. Users must enter this exposure data.
2.4.1 Commitment and Exposure
Commitment refers to the notional (principal or the face value) amount. Input fee and spread
information is typically entered against the commitment amount. Fees and spreads are paid on
commitments based on drawn and undrawn amounts; bonds can be considered fully drawn commitments.
The exposure amount, or the amount subject to credit risk, is determined by multiplying the commitment
amount by an input parameter Usage Given Default (UGD), which is material only for exposures that
include undrawn commitments. Bonds, for example, have a UGD of 100%. UGD is expressed as a
fraction of commitment and is specified at the exposure level.
UGD must be at least as large as the current usage. The most conservative assumption for UGD is 100%:
when the exposure is in default, the entire amount will be drawn. This assumption coincides with the
incentives faced by obligors who have paid a commitment fee for the option to have access to capital.
Because commitments have credit risk only to the extent that they are drawn in the event of default,
exposure provides a suitable numeraire for credit portfolio analysis. Output values in PM are expressed as a
fraction of exposure.
We can think of exposure amounts either as units of a reference currency (for example, U.S. dollars) or as
fractions of the total portfolio value. The specification in terms of fractional weights offers some
mathematical convenience because the total portfolio value is one unit. However, the weights themselves
have no natural units.
Users of PM may specify any reference currency for which there is an available exchange rate schedule;
output values are then converted to their reference currency equivalents. For ease of exposition, we will
typically refer to exposure amounts as currency values rather than weights in the portfolio. Values or prices
will be expressed as fractions of the exposure amount, so 1 is par value, 0.98 is a discount exposure, and
1.02 is a exposure valued at a premium.
2.4.2 Loss Given Default
Estimating expected recovery in the event of default is a difficult task. An equivalent way of thinking about
expected recovery is to think about the expected loss in the event of default or the expected Loss Given
Default (LGD). In PM users input LGD
input
in the Exposure Input tab. Since LGD
input
is the expected
loss in the event of default, expressed as a fraction of the exposure amount, or as a fraction of the no-default
risk comparable value at horizon (see Chapter 9), it is bounded between 0 and 1. In PM, three choices are
available for modeling LGD. In two cases, the LGD
input
is converted to LGD, which is the expected loss in
the event of default expressed as a fraction of the risk-free value of the exposure at horizon (see Chapter 9).
This conversion is done such that, in the event of default, the expected dollar recovery at horizon based on
LGD
input
is exactly the same as the expected dollar recovery based on LGD. This conversion is done for
internal calculation consistencies within PM. It may happen, in some extreme cases, that the LGD
calculated from LGD
input
turns out to be negative, in which case PM gives out a warning signal that the
LGD
input
is too low. Note that this will likely happen for heavily discounted exposures with relatively low
Loss Given Default (LGD) when LGD
input
is modeled as a fraction of the exposure amount. The other
model choice is to use LGD
input
directly as the percentage of the risk-free value of the exposure at horizon.
In this case, the recovery amounts will be dependent on the time-to-maturity of the exposure. This
characteristic of the model may produce unusual results with longer dated (i.e. more than 7 years)
exposures (see Chapter 6 for more details).
If we did not know anything about the recovery rate, i.e., if we thought that all possible recovery rates were
equally likely, we would model LGD as a flat (uniform) distribution between the interval 0 and 1.
However, some large financial institutions possess enough data to develop some intuition around the shape
of the LGD distribution. In order to provide the flexibility to reflect a users intuition around LGD, PM
uses a beta distribution to capture the potential dispersion in realized LGD while staying within the
bounds of 0 and 1. Beta distributions are flexible in that their shape can be fully specified by stating the
desired mean and one more parameter, k.
2.4.3 Related exposures
PM allows two special correlation relationships between exposures. The first operates at the level of
exposure value; the second is based on asset value returns.
Each company in PM has three associated identifiers: a unique exposure ID, an obligor ID, and a Group
ID. Obligor and Group IDs need not be unique. Exposures that share an obligor ID have perfect value and
default correlations. There is no diversification benefit for exposures that share obligor IDs. An appropriate
use of the obligor ID relationship is to model multiple exposures to the same company, or exposures to a
parent and a guaranteed subsidiary.
Companies that share a Group ID are modeled with perfect positive asset correlation. The joint default
frequency for two companies with the same Group ID is simply the smaller of the two EDFs. Common
Group IDs can be used to model semi-independent subsidiaries, joint ventures, or special corporate
associations such as trading groups or keiretsu.
When each exposure has a unique Group and Obligor ID, value correlations are derived solely from shared
systematic risk as measured by the factor model.
2.4.4 Aggregate Exposures
Certain exposures are best modeled as subportfolio aggregates. An aggregate exposure is designed to
represent a large number of homogeneous borrowings. Cohorts of small business or middle market loans,
credit card debt, or mortgage pools can be described with typical characteristics for the cohort, the total
exposure and the effective number of exposures in the cohort.
An aggregate exposure specified with total exposure X and n effective loans is treated as n identical
exposures in the amount X/n. For example, an aggregate exposure of $10M to 100 obligors produces the
same PM output as 100 identical exposures with unique obligor IDs and an exposure of $100,000 each.
Over the past several years, MKMV has worked with a number of financial institutions to determine
appropriate measures of systematic risk for non-corporate exposures. While the user should consult
internal data sources to estimate R
2
when available, Moodys KMV research suggests the following values
for systematic risk proportions for aggregates:
TABLE 2.1 Suggested Systematic Risk Proportions for Aggregates
There is no special correlation structure within aggregates or between the aggregate exposure and other
exposures in the portfolio. For aggregated exposures that lack individual exposure information, industry
and country weights can be constructed from macroeconomic data. For example, U.S. census data includes
employment information by industry. This data can be used to classify the aggregated exposures. For
example, Californias high level of employment in aerospace and computer software would suggest these
industry weightings for credit card exposures in California.
2.5 PARAMETERS AND PRECISION
While the drop in the cost of computing power allows us to reconcile input and output values to any
number of significant digits, too much precision can be dangerous. Artificial levels of precision may
mislead us regarding the appropriate interpretation of the output values. The concreteness of output to ten
significant digits creates a false sense of model accuracy and may contribute to model risk by supplanting
the need for critical judgment.
Model parameters depend on precision of the estimate. If the best estimates of R
2
have a confidence
interval of +/- 3%, an input of 26.3745% seems unreasonable. Standard errors dictate appropriate
precision for statistical measures. For market values such as prices and spreads, precision depends on the
ability to transact at the input values in the interval between analysis and action. The more volatile the
market, the less the available precision.
In the table below we present input parameters with suggested significant digits.
Aggregate Type
R
2
Credit Cards/Personal Loans 5%
Mortgages 7-10%
Small Business Loans 10%
TABLE 2.1 Parameters and Significance
Our intent in this table is not to blunt the pencils of PM users. Rather, we hope to create a sense for which
numbers are important. With respect to credit risk, the critical input is the EDF. It is the fundamental
driver of valuation and risk measures.
R
2
drives correlation calculations; it also impacts valuation through the risk premium in mark-to-model
prices. Industry and country weights determine correlations, Risk Contributions, and Tail Risk
Contributions. In general, the effect of changing weights is largely for poorly diversified portfolios.
Parameter Resolution Example
Input Spreads 1 bp 0.0132 (1.32%, or 132 bp)
Market Sharpe Ratio tenth 0.5
LGD tenth 0.3
k (LGD parameter) integer 4
EDF 1 bp 0.0063 (0.63% or 63 bp)
R
2
1% 0.18 (18%)
Asset Volatility 1% 0.24 (24%)
Industry and Country Weights 1% 0.15 (15%)
Target Probability for Capital 1 bp 0.0006 (0.06%, or 6 bp)
SECTION 2
VALUATION AND RETURNS
CHAPTER
3
INTEREST RATES AND CASH FLOWS
3.1 OVERVIEW
A precursor to any measurement of risk-adjusted return is the risk-free rate. In addition to risk-free rates,
PM also requires reference rates. The reference rates are used to construct future expected cash flows for
exposures in the portfolio. The risk-free rate is used to discount these future cash flows for valuation
purposes. While these two sets of rateswhere a set of rates is typically called a term structure of interest
ratescan be the same, market circumstances may result in these two term structures being different.
The reference rate corresponds with the benchmark curve used to specify income for a particular credit
exposure. For example, many loan spreads are specified as spreads over LIBOR. PM uses the reference rate
term structure to generate forward curves. In this case, the forward term structure of U.S. swap yields can
be used as a proxy for future LIBOR rates. These forward curves can then be used to generate expected
future cash flows for the loan paying a spread over LIBOR. Since LIBOR likely includes some
compensation for credit risk, it is not an appropriate risk-free rate.
Historically, reserve currency sovereign curves such as the U.S. Treasury term structure has been used as a
benchmark for the markets risk-free rate. More specifically, PM requires a credit-risk free rate. However,
Moodys KMV research on non-guaranteed government-sponsored agencies and AAA-rated corporate
issues suggests that spreads to U.S. Treasuries are much wider than can possibly be explained by credit
quality differences with them. This empirical fact is also reported in the financial literature. For example, a
AAA-rated corporate issuer with a default probability of .02% per year may pay a spread of 50 basis points
over U.S. Treasuries on its outstanding bonds. While a credit model may be constructed with unusually
high levels of risk aversion or extra parameters for jump risk to explain this empirical fact, reasonable
models of credit valuation cannot generate this wide a spread for extremely low risk obligors.
Some financial researchers have concluded the problem involves the basic assumptions underlying
standard credit valuation models and that these models need to be substantially modified or augmented to
overcome this systematic under-prediction of spreads to U.S. Treasuries. Moodys KMV research suggests
a different conclusion. The spread to U.S. Treasuries includes compensation for more than just credit risk
(e.g. liquidity risk). Thus, the solution is to find a better benchmark curve representing the credit-risk free
rate. In this way we can isolate the portion of the spread that can be effectively modeled. This solution
facilitates the use of valuation models that explain a large part of the variance in spreads, which is the
difference between option-adjusted bond yields and the zero-EDF rate. From a modeling perspective, this
approach parsimoniously decomposes market observable spreads in a way that facilitates effective portfolio
management. That is, the model explains a large chunk of spread volatility that affects the value of credit-
risky exposures.
Because PM focuses only on credit risk, the benchmark curve needed for discounting should reflect the
credit-risk free or default-risk free rate. Conceptually, the discussion above demonstrates the need for
finding a zero-EDF curve. That is, we must find a credit-risk free rate that reflects the rate paid by a
corporate obligor with an EDF value equal to zero. Since every company that issues debt has a positive
EDF, we cannot directly observe a zero-EDF curve in the market. However, it is reasonable to expect the
zero-EDF curve to lie below the yield curve on AAA bonds or the interest-rate swap curve. This is so since
both of these curves, arguably, have some credit risk premium attached to them that muddies the analysis.
It is also reasonable to expect the zero-EDF curve to lie above the reserve-currency sovereign curve. This is
so because reserve-currency government bonds are much more liquid than high-quality corporate bonds.
Even a corporate issuer with zero default risk will likely pay a premium above and beyond the payment for
credit risk. (The difference is sometimes attributed to differences in liquidity; however, a good theoretical
understanding of this extra premium has yet to be established). While we cannot directly measure the zero-
EDF curve, the swap curves and treasury curves for reserve currencies (e.g. U.S. dollar, Japanese yen, Euro)
provide bounds on where the zero-EDF curve would lie.
In the absence of a directly observable zero-EDF curve, we can look to several other sources for estimating
a proxy curve:
Begin with the spread on AAA bonds and adjust downwards.
Begin with a reserve-currency sovereign curve and add a premium for corporate risk other than credit
risk.
Begin with a reserve-currency interest rate swap curve and determine the appropriate adjustment for
the credit risk of the swap.
Each of these approaches requires both data and assumptions about how to model credit risk. Data is
generally not available for all relevant maturities in the AAA corporate bond market, which makes the first
option impractical.
Data is, however, readily available for both reserve-currency sovereign curves and swap curves. This allows
a zero-EDF term structure to be estimated using the second and the third options according to the
available data. In summary, the reserve-currency sovereign term structure or the reserve-currency swap
term structure is used to establish a starting point. From there, some kind of adjustment based on other
data or a model must be developed to estimate the zero-EDF term structure. Consider the following
graphical representation of the three relevant term structures for the U.S. dollar:
FIGURE 3.1 Zero-EDF Term Structure
Figure 3.1 displays three yield curves:
U.S. Treasury yield curve.
U.S. dollar swap yield curvethe swap rate is the rate that converts a fixed-rate instrument into its
floating-rate equivalent. The swap curve is typically expressed as a spread over LIBOR.
A hypothetical zero-EDF yield curve.
An initial estimate for the premium of the zero-EDF rate over the U.S. Treasury rate is the spread between
short-dated Eurodollar contracts and similarly dated U.S. Treasury bills. This difference is called the TED
spread. A rough approximation of the zero-EDF curve would reflect adding the TED spread to each rate
on the U.S. Treasury curve. This method will do a better job proxying at the short end of the zero-EDF
curve than it will do at the long end.
Other more sophisticated techniques include estimating the zero-EDF curve in the context of a credit
valuation model applied to corporate bonds. Moodys KMV has estimated simple credit valuation models
using U.S. corporate bond data and reported research results suggesting the zero-EDF spread to U.S.
Treasuries is about 80% of the U.S. dollar swap spread. While a parallel shift of the U.S. Treasury curve or
the U.S. swap yield curve is a good first approximation, ongoing research at MKMV is considering the
benefit of richer adjustments accounting for tenor. At this time, the parallel shift reflects the empirical facts
available today. In the future, explicit models of liquidity may enable us to estimate the zero-EDF curve
directly. The reserve-currency sovereign term structures such as the U.S. Treasury curve typically display
more anomalous behavior than the swap curves, so adjusting from the swap yield curve is recommended.
US Treasury and US Dollar Swap Yield Curves
As of 05/01/98
5.5
5.6
5.7
5.8
5.9
6.0
6.1
6.2
6.3
6.4
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
TerminYears
P
e
r
c
e
n
t
a
g
e

Y
i
e
l
d
US Dollar Swap
Zero-EDF
US Treasury
Note: All yieldcurves fromBloombergexcept Zero-EDFcurve, whichis arbitrarilydrawnfor displaypurposeonly.
Credit RiskComponent
Non-Credit RiskComponent
TEDSpread
3.2 ENTERING ZERO-EDF RATES
The term structure of reference rates (e.g. LIBOR or the swap curve) is entered in Set Environment
Parameters in PM. One method for incorporating the zero-EDF curve into PMs calculations is to enter
the estimated zero-EDF curve directly as the reference curve. The difficulty with this method is that the
individual exposure spreads will need to be adjusted for the difference between the appropriate reference
rate for the exposure and the zero-EDF curve entered as the reference curve.
A simpler approach is also available in PM. First, the appropriate reference curve is entered in the Set
Environment Parameters screen. Next, a corporate adjustment spread, S
CA
, is entered for the Corporate
Default-Risk-Free Spread field found in Set Environment Parameters. If the adjustment is a premium added
to the term structure, it is entered as a positive number. A positive adjustment would be appropriate when
the reference curve is a reserve-currency sovereign term structure. If the adjustment is a reduction in the
term structure, it is entered as a negative number. A negative adjustment would be appropriate when the
reference curve is a reserve-currency swap yield term structure. In summary, the adjustment produces a
parallel shift in the term structure to reflect the difference between the zero-EDF curve and the reference
curve used to produce expected future cash flows.
Figure 3.2 shows how to enter the adjustment needed to obtain the zero-EDF rate in PM. In this screen
shot, the reference rate used is the LIBOR spot rate. Alternatively, the reference rates could have been
entered as a par curve.
Note that in this case the Corporate Default-Risk-Free Spread, S
CA
, is a negative adjustment. This makes
sense since the zero-EDF curve most likely lies below LIBOR. Also, note that the adjustment is entered
with a Compounding Frequency, m (in this case the compounding is quarterly or m equals 4).
FIGURE 3.2 Adjusting Reference Rate to obtain Zero-EDF Rate
For a given reference rate and a Compounding Frequency, m, the formula for calculating the zero-EDF rate
is given by equation (3.1). For example, the two-year annualized, quarterly compounded (i.e., m = 4), spot
zero-EDF rate, is given by the following formula:
(3.1)
Thus, the annualized, quarterly compounded two year spot reference rate is 0.0688 and the annualized,
quarterly compounded two-year spot zero-EDF rate is 0.0658.
3.3 DISCOUNT FACTORS
The term-structure of interest rates can be transformed to obtain a discount curve which is used for
computing present and future values. Just as any point on the term structure of interest rates gives the
appropriate rate for discounting, any point on the discount curve gives the appropriate discount factor for
discounting. Sometimes it is more convenient to think in terms of a discount factor than in terms of an
interest rate. Given the reference rate, corporate adjustment, and the frequency of compounding, the credit
risk-free discount factor, , is calculated by equation (3.2). Thus, in accordance with the earlier
example, the two-year risk-free discount factor is given by:
(3.2)
In the limiting case, the discount factor for time 0 is equal to one.
Sometimes, a future cash flow occurs at a point in time for which the discount factor needs to be
interpolated. PM interpolates the discount factors geometrically. That is, the interpolation is done linearly
in the natural logarithm of the rates that are on either side of the time period of interest. Since PM will
build the necessary discount curve regardless of the number of points entered in the Set Environment
Parameters screen, rates that are shorter than the shortest point entered or longer than the longest point
entered will be appropriately interpolated or extrapolated.
Continuing with our example from Figure 3.2, suppose we need to discount a cash flow that occurs at time
t = 1.340862424 years (the choice of time will become clear in the next section). The appropriate
interpolated discount factor is given by the following equation:
(3.3)
zero-EDF rate =
.0658 =0.0688 0.003
R S
t m CA m , ,
+
DF
t
R
f
DF
R S
m
DF
t
R t m CA m
m t
R
f
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3.4 CASH FLOW EXAMPLE
Using the reference rates described above, this section presents how Portfolio Manager computes the
expected future cash flows for an individual exposure. Note that these cash flows are used to determine
exposure value at the as-of date (see Chapter 7). Portfolio Manager uses reference-rate discount factors (in
the sense that the ratio of these discount factors are used to determine the forward rates) and any fee to
determine cash flows for a floating rate exposure. Please note that reference-rate discount factors are used
in PM only to calculate the expected cash flows. More specifically, reference-rate discount factors are not
used for discounting future cash flows. Instead, risk-free or the zero-EDF rates are used for discounting.
Reference-rates (with compounding frequency, m) are converted to reference-rate discount factors using
the following equation:
(3.4)
Continuing with the example given above (i.e., use the reference rates from Figure 3.2) the reference-rate
discount factors are calculated as follows:
Consider the following exposure (taken directly from Portfolio Manager).
TABLE 3.1 Reference Rate Discount Factors
Term .25 .5 1 2 3 4 5
Reference Rates 0.0600 0.0613 0.0661 0.0688 0.0700 0.0706 0.0710
Reference Rate Discount Factors .98522 .97004 .93654 .87247 .81206 .75583 .70336
DF
R
m
t
RR t m
m t
= 1+
,
,
,
]
]
]

FIGURE 3.3 Exposure Input Data
To determine the expected future cash flows, we start by determining the remaining years to maturity
(beyond the as-of date) and then work backwards to compute the payment schedule.
In this case, the bond matures 2.34 years past the as-of date. This is obtained by dividing 855 days (from
as-of date to maturity) by 365.25. PM uses 365.25 days in a year to account for leap years. Since the
exposure pays coupons semiannually, the time remaining to payment dates are determined as follows.
(Notice the time remaining increases by 0.5 years):
Note that, in this example, none of the coupon payment dates coincides directly with the terms listed in
the table above. Therefore, to compute future cash flows we have to first interpolate the discount factors
TABLE 3.2 Payment Schedule
Payment Years Remaining to Payment
1 0.340862423
2 0.840862423
3 1.340862423
4 1.840862423
5 2.340862423
using this payment schedule and then calculate the forward rates. For an explanation of the interpolation
process, including the relevant (3.3) equations, see Discount Factors on page 31.
After calculating the reference rate discount factors for each of the five payments, the expected cash flows is
computed for both coupons and principal payments by equations (3.5) and (3.6).
(3.5)
(3.6)
Comparing the cash flows in Table 3.4 to PM, one can see they are identical.
TABLE 3.3 Interpolated Reference Rate Discount Factor
Payment Years Remaining to Payment Reference Rate Discount Factor
1 0.340862423 0.97967677
2 0.840862423 0.947077001
3 1.340862423 0.914190052
4 1.840862423 0.882362846
5 2.340862423 0.851387293
TABLE 3.4 Calculated Cash Flows
Payment Years Remaining to Payment Principal Coupon Cash Flow
1 0.340862423 0 22,549.23 22,549.23
2 0.840862423 0 36,921.46 36,921.46
3 1.340862423 0 38,473.86 38,473.86
4 1.840862423 0 38,570.43 38,570.43
5 2.340862423 1,000,000 38,882.45 1,038,882.45
Cash Flow Principal Coupon
Coupon
t t t
t
t
RR
t
RR
j j j
j
j
j
DF
DF
+
j
(
,
1
,,
\
,
(
(

j
(
,
,
,
,
\
,
(
(
(
(
+
,
,
,
,
,
]
]
]
]
]
]

j
(
,
,
\
,
(
(
1
1
1
( ) t t f
j j
f fee
( )
t t
f
j j 1
Exposure
where is the coupon fre equency and fee is defined below:
fee =
Recurring fee+Expected Usage Usage Fee +(1-Expected [ ] Usage) Non-Usage Fee
Usage Given Default
[ ]
FIGURE 3.4 Computed Cash flows from PM
It is worth pointing out that accrued interest is not included in the first coupon; the clean price is
computed when valuing exposures (see Chapter 7). This is also true for exposures with fixed coupons.
More specifically, equation (3.5) still determines the coupon, with f set to 0, and the fee representing the
fixed coupon rate.
CHAPTER
4
MODELING DEFAULT PROBABILITY
One primary source of risk in Portfolio Manager (PM) is the probability of default. In the context of PM,
a firm is said to default when it fails to make scheduled principal or interest payments. In other words, a
firm defaults when the market value of its assets (i.e. the value of its ongoing business) falls below its
liabilities payable (i.e. the firms default point). Traditional approaches for measuring default probability
involve a detailed examination of a companys operations in order to project current and future cash flows
of the firm. Other estimation methods such as those used by MKMV rely on observable market prices such
as traded equity and traded debt to determine an implied default probability.
MKMV has found that equity markets are better sources of information than debt markets. The liquidity
of equity markets makes them better sources of data than the opaque, dealer markets used to trade debt.
Moreover, continuous transaction histories are available for companies listed all over the world, facilitating
global coverage. As a result, MKMV recommends (when possible) estimating default probabilities from
equity prices. MKMV currently produces an Expected Default Frequency
TM
(EDF
TM
) credit measure
based on equity prices. This framework can also be extended to firms without publicly traded equity by
using information from similar firms with traded equity. While the EDF credit measure is one possibility
for assigning default probabilities to an exposure, PM can be populated with data not using MKMVs
model of default. Despite the fact that default probabilities used in PM do not need to be MKMVs EDF
values, the framework underlying this model is important for understanding all of PMs calculations. Not
only can we model default with this framework, we can also extend this framework to model correlations
among firms. This chapter focuses on MKMVs model of default.
The approach described in this chapter arises from the insight published by Fischer Black, Myron Scholes,
and Robert Merton in the early 1970s. This type of model has become known as a Black-Scholes-
Merton (BSM) model of default. While MKMVs approach has its intellectual roots in the BSM model, it
has been significantly modified so that it differs substantially from the BSM-type models explained and
tested in most of the published financial literature. MKMVs model of default for calculating EDF values
is called the Vasicek-Kealhofer or VK model.
This model focuses on the relationship of the firms market value of assets and its contractual liabilities.
The market value of assets is not fixed; it evolves over time as new information about the prospects of the
firm becomes available to market participants. This volatility in value reflects the underlying risk inherent
in the business. Because we do not know the nature of the new information, we model the market value of
assets as a random walk.
The classic illustration of a random walk is a staggering drunken man. Suppose we are interested in the
probability that the inebriated fellow falls off the sidewalk. We need to know his distance from the curb
and the size of his steps. If he is very far from the curb and only a little bit tipsy, he is not very likely to
stumble into the street. If, however, he is lurching wildly, then he might fall into the roadway despite a few
feet of clearance. And if he is near the edge of the curb and reeling, his position is very precarious indeed.
In this analogy, the curb corresponds to the default point, the distance to the curb is the difference
between the market value of assets and the book value of liabilities, and the step size represents asset
volatility.
In practice, we observe a kind of risk homeostasis: companies with lower asset volatilities tend to assume
more debt. The assets of financial institutions, for example, are relatively stable (despite intermittent
market gyrations). These firms can take on a great deal of leverage.
The VK model is a structural model used to estimate the EDF value of a firm. There are three main
elements that determine the EDF value of a firm.
Value of Assets: The market value of the firms assets. This is a measure of the present value of the
future free cash flows produced by the firms assets discounted back at the appropriate discount rate.
This measures the firms prospects and incorporates relevant information about the firms industry.
This information also reflects the impact of current economic conditions on the firm.
Asset Risk: The uncertainty or the risk of the asset value. This is a measure of the firms business and
industry risk. The value of the firms assets is an estimate and, thus, is uncertain. As a result, the value
of the firms assets should always be understood in the context of the firms business or asset risk.
Leverage: The extent of the firms contractual liabilities. Whereas the relevant measure of the firms
assets is always their market value, the book value of liabilities relative to the market value of assets is
the pertinent measure of the firms leverage, since that is the amount the firm must repay.
In MKMVs study of defaults, we have found that, in general, firms do not default when their asset value
reaches the book value of their total liabilities. While some firms certainly default at this point, many
continue to trade and service their debts. The long-term nature of some of their liabilities provides these
firms with some breathing space. We have found that the default point, the asset value at which the firm
will default, generally lies somewhere between total liabilities and current, or short-term liabilities. The
relevant net worth of the firm, therefore, is the market value of the firms assets minus the firms default
point:
(4.1)
A firm will default when its market net worth reaches zero. Two firms with the same net worth will not
necessarily have the same likelihood of defaulting; the firm with riskier assets (having higher asset volatility)
will have a higher risk of default. We use this intuition to construct the firms distance-to-default, which
is simply the market net worth of a company divided by the standard deviation of its assets. Thus, for a
given net worth, riskier assets will produce a lower distance-to-default. Generally speaking, there are three
steps to estimate the default probability of a firm:
Estimate asset value and asset volatility
Calculate the distance-to-default (DD)
Map the distance-to-default to an Expected Default Frequency (EDF) value
Market Net Worth Market Value of Assets - Default Poin
[ ]
[ ]
tt
[ ]
The credit dynamics of a firm are driven by changes in the market value of assets, book liabilities, or asset
volatility. Changes in these values not only cause default, but also causes changes in the value of credit
exposures to the firm. Using these drivers, PM can model default as well as credit migration. We find that
change in asset value is the primary driver of credit quality changes, followed by changes in liabilities.
Asset volatilities are relatively stable over time because they reflect the fundamental economic risk of a
business. Changes in volatility generally result from spin-offs, mergers, or acquisitions. These
restructurings are typically accompanied by dramatic changes in liabilities.
4.1 ASSET VALUE AND VOLATILITY
If the market price of equity is available, the market value and volatility of assets can be determined directly
using an option-pricing based approach. This approach models equity as a call option on the underlying
assets of the firm. The limited liability feature of equity means that the equity holders have the right, but
not the obligation, to pay off the debt holders and take over the remaining assets of the firm. Thus, in the
simplest case, equity is the same as a call option on the firms assets with a strike price equal to the book
value of the firms liabilities.
MKMV uses this option-like nature of equity to derive the underlying asset value and asset volatility
implied by the market value of equity, the volatility of equity, and the book value of liabilities. This
process is similar, in spirit, to the procedure used by the options traders in the determination of the
implied volatility of an option from the observed option price. As explained before, MKMV uses an
extension of the Black-Scholes-Merton (BSM) approach called the Vasicek-Kealhofer (VK) model for
estimating the firms market value of assets. The VK model relates the market value of a firms assets to the
probability of default.
The VK model based on diffusion processes assumes lognormal asset value distributions, i.e., the natural
logarithm of the asset value is normally distributed. The log of the asset value at horizon minus the log of
the initial asset value equals the continuously compounded return over the horizon. Since the initial asset
value is a constant, the asset returns follow the normal distribution. Figure 4.1 and Figure 4.2 depict the
lognormal and normal distribution functions, respectively.
FIGURE 4.1 Lognormal Probability Density
Di st ri but i on of Asset V al ue at Horizon
0
0. 25
0. 5
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Asset Value
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
FIGURE 4.2 Normal Probability Density
A simple characterization of a firms asset value process reflects a lognormal distribution for the asset value.
The BSM model uses the following equation to describe this type of asset value process:
(4.2)
where
A, and dA are the firms asset value and change in asset value
,
A
are the rates for firms asset value drift and volatility
dz is a Wiener process
The BSM model allows only two types of liabilities, a single class of debt and a single class of equity. If F is
the face value of the debt due at time t then the market value of equity, E, and the market value of assets
are related by the following expression:
(4.3)
where
and r is the continuously compounded risk free rate.
Dist ribut i on of l n( Asset V al ue at Hori zon)
0
0. 25
0. 5
-5 -4 -3 -2 -1 0 1 2 3 4 5
Log Asset Value
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
dA Adt Adz
A
+
E A N d F e N d
rt
( ) ( )
1 2
d
A
F
r t
t
d d t
A
A
A
1
2
2 1
2
j
(
,
\
,
(
+ +
j
(
,
\
,
(

ln
,
,
Applying Itos lemma to equation (4.3) and equating the variance terms, we arrive at the following:
(4.4)
where
E
is the volatility of the firms equity. (= N(d
1
)) is also known as the hedge ratio. Thus, we have
equations (4.3) and (4.4) in two unknowns, asset value and asset volatility.
As the empirical finance literature demonstrates, using a simple BSM model as described above does not
generate default probabilities large enough or credit spreads wide enough to correspond with actual pricing
data for corporate bonds. The VK model remedies many of the empirical weaknesses in the BSM approach
while retaining the general structural framework. The main differences between BSM and the VK model
for calculating the asset value and asset volatility are as follows:
BSM uses two classes of liabilities, whereas the VK model incorporates five classes of capital structure:
short-term liabilities, long-term liabilities, convertibles, preferred equity, and common equity.
BSM models default only at the maturity of the debt claim, whereas in the VK model, default is possi-
ble at any time, i.e., the default point is the absorbing barrier for the asset value.
BSM models equity as a European call option with expiration date equal to the maturity of the debt
claim, whereas VK models equity as a perpetual option.
BSM assumes distance-to-default (DD) to be normally distributed, whereas VKs model determines
the DD-distribution empirically.
Finding an analytical solution that incorporates all these features is extremely difficult. Hence, MKMVs
implementation for calculating an EDF credit measure solves iteratively for asset value and asset volatility
in the context of the VK model explained above. The two key relationships can be characterized as follows:

Using equity data in this context, MKMV produces EDF values that can be seamlessly accessed by PM.
4.2 DISTANCE-TO-DEFAULT (DD) CALCULATION
We define a measure of leverage, t-period distance-to-default at time 0 (DD
0,t
), as the difference between
the expected market value of assets (t periods ahead) and the default point, divided by the volatility of the
asset returns. In theory (e.g., BSM model), for those firms with only two types of liabilities, e.g. common
equity and debt with a face value F that expires in n periods, the default point, is easily seen to be F. In

E A
A
E
E
A
where
Equity
Price
Asset
Value
Asset
Volatility
,
,
]
]
]

,
,
]
]
]
,
,
]
]
]
f , ,
CCapital
Structure
Risk
Free Rate
Perpetuity
,
,
]
]
]
,
,
]
]
]
j
(
,
\
, ,
,,
(
,
,
]
]
]

,
,
]
]
]
Equity
Volatility
Asset
Value
Asset
Volatilit
f ,
yy
Capital
Structure
Risk
Free Rate
Perpet
,
,
]
]
]
,
,
]
]
]
,
,
]
]
]
, , , uuity
j
(
,
\
,
(
practice, very few firms have only two types of liabilities. Typically, firms have short-term liabilities, long-
term liabilities, convertible debt, preferred equity, and common equity in their capital structure. In fact,
MKMV estimates the debt due at each date using these five classes of liabilities and a combination of
current and long-term borrowing and call this value the Default Point at time t (DPT
t
). Accordingly, the
distance-to-default (DD
0,t
) is calculated as:
(4.5)
In practice, MKMVs implementation of this model also includes dividend and other cash payouts. A firm
that pays dividends will reduce its asset value (holding all else equal) taking it closer to its default point.
The scaling of DD by the asset volatility transforms the simple leverage measure of market value of assets
less liabilities into a number of standard deviations. We can think of a firm as some number (e.g. 2.3) of
standard deviations away from default. All else equal, firms with lower volatility of asset value are farther
from (less likely to) default.
4.3 DD-TO-EDF VALUE MAPPING
Under the BSM model, a firm defaults when its asset value at time t falls below the face value of the
liability, F, at the time of its maturity. Note that the asset value at time t contains a realization of a standard
normally distributed random variable, .
(4.6)
Equation (4.6) implies that a firm will default if the random component of its asset return, , falls below
the point in the equation below:
(4.7)
Since is normally distributed, the probability of default for a firm is simply, N(-DD), where N is the
cumulative normal distribution function. Clearly, this framework implies that the distance-to-default is
normally distributed. MKMVs empirical investigation of the DD distribution indicates otherwise.
Once DD is calculated using equation (4.5) appropriately adjusted for dividends and other cash payouts,
MKMV uses an empirically determined distribution function to calculate a firms probability of default.
MKMV calculates Expected Default Frequencies
TM
or EDF
TM
credit measures for most firms with publicly
DD
A t DPT
t
t
A
t
A
0
0
2
2
,
ln ln
( )+
j
(
,
\
,
(
( )

ln ln A t t F
A
A 0
2
2
+
j
(
,
\
,
(
+ ( )

j
(
,
\
,
(
+
j
(
,
\
,
(
j
(
,
,
,
,
\
,
(
(
(
(

ln
A
F
t
t
DD
A
A
0
2
2
traded equity (these EDF values can be viewed and analyzed with MKMVs Credit Monitor
TM
and
CreditEdge
TM
; as well as be seamlessly integrated with MKMVs Portfolio Manager
TM
.) This distribution
function is estimated by observing the historical default frequency for a given value of DD.
FIGURE 4.3 DD-to-EDF Value Mapping
For instance, the historical default rate for firms with DD equal to 4 is about 1.0%; this is the EDF credit
measure assigned to such firms. The DD-to-EDF value mapping is based on MKMVs proprietary
database of defaults. Figure 4.3 is an approximate representation of a portion of the distribution function.
The probability of an outcome four standard deviations below the mean under the normal distribution is
about 0.0032%, less than one-third of one basis point, or 1/300 of the EDF value MKMV estimates. The
probability of a 5 standard deviation event is essentially zero (2.871x10
-7
, or less than 3/1000
th
of a basis
point). The empirical DD measure assigns positive, non-trivial default probabilities to events that are ten
or more standard deviations from default.
In PM we move between DD and EDF values using MKMVs empirical mapping. If we standardize firm
asset values using DD, we can apply the lognormal distribution to asset values. Each obligor in PM has an
associated EDF value and asset volatility. The current EDF value specifies the (standardized) asset value
today; the forward EDF value specifies the mean of the asset value distribution at the horizon; the asset
volatility determines the distribution of asset values (and hence the distribution of EDF values) around this
mean.
The EDF value embeds all currently available information about the credit quality of the firm. At time 0,
we specify a term structure of EDF values. From this term structure we interpolate or extrapolate EDF
values to any desired date.
DD-to-EDF Mapping
Standardized Distance to Default
E
D
F
(4, 1%)
4.4 EDF VALUE INTERPOLATION
An EDF value is an annualized cumulative probability number. Thus, over t years,
(4.8)
where CEDF is the cumulative EDF value. For each exposure, PM requires only the EDF values for one
through five years. Given the availability of data to estimate the DD-to-EDF value mapping, we are
limited to these tenors. In practice, exposures will have maturities that do not fall on exactly the dates for
which PM has estimated EDF values. Consequently, we need to interpolate and extrapolate the cumulative
probabilities of default. Specifically, PM interpolates or extrapolates to the dates of all cash flows associated
with an exposure. Interpolation is done linearly in the log of the cumulative probability of survival. Thus,
interpolation gives us the following result:
(4.9)
In this way PM determines the appropriate CEDF that is then transformed into a quasi-probability of
default or quasi-CEDF (CQDF). This CQDF will be used to value the exposures cash flows and is the
subject of the next chapter.
4.5 SUMMARY
An exposures EDF value constitutes one of the most important inputs for accurate characterization of a
portfolios risk. While PM will accept any term structure of EDF values a user wishes to input, MKMV
strongly recommends users rely on market-based EDF values. The EDF values available in Credit
Monitor
TM
or CreditEdge
TM
can be easily used in PM. Any credit portfolio model requires approximations
and simplifications to make the calculations tractable. We may have reasonable disagreements about
particular approaches or models implemented in PM; however, most of these choices become irrelevant if
the default probability is specified incorrectly.
PM makes use of a structural model of default to link default probabilities and exposure correlations.
Subsequent chapters will flesh out this relationship. At this stage, the important concept to understand is
distance to default. While the EDF values provided by MKMV rely on an empirically derived DD-to-EDF
mapping, the mathematical relationships inherent in the EDF value calculation are essential to the
portfolio calculations. The components of this calculationasset value, default point, and asset
volatilityare the building blocks of all relevant PM calculations ranging from exposure value to exposure
value volatility.
CEDF EDF
t t
t
( ) 1 1
CEDF CEDF t
CEDF CEDF
CEDF
t
t
t T
T
( )
,
]
]

