In stress-test scenarios, the assumption is : high correlation for everything.
We, bankers – and I used to be one – have been caught with our hand in the low correlation cookie jar. We decided to take action so that it won’t happen again.
To add to our comfort – or rather, discomfort really – markets are confirming our fears and react exactly this way . Looking at CDS prices one could even ask : why bother having one CDS per issuer ? Let’s just have one CDS per industry. One size fits all !
For example, the first CDS 5-year graph is that of Royal Dutch Shell (RDSA), the second one is that of Total SA, and the third one is that of Statoil (renamed Equinor).
Thanks to https://www.datagrapple.com/ for those graphs
Guessed the 85% correlation ?
Immediate consequence : in stress-test scenarios, banks must take into account this thru-the-roof – 85% – CDS implied Probability of Default correlation and put aside a lot of capital.
Why ? since defaults of rock-solid corporates – such as the one we just looked at – are very rate events, there are very little statistics of actual default contagion in high grade credit portfolios.
So, in order to measure default contagion, lenders are left using whatever proxy they can find. But, although CDS – or share, or bond – price correlation is the most obvious one, at 85% it is also a killer !
What if one could statistically measure this domino effect ? That is precisely what ALGOSAVE FinTech does. And it is definitively worth our while and that of our clients.
Indeed, ALGOSAVE shows that, even in very bad economic scenarios, default correlation is actually far lower than CDS thru-the-roof correlation suggests.
Here is an example on our favorite Integrated Oil and Gas portfolio.
For instance, whereas Total/RDSA 5-year CDS correlation is close to 85%, ALGOSAVE shows that it is actually closer to 25% even a very bad economic scenario. Arguably, it is still more that 3 times Total/RDSA conditional default probability in consensus OECD macro-economic scenario. But it is a far cry from the 85% CDS correlation mark.
Well done, from 85% down to 25% default correlation that’s tangible capital saving. It is well worth the time you just invested into reading this article till the end. And, should you want to see these default correlation for another industry, please leave us a comment here. We will graciously send this to you.
ALGOSAVE proprietary credit database is full of those precious nuggets … and some other too such as equity analyst favorite WACC and Beta. But, let’s leave these for our next article.
All the Best
ALGOSAVE team. 13th of June 2018.