Why is the calibration of a credit risk model to the market important in fixed income trading?
What will be an ideal response?
Although superior to what was previously available, there are two concerns that have been expressed about structural models: difficult to calibrate and computationally burdensome.Calibration is a necessary first step in fixed income trading because it allows traders to clearly see relative prices and hence be able to construct arbitrage trading strategies. To calibrate a structural model to price a corporate bond requires calibration to asset volatility, asset value, face value of the corporate issuer's debt, the default barrier (in the case of first-passage time models), and the risk-free rate. Although some of these values required for calibration can be estimated from market data (e.g., using Treasuries to estimate the risk-free rate), many are not observable or easy to obtain. The value of a corporation is estimated from stock prices for publicly traded corporations. Determining the face value of the corporation's debt may seem simple; however, in complex capital structures involving multiple bond issues, bank debt, guarantees on debt issues by others, pension liabilities, leasing obligations, and any interest-rate derivatives that the issuer may be exposed to, it is not simple. For first-passage time models, a suitable default barrier must be estimated. Because of this difficulty, it is argued that structural models are not suitable for the frequent marking to market of credit contingent securities.
You might also like to view...
An organization's social responsibility image is often determined by its
A) desire to earn a profit above all else. B) focus on being the number one patron of the arts. C) attention to be ethical and to improve the quality of life for people. D) focus on looking good rather than doing the right thing.
An advantage of a sole proprietorship is that the owner reaps the benefits and doesn't have to share the equity.
Answer the following statement true (T) or false (F)
A danger to a firm's having a high asset turnover is the _____
a. high operating costs b. high level of old inventory on hand c. high probability of being out of stock d. low profits as a percent of sales
WiMAX is a coding process that takes a digital map feature and assigns it an attribute that serves as a unique ID (tract number, node number) or classification (soil type, zoning category). GIS professionals are certified in geocoding practices to ensure industry standards are met when classifying spatial data.
Answer the following statement true (T) or false (F)