( )

1 1 1
1 1
1
1
1
for
22
1
1
2 1
1
j
(
,
,
\
,
(
(
,
,
,
,
]
]
]
]
]
<
j
(
,
,
\
,
(
(
CEDF
T t
T
t T
T T
for 1
1

( )
,
,
]
]
]
T
CEDF CEDF t
t
t
2
5
5
5
1 1 for >5
We continue to rely on the assumption that a firms asset value is lognormally distributed and assume the
non-normality of the DD results from the interaction of the firms asset value and the firms default point.
MKMVs research demonstrates that asset value is approximately lognormally distributed and firms with
large DDs that default within a relatively short time period tend to increase borrowing as their asset value
collapses. We continue to research this relationship between asset value and a firms leverage. The PM
framework is designed to incorporate adjustments to the model of default as we gain a better
understanding of this relationship between asset value and capital structure.
CHAPTER
5
MODELING QUASI-PROBABILITY OF DEFAULT
Suppose that all market participants were risk-neutral. Then asset pricing theory would reduce to
calculating expected values of assets using actuarial ("fair") probabilities. Determining these probabilities
might be difficult, but, once given, the computation of the value of risky assets would be straightforward.
In fact, investors are risk averse. This means that market participants prefer a fixed payoff for sure to a
variable payoff with the same expected value.
Imagine that your doorbell rings early one morning: you answer it, bleary-eyed, and find the state lottery
commissioner. "Good morning," he says brightly, "Youve just won an expected value lottery." He
produces a coin from his pocket and demonstrates that it is fair. "If you win the coin flip, you get $10
million, lose and you get nothing. Call it in the air." Just as he is about to toss the coin, you wake up a little
bit and exclaim, "Wait! Give me $2 million instead.
The fair probabilities on the coin are, of course, 0.5 for heads, 0.5 for tails. Your certainty equivalent
of $2 million, however, implies a different set of weights on the two outcomes: 0.2 for heads and 0.8
for tails:
$2 million = 0.2 x $10 million + 0.8 x $0
We can interpret these weights as a new set of probabilities (quasi-, risk-neutral, risk-adjusted or subjective
probabilities) that reflect your distaste for risk. To see that the probabilities are indeed subjective, suppose
that the coin flip was for just $1,000. Now how large is your certainty equivalent (i.e. what amount that
you receive for sure is equivalent in terms of its attractiveness to you as the uncertain payoff from the coin
flip?) $400? $490? In this case the subjective quasi-probabilities (0.4, or 0.49) are much closer to the
actuarial probabilities (still 0.5). Or imagine Bill Gates reaction on being presented with the $10 million
coin flip. ("Okay. Tails.")
Note that the subjective probabilities discount the good state (heads), and place a larger weight on the
chance of the bad state. Risk aversion is equivalent to fear of the bad state, an overestimate of the
probability of its occurrence. In general, quasi-probabilities place larger weights on unfavorable events than
are actuarially fair.
The risk premium reflects the difference between the expected value of the coin flip ($5 million) and your
subjective value ($2 million). The risk premium can be measured in various ways; a Sharpe ratio, for
example, calculates the actuarial expected value per unit of standard deviation. A more complete method is
to view the risk premium as a transformation of actuarial probabilities into subjective probabilities. This
transformation forms the basis for MKMVs Risk Comparable Valuation.
In the context of financial markets, where certainty is rare, we transpose the measure of risk aversion.
Instead of thinking in terms of discounts for uncertainty, we say that investors demand compensation for
taking risk. The risk premium per unit of risk is the price of this compensation. Investors require a
premium only for systematic (undiversifiable) risks, and a risk premium is in excess of payments for the
time value of money and expected losses. This premium compensates investors for taking on these
undiversifiable risks.
5.1 EDF AND QUASI-EDF VALUES
A $10 million loan with a 1% Expected Default Frequency (EDF) value and no recovery value is just like a
coin that comes up tails 1% of the time. The EDF value is the actuarial default probability, and the quasi-
probability of default reflects the required risk premium. If the EDF value is 1%, one needs a spread of at
least 1% on the exposure to cover expected loss. But one also needs some "extra" compensation for the
uncertainty around that expected loss. The difference between the quasi- and the actual probability of
default is a measure of the additional required spread. If, for example, the $10 million loan above traded as
a discount bond and market conditions were such that the quasi-EDF (QDF) value were 1.5%, this is
equivalent to an investor saying, "On average I will receive 99 cents on the dollar (a spread of about 1%),
but because of the riskiness of the loan, Im only willing to pay 98.5 cents (a spread of about 1.5%)."
Figure 5.1 shows the QDF value as a function of the EDF value at a one-year horizon using typical values
for systematic risk and for the market risk premium. Note that the QDF value is always higher than the 45
degree line. In other words, the QDF values are always larger than their corresponding EDF values. This
observation is intuitive since risk-averse investors adjust for uncertainty by increasing the subjective
probability of a state of nature with low payoffsthe default state.

FIGURE 5.1 QDF Value vs. EDF Value
QDF as a Function of EDF at a One-Year Horizon
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00%
EDF
Q
D
F
QDF
45-degree line
FIGURE 5.2 QDF Value, EDF Value vs. Time
Figure 5.2 depicts the variation in the risk premium over time by comparing the EDF value and the QDF
value when the annualized EDF value is 1%.
Some facts about quasi-EDF (QDF) values:
The difference between the QDF value and the EDF value increases as the market risk premium
increasesas investors become more risk-averse, the required spread increases.
The difference between the QDF value and the EDF value increases as the R
2
of the asset increases
investors demand larger premia for exposures with higher correlations to the market (more systematic,
or undiversifiable risk).
Up to an EDF value of 50%, the difference between the QDF value and the EDF value is increasing in
the EDF valueinvestors demand more compensation for larger absolute risks.
By exchanging actual probabilities for quasi-probabilities, we account for the uncertainty of the promised
cash flows. Expected cash flows calculated using quasi-probabilities incorporate the appropriate adjustment
for risk and can be discounted at the risk-free rate.
The probability distribution of asset values is more complicated than a simple coin flip. In the next section
we relate quasi- and actual probabilities of default using the asset value process implicit in MKMVs EDF
calculations.
QDF, EDF as Functions of Time, with Annualized EDF = 1%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00%
0.00 5.00 10.00 15.00 20.00 25.00 30.00
Time
C
u
m
u
l
a
t
i
v
e

P
r
o
b
a
b
i
l
i
t
y
Cumulative QDF
Cumulative EDF
5.1.1 Quasi EDF Details
Let CEDF
t
denote the actual cumulative probability of default from time 0 to time t. If the underlying
asset process follows a lognormal distribution, then for a fixed default point, CEDF
t
is given by the
following:
(5.1)
where
For valuation purposes, we are interested in the cumulative, risk-adjusted or quasi-probability of default.
We must adjust the actual probability represented in equation (5.1) such that we account for the risk
aversion of investors buying and selling these risky assets. This adjusted probability incorporates the risk
aversion of investors into probabilities applied to future, uncertain cash flows allowing us to calculate
expected cash flows that can be discounted at the risk-free rate. The adjustment relies on estimates of the
market price of risk which will be discussed in more detail below.
The corresponding cumulative quasi-probability of default from time 0 to time t, CQDF
t
, is characterized
as follows:
(5.2)
where r is the continuously compounded risk-free rate
CEDF N
A t DPT
t
t

( ) +
( )
( )
j
(
,
,
,
\
,
(
(
(
ln ln
0
2
2
A
DPT
0

market value of the firms assets at time 0

default ppoint
asset volatility of return on the firms assets
d
rrift rate, or expected return, on the firms assets

t N () hhe standard normal cumulative probability distribution funnction
CQDF N
A r t DPT
t
t

( ) +
( )
( )
j
(
,
,
,
\
,
(
(
(
ln ln
0
2
2

Comparing CEDF
t
with CQDF
t
, we see that the only difference between them is that the expected return
on the asset, , has been replaced by the risk-free rate, r. Because investors refuse to hold risky assets with
expected return less than the risk-free base rate, must be at least as large as r. It follows that:
(5.3)
The quasi-probability of default exceeds the actual default probability.
Substituting into equation (5.2) and rearranging, we can rewrite CQDF
t
as:
(5.4)
where N
-1
is the inverse of the cumulative standard normal distribution.
Thus, CQDF
t
is a function of CEDF
t
and a term which is related to the Sharpe ratio of the asset.
Assuming the expected excess return on the asset is a function of its sensitivity to systematic market risk
factors, we can write down a formula akin to the Capital Asset Pricing Model (CAPM) as follows:
(5.5)
where
The assets beta to the market, , can be written as:
(5.6)
Using the above relationships, we can express the individual assets Sharpe ratio as a function of the
markets Sharpe ratio. When we discuss the market Sharpe ratio or the market price of risk, we generally
refer to the following ratio:
CQDF CEDF
t t
CQDF N N CEDF
r
t
t t
( ) +
j
(
,
\
,
(
j
(
,
\
,
(
1

the assets beta to the market

the market risk premium,
m
( ) r
cov( , ) asset market

where
the correlation between
m m
R
R
2
tthe asset return and the market return
the volatility o
m
ff the market return
(5.7)
Essentially, we identify an annualized price of risk where we relate the amount of one years excess return
per unit of annual return volatility. The market price of risk, , may or may not stay constant across
maturities. The final adjustment to the actual probabilities uses the appropriate price of risk for the
maturity of the instrument in question and then scales the annualized number to account for the time to
maturity. In theory, the risk premium component is a linear function of time and the volatility component
increases at the rate of . With these assumptions, , scales with . In principle, the market price of risk
could also be a function of tenor. In this case, we could first determine the appropriate
t
which is now
assumed to be a particular function of t. The resulting
t
could then be scaled by .
Using equations (5.5) and (5.6), we can write down the functional relationship between the individual
obligors and markets Sharpe ratios:
(5.8)
With this specification, we do not need to directly estimate the individual obligors drift term (i.e. the
expected return on the obligors asset value.) Expected asset return is notoriously difficult to estimate so
implicit determination of this parameter is convenient. In PM, we specify the market Sharpe ratio, the
obligors R (measure of systematic risk), the obligors asset volatility, and the risk-free rate. Based on the
prior equation, the obligors expected return can be determined. It is important to remember that the
specification of the obligors drift is not nearly as important as specification of the asset volatility. The
option-like nature of these relationships makes volatility the primary driver of the calculations. In this
context, the market Sharpe ratio also plays an important role.
Without more theoretical guidance, we cannot conclude with certainty which functional form
appropriately reflects the market Sharpe ratios dependence on tenor. One possibility involves the tenor
(time), t, raised to a power. In this case, we can write down the scaled market price of risk as follows:
(5.9)
Essentially, we are assuming the existence of a one-year price of risk, , that is adjusted for different tenors.
The adjustment depends on the value of also known as the time scaling parameter in PM. If exceeds
0.5, then the market price of risk,
t
will increase with an increasing tenor. In times of market turmoil, one
may conjecture that the market price of risk increases with tenor as market participants sell down long-
term exposure and buy short-term instruments. If falls below 0.5, then the market price of risk,
t
will
decrease with an increasing tenor. The inability of firms with long-dated liabilities to find similarly dated
assets may create unusual demand for long-dated assets causing the market price of risk to decline with
increasing tenor. If equals 0.5 then
t
always equals and does not change with tenor. The primary
arguments for differing from 0.5 center on supply and demand imbalances, which are typically transitory
( )
m
m
r
t t
t
r
R
t
m
m
t
r t
t
t t
( )

so that we would expect to see values of equal to 0.5. Allowing to float provides this model with more
flexibility to fit actually observed term structures of credit spreads.
Substituting equation (5.6) and equation (5.8) into equation (5.4) we can write the CQDF in terms of the
actual probability of default to time t, the markets Sharpe ratio, , the time parameter, , and the assets
correlation with the market, R:
(5.10)
Now that we have characterized the transformation of actual cumulative probability of default, CEDF,
into the cumulative quasi- (or risk-adjusted) probability of default, CQDF, let us discuss how to estimate
the other parameters of this model. Recall that valuation in this framework depends heavily on our
estimate of CQDF. Understanding the source of parameters used in this transformation will make it easier
to implement this valuation model.
5.1.2 Estimation of a Firms Correlation with the Market
The correlation between the market value of a firms assets and the market embodies the extent to which
systematic risk factors in the economy drive the value of the firms assets (In the last section, we referred to
this correlation as R). A natural question to ask in this context is: What exactly is the market? In theory,
the market comprises all available assets or stores of value. In practice, the market becomes what we can
observe that reasonably proxies for the theoretical market. While this question has fueled economic debate
and research for decades, MKMV takes a practical perspective and defines the market as a customized
index appropriate to the firm (asset) being analyzed.
Using a multi-factor model (see Chapter 11), we construct asset value indices for industries and countries.
Next, we use these asset indices to create a custom index based on the country and industry (or industries)
within which the firm operates. The firms asset return series is regressed on the custom index to determine
the percentage of the asset return variability that is explained by the custom index. The percentage of asset
return variability explained by the index is known as the coefficient of determination or R
2
. This measure
also reflects the amount of systematic or undiversifiable risk inherent in the firms assets. Calculating
or R provides a measure of the assets correlation with the market. (Recall that in the case of a one-factor
regression like this regression of asset returns on a custom market index, the correlation between the asset
returns and the factor is equal to R.) We make the assumption that this custom index proxies for the
market.
In PM, R is an input that can be modified by the user. MKMV provides estimates for many firms with
publicly traded equity. Other approaches to estimating this parameter become necessary in the event
MKMV is unable to estimate this value for the firm. Large public firms typically have R
2
equal to 25%. If
we include small public firms, we see a typical R
2
of 18%. Even if the asset in question does not relate to a
firm (e.g. credit card debt), we can make general assumptions about the extent to which the asset correlates
with the market. The final valuation of an asset will not be sensitive to minor mis-specification of the R
2
.
Other inputs such as CEDF will have significantly greater impact. In the event no information is available
about an assets systematic risk, we recommend using an R
2
of 25%.
CQDF N N CEDF R t
t t
( ) +
( )
1

R
2
5.1.3 Estimation of Market Parameters
While the final valuation of an asset in this risk comparable framework is relatively insensitive to
specification of the asset correlation with the market, specification of the market parameters significantly
affects the results. In principle, estimation of these parameters should be a straightforward fitting exercise
of a large cross section of credit risky instruments with traded prices. Unfortunately, quality price data
covering a large cross section of suitable credit risky instruments such as corporate bonds or loans is not
readily available. Unlike the equity market, transacted prices in the corporate bond and loan markets are
not reported. We must rely on indicative and evaluated prices. Because of the pervasive noise in these types
of prices, this data creates estimation problems.
PM requires specification of the markets Sharpe ratio, and the time parameter, . The user can estimate
these parameters from data entered into two matrices reflecting the prevailing market credit spreads,
overall riskiness of credit risky instruments, and loss given default assumptions. Alternatively, the user can
enter the two parameters directly. Given the noisiness of current credit spread data, populating the
matrices can be a difficult, if not nearly impossible, task. We recommend inputting the parameters
directly. After a discussion of how these market parameters can be estimated from credit spreads, we will
discuss MKMVs recommendations for these parameters based on ongoing research. Understanding the
fitting algorithm used in the software will make it easier to digest the research undertaken to estimate the
parameters from a broad cross section of corporate bonds.
Let us set the stage for this estimation by writing down a simple valuation formula for a one dollar, zero-
coupon corporate bond or loan with maturity t. We will assume this security pays an implicit yield-to-
maturity of r
D
and defaults with a quasi-probability of CQDFsee equation (5.10). In the event of
default, the debt holder will receive (1-LGD) (LGD is technically a random variable, so in this context we
interpret 1-LGD as the expected recovery amountnot the actual amount recovered). As before, we
assume the prevailing default-risk-free rate is r. The value of this security can be calculated as follows:
(5.11)
Because the actual default probabilities have been adjusted to reflect the uncertainty of the future cash
flows, the value of this security can be determined by discounting at r the expected value calculated with
the quasi-probabilities.
We can now rearrange equation (5.11) to arrive at a formula for credit spreads:
(5.12)
This formula constitutes the foundation of the estimation algorithm to find and . We must specify a
credit spread, r
D
-r, for a given maturity, t, a loss given default, LGD, an actual cumulative default
probability, CEDF
t
, and the underlying asset's correlation with the market, R. Note that this model
assumes the entire spread over the default-risk-free rate compensates only for credit risk. To the extent one
enters spreads that include compensation for other factors such as liquidity risk, the market price of risk
will be overestimated.
Value
0
1 1 ( ) + ( )
,
]
]

e e CQDF CQDF LGD
r t rt
t t
D
r r
t
LGD CQDF
D t
( )
1
1 ln
For each credit quality class, the user enters appropriately annualized expected default frequencies, EDF
t

values, for tenors one through five. In addition, the user must enter corresponding credit spreads for each
of the credit quality classes and tenors. The difficulty lies in properly matching the two matrices. Typically,
credit spreads are available by agency rating class such as S&P or Moodys. These credit spreads tend to be
volatile. One may conclude this spread volatility is a function of changing risk premia in the market.
MKMVs research demonstrates it is the riskiness (not the risk premia) of agency rating classes that does
not stay constant over time. Consequently, the matrix of EDF
t
values must reflect the current riskiness of
each rating class. In other words, do not assume that the EDF
t
values for a particular agency rating class
stay constant over time. Current EDF
t
data will need to be entered when re-estimating the market
parameters. Otherwise, these parameters will be severely mis-estimated. The final inputs reflect LGD
assumptions for each credit quality class, as well. All these inputs are used in a weighted, non-linear least
squares estimation routine to arrive at the parameter estimates.
While this fitting algorithm provides intuition regarding the inputs to estimating the market parameters, a
number of issues affect the quality of the estimates. First, the precision of this estimation routine relies
heavily on the homogeneity of the groups used to estimate the EDF
t
value for each credit quality class and
corresponding credit spreads. Since widespread data are not available for groupings of bonds categorized by
EDF class, most users rely on rating agency data. Within any one agency rating class, credit quality tends
to be quite diverse. Calculating a mean or median EDF value or credit spread within these agency rating
classes masks the heterogeneity among the obligors in a particular class creating further difficulties for the
estimation process.
A similar problem arises when assigning LGD to the rating class matrix. The extent to which a particular
credit quality class exhibits homogeneous LGDs is still unknown. As has been explained before, the current
state of bond and loan pricing data leaves much to be desired in terms of producing compact and
reasonable credit spread matrices. Unless explicitly handled, this noise can result in unreliable and
unreasonable parameter estimates.
One final problem lies in limiting the tenors represented to a maximum of five years. For risk analysis at
horizons within five years, this constraint is not much of a problem within PM. The difficulty arises when
estimating market parameters in the context of noisy data. By looking at longer tenors, we include more
data in our estimation routine and reflect the richness in the term structure of credit spreads that appears at
tenors of five to ten years. The estimates described below are based on large data samples covering term
structures out to ten years. Our recommendation is to input the market parameters directly and use the
resulting spread matrices as guides to understanding the qualitative nature of the term structure of credit
spreads.
Ideally, we would like to estimate the market parameters using individual corporate bonds or loans. With
enough observations we could, in principle, use non-linear least squares or even something more general
like maximum likelihood estimation to fit the parameters. In practice, the noisiness in the data coupled
with extreme outliers results in a frustrating cocktail of non-convergence and unconvincing estimates.
One remedy to this estimation dilemma involves filtering and grouping the data sample. In this way, we
minimize the impact of sizable outliers that are characteristic of data for traded debt. First, we focus on
securities that demonstrate sensible behavior and sufficient liquidity. Based on current research at MKMV
we should focus on corporate bonds with duration between one and 12 years. A handful of other filters
such as elimination of bond issues by finance subsidiaries and issues for which we have no EDF
information are applied to arrive at a subset of data that can be relied upon for relatively good (given the
state of the data) estimates. We then use median credit spreads to fit the model, thereby eliminating much
of the estimation difficulty. Dampening the effect of outliers facilitates convergence of non-linear
estimation routines. The data is still noisy and ill-behaved; however, robust estimation techniques reveal a
picture in which both parameters appear stable over time.
In contrast, EDF values vary a great deal over time. Our research demonstrates that the primary driver
behind credit spreads is credit quality. In fact, close to 60% of credit spread volatility can be explained by
variation in EDF values. When the creditworthiness of a firm deteriorates (its EDF value increases), the
spread reflected in the price of the firm's traded debt eventually increases. The price of the credit risk
appears steady. In contrast to research using agency ratings to indicate credit quality, the risk premium
paid for a given level of risk does not change substantially over time. Our research indicates that the market
Sharpe ratio () is approximately .4 with an asymptotic 95% confidence interval around .3 to .5.
Given the interaction of the two market parameters, and , joint estimates of the two parameters
together are not possible given the poor quality of the data. The difficulty lies in the fact that a high and
low can result in the same credit spread as a low and high . The result is artificial volatility in the joint
estimates of these parameters when analyzed over time. That is, the estimates can move dramatically from
week to week or month to month. This kind of movement in the market Sharpe ratio is not reasonable.
Since the theory predicts a time parameter () of .5, we focused on this value. Fixing the time parameter
at .5 results in stable, reasonable estimates of the market Sharpe ratio. The quality of the models fit to the
data does not increase appreciably when allowing the time parameter to float; generally, the model exhibits
an absolute mean error of 10% when fitting median credit spreads, regardless of whether the time
parameter is constrained.
We continue to look at other methods of estimating these parameters, but we are confident enough in the
current results to make recommendations. Practically speaking, the choice of data makes a larger difference
than changes to the model estimation algorithm. Credit default swap data paints a different picture than
asset swap data from the corporate bond market. We look forward to developing a better understanding of
these differences. To date, MKMVs research has focused on the asset swap data from the corporate bond
market.
Based on MKMVs research, we recommend using .4 for the market Sharpe ratio and .5 for the time
parameter. These parameters have stayed within their 95% confidence interval range of .3 to .5 for most of
the 1990s. As we get better data and update the estimation on a semi-regular basis, we will inform clients
of any changes in our recommended values. At this time, these input parameters do not need to be
reviewed more often than once per year.
5.2 SUMMARY
Valuation of exposures in a credit portfolio is a critical aspect of portfolio modeling. The transformation of
actual EDF values into quasi-EDF values is an important step in reflecting the uncertainty in cash flows in
exposure values. PM uses a model parameterized by the market price of credit risk which is sometimes
called the credit-market Sharpe ratio. In this way, the compensation demanded by investors for taking
systematic risk can be incorporated into a larger model of credit valuation. In this chapter and the previous
chapter we have focused on the EDF value which is a primary component in both credit valuation and
credit portfolio modeling. In the next chapter, we turn to the other primary component in this modeling
contextloss given default.
CHAPTER
6
VALUATION
In this chapter we discuss the valuation of individual exposures at the as-of-date, t
0
, the starting point for
analysis in PM. There are five specific valuation options available in PM:
Under Book Value and User-input Pricing, the initial value of the exposure is specified by the user. Risk-
comparable Value, Matrix Pricing, and User-input Spread are mark-to-model prices. The model is
parameterized by spread data in the pricing matrix.
In the latter three cases, valuation proceeds by decomposing the exposure into two parts. The exposure will
pay the recovery amount (1-LGD) whether or not it defaults. The fraction (1-LGD) is, therefore, risk-free.
We can decompose the cash flows as follows:
TABLE 6.1 Valuation Options
Option Flag Name Description
0 Book Value Par value less the unamortized portion of any upfront fee.
1 Risk-comparable Value
(RCV)
A risk-neutral pricing technique that determines a premium for
credit risk from the pricing matrix (a table of user input spreads by
rating and term) and applies this premium to the valuation of credit-
risky cash flows.
2 User-input Pricing Value (net of any upfront fees) as input by the user.
3 Matrix Pricing Uses a discounted cash-flow technique where the discount rate is
the matrix spread plus the risk-free base rate. The matrix spread is
interpolated from a mapping of rating grades in the pricing matrix to
internal ratings in the Rating Map table, with an adjustment for Loss
Given Default.
4 User-input Spread Similar to matrix pricing, it uses a discounted cash-flow technique
where the discount rate is the user input spread plus the risk-free
base rate. The user input spread is entered at the facility level. It is
adjusted for Loss Given Default.
That is, a contingent cash flow which pays (1-LGD) in the event of default and $1 otherwise is equivalent
to two separate cash flows: the first pays (1-LGD) for certain and the second pays 0 in the event of default
and LGD in the event of no default. The first cash flow has no default risk and can be discounted at the
risk-free base rate. The second cash flow contains credit risk; valuation of this component must include a
discount for risk.
(6.1)
where RFV() and RYV() are risk-free and risky values, respectively.
Cash Flows in equation (6.1) include both coupons and principal. For details on cash flow generation in
PM, see Chapter 3. Risk comparable value and matrix pricing are alternative means of computing the value
of risky cash flows. Details of the two methods are provided in Section 6.2 and Section 6.3, respectively.
It is worth noting that the LGD used above can be different from the LGD input by users. Users can enter
recovery data based on a variety of measures (i.e., book exposure). Portfolio Manager will calibrate the
inputted recovery data so that it can be used in the model described above. For the remainder of this
chapter, it is assumed that the LGD inputted by the user is the one used in calculations. Please see Chapter
9 for a detailed discussion of recovery.
6.1 BOOK VALUE/USER INPUT PRICING
Under the Book Value option, the initial value of the exposure is par, less any remaining upfront fee,
which is amortized linearly over the term of the loan:
(6.2)
User Input prices are entered net of any upfront fees. The initial value of the exposure is simply the User-
input price.
6.2 RISK-COMPARABLE VALUATION
The Risk-comparable Value (RCV) method implements a risk-neutral valuation technique adapted from
options pricing theory. Rather than increase the discount rate to reflect risk aversion, we adjust the
probability of default to account for the market price of risk.
We then calculate the expected value of the cash flows using these risk-adjusted (or quasi-) probabilities.
The result can be discounted at the risk-free, i.e, the zero-EDF rate. This technique ensures consistent
valuations across assets with different levels of risk.
Exposure
Value
1- Cash Flows Cas
,
,
]
]
]
( ) ,
]
]
+ ( ) LGD RFV LGD RYV hh Flows ( ) ,
]
]
Book Value
Upfront fee
Usage Given Default
Remainin

j
(
,
\
,
(
1
gg Maturity
Original Maturity
j
(
,
\
,
(
We define:
The Risk Comparable Value at time zero is:
(6.3)
The risk-free value at t
0
discounts each cash flow at the risk-free rate:
(6.4)
where
The risky value calculation adjusts each cash flow by the quasi-probability (see Chapter 5 for determining
CQDF) and then uses the risk-free discount factor for discounting:
(6.5)
6.2.1 RCV Example
Using the equations described above, we replicate the as-of date Risk Comparable valuation calculations
performed by Portfolio Manager for an exposure.
V t
RFV
t
RCV
t
Risk Comparable Value at time

Risk-free value a at time
Risk comparable risky value at time
t
RYV t
t
RCV
V LGD RFV LGD RYV

RCV RCV
0 0 0
1 ( ) +
RFV C DF
t t
R
t
M
f
0
0

>
M
t
C
t
time to maturity
time to payment of a given cash flow
amount of cash flow at time

risk-free discount fa
t
DF
t
R
f
cctor to time t
RYV CQDF C DF
RCV
t t t
R
t
M
f
0
0
1 1 007 580 45 ( )
>
$ , , .
FIGURE 6.1 Risk Comparable Valuation Example
This exposure, a floating rate instrument with semi-annual coupons, has a recurring fee of 0.005, book
exposure of $1,000,000, and 855 days until maturity. This is the same exposure that is discussed in Section
3.4, Cash Flow Example, on page 32. For convenience, we provide the payment dates and expected
promised cash-flows at these dates again in Figure 6.2 below. For details of these calculations, please refer
to the section mentioned above.
FIGURE 6.2 Cash Flows from PM
We have chosen to reuse that example because the first steps in the RCV calculations are nearly identical to
those described there. Specifically, we must first determine the discount factors that correspond to the term
structure of interest rates for this exposure. Then we must interpolate those discount factors to arrive at the
precise values that coincide with the payment dates of this exposure. But unlike the cash flows computed
in Chapter 3, the discount factors we compute here are based on the corporate default risk-free (also called
the zero-EDF) rate rather than the simple reference rate displayed in the Set Environment Parameters field
of PM. Once again, we present the term structure of reference rates:
FIGURE 6.3 Reference Rate Term Structure
The risk-free rate is described in detail in Chapter 3. Essentially, it is a parallel shift from the reference
curve (up or down, depending on the reference curve) intended to model a truly default risk-free universe.
The first thing is to calculate the zero-EDF discount factors using equation (6.6). For example, the two-
year, risk-free discount factor, based on Figure 6.3, is given by:
(6.6)
Similar calculations give the zero-EDF discount factors listed below.
The appropriate, interpolated discount factor is given by equation (6.7) below. For example, the risk-free
discount rate appropriate for the third cash flow from Figure 6.2, i.e. the cash flow at time, t =
1.340862423 is given by:
TABLE 6.2 Zero-EDF Discount Factors
Term .25 .5 1 2 3 4 5
Discount Factor .985950 .971475 .939312 .877631 .81928 .76480 .713807
DF
R S
m
DF
t
R t m CA m
m t
R
f
f
= 1+
=1+
0.0688-0.003
, ,
+
( )
,
,
,
]
]
]
]
(

2
))
,
,
]
]
]
[ ]
( )( )
4
1 01645 0 877631
4 2
8
. .
(6.7)
Similar calculations are used to interpolate the discount factors from Table 6.2 to calculate the discount
factors to specific payment schedule of this exposure. Table 6.3 gives these interpolated risk-free or zero-
EDF discount factors.
Now that we have all the required discount factors, we can calculate the risk-free value of the exposure at
the as-of date and at the horizon date. To compute the as-of date value, we discount the cash flows in
Figure 6.2 using the discount factors described above. Then we sum together each discounted cash flow.
The equation is shown below.
(6.8)
Another required step in the risk-comparable valuation process is to compute the cumulative EDF
(CEDF) values of the obligor (corresponding to the exposure one is valuing). MKMVs EDF values are
entered in PM as annualized values, but in order to compute risk-neutral probabilities one needs the
CEDF values. We convert EDF values to CEDF values using equation (6.9)
(6.9)
TABLE 6.3 Interpolated Zero-EDF Discount Factor
Payment Years Remaining to Payment Zero-EDF Discount Factor
1 0.340862423 .980664464
2 0.840862423 .949431563
3 1.340862423 .917814961
4 1.840862423 .887168456
5 2.340862423 .857286892
DF DF
DF
DF
T t T
DF
t
R
T
R T
R
T
R
t T
T T
f f
f
f

j
(
,
,
\
,
(
(
< <
1
2
1
1
2 1
1 2
1
for
.3340862423
1 3408
0 939312108
0 87763076
0 939312108
R
f

,
,
]
]
]
.
.
.
. 662423 1
2 1
0 917814961
j
(
,
\
,
(
.
RFV C DF
t t
R
t
f
0
0
1 017 318 29
>
$ , , .
CEDF EDF
t t
t
( ) 1 1
Table 6.4 gives the CEDFs.
Just as the discount factors needed interpolation because the payment dates did not coincide with the exact
terms, the same is true with the CEDF values. Using equation (6.10), we interpolate CEDF values:
(6.10)
The CEDF values to various payment dates are converted to the Cumulative Quasi-Default Frequency
(CQDF) values by using equation (6.11).
We can write the CQDF in terms of the actual probability of default to time t, the markets Sharpe ratio,
, the time parameter, , and the assets correlation with the market, R:
(6.11)
In this case the markets Sharpe ratio, , is 0.4, the time parameter, , is 0.5, and the assets correlation
with the market, R, is the square root of 0.45.
TABLE 6.4 Cumulative EDF Values
Year 1 2 3 4 5
EDF .0011 .0013 .0015 .0016 .0017
CEDF .00110000 .00259831 .00449325 .00638466 .00847115
TABLE 6.5 Interpolated Cumulative EDF Values
Payment Years Remaining to Payment Interpolated CEDF Value
1 0.340862423 0.000375085
2 0.840862423 0.000925030
3 1.340862423 0.001610970
4 1.840862423 0.002360023
5 2.340862423 0.003244630
CEDF CEDF t
CEDF CEDF
CEDF
t
t
t T
T
( )
,
]
]

( )

1 1 1
1 1
1
1
1
for
22
1
1
2 1
1
j
(
,
,
\
,
(
(
,
,
,
,
]
]
]
]
]
<
j
(
,
,
\
,
(
(
CEDF
T t
T
t T
T T
for 1
1

( )
,
,
]
]
]
T
CEDF CEDF t
t
t
2
5
5
5
1 1 for >5
CQDF N N CEDF R t
t t
( ) +
( )
1

For convenience, we provide all the numbers relevant for valuing the risky portion of the as-of-date risk
comparable value in Table 6.7.
Equation (6.12) gives the value of the risky portion of the as-of-date risk comparable value.
(6.12)
Now that we have calculated the risk-free value, the risky value, we can calculate the as-of-date risk
comparable value
(6.13)
TABLE 6.6 Cumulative Quasi-Default Frequency (CQDF) Values
Payment Years Remaining to Payment CQDF Value
1 0.340862423 0.000654228
2 0.840862423 0.002070778
3 1.340862423 0.004206508
4 1.840862423 0.006918222
5 2.340862423 0.010403435
TABLE 6.7 Cumulative Quasi-Default Frequency (CQDF) Values
Payment Years Remaining
to Payment
CQDF Value Cash Flows Zero-EDF Discount
Factor
1 0.340862423 0.000654228 22,549.23 .980664464
2 0.840862423 0.002070778 36,921.23 .949431563
3 1.340862423 0.004206508 38,473.86 .917814961
4 1.840862423 0.006918222 38,570.43 .887168456
5 2.340862423 0.010403435 1,038,882.45 .857286892
RYV CQDF C DF
RCV
t t t
R
t
M
f
0
0
1 1 007 580 45 ( )
>
$ , , .
V LGD RFV LGD RYV
RCV RCV
0 0 0
1
1 04392512 1017 31829
( ) +
( ( . ) , , . )) + ( )
04392512 1007 58045

1013 041
. , , .
$ , ,
6.3 MATRIX VALUATION
The Matrix approach uses a discounted cash flow technique where the appropriate discount rate is the
matrix spread plus a reference rate. Matrix valuation is analogous to RCV: we value the default-risk-free
cash flowsthe fraction (1-LGD)using the risk-free rate and value the risky cash flows using the matrix
spread.
The pricing matrix consists of spreads by rating and term. The spreads in the matrix are net of expected
recoveries. In order to produce a spread that is analogous to a continuous quasi-probability, we will need
to gross up the matrix spread for LGD.
Because we are seeking correspondence with spreads based on ratings, we use rating-mapped default
probabilities rather than MKMVs EDF for matrix pricing.
The Matrix valuation procedure is as follows:
First, we determine the 1-year EDF associated with the obligors internal rating from the Rating Map
table. For Matrix valuation, the 1-year EDF will be interpolated or extrapolated to the term of the loan.
Matrix spread is interpolated or extrapolated from the Matrix table. The interpolation uses the cells from
the pricing matrix that are closest to the term of the loan. Note that this spread is adjusted for the
exposures LGD. Finally, we discount risky cash flows using the matrix spread plus a reference rate,
discount risk-free cash flows using the risk-free rate, and compute a weighted sum of the two using LGD
and (1-LGD) as the weights.
6.3.1 Valuation Using Matrix Spreads
Matrix Value at time zero is given by:
(6.14)
V LGD RFV LGD RYV
Matrix Matrix
0 0 0
1 ( )( )+ ( )( )
The risk-free value, RFV
0
, is calculated, as before, using equation (6.8) on page 62. The risky value
incorporates the spread from the pricing matrix:
(6.15)
where
6.3.2 Computing the Matrix Spread
First we obtain the 1-year EDF for the internal rating. If this corresponds to an EDF in the matrix table,
we can take the spread directly from the matrix. If not, we interpolate as follows:
(6.16)
where
s is the interpolated matrix spread, adjusted for LGD:
EDF is the rating-mapped 1-year EDF of the exposure;
s
-
, EDF
-
, and LGD
-
denote the spread, EDF and LGD, respectively, of the rating grade with the clos-
est EDF that is smaller than the rate-mapped value for the exposure;
s
+
, EDF
+
, and LGD
+
denote the spread EDF and LGD respectively, of the rating grade with the closest
EDF that is larger than the rating-mapped value for the exposure.
The interpolated spread s is an annualized continuous matrix spread. This continuous spread s is gross of
LGD and is directly analogous to the continuous quasi-probability of default. The risky value, discounted
by the gross continuous matrix spread, is weighted by LGD in the matrix valuation formula.
6.3.3 Matrix Value Example
Matrix value methodology, like RCV, breaks the valuation into two distinct portions: one that depends on
the risk-free value (RFV
0
) and one that depends on the risky value (RYV
0
). The difference between the
two methods stems from the manner in which the risky value is computed. Whereas RCV uses risk-
neutral probabilities as weights on the cash flows and then discounts these cash flows at the zero-EDF rate,
RYV C DF e
s t
C DF
Matrix
t t
RR
t
M
t t
Risky
t
M
0
0 0

( )

> >

M
t
C
t
time to maturity

reference rate discou
t
DF
t
RR
nnt factor to time
continuous matrix spread to maturity
t
s of the exposure
rounded to the nearest integer
s
s
LGD
EDF EDF
EDF EDF
s
LGD
s
LGD
+

j
(
,
\
,
(

j
(
,
\
,
(
+
+
+

the matrix method uses a modified discount ratea credit spread over a reference rateto discount each
of the credit risky cash flows.
We demonstrate this valuation method by again valuing the exposure discussed in the RCV example above
and in Section 3.4, Cash Flow Example, on page 32. For convenience, we present the cash flows again.
FIGURE 6.4 Cash flows from PM
In this example the objective is to compute the as-of date Matrix value given by:
(6.17)
We discussed in detail the calculation of the risk-free value at the as-of-date, RFV
0
. Please refer to the RCV
Example section for the details of these calculations. Equation (6.18) gives the as-of-date risk-free value.
(6.18)
Thus, we need to only compute the risky value part of the Matrix value. To do so, we use equation (6.15)
for the Matrix risky value. In this the risky discount factor is obtained by adding an appropriate spread to
the reference rate discount factors shown in Table 3.3 on page 34:
For convenience, we reproduce the reference rate discount factor values in Table 6.8. Note that the
reference rate discount factors in Table 6.8 are calculated by equation (3.4) and equation (3.3).
V LGD RFV LGD RYV
Matrix Matrix
0 0 0
1 ( )( )+ ( )( )
RFV C DF
t t
R
t
f
0
0
1 017 318 29
>
$ , , .

