Posts Tagged ‘loans’
Monday, October 26th, 2009
The correlation between the debt and equity markets’ measures of risk has been extremely strong over the recent years. External shocks, for example the tragic events of September 11, 2001, the LTCM disaster in 1998 or the Asian crisis, have a substantial impact on credit spreads as well as on implied equity volatility. Consider the relationship between implied volatility of call options on Dow Jones Euro Stoxx 50, and the spread versus government bonds of the MSCI Euro corporate bond index.
One way of interpreting implied volatility on an equity index is as the compensation that the investors receive for taking on equity risk. The index of credit spreads represents the additional yield investors demand for holding corporate debt over benchmark government debt. While there have at times been brief periods of divergence, these two risk measures typically move together. For example, in 1993/94 banks in the United States cleaned up their balance sheets by writing down nonperforming assets, causing the VIX index, representing the implied volatility of put and call options on the S&P 100, to fall to a historical low just above 10 percent. The decline in implied equity volatility triggered a credit spread rally. Asimilar thing happened in 2002. Average credit spreads collapsed by half, as did optionimplied volatility. So the decline in volatility was a major driver of credit spread tightening. However, one tends to find that when implied volatility falls below a certain threshold the effect of small changes on spreads is rather subdued.
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Sunday, October 25th, 2009
The level of implied volatility is a widely used indicator for risk appetite, and, on the individual company level, for the uncertainty related to future earnings. It is also considered a good measure of equity-market risk, because the higher the implied volatility the higher the price of equity options, and thus the higher the cost of insuring against equity-market downturns. Corporate bond spreads reflect the compensation that the investors demand for taking on credit risk. While the debt and equity markets’ estimates of risk, as explained by the Merton model, tend to move together, temporary disconnections do occur. The combination of low levels of implied equity volatility and wide credit spreads suggests the potential for the credit spreads to tighten, as the divergence in the equity and credit market eventually gets corrected. Conversely, when implied equity volatility appears high relative to credit spreads, credit markets are more optimistic about business risks in the corporate sector. The decoupling in the second half of 2003, however, was not an indication that credit spreads were rich relative to implied equity volatility. Rather credit markets were faster to cash in on the reduced risks in the corporate sector because of the massive balance sheet deleveraging, especially in the telecom sector.
Corporate managers were selling off assets, issuing equity and keeping cash for the debtholders, as opposed to using the cash to buy back stock for the first time in 10 years. By the end of the year, equity volatility came down significantly, closing the gap in the assessment of risk.
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