Credit Crunch: Never Goes Soggy in Liquidity


New York – It is clear that the current market environment is not one that lends itself to those research models that seek to find value. In these times of excess fear, volatility becomes a more poignant measure of market psychology. In this entry, we we look at the current situation, profile a research providers that has the potential to estimate this excess volatility and recommend a recent academic modeling approach to capture what is missed in traditional models.

Most of the classical quantitative models will tell us what to do in these scenarios, but few of them have a strong enough sensitivity to near term events to give us a heads up ahead of time. What is needed is an “instantaneous volatility over-ride” switch that recognizes that we are in the extreme fear/greed region of market activity.

So what research should we be watching to try to capture the anxiety of the market; one that tries to capture the potential energy rather than the kinetic energy of price movements. For example, think about the Treasury market 3 minutes ahead of the release of the monthly employment numbers. There is little to no movement in price (kinetic energy), but there is certainly a high level of anxiety (potential energy).

One of the more interesting ways to assess this anxiety directly, is to look at the trend in the spread between historic and actually volatility in the options market. Another way is to look directly at the credit default spreads market. While there are several research providers that look at this spread, we have chosen one that looks almost exclusively at this spread and its negative relationship with equity prices.

Tradition Equity Research is focused on idea generation through the analysis of credit default swaps (CDS) and their implications for equity price movement. The analysis is based upon the understanding that the CDS market is continuously pricing default risk in the market. A CDS spread is the number of basis points the insurance premium costs the buyer. When this spread increases it reflects a growing anticipation of a credit event and can be used as a proxy for the future share prices. There is typically an inverse relationship between share price returns and the change in the CDS spread. Since rising spreads often indicate worsening cash flows at companies, the spread is an inverse barometer of the future stock price. In application of the CDS, Tradition Research suggests that the CDS spread is a sensitive and accurate measure of takeover risk as well.

Of course, there is also a good deal of academic work being done in this area as well. So-called regime-switching or structural break models have been studied at length. One recent article in the Staff Reports of the New York Fed incorporates many of the most recent approaches in a more general model. The article is entitled: “A Flexible Approach to Parametric Inference in Nonlinear Time Series Models” (download PDF) and is written by Gary Koop and Simon Potter (No. 285, May 2007). Despite the complete lack of a catchy title, the article looks like a must read for the quantitative elite.


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