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World

Sector Report

01/07/2007

QUANTITATIVE STRATEGY
Calculating the VaR of a credit relative value portfolio

Analysts
Julien Turc ■ This article compares two methods of calculating the Value-At-Risk of a credit
(33) 1 42 13 40 90 portfolio. This is useful to deduce the capital allocation required for such a portfolio.
julien.turc@sgcib.com

David Benhamou
(33) 1 42 13 94 75 ■ We calculate the capital allocation of our relative value portfolio since March 2005.
david.benhamou@sgcib.com
Our trades generate a EUR+4.7% return per year after transaction costs.
Benjamin Herzog
(33) 1 42 13 67 49
benjamin.herzog@sgcib.com
■ One VaR method is to compute the P&L of each trade in predefined catastrophe
Marc Teyssier
(33) 1 42 13 55 96 scenarios. These scenarios are calibrated on historical data since 2001. The second
marc.teyssier@sgcib.com
method is to calculate a VaR at the portfolio level by jointly simulating all the instruments
Sandrine Chapelon
(33) 1 42 18 05 39 in the portfolio. This second method is based on the GVaR tool developed by SG R&D
sandrine.chapelon@sgcib.com
team for CPPI management.

With the cooperation of


Xavier Lemonnier (Ecole Polytechnique) ■ Our study shows that for individual trades, both approaches are fairly close. However,
Jérôme Brun (Head of quantitative credit when applied to the whole portfolio, the GVaR approach leads to smaller VaRs thanks to
research and development)
a netting effect.

Our relative value portfolio generated a +7.4%/yr total return after transaction costs since March
Contents 2005 with a capital allocation based on GVaR.
Introduction to the VaR 2
methodology Risk-free With transaction costs No transaction costs
Two VaR methods 5
Performance of SG quant 15
NPV of a €100 investment in March 05

130
portfolio
Appendix: summary of 18 125
spread stresstests 120

115

110

105

100

95

90
03/05 07/05 11/05 03/06 07/06 11/06 03/07

Source: SG Credit Research


Quantitative Strategy

Calculating the amount of money that can be lost in an investment portfolio is a very important
task for any money manager. This amount is called the Value-At-Risk or VaR. In practice, it is
useful in particular for:
„ Capital allocation: Within a fund or a trading desk, a VaR is useful to know the maximum
loss that could be generated by a given type of strategy in order to determine how much
capital to allocate to this strategy and to know whether the risk/reward of this strategy is
attractive.
„ Leverage limits: Prime brokers for hedge funds need to know the maximum loss of the fund
in order to ensure that the fund would have enough money to liquidate all its positions without
any loss for the prime broker. Similarly, CPPI management requires the calculation of this
maximum loss to control the gap risk (i.e. to make sure that the net present value of the fund
always remains higher than the value of a zero-coupon).
In the first section of this paper, we define precisely what the Value-at-Risk is and discuss the
different methods to calculate it. The second part of the paper is dedicated to the description
of two different methods to calculate the VaR of a credit portfolio. The first VaR method (called
GVaR) is a very comprehensive approach that simulates all the assets of the portfolio jointly. It
was developed by SG Research and Development team for CPPI management. It is the official
risk management tool to calculate the leverage limits of the credit CPPIs structured by SG.
The second method is a rule-of-thumb technique that we call EasyVar: it calculates the VaR as
the sum of the VaR of individual trades.

In the third and last section, both approaches are applied to the portfolio of trades
recommended in our weekly Relative Value Trader. We calculate the performance of our
quantitative portfolio with and without transaction costs since 2005 and show that, with a
GVaR capital allocation, the performance was +10.8%/yr without transaction costs and
+7.4%/yr including transaction costs.

2 01/07/2007
Quantitative Strategy

Introducing the VaR methodology

Definition of the Value-At-Risk


The Value-At-Risk of a given position is the maximum amount of money that can be lost with a
given probability (called the confidence level). For example if the 1-day 99% VaR of a portfolio
is €1m, it means that with a 99% probability, the amount of money lost within one day by the
portfolio should be lesser than €1m.

Setting up a VaR calculation system requires two important parameters:

„ The time horizon: A VaR is a measure of loss at a given horizon. In the GVaR methodology

that was developed by SG for CPPI management, the horizon is set to a few days because the
leverage is adjusted on a daily basis. In the EasyVar approach, we decided to set the horizon
to one week which is the trading frequency in our strategies (all trades are recommended in
the weekly Relative Value Trader).
„ The confidence level: The probability is that the loss will be below the Value-At-Risk.

Obviously, the higher the confidence level, the bigger the VaR. In the GVaR model, the
confidence level is set to 99.96% which means that the VaR is hit once every ten years. For
the EasyVar approach, we also chose to use a 99.96% confidence level.

VaR vs. cVaR


The Value-At-Risk is not the only indicator that may be used to monitor the maximum loss of a
portfolio at a given confidence level (say 99.96%). Another possible indicator is the conditional
Value-At-Risk or cVaR which measures the expected loss of the portfolio in the cases where
the confidence level is breached (i.e. in the 0.04% worst cases here). The cVaR is more
conservative than the VaR because the VaR calculates the minimum loss in the 0.04% worst
cases while the cVaR calculates the expected loss of these 0.04% worst cases.

VaR and cVaR calculations for a Gaussian-distributed P&L

0.45
0.4
0.35
0.3
Var(95%)=-1.65
0.25
0.2
0.15
0.1
0.05
0
-4 -3 -2 -1 0 1 2 3 4
P &L
cVar(95%)=-2.05

Source: SG Credit Research

The diagram above shows a theoretical example of a P&L distribution which is Gaussian and
centered in zero. If the confidence level is set to 95%, the VaR is €1.65 (i.e. only 5% of the
scenarios lead to a loss worse than €1.65). The cVaR is €2.05 which means that the expected
loss of the worst 5% scenarios (i.e. the scenarios with losses bigger than €1.65) is €2.05.

