Mean loss rate

[narayananvenkat]

David..

The following may be considered as proxies for mean loss rates
1.credit spread, 2. default swap rate paid bythe protection buyer in a credit default swap agreement.

But diff between bond yield and treasury yield is not considered. There is an explanation or this bit I am ubable to comprehend that.

Help

venkat

 

[narayananvenkat]

David..

i request ur reply. Thanks

 

[David Harper CFA FRM]

Hi venkat,

the reason i hesitated is, you can tell when a question is plucked literally out of a reading, like this one... and i hesitate to explain/defend questions like this because (I feel) they are open to debate and nuance and I didn't write the question so i don't feel like defending it

...but it comes literally from the Canabarro reading on counterparty risk
the easiest thing i can do is connect it to John Hull's approximation (chapter 22.2):

default intensity (hazard rate) = spread / (1-recovery), so where the default intensity is the prob of default:
PD = spread / (1-recovery), or simply
PD*(1-recovery) ~ spread (approximation!)

Canabarro's "mean-loss rate" is the PD*(1-recovery) so he equates it to the credit spread.
e.g., if you pay $100 for bond with 10% PD and 50% LGD, then your expecteed loss is $5, your mean loss rate = 5% and (this part i don't want to defend, it's just an approximation) you will charge about a 5% spread for the risk of default

so, if you buy the 5% mean loss is a proxy for the spread; the spread is further a proxy for the CDS spread (the default swap rate)...and that is another approximation

i hope that helps interpret the question, thanks, David