Risk Transfer and Pricing of Illiquid Assets with Loan CDS
The shipping industry as a whole is going through a significant downturn in charter rates due to an overcapacity in transportation capacities, especially container, created to a great extent by the financial crisis. It is now a major undertaking to estimate the fair value of ships and the respective loans secured on them.
It is common practice in banking to base one’s risk assessment on the usually statistically derived properties: probability of default (PD) and recovery rates (RR). Once these key figures have been calculated, expected loss (EL) can be obtained and the minimum margin a bank has to charge on a loan to such entities is known. The actual margin will have to cover additional costs such as liquidity, capital and other operations.
The Basel II regulatory framework includes the so-called internal rating-based approach, which forms the basis for a fair margin calculation. It uses transition matrices that are then used for a “real-world” parameterization, which cannot be interpreted as risk-neutral. The credit risk modeling approach used in this context will vary depending on the banks’ sophistication and regulatory requirements. Popular modeling approaches are based on Gupton, Finger and Bhatia (1997) and CSFB (1997). All of these modeling approaches are used to compute the loss distribution. Once it is known the required economic capital ...