01/07/2007 3
Quantitative Strategy

Another mathematical characteristic of the cVaR is that the cVaR of a portfolio of two assets is
always the same or lower than the sum of the cVaRs of each asset (the cVaR is said to be
sub-additive). This characteristic is not true for the VaR measure: the VaR of a portfolio of two
assets may be higher than the sum of the two VaRs. Therefore, it makes mathematical sense
to add the cVaRs of individual trades in order to get the cVaR of the portfolio, however, adding
the VaRs of each trade in the portfolio may not be conservative enough.

Several approaches are then possible for calculating a VaR or a cVaR

„ Historical analysis: for each trade, the VaR is calculated as the worst loss on this trade for

the desired horizon on all the historical data available for this trade. For example a long
General Motors stock position would be backtested since the GM IPO and the 99% daily VaR
would be calculated as the loss corresponding to the 1% worst daily losses.
„ Scenario analysis: predefined extreme scenarios are set for each type of position (for

example a +100bp widening for a long credit risk position). The amount of money that can be
lost is calculated as the P&L generated by these predefined scenarios. These scenarios can
be calibrated to historical data or may rely on common sense assumptions. For example, one
possible predefined scenario could be to multiply all spreads by two and calculate the loss in
that case.
„ Asset modelling: all assets within the portfolio are modelled jointly. The amount of money
that can be lost is calculated through a simulation of the portfolio in the future, based on the
model assumptions. The parameters of the model are calibrated to be consistent with realized
historical data.
This paper presents a version of the two latter approaches: the first one is a scenario-based
methodology called EasyVar while the second one is based on asset modelling and was
developed by SG in 2006 for CPPI management and is called GVaR.

4 01/07/2007
Quantitative Strategy

Two methods of calculating the VaR of a credit


portfolio

This section compares two approaches for VaR calculation of a credit portfolio. The GVaR
approach is the most precise as it performs a joint simulation of all assets jointly. This is the
official methodology used by SG for CPPI management. The second approach (that we call
EasyVar) is a rule-of-thumb technique to calculate the VaR or cVaR of a credit portfolio. It is
calculated at the trade level.

It is hard to mix default risk and marked-to-market risk while calculating the loss of a credit
portfolio. In fact, default risk is fairly equivalent to a spread jump to very high levels (+10000bp
for example). In practice, default is sometimes sudden and can happen even if spreads are
fairly low. Therefore, it is easier to calculate two separate VaRs (the default VaR and the
spread VaR) and then add them. The first part of this section analyses default VaR calculations
while the second part explains how to calculate a spread VaR. In each section, we compare
the EasyVar and GVaR approaches.

Calculating the default VaR


Using CDO pricing tools…
Calculating the default VaR of a given credit portfolio is a classical problem that is fairly similar
to the pricing of a CDO. Therefore, one option is to use CDO pricing techniques in order to
calculate the loss distribution of the portfolio and then find the maximum loss for a given
confidence level. This requires a correlation assumption for the portfolio. It is used in SG’s
GVaR tool for CPPI leverage calculations.

More specifically, the default VAR calculation requires four steps:


„ Calculate the loss due to the default of each name. To do so, positions are netted on each
name and a recovery assumption is made. The output of this step is a list of names with their
loss given default.
„ Calculate the default probability for the VAR horizon for each name using market CDS

spreads. For example, if the VaR is calculated on a one day horizon like in the GVAR tool,
1-day default probabilities are calculated. In the GVaR tool, these probabilities are implied
from 5y CDS spreads. This is conservative because these are risk-neutral probabilities and
because 1 day spreads are assumed to be equal to 5y CDS spreads.
„ Assuming a given correlation assumption, calculate the loss distribution of the portfolio
using CDO pricing techniques. This then gives the loss corresponding to the required
confidence level (99.96% here). Statistical studies show that default correlation is usually
small in practice (below 10%). A conservative value around 30% for correlation makes sense
in our view.
„ Floor the loss to the worst loss due to one default: even if spreads are very tight, the VAR

should be higher than the loss due to any unexpected default.


The graph below shows one theoretical example of the loss distribution of a portfolio. Once
the cumulative loss function is computed (i.e. the probability that the loss will be below any
level), it is easy to find the loss corresponding to a given confidence level.

01/07/2007 5
Quantitative Strategy

The VaR is calculated by looking at the cumulative loss distribution

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
0% 5% 10% 15% 20% 25% 30% 35% 40%
S t rik e
90% VaR: 3.6% loss

Source: SG Credit Research

Using the GVaR parameters, the default VaR for a short €10m protection position on the 5y
iTraxx S7 Main index was €96,000 on 31 May 2007 which corresponds to two defaults in the
index. The default VaR of a short €10m protection position on the 5y iTraxx S7 X-Over index
was €120,000 on 31 May 2007 which corresponds to one default in the index.