Figure 6.5 gives the details of the exposure being valued in the example.
FIGURE 6.5 Matrix Valuation Example
Note that the Internal Rating of this exposure is A. From the RatingMap table (Figure 6.6) we see that
the 1-year EDF is 0.0013.
1 0.340862423 0.97967677
2 0.840862423 0.947077001
3 1.340862423 0.914190052
4 1.840862423 0.882362846
5 2.340862423 0.851387293
FIGURE 6.6 The Rating Map Table
FIGURE 6.7 The Spread Matrix
To compute the appropriate spread to use in the exponential term in equation (6.15), we use equation
(6.16):
(6.19)
s
s
LGD
EDF EDF
EDF EDF
s
LGD
s
LGD
+

j
(
,
\
,
(

j
(
,
\
,
(
+
+
+
0 002 . 44
0 5
0 0013 0 0010
0 0034 0 0010
0 0062
0 5
0 0024
0 5 .
. .
. .
.
.
.
.
+

j
(
,
\
,
(

jj
(
,
\
,
(
0 00575 .
Note that this spread is a spread-to-maturity value (rounded to the nearest integer) and hence a constant
value for the spread is used for all the payment dates.
Using this annualized, continuously compounded spread value of 0.00575 and the reference rate discount
factors from Table 6.8 on page 68, we get the following values for the matrix risky discount factors by
using the following equation:
(6.20)
Table 6.9 gives the risky discount factors
Substituting these numbers into equation (6.21), we get the Matrix risky value at the as-of date.
(6.21)
TABLE 6.9 Matrix Risky Discount Factor
Payment Years Remaining to Payment Matrix Risky Discount Factor
1 0.340862423 0.977758525
2 0.840862423 0.942508974
3 1.340862423 0.907168785
4 1.840862423 0.873072328
5 2.340862423 0.840004433
DF DF e
s t
t
Risky
t
RR

RYV C DF
Matrix
t t
Risky
t
M
0
0
998 089 43
>
$ , .
Finally substituting this risky value into equation (6.22),
(6.22)
we get the Matrix value at the as-of-date.
6.4 USER INPUT SPREAD
The methodology employed for valuation using user input spread is very similar to Matrix valuation.
Specifically, users enter a spread for each facility, along with a spread frequency. The combination of an
input spread and frequency is used to compute a spread analogous to the input spread in Figure 6.7.
Following the Matrix pricing example, valuation for User-input Spread is given by:
(6.23)
As with Matrix valuation, the risk-free value, RFV
0
, is calculated, using equation (6.8) on page 62. The
risky value incorporates the spread from the User-input Spread:
(6.24)
where
V LGD RFV LGD RYV
Matrix Matrix
0 0 0
1
1 0 43925 1 015
( )( ) + ( )( )
( ) . , ,1125 17 0 43914 998 955 35
1 009 252
. . , .
$ , ,
( ) + ( )( )
V LGD RCV LGD RYV

UIS UIS
0 0 0
1 + ( )( ) ( )
RYV C DF e C DF
UIS
t t
RR st
t
M
t t
Risky
t
M
0
0 0

> >

( ) ( )
M
t
C
t
time to maturity

reference-rate discou
t
DF
t
RR
nnt factor to time
clean continuous User Input Spread
t
s
6.4.1 Computing the User Input Spread
The clean continuous spread, s, is computed from the inputted spread using the following equation:
(6.25)
where
6.4.2 User Input Spread Example
User input spread value methodology, like Matrix Valuation, breaks the valuation into two distinct
portions: one that depends on the risk-free value (RFV
0
) and one that depends on the risky value (RYV
0
).
We demonstrate this valuation method by again valuing the exposure discussed in the Matrix example
above and in Section 3.4, Cash Flow Example, on page 32. For convenience, we present the cash flows
again.
FIGURE 6.8 Cash flows from PM
In this example the objective is to compute the as-of date Matrix value given by:
(6.26)
Since the risk-free value at the as-of-date ($1,017,318.29) was analyzed in the RCV Example, we will focus
on the computation of RYV
0
. Focusing on equation (6.24) for the user input spread risky value, the risky
discount factor is obtained by adding an appropriate spread to the reference rate discount factors shown in
Table 3.3 on page 34:
s m S m DF LGD
d M
RR M m
+ ,
]
]
ln ( / )( ) / ,
/
1
1
m
S
d
=the quoting frequency of the spread
=the user-input spread (frequency )
=time to maturity
m
M
V LGD RCV LGD RYV
UIS UIS
0 0 0
1 + ( )( ) ( )
For convenience, we reproduce the reference rate discount factor values in Table 6.8. Note that the
reference rate discount factors in Table 6.10 are calculated by equation (3.4) and equation (3.3).
Figure 6.9 gives the details of the exposure being valued in the example.
FIGURE 6.9 User Input Spread Valuation Example
The next step is to use equation (6.25) to convert the spread that was entered into a clean continuous
spread:
1 0.340862423 0.97967677
2 0.840862423 0.947077001
3 1.340862423 0.914190052
4 1.840862423 0.882362846
5 2.340862423 0.851387293
(6.27)
Note that this is a spread-to-maturity value, and hence a constant value is used for all the payment dates.
Using this continuously compounded spread value of 0.008946875, and the reference rate discount factors
from Table 6.8 on page 68, we get the following values using equation (6.24):
Substituting these numbers into equation (6.24), we get the user input spread risky value at the as-of date.
(6.28)
Finally substituting this risky value into equation (6.22),
(6.29)
we get the user input spread value at the as-of-date.
6.5 FACILITIES DENOMINATED IN FOREIGN CURRENCIES
In Portfolio Manager, users must choose a denomination for each facility. When the denomination of the
facility is different from the reporting currency, one has to consider the exchange rate, as well as differences
in discount rates. Specifically, valuation at the as-of date is conducted by discounting all cash flows using
the reference rate, and zero-EDF rate associated with the facility. Once the as-of date value is computed in
the foreign currency, it is converted to the reporting currency using the as-of date exchange rate. It is worth
noting that in the examples above, this issue was not considered since the facilities had the same
denomination as the reporting currency.
TABLE 6.11 User Input Spread Risky Discount Factor
Payment Years Remaining to Payment UIS Risky Discount Factor
1 0.340862423 0.976693647
2 0.840862423 0.939978788
3 1.340862423 0.903288466
4 1.840862423 0.867949381
5 2.340862423 0.833741769
s m S m DF LGD
s
d M
RR M m
+ ,
]
]

+
ln ( / )( ) /
ln ( . / )(
/
1
4 1 0 004 4
1
0.8513387293
0.008946875
)
/ . 1 2 340862 4
,
]
]
RYV C DF
UIS
t t
Risky
t
M
0
0
991 118 95
>
$ , .
V LGD RFV LGD RYV
UIS UIS
0 0 0
1
1 043914 101512517
( )( ) + ( )( )
( ) . , , . (( ) + ( )( )
043914 99111895
1005810
. , .
$ , ,
Taking the RCV example above, we can analyze the MTM value had the user chosen Australian Dollars as
the reporting currency under Run Parameters:
FIGURE 6.10 Choosing a Reporting Currency
Looking at the associated exchange rate:
FIGURE 6.11 AUD Interest Rates
We can compute the MTM under AUD by multiplying the US dollar MTM from equation (6.13)
($1,010,859) by the spot exchange rate in terms of AUD per USD (X
0
AUD/USD
):
(6.30)
V V X
RCV AUD RCV USD AUD USD
0 0 0
1010859
, , /
$ , ,

1.508900/1.000000
==$1.528,577
CHAPTER
7
CREDIT MIGRATION
If a portfolios risk is determined by its variation in value over a particular time horizon, a portfolio risk
model must reflect the key sources of uncertainty underlying this variation. In general the drivers behind
change in value of an exposure can be attributed to the following:
Term structure of the exposures expected default probability, and
Expectations around loss given default
The expected probability of default over the horizon of analysis determines whether the exposure is
expected to be in the non-default state or the default state at horizon. In a model with no credit migration
(i.e., time-to-maturity is set equal to the horizon of analysis), the value in the non-default state is always
par. In a credit migration model, the value in the non-default state is uncertain and depends on the
expected forward default probabilities. PM provides a model for the more general case of credit migration.
The loss given default (LGD) parameterization determines the uncertainty in the exposures value in the
default state. As explained in Chapter 6, PM assumes LGD is beta distributed with the actual
parameterization determined by the user. Combining the uncertainty in either the default or non-default
state with the probability of ending up in either of the two states provides the basis for calculating risk for
the exposure and the portfolio at the horizon of analysis.
In this chapter we address the question of modeling credit migration. In subsequent chapters, we will
explain how the credit migration modeling fits into the estimation of the portfolios loss distribution with
an emphasis on the standard deviation of a portfolios loss known as the portfolios unexpected loss (UL).
7.1 DISTANCE TO DEFAULT
In Chapter 4, we introduced the Vasicek-Kealhofer (VK) structural model of default. MKMV implements
this model to estimate a term structure of Expected Default Frequencies
TM
or EDF
TM
values. An important
aspect of this model is a firms distance to default (DD) which is simply the net worth of the firm scaled by
the standard deviation of its market asset value. For ease of reference we repeat the DD equation below:
(7.1)
A large DD implies the firms asset value is far away from its default point coinciding with a low EDF
value. In contrast, a small DD implies the firms asset value is close to its default point coinciding with a
high EDF value. Converting DD to an EDF value requires an assumption about the distribution of DD.
Market Value of Assets - Default Point
Market Value of
[ ] [ ]
AAsset Volatility

MKMV uses an empirical distribution to transform the DD into an EDF value (refer to Chapter 4 for
more details.)
Since MKMVs Portfolio Manager
TM
(PM) uses a similar structural model of default as the one used to
calculate the EDF values, we can analyze credit quality in terms of change in the drivers entering into the
DD calculation. One method is to focus only on changes in the market value of assets. In this case the
default point is static. That is, particular realizations of market asset values at horizon will not affect the
default point. The implicit assumption in this modeling approach is that a firm will not change its
liabilities in reaction to changes in its market asset value. Earlier versions of MKMVs PM used this
approach in determining simulated values at horizon. The non-normal distribution of actual DDs
highlighted in Chapter 4 suggests this assumption is likely to be in error. In fact, defaults of high DD
companies likely result from a correlated change in liabilities as the market value of assets falls.
We must turn to the other components of DD to reflect a more realistic dynamism in a firms credit
quality. For example, a firm may change its liabilities over time in reaction to changes in asset value. In this
case, the default point will be correlated with the market asset value. Anecdotal evidence suggests firms in
distress (i.e., falling market asset values) increase liabilities. After some threshold value, this negative
correlation between asset value and liabilities appears to turn positive as a firm targets a particular leverage
ratio. The third component that may change over time is asset volatility. In practice, however, we find asset
volatility to be remarkably stable.
Regardless of the source of change in the DD, a comprehensive model of credit migration allows for each
of the components of DD to change in a correlated manner. We call this behavior DD dynamics or
alternatively, EDF dynamics. PM captures these dynamics in the context of a structural model
parameterized with empirical distributions of changes in DD.
7.2 DD DYNAMICS
DD dynamics captures the change in a firms credit quality over time. The EDF value embeds all currently
available information about the credit quality of the firm. At time 0, we specify a term structure of EDF
values. From this term structure we interpolate or extrapolate expected default frequencies to any desired
date. Specifying a term structure of EDF values is equivalent to specifying a term structure of DD values.
Thus, changes in credit quality are modeled as the change in an obligors DD from time 0 to some future
horizon, H. As mentioned above, an obligors DD can be interpreted as a scaled measure of leverage, and is
defined as the excess of its (log) market value of assets over (log) liabilities, scaled by the standard deviation
of its asset returns. More specifically, let the n-year distance-to-default, from t to time t+n, DD
t,t+n
be
given by:
(7.2)
where
A
t
= market value of asset at time t
DPT
t+n
= default point at time t+n
expected return on assets
= asset return volatility.
The focus is on the distance-to-default expected at the time of a promised cash flow expected n years
beyond a particular date, t. Recall that default probabilities or EDF values are calculated based on the DD
expected sometime in the future.
By modeling credit quality changes via DD rather than only changes in asset value, one can analyze
changes in asset value in conjunction with changes in the liability process (of which little is known), and
thereby avoid various ad hoc assumptions on how liabilities evolve over time. Thus, even though an
obligors credit risk at horizon is uncertain, it can be characterized by its distribution of DD at horizon.
DD
A
DPT
n
n
t t n
t
t n
,
ln
+
+
j
(
,
\
,
(
+
j
(
,
\
,
(
2
2
Since DD depends on the asset volatility, default point, and the expected (log) asset value, its value from
horizon to maturity depends on the particular realization of the (log) asset value at horizon, which is given
by:
(7.3)
where
FIGURE 7.1 Random Walk of Asset Value
Figure 7.1 depicts a possible asset value path for an exposure with an asset volatility of 15% and a drift rate
of 1.425%. The dotted line, with its small positive slope, represents the expected change in asset value. The
jagged solid line is the random walk of asset values. If this walk results in a value below the dashed
horizontal line labeled DPT at the horizon, the firm will default. In this example, the probability of this
event is 1%.
At the horizon, there will be a random realization of asset value. Each point on the asset value distribution
at the horizon corresponds to a CEDF value from horizon to maturity. The point that corresponds to the
forward-CEDF value from the horizon to maturity specified at time 0 is associated with the realized DD at
horizon based on a particular asset value draw. Given a particular liability structure, asset value realizations
below this point reflect credit deterioration; realizations above this value reflect improvement in credit
quality. Note that using the empirically derived DD transition densities implies that the asset value and
liabilities are correlated. This correlation will be reflected in the realized DD based on a particular asset
value draw.
ln ln A A H H
H H
+
j
(
,
\
,
(
+
0
2
2
A t
A
H
H
0 0
asset value at
asset value at horizon
a standar
dd normal random variable

A Possible Asset Value Path
0.50
0.75
1.00
1.25
1.50
0 1
Ti me
L
o
g

(
M
a
r
k
e
t

V
a
l
u
e

o
f

A
s
s
e
t
s
)
Asset Dr i f t
Ini ti al
EDF=1% Def aul t
Lower Cr edi t Qual i ty
Hi gher Cr edi t Qual i ty
Asset Val ue
Hor i zon
DPT
ExpectedAsset Val ueat Hor i zon
Figure 7.2 shows the effect of asset volatility, . Smaller values for result in a narrower distribution of
asset values at the horizon. If the default point remains constant, a smaller will imply a smaller default
probability. The firm depicted in Figure 7.2 is approximately 2.33 standard deviations from default under
the normal distribution.
FIGURE 7.2 Asset Volatility
Recall that a 1% EDF value corresponds to a DD of about 4. Again, the empirical distribution of asset
returns is not normal, and and DD are not directly comparable. But given the EDF value from the DD-
to-EDF mapping, we can proceed as if the distribution were normal. The probabilities themselves have no
units and can be compared across distributions:
Assuming a particular credit rating consistently mapped into an EDF value, we can relate the asset value
graph to more conventional analysis by assigning rating grades to the EDF value at the horizon. The firm
begins with an EDF value of 1%; this default rate is approximately equivalent to an agency rating of BB.
TABLE 7.1 DD, EDF value, and Standard Deviations to Default
DD EDF Number of standard deviations to default
N
-1
(EDF)
> 4 (proprietary) 0.62% 2.5
4 1.00% 2.33
< 4 (proprietary) 2.28% 2
< 4 (proprietary) 6.68% 1.5
St andard Deviat ions of Asset Ret urns
0.50
0.75
1.00
1.25
1.50
0 1
Time
L
o
g

(
M
a
r
k
e
t

V
a
l
u
e

o
f

A
s
s
e
t
s
)
Expected Asset Val ue at Hor i zon
FIGURE 7.3 Asset Value and Upgrades/Downgrades
We can partition the normal distribution into regions that correspond to agency ratings. The transition
probability is given by the area of each region. The most likely event is that the firm remains in the BB
range.
These transition probabilities are much larger than historical agency rating transitions and reflect the
dynamic nature of credit quality. Agency rating transition matrices are essentially diagonal; off-diagonal
elements (transitions to another rating grade) have negligible probabilities, except for the probability of
default. While ratings do change over time, the only meaningful "transition" probabilities in the agency
rating matrix are default events. In contrast, transition matrices constructed for buckets of EDF values that
approximate rating grades show much larger probabilities of changes in credit quality. Consequently,
EDF-based measures of credit migration will imply more movement in credit quality by the horizon date
than historically calibrated agency rating-based measures of credit migration.
From a modeling perspective, the characterization of credit migration at the horizon date requires
specification of the transition probability of moving from the firms starting credit quality (e.g. one-year
DD at time 0) to a particular credit quality or DD at the horizon date. As a result, we need to somehow
specify a distribution reflecting transition probabilities. PM implements empirically derived DD
distributions conditional on the one-year DD of the firm at time 0.
7.3 ESTIMATION OF DD DISTRIBUTIONS
MKMV estimates the distribution of one-year distance-to-default t-years ahead (DD
t,t+1
) empirically using
monthly, historical DD
0,1
data on a sample of publicly traded companies in the MKMV database over a
particular time period for which data is available (e.g. one estimation used the period January 1990 to
February 1999). These distributions continue to be studied at MKMV. They exhibit reasonable stability
across countries, reflecting the strength and applicability of a structural model in different economic
environments. The components of the DD calculation, particularly the asset volatility, reflect the
systematic differences in countries and industries. The estimation process is briefly described below:
For a given horizon H, a synthetic data set is constructed by grouping each observation of DD
0,1
into one
of 32 separate buckets with various DD
0,1
ranges. For example, bucket 2 contains all the observations of
Credit Migration in Rating Terms
0. 50
0. 75
1. 00
1. 25
1. 50
0 1
T ime
L
o
g

(
M
a
r
k
e
t

V
a
l
u
e

o
f

A
s
s
e
t
s
)
Ex pec t ed As s et
Val ue at Hori z on
BB
B
CCC
BB B
A
AA
D
DD
0,1
between 0.5 and 1.0 whereas bucket 3 contains all the observations of DD
0,1
between 1.0 and 1.5.
The last bucket captures all observations with DD
0,1
greater than 15. For each observation in a DD
0,1

bucket, the corresponding DD
H,H+1
, which is the distance-to-default H-months later, is tracked and
recorded. A cumulative frequency table of DD
H,H+1
is calculated, thus yielding an empirical transition
probability distribution for a given horizon for a given bucket of DD
0,1
.
Since the number of observations in most of the DD
0,1
buckets is typically very large, we get a nearly
continuous transition probability distribution. Figure 7.4 depicts the families of transition probability
distributions for a horizon of one year. PM includes the estimated distributions for various horizons. The
horizontal axis is the obligors one-year distance-to-default while the vertical axis represents
P(DD
H,H+1
>DD
1
|DD
0,1
,H), or one minus the cumulative probability distribution of DD
H,H+1

conditional on DD
0,1
and horizon H. These probability distributions are conditional upon no default at
horizon. Each curve corresponds to one of the DD
0,1
buckets. From left to right, the buckets comprise a
fixed range of increasing values of DD
0,1
.
FIGURE 7.4 Empirical DD Distribution for Horizon of one year
7.3.1 Obligor-Specific DD Distributions
Using an obligors EDF term structure from one to five years, PM calculates cumulative EDF values to
these five years. Calculating credit migration at horizon requires knowledge of the forward-EDF term
structure from horizon to maturity conditional upon a realization of DD
H,H+1
, which is unknown at time
0. PM uses the empirical DD distributions (shown in Figure 7.4) to map a value of DD
0,1
for an obligor
to average future values of DDs, which, in turn, provide expected forward-EDF values using a DD-to-
EDF empirical mapping. Finally, PM accounts for individual departures from the average EDF term
structure by making adjustments that are calibrated to each exposures input EDF term structure.
In other words, the distribution of DDs at horizon from above corresponds to the average DDs for all the
firms within a given DD
0,1
category. We next adjust these DDs (call them DD*s) to account for the
obligors term structure of EDF values.
7.3.2 Adjusting the DD Distributions
We do these adjustments by ensuring that the obligors forward survival probabilities to each point on the
inputed EDF term structure, (1-CEDF
H,t
), exactly equals the expected forward survival probabilities
arising from the associated empirically derived DD transition probability distribution. The adjustments
take the following form:
(7.4)
The a
t
s are chosen such that the following system holds true for all ts:
(7.5)
(7.6)
Using the adjustments a
t
s, PM converts the average DD (i.e., DD*) into a DD calibrated to the obligors
actual term structure of EDF values.
7.4 SUMMARY
Capturing the dynamics of a firms DD, and by extension its EDF, produces richer distributions of
exposure values at horizon. Currently, the conditional distributions of DDs at horizon are conditioned
only on the DD of the firm at the as-of date. As we develop a better understanding about how a firm
changes its capital structure as its asset value changes, we can incorporate richer characterizations of these
distributions. The empirical distributions included with PM represent the best estimates we have today.
Moving to this DD dynamics framework has produced much better estimates of variance in value for
longer-dated exposures.
PM relies on the term structure of EDF values to determine the expected forward-EDF values for each
firm. These forward-EDF values are combined with the expected LGD to determine the expected value of
the exposure associated with the firm. Since we are also interested in understanding the distribution of
these exposure values, we model the dynamics of the firms DD to determine the shape of the exposure
value distribution. We begin with distributions based on the typical behavior of a firm that starts at a
DD DD a H t H t
t

, ,
*
+ ( ) 1
S
CEDF
CEDF
H t
t
H
,

( )
( )
1
1
S CEDF DD
P DD DD DD H
DD
dDD
H t H t H t
H t
H t
H , , ,
, ,
,
,
| ,

( )
,
]
]

( )
1
1 0 1
tt
0

particular DD level (i.e., credit quality). We then adjust the calculations to ensure that the expected
forward-EDF value resulting from the empirical distribution exactly equals the exposures input forward-
EDF term structure. In this way, we retain the individual exposure information in the calculation.
This approach represents an effective blending of empirical understanding with a structural model of
default. The result is a robust measure of individual exposure unexpected loss. Furthermore, we can
combine this model with MKMVs Global Correlation Model
TM
to calculate the portfolios unexpected
loss and each exposures contribution to the portfolios overall risk. We now turn to a discussion of these
calculations.
CHAPTER
8
VALUATION AT HORIZON AND SPREADS
At the exposure level, Portfolio Manager computes several output values of interest. These include the
spreads earned, Expected Loss and Expected Spread, and Unexpected Loss.
Spread calculations summarize valuation and coupon information into a single number, the internal rate of
return for a given exposure. Spreads can be calculated between any two dates for which we have an
exposure value. Two spreads computed by Portfolio Manager are Spread to Maturity (STM) and Total
Spread to Horizon (TS
H
) which are the promised return on the asset to maturity and horizon,
respectively.
Combining spread information with EDFs allows us to compute an additional return measure, namely,
the Expected Spread to Horizon (ES
H
), which is the expected return on the asset to the horizon. Expected
Loss to Horizon, EL
H
is a measure of the difference between the promised return and the expected return,
i.e., the difference between the Total Spread to Horizon, TS
H,
and the Expected Spread to Horizon, ES
H
.
8.1 VALUATION AT HORIZON
For the purpose of computing spreads, PM offers three options for valuation at the horizon: linear
amortization, exponential amortization, and RCV.
The expected value at the horizon is a weighted average of default and non-default state expected values,
with the EDF to the horizon as the weights:
(8.1)
8.1.1 Value at Horizon in the Non-Default State
The selected amortization schedule determines V
H|ND
, the horizon value given that the exposure does not
default. In general, for discount exposures, RCV at the horizon is the fastest appreciation schedule,
followed by linear amortization. Exponential amortization has the slowest appreciation to par value. This
pattern is depicted in Figure 8.1 below:
E V CEDF E V CEDF E V
H H H D H H ND
[ ]

[ ]
+ ( )
[ ]
| |
1
FIGURE 8.1 User-Specified Value at Horizon
It is worth pointing out that the choice of horizon valuation method has no bearing on V
H|D
, the value in
the default state.
Under Linear Amortization, we set the value at horizon to:
(8.2)
where
Amortization Schedules
Time
F
a
c
i
l
i
t
y

V
a
l
u
e
RCV Linear Exponential
1.0
H M
E V V V
t
t
C C
H ND
H
M
H H t
H
| , ,
[ ] + ( ) + +
+
0 0 0
1
1
t
t t
M
H M
time from origination to maturity

time from or min{ , iigination to horizon
time at first coupon after Hori
}
t
H+

1
zzon
time at last coupon before Horizon t
C C
DF
DF
H
H t
t
R
f

1
0,
HH
R
H t
H t
H
H H
t
f
H H
C
H t
t t
C
>
+
+
+ +
0
1
1 1
1 1
,
Notice that interest accrued since the last coupon before horizon is included in the value at horizon.
Adding the accrued interest avoids distortions associated when coupons are asynchronous relative to
horizon. Otherwise, a one-day change in origination (or maturity) date can result in a discreet change in
horizon value, since the coupon around horizon can land right before or after horizon.
Similarly, under Exponential Amortization we have:
(8.3)
Under RCV, the value is:
(8.4)
where
(8.5)
It is worth pointing out that in general,
(8.6)
This is due to the fact that the CEDF to CQDF mapping is non-linear; the mapping of the expectation,
does not equal the expectation of the mapped values.
Notice that under RCV, the value at horizon in the non-default state is a function of credit migration (i.e.,
forward CQDFs). Credit quality changes are modeled through changes in the DD value (also see Chapter
7). Given a distribution of DD values at the horizon, we can determine the variance of exposure value at
the horizon in the non-default state using an analytical calculation. We will now turn to the details of this
calculation.
Each DD value realization has an associated forward cumulative EDF from horizon to maturity, or
CEDF
H,M
. Each CEDF
H,M
has an associated CQDF
H,M
, and this quasi-default probability can be used to
value the cash flows from horizon to maturity. We can write the random exposure value at horizon, ,
E V V C C
H ND
t
t
H H t
H
M
H
| , ,
,
]
]
+ +
j
(
,
\
,
(
+
0
1
0
1
E V
E C C C
H ND
H t
t H
t
DF
DF
DF
DF
t
R
H
R
t
R
H
f
f
f
|
,
,
]
]
( ) + +
>
0
1 LGD LGD
RR
f
t ND
t H

( )
,
,
,
]
]
]
] >
1 CQDF
|
CQDF random cumulative quasi-probability of default f
t ND |
rrom to , given no default up to
CEDF CEDF
CE
H t H
N N
t H
1
1
DDF
H
R t H
j
(
,
,
\
,
(
(
+ ( )
j
(
,
,
\
,
(
(

E CQDF N N R t H
t ND
t H
H
[ ]
|
j
(
,
\
,
(
+ ( )
j
(
,
,
\
,
(
(
1
1
CEDF CEDF
CEDF

V
HND |
as a function of the random DD value at horizon. To make explicit the dependence of the horizon value
on this realization, we will write . The expected value conditional on no default can be
computed as:
(8.7)
8.1.2 Value at Horizon Given Default
In the default state, we use the random variable, , which is drawn from a beta distribution to determine
the recovery value (see Chapter 9). LGD applies to the risk-free value at horizon:
(8.8)
At horizon, RFV
H
is known. So we have:
(8.9)
The Loss Given Default distribution has two parameters: its mean (the LGD for each exposure) and a
portfolio-wide variance parameter. Since
(8.10)
(8.11)
Please note that LGD used above can be different from the LGD that users input. Users can enter recovery
data based on a variety of measures (i.e., book exposure). Portfolio Manager will calibrate the inputted
recovery data so that it can be used in the model described above. For the remainder of this chapter, it is
assumed that the LGD inputted by the user is the one used in calculations. Please see Chapter 9 for a
detailed discussion of recovery.
8.2 INPUT SPREADS
As a preliminary, Portfolio Manager calculates the Simple Cash Spread (SCS) for each exposure. SCS is the
spread income received against the face value of the loan. Exposures can be entered either as fixed-rate or
floating-rate instruments. The input spread on fixed-rate instruments is the difference between the coupon
and the risk-free rate. For floating-rate instruments, PM computes spreads based on usage fees and the
drawn amount, recurring (or commitment) fees, and any upfront fees received at loan origination.
V DD
H ND H H | ,
( )
+1
E V V DD
P DD DD DD H
DD
H ND H ND H H
H H H
H H

| | ,
, ,
,
( | , )
(
,
]
]
( )

+
+
+
1
1 1 0
11
1
0
)
( )
,
d DD
H H+
~
L
E V E L RFV
H D H |
,
]
]

( )
]
]
1

E V E L RFV
H D H |
,
]
]

( )
,
]
]
1

E L
]
]
LGD
E V RFV
H D H |
,
]
]
( ) 1 LGD
8.2.1 Computed Spreads on the Exposure Editor screen
The Drawn Spread is the spread that would be received if the exposure were 100% drawn; the Undrawn
Spread is the spread received when the exposure is not drawn at all. Upfront Fees are amortized linearly
over the term of the loan; the remaining unamortized portion is added to Drawn Spread and Undrawn
Spread. The All-In Spread (AIS) is a weighted average of Drawn Spread and Undrawn Spread, with the
Expected Usage providing the weights.
(8.12)
These are contractual spreads; they are completely specified by the fee schedule and expected usage. The
All-In Spread + Price Discount value displayed on the Exposure Editor screen adds any discount received
(or subtracts any premium paid) at the user input price to the AIS.
As an example, suppose the loan is specified as follows:
Then the computed spreads are:
Expected Usage 0.75
Time to Maturity 1.00
Price (Net of Upfront Fee) 0.95
Usage Fee 8 bp
Non-Usage Fee 0
Remaining Upfront Fee 4 bp
Recurring Fee 12 bp
Drawn Spread 24 bp = 8 + 12 + 4/1.00
Undrawn Spread 16 bp = 0 + 12 + 4/1.00
All-In Spread 22 bp = [0.75][24] + [0.25][16]
All-In Spread + Price Discount 518 bp = 22 + [500 - 4]/1.00
Drawn Spread=
Usage
Fee
Recurring
Fee
Upfront Fee

,
,
]
]
]
+
,
,
]
]
]
+
[[ ]
[ ]
,
,
]
]
]
+
Time to Maturity
Undrawn Spread=
Non-Usage
Fee
Recuurring
Fee
Upfront Fee
Time to Maturity
All-In Spr
,
,
]
]
]
+
[ ]
[ ]
eead (AIS)=
Drawn
Spread
Expected
Usage
Undrawn
Spr
,
,
]
]
]
j
(
,
\
,
(
+
eead
Expected
Usage
AIS+Price Discount= AI
,
,
]
]
]

j
(
,
\
,
(
j
(
,
\
,
(
1
SS
Price Net of
Upfront Fee
Upfront Fee
Ti
[ ]+
j
(
,
\
,
(
,
,
]
]
]
[ ] 1
mme to Maturity [ ]
8.2.2 Simple Cash Spread
The Simple Cash Spread that appears on the Exposure Output Details window is an effective All-In Spread
and may differ from the AIS computed on the Exposure Editor form. SCS includes an adjustment for
exposure (UGD).
For floating-rate instruments, SCS equals AIS divided by UGD
(8.13)
For example, if you receive an AIS of 20 bp on a Commitment which has a UGD of 75%, then the Simple
Cash Spread on the exposure is 20/0.75 or about 27 bp.
For fixed-coupon instruments, SCS is given by the margin of a par interest-rate margin swap, defined as:
(8.14)
where
8.3 OUTPUT SPREADS
Portfolio Manager outputs spreads at two dates, the maturity date of the exposure and the portfolio
planning horizon. The spreads themselves fall into two classes: total spreads, or those gross of Expected
Loss, and expected spreads, which account for the expected value of losses due to default. Spread to
Horizon and Spread to Maturity are total spreads; Expected Spread is the spread to horizon net of
Expected Loss.
Simple Cash Spread=
All-In Spread
Usage Given Default
[ ]
[ ]
SCS c p
C DF DF
DF
fixed
t t
RR
M
RR
t
RR
t M

+
( )

,
,
,
,
]
]
]
]
]
<
1
1 1
0
c
p
t
fixed coupon
payment frequency
time to first cash flo
1
ww
maturity date
reference-rate discount factor to t
M
DF
t
RR
oo time
t
C t
t

8.3.1 Understanding Spread to Maturity
Spread to Maturity (STM) for an exposure is given by the following formula:
(8.15)
where V
0
is the initial value of the exposure, C
t
and R
t
are the cash flows for the exposure and the
annualized risk-free rate for time t.
The initial value can be taken as the output of any of the five pricing methods available in PM (see Chapter
6). Once we have an initial value, the cash flows are completely specified: the lender pays the market
price, acquires the asset, and receives a stream of fees and the return of principal. Note that this is a gross
yield: we have not accounted for Expected Loss.
STM and price are interchangeable: given one, we can obtain the other. Market Value is the value of an
existing loan; STM is the lenders compensation for assuming default risk. In the example below, we use
the same exposure that we used in the chapter on Valuation.
8.3.2 Total Spread to Horizon
Total Spread, TS, is a measure of annualized promised excess return to horizon, or the excess return to
the horizon given no default. Annualized Return Total Spread is given by:
1

(8.16)
where
Total Spread to Horizon (TS
H
) is the total spread earned until the horizon. It is given by:
(8.17)
1
Yield Total Spread (annualized) is calculated by:
V C DF STM
t t
RR t
t
t
M
0
1
0
+
( )

>
[ ]
/
V C DF TS E V C DF
t t
RR
t
Y
t
t H
H ND H H
RR
0
1
0
,
]
]
+
j
(
,
\
,
(
+
( )

( )
,
| ,
]]
]
+
j
(
,
\
,
(
1
H
Y
H
TS
TS
E V
V
DF
H ND
H
H
RR
H
]
]
j
(
,
,
\
,
(
(

|
( )
0
1
1
V
H ND |
value at horizon given no default
TS DF TS DF
H H
RR H H
H
RR
+

