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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Today’s blog focuses on the U.S. dollar funding shortfall that took place at State Street during the period from February 8, 2008 to March 16, 2009. Today’s blog shows that much of State Street’s funding needs came from an unexpected source: losses in the firm’s investment management business, which normally would be borne by the investors in the funds managed by State Street.  We reach a conclusion that we have reached often in this liquidity risk series: State Street borrowed nearly three times more money from the Federal Reserve than Lehman Brothers was refused until after its bankruptcy was announced September 14, 2008.

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10 Year Forecast of U.S. Treasury Yields And U.S. Dollar Interest Rate Swap Spreads
Today’s forecast for U.S. Treasury yields is based on the July 14, 2011 constant maturity Treasury yields that were reported by the Board of Governors of the Federal Reserve System in its H15 Statistical Release at 4:15 pm July 15, 2011. The “forecast” is the implied future coupon bearing U.S. Treasury yields derived using the maximum smoothness forward rate smoothing approach developed by Adams and van Deventer (Journal of Fixed Income, 1994) and corrected in van Deventer and Imai, Financial Risk Analytics (1996). For an electronic delivery of this interest rate data in Kamakura Risk Manager table format, please subscribe via info@kamakuraco.com.

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Today’s blog focuses on the U.S. dollar funding shortfall that took place at Wachovia Bank NA during the period from February 8, 2008 to March 16, 2009, through the merger battle by potential acquirers Citigroup and Wells Fargo and post the December 31, 2008 closing of the merger with Wells Fargo. Today’s blog shows that the funding squeeze at Wachovia was acute and quickly peaked at $36 billion in borrowings from the Fed.  As we have seen often in this series of blogs, Wachovia was granted more money from the Fed than Lehman Brothers was refused until after its bankruptcy was announced September 14, 2008.

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The credit crisis of 2007-2009 in the United State and Europe and the collapse of the Japanese bubble in the 1990-2002 period show that, without hedging credit risk, the largest financial institutions in the world are very likely to fail. Many trillions of dollars of taxpayer bailouts have put the credit quality of the United States and Japan at risk.

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ABSTRACT

KEYWORDS: credit risk model, default probability, default probability model, term structure of default probabilities, Merton model, Black-Scholes model

This chapter introduces the topic of credit risk modeling by first summarizing the key objectives of credit risk modeling.1  We then discuss ratings and credit scores, contrasting them with modern default probability technology.  Next, we discuss why valuation, pricing and hedging of credit risky instruments are even more important than knowing the default probability of the issuer of the security.  We review some empirical data on the consistency of movements between common stock prices and credit spreads with some surprising results. Finally, we compare the accuracy of ratings, the Merton model of risky debt, and reduced form credit models.

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