… or a rule-of-thumb
In addition to this rather precise default VaR calculation, we developed a rule-of-thumb
technique to calculate an alternative default VaR. We call this technique the EasyVar as it is
very easy to implement and does not require the use of a CDO pricer. This technique relies on
four steps (the first two steps being the same as in the previous method):

„ Calculate the loss due to the default of each name. To do so, positions are netted on each
name. The output of this step is a list of names with their loss given default.
„ Calculate the default probability for the VAR horizon for each name using market CDS
spreads. In order to be conservative, we decided to use the 1y default probability instead of
one day probabilities. These probabilities are based on 1y CDS spreads.
„ Assume that the worst loss due to one default will occur in the portfolio.
„ Calculate the expected loss of the remaining portfolio. To do so, for each name, multiply the
default probability by the loss given default of this name. It gives the expected loss on a
name-by-name basis. Then sum up the expected losses of all names to get the portfolio
expected loss.
Both techniques (the GVAR and the EasyVar) give the same results in a limit case: if there are
an infinite number of names in the portfolio and if their default correlation is zero, then the loss
in the portfolio will always be equal to the expected loss of the portfolio and therefore the
GVaR and EasyVar methods will give the same results (as long as the VaR is higher than the
floor of one default).
The EasyVar approach gives a €51,500 default VaR for a short €10m Main position. This is
smaller than the GVaR result of €96,000. On the contrary, it gives a €167,000 default VaR for a
short €10m XOver position which is higher than the default GVaR of €120,000. This comes
from the expected loss part which is not negligible for the X-Over index (€47,000).

6 01/07/2007
Quantitative Strategy

Calculating the spread VaR


Getting a portfolio spread VaR is a complicated task: all instruments are correlated and should
be jointly simulated to get a precise calculation. This is what is done in SG’s GVaR tool.
Another option is to calculate a VaR at the trade level and then to sum these VaRs. This is
what is done in the EasyVar approach. Obviously, this approach is much easier to implement
but more conservative because all the diversification effects and netting effects across
positions are ignored.

A VaR at the trade level: the EasyVar approach


To calculate the individual VaR of each trade, the EasyVar approach relies on predefined
scenarios (corresponding to catastrophe events) and then calculates the theoretical P&L of
each trade in each of these scenarios to find the Value-At-Risk of the trade.

The calibration of these predefined scenarios is crucial as they are directly linked to the
confidence level of the VaR calculation (i.e. to the probability for the loss to be below the VaR,
here 0.04%). We decided to set specific scenarios for each type of trade ranging from the
directional trades (long or short positions on a given name) to the relative value trades like
long/short index trades or curve trades. These scenarios are calibrated to historical data on
bonds and CDS. The data set that we used comes from three different sources:
„ Markit CDS data since 2001.
„ Bond spread data from SG’s internal database since 2003
„ MSCI corporate bond spread index data since 1996
For each type of trade, we calculated the loss corresponding to a 99.96% VaR and cVaR. The
table below summarizes these scenarios.

Summary of VaR and cVaR simulated scenarios


Type of trade Scenario VaR scenario cVaR scenario
Long bond or short CDS protection Spd widening worst of +100% and +100bp worst of +125% and +160bp
Short index protection Spd widening worst of +40% and +35bp worst of +40% and +40bp
Short bond or long CDS protection Spd tightening -36% -45%
Long index protection Spd tightening -25% -30%
Long/short trade One leg moves, other leg stable see above see above
CDS steepener LT spd tightening, stable ST spd -35% -45%
Index steepener LT spd tightening, stable ST spd -30% -30%
CDS flattener LT spd widening, stable ST spd +50% +65%
Index flattener LT spd widening, stable ST spd +35% +35%
Negative basis trade CDS tightening, stable bond spread worst of -40bp and -47% worst of -45bp and -50%
Positive basis trade CDS widening, stable bond spread worst of +60bp and +30% worst of +105bp and +50%
Source: SG Credit Research

The sections below detail the analysis that we performed to come up with each of these
scenarios.

Directional bond or CDS positions


Directional trades (i.e. long or short only positions) are the types of trades with the simplest VaR
calculation. Calculating a VaR for this type of positions involves setting catastrophe scenarios of
tightening and widening. To do so, we used our CDS database which contains Markit data for
European and US names since 2001. We eliminated CDS quotes higher than 1000bp because
we found that the data on names trading above 1000bp was not reliable. We calculated the
biggest 5y CDS weekly moves over this period and used this data to build a distribution of

01/07/2007 7
Quantitative Strategy

spread tightenings and widenings in order to find the worst moves with the desired confidence
level. The density of spread weekly moves is shown in the two graphs below.

The density of spread moves is different from a Gaussian … because it has fat tails
density…

Actual density Best-fit Gaussian density Actual log density Best-fit Gaussian log density

-100% -50% 0% 50% 100%


Probability

Probability
-50% -30% -10% 10% 30% 50%
Spread move as a % of initial spd Spread move as a % of initial spd

Source: SG Credit Research

The two graphs above show that the density of percentage spread moves is not well
approximated by a Gaussian density. In the whole section below, we do not make any
Gaussian assumption. We simply look at the actual spread distribution and calculate the VaR
and cVaR levels from this distribution.

Looking at the data for weekly tightenings, it is clear that tightening moves depend on the
initial spread: the higher the initial spread, the bigger the potential tightening. The biggest
percentage tightening happened in November 2006 on Verizon: -79% of the then current 5y
spread (from 75bp to 16bp). With a 99.96% confidence level, the biggest tightening was
Countrywide Home Loans in January 2007: -36% (spread from 27bp to 17bp). Therefore the
99.96% VaR corresponds to a 36% tightening. Lastly, the 99.96% cVaR corresponds to a
44% tightening.

Analysing widening moves is a little bit more complicated. The biggest widenings in
percentage terms happened on companies with tight spreads. For example the worst
percentage widening in the database happened on ISS in March 2005: +808% (spread
moving from 37bp to 338bp). Therefore we decided to distinguish companies trading with a
tight spread from those trading with a wide spread. We set this threshold at 200bp because
the data shows that for CDS trading above 200bp, percentage moves are contained in a
tighter range.