(( ) ) ( )
/ 1 1
In order to compute Total Spread (TS), we require a value for the exposure at the as-of date, as well as
horizon. In Chapter 6, we provided details for the as-of date value calculation. We now describe the details
of horizon value calculations.
8.3.3 Expected Spread and Expected Loss
In the previous section we computed the expected values at horizon in both default and non-default states.
To combine these two values into the unconditional expected value, we take a weighted average, using the
EDF and its complement as the weights:
(8.18)
Expected Spread (ES) is the expected excess return to horizon. We calculate ES using the unconditional
expected value of the exposure at the horizon. This expected value includes the possibility of default.
Mathematically,
(8.19)
Expected Spread to Horizon, (ES
H
), is the spread one would expect for holding an exposure out to the
horizon. It is given by:
(8.20)
The Expected Loss to Horizon, EL
H,
is the difference between the Total Spread to Horizon and the
Expected Spread to Horizon. Mathematically:
(8.21)
Expected Loss for an exposure, EL, is EL
H
expressed as an annually compounded, annualized rate. It is
calculated by annualizing the rate to horizon:
(8.22)
E CEDF E CEDF E V V V
H H H D H H ND
[ ] [ ] ( ) [ ] +
| |
1
ES
E V
V
DF
H
H
H
RR
H

[ ]
,
,
,
]
]
]
]
,
]
]
0
1
1
ES
H H
RR
H
H
H
RR
DF ES DF ,
]
]
+
j
(
,
\
,
(
,
]
]

1
1
EL TS ES
H H H

EL EL
H
H
[ ] 1 1
1
An alternative definition for EL is to take the difference between the annualized Total Spread and
Expected Spread:
(8.23)
Clearly, if horizon is equal to one year, the two definitions for EL are identical. In this case, EL is the
difference between the Total Spread and the Expected Spread for the exposure.
Some facts about Expected Loss:
If the initial value is par, there are no coupons or fees, and the exposure matures at the horizon, then
the Expected Loss will equal the risk-free forward value to the horizon of EDF times LGD. (Recall
that LGD includes the time value of the delay in recovery).
Because LGD applies to interim cash flows as well as principal, EL increases as coupons or fees
increase.
EL increases when the non-default value at horizon increases relative to the initial value. This effect
applies to exposures that are trading at a discount or premium. We expect bonds to converge to par
over their maturity. If the EDF term structure is flat, we will see an increase in exposure value for
exposures trading at a discount and a decrease in those that trade at a premium today as the time to
horizon elapses. This change in value, because it is expected at t
0
, is incorporated into the EL.
8.3.4 Portfolio Total Spread, Expected Spread, and Expected Loss
Portfolio Total Spread to Horizon is the weighted sum of the Total Spread to Horizon for individual
exposures, with the weights being the initial MTM value (or Norm) as a percentage of the portfolio MTM
(or Norm). Mathematically,
(8.24)
When portfolio Total Spread is annualized, the rate to horizon is computed and then annualized:
(8.25)
Similarly, we can compute Portfolio Expected Spread to Horizon as:
(8.26)
EL TS ES
TS wTS
H
p
i
i
H
i

TS DF
P
H
P
H
H
RR
H
TS ,
]
]
,
]
]
1 1
ES w ES
H
p
i
i
H
i

The annualized rate to horizon is computed as:
(8.27)
Portfolio Expected Loss to Horizon is the weighted sum of the Expected Loss to Horizon of individual
exposures, with the weights being the initial MTM value of the exposure as a percentage of the portfolio
initial MTM value. Mathematically,
(8.28)
Similar to the facility level statistic, annualized Portfolio Expected Loss can be computed in two different
ways. Specifically, it can be calculated by annualizing the rate to horizon:
(8.29)
An alternative definition for EL is to take the difference between the annualized Total Spread and
Expected Spread:
(8.30)
8.3.5 Portfolio Value Distribution, Spreads, and Losses
Figure 8.2 shows expected spread, total spread, and expected loss as they relate to the value distribution of
the portfolio at horizon. The mean of the value distribution, E[V
H
], corresponds to the initial value of the
portfolio, V
0
, growing at the compounded reference-rate, R
H
, plus the Expected Spread, ES. The full sum
of the promised payments, if received, will yield a value at horizon equal to the initial value growing at an
annual compounded rate of the default risk-free rate, R
H
, plus the total spread, TS. If the portfolio value
were to grow at only the default risk-free rate, there would be a loss in value of TS
H
times V
0
from the
promised payments and ES
H
times V
0
from the mean of the value distribution. Note also that if the
portfolio were to grow at an annual compounded rate of the default risk-free rate, R
H
, plus the expected
spread, ES, and achieve its mean value, it would suffer a loss of EL
H
of the initial value over the value of
the promised payments. Finally, note that the portfolio can achieve a value higher than the promised
payments at horizon. This results when, in addition to paying the promised payments, exposures in the
portfolio are upgraded in credit quality, leading to a portfolio capital gain.
ES
P
H
P
H
H
RR
H
ES DF ,
]
]
,
]
]
1 1
EL w EL
H
p
i
i
H
i
EL EL
P
H
P
H
,
]
]
1 1
1
EL TS ES
P P P

FIGURE 8.2 Portfolio Value Distribution at Horizon Showing ES
H
, TS
H
, and EL
H
8.4 FOREIGN CURRENCY DENOMINATED FACILITIES
When a facility is denominated in a foreign currency, Portfolio Manager uses covered interest rate parity to
convert horizon values to the reporting currency. Under covered interest rate parity, one is indifferent
between (a) investing at the risk-free rate in one the reporting currency, and (b) converting money into a
foreign currency at the spot exchange rate, earning interest in the foreign currency, and then converting
the proceeds back to the reporting currency at the forward exchange rate. If this is not true there would be
an arbitrage opportunity. Mathematically, covered interest rate parity adheres to the following
relationship:
(8.31)
where
Chapter 8 (Spreads)
Portfolio Value at Horizon (V
H
)
P
r
o
b
a
b
i
l
i
t
y
V
0
(DF
H
RR
)
-1
V
0
((DF
H
RR
)
-1
+TS)
H
Corresponds to mean
of value distribution, E[V
H
]
(EL
H
)(V
0
) (ES
H
)(V
0
)
(TS
H
)(V
0
)
V
0
((DF
H
RR
)
-1
+ES)
H
Corresponds to value of
promised payments
( ) ( ) / DF X DF
H
RR
H
RR Reporting Foreign/Reporting Foreign

1
0
1
XX
H
Foreign/Reporting
X
0
Foreign/Reporting
spot exchange rate in terms of units o ff reporting
currency per unit of foreign currency
Foreign
X
H
//Reporting
=forward exchange rate in terms of units of repo orting
currency per unit of foreign currency
Solving for the implied forward exchange rate yields:
(8.32)
When valuing a foreign denominated facility at horizon, the value is first computed under the foreign
denomination. The value in the foreign currency is then divided by the forward exchange rate, in terms of
the foreign currency per reporting currency (X
0
Foreign/Reporting
), to arrive at the value in the reporting
currency.
X X DF DF
H H
RR Foreign/Reporting Foreign/Reporting Reporting

0
/
HH
RR Foreign
CHAPTER
9
MODELING RECOVERY
Estimating the expected recovery value in the event of default presents several challenges. Initially, we must
determine whether recovery is an absolute amount or a percentage of some specified value. Various
arguments can be put forward concerning how expected recovery should be specified. We will not attempt
to defend any particular approach in this document. What is more important is to ensure the data entered
for an exposure are collected in a way that is consistent with how PM treats expected recovery in the event
of default.
9.1 SPECIFYING EXPECTED RECOVERY VALUE
In PM, users input LGD
input
in the Exposure Input tab. Users can choose to model LGD as a fraction of
the as-of date book exposure, as a percentage of the exposures no-default, risk comparable value at horizon
(see Chapter 8), or as a percentage of the risk-free value of the exposure at horizon (see Chapter 8).
1
In all
cases, PM coverts the inputted LGD to an LGD that is used in valuation (see Chapters 6 and 8). The
conversion is done so that the LGD used implies the same recovery amount at horizon as the LGD that
was inputted.
9.1.1 Recovery as a Percentage of Book Exposure
If the user chooses to model the expected losses in the event of default as a percentage of the book exposure
amount, the LGD
input
is converted to LGD, which is the expected loss in the event of default expressed as
a fraction of the risk-free value of the exposure at horizon, RFV
H
(see equation (9.2) below for the
calculation of the risk-free value at horizon). This conversion is done so that, in the event of default, the
expected amount recovered based on LGD
input
is exactly the same as the expected currency-amount
recovery based on LGD. Mathematically speaking, the relationship can be characterized as follows:
(9.1)
When recovery is modeled as a fraction of Book Exposure, the user can enter LGD
input
through the
Exposure Editor. Using the RCV example from Chapter 6, with LGD
input
chosen so that LGD is equal to
the one used in the RCV example in Chapter 6.
1
Please refer to the Portfolio Manager User Guide for details on specifying PMs approach for handling LGD.
1-LGD = 1-LGD Book Exposure
input
( )
( )
[ ]
RFV
H
FIGURE 9.1 Risk Comparable Valuation Example
To compute LGD, note that Commitment times Usage Given Default is equal to the Book Exposure in
equation (9.1). The risk-free value at horizon is computed by taking the as-of date risk-free value
equation (6.4) and multiplying it by the inverse of the risk-free discount factor for the length of the
horizon. Note that in this case, because the horizon is two years, the discount rate comes directly from
Table 6.2.
(9.2)
We can now compute LGD:
(9.3)
RFV DF C DF
H H
R
t t
R
t
f f
( )

( ) ( )
>
1
0
1
0 87763 1 017 318 29
1 1
. , , .
, 559 164 34 , .
LGD =1-
1-LGD Book Exposure
input
( )
[ ]
,
,
,
]
]
]
]

(
RFV
H
1
1 0 35 . )) ( ) ,
,
]
]
]
1 000 000
1 159 164 34
0 432512
, ,
, , .
.
This value can be found in the Exposure Output Table:
FIGURE 9.2 Calculation of LGD used in PM
It is worth noting some properties of LGD when LGD
input
are entered as a fraction of book exposure.
First, LGD
input
is the expected loss in the event of default, and is bounded between 0 and 1. However,
LGD calculated from LGD
input
may turn out to be negative, in which case PM gives out a warning signal
that the LGD
input
is too low. Negative LGD is most likely to happen for heavily discounted exposures
with relatively low LGD
input
. Second, the conversion is done to maintain the same currency-amount
recovery regardless of the horizon and time-to-maturity of the exposure.
9.1.2 Recovery as a Percentage of No-Default, Value at Horizon
The option to model recovery as a percentage of the exposures no-default, risk comparable value at
horizon is designed so that it is much easier to incorporate term and market value effects into the recovery
modeling. The currency amount of the recovery will now depend on the horizon and time-to-maturity.
Similar to modeling recovery as a fraction of book exposure, LGD
input
is converted to LGD, which is the
expected loss in the event of default expressed as a fraction of the risk-free value of the exposure at horizon,
RFV
H
. This conversion is done such that, in the event of default, the expected currency amount recovery,
based on LGD
input
, is exactly the same as the expected currency-amount recovery based on LGD.
Mathematically speaking, the relationship can be characterized as follows:
(9.4)
Since the risk comparable value at horizon was defined in equation (8.10) as:
(9.5)
( ) ( ) [ ]
/
1 1 LGD RFV LGD E V
H input H ND
E V
E C C C
H ND
H t
t H
t
DF
DF
DF
DF
t
R
H
R
t
R
H
f
f
f
|
,
,
]
]
( ) + +
>
0
1 LGD LGD
RR
f
t ND
t H

( )
,
,
,
]
]
]
] >
1 CQDF
|
We can now solve for LGD when recovery is entered as a fraction of the exposures no-default, risk
comparable value at horizon:
(9.6)
9.1.3 Recovery as a Percentage of the Risk Free Value at Horizon
In this case that the expected losses in the event of default are specified as the percentage of the risk-free
value of the exposure at horizonLGD
input
equals LGD. Thus, in this case, PM uses LGD
input
as the
percentage applied against the risk-free value at horizon. As with modeling recovery as a percentage of the
exposures no-default, risk comparable value at horizon, the currency amount of the recovery will now
depend on the horizon and time-to-maturity. The user should determine which method best represents
the data used to specify an exposures expected losses in the event of default.
If we did not know anything about the recovery rate, i.e., if we thought that all possible recovery rates were
equally likely, then we would model LGD as a flat (uniform) distribution between the interval 0 and 1.
PM uses the beta distribution to provide flexibility to capture the uncertainty and varying shapes of LGD
distributions, while staying within the bounds of 0 and 1. Beta distributions are flexible in that their shape
can be fully specified by stating the desired mean and one more parameter, k.
9.2 THE BETA DISTRIBUTION
The Beta function is characterized by two parameters:
(9.7)
A Beta distribution density function is given by:
(9.8)
The mean of the beta distribution is given by:
(9.9)
LGD
LGD RFV
RFV E LGD
DF
DF
C CQDF
input H
H input
t
R
H
R
t H
t
f
f

>
[( ) 1

H t ,
]
B a b
a b
a b
, ( )
( ) ( )
+ ( )

f x a b
B a b
x x
a
b
, ,
,
( )
( )
( )
1
1
1
1
a b
a
a b
, ( )
+
The variance is given by:
(9.10)
9.2.1 Parameter Assumptions for LGD
The following assumptions are made to give the distribution meaningful properties for LGD.
The LGD value assigned in the portfolio model is used as the mean of the distribution. So by definition:
(9.11)
The relationship between a and b, which determines the shape of the Beta distribution for a given LGD is
determined by their relationship in the variance of the distribution.
(9.12)
Thus, the distribution for Loss Given Default can be defined by its mean, LGD and k = a + b +1.
The shape parameters, a and b, can be determined from LGD and k:
(9.13)
and the variance is:
(9.14)
9.2.2 Choosing the k Parameter
Little empirical research exists for specifying the appropriate shape of an exposures LGD distribution.
Nonetheless, many users possess intuition around the qualitative characteristics of the distributions shape.
Notice in the equations above that k is in the denominator of the variance function. As k becomes large the
variance of the distribution goes to 0. Thus large k values imply that the estimate of the mean LGD
specified for the exposure has little uncertainty around it. If the data represents confident estimates of
2
2
1
a b
ab
a b a b
, ( )
+ + ( ) + ( )
LGD
a
a b
2
1
1
( )
+ + ( )
LGD LGD
a b
a k LGD
b k LGD
( )
( ) ( )
1
1 1
2
1
( ) LGD LGD
k
LGD with low standard errors, a large value of k is the appropriate specification. Most data to date,
however, suggests the confidence intervals for estimated LGD values are quite large. Using smaller k values
are likely to be more accurate characterizations of actual expectations. A k value of 4 produces a
distributional shape that spreads probability density liberally along the full spectrum of possible LGD
values. PMs preset value of k is 4 which is the recommended value when the user possesses no strong
priors about the shape of the LGD distribution.
Consider two examples of differing specifications of the k parameter: A particular type of loan may exhibit
a mean LGD of 50% of face value; however, loss histories reveal that many observations occur at the
extremes (either 0% loss or 100% loss). In this case, the k parameter can be set less than 4 which combined
with a 50% mean will produce a distribution with relatively more density in the edges of the distribution.
Another type of loan may exhibit predictable loss behavior with little variance around these losses when
this type of loan is in default. In this case, the k parameter can be set quite high to reduce the variance
around the specified LGD mean.
PM allows the user to specify the k parameter globally for each exposure in the entire portfolio or
individually to represent differences in types of exposures. In the case of all these choices, care should be
taken to understand the conditions under which the LGD data was collected.
SECTION 3
RISK MODELING
CHAPTER
10
STAND-ALONE RISK
Exposure stand-alone risk is measured by Unexpected Loss (UL), which is defined as the standard
deviation of the exposure value at the horizon, expressed as a fraction of the initial value in order to place it
on the same scale as an expected return:
(10.1)
We can write the variance of a random variable x as the sum of the expectation of its conditional variance
and the variance of its conditional expectation:
(10.2)
In the context of default events this becomes
(10.3)
where
The calculation of exposure UL requires expected values in default and non-default states and the variances
around those values. In default, the exposure has a random recovery value governed by the Beta
distribution. The mean value in the default state is (1-LGD); the variance is determined by a parameter, k
(see Chapter 6 for details). Larger values for k imply a narrower (less volatile) distribution of LGD.
In general, the variance of the exposure value at horizon is a function of expected credit migration as well
as the probability of default. Exposures that mature at or before the horizon have no migration risk. On the
UL
V
H
V

2
0

X X Y E X Y
E
2 2 2
+
,
]
]
,
]
]
UL
V
CEDF CEDF CEDF CEDF E V
H H H H H D H ND H ND
+ + ( ) ( ) [ ]
1
1 1
0
2 2

| | |
EE V
H D |
[ ] ( )
2
CEDF H
H
H D
cumulative EDF from time 0 to time

variance o
|
2
ff value in the default state
variance of value in t
H ND |
2
hhe non-default state
other hand, exposures that mature after horizon face the risk of change in value at horizon due to change in
credit riskiness. First, we will look at the general case making no assumptions about the exposures time-to-
maturity and then look into a simpler case of no credit migration, i.e., when maturity is less than or equal
to horizon.
10.1 GENERAL CASE: DD DYNAMICS
Credit quality changes are modeled through changes in the Distance-toDefault (DD); also see Chapter 8.
Given a distribution of DD values at the horizon, we can determine the variance of exposure value at the
horizon in the non-default state using an analytical calculation. We will now turn to the details of this
calculation.
Each DD value realization has an associated forward cumulative EDF from horizon to maturity, or
CEDF
H,M
. Each CEDF
H,M
has an associated CQDF
H,M
, and this quasi-default probability can be used to
value the cash flows from horizon to maturity. We can write the random exposure value at horizon, ,
as a function of the random DD value at horizon. To make explicit the dependence of the horizon value
on this realization, we will write for the remainder of this section. In order to compute
the variance of we need its expected value and the expected value of
conditional on no default. Note that the risk comparable value approach (see Chapter 8) is used in
computing both the expected value, and the expectation of value squared:
(10.4)
(10.5)
The lower limit of integration is 0 since the probability density we are using to integrate is conditional on
no default, and by assumption a firm with negative DD, must be in default. PM evaluates these integrals
using a standard trapezoid formula.
The variance of exposure value in the non-default state is then:
(10.6)
Next, following equation (9.14), and the ensuing discussion, the variance in the default state is equal to:
(10.7)
V
HND |
V DD
H ND H H | ,
( )
+1
V DD
H ND H H | ,
( )
+1

V DD
H ND H H | ,
( )
+
,
]
]
1
2
E V V DD
P DD DD DD H
DD
H ND H ND H H
H H H
H H

| | ,
, ,
,
( | , )
(
,
]
]
( )

+
+
+
1
1 1 0
11
1
0
)
( )
,
d DD
H H+
E V V DD
P DD DD DD H
DD
H ND H H H
H H H
H H

| ,
, ,
,
( | , )
(
2 2
1
1 1 0
1
,
]
]
( )

+
+
+
))
( )
,
d DD
H H+
1
0
H ND H ND H ND
E V E V
| | |
2 2
2
,
]
]
,
]
]
( )
,
,
]
]
]

H D H
LGD LGD
k
RFV
|
2
2
1
( )
,
,
]
]
]
( )
The final component necissary to compute variance is the distance between the expected value in no-
default and the expected value in default; the last term in equation (10.3). Following equation (9.1):
(10.8)
Finally, the expected value in no-default is computed using equation (10.4).
We have assembled all of the terms necessary for the UL calculation. The next section presents an explicit
calculation for the simple case in which maturity is less than or equal to horizon. In that case, there is no
credit migration riskonly default riskand the computation does not require the evaluation of a
stochastic integral.
10.2 DEFAULT-NO-DEFAULT CASE
If the exposure matures at or before the horizon, E[V
H|ND
] is RFV
H
, the non-default variance is zero, and
the expression for UL simplifies to:
(10.9)
This calculation is for the obligor labeled "UL maturity not after horizon. For this exposure, note that the
horizon is one year. PM treats one year as equal to 365.25 days, so non-leap years have a length of 365/
365.25, or about 0.99316; In this case the exposure matures in 365 days and hence slightly before
horizon. Since the obligors potential default after the exposures maturity is irrelevant for this exposure, we
use the CEDF to maturity as the CEDF to horizon. Thus, instead of using a one-year EDF of 0.0011 from
Figure 10.1, we use CEDF to maturity value, CEDF
H
of 0.01099.
(10.10)
E V LGD RFV
H D H
|
,
]
]
( ) 1
UL
V
RFV E V
H H H H H D H D
+ ( ) [ ] ( )
1
1
0
2
2
CEDF CEDF CEDF
| |
CEDF CEDF
H M

,
,
]
]
]
1 1 00011 001099
365
36525
( . ) .
.
FIGURE 10.1 Unexpected Loss Example
The loss distribution parameter k is equal to 4; The coupon payment will be slightly less than 0.06 since
we have 365 days, which is less than one year in PM. The risk-free value at horizon is calculated and used
in the calculation of LGD used in PM (based on LGD
input
of 0.35). Equation (10.11) gives the details of
these calculations. Note that these calculations are based on per dollar of book exposure.
(10.11)
Coupon =
365
365.25
,
,
]
]
]

+ ( )
006 005995893
1 05995893
. .
. RFV
H
( )

[ ]
,
]
]
]
106 106000121
1
1
365
36525
. .
.
LGD
Book Exposure 11
1
1 1 035
106000121
0386793
,
]
]

[ ]
LGD
RFV
H
input
.
.
.
(10.12)
(10.13)
Using equation (10.9) we get:
(10.14)
10.3 SOME FACTS ABOUT EXPOSURE UL
When the initial value is par, the exposure matures at the horizon, and the recovery amount is certain.
UL is given by:
(10.15)
An increase in the variability of recoveries (LGD variance) increases UL.
H D H
LGD LGD
k
RFV
|
.
2
2
1
0 0666252
( )
( )
RFV E V
H H D
,
]
]
( )

[ ] ( )

|
. ( . ) .
2
2
1 06000121 1 0 35 1 0 168101
UL
V
RFV E V
H H H H H D H D
+ ( ) [ ] ( )
1
1
0
2
2
1
0998994
0
CEDF CEDF CEDF
| |
.
.. . . . .
.
01099 00666252 001099 1 001099 0168101
0016
( ) + ( ) ( ) ( )
0073
UL LGD CEDF CEDF ( ) 1
UL increases with an EDF value of up to 50% for exposures with constant recovery and maturity
equal to horizon:
FIGURE 10.2 UL as a Function of EDF Value
10.4 PORTFOLIO UNEXPECTED LOSS
Portfolio UL is analogous to exposure UL: we are interested in the dispersion of realized losses around the
expected loss. Figure 10.3 provides a graphical representation of portfolio unexpected loss. Figure 10.3
below shows UL superimposed on the portfolio value distribution at horizon. We can see that UL provides
a measure of the spread of the value distribution at horizon around its mean, E[V
H
].
UL as a function of EDF value, M = H, LGD variance = 0
0% 25% 50% 75% 100%
EDF
U
L
FIGURE 10.3 Portfolio Value Distribution at Horizon Showing UL
Figure 10.4 shows one hundred samples of realized losses over a one-year horizon for a portfolio whose
characteristics have been held constant.
H
)
P
r
o
b
a
b
i
l
i
t
y
E[V
H
]
E[V
H
](1+UL)
Corresponds to mean of value distribution
E[V
H
]= V
0
(1+R
H
+ES)
H
2(E[V
H
] )(UL)
E[V
H
](1-UL)
FIGURE 10.4 One Hundred Samples of Realized Portfolio Loss
The x-axis, drawn in bold at portfolio loss value of 0.2%, gives the level of ex ante Expected Loss. Values
below the x-axis are negative losses (gains), years in which the portfolio returns more than expected. Most
years the portfolio shows a small gain. On occasion, however, the portfolio suffers a substantial loss. The
height of each bracket represents one standard deviation of portfolio loss.
The realized losses differ from the Expected Loss, but note that the distribution of portfolio losses has a
much smaller range than the distribution of losses for a single exposure. The exposure loss distribution
ranges from 0 to 100%; all one hundred portfolio value realizations are within 1% of the expected value.
The risk of the portfolio is much less than the sum of the risks of its exposures. Unexpected Losses, except
in the special case of independence, are not additive:
(10.16)
where
UL
A
unexpected loss of exposure A
UL
B
unexpected loss of exposure B
w
A
= weight of exposure A in the portfolio
w
B
= weight of exposure B in the portfolio
AB
correlation between A and B
UL
A+B
unexpected loss of portfolio of A and B
- 1.0%
- 0.5%
0.0%
0.5%
1.0%
1.5%
P ort f olio Run
Expected Loss
+1
+2
-1
UL w UL w UL w w UL UL
A B A A B B A B AB A B +
+ +
2 2 2 2 2
2
When the correlation is equal to one, the UL of the weighted sum is the sum of the weighted ULs:
(10.17)
But when the correlation is less than one, the risk of the total is less than the sum of the risks of the parts:
(10.18)
This is the positive effect of diversification: only a portion of each stand-alone risk (the individual ULs)
contributes to the portfolio risk. The remainder of each exposures stand-alone risk is eliminated by
diversification.
The smaller the correlation in value, the larger the gains from diversification. In typical equity portfolios,
the correlation between pairs of assets is around 60%. This large correlation means that the marginal
benefit from diversification falls off quickly. In typical debt portfolios, value correlations are between 1 and
10%. The risk reduction available from diversification (or the cost of concentration) is large relative to
equity portfolio and persists, at the margin, for the hundredth or thousandth asset. Moreover, the risk of
the portfolio is much less than the sum of the risks of its individual exposures.
AB
A B A A B B A B A B
A A B B
A
w UL w UL
UL

+ +
+
+
1
2
2 2 2 2 2
2
( )
++
+
B A A B B
w UL w UL
AB
A B A A B B A B AB A B
A A B B
w UL w UL
<
+ +
< +
+
1
2
2 2 2 2 2
2 2 2 2 2
2
2 +
+
< +
+
w w UL UL
w UL w UL
UL w UL w UL
A B A B
A A B B
A B A A B B
( )
FIGURE 10.5 Diversification with Two Exposures
Figure 10.5 shows two exposures in risk/return space. On the y-axis is Expected Spread; on the x-axis is
risk as measured by UL. Improvement on a risk/return basis consists of moving up (more return) or to the
left (less risk). If A and B have a correlation of +1, the possible combinations (without leverage) of A and B
lie on the dashed straight line. In this case, there is no benefit from diversification: the slope of the
portfolio (the return/risk, or Sharpe Ratio) is constant for all sets of weights on A and B.
If the exposures have a small positive correlation, the possible risk/reward combinations are given by the
solid curved line. The shaded area represents the available benefit: portfolios with less risk and/or more
return than the perfectly correlated case.
While some exposures may have perfect positive correlationfor example, multiple exposures to the same
obligor, or exposure to both a parent and its guaranteed subsidiarywe typically observe small positive
correlations which give rise to the curved shape of possible portfolio combinations. Independence of
exposure values (zero correlation) is implausible, since most obligors have some relationship to the global
macro-economy (see Chapter 11 for details about correlation). We do not observe negative correlations
(hedges) in asset values, with the exception of short positions.
Generalizing equation (10.16), for more than two exposures, we get UL for the portfolio as:
(10.19)
If we calculate the individual exposures ULs and the correlation among the exposure values, we arrive at
the portfolio UL with little difficulty. The difficulty, of course, lies in the individual exposure and
correlation calculations.
Diversification
UL
E
x
p
e
c
t
e
d

S
p
r
e
a
d
Portfolio Risk/Return for Small Positive Correlation
Perfect Positive Correlation Risk/Return
A
B
Less Risk
M
o
r
e

R
e
t
u
r
n
UL w w ULUL
p i j ij i j
j i

CHAPTER
11
CORRELATION
A typical portfolio consists of more than a single exposure. Clearly, the overall risk of a portfolio depends
not only on the risk of individual exposures but also on how the values of these exposures are correlated
with each other. Thus, estimating the correlation of the value of an exposure with the values of other
exposures is an important step towards measuring portfolio risk. We know (from the chapter on valuation)
that the value of a firms debt depends strongly on the distribution of the asset returns of the firm. Thus,
the correlation in the values of two different exposures will similarly depend on the asset return correlation
and the EDF values of their respective firms. In other words, we can compute the correlation in the values
of any two exposures as long as we know the asset correlation and the EDF values for the corresponding
firms.
The market value of a firms assets is not directly observable. We have evidence that equity correlations are
poor substitutes for asset correlations because equity returns reflect the effects of leverage. If equity values
were a linear function of asset values, the two correlations would be identical. However, we observe
nonlinear and unstable levels of leverage in many firms, particularly those with highly leveraged balance
sheets such as financial institutions and utilities as well as low credit quality firms.
11.1 FACTOR MODELOVERVIEW
MKMV uses a factor model, rather than direct historical observations, to measure asset return correlations
between firms. Historical correlations are subject to a large amount of sampling error thereby limiting their
usefulness in predicting future correlations. The predictive power of a factor model, on the other hand,
results largely from its control over these errors. In almost all areas of applied finance, factor models are
accepted as the best approach to estimating correlations. In addition to controlling for random noise in the
sample, the factor model enables us to estimate correlations for firms without publicly traded equity.
Private companies are "plugged" into the factor model based on firm size, country, and industry
composition.
The factor model approach imposes a structure on the correlation of asset returns, which implies that the
correlation between the asset returns of any pair of firms can be explained by the firms relationships to a
set of common factors.
There are three levels used in MKMVs factor structure (see Figure 11.1):
A composite company specific factor;
Country and industry factors;
Global, regional, and industrial sector factors
The first level of the structure differentiates between firm-specific, or idiosyncratic risk, and systematic, or
undiversifiable, risk. Systematic risk is captured by a single composite factor. This factor is unique to each
firm and is a weighted sum of country and industry factors to which the firm has exposure.
The country and industry factors at the second level of the factor structure are correlated with each other.
Therefore, their risk can also be decomposed into systematic and idiosyncratic components. The
systematic component of the risk is captured by the basic economic factors in the third and last level of the
structure. There are three types of basic factors: global economic effects, regional economic effects, and
industrial sector effects. We retain the idiosyncratic risk components of countries and industriesthe risk
that is unrelated to the basic factorsas country- and industry-specific factors. Note that the third level of
factors are only needed for interpreting the drivers of correlation. The actual correlation estimate depends
only on the division between idiosyncratic and systematic parts of the country and industry risks. The way
in which the systematic risk can be decomposed into different drivers helps us understand what accounts
for the overall systematic component driving the asset value of a particular firm.
FIGURE 11.1 Risk Factors
The global, regional, and sector factors describe all of the common risk between countries and industries.
That is, they capture all of the correlation between the country and industry factors. The basic factors also
explain all of the common risk between firms in different countries and industries. Firms with exposure to
the same country or industry also share country- or industry-specific risks.
(1) Composite Risk
Firm Risk
Systematic Risk
Firm Specific Risk
Industry Specific Risk Country Specific Risk
(2) Country and
Country Risk Industry Risk
Industry Factors
(3) Global, Regional and Sector Factors
Regional Risk
Industrial Sector Risk Global Economic Risk
11.2 FACTOR MODEL - ESTIMATION
The empirical estimation process of the factor model consists of the following four steps:
Construct 45 country and 61 industry return indices using week-by-week cross-sectional regressions of
asset returns on country and industry weights.
1
Construct 14 orthogonal factors from the 2 global factors and the above 106 country-industry indices.
Regress the 106 country-industry return indices on the 14 orthogonal factors to obtain the country
and industry betas on these 14 factors. Also, obtain country and industry-specific risks.
Regress each firms return series on its composite index returns to obtain the firm-specific beta and R-
squared.
11.2.1 Constructing Country and Industry Return Indices
The country and industry indices are obtained by using a cross sectional regression of weighted
country-industry returns on industry and country weights. The equation below, represents the
calculation of the value-weighted industry return for country js industry i:
(11.1)
where
(11.2)
These returns are then used in the following week-by-week regression:
1
These numbers periodically change as more and more countries and industries enter the data. These numbers are as of estimation
completed in 2001.
r
i
j
r w V
w V
k
i j
k
i j
k
i j
k
n
i j
k
i j
k
i j
k
n
i j
, , ,
,
, ,
,
1
1
r j s i
i
j
is the return of country industry for a given w eeek,
is the return of firm k (in industry i and coun r
k
i j ,
ttry j) for a given week,
is the weight of firm in c w k
ik
j
oountry industry for a given week,
is the marke
j s i
V
k
i j
,
tt value of assets of firm in country and
is the
k j
n
i j
,
,
nnumber of firms that belong to country industry j s i .
(11.3)
where
R
R
R

C
C
C
1
2
45
1
2
45
1
2
45
1
2

,
,
,
,
,
]
]
]
]
]
]
,
,
,
,
,
]
]
]
]
]
]
]
I
I
I
C
C
C
61
1
2
45
1
2
45
,
,
,
,
,
,
,
,
,
,
,
,
]
]
]
]
]
]
]
]
]
]
]
]
]
+
,
,
,
,
,

]]
]
]
]
]
]
R
j
j
j
j
j
j
j
r
r
r
,
,
,
,
,
,
,
,
,
,
,
]
]
]
]
]
]
]
]
]
]
]
]
]
1
1
2
2
61
61
, the vec ctor of normalized industry indices of country j,

repr
i
j
eesents the standard deviation of a country s industry i j ,,
C
j
j j j
j j j
C C C C C
C C C C C
C
+
+
1
1
1
1
1 1
1
1
45
2
1
2
1
2 2
1
2
45
6

11
1
61
1
61 61
1
61
45
0 0 1 0 0
0 0 1 0

C C C C
j j j +
,
,
,
,
,
,
]
]
]
]
]
]
]

00
0 0 1 0 0

,
,
,
,
,
]
]
]
]
]
]
, is the matrix of country weigghts for , R
j
The 106 beta estimates are interpreted as the weekly asset return estimates for the various industry
and country indices. This regression is repeated for each week in the sample period so that one obtains
a time series of weekly industry and country index return estimates.
11.2.2 Constructing the Basic Economic Factors
There are two global economic factors. The first factor (global return) is a market-weighted index of
returns for all firms and reflects the overall effect of the global economy. The second factor (small firm
return) is a return index weighted by the log of market value of assets. Technically, it is the residual
obtained by regressing a return index weighted by the log of market value on the first factor, as described in
the equation below
(11.4)
The second factor reflects the relatively more weight on small firms and captures broader effects in the
global economy. Note that the second factor is, by construction, orthogonal to (independent of) the first
factor.
The regional factors capture regional economic effects. These effects are measured after the global
economic influences have been removed. That is, they are the common regional economic effects that
cannot be explained by global economic effects. There are five regional factors:
1. Europe
2. North America
3. Japan
4. Southeast Asia
5. Australia/New Zealand
I
j
I I I
I I I
I I I
,
,
,
,
,
]
]
]
]
]
]
]
1
1
1
2
1
61
2
1
2
2
2
61
61
1
61
2
61
61
11 0 0
0 1 0
0 0 1
,
,
,
,
]
]
]
]
]
]
, the matrix of industry weighhts for
the vector of the
R

j
j
j
j
j
,
,
,
,
,
,
,
,
]
]
]
]
]
]
]
1
2
61
regression error terms for industry . i

