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Archive for Technical

Learning the Difference Between Risk and Uncertainty, or not

Andy Spero | April 20, 2009 | 0 Comment(s) |

Update: if you’re looking for an academic distinction, see: The Difference between Risk and Uncertainty. In the post below, we criticize firms for not changing their practices despite the recent failures of their estimations, methodologies, and models. Of course, we think that both are worth reading.

Every Monday morning for the past several years, we’ve received an e-mail from http://jobs.phds.org that lists available positions according to our specifications, which are:

“Send Weekly emails containing jobs…
…for PhDs in: Business / Finance / Economics
…of types: Contract… Read the rest

Calculating Counterparty Credit Reserves

Andy Spero | April 8, 2009 | 0 Comment(s) |

Implied Risk Neutral Default Rates Versus Historical Default Rates

For some problems, there is no good or true solution, but something must be done or estimated. Such is the case with calculating credit reserves because real default rates can never be known, but risk-neutral implied or historical default rates can be calculated and used, but both are flawed.

Generally, when we discuss this topic, we have reduced-form models in mind (as opposed to structural ones, but there’s no shortage of assumptions in structural models, either).

We’ve written about implied… Read the rest

Multi-period Bond Price Implied Default Rates and CDS

Andy Spero | December 12, 2008 | 0 Comment(s) |

Implied Under the Assumption of Risk Neutrality

We have several posts related to the calculation of price-implied default rates under the assumption of risk neutrality and several posts related to simple CDS calculations.

Those posts have involved discrete, single-period problems, where there are only two dates of interest: today and a future date where an uncertain claim or cash flow will be realized, i.e., when bankruptcy would occur.

We’ve focused on binary models and will continue to do so here.  In fact, to analyze a two-period problem, we’ll just build upon our… Read the rest

Price Implied Default Rates

Andy Spero | December 2, 2008 | 0 Comment(s) |

Update: December 12, 2008.  While none of our analysis or calculations was incorrect, we did have a minor error in the penultimate paragraph. We should of said “first” not “last.” To make amends, here is a multi-period problem, Multi-period Bond Price Implied Default Rates and CDS, but it won’t make sense without reading this one first. We also added a few paragraphs below, which should help explain the multi-period case.

Further update: April 14, 2008. We also have a new, related post on default rates. It is Calculating Counterparty… Read the rest

Risk Neutral Valuation: There Are at Least Two Expected Values

Andy Spero | November 13, 2008 | 0 Comment(s) |

But You’ll Never Know the One

We also have a newer post, Price Implied Default Rates, that provides an example more like a risky bond, and this one: Multi-period Bond Price Implied Default Rates and CDS. And we’ll have more related posts soon.

We’ve noticed that our few posts on risk neutral probabilities and implied default probabilities have been among our most popular content for readers throughout the world.  (And it is cool to write “throughout the world.”)

So, we’ve finally starting composing a longer essay to cover continuous density functions, but an earlier… Read the rest

implied RISK NEUTRAL probability of default, redux

Andy Spero | October 9, 2008 | 0 Comment(s) |

Update: we have newer posts on the topic, too, including Risk Neutral Valuation: There Are at Least Two Expected Values, that describes the difference between real and risk neutral distributions.  We also have: Price Implied Default Rates that provides an example more like a risky bond, and a multi-period example: Multi-period Bond Price Implied Default Rates and CDS.

The Wall Street Journal has an article about Iceland’s financial problems in today’s paper: Aftershocks Felt From Iceland.  It turns out that the country has more problems than being a… Read the rest

Forced Mergers? Bigger Is Not Necessarily Better!

Andy Spero | September 16, 2008 | 0 Comment(s) |

We read in Monday’s (September 15) Wall Street Journal that the Federal Reserve nudged Merrill Lynch towards a merger: Crisis on Wall Street as Lehman Totters, Merrill Seeks Buyer, AIG Hunts for Cash.

We think it is a mistake, and we’re not certain of the Fed’s goal when its propose such arrangements.  Presumably, such a nudge is rationalized on the basis of “stabilizing” the financial system, but we’re not so sure that such a rationalization is a justification.  It seems like a knee-jerk reaction for the sake of “temporary… Read the rest

Good Column, Bad Math.

Andy Spero | September 3, 2008 | 0 Comment(s) |

The Good: In today’s (September 3) The Wall Street Journal, Holman Jenkins has a nice Business World column entitled, The Inflation Hurricane.

The print version’s blurb perfectly summarizes the essay: “Does the federal government have to be responsible for everything?”  By now, through constant media reinforcement, we know that everything that goes wrong is Bush’s fault, but Mr. Jenkins seem to mean why do we taxpayers—at, say, 1,200 feet above sea level—need to subsidize folks who choose to live below sea level?

Ignore the poor folks, who may be helpless, for whom we have… Read the rest

Implied Risk Neutral Probabilities (of Default)

Andy Spero | August 27, 2008 | 0 Comment(s) |

An Illustration with Only One Simple Equation.

Update: we have several newer, related posts: Implied RISK NEUTRAL probability of default, redux, expands the analysis presented here by using a different utility function and considering a couple of different situations;Risk Neutral Valuation: There Are at Least Two Expected Values describes a common source of confusion: the various distributions involved; and Price Implied Default Rates provides an example that is more like a risky bond.

We get a decent number of hits on the little that we have actually posted about risk neutral probabilities.  We take that as a sign… Read the rest

On Nedges and Sledges and Paving the Road to Hell

Andy Spero | June 23, 2008 | 0 Comment(s) |

Or when is a “hedge” not a hedge?  —when it is a nedge or a sledge or a wild*** guess, of course.

To paraphrase St. Francis de Sales, the road to hell is paved with good intentions because execution matters!  (Elsewhere he scolds perfectionism, too, and argues for a balance: do not be rash, do not over-analyze.  Realize that it is not a sin to be imperfect, but it is a sin to do wrong.)

Back on May 21, we posted Read the rest

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