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The Federal Reserve’s 2015 Comprehensive Capital Analysis and Review stress testing exercise is moving toward its conclusion, but the biggest banks in the United States live in fear of delivering a “wrong answer” to the Federal Reserve. None of the big banks is immune from this fear, including the big four Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), and Wells Fargo (WFC). In this note, we explain this fear and present a worked example of the right answer, a stress test using the Federal Reserve’s CCAR 2015 scenarios for an equal-weighted portfolio of loans to all public firms in North America. Along the way, we make suggestions about how to improve the CCAR stress testing process from the point of view of both the Federal Reserve and the banks that it regulates.

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We last ranked the best value fixed rate corporate bond issues on October 17, 2014 for maturities of 20 years or more. Today we rank the best value corporate bond trades with daily trading volume of at least $5 million and maturities of 20 years or more. On December 1, 2014 in the U.S. bond market, there were 18,184 bond trades in 3,173 non-call fixed rate corporate bond issues of 982 bond issuers representing $5.2 billion in notional principal. Which 20 trades were the best trades of the day, and how do we decide the answer to that question?

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As the Federal Reserve’s 2015 Comprehensive Capital Analysis and Review stress testing exercise moves to its conclusion, a steady stream of well-intended but incorrect models are coming into public view. In particular, many analysts have been using lagged default probabilities as inputs to their 13 quarter stress tests, a modeling strategy that Professors Joshua Angrist and Jorn-Steffen Pischke label “forbidden models” in their classic econometrics text “ Mostly Harmless Econometrics: An Empiricist’s Companion” (2009).

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In the past week, I have spoken with many regulators and bankers on the proper role of intuition in the econometric estimation of credit models for the Federal Reserve’s Comprehensive Capital Analysis and Review 2015. In our review of best practices for stress testing , value at risk, and credit value at risk on October 20, 2014, there was no role for “intuition,” just for science. The same is true for our November 13, 2014 update of model validation procedures for CCAR 2015

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On October 20, we noted that the Federal Reserve’s decried banks’ reliance on poor risk models. The Fed’s comments were contained in the final rules for Comprehensive Capital Analysis and Review (“CCAR”) stress testing in 2015 and beyond in a document released Friday, October 17, 2014. In our October 20 note “ Best Practice Model Validation for Stress Testing, Value at Risk and Credit VAR,” we described the systematic best practice for model validation for these model types.

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