(small firm return)
t
= a + b (global return)
t
+ e
t
These factors are obtained by the following method: Returns for each of the countries belonging to a
particular region (say, Europe) are regressed on the two global factors. An appropriately weighted sum of
the residuals from these regressions constitutes the regional (European) factor. The rest of the regional
factors are obtained in a similar manner except that the returns for the countries belonging to a given
region are regressed on not only the two global factors, but also the regional factors already estimated. As a
result, each of the regional factors are independent of the global factors and of each other.
The sector factors capture common industry effects after the global and regional economic effects have
been removed. There are seven sector factors:
1. Interest sensitivity: banks, real estate, and utilities
2. Extraction: oil and gas exploration and mining
3. Consumer non-durables
4. Consumer durables
5. Materials processing: chemicals, paper, and steel production
6. Technology: computer hardware and software, electronic equipment, and semiconductors
7. Medical: medical services, pharmaceutical, and medical instruments
The sector factors are estimated in the same way as the regional factors. The returns for various industries
falling under a given sector are regressed on the two global factors, the five regional factors, and any sector
factors already estimated. An appropriately weighted sum of the residuals from these regressions constitutes
the sector return. Clearly, all of these factors are constructed to be independent of each other. This means,
for example, that the interest sensitivity factor is not the total effect of interest rates but only the portion of
that effect that cannot be explained by the global and regional factors. As a result, these factors cannot be
directly related to external measures such as employment, GNP growth, or interest rates. There is no loss
of correlation information in this approach, and it has the advantage that the calculation of the correlations
is considerably simplified. This is an important consideration when a portfolio of just 1,000 assets requires
the calculation of almost 500,000 correlations.
11.2.3 Decomposing Country and Industry Risks
The risks of countries and industries are decomposed into systematic and idiosyncratic components. The
systematic component is captured by the basic economic factors, (global, regional and sector). Figure 11.2
provides a schematic of this part of the factor structure.
FIGURE 11.2 Decomposing Country and Industry Risk
Country or industry risk is decomposed into systematic risk arising from either global, regional or sector
effects and specific, or idiosyncratic, risk.
(11.5)
(11.6)
While the global, regional and sector factors are common to all industries and countries their effects are
not. The individual effects for a particular country or industry are determined by a time series regression of
the industry or country returns on the factor returns.
Mathematically, the regression model can be written as:
(11.7)
(11.8)
Countries
Industries
Global
Sector
Industry
Country
(45)
(61)
Economic
Factors
(2)
Factors
(7)
Specific
Factors
(61)
Specific
Factors
(45)
= + + +
Regional
Economic
Factors
(5)
Country
Return
Global
Economic
Effect
Regiona
,
,
]
]
]
,
,
,
,
]
]
]
]
]
+
ll
Factor
Effect
Sector
Factor
Effect
Coun ,
,
,
,
]
]
]
]
]
,
,
,
,
]
]
]
]
]
+ +
ttry
Specific
Effect
,
,
,
,
]
]
]
]
]
Industry
Return
Global
Economic
Effect
Region
,
,
]
]
]
,
,
,
,
]
]
]
]
]
+
aal
Factor
Effect
Sector
Factor
Effect
Ind ,
,
,
,
]
]
]
]
]
,
,
,
,
]
]
]
]
]
+ +
uustry
Specific
Effect
,
,
,
,
]
]
]
]
]
r r r r
c cG G
G
cR R
R
cS S
S
c
+ + +

1
2
1
5
1
7
r r r r
i iG R
G
iR R
R
iS S
S
i
+ + +

1
2
1
5
1
7
where
The global, regional and sectorial factors, r
G
, r
R
and r
S
, are common to all industries and countries, but
each industry and country has its own global, region and sector effects measured by their s.
The risk decomposition (Figure 11.3) can be calculated directly from the regression results and the basic
sector risks. The global, regional and sectorial factors are uncorrelated with each other. The variation in
return for countries and industries can be calculated as simple sums of squares:
(11.9)
(11.10)
where
r c
r i
r
c
i
G
return for country

return for industry
return fo or global market
return for region
return for sec
G
r r
r
R
S
ttor
effect of global market on country
effect
s
G c
cG
iG
of global market on industry

effect of region o
G i
R
cR
nn country
effect of region on industry
effect
c
R i
iR
cS
of sector on country
effect of sector on indust
S c
S
iS
rry
country-specific effect for country
industry-s
i
c
c
i
ppecific effect for industry i

c cG G
G
cR R
R
cS S
S
c
2 2 2
1
2
2 2
1
5
2 2
1
7
2
+ + +

i iG G
G
iR R
R
iS S
S
i
2 2 2
1
2
2 2
1
5
2 2
1
7
2
+ + +

G
R
G
2
2
variance of global market factor s return

varianc
ee of region factor s return

variance of sector facto
R
S
2
rr s return S
FIGURE 11.3 Variance Breakdown of Country and Industry Factors
11.2.4 Decomposing the Firm Risk
The firm risk is decomposed into systematic and idiosyncratic components. That is, the model posits that
two effects explain the return of a given firm:
(11.11)
All of the risk in the firms return that is in common with other firms is captured by its composite factor.
The composite factor is constructed individually for each firm based on country and industry
classifications. These classifications are determined from the firms reported sales and asset levels in a
particular country or industry.
A firms lines of business are often reported by SIC code
2
(in the case of Compustat and Global Vantage),
but any coding scheme that maps to MKMV industry codes can be used (see MKMVs Portfolio Manager
documentation for a listing of MKMV industry codes).
2
Standard Industrial Classification is a US-based system for classifying businesses.
Countries
Industries
Global
Sector
Economic
Factors
Factors
= + + +
Regional
Economic
Factors
c
2
i
2

iG G
2 2

cG G
2 2

iR R
2 2

cR R
2 2

iS S
2 2

cS S
2 2
c
2
i
2
Firm
Return
Composite-Factor
Return
Firm-Specifi ,
,
]
]
]

,
,
]
]
]
+
cc
Return
,
,
]
]
]
For example, suppose a firm has two lines of business and we are using data from Compustat. In particular,
assume that the firm reports the following breakdown:
For each line of business the firm has reported both a primary and a secondary SIC code. In both these
cases, the primary and secondary SIC classifications belong to the same MKMV industry. (In cases where
they differ we weight the primary by 70% and the secondary by 30%). The SICs for Sawmilling, 2431 and
2421, both map to the Lumber and Forestry industry; the SICs for Paper Production, 2611 and 2621,
both map to the Paper industry.
Compustat and Global Vantage report a breakdown across business lines by both sales and assets. To
determine the breakdown by industry we average the sales and asset breakdowns. For this company, the
weight for Lumber and Forestry is:
(11.12)
and for Paper we have:
(11.13)
The weights for country exposure are restricted to be either one or zero. Clearly, the country weights and
the industry weights must sum to one. For our example we assume that the firm is 100% US risk.
The composite factor is constructed as a weighted sum of country and industry factors.
(11.14)
For our example the composite factor is:
(11.15)
TABLE 11.1 Industry Breakdown by Sales and Assets
Business Line Primary SIC Secondary SIC Assets Sales
Sawmilling 2431 2421 35% 45%
Paper Production 2611 2621 65% 55%
TOTAL 100% 100%
40
1
2
35 45 % % % + ( )
60
1
2
65 55 % % % + ( )
Composite-Factor
Return
Country-Factor
Returns
I ,
,
]
]
]

,
,
]
]
]
+
nndustry-Factor
Returns
,
,
]
]
]
Composite-Factor
Return
USA paper lumber
,
,
]
]
]
+ + 1 0 0 6 0 4 . . . r r r
More generally, the composite factor can be written as:
(11.16)
where

and
(11.17)
The decomposition of the systematic and idiosyncratic components of the firms risk is determined by a
time series regression of its weekly returns against its composite factor. Mathematically, this can be written
as:
(11.18)
where
The systematic, or undiversifiable, risk of the firms returns is represented by the composite factor
coefficient
k
, "the firms beta," and the diversifiable, or firm specific, component by .
3

3
This is not the same as the firms stock beta. The stock beta is against a single index, the market, which is common to all firms. In
this model the index is different for every firm.
k kc c ki i
i c
w r w r +

1
61
1
45
k
kc
k
w k
composite factor for firm

weight of firm in counttry
weight of firm in industry
return for coun
c
w k i
r
ki
c
ttry
return for industry
c
r i
i

w w
kc
c
ki
i

1
45
1
61
1
r
k k k k
+
r k
k
k
k
k
return for firm

beta for firm
firm-specific eff
eect for firm k
k
For private firms, or firms where market return data are not available, we use the following procedure. The
firms composite index is built in the same way using available or prepared country and industry weights.
The more accurate the breakdown of countries and industries the better the model is able to perform.
However, the model is not particularly sensitive to small changes in weights. A private firms beta, or R
2
, is
estimated using a comparables-based model.
4
This model is driven by the size of the firm and its country
and industry classifications. Once the country and industry weights are set and the R-squared has been
estimated, any firm can be entered into the factor model and its correlation with any other firm
determined.
11.3 APPLYING THE FACTOR STRUCTURE
The factor structure is applied sequentially to derive the effect of the basic economic factors and country-
and industry-specific effects on an individual firm. This step pushes the basic factors through the country
and industry factors to the composite factor for the firm. Remember that we can restate any country or
industry factor as a combination of the basic factors and its specific factor (see Figure 11.2). Further,
because the composite factor is simply a combination of the industry and country factors, it too can be
restated as a combination of the basic factors and country- and industry-specific effects. Any firms return
can be decomposed into the following components:
(11.19)
Mathematically the relationship can be written as:
(11.20)
where
The derivation of this formula (a straightforward algebraic substitution) is presented on the next page.
kG
,
kR
, and
kS
are firm ks betas on the global, regional, and sector factors;
ki
and
kc
are betas for country-
and industry-specific risk. These betas are not estimated directly but are calculated from the firms
4
We usually refer to the equivalent measure R
2
which is the proportion of the firms risk that is captured by the composite factor.
The beta is related to the R
2
by: .
k
R
k
k
2
Firm
Return
Global
Economic
Effects
Regional
E
,
,
]
]
]
,
,
,
,
]
]
]
]
]
+ cconomic
Effects
Industrial
Sector
Effects
,
,
,
,
]
]
]
]
]
,
,
,
,
]
]
]
]
+
]]
,
,
,
,
]
]
]
]
]
+ +
Industry
Specific
Effects
Country
Specific
Effectss
Firm
Specific
Effects
,
,
,
,
]
]
]
]
]
,
,
,
,
]
]
]
]
]
+
r
r r r
k k k k
kG G
G
kR R
R
kS S
S
ki i
i
k
+
+ + + +

1
2
1
5
1
7
1
61
cc c
c
k

+
1
45

ki k ki
kc k kc
w
w

estimated beta on its composite index,
k
. The algebra on the next page relates the composite factor to the
basic factor structure.
For example, the effect of the global economic factor,
kG
, is calculated as:
(11.21)
where the country and industry global factor effects,
cG
and
iG
, are the same for all firms.
The global, regional, sector and country- and industry-specific factors are constructed to be uncorrelated
with each other. As a result, the total risk of the firm can be expressed as its unsystematic risk plus the
weighted sums of squares of the factor variances:
(11.22)
The second level of factors is comprised of individual countries and industries. Unlike the regional and
sector factors, the more detailed industry and country factors are correlated with each other. These factors
are used to aid in the interpretation of the factor model and to compute correlations between firms
without traded equity. Private firm correlations are estimated in the factor model based on their country
and industry classifications.
The country factors measure the overall effect of local economies. However, in some cases countries have
been grouped into regions because there is insufficient data on firms in that country. This country
aggregation will change as our data coverage improves in the affected regions. Portfolio Managers
documentation contains a listing of all the countries in the factor model and any aggregations we have
made. The industry factors are constructed from an aggregation of standard industrial classification codes,
SIC (or an equivalent mapping from ISIC, ANZSIC, etc.).
11.4 USING THE FACTOR MODEL TO CALCULATE CORRELATIONS
Calculating the correlation between any two firms j and k is simplified considerably by the factor structure.
The risk decomposition and uncorrelated basic factors allow us to calculate the covariance of two firms as
the sum of their joint exposure to the basic factors and any country and industry risk that they have in
common. That is, the covariance in the asset returns of two firms can be calculated as:
(11.23)
Mathematically this can be written as:
(11.24)

kG k
w
kc cG
c
w
ki iG
i

j
(
,
,
,
,
\
,
(
(
(
(
1
45
1
61

k kG G
G
kR R
R
kS S
S
ki i
i
2 2 2
1
2
2 2
1
5
2 2
1
7
2 2
1
61
+ + + +

kkc c
c
k
2 2
1
45
2

+
Firm
Covariance
Global
Economic
Effects
Regio
,
,
]
]
]
,
,
,
,
]
]
]
]
]
+
nnal
Economic
Effects
Industrial
Sector
Effects
,
,
,
,
]
]
]
]
]
,
,
,
,
+
]]
]
]
]
]
,
,
,
,
]
]
]
]
]
+ +
Industry
Specific
Effects
Country
Specific
Efffects
Firm
Specific
Effects
,
,
,
,
]
]
]
]
]
,
,
,
,
]
]
]
]
]
+
j k
jG kG G
G
jR kR R
R
jS kS S
S
ji ki
, ( ) + + +

2
1
2
2
1
5
2
1
7

i c
i
jc kc
c
2
1
61
2
1
45

+
The return correlation between any two firms is related to the covariance in the following way:
(11.25)
or,
(11.26)
Thus, covariance is just an unscaled correlation. Dividing through by the product of the two individual
firm return risks scales the covariance to a correlation between 1 and +1.
This factor correlation is the basis for calculations of correlations in PM.
11.5 DEFAULT CORRELATION
If we have a portfolio comprised of exposures with tenors longer than our horizon of analysis, we will want
to calculate the correlation in exposure value. Before we consider this more involved calculation, let us
consider the case where we assume all exposures mature at or before the horizon date. In this case, we are
concerned only with the correlation in default. This special case will provide the intuition needed to
understand the more general correlation calculation.
The default correlation is related to the asset correlation by the Joint Default Frequency (JDF), which, in
turn, depends on the joint asset value distribution. The JDF is also a function of the individual CEDF
5

values of the two correlated firms.
In Figure 11.4 we display a joint distribution of log asset values for two obligors. The vertical line is firm
Xs default point (DPT); the horizontal line is the DPT for firm Y.
5
We use the cumulative EDF value in this discussion to reflect the possibility that the horizon of analysis exceeds one year. In the
case where the horizon is one year the EDF value equals the CEDF value.
Return
Correlation
j and k
Return
Covariance
j and k
,
,
,
,
]
]
]
]
]
,,
,
,
,
]
]
]
]
]
,
,
]
]
]
,
,
]
]
]
Return
Risk j
Return
Risk k

jk
j k
j k
( ) ,
FIGURE 11.4 Joint Default
Building on our previous explanations, we have the individual probability distributions for the log asset
values of the two firms. We divide the graph into four sections based on the event of default. The
probabilities assigned to each region are functions of the correlation between the asset values of X and Y.
The firms default at the same time if both asset values are below their respective default points.
If we were interested only in default correlation, we would need only four probabilities for each pair of
firms. But if the loans do not mature at the horizon, we also require a value correlation based on possible
credit migration.
In Figure 11.5 we delineate regions for joint changes in log asset value for a pair of firms whose asset values
are uncorrelated. The outcomes have been divided into approximate rating ranges. The rectangles
demarcate possible joint transitions. The largest rectangle at the center of the graph represents the most
likely outcome: the firm on the y-axis remains approximately BB in quality and the credit quality of the
firm on the x-axis remains at about BBB.
X: BBB-rated firm
ed firm
D
Both pay
X

d
e
f
a
u
l
t
s
,

Y

p
a
y
s
X pays, Y defaults
Both default
FIGURE 11.5 Uncorrelated Joint Log Asset Value Distribution
The rectangle at lower left (described by the axes and the segments labeled D) represents the event that
both firms default. In the uncorrelated case, the probability of this event, the Joint Default Frequency
(JDF), is the product of the two CEDF values:
(11.27)
When the asset values are correlated, a high asset value realization for firm X is likely to be accompanied by
a high asset value realization for firm Y. The joint density increases over these areas. In order to compute
the probabilities under the joint distribution, we need the correlation in asset returns, . We obtain
this value from the factor model.
X: BBB-rated firm
ed firm
CCC
D
B
BB
BBB
A
BB A
BBB
AA AAA B
CCC
D
XY
A
XY X Y
JDF

0
CEDF CEDF
XY
A
FIGURE 11.6 Correlated Joint Log Asset Value Distribution
In Figure 11.6 we see that the circles have been squeezed into ellipses. The ellipses are more dense over
regions where both X and Y are large or both X and Y are small (upper right and lower left) and less dense
in regions where one value is low and the other high (upper left and lower right). In this case the JDF is a
function of the two CEDF values and the correlation in asset values. The larger the correlation, the larger
the JDF. In particular, for positive asset correlations, the JDF in the correlated case always exceeds the JDF
in the uncorrelated case.
To calculate the default correlation, given Joint Default Frequency (JDF), consider Table 11.2.
(11.28)
(11.29)
TABLE 11.2 Observed Defaults for j and k
Observed Default for
Firm j (D
j
)
Probability Observed Default for
Firm k (D
k
)
Probability
1 CEDF
j
1 CEDF
k
0 (1-CEDF
j
) 0 (1-CEDF
k
)
X: BBB-rated firm
Y: BB-rated firm
BB A
BBB
AA AAA B
CCC
D
CCC
D
B
BB
BBB
A
AA
AAA

jk
D j k
D D
D D
j k
cov( , )
cov( , ) D D E D E D D E D
E D D
j k j j k k
j j k k
,
]
]
( )

[ ] ( )
,
]
]

( )
CEDF CEDF (( )
,
]
]
,
]
]
E D D
j k j k
CEDF CEDF
It is relatively straightforward to see that:
(11.30)
So,
(11.31)
Note that the default correlation depends not only on the asset correlation but also on the CEDF values.
As a matter of fact, as the CEDF values increase, their influence on the default correlation swamps the
influence of asset correlation. When the exposures in the portfolio mature at or before the horizon, value
correlation equals default correlation, and we can solve for the portfolio UL explicitly. When there are
exposures whose maturity exceeds the horizon, there is credit migration risk.
11.6 VALUE CORRELATION
Each possible realization of the asset value at the horizon implies an EDF from horizon to maturity. Each
EDF from horizon to maturity implies an exposure value. If the exposure is in default, its value at the
horizon, on average, is the recovery amount, or (1-LGD). If the exposure is not in default, we revalue it
based on its change in credit quality.
FIGURE 11.7 Asset Value and Expected Exposure Value
D
CEDF 1-CEDF ( )

jk
D
jk j k jk
A
j k
j j k
JDF
( )
( )
CEDF CEDF CEDF CEDF
CEDF CEDF CEDF
, ,
1 11 ( ) CEDF
k
Representative EDFs from Horizon to Maturity and Facility Value
0.50
0.75
1.00
1.25
1.50
L
o
g

(
M
a
r
k
e
t

V
a
l
u
e

o
f

A
s
s
e
t
s

a
t

H
o
r
i
z
o
n
)
0.02%
0.10%
0.25%
0.50%
0.75%
1.00%
2.00%
5.00%
20.00%
Facility Value
0 1 (1 - LGD)
Probability Density
Possible EDF from
Horizon to Maturity
(based on asset value
realization)
At the left in Figure 11.7 is the probability distribution of asset values at the horizon. Each asset value has
a corresponding EDF from horizon to maturity. At the right is the exposure value at horizon associated
with each possible credit migration outcome. The same probability distribution applies. We can compute
an expected value for the exposure at the horizon using this probability distribution.
We can overlay exposure value graphs along each axis of the joint asset value graph, as in Figure 11.7, to
produce a joint exposure value distribution. This joint value distribution is the basis for the value
correlations in PM. The value correlations in PM are continuous. As an approximation, we can examine
the 64 discrete joint transition states in Figure 11.6. Each rectangle represents a particular rating transition.
The (correlated) joint asset value distribution yields the probability of realizing each of the 64 transitions.
Given those probabilities and a function that revalues each exposure on up or down grade, we can compute
64 values for a portfolio consisting of these two exposures. From this discrete distribution we can calculate
the expected value (first order) and variance (second order) of the portfolio. We can also obtain a discrete
frequency distribution of portfolio values. In order to obtain a continuous distribution of portfolio values,
we need continuous exposure values based on EDF values and quasi-EDF values that are fundamental to
the model in PM.
11.7 MKMV GLOBAL CORRELATION MODEL
The software component used to analyze the results of MKMVs Global Correlation Model, GCorr, ships
with PM. GCorr provides a viewer for pairwise correlations and the factor structure. Gcorr allows you to
determine the sources of correlation within your portfolio. Using the data within GCorr, you can replicate
the actual calculation of asset correlation used within PM.
GCorr can also be used to evaluate the sensitivities to particular factors and their interaction in the
economy as reflected in MKMVs factor model. For example, some portfolio managers have assumed that
firms from particular industries should exhibit not only low correlations, but sometimes negative
correlations. GCorr will provide the information to demonstrate that much of two firms correlations
derives from exposure to a common global factor. Two firms may, in fact, exhibit some negative
correlation arising from their regional or sector factors, but these effects will tend to be overwhelmed by
the impact of the common global factor. The example in Figure 11.8 highlights this phenomenon. The
regional factors produce a slightly negative correlation, but the correlation arising from exposure to the
common global factor swamps the regional effect to produce an overall positive asset correlation.
FIGURE 11.8 GCorr
In Figure 11.8 we see that the asset correlation between IBM and UAL is 0.2915 and the default
correlation is 0.0368. We can obtain the default correlation under different scenarios by changing either
companys EDF value or the asset correlation in the What If box.
w w
ji ki
i
j k
i
2
1
61
w
jc c
c
1
45
w
jc c
c
1
45
jf f
r
j
w w
ji ki
i
j k
i
2
1
61
w w
jc kc
c
j k
c
2
1
45
w
ji i
i
1
61
CHAPTER
12
PORTFOLIO VALUE AND LOSS DISTRIBUTIONS: THEORY
Portfolio Manager
TM
(PM), among other things, determines the distribution of portfolio values at the
horizon. The portfolio value distribution is then translated into a loss distribution by specifying a horizon
value that is equal to the zero loss point. This point is usually taken to be either the risk-free return value
for the portfolio, i.e., a loss is defined as earning less than a zero spread on the portfolio, or the expected
value of the portfolio at the horizon. The loss distribution is the downside portion of the value distribution
below the zero loss point.
The capital distribution is determined from the loss distribution by discounting the loss amounts to the
initial date using the risk-free rate. Discounting is required because capital is specified at the as-of date.
The capital distribution restates the loss distribution from value at the horizon to present value at the as-of
date. The capital required to support the portfolio for a desired level of safety can be read directly from the
capital distribution. For each level of capital, there is a corresponding probability that losses exceed capital.
This probability can be made arbitrarily small by selecting sufficiently large amounts of capital.
The loss and capital distributions are simple transformations of the portfolio value distribution. MKMV
offers three solutions to the estimation of the portfolio value distribution. The first is an analytic
formulation pegged to a certain range of probabilities. The other two are Monte Carlo methods; they
sample over possible realizations of portfolio value at the horizon and construct a frequency distribution
from these values.
12.1 VALUE DISTRIBUTION
The value of an individual exposure in the portfolio at the horizon is determined by whether it is in default
at the horizon, or, if not in default, by its default probability over its remaining maturity. The default
probability of the obligor to the horizon is input data; the default probability at the horizon for the
remaining term is a random variable with a mean equal to the forward EDF value of the obligor from
horizon to maturity. Using a model, PM determines the distribution of an obligors possible forward EDF
values. This distribution determines the variance of the value of the exposure in the non-default state at the
horizon.
The portfolio value at the horizon also depends on the relationships among exposure values. PM
determines these relationships from the individual EDF values associated with each exposure and from
correlations among asset values of the underlying businesses of the obligors. A pair of firms defaults at the
same time if both of their asset values fall below their respective default points at the horizon. For
exposures whose obligors are not in default at the horizon, their values depend on their default
probabilities over their remaining terms. The default probabilities, in turn, depend upon the obligors asset
values at the horizon. Thus the correlation of these values depends upon the correlation between the two
obligors asset values at the horizon.
The default correlations between different exposures result in a long-tailed portfolio value distribution. A
typical value distribution might look like that shown in Figure 12.1
On the x-axis is the value of the portfolio at the horizon; on the y-axis is the probability of realizing that
value. Let
(12.1)
FIGURE 12.1 Portfolio Value Distribution (at Horizon)
Reference points on the x-axis are:
V
MAX
The maximum possible value of the portfolio at the horizon. This value is only obtained
if there are no defaults and every obligor upgrades to AAA (an EDF value of 2 bps).
V
TS
The value of the portfolio realized if there are no defaults and all obligors migrate to
their forward EDF values. V
TS
equals: .
V
ES
The value realized when the portfolio suffers losses exactly equal to the expected loss or,
equivalently, earns exactly the expected spread ES, over the risk free rate. This is the
expected value of the portfolio:,
.
V
0
initial portfolio value
R=risk-free rate (simple, annual))
=horizon in years
=Total Spread (simple, annual)
=Exp
H
TS
ES eected Spread (simple, annual)
Portfolio Value
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
Corresponds to the Portfolio Manager Value
Distribution Output
V
BBB
V
RF
V
ES
V
TS
V
MAX
V R TS
H
0
1+ + ( )
V R ES
H
0
1+ + ( )
The results for a demo portfolio are shown in Figure 12.2. For this example, we set R equal to 5%, H=1,
and obtained the results below.
FIGURE 12.2 Portfolio Log
Thus,
(12.2)
(12.3)
(12.4)
(12.5)
The value selection in the Loss Distribution Report typically presents only the tail of the distribution, or
roughly the worst 1% of possible portfolio values at the horizon:
V
RF
The value of the portfolio when credit losses wipe out all the spread income. It is the
zero spread value of the portfolio, or V
0
(1+R)
H
.
V
BBB
The value at which the portfolio would consume all of its capital if it were capitalized to
achieve a BBB rating (equivalent to approximately a 15 basis point (bp) EDF value).
V
0
13 408 785 628 , , ,
V V R TS V
TS
+ + ( ) ( )
0 0
1 1 053392 .
V V R ES V
ES
+ + ( ) ( )
0 0
1 1 051502 .
V V R V
RF
+ ( ) ( )
0 0
1 1 05 .
FIGURE 12.3 Cumulative Value Distribution Graph
In Figure 12.3 we see the left-hand tail of the cumulative Value Distribution for the Current and the
optimized Maximum Sharpe Ratio portfolios. X-axis units are portfolio horizon values expressed as a
percentage of the initial value of the portfolio; the y-axis represents the probability of realizing a horizon
value less than or equal to the x-axis value. For example, the probability that the value of the Current
portfolio will be less than 102.00 at the horizon is approximately 14 bp. Note that the Max Sharpe
portfolio has virtually no chance of falling below 102.75, while the tail of the Current portfolio extends
down to 100.5 and below. Moving down from the Actual portfolio value curve to the Max Sharpe
portfolio value curve (smaller probabilities for the tail of horizon values) or, similarly, moving to the right
to the Max Sharpe portfolio value curve (larger horizon values for a given probability) on this graph reflects
an improvement in the risk/return profile of the portfolio.
FIGURE 12.4 Cumulative Value Distribution Table
The table in Figure 12.4 contains the data graphed on the previous page. The leftmost column contains
horizon values as a percentage of V
0
. The four columns at the right contain cumulative probabilities for
the current portfolio and three optimized portfolios. In the row with circled numbers, we see that the
probability of a horizon value lower than or equal to 102.585 is about 34.7 bp for the current portfolio.
The portfolios optimized for risk and return (Same Return, Max Sharpe) say N/A since the portfolio was
not run to optimize based on these options.
12.2 LOSS DISTRIBUTION
Losses are a measure of adverse portfolio value outcomes and thus can be represented by the reverse of the
portfolio value distribution. The Loss Distribution displays losses realized at the horizon rather than
portfolio values. Loss is defined as the difference between the realized portfolio value and a chosen zero
loss reference point.
FIGURE 12.5 Portfolio Loss Distribution (at Horizon)
Figure 12.5 shows the mirror image of the value distribution in Figure 12.1. Reversing the distribution
presents portfolio values from right to left; on this graph, losses increase from left to right.
We can define loss relative to any point on the x-axis. PM offers the choice of loss in excess of Total Spread
or in excess of Expected Loss. Measuring Loss in excess of Total Spread means we start counting losses
only after all the portfolio spread income has been lost, or at V
RF
. This is equivalent to saying the loss
reference point is equal to V
0
(1+R)
H
. Measuring losses in excess of Expected Loss means we start counting
losses after the portfolio expected loss has been lost. This is equivalent to saying the loss reference point is
equal to the expected value at horizon, E(V
H
).
12.2.1 Loss in Excess of Expected Loss
Recall that the Expected loss to horizon, EL
H
, for an exposure is the difference between the Total Spread
to Horizon and the Expected Spread to Horizon for the exposure:
(12.6)
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
Portfolio Manager Loss
Distribution Output
V
BBB
V
RF
V
ES
V
TS
V
MAX
Loss After Expected Loss
Loss After Total Spread
V
0
EL TS ES
H H H

Loss after Expected Loss, L
EL
, is:
(12.7)
where is the random value of the portfolio at the horizon.
FIGURE 12.6 Loss in Excess of Expected Loss (at Horizon)
In order to display Loss in Excess of Expected Loss, we set the portfolio Expected Spread (the point labeled
V
ES
on the x-axis in Figure 12.5) to zero. The portfolio earns its Expected Spread to Horizon when it loses
exactly its Expected Loss to Horizon. Positive losses result when the portfolio loses more than its Expected
Loss (or, equivalently, earns less than its Expected Spread) over the horizon; negative losses (gains) occur
when the portfolio loses less than expected.
12.2.2 Loss in Excess of Total Spread
Loss in excess of Total Spread, L
TS
, is defined as:
(12.8)
L
TS
starts counting losses only after all the portfolio spread income has been lost; the reference point here
is the future value of the portfolio computed at the risk-free rate. As long as the portfolio Expected Spread
is positive, L
EL
will exceed L
TS
.
L V V
V R ES V
EL ES H
H
H

+ + ( )
0
1
V
H
Loss
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
0
Portfolio Manager Loss
Distribution Output
L V V
V R V
TS RF H
H
H

+ ( )
0
1
FIGURE 12.7 Loss in Excess of Total Spread (at Horizon)
In Figure 12.7, the x-axis zero is set at V
RF
. Losses are realized when the realized portfolio value is less than
V
RF
.
When H=1, the difference between L
TS
and L
EL
is simply the portfolio Expected Spread in currency units.
Table 12.1 shows the Loss values and associated probabilities from Portfolio Manager. We can see that the
difference between loss in excess of EL in the middle column and loss in excess of TS in the rightmost
column is always 0.1502 (to be precise, 0.015019); from the Portfolio Log (Figure 12.2) we see that this is
indeed the ES.
TABLE 12.1 Loss Distribution in Excess of EL and TS
Probability of a loss this
large or greater (bp)
Loss in excess of EL
(% of initial value)
Loss in excess of TS
(% of initial value)
106.3 1.72519 1.57500
91.4 1.83019 1.68000
78.9 1.93519 1.57500
68.3 2.04019 1.89000
59.4 2.14519 1.99500
51.7 2.25019 2.10000
Loss
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
0
Portf olio Manager Loss
Distribution Output
12.3 IMPLICATIONS
The target probability used to specify the capital level should be consistent with the desired credit quality
for the portfolio. Specifying loss in excess of total spread implies the portfolios expected spread is available
to cover extreme losses. Specifying loss in excess of expected loss implies the provisions for expected loss are
all that are available to cover extreme losses. You should think carefully about what is sensible in your
particular circumstances.
At this level, calculation of the portfolio value distribution provides the basis for determining the total
capital for the portfolio. In the following chapters, we discuss the details of how to estimate the portfolio
value distribution as well as how to allocate total capital to individual exposures.
CHAPTER
13
MARGINAL RISK MEASURES
When a portfolio is comprised of exposures with value correlations less than one, the overall risk of the
portfolio cannot be determined by simply summing the individual exposure risks. The presence of low
correlations among credit-risky exposures makes them well suited for building well diversified portfolios.
Unlike securities with symmetrical return distributions such as equities, credit-risky exposures exhibit
sufficiently low correlations with each other to justify building portfolios with thousands of exposures. The
diversifying impact of an exposure requires specific calculations to determine the post-diversification,
portfolio risk contribution of an exposure. Thus, in order to calculate the contribution of each exposure to
the risk of the portfolio, PM provides measures of an exposures marginal risk. By definition, a marginal
risk measure is one that looks at the effect on risk of holding an additional currency unit of exposure.
The risk of a portfolio can be characterized either by the variability of portfolio value (UL) or by the
probability of insolvency (Tail Risk). Clearly, the marginal risk of an exposure will depend on the type of
portfolio risk in question. As a result, we look at two different marginal risk measures: Risk Contribution
(or contribution to the portfolio UL and Tail Risk Contribution), or contribution to a particular interval
on the loss distributions tail region. These marginal risk measures will determine how much capital to
allocate to a particular exposure. Care should be taken in evaluating the objective of a particular capital
allocation approach. In some cases, pricing is at issue. In other cases, financial solvency is at issue. The
marginal risk measure used in practice will depend on the nature of the portfolio analysis and ones
perspective regarding how to manage a portfolio.
13.1 RISK CONTRIBUTION
Risk Contribution (RC) is defined as the marginal contribution to the volatility of the portfolio value. In
other words, it looks at the effect on the portfolio UL of a marginal increase in the portfolio weight of an
exposure. Using equation (10.19), we can write down the following:
(13.1)
where is the correlation between the value of an exposure i and the value of the portfolio. In other
words, RC, for an exposure, measures the change in portfolio standard deviation (in currency units) due to
one additional currency unit of this particular exposure. Using the relationships implicit in the above
equation, we can write down the following:
RC
UL
w
w ULUL
UL
ULUL
UL
UL
i p
i
j ij i j
j
p
ip i p
p
ip i
iP
(13.2)
That is, weighted sum of exposure RCs equals portfolio UL.
Risk Contribution can also be interpreted as the portion of the individual exposures risk that remains after
diversification.
The stacked bar in Figure 13.1 is the total Unexpected Loss of the exposure. The bottom segment
represents the fraction of UL that could not be eliminated through diversification even in the broadest
possible portfolio. This is called the systematic risk of the exposure. For a given portfolio, diversification
will be less than perfect, and each exposure will contribute some diversifiable risk to portfolio UL. The
middle segment represents the portion of the exposure UL that theoretically could be diversified away but
is not in the context of this portfolio. Diversifiable risk presents an opportunity for gains from portfolio
management. The top segment represents risk that was eliminated by diversification in this portfolio.
FIGURE 13.1 Risk Contribution and Diversifiable Risk
The difference between an exposures UL and its RC is the benefit from diversification. We can express RC
as a fraction of exposure UL; this fraction is called Retained Risk (RTR), and is the fraction of the stand-
alone risk not diversified away. The fraction of Retained Risk is also the correlation of the exposure with
the portfolio.
(13.3)
UL
w w ULUL
UL
w
w ULUL
UL
w UL w
p
i j ij i j
j i
p
i
j ij i j
p j i
i
i
iP i

ii
i
i
RC
UL, Risk Contribution and Systematic Risk

Unexpect ed Loss
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
Unexpect ed Loss
Diver sif ied
Diver sif iabl e
Syst emat ic, Non- diver si f iabl e
Risk Cont r ibut ion
RTR
RC
i
i
i
ip

RC and RTR are central to the active management of debt portfolios because they relate the risk of an
exposure to its portfolio weight.
Some facts about Risk Contribution:
RC is less than exposure UL, except in the trivial case where a portfolio consists of exposure to only
one obligor and there is no benefit from diversification.
RC increases with exposure UL; exposure UL increases with exposure weight. RC increases as the
weight of the exposure in the portfolio increases. As we add units of exposure to a given exposure, the
quantity of risk diversified away decreases as a percentage of the added exposure. This becomes obvi-
ous in limiting cases: if we placed a $1m exposure in a $100m portfolio and added $1b worth of expo-
sure to that obligor, a marginal dollar of exposure to the obligor will have a very high correlation to the
portfolio.
RCs are large when portfolios consist of many obligors in the same industry or country.
RCs are large when individual obligors EDFs are large.
RCs are large when individual obligors systematic risks (R
2
with the market) are large.
When the correlation between an exposure and the portfolio is small, the marginal risk per unit of
weight graph is flat. In this case, the most important driver of the RC is weight in the portfolio.
13.2 TAIL RISK CONTRIBUTION
Tail Risk Contribution (TRC) is a facility-level marginal risk measure. While RC measures a facilitys
contribution to portfolio UL, TRC measures the contribution to the risk of an extreme (i.e., tail) event.
Although closely related, RC and TRC are different risk measures, and provide a different view of the
riskiness of a facility within the context of the portfolio in question. The relation between RC and TRC is
similar to the relation between portfolio UL and portfolio capital.
More rigorously speaking, Tail Risk Contribution is defined as the currency amount change in portfolio
capital required for a currency unit change in an exposures position size, holding all other positions and
the target probability (or interval around this level) constant. In PM, this marginal risk measure can also
be defined as contribution to a particular probability level (or interval) on the capital distribution. That is,
PM measures the marginal contribution of an exposure to the overall portfolio capital given that the
overall portfolio capital is within the specified interval. The interval of interest is generally in the tail region
on the capital distributionhence, the name, tail risk contribution. The user should choose the interval in
accordance with the objective underlying the allocation of portfolio capital.
We can write the mathematical definition of TRC as follows:
(13.4) TRC
C
V
i
p
i
0
To evaluate the expression above, consider the following expression in which capital is expressed as the
expected value of the present value of loss, where the expectation is taken over only the states in which the
present value of the loss equals capital. Notice that loss is defined in excess of a loss reference point denoted
as LP:
\ (13.5)
where and are exposure is values at time 0 and at horizon, respectively. is the loss reference
point for exposure i below which we measure losses. is the initial value of exposure i. Note that this is
definition is generalized in Appendix A, Understanding Exposure Profile Calculations, to include
exposures that could have a mark-to-market value, , of zero. is the conditional expectations
operator. and are the risky return to horizon, and the return on the exposure i such that it
corresponds to the Loss Reference for exposure i when multiplied by .
In the above equations, the expectation is conditional on realizing a particular present value of loss defined
as capital. Thus, evaluating the partial derivative of capital with respect to the initial position, , of
exposure i, we arrive at the following equation:
(13.6)
TRC depends on the level of capital (which itself depends on the confidence interval one is seeking for risk)
and the loss reference point one has chosen. In PM, loss is calculated in two different ways related to the
chosen loss point, and hence we have two cases of TRC as follows:
(13.7)
(13.8)
C E DF DF C
E LP
p
H
R
H
R
p f f