For companies trading below 200bp, the worst absolute widening scenario occurred on Ahold
in February 2003 (+662bp from 198bp). With a 99.96% confidence level, the worst move
happened on Adecco in April 2004 (+92bp from 145bp). The cVaR at this confidence level
corresponds to a +158bp widening.

For companies trading above 200bp, it is more relevant to look at widenings as a percentage
of the spread. The worst percentage widening occurred on Tenet Healthcare in November
2002 (+138% from 202bp). With a 99.96% confidence level, the worst scenario occurred on
Capital One Bank which widened by +99% in July 2002. The cVaR at this level corresponds to
a +124% widening.

8 01/07/2007
Quantitative Strategy

Therefore we decided to use a combined rule to analyse long risk positions. We set the cVaR
as the maximum of the losses generated by one of the two following scenarios:
„ Spreads widen by 160bp
„ Spreads widen by +125%
For CDS trading below 128bp, the first scenario is the worst, and for CDS trading above
128bp, the second scenario is taken into account.

Directional index positions


We applied the same methodology to find the worst scenarios for index tightening and
widening. Index positions require specific scenarios because extreme moves are much
smaller than idiosyncratic positions. To perform this analysis, we first analysed the history of
iTraxx and CDX indices (Main, HiVol, X-Over and HY) since their creation in 2004.

The analysis of the data shows that the tightening moves of the indices are proportional to their
spread. Therefore, it makes sense to find the extreme tightenings in the percentages of the then
current spread. We find that the weekly tightening corresponding to the 99.96% confidence level
is a -25% tightening (CDX HiVol S3 moving from 124bp to 93bp on the week of the 6 February
2006). The cVaR at this level corresponds to a -26.5% tightening of the index.

For short index protection positions, as well as for short CDS protection positions, it is
necessary to distinguish between low spreads and high spreads. For spreads below 100bp,
we find that the 99.96% VaR corresponds a +33bp widening (iTraxx XOver S3 moving from
95bp to 128bp on the week of the 26 February 2007). The cVaR corresponds to a +39bp
widening. For spreads above 100bp, the VaR and cVaR correspond to a +39% widening.

We also performed the same analysis on MSCI corporate bond data starting in 1996 (MSCI
indices are bond indices calculated on a basket of liquid European Investment Grade bonds).
The worst weekly widening in this set of data was a +34% widening and the worst tightening
was a -26% tightening.

Therefore the Easy cVaR calculation for a directional position on an index is a result of the
worst of one of the following three scenarios:
„ The index spread tightens by 30%
„ The index spread widens by 40%
„ The index spread widens by 40bp

Long/short CDS, bond or index trades


For long/short pair trades, we decided to apply the same rule as described above for
directional positions and to apply the scenarios to only one leg of the trade. This is fairly
conservative because it assumes that the second leg of the trade will not hedge the first leg.
For example, to analyse a long €9m OTE vs. short €10m Telenor protection, we would
calculate the maximum loss of the three following adverse scenarios:

„ Telenor spreads widen by 160bp


„ Telenor spreads widen by +125%
„ OTE spreads tighten by 45%
Nevertheless, this cVaR is smaller than the sum of the cVaRs of each leg of the trade (the long
€9m OTE and the short €10m Telenor).

01/07/2007 9
Quantitative Strategy

For long/short index trades, the methodology is similar. We calculate the loss due to the move
of only one index with a perfect stability of the other. This is once again conservative because
one could expect that a widening in one index would lead to a widening in the other, therefore
offsetting some of the losses in the long/short position.

CDS curve trades


CDS curve trades require a specific methodology because they are less risky than a long/short
CDS trade on two different companies. This is why we analysed the curve movements within
our CDS database since 2001.

A first possible approach is to analyse curve movements in absolute terms. For example, the
99.96% cVaR for a CDS steepener corresponds to a -165bp flattening. This seems too
conservative for steepeners with a 5y CDS trading at 20bp. In fact, companies with a very
wide spread have sharper spread movements than companies with a tight spread. Therefore,
it makes more sense to analyse relative movements.

A second possible approach is to analyse curve movements as a percentage of the initial


curve. This does not work either as the 99.96% cVaR corresponds to an increase of the initial
curve by +2200%. This is because the initial curves were very flat in these cases (average
initial 5-10 curve in the 0.04% worst cases: 2.5bp).

A third approach is to analyse curve movements as a percentage of the initial long-term


spread. This approach is far more successful and realistic. The 99.96% VaR of a flattener
corresponds to a steepening by 50% of the initial long-term spread. This scenario is
equivalent to a 50% widening of the long-term spread, with a stable short-term spread. The
cVaR at the same level corresponds to a steepening by 65% of the initial long-term spread.
Conversely, the VaR of a steepener corresponds to a flattening by 35% of the long-term
spread and the cVaR corresponds to a flattening by 45% of the long-term spread. These
values are valid for the following types of curve buckets: 3y-5y, 5y-7y, 5y-10y and 3y-7y.

It is interesting to notice that CDS curve trades have a smaller VaR than long/short CDS
trades between two different companies: for example, the cVaR for a long/short trade is
calculated by taking the worst loss between one CDS widening by 125% or 160bp or one
CDS tightening by 45% while the cVaR of a curve trade is the worst of the loss generated by a
+65% widening or a -45% tightening of the long-term spread. Therefore, it makes total sense
to distinguish between long/short trades and curve trades.

