From pricing to rating structured credit products and vice-versa

3.4.2 Hypothetical stress-scenarios

Being aware of some obvious limitations in its modelling of risk factors, Moody's requires the DPPI to achieve the target rating in the base-case scenrio and to pass looser target Moody's Metrics in a series of stress-scenarios. Major ones are analyzed hereafter: results are shown in table (3.1).

Credit crisis: systemic brutal spread widening

In order to assess the impact of a brutal widening in CDS spreads, Moody's requires the market spreads of initial long CDS positions to be bumped by á = 25% immediately after the deal's inception. Equivalently, this adverse MtM impact ÄMtM(0) can be expressed in terms of an upfront haircut to be subtracted from the deal's initial notional A:

ÄMtM(0) = á

XN n=1

sn(0)^An(0) A TNE(0) · Dn(0)

where 0 denotes the initial CDS tenor and D_n(0) the initial duration of the n^th CDS. Given initial market conditions and structural features provided in figures (12) and (11), we compute ÄMtM(0) = 3.83% and add this haircut to the initial upfront fee of 1% charged by the arranging investment bank. Results are shown in table (3.1)

Bullish but punctually volatile credit markets: low spreads stressed by punctual default events

The rationale for testing the DPPI in such mixed market environments is to test whether the structure can sustain below-average market spreads, meaning that it does not receive enough CDS premia to cover its liabilities towards investors (the structure is then deemed to be in «negative carry»). To do so, Moody's acts on the parametres of the credit spread process detailed in equation (3.1): it lowers arbitrarily the long term mean â by decreasing ADR as well as b, and divides the volatility parametres ó and ó by two. Results are shown in table (3.1).

Short term default risk concerns: flat credit spread term structure

As seen earlier, the increasing term structure of credit spreads is assumed to be deterministic and to result from a shaping function specific to each rating group. Such an upward slope translates into a positive time-decay when holding long CDS positions. This increasing term structure gets attenuated as ratings get worse: it reflects the fact that conditional on the obligor not defaulting in a near future, its survival probability in the long run is not worse than presently. Moody's cancels that overall positive time-decay effect by assuming a flat credit spread term structure guided by 5-year CDS spread levels. Results are shown in table (3.1).

?n E {1,..,N}, ?t E [0,T], ?0 E [0,10], s_n(t,t + 0) = s_n(t,t + 5)

Hypothetical stress-scenario results

Scenario	L(M)	Moody's Metric		Rating	Base case
0.089%	2.697	Aa2		Early credit crisis
0.248%	4.219	A1		Low spreads
0.447%	5.276	A2		Flat term structure
0.685%	6.091	A3

Table 3.1: DPPI behaviour under base-case and stress scenarios, 20,000 simulations each except for base-case 30,000 draws

As expected, the DPPI's rating worsens in stressed scenarios. The structure's resiliency to adverse market environments is obvious: the magnitude of the potential rating to downgrade is limited to 4 notches in the flat term structure scenario.