,
]
]
(Portfolio Loss) (Portfolio Loss)

(
ii
H
i
i i
H
R
H
R
p
i
LP
i
V DF DF C
E V R
f f

,
,
]
]
]

) (Portfolio Loss)
(
0
VV Y DF DF C
i
i
i i
H
R
H
R
p f f
0

,
,
]
]
]

) (Portfolio Loss)
V
i
0
VH
i
LP
i
V
i
0
V
i
0
E
[ ]
|
Y
i
R
LP
i
V
i
0
V
i
0
TRC
C
V
E R Y DF DF C
LP
i LP
p
i LP
i
i
H
R
H
R
LP
f f

( )

0
(Portfolio Loss)
pp ,
,
]
]
]
TRC
C
V
E DF ES Y DF
EL
i EL
p
i H
RR
H
i
i
H
R
f
]
]
+
( )
0
1
(Portfolio Los ss)DF C

H
R
EL
p f
,
]
]
]
TRC
C
V
E DF Y DF D
TS
i TS
p
i H
RR
i
H
R
f
]
]

( )
0
1
(Portfolio Loss) FF C
H
R
TS
p f
,
]
]
]
TRC
EL
reflects contribution when capital is calculated in excess of Expected Loss while TRC
TS
reflects
contribution when capital is calculated in excess of Total Spread. (See Chapter 14 for more discussion on
these two methods for determining capital). Care should be taken in choosing the particular TRC aligned
with the users circumstances and objectives.
In practice, PM allows for the more general case where the calculation of TRC is conditional on the present
value of losses falling into a particular interval on the portfolio loss distribution. In PM, the user can
specify a lower and upper bound for the target probabilities. The user may also specify a lower and upper
bound for portfolio capital, C
LB
and C
UB
. However, this requires an initial run of the simulator to
determine the corresponding capital bounds. Based on these capital bounds, we can extend the two
equations above as follows:
(13.9)
(13.10)
When the conditioning expression is just the capital number, we can see that the MTM value weighted
sum of Tail Risk Contributions (e.g. TRC
TS
) is equal to the total capital for the portfolio:
(13.11)
It should be noted that when the weights are calculated as MTM values of the exposures divided by the
portfolio MTM value, the weighted sum of Tail Risk Contributions equals the portfolio Capitalization
Rate, CR
p
.
In the case where the conditioning expression is an interval, the resulting value weighted sum of TRC
values will not necessarily sum to the overall portfolio capital amount. In this case PM re-scales the capital
allocations such that the sum of all individual allocations equals the overall capital amount for the portfolio
(based on the user-specified target probability).
TRC
C
V
E DF ES Y DF C
EL
i EL
p
i H
RR
H
i
i
H
R
LB
p f
]
]
+
( )
<
0
1
(Portfollio Loss)DF C
H
R
UB
p f
<
,
,
]
]
]
TRC
C
V
E DF Y DF C
TS
i TS
p
i H
RR
i
H
R
LB
p f
]
]

( )
<
0
1
(Portfolio Losss)DF C
H
R
UB
p f
<
,
,
]
]
]
V TRC E V DF V Y DF
i
TS
i
i
i
H
R
i
i
i
H
i
H
R
f f
0 0
1
0
1
,
]
]
+
j
(
,
\
,
(
( )
Porrtfolio Loss
Portfolio Loss Port
( )
,
,
]
]
]
( )
DF C
E DF
H
R
TS
p
H
R
f
f
ffolio Loss , thus

( )
,
]
]

DF C C
w TRC CR
H
R
TS
p
TS
p
i TS
i
i
TS
p
f
where w V V
i
i i
i

j
(
,
\
,
(
0 0
1
It is worth pointing out that TRC has many of the same drivers as RC:
TRCs are large when portfolios consist of many obligors in the same industry or country.
TRCs are large when individual obligors EDFs are large.
TRCs are large when individual obligors systematic risks (R
2
with the market) are large.
13.3 EXPOSURE CAPITAL
PM first determines the overall portfolio capital amount based on the method specified by the user.
Allocation of capital to individual exposures depends on the method chosen for calculating the
contribution to risk. For convenience, we define contribution to the portfolio UL as Risk Contribution
(RC) and define contribution to an interval on the portfolio loss distribution as Tail Risk Contribution
(TRC). Users should consider carefully the implications of the methods they are using in each step of the
capital allocation. This separation in steps for allocation can also result in capital allocations that exceed the
total amount of an exposure.
PM also allows the user to constrain individual capital allocation to levels such as the exposures (LGD-EL)
to reflect the fact that one would not want to allocate to an exposure a capital amount that exceeds the
amount set aside in reserve (Expected Loss or EL) plus the expected loss in the event of default (LGD).
Finally, the user can choose to re-scale individual capital allocations so that the sum of all individual
allocations equals the overall portfolio capital amount.
Little theoretical guidance exists regarding the best method for individual capital allocation. Roughly
speaking, RC may be appropriate when the objective is purely pricing a transaction while TRC may be
appropriate when the objective is purely minimizing the risk of insolvency. Even then, reasonable
arguments abound concerning which objectives fit which method. PM provides a basket of tools to
investigate these issues.
13.3.1 Risk Contribution based Capital
Exposure capital based on RC, , is given by portfolio capital, C
P
, times the ratio of the weighted RC to
portfolio UL:
(13.12)
Let us now turn to an actual portfolio example to demonstrate this capital allocation calculation. Figure
13.2 presents the Portfolio Overview from PM for a sample portfolio of 997 exposures. This portfolio
contains the types of exposures held by large global, commercial banks. We will be focusing on the
Unexpected Loss and the Capital numbers.
C
RC
i
C
w RC
UL
C C
w RC
UL
C
RC TS
i i
i
p
TS
P
RC EL
i i
i
p
EL
P
( ) ( )

and
where ww V V
i
i i
i

j
(
,
\
,
(
0 0
1
FIGURE 13.2 Portfolio Overview
The portfolio capital amount in this case resulted from specifying a target probability of 15 bps and
calculating the portfolio loss distribution using an analytical approximation. Since the allocation to the
individual exposure is calculated after the overall portfolio capital is calculated, the user could just as easily
have specified a different methodsuch as the Monte Carlo simulationfor calculating the portfolio loss
distribution.
FIGURE 13.3 RC Based Capital for an Individual Exposure
On the Exposure Output Details screen (Figure 13.3), RC is reported as a fraction of the initial value of the
exposure. In order to put this value on the same scale as portfolio currency amount UL and capital, RC is
multiplied by the exposures MTM Exposure. Note that the portfolio amounts are taken from Figure 13.2.
(13.13)
The Risk Contribution based Capitalization Rate (CR
RC
) is equal to Risk Contribution based exposure
Capital divided by the initial value of the exposure:
(13.14)
C
RC TS
i
( )
. , ,
, ,
$
( ) ( )
( )
0 001083 1 186 500
52 191 847
10 438,614,710 ,, 798
CR
C
V
CR
C
V
RC TS
i RC TS
i
i RC EL
i RC EL
i
i ( )
( )
( )
( )

0 0
and
Continuing with the example, we have
(13.15)
13.3.2 Tail Risk Contribution based Capital
Exposure capital based on Tail Risk Contribution, , is given by portfolio capital, C
P
, times the ratio
of weighted TRC
i
to the weighted sum of all TRC
i
s in the portfolio. Essentially, we are insuring that if we
sum all the individually allocated capital amounts, we always arrive back to the total portfolio capital
calculated on the basis of the portfolio loss distribution. Refer to the discussion of Vasicek ratios (in the
next chapter) for more details. Since we calculate the Tail Risk Contribution two different ways we allocate
capital to individual exposures (based on TRC) two different ways:
(13.16)
Tail Risk Contribution based Capitalization Rates are defined below:
(13.17)
CR
C
V
RC TS
i RC TS
i
i ( )
( )
,
, ,
.
0
10 798
1 186 500
0 009101
C
TRC
i
C
w TRC
w TRC
C C
w TRC
TRC TS
i i TS
i
i TS
i
i
TS
P
TRC EL
i i E
( ) ( )
and
LL
i
i EL
i
i
EL
P
w TRC
C
CR
C
V
CR
C
V
TRC TS
i TRC TS
i
i TRC EL
i TRC EL
i
i ( )
( )
( )
( )

0 0
and
FIGURE 13.4 TRC Based Capital for an Individual
The denominator in equation (13.18) is calculated from the file TRskTotS.dbf found in the same folder
as the portfolios.
(13.18)
TRC based Capitalization Rate (for Total Spread) is calculated below:
(13.19)
C
w TRC
w TRC
C
TRC TS
i i TS
i
i TS
i
i
TS
P
( )
, , .
( )
=
6
1 186 500 0 017685
556,111,755.3
438,614,710 =$14,027
,
,
]
]
]
( )
CR
C
V
TRC TS
i TRC TS
i
i ( )
( )
,
, ,
.
0
14 027
1 186 500
0 011822 =
13.3.3 Dynamics of Risk Contribution and Tail Risk Contribution
based Capital
RC and TRC are two alternative measures of contribution to portfolio risk; RC measures a facilitys
contribution to portfolio UL, TRC measures the contribution to the risk of an extreme event. As a result,
RC based capital will generally be different from TRC based capital. This section discusses some of the
differences, as well as the intuition behind why those differences prevail. As a practical matter, this
information is relevant when considering the sort of facilities that will be charged higher capital when
choosing one measure over another.
Although the relative behavior of TRC and RC is very dependant on facility as well as portfolio
characteristics, there are some patterns that have been observed and are worth discussing. Specifically, for a
wide range of portfolios we have noticed that TRCs are generally more sensitive to R
2
s, while RCs are
generally more sensitive to EDFs. Intuitively, TRC measures a facilitys contribution to the risk of an
extreme event. This event is generally associated with a massive negative systematic shock; a shock that will
have an increasingly large impact on higher R
2
obligors. Following this logic, TRC will be very sensitive to
the underlying obligor R
2
. Meanwhile, RC is very sensitive to facility UL. Since UL is very sensitive to
EDFs, RC tends to be very sensitive to EDFs.
Figure 13.5 demonstrates this pattern for Portdemo, the portfolio that is shipped with Portfolio Manager.
The figure presents the average ratio of TRC-to-RC based capital for facilities with obligors in 1-year EDF-
R
2
buckets.
1
Although the different buckets have very different facility characteristics (such as different
maturities or associated obligors of different industries and countries), the general pattern prevails.
FIGURE 13.5 TRC versus RC Based Capital
1
Buckets are chosen so that the number of facilities in each bucket is approximately constant.
CHAPTER
14
PORTFOLIO VALUE AND LOSS DISTRIBUTIONS: ESTIMATION
PM can estimate the value distribution using either analytic or Monte Carlo methods. These methods are
based upon certain assumptions regarding the random processes that generate portfolio value. The value of
an individual exposure in the portfolio at the horizon is determined, among other things, by whether it is
in default at the horizon, or, if not in default, by its default probability over its remaining maturity. The
default probability of the exposure to the horizon is input data; the default probabilities at the horizon for
the remaining terms to various cash flow dates after horizon are random variables with means equal to the
forward EDFs of the obligor from horizon to these cash flow dates. Using a model, PM determines the
distribution of an obligors possible forward EDF values. This distribution determines the variance of the
value of the exposure in the non-default state at the horizon.
An analytical calculation of the portfolio value distribution requires the calculation of a portfolio value for
each possible loss combination in the portfolio. A loss combination consists of a set of defaults in the
portfolio; for example, only asset 1 defaults, asset 1 and asset 2 default, asset 2 and asset 5 default, and so
on. The total number of such combinations in a portfolio of n assets is 2
n
-1. A portfolio of just 300 names
has approximately 2.03 x 10
90
combinations. Add to this number the near-continuum of possible losses
due to credit migration and this methodology quickly becomes intractable.
MKMV offers three solutions to the estimation problem.
Analytical Approximation
Calculated Loss Distribution
Monte Carlo Simulation
The first is an analytic formulation pegged to a certain range of probabilities. It imposes the largest set of
assumptions but can be computed in a matter of seconds or minutes (depending on the size of the
portfolio). The other two, Monte Carlo Simulation and Calculated Loss Distribution, are Monte Carlo
methods; they sample over possible realizations of portfolio value at the horizon and construct a frequency
distribution from these values. The Monte Carlo Simulation is generally more accurate but can be quite
time-consuming to run. As a result, Portfolio Manager offers an Accelerated Monte Carlo technique that
reduces the number of simulation runs required to achieve a given accuracy. The basic idea behind
Accelerated Monte Carlo is to concentrate the random sample around the region that has the greatest
impact on calculations. Calculated Loss Distribution method provides an effective compromise between
speed and accuracy.
14.1 ANALYTICAL APPROXIMATION
PM uses a proprietary algorithm to compute an approximate loss distribution analytically, typically within
a matter of seconds. The algorithm maps the actual portfolio to an "equivalent" uniform portfolio that has
known loss characteristics. The loss distribution for the actual portfolio is inferred from the loss
distribution of the equivalent uniform portfolio. The approximation has been extensively tested against
simulations and has proven to be robust and accurate across a variety of commercial bank portfolios. It
works best with larger portfolios (i.e. with more than 1,000 exposures) and with reasonably homogeneous
exposures.
The equivalent portfolio is constructed from summary data for the actual portfolio. This data includes the
portfolio Expected Spread, the minimum and maximum possible portfolio values, and a weighted average
maturity of exposures in the portfolio.
The Analytical Approximation applies to portfolios with initial exposure values determined by the Risk
Comparable Valuation procedure. The smallest approximation errors are obtained when the portfolio is
relatively uniform, EDF values are investment grade, spreads are not unusually large, and the target
probability for capital is near the 10 basis point (bp) level.
14.2 CALCULATED LOSS DISTRIBUTION
The Calculated Loss Distribution provides an alternative means of determining the portfolio value, loss
and capital distributions. Although it relies upon the same assumptions as the analytical approximation
about the processes governing the obligors business values and uses the same functions to determine
exposure value from business value, the Calculated Distribution involves none of the additional
assumptions used in the analytical approximation. Instead, it simply generates a frequency distribution of
portfolio value outcomes. The Calculated Distribution does assume that, under certain conditions, the
limiting distribution of portfolio values is well-behaved. To elaborate, it assumes that conditional on a
realization of systematic risk, the portfolio value distribution converges to the normal distribution when
exposures in the portfolio are relatively homogeneous and the number of exposures is large. That is, once
we have a realization for the correlation structure (a state of the world), the residual credit risks in the
portfolio are uncorrelated. It exploits these convergence properties in the structure of correlations to reduce
computation time.
With sufficient repetition, the frequency distribution provides a very good approximation to the true value
distribution that would be obtained under the stochastic process assumptions of the model. The cost of
greater precision is increased run time.
The Calculated Distribution generates a single random outcome for the state of the world, or the
systematic risk. The impact of this outcome on the portfolio value is constrained by the correlation in asset
returns for each pair of obligors given by the factor model. The realization of a particular value for each
factor (a state of the world) plus a random draw of obligor specific risks implies a horizon business value for
each obligor in the portfolio. Given these business values, we determine whether a given obligor has
defaulted. If so, exposures mapped to that obligor are assigned a random recovery value; if not, we
determine the probability of default from horizon to maturity for the obligor and revalue the exposures
based on that default probability. Summed over all the exposures in the portfolio, we get a single value for
the portfolio at the horizon.
We repeat the process with a new random draw for the state of the world at the horizon. The result is
another possible horizon portfolio value. Each draw is equally likely, so these values can be compiled into a
frequency distribution. Iterating 50,000 to 200,000 times results in a frequency distribution that is very
close to what the true portfolio value distribution would be under the assumptions of the model. The
corresponding loss and capital distributions can then be derived from this value distribution.
The assumptions on the limiting behavior of the portfolio break down when the number of exposures in
the portfolio is small. Fortunately, in those cases, the full Monte Carlo Simulation will produce a precise
distribution quickly.
14.3 MONTE CARLO SIMULATION
The Monte Carlo makes no assumptions about the limiting behavior of exposures in the portfolio. It is
otherwise similar to the Calculated Distribution. The Monte Carlo Simulation is the most accurate
measure of aggregate capital required to support a portfolio. It provides a benchmark for both the
Calculated Loss Distribution and the Analytical Approximation. The main drawback of the full Monte
Carlo Simulation is its lack of speed. Depending on the size of the portfolio and the desired target
probability, the simulation might take anywhere from one hour to a few days to run on a fast PC.
However, the Monte Carlo results can be readily incorporated into one of the faster methods for daily use.
In each trial of the simulation, the value of a particular exposure is determined by the simulated market
value of the obligors underlying asset value. The obligor is assumed to default if the value at horizon of its
underlying assets falls below its default point. The change in asset value is unknown and has two random
components, one systematic and the other unsystematic, that comprise the obligors business risks. The
systematic risk is constructed from the MKMV Global Correlation factor model (see Chapter 11). The
unsystematic risk is a standard normal random variable.
The sampling proceeds as follows:
Draw a set of factor realizations, one for each factor. The factors are independent and identically dis-
tributed standard normal random variables.
Draws specific risk for each firm. These draws are also i.i.d. standard normal random variables. Com-
pute the random component of each firms asset value as a weighted sum of the specific and systematic
risks.
Compute the value of each exposure at the horizon from its asset value realization; the value of each
exposure at the horizon is determined using MKMVs Risk Comparable Valuation methodology and
is a function of each exposures LGD, EDF value, R-squared, and the random realization of asset value
at the horizon. For each trial, the value of the portfolio at the horizon is obtained by summing the val-
ues of the individual exposures in the portfolio.
Iterate, and tabulate the results into a frequency distribution. A typical simulation would use 50,000
to 200,000 trials in order to produce sufficient resolution of the extreme tail of the distribution.
14.3.1 Sampling Obligor Asset Values at the Horizon
Sampling in the Monte Carlo Simulation takes place over the asset values of individual obligors. The asset
value at the horizon for an obligor, A
H
, is calculated as:
(14.1)
where
The simulation draws a value of for each obligor; these values are not independent. The MKMV factor
model provides a structure for the correlations in asset returns through 2 global macroeconomic, 5
regional, 7 sectorial, 45 country-specific, and 61 industry-specific effects.
(14.2)
These 120 systematic risk factors,
j
s, and the firm-specific factor, , are independent draws of standard
normally distributed random variables. The random component of asset return, , is obtained by first
calculating the weighted sum of the firm specific return, , and the 120 systematic risk factors,
j
s, the
weights being the coefficients in equation (14.2), and then scaling the sum by dividing by the standard
deviation of the firms asset return. Thus, by construction, the random component of a firms asset return,
, is standard normally distributed and has a correlation structure consistent with the factor model of
correlation.
The next section describes the calculation of exposure values from asset value realizations.
14.3.2 Exposure Value at the Horizon
The value of a given exposure is determined as the sum of two exposures, a riskless portion, which pays (1-
LGD)(RFV
H
) whether the exposure has defaulted at the horizon or not, and a risky portion, which pays
when the exposure is not in default and zero otherwise:
(14.3)
where RFV
H
is the risk-free value of the exposure from horizon to maturity which includes the risk-free
value at H of any cash flows received from 0 to H. RYV
H
is the value of the risky portion of the exposure
from horizon to maturity, and LGD is the expected loss given default. RYV
H
also includes coupons from
ln ln A A t t
H H H H
+
j
(
,
\
,
(
+
0
2
2
A t
0 0
the borowers underlying asset value at

expected re tturn on the underlying assets
volatility of the return o nn the underlying assets
the random component of the as
H
sset return

H
j j
j
u
j j j
j
u
u
+
+
,
,
]
]
]
1
2 2
1
120
2
1
120
u
H
u
H
LGD RYV
H
V LGD RFV LGD RYV

H H H
( ) + 1
time 0 to time H. Notice that the coupons or cash flows received before horizon are assumed to be risk-free
and enter into the loss given default calculation. If LGD is set as a fixed percentage of exposure, PM
calculates an LGD amount such that the expected recovery is the same regardless of the value of RFV
H
. See
Chapter 6 for a discussion of the choices for modeling loss given default.
If the exposure defaults before the horizon then the value of the risky portion of the exposure, RYV
H
, is
equal to zero and the obligor is assumed to receive an amount based on the parameterized LGD
distribution. That is, PM allows for uncertainty in the actual recovery given the difficulty in characterizing
LGD.
1
Since LGD is assumed to be random, PM then draws a realization to determine the fractional loss
for each defaulted exposure. The fractional loss of the exposure, , is assumed to be a random variable
drawn from a Beta distribution with mean LGD and variance . The parameter k is a
constant which determines the shape of the Beta distribution for given values of LGD. Please see Chapter 9
for a detailed description of the Beta distribution.
The value of the exposure at horizon is calculated as:
2
(14.4)
(14.5)
The risk-free value of the exposure at horizon H, is calculated as the discounted value of the exposures
cash flows, C
t
s from time 0 to maturity M, using the risk free rate, R.
(14.6)
Notice that the risk-free value of the exposure at horizon includes the coupons received from the as-of date
to the horizon date. We consider two cases to determine the risky value of the exposure at the horizon:
default and non-default.
14.3.3 Exposure Value in the Default State
If the asset value at the horizon, ln(A
H
), falls below the default point, ln(DPT
H
), then the obligor will
default. Using equation (14.1), we can say that an obligor will default if the realization of the random
component of the obligors asset return, , is larger (in absolute value) than the H-period distance-to-
default at time 0, which is obtained by the inverse of the H-period DD-to-EDF mapping. This
mathematical comparison represents the assumption that if a fall in asset value generates a negative return
1
Financial researchers report large standard errors when estimating recovery rates on defaulted loans and bonds.
2
In the following equations remember that the mean of the loss-given-default distribution is LGD. When valuing the exposure in the
non-default state the mean, LGD is used. When valuing the exposure in the default state, the loss given default is drawn from the
Beta distribution.
LGD
LGD LGD k 1 ( )
V LGD RFV LGD RYV H
H
H

( ) + 1 in non-default
V LGD RFV H
H

( )
1 in default
RFV R C R
H H
H
t t
t
t
M
+ ( ) + ( )
>
1 1
0
H
realization large enough that the obligors distance-to-default is exceeded, the obligor will be in default.
Mathematically, we write down the comparison as follows:
(14.7)
where
In the event of default, the risky value of the exposure, RYV
H
, is set to zero. A risky value of the exposure is
only possible if the obligor is not in default at horizon. In the default case, the LGD draw drives the
exposure value realization as shown in equation (14.5).
14.3.4 Exposure Value in the Non-Default State
If the exposure does not default, we must value it as a function of the default risk of the obligor at the
horizon. We are interested in calculating CEDF values for each promised cash flow associated with the
exposure that occurs at time period t, where t>H. Based on the asset return realization for each iteration of
the simulation, PM calculates a conditional CEDF value used to value all risky cash flows for the exposure
occurring between horizon and maturity. Let us walk through one iteration for a cash flow expected to
occur at time t>H.
Let G
H,t|DD0,1
denote the conditional, cumulative probability distribution of (t-H) period distance-to-
default at horizon, DD
H,t
, conditional on the bucket in which the value of the 1-year distance-to-default,
DD
0,1
falls (see Chapter 8). We simulate , which is standard normally distributed, and transform it to
a uniform [0,1] distribution. A draw from this uniform distribution is mapped to a draw of DD
H,t
using
the inverse G
H,t|DD
0,1
function. Thus, even though we simulate , we are, effectively, able to make draws
of DD
H,t
from the distribution, G
H,t|DD0,1
. Mathematically,
(14.8)
In words, we start with our random draw to determine the realized asset return. We use an empirical
specification to translate this draw into an appropriate DD
*
that reflects the typical DD for an obligor that
starts with this particular DD
0,1
. Because this calculation is relevant only in the non-default states,
equation (13.7) reflects the probability of surviving to horizon, (1-CEDF
H
).
H
A
DPT
H
H
N C
H

j
(
,
,
,
\
,
(
(
(
+
j
(
,
,
\
,
(
(
,
,
,
,
]
]
]
]
]
]
ln
0
2
2 1
EEDF
H
( )
DPT
CEDF
H
H
= standardized default point at horizon

cumula ttive probability of default to the horizon
inverse N
()
1
sstandard normal distribution function
H
DD G
N CEDF
CEDF
H t
H t DD
H H
H

,
*
, |
,
( )
j
(
,
\
,
(
0 1
1
1

Up until this point in the calculation the information specific to the obligor is primarily the obligors one-
year DD bucket at the as-of date, DD
0,1
. Conditional on the asset return draw, the DD needed for valuing
a particular cash flow at time t, DD
*
H,t
reflects the average behavior for a firm starting out at DD
0,1
. We
have not yet incorporated the actual term structure of EDF values (reflecting DDs) for this particular
obligor.
We adjust the DD
*
s calculated in equation (13.7) to account for the obligor-specific information available
from the input term structure of EDF values. Thus, we obtain an obligor-specific distribution of DDs. We
do this adjustment by ensuring that the forward survival probabilities after horizon of the exposure
reflected in the obligors term structure of EDF values exactly equal the expected forward survival
probabilities arising from the empirically derived DD transition probability distribution for horizon H and
for obligors in the same DD
0,1
bucket. We make either a single DD adjustment or multiple DD
adjustments. Using the adjustments (for details on adjustments, see Chapter 8), PM converts the average
DD (i.e., DD*) distribution to a DD distribution calibrated to the obligors actual term structure of EDF
values. Mathematically,
(14.9)
With this calibrated or obligor-specific random DD draw, we can determine the appropriate CEDF
H,t

needed for valuing promised cash flows at each period t. Since we are using the empirical distribution for
DD, we must convert the DD to a CEDF using MKMVs empirically estimated DD-to-EDF mapping as
follows:
(14.10)
Now that we have an actual forward CEDF
H,t
, the next step is to calculate a risk-adjusted (or risk-neutral)
default probability, CQDF
H,t
for valuing the cash flow occurring at time t. This conversion discussed
previously in Chapter 5 is shown again for ease of reference:
(14.11)
where R is the correlation of obligor firms asset return with its custom index (see Chapter 11), is the
market Sharpe ratio, and is the time parameter which determines how the market price of risk scales with
time.
The value of the risky portion of the loan at horizon, when it does not default, is:
(14.12)
DD DD H t H t

,
*
,
DD Adjustment(s)

CEDF KMV DD H t H t

, ,
( )
CQDF N N CEDF R t H
H t
H t

,
,
( )
+ ( )
( )
1

RYV R C CQDF R C R H
H
H
t H t t
t
t t
t
t H
H
t H
M
+ ( )
( )
+ ( ) + + ( )
,

>

1 1 1 1
, ,,
]
]
]
Thus, given a realization of the random component of the asset return, , we are able to generate
random exposure values at horizon. Similarly, we simulate the asset returns for all the exposures and
calculate their values at horizon.
To reduce the time needed to do the simulation, exposure values at horizon are calculated using a valuation
grid. An example of a grid is given below:
(14.13)
Each point in the epsilon grid corresponds to a particular asset value which can then be converted into an
exposure value, for example, = 5 corresponds to the risk-free valuation of the exposure. Clearly, the
lower the realization of , the lower the valuation at horizon. A value at horizon corresponding to a
particular that is not in the epsilon grid is calculated by linearly interpolating between values
corresponding to the closest grid points.
The random value of the portfolio at horizon is obtained by summing the values of the individual
exposures in the portfolio. Loss is defined as difference between a reference loss point and the random
value at horizon (see Chapter 12). The whole process is iterated and the portfolio value along with the loss
results are tabulated into a frequency distribution. Thus, we obtain the portfolio value and loss
distributions.
14.3.5 Monte Carlo Portfolio Statistics
Monte Carlo statistics such as portfolio UL and capital are computed using the simulated portfolio horizon
values. Specifically, in each trial n, the value of the portfolio, V
H,n
is obtained by summing the realized
exposure values as described above. Portfolio UL is computed using the sample of N simulated values:
(14.14)
Notice that as the number of trials, N, increases, UL
P
converges to the true standard deviation of the
portfolio value at horizon:
(14.15)
H

10 354 309 233 188 164 104 067 039 013
013 03
. . . . . . . . .
. . 9 9 067 104 164 188 233 309 5 . . . . . .
,
,
]
]
]
H
UL
N
V
N
V
P H n H n
j
(
,
\
,
(
1
2
1
1
2
2
, ,
UL S D V
P N H
. .( )

14.3.6 Accelerated Monte Carlo
Monte Carlo simulation is the most accurate way of estimating a portfolio's loss distribution. This,
however, can be very time consuming. In general, one must simulate the value of every asset for each state
of the world. It is not uncommon for Portfolio Manager to simulate 10 billion asset values; a portfolio
of 100,000 facilities with 100,000 trials. Accelerated Monte Carlo (AMC) is a technique that reduces the
number of simulation runs required to achieve a given accuracy. In our example, AMC can reduce the
number of runs to fewer than 0.5 billiona factor of 20.
The basic idea behind Accelerated Monte Carlo is to change the distribution from which the random
samples are taken. Specifically, a greater concentration of the sample is chosen from the region with the
greatest impact on the calculation. For computing capital in Portfolio Manager, this means sampling
scenarios that lead to large losses.
Intuitively, the methodology is similar to a change of measure technique. When statistics are computed,
the integration is conducted over the Accelerated density ( ), along with an additional term
that is equal to the ratio of the original density ( ) and the accelerated density. More
formally, a change of measure technique integrates a function (f) over an alternative (accelerated) density,
along with a weight , so that the integral equals the function
integrated over the original density:
(14.16)
Accelerated Monte Carlo is analogous to a change of measure technique when sampling a distribution.
When using Standard Monte Carlo, aggregating the values across the draws will provide the following
asymptotic result:
(14.17)
The result follows from the fact that x
n
is sampled from .
Similarly, one can use Accelerated Monte Carlo, and aggregate the random values along with the ratio of
the pdfs to provide a similar asymptotic result:
(14.18)
pdf
accelerated
pdf
original
w x pdf x pdf y ( ) ( )/ ( )
original accelerated
f y
pdf y
pdf y
pdf y y f ( )
( )
( )
( ) (
original
accelerated
accelerated

xx pdf x x ) ( )
original

1
N
f x f x pdf x x E f x
n N original
( ) ( ) ( ) [ ( )]

pdf
original
1
N
f x
pdf x
pdf x
f x
pdf
n
n
n
N
( )
( )
( )
( )

original
accelerated
originaal
accelerated
accelerated origina
( )
( )
( ) ( )
x
pdf x
pdf x x f x pdf
ll
( ) x x

The asymptotic result follows from the fact that x
n
is now sampled from .
As an example, consider computing capital at 10 bp. Assume we know the capital value C, and are
computing the probability of exceeding a loss of C. For the Standard Monte Carlo simulation, 100,000
simulation runs would produce on average 100 sample points with losses greater than C. If the actual
number of points exceeding C is N
MC
, then the estimate of the probability for exceeding C is
. Using Accelerated Monte Carlo, however, we might sample 5,000 points with
losses greater than C. With each sample point we associate the weight w
i
(equal to the ratio of the original
and accelerated densities) such that the estimate for the probability of exceeding C becomes
, where the sum is taken over all samples that exceed C.
It is worth pointing out a few properties of the procedure. First, for Standard Monte Carlo, all the weights
are 1 (i.e. the ratio of the densities is 1). Second, a good implementation of Accelerated Monte Carlo will
have many more points in the region of interest than N
MC
. Finally, the associated weights will all be
approximately equal to or less than 1 in the region of interest. After all, the accelerated density was chosen
to be more concentrated than the original density in this region.
The next step is to determine an accelerated distribution. This choice is somewhat of an art, and is very
problem dependent. Concentrating sample points in one region necessarily means that other regions are
less represented; problems that depend strongly on these depleted regions may show a decrease in accuracy.
Also, if a large number of samples appear in the region of interest, but with very small weights, while a few
samples have very large weights, the accuracy will suffer.
The approach used in Portfolio Manager focuses on the risks associated with the underlying obligors.
More specifically, a portfolio with N (unrelated) facilities has in effect N dimensions, each represented in
the simulation by a Standard Normal draw for its asset return. The goal is to find a dimension associated
with these correlated asset returns that has the largest impact on the portfolio value. Intuitively, the
obligors' underlying asset covariances are exaggerated in this dimension. This increases the prevalence of
simultaneous defaults, thus increasing the prevalence of extreme portfolio losses.
More formally, the accelerated distribution uses the original covariance matrix, with the largest eigenvalue
magnified. Intuitively, the eigenvector associated with the largest eigenvalue corresponds to the single
dimension that has the largest impact on the portfolio; i.e., the most prominent source of risk (factor)
associated with the original covariance matrix. Therefore, magnifying this eigenvalue magnifies the overall
covariance, and increases the prevalence of simultaneous defaults.
14.3.7 Choosing an Accelerated Distribution: Testing AMC
As discussed above, it is necessary to specify an accelerated distribution when applying Accelerated Monte
Carlo. Within the context of Portfolio Manager, this entails choosing a parameter that determines the
extent to which the covariance matrix is magnified; a high results in more extreme asset draws. The trick
is to choose a sufficiently high so that a large number of draws are chosen from the desired region, but
not so high that the resulting weight function is overly volatile and difficult to estimate. Since the optimal
is problem dependent, a variety of client portfolios were tested. The objective was to estimate how
alternative choices of affected the precision of relevant statistics.
The graph below demonstrates how the standard error of a target probability of 10 bp (y-axis) varies with
(x-axis). The graph represents the average standard error across several client portfolios. The U-shaped
pdf
accelerated
/ , p N
MC MC
100 000
/ , p w
AMC i
( )
5 000
image, with a wide bottom, indicates that the standard error is near the minimum over a wide range of .
This is particularly encouraging since it suggests that most of the benefits associated with Accelerated
Monte Carlo will be achieved when is set to 2.5. Looking at the graph, and recognizing that the standard
error of the estimate scales by (number of trials)
-0.5
, one can achieve the same level of precision as Standard
Monte Carlo (i.e., =1) when running approximately 5.6% of the number of trials.
FIGURE 14.1 Standard Error for a Target Probability of 10 bp
A few additional comments are worth making. First, all of the client portfolios that were tested had a wide-
bottomed U shape, relationship between the standard error and . Second, of 2.5 fell within the bottom
portion of the U for all of the portfolios. Third, the same level of precision as Standard Monte Carlo (i.e.,
=1) was achieved when running 3.2% to 31% of the number of trials. In general, portfolios with highly
correlated facilities benefited most. Fourth, the qualitative relationship between the standard error and
was similar for a variety of target probabilities (3 bp to 50 bp). In general, the benefit of Accelerated Monte
Carlo increased with a smaller target probability. This is not surprising given that more extreme
observations are needed to estimate a small target probability. In some cases 1.25% of the number of
Standard Monte Carlo trials were necessary to achieve the same level of precision. Finally, as the following
graph demonstrates, the relationship between the standard error of the average portfolio variance (i.e.,
UL
2
) and s is similar to the relationship with the target probability. The intuition for this result follows
from the fact that Accelerated Monte Carlo increases the variances of the underlying assets. This results in
both extreme negative and positive realizations, allowing for better measurement of the tail as well as UL.
0
0.03
0.06
0.09
0.12
0.15
0 1 2 3 4 5 6 7 8
Sigma
S
t
a
n
d
a
r
d

E
r
r
o
r
FIGURE 14.2 Standard Error for UL
2
14.3.8 Technical Discussion
In order to derive the formulas, let us assume that we have the true asset return correlation matrix for the
obligors in the portfolio, as well as its eigenvalue-eigenvector decomposition. Let P be the correlation
matrix, Q be the orthogonal matrix whose columns are the orthonormal eigenvectors of P, and be the
diagonal matrix of eigenvalues sorted such that . Then:
(14.19)
Let q
1
be the first column of Q, corresponding to the largest eigenvalue so that:
(14.20)
The problem we are interested in solving is to find the probability p(J) that (normalized) losses lie in a
given interval J. For example, we would typically take to find the probability that losses
exceed a capital level C. This probability can be expressed as the integral
(14.21)
0.000
0.005
0.010
0.015
0.020
0.025
0.030
0 2 4 6 8
Sigma
S
t
a
n
d
a
r
d