Index curve trades


The same analysis can be performed on index curve movements. Once again, we used iTraxx
and CDX index data since 2004, as well as MSCI corporate bond indices by maturity, to
generate an average curve in the investment grade bond market since 1996. The 99.96% VaR
for a steepener corresponds to a 25% tightening of the long-term spread. The cVaR at that
level corresponds to a 26% tightening. Conversely, the VaR for an index flattener corresponds
to a +32% steepening (cVaR: 35% steepening).

Basis trades
Like curve trades, basis trades require a specific methodology because playing one bond
against the CDS of the same company is far less risky than playing a bond against a CDS of
another company. This is quite obvious when looking at our data set comprised of bond
spreads and CDS spreads since July 2003 on a basket of 400 euro-denominated bonds.

10 01/07/2007
Quantitative Strategy

The first possible approach is to study basis moves in absolute terms. The 99.96% cVaR for a
negative basis trade corresponds to a -158bp decrease of the basis which seems far too
conservative for bonds trading at 30bp. In fact, the higher the initial spreads, the bigger the
potential movements of the basis. This is why we decided to split the universe between the
bonds with a corresponding CDS below 200bp and the others. For bonds with a CDS trading
below 200bp, the 99.96% VaR of a negative basis position corresponds to a 40bp decrease of
the basis and the cVaR corresponds to a 45bp basis tightening. Conversely, the VaR for a
positive basis position corresponds to a +60bp increase of the basis (cVaR=+105bp).

For bonds with a CDS wider than 200bp, absolute movements are big but relative movements
evolve in a fairly tight range. The most reliable way to analyse relative basis movements is to
study basis changes as a percentage of initial CDS spread. We find that the 99.96% VaR of a
negative basis position for these bonds corresponds to a basis decrease by 47% of the initial
CDS spread (cVaR=-50%). Conversely, the VaR for a positive basis position corresponds to
an increase of the basis by 30% of the initial CDS spread (cVaR=+50%).

Simulating all assets jointly: the GVaR approach


The GVaR methodology aims at simulating a portfolio of bonds and CDS. This integrated
approach is more realistic than the trade-by-trade approach detailed in the section above. To
do so, in the GVaR framework, each spread follows a given diffusion which is the sum of two
components:
„ A log-normal diffusion process: like in the Black and Scholes model for stock price diffusion,

percentage moves for spreads (i.e. dS/S) are supposed to be normally distributed around a
given trend.
„ Random jumps: at any point in time, spreads can jump downwards or upwards with a given

probability and a random jump size.


This is consistent with observed market data: most spreads move by a few percentage points
every day but in some cases (unexpected defaults a la Enron, LBO…) spreads jump (usually
upwards but downward jumps also exist in case of a takeover by a better-rated company or
an orphaning situation for the CDS).

Mathematically, the diffusion writes:

dS
= µdt + σdWt + JdN t (1)
S

where S is the spread, µ is the trend, σ is the volatility, Wt is a Brownian motion, J is the jump
size and Nt is a Poisson process (i.e. a discrete process which jumps up with a given
intensity).

It is hard to calibrate such diffusion to historical data on spreads because volatility is not
constant over time. In fact, market data is fairly consistent with the existence of two regimes
with each regime having its own volatility. One regime is the base case scenario (for example
the 2003-2007 period), while the second regime is a stress scenario where volatility is bigger
and jumps are more frequent (like in the summer of 2002).

Once the parameters µ, σ and J have been calibrated for each of the two regimes, the last
step of the GVaR approach is to specify the dependence of the uncertain parts of each
spread, i.e. the Brownian motions and the jumps. Brownian motions of each asset are more

01/07/2007 11
Quantitative Strategy

correlated when the two assets have the same maturity and are in the same region (Europe or
US). For example, the correlation of the two Brownian motions driving the spread of two
European 5y CDS is around 50%. This correlation is smaller if the maturity is different, if the
two names are in two different regions (one in Europe and one in the US) or if one asset is a
bond and the other is a CDS. Jumps are correlated the same way but are independent from
the Brownian motions.

Comparison of GVaR and EasyVar methods


A few case studies
Let us have a look at a few case studies to compare the results of the GVaR and EasyVar
approaches to calculate the spread VaR. The graph below summarizes the spread VaR
calculations based on the GVaR and also on the rule-of-thumb stress tests corresponding to
the EasyVar and Easy cVaR approaches.

Comparison of spread VaR calculations for the GVaR, EasyVaR and Easy cVaR methods

Easy VaR Easy cVaR GVaR

€ 700,000

€ 600,000

€ 500,000

€ 400,000

€ 300,000

€ 200,000

€ 100,000

€0
Short €10m Short €10m Long €10m Long €10m Long €1m Long OTE vs. BA 5-10y Grohe 3-5y IMPTOB 13
Main Xover Main Xover Xover vs. €10m Telenor steepener flattener negative basis
Main

Short positions on indices refer to protection selling positions.


Source: SG Credit Research

The graph shows that the Easy cVaR and GVaR numbers are fairly close especially for single-
name trades like basis trades or curve trades. On the other hand, the GVaR is higher for index
positions like selling X-Over protection (€449k vs. €304k for the Easy cVaR). Another
interesting feature is that the GVaR of a short Main vs. X-Over protection is lower than the
GVaR of selling Main protection alone (€199k vs. €242k). This is not the case in the EasyVaR
approach as the VaR of a long/short position is equal to the worst VaR of each leg of the
trade. For example the cVaR of a long €1m XOver vs. €10m Main protection position is
€175k, which is also the cVaR of a short €10m Main position.

