Tuesday, 4 November 2008

What are the dynamics of risky bond prices?

The Basel Committee's two papers on incremental risk in the trading book (incremental to that captured by VAR, that is) - here and here - led me to muse on what the real dynamics of risky bond prices are.

Firstly clearly there is an interest rate risk component. Let's ignore that as it is the best understood.

Second there is jump to default risk. The phrase itself is slightly misleading in that bond prices often fall a long way in the period before default, and indeed recoveries are sometimes higher than pre-default bond prices would suggest. Skip to default might a better term. Still, the idea that there is a jump process which can cause non-continuous changes in risky bond prices is reasonable.

Then there are 'everyday' movements in credit spreads. Now, here's the six hundred and forty billion dollar question (OK, OK, not the size of the corporate bond market I know) - if you take out the jumps, is what you are left with even vaguely normal? My guess is that it isn't, and that autocorrelation is significant even after jumps have been taken out. The hard part is that you need a lot of credit spread data to look at this kind of thing, and it isn't easy to come by. CDS data won't do in this instance simply because single name CDS have only been liquid for ten years or so, and you'd at least want data going back well before the '98 LTCM/Russian crisis. I'll get around to this sometime soon...

Spread dynamics are the flipside to my earlier post on what CDS spreads mean: that was about what causes the spread to move; this is about how you can model those movements.

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