E
r
r
o
r

1 2
0
N
P Q Q
T

Pq q
1 1 1

J C [ ] ,
p J e N e P de
J
R
N
( ) ( | , ) ( ) ( )
0
Here N(0,P) is the Normal density function for vector e with mean zero and covariance matrix P:
(14.22)
The notation |P| indicates the determinant of P. The function
J
is the characteristic function of the
interval J, and (e) is the (normalized) value of the portfolio given the asset returns e.
To apply Accelerated Monte Carlo to this problem, we represent this integral as
(14.23)
where is another positive definite symmetric NxN matrix and the weight function is defined as
(14.24)
The key to the method described here is in how is chosen. Let us define
(14.25)
where and . In other words, is the covariance matrix which results from
scaling up the largest eigenvalue by a factor
2
. Notice that
2
determines the Accelerated distribution. As
discussed above, the optimal choice for
2
is problem specific; some experimentation will allow one to
determine a reasonable range for
2
. From the properties of orthogonal matrices, it follows that:
(14.26)
Note that when , it is easy to show that . This makes it possible
to compute what percentage of samples will have weight less than one as a function of .
N e P
P
e P e
N
T
( | , )
( ) | |
exp . 0
1
2
5
1

( )
p J e w e N e P de
J
R
N
( ) ( | , ) ( ) ( ) ( )
P
w e
N e P
N e P
P
P
e P P e
T
( )
( | , )
( | , )
| |
| |
exp . ,
]
]
( )

0
0
5
1 1
P

P Q Q
T

1
2
1

j j
j , 2

P
w e
q e
T
( ) exp .
j
(
,
\
,
(
( )
j
(
,
,
\
,
(
(

5 1
1
2
1
2
1
e N P

0,
( )
q e N
T
1
1
2
0 / ,
( )
In order to implement this Accelerated Monte Carlo approach, we need to be able to sample
. Now suppose we have a random sample . This is just the standard asset
return sample that can be obtained from the factor model approach currently implemented in Portfolio
Manager. If we define the diagonal matrix such that
11
= and
jj
=1, j>1, and we define:
(14.27)
it is easy to show that . With a little algebra we have that
(14.28)
Moreover, we also have that
(14.29)
Thus we can generate the scaled up sample e and the appropriate weight function from the original
unscaled sample e
*
, the largest eigenvalue, the corresponding orthonormal eigenvector, and the scale up
factor.
With
1
and q
1
available, we can sample and compute w(e). The Monte Carlo simulation
runs exactly as it currently does in PM, except that expected values which were previously estimated as
(14.30)
are now estimated as:
(14.31)
In particular, for computing the loss distribution, instead of counting the number of sample points that fall
in a given bin, the estimate is now the sum of the weights of the samples points that fall in that bin.
e N P

0,
( )
e N P
*
, 0 ( )
e Q Q e
T
( )
*
,
e N P

0,
( )
e q e q e
T
( )( )
+ 1
1 1
* *
w e
q e
T
( ) exp .
*

( )
( )
j
(
,
,
\
,
(
(

05 1
2
1
2
1
e N P

0,
( )
E f
N
f e
i
i
N
( ) ( )
*
1
1
E f
N
f e w e
i i
i
N
( ) ( ) ( )
1
1
14.4 USING THE THREE METHODS
In PM, the role of the loss distribution is to determine aggregate capital. Aggregate capital is allocated to
individual exposures based on their marginal risk measures. The required capital from the Monte Carlo
Simulation can be substituted for capital determined by other methods in a number of ways. The simplest
is to compute the ratio of required capital from the simulation to required capital from the faster method
at the desired target probability. When the composition of the portfolio changes, the required capital can
be determined by using the faster method and scaling it by the ratio. No other calculation is affected by
this substitution, and the allocated and total capital amounts will reflect the simulation-based required
capital.
In practice, the relationship between the Monte Carlo Simulation and Analytical Approximation remains
fairly constant for the types of changes that are likely to occur in a bank portfolio over a three-month
period of time. As a result, the Simulation/Approximation ratio can be computed once per month or once
per quarter. If there were large-scale changes to the portfolio, such as a purchase or sale of a substantial
amount (say, 5% or more) of the existing exposure, we recommend running the Monte Carlo Simulation
again in order to obtain the best possible estimate of required capital.
For most portfolios that we have tested, we find a close agreement between the Calculated Distribution
and the Monte Carlo Simulation. We also find that in most cases the Calculated Distribution is
sufficiently fast to be practical for everyday use. We therefore recommend that the Calculated Distribution
be the main workhorse for producing loss distributions in Portfolio Manager, with periodic benchmarking
against the full Monte Carlo Simulation. Of course, if the portfolio under analysis appears to meet the
assumptions of the more narrowly applicable Analytical Approximation (if benchmarks show very similar
output from the three methods), the Analytical Approximation can be used to produce a nearly
instantaneous picture of portfolio risk.
Figure 14.3 shows the loss distribution of a typical loan portfolio. The horizontal axis gives the fractional
capital. The vertical axis is the cumulative probability that losses will exceed that level of capital.
Portfolio Loss Distribution
0.0001
0.001
0.01
0.1
1
-0.05 -0.03 -0.01 0.01 0.03 0.05 0.07 0.09
Capital
P
r
o
b
a
b
i
l
i
t
y

L
o
s
s

>
=

C
a
p
i
t
a
l
Simulation
Analytical Approximation
FIGURE 14.3 Loss Distribution of a Typical Loan Portfolio
14.5 MODELING AGGREGATES
This feature in Portfolio Manager allows users to enter a set of homogeneous facilities as a single
facility. The option to model facilities as aggregates serves two purposes. The first allows for a
simplified data input process. The second purpose is to reduce computation time when Monte Carlo is
the chosen loss distribution method. The approximation that allows for faster computation relies on
the properties of the aggregate value distribution when the set of facilities is homogenous.
When a user inputs a set of facilities as an aggregate, they specify the effective and actual number of
loans under the Other Tab in the Exposure Details Table. The set of loans is treated as an aggregate if
the effective number of loans is greater than the cutoff (minimum of 100) specified under the Loss
Distribution Methods tab in Set Run Parameters. Otherwise, each effective loan is treated as any other
facility in the portfolio. The user can also force Portfolio Manager to model aggregates as individual
exposures under the Loss Distribution Methods tab in Set Run Parameters. It is worth mentioning that
the Actual number of loans does not influence statistics reported in the output tables.
When modeling a set of facilities as an aggregate, Portfolio Manager will first check if the effective
number of loans (n) is greater than specified cutoff. As with anysimulation run, Portfolio Manager
begins by simulating factor shocks. However, instead of simulating an idiosyncratic draw for the
obligor, Portfolio Manager computes a probability of default, conditional on the factor draws, in
addition to the conditional distribution of facility value in the non-default state. Since the no-default
value distributions are independent across obligors, conditional of the factor draws, the Central Limit
Theorem is used to approximate the aggregate value using a Normal distribution.
More specifically, for each trial t, the distribution of the number of defaulted obligors in the aggregate
is based on the expected CEDF
0,H
for each obligor j, conditional on the realized composite factor draw
(
j
). Formally, all obligor in the aggregate face the same composite Beta (
j
) and
j
, but different
idiosyncratic shocks , for a total asset draw of . Since a Normal distribution is
used, this conditional default probability can be written as:
(14.32)
After computing the conditional CEDFs to horizon (this will be different for each trial), the number of
facilities that default is determined by taking n random independent draws from a binomial distribution. If
n
D
, the number of defaulted obligors, is ten or fewer a separate Loss Given Default is simulated from a beta
distribution with a mean equal to LGDimplied by equation (9.1) on page 99and a variance based on
the chosen variance parameter (k). If more than ten facilities default, Portfolio Manager uses the Central
Limit Theorem to simulate the value of all the defaulted securities. Specifically, a random value is chosen
from a conditional normal distribution with a mean of
n
D
(1-LGD)RFVH and variance as follows.
(14.33)
j
r
j j j j
+
E CEDF N CEDF
N N CEDF
H j j j j j H j j
[ | ] Pr ( )|
[( (
,
-
,
-
0
1
0
1
0
[ + ]
=
,,
) )/ ]
H j j
j

n LGD LGD
k
D
( ) 1
Meanwhile, a Normal distribution can be used to approximate the value distribution of non-defaulted
facilities. This follows from an application of the Central Limit Theorem; each facility's horizon value
is identically, and independently distributed, conditional on the factor draws. Following this logic, the
total value distribution for non-defaulted facilities is approximately:
(14.34)
where and represent the conditional mean and variance of the no-
default facility value distribution. In each Monte Carlo trial, the aggregate value at horizon for
facilities that do not default is determined by a draw from this distribution.
To summarize, the option to model facilities as aggregates allows for a simplified data input process,
as well as reduction in computation time. The methodology that reduces computation time relies on
independence of the conditional value distribution for facilities in the aggregate. As a result, the
Central Limit Theorem can be applied, and the value of the non-defaulted aggregate has a conditional
distribution that is approximately Normal. For each trial, the value of the aggregate is computed by
adding the realized value from the non-defaulted facilities with the realized value of the defaulted
facilities.
To test the aggregate model we have compared results from simulations run with and without the
aggregation procedure. Figure 14.4 and Figure 14.5 compare the loss distributions from the two runs for a
portfolio consisting solely of one aggregate with 1,000 effective loans. The y-axis shows the probability that
the loss is larger than the given capital amount. (For details on the capital calculation, refer to the next
chapter.) The aggregate has an R-squared of 0.15 and an EDF value of 50 bp. The aggregate in Figure 14.4
has a maturity of one year, while the aggregate in Figure 14.5 has a maturity of 3 years; the horizon in both
cases was set to one year. The comparison shows excellent agreement between a simulation run (labeled
Detail in the graphs) where all exposures, including those loaded as aggregates, are treated individually
and a simulation run (labeled Aggregate Model in the graphs) where the aggregates are handled with an
approximation procedure.
In Figure 14.6 we compare results for a more typical loan portfolio. Again, we see excellent agreement
between the simulation with and without the aggregate approximation.
N n n E V n n
D H ND j j D H ND
j j
(( ) [ | ],( ) )
| | ,

2
E V
H ND j j
[ | ]
|

H ND
j j
| ,
2
FIGURE 14.4 Testing the Aggregate Approximation, 1-Year Maturity
0.0001
0.001
0.01
0.1
1
-0.05 -0.03 -0.01 0.01 0.03 0.05 0.07 0.09
Capital
P
r
o
b
a
b
i
l
i
t
y

(
L
o
s
s
>
=
C
a
p
i
t
a
l
)
Detail
Aggregate Model
FIGURE 14.5 Testing the Aggregate Approximation, 3-Year Maturity
0.0001
0.001
0.01
0.1
1
-0.05 -0.03 -0.01 0.01 0.03 0.05 0.07 0.09
Capital
P
r
o
b
a
b
i
l
i
t
y

(
L
o
s
s
>
=
C
a
p
i
t
a
l
)
Detail
Aggregate Model
FIGURE 14.6 Testing the Aggregate Approximation, Typical Portfolio
0.0001
0.001
0.01
0.1
1
-0.05 -0.03 -0.01 0.01 0.03 0.05 0.07 0.09
Capital
P
r
o
b
a
b
i
l
i
t
y

(
L
o
s
s
>
=
C
a
p
i
t
a
l
)
Detail
Aggregate Model
CHAPTER
15
CAPITAL DISTRIBUTION
Portfolios of credit-risky exposures have the potential of generating relatively large losses with small, but
not negligible, probabilities. On the other hand, the maximum return scenario is well-definedno
exposure is in default and every obligor upgrades to AAA. Most of the time the actual return will lie near
this upper bound. The result is the skewed or asymmetric distribution for the portfolio value at the horizon
shown in Figure 12.1.
The distribution has this skewed, long-tailed shape because of the correlations among default and credit
migration risks. If there is a severe downturn in the overall economy, many of the assets in the portfolio
will decline in quality, and the likelihood of multiple defaults will increase markedly. Although these
events are rare, they are unavoidable. All portfolios, no matter how well constructed, are ultimately subject
to these dynamics. However, the extent of this risk can be sharply reduced by diversification strategies.
The portfolio value distribution can be used to determine economic capital requirements. The objective of
economic capital is to absorb extreme losses. Presumably, reserves are held against expected losses and, in
some cases, the expected spread income can be used to cover losses beyond the expected loss. For a given
level of economic capital, there is a probability of suffering a loss large enough to use up all reserves, all
expected spread (if available), and all the capital. Capital exhaustion implies institutional failure: the
probability of consuming economic capital is equivalent to the default risk of the institution.
The capital at risk for a portfolio, C
p
, is defined as the loss that will be exceeded only with a given
probability (called the confidence level)
(15.1)
Thus, with probability 1 - , the portfolio will not lose more than C
p
(a positive currency amount) over the
indicated time horizon.
Capitalization Rate for the portfolio is simply the economic capital in currency units expressed as a
percentage of MTM value of the portfolio. Mathematically,
(15.2)
P C
p
( ) Loss >
CR
C
V
p
p
p
0
From this point in this chapter the superscript p on the portfolio capital or the portfolio Capitalization
Rate will be suppressed for notational clarity.
Loss, L, is defined, in general, with respect to a loss reference point, V
LP
, and hence Capital can be defined
as:
(15.3)
Capital must be set aside at time 0, so we need to estimate the capital in present value terms. As implied
above, the Capital Distribution presents Loss Distribution values discounted to the present using the risk-
free discount factor to horizon. This adjustment has the effect of contracting the x-axis by the risk-free rate.
Unless the horizon is very long, the graph of required capital will be substantially similar to the loss
distribution.
As mentioned above, some amount of cushion should already exist to absorb loss. At the very least, reserves
should be held against expected loss. If the expected spread income is not available to absorb losses, capital
should be calculated such that a cushion exists to cover losses in excess of expected loss. The equation for
capital to cover losses in excess of expected loss is as follows:
(15.4)
If expected spread income is also available to absorb losses, capital should be calculated such that a cushion
exists to cover losses in excess of total spread. (Recall that total spread to horizon equals expected spread to
horizon plus expected loss to horizon). In this case the loss reference point becomes the value at horizon of
the portfolio if it increased in value at the risk-free rate. The equation for capital to cover losses in excess of
the portfolios total spread is as follows:
(15.5)
In Figure 15.1 below we show how one case of capital (capital in excess of expected loss, C
EL
) can be read
from the loss distribution. The graph shows C
EL
to be the maximum value of the loss distribution (in
present value terms) below the target probability set of events. Similarly (not depicted), C
TS
is the
maximum value of the loss distribution (in present value terms) below the target probability set of events,
when losses are measured from the loss reference point of V
0
(1+R
H
)
H
; that is, when losses are measured
after the total spread to the horizon (TS
H
) times the initial value (V
0
) has already been lost over the
promised payments.
L V V
C L DF
LP H
H
R
f

C V R ES V DF L DF EL
H
H
H H
R
EL
H
R
f f
+ + ( )
,
]
]

0
1
C V R V DF L DF TS
H
H
H H
R
TS
H
R
f f
+ ( )
,
]
]

0
1
FIGURE 15.1 Portfolio Loss Distribution at Horizon Showing Capital in Excess of Expected Loss
In Figure 15.2 we present the (reversed) cumulative Capital Distribution graph from Portfolio Manager.
This corresponds to the present value of the right tail of the Loss graph shown in Figure 15.1. (Capital here
is expressed as a percentage of initial value and is calculated in excess of Expected Loss). We see that the
optimized portfolio requires less capital than the current portfolio. This is a reflection of the value
distribution graph: the optimized portfolio is much less likely to suffer extreme losses.
P
r
o
b
a
b
i
l
i
t
y
E[V
H
] = V
0
(1+R
H
+ES)
H
Target Probability
(e.g. 10 b.p.)
C
TS
(1+R
H
)
H
0
Portfolio Loss at Horizon (L
H
)
(ES
H
)(V
0
)
(TS
H
)(V
0
)
- (EL
H
)(V
0
)
FIGURE 15.2 The Capital Distribution
In Figure 15.3 below we show the two cases of capital as they relate to the value distribution of the
portfolio at horizon. Capital in excess of expected loss (C
EL
) measures the value difference (in present value
terms) between the expected value of the value distribution (E[V
H
]) and the value corresponding to the
target probability. That is, C
EL
measures the maximum loss that may occur (in present value terms) in all
except the target probability set of events, after expected loss to horizon, EL
H
, times the initial value, V
0,

has already been lost over the promised payments. Similarly, capital in excess of total spread (C
TS
)
measures the difference in value (in present value terms) between the risk-free-grown value at horizon,
V
0
(1+R
H
)
H
, and the value corresponding to the target probability. That is, C
TS
measures the maximum
loss that may occur (in present value terms) in all except the target probability set of events, after total
spread to the horizon, TS
H
, times the initial value, V
0
, has already been lost over the promised payments.
FIGURE 15.3 Portfolio Value Distribution at Horizon Showing Capital
H
)
P
r
o
b
a
b
i
l
i
t
y
E[V
H
]
Target Probability
(e.g. 10 b.p.)
C
EL
(1+R
H
)
H
C
TS
(1+R
H
)
H
V
0
(1+R
H
)
H
V
0
(1+R
H
+TS)
H
V
0
(1+R
H
+ES)
H
(EL
H
)(V
0
) (ES
H
)(V
0
)
(TS
H
)(V
0
)
CHAPTER
16
MEASURING RETURN/RISK
When taking on risk, investors demand some kind of return. Thus, it is meaningful to evaluate return only
in the context of the risk associated with the return. Reward-to-risk ratios are commonly used in the
financial literature to evaluate the performance of a financial instrument. Reward for bearing credit risk is,
more often than not, quoted in terms of the expected spread where the spread is calculated in excess of an
appropriate benchmark credit risk-free rate. While the reward or return measure is reasonably
straightforward to calculate, the risk measure presents more challenges. Two common characterizations of
the risk of a portfolio are the variability of portfolio value (UL) and the probability of insolvency (Tail
Risk). PM facilitates evaluation of the reward/risk trade-offs based on these two measures of risk.
Depending on the users objectives, both measures of risk may be relevant.
16.1 SHARPE RATIO
A frequently used measure for capturing the return to total variability trade-off is the Sharpe ratio which
compares an expected return with the volatility of that return. The Sharpe ratio possesses convenient
mathematical properties and is easy to interpret. PM defines portfolio return as the portfolios Expected
Spread (ES) to horizon paid by the exposures in the portfolio. Recall that the ES is net of the portfolios
Expected Loss. The volatility of the portfolio is defined as the portfolios Unexpected Loss (UL). Note that
the Expected Spread is an annualized number, whereas UL is not. UL cannot be annualized. Hence, one
needs to calculate the cumulative expected spread to horizon for use in the portfolio Sharpe ratio
calculation. Recall (from Chapter 9) that the Expected Spread to Horizon for exposure i and for portfolio,
p, is given by the following:
(16.1)
We will use an example (involving the same portfolio as used in the previous chapter) along with the
description of the concepts to demonstrate all of the calculations in this chapter. Figure 16.1 presents the
Portfolio Overview from PM for a sample portfolio of about 1,000 exposures. This portfolio contains the
types of exposures held by large global, commercial banks. We will be focusing on the numbers circled.
ES R ES R
ES w ES w V V
H
i
H
i
H
H
H
H
p
i
i
H
i
i
i
+ +
( )
+ ( )

1 1
0
and
where
00
1
i
i
j
(
,
\
,
(

FIGURE 16.1 Portfolio Overview
At the portfolio level, the Sharpe Ratio, (SR
p
), for the period time 0 to horizon, is given by the following:
(16.2)
On a graph of Expected Spread versus Unexpected Loss, the Sharpe ratio is the slope of the line that
connects the exposure or portfolio with the origin. Steeper lines represent more attractive reward/risk
ratios. It is important to emphasize that in this context the focus on UL is appropriate only at the portfolio
level. When we move to a discussion of individual exposure Sharpe ratios, we are interested in the post-
diversification risk of the exposure which will reflect the residual contribution to the portfolios overall risk.
SR
ES
UL
p H
p
p

20,138,055
52,191,847
0 38585 .
FIGURE 16.2 Sharpe Ratio in Risk/Return Space
In Figure 16.2, the x-axis shows UL (not Risk Contribution, RC, the post-diversification contribution to
portfolio risk), so the slopes for individual exposures do not reflect risk reduction from diversification. On
a stand-alone basis, exposure B is more attractive than exposure A. Possible combinations of A and B result
in points along the curved line. The Maximum Sharpe Ratio portfolio, the result of an optimization on the
weights of the two exposures, is more attractive than either A or B alone. This particular portfolio
represents the point along the curve (reflecting different combinations of A and B) with the maximum
slope to the origin.
Given that the individual unexpected losses do not add up to the unexpected loss of the portfolio, the
relevant Sharpe ratio for individual exposures in the context of a portfolio is the Expected Spread to
Horizon divided by the Risk Contribution. Consider the following exposure in Figure 16.3:
Sha rpe R a t i o s
UL
E
x
p
e
c
t
e
d

S
p
r
e
a
d
A
B
Max imum Shar pe Ratio Por tf olio
FIGURE 16.3 An Exposure Example for Risk/Return Trade-off
Mathematically, the Sharpe ratio of an exposure is defined as:
(16.3)
16.2 VASICEK RATIO
As stated earlier, one measure of portfolio risk is the variability of value and the other is the risk of
insolvency (tail risk). Thus, we construct another measure called the Vasicek ratio to capture the return to
tail risk
1
trade-off.
1
As mentioned in Chapter 15, PM allows a more general definition of this measure which allows for contribution to any interval on
the portfolio loss distribution. Most users will define the interval as some portion of the loss distribution tail; however, it may be
the case that a user will choose a different interval on the loss distribution. Despite the fact that a user may not necessarily define
the interval to reflect only tail-risk contribution, we will use the term tail risk to refer to all uses of this measure for ease of exposi-
tion.
SR
ES
RC
i H
i
i

0 001182
0 001083
1 091390
.
.
.
Before we define the Vasicek ratio, we should understand the difference between Tail Risk Contribution
(TRC
i
), and the Capitalization Rate (CR
i
) for an exposure i (see, Chapter 15). If the conditioning
expression in the TRC calculation is not an interval, but rather a specific point on the distribution, then
TRC
i
will equal CR
i
. Because it is difficult in a simulation with a reasonable number of iterations to realize
any particular point on a loss distribution, we must specify an interval even if it is a small interval around a
desired point. In this case, TRC
i
, in general, will not equal CR
i
. Furthermore, we are faced with the
problem that the weighted sum of all TRC
i
in the portfolio will not necessarily equal the overall portfolio
Capitalization Rate, CR
p
. Consequently, we must re-scale the TRC
i
and calculate a CR
i
. Ultimately, the
CR
i
will serve as our measure of risk, and thus, our denominator in the Vasicek ratio.
Clearly, the larger the tail risk of a portfolio, the larger the economic capital required to hedge against the
tail risk. Thus, at the portfolio level, the Capitalization Rate is a good proxy for measuring the tail risk.
The Vasicek ratio is simply the ratio of Expected Spread to Horizon and the Capitalization Rate
representing the amount of economic capital held against the total portfolio exposure. Thus, the Vasicek
ratio depends on how conservative one is in setting the economic capital. Based on the two measures of
capital used in PM, C
TS
and C
EL
, we get two Vasicek Ratios, VR
TS
and VR
EL
. Mathematically,
(16.4)
Note that in these calculations, the portfolio Capitalization Rate is simply the portfolio economic capital
expressed as a percentage of the mark-to-market value of the portfolio. Continuing with our example,
using Figure 16.1, we get:
(16.5)
Contribution of an individual exposure to the risk of insolvency for the whole portfolio is measured by the
Tail Risk Contribution (TRC
i
) of the exposure. As explained above, this measure may then need to be re-
scaled to arrive at the CR
i
for each exposure. Thus, we can determine the Vasicek ratio for each exposure as
follows:
(16.6)
VR
ES
CR
VR
ES
CR
TS
P H
P
TS
P EL
P H
P
EL
P
and
VR
ES
CR
TS
P H
P
TS
P

20,138,055
438,614,710
0 04591 .
VR
ES
CR
VR
ES
CR
TS
i H
i
TS
i EL
i H
i
EL
i
and
It should be noted that the weighted sum of exposure Capitalization Rate adds up to the portfolio
Capitalization Rate. Continuing with our example, a Vasicek ratio of this exposure (Figure 16.3) is
calculated as:
(16.7)
16.3 MISPRICING
In an appropriately optimized portfolio, the weights on individual exposures are such that all of the
individual reward to risk ratios are equal. Consider a portfolio which is optimized to yield a maximum
Sharpe ratio. It must be the case that the Sharpe ratios on individual exposures in this portfolio are all
equal to the Sharpe ratio of the portfolio. If this were not the case, it would be possible to increase portfolio
Expected Spread to Horizon without changing portfolio UL by shifting weights away from exposures with
Sharpe ratios below the portfolio average towards exposures with Sharpe ratios above the portfolio average.
Parallel reasoning would imply that for a portfolio optimized to yield a maximum Vasicek ratio, all the
individual exposures will have the same Vasicek ratio as the portfolio.
One possible definition of mispricing in the portfolio context concerns the extent to which an exposures
reward/risk measure deviates from the portfolios reward/risk measure. In PM we use this definition of
mispricing to characterize exposures that are more or less attractive for a particular portfolio. To elaborate,
if an exposures reward-to-risk (e.g. Sharpe) ratio is higher than that of the portfolio, this exposure can be
said to be more attractive for this portfolio reflecting a positive mispricing. Hence, one can obtain better
reward/risk ratios for the portfolio by increasing concentration in positively mispriced securities and selling
down negatively mispriced securities. In an appropriately optimized portfolio all exposures should have
zero mispricing. Mispricing depends on whether one uses risk contribution or tail risk contribution to
measure an exposures risk.
16.3.1 Risk Contribution Based Mispricing or Sharpe-Mispricing
In order to determine mispricing with respect to the portfolio, we need to choose a particular definition of
risk. Let us start with the case where we define risk as RC or contribution to the portfolio UL. We calculate
the degree to which the exposures ES needs to change so that the exposures Sharpe ratio equals the
portfolio Sharpe ratio. Hence, we define RC-based mispricing or Sharpe-Mispricing as follows:
(16.8)
Rearranging the previous equation we see another way of characterizing Sharpe-Mispricing:
(16.9)
VR
ES
CR
TS
i H
i
TS
i

0 001182 .
0.011822
=0.099972
MP RC
ES
RC
ES
UL
RC
i i H
i
i
H
p
p

,
,
,
]
]
]
]
0 001083
0 001182
0 00108
.
.
. 33
0 00150
0 00389
0 000764
,
,
]
]
]

.
.
.
ES MP
RC
ES
UL
H
i
RC
i
i
H
p
p

Thus, in this context, we interpret Sharpe-Mispricing as the change in spread required to equate the
Sharpe ratio of the exposure with the Sharpe ratio of the portfolio.
FIGURE 16.4 Sharpe-Mispricing Graph
Figure 16.4 shows the RC-based Mispricing or Sharpe-Mispricing graph in PM. The upright triangles ()
indicate exposures with Sharpe-Mispricing near zero. The slope of the line described by these exposures is
the portfolio Sharpe ratio.
The squares above and to the left of the upright triangles are positively mispriced exposures; increasing the
weights of these exposures would improve the portfolio Sharpe ratio. The diamonds to the right of the
inverted triangles are negatively mispriced; decreasing the weights of these exposures would also improve
the portfolio Sharpe ratio.
Note that mispricing is calculated for the period up until horizon. The annualized value of Sharpe-
Mispricing, for exposure, i, , is calculated as follows:
(16.10)
MPRC
i
MP MP R R RC
i
RC
i
H
H
H
H
+ +
( )
( ) 1 1
1
The continuously compounded value of this Sharpe-Mispricing equation is given by:
(16.11)
Other measures of Sharpe-Mispricing are annualized in a manner similar to these two methods.
16.3.2 Tail Risk Contribution Based Mispricing or Vasicek-Mispricing
The other risk measure in PM focuses on contribution to a portion of the portfolio loss distribution. We
use this measure of Tail Risk Contribution (TRC) to determine the Capitalization Rate (CR) for each
exposure. Using these measures, we can compare Vasicek ratio of an exposure with the Vasicek ratio of the
portfolio to determine Vasicek-Mispricing as follows:
(16.12)
(16.13)
Once again, rearranging the above equations results in another characterization of Vasicek-Mispricing:
(16.14)
MP
H
MP e r RC
i
RC
i r H
H
H
+
( )
1
ln
MP CR
ES
CR
ES
CR
TRC TS
i
TS
i H
i
TS
i
H
p
TS
p ( )
.
.

,
,
]
]
]

0 011822
0 0011182
0 011822
0 00150
0 03271
0 000639
.
.
.
.
,
]
]
]
and
MP CR
ES
CR
ES
CR
TRC EL
i
EL
i H
i
EL
i
H
p
EL
p ( )

,
,
]
]
]

ES MP
CR
ES
C
ES MP
CR
ES
H
i
TRC TS
i
TS
i
H
p
TS
P
H
i
TRC EL
i
EL
i
H
( ) ( )
and
pp
EL
P
C
FIGURE 16.5 Vasicek-Mispricing Graph
Figure 16.5 shows the TRC-based Mispricing or Vasicek-Mispricing graph in PM. The upright triangles
() indicate exposures with Vasicek-Mispricing near zero. The slope of the line described by these
exposures is the portfolio Vasicek ratio.
The weighted sum of all the Vasicek-Mispricings in a portfolio must be zero. The equations below show
this result in the context of a particular TRC-based mispricing. Clearly, the same reasoning applies to the
other Mispricing measures.
(16.15)
16.4 REQUIRED SPREAD
Recall (from Chapter 9) that the Total Spread to Horizon (TS
H
) is defined by:
(16.16)
w MP wCR
ES
CR
ES
CR
w ES
i TRC TS
i
i TS
i H
i
TS
i
H
p
TS
P
i i
i
i
H
( )

j
(
,
\
,
(
ii H
p
TS
P i
i
TS
i
H
p H
p
TS
P
TS
P
ES
CR
w CR
ES
ES
CR
CR

0
TS R TS R
H
i
H
i
H
H
H
+ +
( )
+ ( ) 1 1
Required Spread (RS) is defined as the Total Spread to Horizon (TS
H
) less Mispricing. Thus, depending
on the particular measure of mispricing used, we define RS as follows:
(16.17)
Exposures whose TS
H
exceeds their RS offer better return/risk ratios than the average exposure in the
portfolio (i.e. they exhibit positive mispricing). Required Expected Spread (RES) is the spread necessary to
equate the exposures return/risk ratio with the portfolio return/risk ratio. Consider, for example, a RC-
based Required Expected Spread,
(16.18)
Similarly, The Required Expected Spreads based on Tail Risk Contribution are given by:
(16.19)
Thus, RES is RS net of Expected Loss to Horizon (EL
H
). The Required Spread vs. Weight graph ties
together Mispricing, Required Spread, and optimization.
RS TS MP
RS TS
RC
i
H
i
RC
i
TRC TS
i
H
i

0 001568 0 000764 0 000804 . . .

( )

MP
RS TS MP
TRC TS
i
TRC EL
i
H
i
T
( )
( )
. . . 0 001568 0 000639 0 000929
RRC EL
i
( )
RES
RC
ES
UL
RES
ES
UL
RC
ES MP
TS EL
RC
i
i
H
p
p
RC
i H
p
p
i
H
i
RC
i
H
i
H
i

( ))
. . .

MP
RS EL
RC
i
RC
i
H
i
0 000804 0 000386 0 000418
RES RS EL
TRC TS
i
TRC TS
i
H
i
( ) ( )
. . . ; 0 000929 0 000386 0 000543 aand
RES RS EL
TRC EL
i
TRC EL
i
H
i
( ) ( )

FIGURE 16.6 Required Spread vs. Weight
The curve in Figure 16.6 shows RS as a function of the exposures weight in the portfolio. Exposures that
lie above the curve are positively mispriced and attractive to the portfolio optimizer. Note that as the
weight of the exposure increases, RS increases at an increasing rate.
Note also that RS is calculated for the period up until horizon. The annualized value of the RS for exposure
i based on RC, , is calculated as follows:
(16.20)
The continuously compounded value of RS is given by:
(16.21)
Other RS measures are annualized in a similar manner.
16.5 RETURN ON RISK ADJUSTED CAPITAL
Another return-to-risk ratio of interest is the Return on Risk-Adjusted Capital (RORAC). This measure is
related to a popular measure known as Risk-Adjusted Return on Capital (RAROC). In PM, we focus on
calculating capital such that an intuitive measure of risk can be placed alongside an intuitive measure of
RSRC
i
RS RS R R RC
i
RC
i
H
H
H
H
+ +
( )
( ) 1 1
1
RS
H
RS e r RC
i
RC
i r H
H
H
+
( )
1
ln
return to arrive at a useful measure of return on capital. Since capital is the output reflecting an adjustment
for risk, we define the output as RORAC. One could argue that we also adjust our return measure by
subtracting EL from the total spread earned by the exposure; however, we do not view EL as a measure of
risk. As a consequence, we do not call the measure Risk-Adjusted Return on Risk-Adjusted Capital
(RARORAC). In the case of individual exposures analyzed within PM, RORAC is defined as the Expected
Spread to Horizon divided by the Capitalization Rate for an exposure, plus the risk-free return to horizon.
We add the risk-free return to horizon since we are not placing any capital at risk to earn that portion of
the return. There are several ways to calculate individual exposure capital in PM. Thus, we have different
measures of RORAC.
16.5.1 Risk Contribution based RORAC
RC-based RORAC or Sharpe-RORAC numbers are obtained when RC is used to determine the CR of an
exposure. More specifically in the context of the output listed in Figure 16.5 the calculation is as follows
(note that H=1 in the current example):
(16.22)
and
(16.23)
Note that RORAC is calculated for the period up until horizon. The annualized value of Sharpe-RORAC,
for exposure i, where capital is calculated to cover losses in excess of Total Spread, , is
calculated as follows:
(16.24)
The continuously compounded value of Sharpe-RORAC is given by the following:
(16.25)
Other Sharpe-RORAC measures are annualized in a similar manner.
RORAC
ES
CR
R
RC TS
i
i
RC TS
i H
H
( )
( )
.
.
. + + ( ) + 1 1
0 001182
0 009101
0 05 00 179867 .
RORAC
ES
CR
R
RC EL
i
i
RC EL
i H
H
( )
( )
+ + ( ) 1 1
RORACRC TS
i
( )
RORAC RORAC RC TS
i
RC TS
i
H
( )
( )
+
( )
1 1
1
RORAC
H
RORAC RC TS
i
RC TS
i
( )
( )
ln +
( )
1
1
16.5.2 Tail Risk Contribution based RORAC
TRC-based RORAC or Vasicek-RORAC numbers are obtained when TRC is used to determine the
Capitalization Rates of an exposure. The mathematical expressions can be written as follows:
(16.26)
and
(16.27)
These measures are also annualized in the manner explained above.
16.6 CONCLUSION
This chapter has identified a variety of measures characterizing an exposures return per unit of risk. A
natural question to ask is: Which measure is appropriate in which circumstances? At this stage, we do not
have strong theoretical guidance in this respect. Focusing on contribution to UL via RC may be more
appropriate for pricing since it seems intuitively reasonable to assume the volatility of value is most
important to the shareholders who ultimately own the institutions portfolio. On the other hand, focusing
on contribution to tail events on the portfolio loss distribution via TRC may be more appropriate for
sorting out exposures that present particular danger to the portfolios solvency. PM users should make use
of the various reward-to-risk measures to develop a more complete picture of each exposures behavior in
the context of the portfolio. As we develop more understanding from both a theoretical and empirical
perspective, we will be able to make stronger statements about how best to measure and manage a
portfolio. In the meantime, PM facilitates this investigation.
Once we have identified return per unit risk at both the portfolio and individual exposure level, we
naturally turn to the question of portfolio improvement. That is, now that we have identified relative
attractiveness of exposures, what do we do? Subject to the caveat that we still have an incomplete
understanding of the reward-to-risk measures, the next chapter presents some ideas around strategies for
improving portfolio performance.
RORAC
ES
CR
R
TRC TS
i H
i
TRC TS
i H
H
( )
( )
.
.
. + + ( ) + 1 1
0 001182
0 011822
0 005 0 149972 .
RORAC
ES
CR
R
TRC EL
i H
i
TRC EL
i H
H
( )
( )
+ + ( ) 1 1
CHAPTER
17
OPTIMIZATION
PM provides a flexible set of optimization tools for evaluating individual transactions, groups of possible
transactions, or a global realignment of the portfolio. The process of seeking performance improvement in
large-scale portfolios is complex because of the difficulties in evaluating the myriad of risk interactions.
Optimizers play a critical role in sorting out these interactions and highlight opportunities for improving
diversification and return. An optimization tool should be interpreted as a source of guidance in the
portfolio management process, rather than as a fly by wire solution to the problem of portfolio
management.
There are two basic optimization routines in PM. First, the Trades optimization routine, produces a
recommended buy or sell amount for exposures marked as tradable. Tradable exposures must include
constraints on the quantity available for purchase or sale. The Trades optimization routine produces
guidelines for action on specific transaction opportunities. Second, the Global optimization routine
assumes that all exposures are tradable: its output is a new set of portfolio weights that sum to the current
portfolio exposure. The Global optimization routine produces a hypothetical optimal portfolio; it is
designed to suggest the scope of possible benefits of portfolio diversification available from a reweighting of
the current set of exposures.
Optimization requires prices. When there are real transaction opportunities, the Trades optimization
routine can be used. Ideally, the user should input actual quantities and prices. Hypothetical trades can
also be analyzed. The Global optimization routine takes user-specified valuations as tradable prices. These
may be par values, mark-to-model values, or direct user-input prices.
Both routines employ quadratic (second-order, or mean-variance) optimization to produce the maximum
Sharpe ratio for a given level of risk. However, PMs algorithm incorporates adjustments to more classical
quadratic optimization procedures in order to deal with the difficulties commonly encountered when
optimizing credit portfolios. The optimization routine is driven by Expected Spread (ES), portfolio weight,
and Risk Contribution (RC). That is, the relationship of ES and RC is used to determine exposure weights
such that the overall portfolio Sharpe ratio (ES/UL) is maximized. Alternatively, the optimizer can find
weights to maximize ES holding UL at its current level or minimize UL holding ES at its current level.
17.1 QUADRATIC OPTIMIZATION
The quadratic portfolio optimization process maximizes portfolio expected return subject to three
constraints: a constant portfolio variance, the portfolio weights sum to one, and upper and lower bound
constraints for individual exposures:
(17.1)
subject to
(17.2)
and
(17.3)
The optimality conditions maximize return for a given Portfolio UL. Because the portfolio value
distribution is skewed and long-tailed, its shape is not fully specified by first- and second-order measures:
two portfolios with the same ES and UL (and consequently, identical Sharpe ratios) can have different
probabilities of large losses.
To date, this problem has admitted no simple solution, despite some three decades of academic study and
untold efforts by finance practitioners. The portfolio management framework due to Markowitz relies on
quadratic risk measures: variances and covariances. Higher-order risk measures for portfolios are available
only at the cost of significant computation time; higher-order measures for individual exposures in the
context of a portfolio are currently impractical. The optimization framework implemented in PM is in the
spirit of Markowitz: RC is a covariance measure; UL is a variance measure.
For portfolios consisting of approximately equally weighted exposures, we have found that RC provides a
good measure of incremental risk. With the addition of the TRC measure, we now have other choices with
which to analyze incremental risk. We encourage the user to experiment with these alternatives. We
continue to work on the theoretical implications of the TRC in the optimization context.
Currently, RC is the only available measure to use in conjunction with PMs optimization routines to
arrive at recommended exposure weights. The exposure weights after optimization, however, may be quite
disparate. In such cases, RC can fail to provide an accurate measure of the contribution to tail risk. As the
portfolio departs from approximately uniform weights, the rate of increase in tail risk is progressively
understated by RC. This makes it necessary to modify the quadratic optimization process so that the
optimal portfolios have small probabilities of extreme losses as well as large Sharpe ratios. In the future, we
expect to use the TRC measure to understand this degree of understatement in tail risk by the RC measure.
max
w
i H
i
i
i
w ES
p
i
i
c
w
2
1
w w w
i i i
+

minimum
holding
maximum
holding

Given our current level of understanding, the modifications explained below are a good start at developing
robust optimization routines.
To deal with issues of speed and contribution to tail risk, we have modified the standard quadratic
optimization algorithms. These modifications include soft constraints which correct for the risk of
extreme portfolio outcomes. As a result, the optimized portfolios may not satisfy the zero Mispricing
condition exactly.
17.2 OPTIMIZATION DIRECTION
An efficient or optimized portfolio has the maximum return for a given level of risk, or, equivalently, the
minimum risk for a given level of return. In Figure 17.1, efficient portfolios lie along the curve labeled
Efficient Frontier. All portfolios that can be constructed by rearranging the current portfolio weights lie
on or below the theoretical Efficient Frontier (EF). Improving a portfolio means obtaining more return
and less risk, or moving up and to the left. Optimized portfolios lie along the EF; no feasible portfolios lie
above and to the left of the EF. Delineating the theoretical EF is computationally overwhelming. PM
sketches the EF using the three optimal portfolios as reference points.
FIGURE 17.1 Optimization Targets
Optimization Directions
ULp
E
x
p
e
c
t
e
d