A large-scale calculation on SG’s quantitative portfolio


It is interesting to compare the results of the GVaR and EasyVaR approaches on a bigger
portfolio. We chose to perform this comparison on our relative value portfolio, comprised of

12 01/07/2007
Quantitative Strategy

index trades, curve trades, basis trades, long/short trades and hybrid trades. All these trades
were recommended in our weekly publication, Relative Value Trader. We did not include
equity-credit trades which make up a significant part of our portfolio because the EasyVaR
and GVaR methodologies do not cover stocks and equity options. The results are shown in
the graph below.

EasyVaR amounts are correlated with GVaR but are higher

Easy VaR Easy cVaR Total GVaR

€ 60,000,000

€ 50,000,000

€ 40,000,000

€ 30,000,000

€ 20,000,000

€ 10,000,000

€0
03/05 06/05 09/05 12/05 03/06 06/06 09/06 12/06 03/07

Source: SG Credit Research

The graph shows that Easy VaR and cVaR are very close and are also correlated with GVaR
(correlation between EasyVaR and GVaR: 94%). GVaR amounts are always lower than
EasyVaR amounts due to the netting effects within the GVaR methodology.

Let us analyse these results in more details by splitting the VaR calculations between spread
and default VaR. The graphs below show the history of default Value-At-Risk (left-hand graph)
and spread Value-At-Risk (right-hand graph) with the EasyVaR and GVaR methodology on
SG’s quant portfolio.

The left-hand graph shows that default VaRs are very much in line in both methodologies. In
fact, they are very close to the worst jump-to-default in the portfolio which is due to the
SwissRe steepener recommended in January 2006.

01/07/2007 13
Quantitative Strategy

Default VaR are very much in line between GVaR and … but spread GVaR is much smaller than spread EasyVaR
EasyVaR…

Default EasyVaR Default GVar Spread EasyVaR (LHS) Spread Easy cVaR (LHS)
Spread GVaR (RHS)
30
30 6
25

Spread EasyVaR in m€
25 5
Default VaR in m€

Spread GVaR in m€
20
20 4
15
15 3
10
10 2

5 5 1

0 0 0
03/05 07/05 11/05 03/06 07/06 11/06 03/07 03/05 07/05 11/05 03/06 07/06 11/06 03/07

Source: SG Credit Research

The right-hand graph is more interesting. It shows that the results of the three methodologies
are strongly correlated (81% correlation), but that GVaR amounts are much smaller than
EasyVaR amounts. While the Easy cVaR is €20m at the beginning of June 2007 (see left-hand
scale), the spread GVaR is €3.2m (right-hand scale). This comes from the strong netting effect
between the different trades in our portfolio.

Comparing the GVaR of the total portfolio with the GVaRs of each strategy within the portfolio,
(curves, basis, hybrids, long/short and index trades) gives a striking example of these netting
effects. The spread GVaR of the total portfolio was 3.2m at the beginning of June 2007. At the
same time, the sum of the spread GVaRs of each strategy is 6m. This shows that aggregating
the five strategies almost halves the total spread GVaR of our relative value portfolio. On the
contrary, the spread EasyVaR of the total portfolio is exactly equal to the sum of the EasyVaRs
of each strategy.

14 01/07/2007
Quantitative Strategy

Calculating the performance of SG’s quantitative


portfolio

Once the VaR calculation methodology has been set, it is possible to calculate the
performance of our quantitative portfolio. As the last section shows, the GVaR of our portfolio
has evolved between 0 and €14m in 2005 and between €14m and 31m from 2006 to June
2007. Therefore a hedge fund playing all our strategies would have needed a €31m funding.
The performance of this theoretical hedge fund would include the performance of our
strategies plus the return of the €31m funding invested in the money markets at the EONIA
rate. In this section we first calculate the performance without transaction costs and then
make assumptions to calculate theoretical transaction costs on all trades in the portfolio.

Assumptions for transaction costs


Calculating realistic values for transaction costs is fairly difficult because historical bid/offer
data is not easily available (the Markit database for example only contains mid-data).
Therefore, one needs to make assumptions for transaction costs. These assumptions depend
on the spread level of each instrument. These assumptions are detailed in the table below.
These assumptions are more aggressive than the standard bid-offer provided by one dealer
but are fairly realistic in our view for investors that compare the prices of a few dealers for
each transaction.

Summary of transaction cost assumptions


Type of trade Bid/offer on each leg Example of bid-offers
Index trade 0.125bp+0.5% Main: 0.23bp, Xover:1.1bp
Single-name trade 1bp+1.5% Telefonica:1.375bp, Grohe:6.7bp
CDS curve trades 0.5bp+0.75% Fiat 5y-10y curve: 2bp
Basis trades 0.75bp+1.125% Fiat Nov-11 basis package: 2.4bp
Hybrid trades 0.5bp+1% Suedzucker perp: 1.8bp
Source: SG Credit Research

For indices, we decided to apply a bid-offer of 0.125bp+0.5% of the spread. This gives a
0.23bp bid-offer for the Main index @21bp, a 0.325bp bid-offer for the HiVol index @40bp and
a 1.1bp bid-offer for the X-Over index @195bp.

For single name CDS or bonds, we apply a bid-offer of 1bp+1.5% of the spread. For example
it gives a bid-offer of 1.375bp for Telefonica 5y CDS @25bp. It gives a 2bp bid-offer for Valeo
@70bp, a 4bp bid-offer for Seat Pagine @200bp and a 6.7bp bid-offer for Grohe @380bp.

For CDS curve trades, we apply half of the bid-offer on each CDS (i.e. 0.5bp+0.75% of the
spread on each leg). This is because trading the curve as a package with one single dealer is
less costly than trading each leg separately. For example, a Fiat 5y-10y steepener (curve
@40bp) would have a 2bp bid-offer with these assumptions.

