The scope and breadth of this paper aims at constructing an early warning index for estimating bank distress based on custom market indicators as to include scores that monitor credit and portfolio risk, geographic risk as well as moral hazard effects. The rationale of this paper stems from the fact that, albeit extensive literature on supervisory risk assessment and early warning systems have been widely available, the majority of the focus has been on accounting standards as opposed to portfolio risk indicators. I advocate the use of Merton's model of distance-to-default and probability-of-default derived from the implied volatility of option prices and credit default swap prices as my explanatory market-driven indicators, as well as the introduction of new custom market variables that rely on peer group analysis.
¶ … Lehman and JP Morgan, we consider a period of four months as our observation window, for the years starting in 2006 to 2009. We use the KMV definition of debt as short-term liabilities plus half long-term liabilities. The interest rate is given by the 4-mos. LIBOR or swap rates. For illustration purposes, we use 5%. The benchmark index is given by the S&P500 index. The initial asset values are given by the sum of equity market cap plus liabilities and consequently derived via the Merton call option pricing framework described previously.
The table below depicts the range of minimum and maximum values for the component variables, whereby the EW Index score is given by the weighted average of the following indicators: idiosyncratic-specific volatility, default probability (given historical equity stock prices), default probability (given option prices), default probability (given CDS prices), market deviation (stock return vs. benchmark index return), country-specific risk, and rating grade.
The table below depicts the range of values for the main indicators and their underlying component variables.
Asset
Asset Vol
Specific Vol
Yearly
Return
DD
PD
Equity
Dev
Asset
Asset
Vol
DD
PD
Options
PD
CDS
EW Index
LEH
min
0,014
0,191
-0,965
-4,7
0
0
0,211
-3,6
0
0,010
0,08
5231589
7,953
1
0,024
10,9
1
1
4976442
4,575
11,2
1
1
0,96
JPM
min
7894566
0,134
0,102
-0,095
0,42
0
0
7555353
0,134
0,7
0
0,006
0,05
22492851
1,428
1
0,058
20,5
1
1
21401119
1,156
20,7
0,94
0,171
0,66
As illustrated in the table above, idiosyncratic risk and default probability rise in tandem during times of distress and point to a higher EW index score accordingly, and peaks at 100%. Meanwhile, market deviation from the S&P500 index, may range from 0 to 100%, and ought to be considered in complement with idiosyncratic risk to gauge entity-level fragility.
Idiosyncratic-specific volatility for Lehman and JP Morgan range from 20% and 10% respectively, up to 100%. In the case of Lehman, idiosyncratic risk sees a considerable spike higher within a span of three months, between 27/01/2008 to 27/04/2008, and reaches its maximum at default on 27/07/2008. Yearly returns depicted in the graph below, denotes the drift parameter, and in the Lehman case trails at an approximate average of -1,2% return up until 09/09/2008 where it then dips lower to negative double digit rates of return until it ceased to be a going concern.
In the case of Lehman, probability-of-default inferred either through historical time series data, (Def Prob Ind), option prices (Def Prob) or CDS prices (Def ProbCDS) yield slightly different results and varies according to the level of asset volatility, contingent on the given approach used for estimation purposes. Meanwhile, in evaluating JP Morgan, the estimated default probability given CDS prices was significantly lower compared against the alternative two default probability indicators.
We considered 2YR CDS prices where the default probability is a function of the recovery rate. Further, in comparing 2YR CDS prices for JP Morgan and Lehman we see a considerable difference in price range, with Lehman demonstrating a pointedly lower credit quality level.
You’re 81% through this paper. Sign up to read the full paper.
Sign Up Now — Instant Access Already a member? Log inAlways verify citation format against your institution’s current style guide requirements.