S
p
r
e
a
d
Max Sharpe
Less Risk
M
o
r
e

R
e
t
u
r
n
Same Return
Same Risk
Current Portf olio
Ef f icient Frontier
PM offers three choices for the direction of the optimization; Same Risk, Max Sharpe, and Same Return:
The three optimized portfolios have different Sharpe ratios, but each is efficient.
In efficient portfolios, the Sharpe ratio of each exposure is the same. If this were not the case, the portfolio
Sharpe ratio could be improved by selling (buying) exposures with Sharpe Ratios lower (higher) than the
portfolio Sharpe Ratio. If all exposures have the same Sharpe Ratio, then each exposure has zero
Mispricing.
In the presence of buy or sell constraints on particular exposures (e.g. liquidity), it may not be possible to
align the Sharpe ratio of an exposure with the Sharpe ratio of the portfolio. We can imagine cases in which
exposures available for purchase are so attractive from a mean-variance perspective that the optimization
algorithm would like to purchase more than is on offer in the market. In this case, the constraint is
binding. These binding constraints exercise some influence on the optimal quantity of all exposures in the
portfolio.
17.3 TRADES OPTIMIZATION
The process of debt portfolio management is incremental. The entire portfolio cannot be transformed
overnight. Fortunately, because correlations between credit instruments are small, a series of incremental
transactions can lead to substantial improvement in the return-to-risk profile of the portfolio over time.
The Trades optimization routine is designed to evaluate specific transaction opportunities in the context of
the existing portfolio. This process is subject to a variety of practical constraints. The primary constraint is
liquidity in the credit markets. Most exposures will have constraints on the amount available for purchase
or sale. Other restrictions might arise from investment banking agreements or relationship issues.
The Trades optimization routine is designed to deal with these circumstances. Liquidity constraints can be
entered into the model. Other constraints can be evaluated by looking at the implicit cost of holding more
or less than the optimal quantity.
For instance, a common problem for a financial institution is to decide how much to hold from new
originations, and how much to sell or syndicate. The Trades optimization routine can be used to calculate
the best hold levels in terms of maximum improvement for the current portfolio. It calculates these levels
subject to minimum and maximum holdings. If there are other practical reasons for choosing a different
quantity to hold, the software can calculate the implicit cost of deviating from the optimal holding. PM
can also be used to evaluate the choice between different tranches of a particular deal or to compare bonds
or notes with a loan to the same obligor.
TABLE 17.1 Optimization Directions
Same Risk Produces the maximum possible return (ES) with the UL of
the optimized portfolio equal to the current portfolio UL.
Same Return Produces the minimum possible risk (UL) with the ES of the
optimized portfolio equal to the current portfolio ES.
Max Sharpe Produces the maximum possible portfolio Sharpe ratio (ES/
UL). The Max Sharpe ratio portfolio typically has both less
risk and more return than the current portfolio and can be
expected to lie between the Same Risk and Same Return
portfolios on the efficient frontier.
Another common situation faced by credit portfolio managers is deterioration in credit quality
accompanied by a decline in the price of the exposure. The appropriate action cannot usually be
determined by reference solely to the change in risk. It is possible that the price decline has created a
buying opportunity. The Trades optimization routine evaluates such opportunities.
The Trades optimization routine reports recommended buy or sell amounts and the resultant changes to
portfolio ES and UL. The marginal Sharpe ratio for the trades is calculated from these changes. Since the
trade portfolio is typically small relative to the Current Portfolio, even transactions with very good
marginal economics will generally have a small impact on the portfolio Sharpe Ratio. Improving the
portfolio as a whole requires a concerted optimization effort over time.
17.4 PORTFOLIO GLOBAL OPTIMIZATION
In contrast to the Trades optimization routine, the Global optimization routine is not designed to
recommend actual transactions. It is a strategic rather than a tactical tool and is intended to reveal the
characteristics of an efficiently constructed portfolio. Global optimization produces a hypothetical optimal
portfolio which can be used to explore the full range of alternative exposure weights, and thus to help chart
the direction of the portfolio management process.
The methodology for the Portfolio Global optimization routine is identical to the Trades optimization
routine, except that all individual exposures are liquid. The Global optimization process does not,
however, allow net short positions.
The current Global optimization routine uses mark-to-model prices (see Chapter 7 for details on
valuation). Because these are not market prices, the optimized weights indicate general direction rather
than specific action. And because there is no upper bound on individual exposure weights, the Global
optimization routine may recommend purchases in quantities that exceed the available liquidity in the
market.
17.5 AGGREGATE EXPOSURES
Optimization is not well defined for aggregates. Increasing exposure to an aggregate could take the form of
increasing either the number of exposures or the average borrowing for each exposure. These two effects
are different. Change in either will generally result in a shift in the characteristics of the exposures, and thus
of the aggregate.
Aggregate exposures are excluded from the liquid portfolio in both the Trades and Portfolio Global
optimization routines. However, the Sharpe ratio of an aggregate exposure can be compared with the
portfolio Sharpe ratio in order to indicate the direction and magnitude of desirable changes in exposure to
the aggregate.
17.6 CONCLUSION
Because the optimization of a credit portfolio presents both theoretical and practical difficulties, the results
from PM should be a starting point for thinking about how best to improve a portfolio. The addition of
the TRC provides another point of reference as decisions are made about which exposures constitute
opportunities and which exposures constitute problems. In heterogeneous portfolios, the Global
optimization routine will have a tendency to cherry-pick the best exposures from a return-to-risk
perspective. The resulting portfolios will sometimes have an unreasonably small number of exposures. The
adjustments included in the optimization algorithm are designed to counteract this tendency. The user
should also consider setting all exposures available to trade with suitable constraints on buy and sell
amounts. Running the Trades optimization routine in this way will also generate a globally constrained
optimal portfolio. The presence of constraints on each exposure eliminates the cherry-picking problem.
Unfortunately, this strategy may produce a portfolio defined only by the trade constraints; regardless, it
will produce another global view for the portfolio useful for making strategic decisions about what business
opportunities to pursue and what opportunities to avoid. In many cases, this constrained global
optimization will produce attractive portfolios with reasonable looking suggestions for portfolio
adjustments.
While many issues remain unresolved around optimizing a credit portfolio, PM provides several tools for
gaining insight into strategies for improving portfolio performance. Users are encouraged to experiment
with both the Global optimization and Trades optimization routine to develop intuition around where a
portfolio can be changed for the better. The Portfolio Viewer tool provides a nearly limitless number of
reports to understand the impact of these strategies. Comparing the resulting exposure Sharpe and Vasicek
ratios of portfolios adjusted based on the optimization routines produces a clearer picture of what to do.
MKMV looks forward to the insight generated by clients using these tools to investigate their portfolios.
All of us working together on these issues will continue to expand our understanding of the strategies best
suited for efficient credit portfolio management.
APPENDIX A
UNDERSTANDING EXPOSURE PROFILE CALCULATIONS
For many types of financial securities or contracts, the amount at risk at each point in time can be specified
in advance. However, the nature of some contracts (i.e., derivative contracts) is that they require an
unknown future payment, whose size (and sign) will depend up the outcome of certain market variables
that are not known in advance. At any point in time, the exposure is a potentially random market value (or
equivalently, the replacement cost) of the security or contract. Exposure Profiles allow users to account for
credit risk associated with an arbitrary contract. At each point in time, users are requiring to define non-
random exposure amounts, that can be substituted for the random exposures to obtain a reasonable
approximation to the credit risk for the derivative contract.
Users will need to generate the profile from another system. For instruments with stochastic exposure such
as market derivatives, another system will be needed to calculate exposure distributions at each payment
date between the as-of date and the maturity date. Moreover, for each counterparty, the exposures at the
instrument level must be aggregated using netting and collateral provisions, before the exposure profile is
calculated.
Depending on the objective, the Exposure Profile can be populated with different values from the exposure
distribution. If the objective is to estimate a reasonable as-of date value, the Exposure Profile can be
populated with the expected exposure level at each payment date. Depending on the sign of the expected
exposure, the user can populate either the positive or negative exposure column. Note that using expected
exposure levels in the exposure profile reflects the assumption that the instrument will follow the exposure
path over time without deviation. This assumption simplifies the actual circumstances where the exposure
path is uncertain. Consequently, using expected exposure understates the risk calculations. Notice that a
more accurate (and complicated) approach would entail populating both the positive and negative
exposure column at each payment date. The two values can represent the expected marginal positive and
negative exposures; the expected marginal represents the conditional expectation times the probability of
the conditioning event. This approach provides a more accurate distinction between credit risk associated
with the counterparty, and credit risk associated with the user.
An alternative approach that can provide a more accurate assessment of the credit risk associated with the
Exposure Profile is to populate exposure values with points from the exposure value distributions. For
example, cane choose a particular percentile (e.g. 95th) reflecting a conservative view with respect to future
credit risk exposure. Once again, the user can enter a marginal percentile in each of the positive and
negative exposure columns. Yet another approach is to use effective exposure. In this case the user must
determine the exposure that best characterizes the credit risk exposure of the instrument. In some cases this
can be approximated by the expected exposure plus a fraction of the standard deviation of the exposure.
(Note that this is just another percentile choice on the exposure value distribution.)
The remainder of this appendix describes the methodology used by PM in analyzing Exposure Profiles.
1
A.1 VALUATION AT TIME ZERO
Recall that the value at time zero of an exposure is given by:
(A.1)
Thus, the value of an exposure is its Credit Risk-free Value, X
0
, minus the expected loss (under quasi-
probabilities). X
0
could also be thought of as the exposure at time 0. It may be worthwhile to
differentiate between this (derivative) exposure and the (loan) exposure we have used in most of this book.
The (loan) exposure term used earlier was simply the Usage Given Default times the commitment amount.
To generalize the concept, we define the value of the exposure at time t, X
t
:
(A.2)
where E
t
[.] denotes the conditional expectation with respect to the state at time t. From equation (A.2),
and the fact that the exposure is zero after maturity, it follows that
(A.3)
Substituting equation (A.3) in equation (A.1), we get:
(A.4)
When exposures are not always positive, i.e., when the facility may become either an asset or a liability, our
generalization to the valuation is to replace the expected exposures in the expected loss term by the
expected value of the positive part of the exposures, which yields:
1
In some cases Custom facility types are treated as Exposure Profiles. Specifically, when the resulting promised cash flows (principle
and interest) change signs across time.
V LGD C DF LGD C DF CQDF
C DF LG
t t
R
t
t t
R
t
t
t t
R
f f
f
0
0 0
1 1
1
+

( ) ( )
( DD CQDF
X C DF LGD CQDF
t
t
t t
R
t
t
f
)
0
0
0
X DF DF E C
t t
R
s
R
t s
s t
f f
( )
[ ]
1
DF C DF X DF E X
t
R
t t
R
t t
R
t t
f f f
[ ]
+ + 1 1
V X DF E X DF E X LGD CQDF
X DF E
t
R
t t
R
t t
t
t
t
R
f f
f
0 0 1 1
0
0
[ ] [ ]
( )

+ +
XX LGD CQDF CQDF

t t
t
t
[ ]
>

( )
0
1
(A.5)
We note that the model is not symmetric, in the sense that the value of the deal from the point of view of
the counterparty is not negative of the value from the point of view of the user. To make the model
symmetric, we make the adjustment which takes into account the counterpartys exposure to the user as
follows:
(A.6)
where the superscripts CP and US refer to the counterparty and the user respectively. The risk-free market
exposures, X
t
, are accounted for from the users point of view. Using this approach, the valuation becomes
symmetric, in that the value of the deal from point of view of the counterparty is exactly V
0
:
(A.7)
For brevity, we will use the following notation:
(A.8)
Example: The formulas become simpler when the present values of the exposures are constant and positive.
This corresponds to the case of a zero-coupon bond that pays a principal amount X at the maturity T. In
this case, the time T exposure is X, and the Credit Risk-free Value is:
(A.9)
In this case, the value at time zero is given by
(A.10)
V X DF LGD CQDF CQDF E X
E X E
t
R
t
t
t t
t
f
0 0
0
1
( )
( )
>
+
+
( )
max

where ( ( , ) 0 X
t
[ ]
V X DF LGD CQDF CQDF E X
DF LGD
t
R
US
t
US
t
US
t
t
t
R
CP
f
f
0 0 1
0
+
( )
( )
>
+
CCQDF CQDF E X
t
CP
t
CP
t
t
( )
( )
+
>
1
0
+
( )
( )
+
>
V X e LGD CQDF CQDF E X

e LGD
r t CP
t
CP
t
CP
t
t
r t U
t
t
0 0 1
0
SS
t
US
t
US
t
t
CQDF CQDF E X
( )
( )
>
+
1
0
T
US
t
R
US
t
US
t
US
t
t T
T
CP
t
R
DF LGD CQDF CQDF E X
DF LG
f
f

( )
( )
+
>
1
DD CQDF CQDF E X
CP
t
CP
t
CP
t
t T
( )
( )
+
>
1
X DF X
T
R
f
0

V X DF LGD CQDF
T
R
T
f
0
1 ( )
A.2 VALUATION AT HORIZON
Conditional on non-default state at horizon, the valuation, is given by
(A.11)
We stress the fact that the formula does not represent an expected value, but a specific value corresponding
to the market or credit state at horizon. For instance, the first term describes the default free value at
horizon including the reinvested value of realized cash flows before horizon. The second term describes the
expected loss conditioned on the state at horizon. It contains risk-neutral default probabilities at horizon
which depend on the credit state at horizon, and expected exposure profiles from horizon to maturity.
Conditional on the default state at horizon, the valuation is given by
(A.12)
The last term, which is the loss given default occurred before horizon, includes the probabilities that reflect
the uncertainty of when the default occurred.
It is worth pointing out that the users default risk is not taken into account. Valuation at horizon only
considers the counterpartys default risk. Horizon values should therefore be interpreted as the horizon
value, conditional on the user not defaulting.
V DF X LGD DF CQDF CQDF E
H ND H
R
H
US CP
t
R
H t
CP
H t
CP f f
| , ,
( )
+
( )
1
0 1
XX
t
t H
( )
,
,
>
V DF X LGD DF
CQDF CQDF
CQDF
H D H
R
H
US CP
t
R
t
CP
t
CP
H
CP
f f
|

( )
+
j
(
1
0
1
,,
\
,
(
( )
,
,
,
]
]
]
]
+
E X
t
t H
A.3 EFFECTIVE INITIAL VALUE AND SPREADS
For traditional exposures, we use the concept of return as the change in the value of the exposure expressed
as a percentage of initial value, V
0
. This definition makes sense for loans and bonds, for which the value at
time zero is positive and represents the actual investment cost. For derivative exposures, however, using the
same concept may not make sense because the initial value, V
0
, may be zero. To get around this problem
we define an Effective Initial Value (i.e., a norm) used to normalize statistics.
We use the following definition of Expected Spread to Horizon (unannualized) for derivative exposures:
(A.13)
where the denominator, the Effective Initial Value, is either the maximum or the average exposure over the
lifetime of the facility:
(A.14)
Similarly, we define Total Spread to Horizon (unannualized) for derivative exposures as:
(A.15)
Notice that when , the definitions for spreads match those defined in Chapter 8 for classical
facilities. Maintaining the structure in Chapter 8, we define annualized Expected and Total Spreads as:
(A.16)
Meanwhile, Expected Loss is defined using the equations in Chapter 8.
ES
E V V DF
V
H
H H
RR
( )
( )
0
1
0
V E X e e
V
s
s s
r s
s
US
r s
s
CP
i
i i
s
i
i
i
s
i
i
i
0 0
0
( )
+
,
]
]
>
+
max or
ss e E X e e
s s
i
r s
s
r s
s
US
r s
s
CP
s
i
s
i
i
i
s
i
i
i
s
i
i
i
i
+
>
( ) ( )
+
,
]
]
1
0

ii
r s
s
e
s
i
i
i
>
( )
1
0
TS
E V V DF
V
H
H H
RR
( )
( )
0
1
0
V V
0 0
ES DF ES DF
TS DF TS
H
RR
H
H
H
RR
H
H
RR
H
,
]
]
+
( )
,
]
]
,
]
]
+
( )

1
1
1
1
1
/
/
//
/
H
H
RR
H
DF ,
]
]
1
A.4 MEASURING RISK
When it comes to measuring risk, it is also necessary to make sure that the formulation developed in
Chapter 13 is well defined for Exposure Profiles. Looking at the definition for Risk Contribution,
equation (13.1) is well defined for Exposure Profiles, if the weights are based on Effective Initial Values.
However, the definition for TRC in equation (13.4) needs to be adjusted. Specifically, TRC for facility i
will now represent the change in capital for an associated marginal ( ) increase in exposure, ,
at every point in time. Notice that increase by a factor of 1+ as well. For example,
working through for :
(A.17)
TRC is now defined as follows:
(A.18)
More specifically, when capital is in measured in excess of TS, the Loss Reference Point (LP) is defined as
, and TRC is defined as:
(A.19)
i
X
t
i i
( ) 1+
V V H
i
i
and
0

i
V
i
0
X DF E X LGD CQDF CQDF
X
i i
t
edf i i
t
t
t
t 0
1 1
0
0
1
( ) ( ) ( ) + + ,
]
]

>

00
0
0
1
1
i
t
edf i
t
t
t
i
DF E X LGD CQDF CQDF
V
t
,
]
]

j
(
,
\
,
(
+
>

( ) ( )
00
1
i i
( ) +
TRC
C
V
E LP V LP V
LP
i LP
p i
i
H
P
H
P
H
i i
H
i
i
i
i
+ + +
(

/
( ) ( )

0
1 1

))

,
,
]
]
]

(
DF DF C
V
E LP V
H
R
H
R
LP
p
i
i
H
i
H
i
f f
(Portfolio Loss)
/
0
))

,
,
]
]
]
DF DF C V
H
R
H
R
LP
p i f f
(Portfolio Loss) /
0
LP V DF
H TS
i i
H
RR
,

( )
0
1
TRC E V DF V DF DF
TS
i i
H
RR
H
i
H
R
H
R
f f
,
]
]

( )

0
1
(Portfolio Loss) C { aapital or Associated Probability Interval}

,
,
]
]
]
/V
i
0
Similarly, when capital is in measured in excess of EL, the Loss Reference Point (LP) is defined as
, and TRC is defined as:
(A.20)
LP V DF V ES
H EL
i i
H
RR i i
,

( )
+
0
1
0
TRC E V DF V ES V DF
EL
i i
H
RR i i
H
i
H
R
f
,
]
]
+
j
(
,
\
,
(
0
1
0

(Portfolio Losss) Capital or Associated Probability Interval} DF
H
R
f
,
]
{
]]
]
/V
i
0
APPENDIX B
SYMBOLS AND ABBREVIATIONS
B.1 SYMBOLS
Is defined as
|
Given; for example, P(X|Y) is the probability of X given that Y
is true
Random realization of asset value
A
0 Asset value at time zero (initial asset value)
A
H Asset value at horizon
c
s,t Cash flows from time s to time t
C
Change in capital, or amount of capital consumed
D
H Standardized default point at horizon
D
M Standardized default point at maturity
E[X]
Expected value of X
CEDF
s,t Probability of default from time s to time t
Random draw from the standard normal distribution
Systematic component of firm risk
JDF
xy Joint Default Frequency of x and y; probability that both x and
y default
Parameter for the Loss Given Default distribution
Expected return
N( )
Cumulative normal distribution function
N
-1
( )
Inverse of the cumulative normal distribution function
P(X)
Probability of X
Market risk premium

CQDF
s,t Quasi-probability of default from time s to time t
~
A
~
~
f
~
f
r
t Continuously compounded risk-free rate to time t
R
t Annualized, annually compounded risk-free rate to time t
f
s,t Forward continuously compounded risk-free rate from time
s to time t
F
s,t Forward annually compounded risk-free rate from time s to
time t
Correlation between x and y
Asset correlation between x and y
Default correlation between x and y
s
Spread
Standard deviation of x
Variance of x
Covariance between x and y
t
H Time to horizon
t
M Time to maturity
Specific risk component of firm risk
Random draw from the standard normal distribution that
represents firm-specific risk
Random realization of exposure value
V
0 Initial value
V
H Unconditional value at horizon
V
H|D Value at horizon in the default state
V
H\ND Value at horizon in the non-default state
w
i Weight of facility i in the portfolio
X
Exposure Amount
B.1 SYMBOLS (CONTINUED)
xy
xy
A
xy
D
x
2
xy

xx x
2
e j
u

B.2 ABBREVIATIONS
AIS All-In Spread
ASG Asset Sigma
AVL Market value of assets
l Market Sharper ratio
g Time Parameter for the Market Sharpe ratio
C Cash flow (or Coupon)
CAPM Capital Asset Pricing Model
CEDF Cumulative Expected Default Frequency
CQDF Cumulative Quasi-Default Frequency
CR Capitalization Rate
DD Distance to Default
DPT Default Point
EDF Expected Default Frequency
EL Expected Loss
ES Expected Spread
H Time to Horizon
JDF Joint Default Frequency
L Loss
LGD Loss Given Default
M (or m) Time to Maturity
MAT Matrix Value
MP Mispricing
MTM Mark-to-Market
PFM MKMV Private Firm Model
PM MKMV Portfolio Manager
PV Present Value
QDF Quasi-Default Frequency
r Risk-free rate
R Square root of systematic risk proportion
R
2
R-squared; proportion of systematic risk; squared correla-
tion coefficient
RAROC/
RORAC
Risk-Adjusted Return on Capital/Return on Risk-Adjusted
Capital
RC Risk Contribution
RF Risk-Free
RFV Risk-Free Value
RS Required Spread
RTR Retained Risk
RYV Risky Value
STH Spread to Horizon
STM Spread to Maturity
T Time
TS Total Spread
UGD Usage Given Default
UL Unexpected Loss
VAR Value at Risk
X Exposure Amount
YTM Yield to Maturity
B.2 ABBREVIATIONS (CONTINUED)
GLOSSARY
actual usage Percentage of commitment currently drawn.
aggregate A facility which consists of two or more identical loans. The loans within the aggre-
gate are treated as related entities, but they cannot be related to other facilities.
capital Capital required to achieve the portfolio target debt rating. Portfolio capital is then
allocated to individual facilities on the basis of risk contribution.
capitalization rate Capital allocated to the facility divided by the commitment.
correlation This coefficient, which is between -1 and 1, measures the degree of linear relationship
between two variables. It is equal to the covariance of the variables scaled by the prod-
uct of their standard deviations.
covariance The average joint deviation of two processes. A positive value indicates that when one
value is high (above its mean), the other value is also likely to be high (above its
mean). A negative value indicates that when one value is high (above its mean) the
other value is more likely to be low (below its mean). The covariance of x and y is
given by:
Cumulative
Expected Default
Frequency
(CEDF)
Cumulative default probability over a given horizon. This number must have a date
attached. For example, a 1-year CEDF is the cumulative probability of default over
the next year; CEDF to Horizon is the cumulative probability of default to the hori-
zon. CEDFs for periods longer than one year are typically annualized. The formula
for a CEDF is as follows:
current portfolio The current portfolio. Consists of all facilities with non-zero commitments.
( ) cov , X Y
x y
cov , X Y
n
x y
xy i x i y
i
n
( ) ( )
( )

1
1
CEDF EDF
t t
t
1 1 ( )
ex ante "From before"; refers to predictions or expected values before the realization of the
uncertain outcome.
ex post "From after"; used in reference to historical statistical averages or realized values.
Expected Default
Frequency (EDF)
Annualized default probability over a given horizon. This number must have a date
attached. See the definition of CEDF for the relationship between the cumulative
expected default frequency and the annualized expected default frequency.
Expected Loss
(EL)
The average loss from the credit risk of the facility given the portfolio horizon. EL
equals the product of the Expected Default Frequency and the Loss Given Default
valued at the horizon.
Expected Spread
(ES)
Promised Spread (or Total Spread to Horizon) less Expected Loss.
expected usage Percentage of commitment expected to be drawn under normal conditions.
exposure The maximum possible loss, equal to the product of Commitment and Usage Given
Default.
International
Standards
Organization
(ISO)
MKMV uses ISO codes for country and currency designations. Please see the Portfolio
Manager User Guide for tables of these codes.
LIBOR London Inter-Bank Offered Rate (LIBOR)The primary fixed income index refer-
ence rates used in the Euromarkets. Most international floating rates are quoted as
LIBOR plus or minus a spread. In addition to the traditional Eurodollar and sterling
LIBOR rates, yen LIBOR, D-mark LIBOR, Swiss franc LIBOR, etc., are also avail-
able and widely used.
liquid portfolio The portion of the portfolio available for optimization.
Loss Given
Default (LGD)
Percentage of commitment lost in the event of default, or, equivalently, one minus
the recovery rate. This value takes account of collateral, the priority of the exposure,
covenant protection and expected workout costs, including delay.
mispricing to
portfolio
A relative measure of facility and portfolio Sharpe ratios. Assets with positive mispric-
ing have Sharpe ratios larger than that of the portfolio and are attractive purchases.
Assets with negative mispricing have Sharpe ratios smaller than that of the portfolio
and are recommended sales.
numeraire A unit of wealth. Typically this is currency. In prison a common numeraire is a cig-
arette.
PID MKMV permanent identifier.
promised return The rate of return if all interest and principal payments are received as specified.
related facilities Two or more entities that share the same Group ID. These facilities are modeled as
having a larger default correlation than that indicated by the factor model.
retained risk Fraction of the facility Unexpected Loss that is not diversified by portfolio effects.
risk contribution Undiversified facility Unexpected Loss. The Risk Contributions of the facilities in the
portfolio sum to the portfolio Unexpected Loss.
RORAC (also
RAROC)
Return on Risk-Adjusted Capital (also Risk-Adjusted Return on Capital), the eco-
nomic rate of return on capital. Equal to Expected Spread divided by required capital.
R-squared (R
2
) The multiple coefficient of determination from the MKMV factor model. R
2
mea-
sures the proportion of the borrower's asset volatility that is systematic (due to indus-
try and country factors). Specific risk, equal to 1-R
2
, can be diversified; systematic
risk cannot. Larger values of R
2
indicate large correlations with other asset values (and
default probabilities) and with the portfolio.
Sharpe ratio Return per unit of risk. In the context of a loan portfolio, return consists of portfolio
Expected Spread and the unit of risk is portfolio Unexpected Loss. At the facility
level, return is the Expected Spread on the facility and the unit of risk is Risk Contri-
bution.
SIC Code Standard Industry Classification code. MKMV displays SIC codes in the Group
Lookup Window as an aid to matching facilities with the appropriate group and/or
industry weights.
spread Yield spread over the risk-free rate.
standard deviation A measure of dispersion about the expected value, equal to the square root of the aver-
age squared difference from the mean:
static portfolio The portion of the portfolio that is not tradable.

x i x
i
n
n
x ( )
1 2
1
Target Probability
that Losses Exceed
Capital
The level of portfolio planning risk. The user should select the probability of loss that
corresponds to the desired default frequency of the loan portfolio as a whole.
Unexpected Loss
(UL)
Standard deviation of the expected loss.
usage See Actual Usage, Expected Usage, and Usage Given Default.
Usage Given
Default (UGD)
Percentage of commitment expected to be drawn in the event of default. This is the
maximum possible loss for a given facility.
volatility A synonym for standard deviation. Volatility typically refers to an annualized percent-
age value.
INDEX
A
actual usage 219
aggregates 22, 176, 219
analytical approximation 162
asset value 39
asset volatility 39
at 88
B
beta 127
Beta distribution 102
Black-Scholes-Merton or BSM model 37
C
Calculated Loss Distribution 162
capital
for an exposure
based on Risk Contribution 154
based on Tail Risk Contribution 157
for the portfolio 181
Capital Asset Pricing Model(CAPM) 51
capital distribution 181
Capitalization Rate
exposure
based on RC 156
based on TRC 157, 158
portfolio 181
CEDF 44
certainty equivalent 47
commitment 20
Corporate Default-Risk-Free Spread 30
correlation
asset 117, 130
default 131, 135
value 135
country index 119
CQDF 51, 53
credit migration 77
D
DD dynamics 79, 108
DD, see distance-to-default 77
DD-to-EDF mapping 42, 81
default 37
default correlation, see correlation 135
default point 10, 11, 38
discount factors 31
distance-to-default 11, 41, 77, 79
diversification 115
E
EDF 10, 38, 217
EDF Value Interpolation 44
Expected Loss
discrete 94
Expected Loss to Horizon
for an exposure 94
expected loss to horizon
for an exposure 144
expected recovery, see LGD 99
exposure amount 20
exposure profile calculations 207
F
factor model
composite factor 126
country risk decomposition 122
estimation 119
firm risk decomposition 125
global factors 121
idiosyncratic risk 125
industry risk decomposition 122
overview 117
putting together 130
regional factors 121
sector factors 122
systematic risk 125
firms correlation with the market 53
G
gamma, see time scaling parameter 52
GCorr, see Global Correlation Model 136
Global Correlation Model 136
H
hedge ratio 41
I
industry index 119
J
JDF, see Joint Default Frequency 131
Joint Default Frequency 131, 133
K
k, see LGD variance parameter 102
L
lambda, see market price of risk 52
LGD 99, 107, 117, 139, 217
LGD distribution, see Beta distribution 102
LGD input 99
LGD variance parameter 102, 103
lognormal distribution 40
loss
in excess of expected loss 144
loss distribution 143
loss distributions 139
loss in excess of total spread 145
M
market price of risk 51
market risk premium 19
market Sharpe ratio 19
recommended value 56
Mispricing 192
Sharpe, based on RC 192
Vasicek, based on TRC 194
Monte Carlo 161
Monte Carlo simulation 163
O
optimization 201
Q
QDF 48
quasi-probability of default 47
R
random walk 37
RAROC See RORAC
RCV, see valuation at horizon or/and valuation at the as-of-
date 58
related facilities 21
retained risk 150
risk aversion 47
risk contribution 149, 221
risk-neutral probability of default 47
RORAC 197
R-squared 53, 128
S
sampling 163
SCS, see Simple Cash Spread 87, 90
Sharpe ratio 51, 54
for an exposure 189
simulation, see Monte Carlo simulation 163
spread data 19
spreads
All-in Spread 91
Drawn Spread 91
Expected Spread
discrete 94
Expected Spread to Horizon
for an exposure 94
output spreads
Spread to Maturity 93
Required Expected Spread 196
Required Spread 195
Return Total Spread 93
Simple Cash Spread 87, 90, 92
Total Spread
continuous 93
discrete 93
Total Spread to Horizon 93
Undrawn Spread 91
stand-alone risk 107
T
tail risk contribution 151
time scaling parameter 52
recommended value 56
U
UGD 20
UL, see, Unexpected Loss 107
Unexpected Loss
facility 107
portfolio 112, 116
Usage Given Default, see UGD 20
V
valuation at horizon
given default 90
given no default
Exponential Amortization 89
Linear Amortization 88
RCV 89
valuation at the as-of-date
book valuation 58
matrix valuation 65, 71
risk comparable valuation 58
user input pricing 58
valuation grid 168
value correlation, see correlation 135
value distribution 139
value distributions 139
Vasicek-Kealhofer model 37
VK model, see Vasicek-Kealhofer model 37

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MODELING PORTFOLIO RISK

market value of the firms assets at time 0

rrift rate, or expected return, on the firms assets

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 51

the assets beta to the market

cov( , ) asset market

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 53

Risk Comparable Value at time

V LGD RFV LGD RYV

amount of cash flow at time

04392512 1007 58045

amount of cash flow at time

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 67

V LGD RCV LGD RYV

amount of cash flow at time

dd normal random variable

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 85

time from origination to maturity

cumulative EDF from time 0 to time

, the vec ctor of normalized industry indices of country j,

regression error terms for industry . i

return for country

of global market on industry

ppecific effect for industry i

variance of global market factor s return

ee of region factor s return

composite factor for firm

return for firm

eect for firm k

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 129

UL, Risk Contribution and Systematic Risk

(Portfolio Loss) (Portfolio Loss)

(Portfolio Los ss)DF C

the borowers underlying asset value at

V LGD RFV LGD RYV

= standardized default point at horizon

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 167

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 169

170 CONTROL #: 000-INTERNAL

188 CONTROL #: 000-INTERNAL

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 193

0 001568 0 000764 0 000804 . . .

XX LGD CQDF CQDF

V X e LGD CQDF CQDF E X

(Portfolio Loss) C { aapital or Associated Probability Interval}

Parameter for the Loss Given Default distribution

Market risk premium

MODELING PORTFOLIO RISK CONTROL #: 000-INTERNAL 217

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