Previous

Part - IX

"I think people can get too hung up on the model issue," says CIBC's Rai. "Evaluating credit is not a new task for banks. They have been making millions of dollars on corporate loans for decades." According to Morgan's Masters, "Every institution has its own approach to valuing credit, based on its years of experience as well as the composition of its portfolio. The value of any credit instrument is relative. For example, a bond issued by Company A-even if it has a AAA rating-may not be worth much to a company that already offers Company A a substantial line of credit."

Masters adds that for basic credit structures such as vanilla credit swaps and total return swaps where the reference credit is a loan or a bond, models are generally not necessary. "Bond traders don't use models to trade," she says. However, she emphasizes that for market participants using credit products where the reference credit may be a basket of credits or where there is optionality-as in the case of credit spread options modeling is a useful tool.

"Of course dealers say that you don't need a pricing model; they love to trade with counterparties that don't use models," says Don Van Deventer, president and founder of Kamakura, a software and financial research and development firm that has plans to offer a credit-pricing module in the near future. "But theoretical prices are an important supplement to market prices."

Van Deventer adds, however, that efforts to develop a standard pricing model for credit have been stymied by a lack of historical data. There are three main reasons for this: credit derivatives themselves haven't been around that long; there is a dearth of data on the underlying assets upon which credit derivatives are typically based (that is, corporate bonds and loans); and credit is idiosyncratic, meaning that all credits which fall into the same broad ratings category are not interchangeable.

Another stumbling block on the path to more liquid credit derivatives is the lack of appropriate systems and controls that can accommodate next-generation credit products. Although CreditMetrics promises to go along way toward providing a standardized methodology for credit risk measurement, most institutions have yet to implement credit Value-at-Risk-or other quantitative credit risk management methodologies. Likewise, most risk management systems on the market cannot handle credit derivatives. According to one New York-based broker, "I've seen a lot of traders input credit derivatives into market risk management systems by recording the tickets as corporate bonds."

Next

* Contributed by -
Prashant Jadhav,
2nd Year PGeMBA (Finance),
Mumbai Educational Trust (MET) Schools of Management, Mumbai.