why is loan return nonsymmetric?
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Hi asja,
That is a very interesting question; can you remind me of the assignment (is that Jorion?). In the meantime, can I challenge you to try to answer if i give the following hints? I perceive two possible meanings:
1. Short-term: what does convexity imply about short term returns?
2. (more likely the reference) Long term: what does "pull to par" imply about the return?
David
That is a very interesting question; can you remind me of the assignment (is that Jorion?). In the meantime, can I challenge you to try to answer if i give the following hints? I perceive two possible meanings:
1. Short-term: what does convexity imply about short term returns?
2. (more likely the reference) Long term: what does "pull to par" imply about the return?
David
...sorry to append, there is another perspective I can think of to access this: how does Stulz characterize debt issued by the firm under the Merton model? so this becomes a useful meditation, to perceive the asymmetry in three ways:
1. Short-term: what does convexity imply about short term returns?
2. (more likely the reference) Long term: what does “pull to par” imply about the return?
3. Merton model characterizatio of firm debt
David
1. Short-term: what does convexity imply about short term returns?
2. (more likely the reference) Long term: what does “pull to par” imply about the return?
3. Merton model characterizatio of firm debt
David
Hi David,
it is within:
Michael Ong, Internal Credit Risk Models: Capital Allocation and Performance Measurement (London: Risk Books, 2003).
Chapter 4 – Loan Portfolios and Expected Loss
especially the AIM: Explain how a credit downgrade or loan default affects the return of a loan.
so it emphasizes loan, than (or compared to) bond...
1 (positive) convexity means price increases more when yield decreases than price decrease when yield increases. i agree it is nonsymmetric,
2. i think pulling to par is symmetric
3. you mean shorting call introduces similar convexity of a bond?
Thanks.
it is within:
Michael Ong, Internal Credit Risk Models: Capital Allocation and Performance Measurement (London: Risk Books, 2003).
Chapter 4 – Loan Portfolios and Expected Loss
especially the AIM: Explain how a credit downgrade or loan default affects the return of a loan.
so it emphasizes loan, than (or compared to) bond...
1 (positive) convexity means price increases more when yield decreases than price decrease when yield increases. i agree it is nonsymmetric,
2. i think pulling to par is symmetric
3. you mean shorting call introduces similar convexity of a bond?
Thanks.
Hi asja,
thanks, I wasn't thinking of Ong's loan/bond distinction; he generally refers to a loan as an instrument that (i) lacks liquidity (must be held to maturity) and (ii) is not traded (so the lack of trading removes the quasi-symmetrical returns that would associate with short term trading) ... so I *think* that the Ong interpretation (i.e., a loan is more "stuck" with the terms, so no tradeable upside, but yet incurs default risk) ... in recent years (he published that in 1999) the FRM has seemed to make less of the loan/bond distinction with the rise of secondary markets
...but i think your original point has validity in regard to short-term market risk: in the short-run (e.g., node 0 to node 1), the interest rate models often exhibit rate symmetry (which corresponds to quasi-price symmetry)
1. agreed
2. agreed ... i meant that the P2P, if you hold, limits your up and down (you return will be the initial yield to maturity +/- realized reinvestment) ... so the initial yield is fairly limited the further you are pulled to par. But then default is your “asymmetric” loss; this is the essential skew that informs (e.g.) a non-normal credit curve like Basel IRB: most of the time upside in a narrow range (where P2P narrows the range as time increases), with occasional/rare large losses
3. Under Merton, the yield on a risky bond = riskfree yield + premium for writing an OTM put on firm’s assets (asset price = firm value, strike = face value of firm’s debt).
From this perspective, bond spread (yield above RF) is asymmetric in the same way is writing a put option;
i.e., collect modest premium (yield as compensation for bearing default risk) but at the cost of large contingent loss (~ your counterparyt, the option buyer, exercises the put)
Thanks, David
thanks, I wasn't thinking of Ong's loan/bond distinction; he generally refers to a loan as an instrument that (i) lacks liquidity (must be held to maturity) and (ii) is not traded (so the lack of trading removes the quasi-symmetrical returns that would associate with short term trading) ... so I *think* that the Ong interpretation (i.e., a loan is more "stuck" with the terms, so no tradeable upside, but yet incurs default risk) ... in recent years (he published that in 1999) the FRM has seemed to make less of the loan/bond distinction with the rise of secondary markets
...but i think your original point has validity in regard to short-term market risk: in the short-run (e.g., node 0 to node 1), the interest rate models often exhibit rate symmetry (which corresponds to quasi-price symmetry)
1. agreed
2. agreed ... i meant that the P2P, if you hold, limits your up and down (you return will be the initial yield to maturity +/- realized reinvestment) ... so the initial yield is fairly limited the further you are pulled to par. But then default is your “asymmetric” loss; this is the essential skew that informs (e.g.) a non-normal credit curve like Basel IRB: most of the time upside in a narrow range (where P2P narrows the range as time increases), with occasional/rare large losses
3. Under Merton, the yield on a risky bond = riskfree yield + premium for writing an OTM put on firm’s assets (asset price = firm value, strike = face value of firm’s debt).
From this perspective, bond spread (yield above RF) is asymmetric in the same way is writing a put option;
i.e., collect modest premium (yield as compensation for bearing default risk) but at the cost of large contingent loss (~ your counterparyt, the option buyer, exercises the put)
Thanks, David
Hi asja, Any bond/loan distinctions (rather than Ong) really concern de Servigny Ch 4 (i.e., loans are less liquid, less standardized and "more complex")
...then re: the asymmetry, yes i think that (i) applies to loan/bond and (ii) is generally about the limited upside versus exposure (downside) of the entire principle (so, yes, it's all about the default putting the entire principal at risk) - David
...then re: the asymmetry, yes i think that (i) applies to loan/bond and (ii) is generally about the limited upside versus exposure (downside) of the entire principle (so, yes, it's all about the default putting the entire principal at risk) - David
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