For basis trades, we apply 75% of the bid-offer on each leg. Trading the basis as a package is
less costly than trading the bond and CDS separately, but is still more expensive than trading
only one leg of the trade. For example, a negative basis package on Fiat Nov-2011 (basis @-
8bp) would have a 2.4bp bid-offer with these assumptions.

01/07/2007 15
Quantitative Strategy

Lastly, we apply a specific assumption for subordinated bonds because these bonds are very
liquid. We apply half of the bid-offer of regular bonds for subordinated bonds (i.e.
0.5bp+0.75% of the spread). For example the Axa 5.777 perp-16 (trading at 109bp) would
have a 1.3bp bid-offer with these assumptions. Similarly, the Suedzucker perp @170bp has a
1.8bp bid-offer with these assumptions.

Performance of SG’s relative value portfolio


The graph shows the performance of our relative value portfolio since its creation in 2005. This
performance is calculated with and without transaction costs, using the transaction cost
assumptions described above.

Performance with and without transaction costs of our relative value portfolio since March 2005

Perfs without TC Perfs with TC

€ 7,000,000

€ 6,000,000

€ 5,000,000

€ 4,000,000

€ 3,000,000

€ 2,000,000

€ 1,000,000

€0
03/05 07/05 11/05 03/06 07/06 11/06 03/07
-€ 1,000,000

Source: SG Credit Research

The graph shows that without transaction costs, our portfolio generated a steady performance
since 2005. The performance including transaction costs is less convincing in 2005 (flat
performance until December 2005). This comes from two reasons in our view:

„ Our trade targets were not aggressive enough during this period. They barely compensated
transaction costs and therefore the performance including bid-offer costs remains fairly flat.
For example our Portugal Telecom 3y-5y steepener recommended in October 2005 was
closed in December 2005 for a +€27,000 performance without transaction costs, which
corresponds to a 6bp steepening. After transaction costs the performance is +4bp. Waiting
two more months would have generated a +€120,000 additional performance in mid-February
2006, thanks to the announcement of the Sonaecom leveraged bid on PT.
„ The performance shown above does not include our flagship strategy in 2005: the equity-
credit strategy. This strategy is not included here because our VaR tools (GVaR and EasyVaR)
are not compatible with equity and equity volatility positions. The performance of this strategy
was excellent in 2005 and would have offset the flat performance after the transaction costs of
our other strategies in 2005. After the 2005 correlation crisis, the strategy remained flat as we
reduced the frequency of our trades and balanced our long and short positions.

16 01/07/2007
Quantitative Strategy

The performance without transaction costs of our equity-credit strategy was good between
2004 and July 2005

€ 2,500,000

€ 2,000,000

€ 1,500,000

€ 1,000,000

€ 500,000

€0
04/04 08/04 12/04 04/05 08/05 12/05 04/06 08/06 12/06 04/07
-€ 500,000

Source: SG Credit Research

Finally, assuming a €31m funding for a hedge fund investing in all our strategies (except the
equity-credit one), it is possible to calculate the return of this hedge fund. The graph below
shows the return of €100 invested in this hedge fund (both with and without transaction costs)
and compares it with the risk-free return of an investment at the EONIA rate during this period.

Our relative value portfolio generated a total return of +7.4%/yr after transaction costs since
March 2005.

Risk-free With transaction costs No transaction costs


NPV of a €100 investment in March 05

130

125

120

115

110

105

100

95

90
03/05 07/05 11/05 03/06 07/06 11/06 03/07

Source: SG Credit Research

The graph shows that an investment of €100 in March 2005 in our portfolio ended with a €118
value in June 2007, which corresponds to a +7.45%/yr total return. The same strategy, but
without transaction costs, yields a +10.8%/yr total return, while an investment in a risk-free
asset generates a +2.75%/yr return. Therefore our portfolio generates an excess return of
+4.7%/yr over a risk-free strategy. The Sharpe ratio of this portfolio is 1.9. This result is fairly
satisfying in our view because our portfolio is as market-neutral as possible and performance
is generated through pure credit alpha.

01/07/2007 17
Quantitative Strategy

Appendix: summary of EasyVar stresstest scenarios

The table below summarises the different scenarios used to design the EasyVar stresstests for spread VaR.

Summary of EasyVar stresstest scenarios


Type of trade Initial spread Scenario Worst case VaR scenario cVaR scenario
Long bond or short CDS protection <=200bp Spd widening Ahold, Feb 03, +662bp Adecco, April 04, +92bp +158bp
Long bond or short CDS protection >200bp and <1000bp Spd widening Tenet Healthcare, Nov 02, +138% Capital One Bank, Jul 02, +99% +124%
Short index protection <=100bp Spd widening iTraxx X-Over S4, Feb 07, +45bp iTraxx XOver S3, Feb 07, +33bp +39bp
Short index protection >100bp and <1000bp Spd widening iTraxx X-Over S5, Feb 07, +39.5% iTraxx XOver S5, Feb 07, +39.5% +39.5%
Short bond or long CDS protection <1000bp Spd tightening Verizon, Nov 06, -78% Country Wide Home Loans, Jan 07, -36% -44%
Long index protection <1000bp Spd tightening iTraxx SubFin S2, May 05, -27.5% CDX HiVol S3, Feb 06, -25% -26.5%
CDS steepener <1000bp Curve flattening as a % of LT spd TXU Corp 5y-10y, Sep 02, -124% Swiss Re 5y-10y sub, Jun 02, -35% -45%
Index steepener <1000bp Curve flattening as a % of LT spd CDX XO7, Feb 2007, -27% MSCI 5y-10y, Mar 97, -25% -26%
CDS flattener <1000bp Curve steepening as a % of LT spd ISS 5y-10y, March 05, +175% ING Groep, March 05, +50% +65%
Index flattener <1000bp Curve steepening as a % of LT spd CDX XO7, March 2007, +32% MSCI 5y-10y, Aug 98, +26% +32%
Negative basis trade <=200bp Basis tightening Ford Motor Credit 2007, Oct 05, - Lanxess 2012, Oct 05, -40bp -45bp
69bp
Negative basis trade >200bp and <1000bp Basis tightening as a % of CDS spd Adecco 2006, Jun 04, -50% Ahold 2007, March 05, -47% -50%
Positive basis trade <=200bp Basis widening Grohe 2014, April 06, +147bp Heidelberg 2009, Jun 05, +58bp +105bp
Positive basis trade >200bp and <1000bp Basis widening as a % of CDS spd Bombardier 2008, Nov 05, +51% GMAC 2008, Oct 05, +27% +50%
Source: SG Credit Research

