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Donald van Deventer
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Donald R. van Deventer founded the Kamakura Corporation in April, 1990 and is currently Chairman and Chief Executive Officer. Dr. van Deventer's emphasis at Kamakura Corporation is enterprise wide risk management and modern credit risk technology. The second edition of his newest book, Advanced... More
My company:
Kamakura Corporation
My blog:
Donald R. van Deventer's Kamakura Blog
My book:
Advanced Financial Risk Management, 2nd Edition 2013
  • Walter Energy Inc. 1 Year Default Probability 3.74%, Up 0.10% Today 4 comments
    May 23, 2014 2:25 PM | about stocks: WLT, KOL

    (click to enlarge)374up10

    The blue line is the firm's one year default probability. The yellow line is the annualized one month default probability.

    Background on the Default Probability Models Used

    The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model ( abbreviated KDP-jc5) makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. KRIS covers 35,000 firms in 61 countries, updated daily. Free trials are available at Info@Kamakuraco.com. An overview of the full suite of Kamakura default probability models is available here.

    Using Default Probabilities in Asset Selection

    We recommend this introduction to the use of default probabilities in fixed income strategy by J.P. Morgan Asset Management.

    General Background on Reduced Form Models

    For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: WLT, KOL
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Comments (4)
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  • fliper2058
    , contributor
    Comments (3866) | Send Message
     
    Don,

     

    Another low grade one I own..ha. You're saying a 3.75% risk of default? The bonds now are in the high $50, it seems much higher than 3.74% probability. Do I have this incorrect? TIA.
    23 May 2014, 04:37 PM Reply Like
  • Donald van Deventer
    , contributor
    Comments (2084) | Send Message
     
    Author’s reply » Hi fliper, the bond spreads are usually 2-10 times higher than the default probabilities. When you factor that in, you'll get to 50. There is also zero liquidity. There were zero trades reported by TRACE in the US bond market on May 22. That means any prices you've seen in the last 24 hours are probably based on zero trades.
    23 May 2014, 05:48 PM Reply Like
  • fliper2058
    , contributor
    Comments (3866) | Send Message
     
    Thank you Don,

     

    bond spreads "2-10 times" the default probability....That is a wide range. say 4% times 2 versus 4% times 10 is 8% to 40%. Would the point be the initial "4%" is a clue to look further? TIA.
    24 May 2014, 04:43 PM Reply Like
  • Donald van Deventer
    , contributor
    Comments (2084) | Send Message
     
    Author’s reply » We've posted a ranking of companies from highest spread to default probability to lowest a bunch of times recently, at maturities from 1 to 20 years. Next post will go up Monday afternoon. Will post both the "best 20" and "worst 20" on the list. The riskiest firms tend to be near the bottom 20.
    24 May 2014, 05:07 PM Reply Like
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