01/07/2007
Quantitative Strategy

SG Quantitative Credit Strategy past publications


June 2007 Right on the hedge of the CDS curve
May 2007 SG’s CDS curve model : a user’s guide
May 2007 Analysing iTraxx Main+XOver tranches
April 2007 Credit spread options: reading the market’s smile
February 2007 Credit trackers: benchmarking default risk
February 2007 Is there value in the High Yield bond market?
November 2006 Quantitative Outlook 2007
October 2006 Zero-coupon Equity demystified
October 2006 Event risk analysis: beyond decision trees
September 2006 Statistical trading in the world of interest rate and credit default swaps
July 2006 Pricing bespoke CDOs: latest developments
June 2006 A primer on CPPI
May 2006 The quest for a better firm model: estimating jump-to-default out of the equity volatility smile
April 2006 Looking for value in the Bank Tier 1 market
April 2006 Finding the fair spread of credit indices
March 2006 Taking advantage of LBO speculation
March 2006 Building correlation trades: a case study
February 2006 CDO²: new opportunities
December 2005 Looking for value in the sub insurance market
November 2005 The wise man is he who knows the relative value of things
October 2005 Do corporate hybrids offer value?
September 2005 Playing long term bonds against 10yr CDS
July 2005 Local correlation: a backtesting study
June 2005 A note on the distribution of asset value in the local correlation model
May 2005 Hedging CDS curve trades: a case study
April 2005 CMCDS: sense and sensitivity
March 2005 The basics of spread option pricing
February 2005 The relative value of EDS against credit and equity derivatives
February 2005 Pricing CDOs with a smile
November 2004 Introducing the CDS Curves Monitor
October 2004 Empirical evidence on the BFM model
September 2004 CDS vs. Stock – the quest for the optimum hedge ratio
July 2004 Pricing and hedging of correlation products
July 2004 The new iTraxx indices
April 2004 A hedging model for capital structure arbitrage
March 2004 Back to basics: which spread for measuring credit?
January 2004 Backtesting basis trades: a case study
December 2003 Forecasting the iBoxx Diversified CDS index
October 2003 Kohonen maps: going beyond classification for enhanced management strategies
September 2003 Arbitrage between credits and equities – new strategies, more opportunities
August 2003 Pricing the basis
July 2003 Hedging bonds using CDS and taking advantage of convexity
June 2003 Firm models with event risk
May 2003 Beta-neutral relative value analysis
April 2003 Arbitrage between CDS and bonds
March 2003 Forecasting individual corporate credit spreads
December 2002 2002: of useful models
October 2002 Firm models and trading strategies (2)
September 2002 Firm models and trading strategies (1)
July 2002 Backtesting systematic Rich/Cheap strategies
June 2002 An analysis of CDO downgrades
May 2002 How to optimize a credit portfolio
April 2002 CDOs as balance sheet management tools
March 2002 A spread forecasting model
February 2002 Cash-flow CDOs – highly enhanced assets

19
01/07/2007
Quantitative Strategy

SG Quantitative Credit Strategy past publications


January 2002 Beyond volatility and correlation
November 2001 Some applications of a firm value model
October 2001 Why can a credit curve invert?
September 2001 Looking for value on the European Credit Market
September 2001 Pricing put options indexed on ratings
July 2001 A smile model for valuing capital securities
June 2001 Understanding the dynamics of Credit Spreads
May 2001 What are the incentives to use internal ratings in the new Cooke ratio?
April 2001 A rule-of-thumb for valuing Telecom coupon step-ups
March 2001 How does the market reward the risks of default or rating downgrade?
Source: SG Credit Research
Quantitative Strategy

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21
01/07/2007
Quantitative Strategy

Credit, Fixed Income & Forex Research

Global Head of Credit, Fixed Income & Forex Research Benoît Hubaud (33) 1 42 13 61 08 / (44) 20 7676 7168

Research Manager Denis Groven (33) 1 42 13 78 21 Quant Research


Head Julien Turc (33) 1 42 13 40 90
David Benhamou (33) 1 42 13 94 75
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Consumers & Services Sonia van Dorp (33) 1 42 13 64 57 Credit Strategy


Olivier Monnoyeur, CFA (33) 1 42 13 43 87 Suki Mann (44) 20 7676 7063
Caroline Duron (33) 1 58 98 30 32 Guy Stear, CFA (33) 1 42 13 40 26
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Ozana Breaban (44) 20 7676 7160 Fixed Income & Forex Strategy
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Fixed Income
Telecom & Media Terry Nguyen, CFA (44) 20 7676 7162 Adam Kurpiel (33) 1 42 13 63 42
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