Navigating through the vocabulary maze

[hhao]

Hi, I have little understanding of fancy finance terms, but I do understand that most, if not all, complicated terms represent rather simple ideas. So I am starting a thread to ask some quick questions to which I am hoping to get some short and sufficient responses. Thank you in advance for your help!

In the study notes for 2007 credit crisis, there is a graphic that says that the real estate bubble burst in 2007, and it lead to an increase in "credit spread" and "liquidity dry-up".

1. What does "credit spread" mean in this case? I understand what credit spread means in terms of stocks and bonds, but what does it mean in terms of housing/mortgages?

2. Does "liquidity dry-up" just means inability to sell? aka an illiquid situations with houses/mortgages?

 

[ShaktiRathore]

1. Credit spread measures the credit quality of securities as Bonds or Mortgage backed securities ,higher the spread the lower the credit quality ,during crisis there was degrade in credit quality therefore there was rise in Credit spread.Rise in credit spread means that the prices of the bonds and Mortgage backed securities went down during the crisis as credit spread is inversely related to the prices of the bonds and Mortgage backed securities .As housing prices came down,the credit quality of the mortgages came down,this mortgages were collateral which backed the Mortgage backed securities(MBS) resulted in the prices of the MBS to go down due to degrade in the credit quality of the mortgages.This resulted in the rise in credit spread.
2. Yes,liquidity dry-up means inability to sell that is it was difficult to sell or buy the securities during the crisis, this was liquidity dry-up.liquidity dry-up was also seen in houses and mortgages as the credit dried up and it was difficult to sell or buy the houses.
thanks

 

[hhao]

So credit spread measures the quality and not the difference between securities? If there's no comparison of a difference, why is it called a "spread"?

 

[ami44]

The difference is between a loan to a borrower with no risk to default and a risky borrower.
Im reality a borrower with no risk doesn't exist, but there are approximations like AAA rated Banks or certain goverments.
If a riskless entity has to pay x% on a loan and you have to pay y% than y% - x% is your credit spread.

The same is true for Bonds. Their market price reflects the credit quality of the issuer, which can be measured as spread to a riskless issuer.

 

[ShaktiRathore]

Hi,
Credit spread is the spread/difference between the interest rate on the mortgages and the risk free rate.Its given by interest rate on the mortgages-risk free rate.
Its also defined as credit spread=Probability of default*loss given default,during the crisis both the Probability of default and loss given default increased on the mortgages therefore increasing the credit spread.
thanks

 

[hhao]

Thanks for the answers, a separate but related question - how did the housing bubble burst lead to an increase in credit spread? Or did the housing bubble burst + false bank ratings lead to an increase in credit spread? If we define credit spread as the difference between rates for an AAA entity/security vs. a riskier entity/security, how does a housing bubble cause the difference between the two rates to increase?

 

[ShaktiRathore]

housing bubble burst ->collapse in the prices of the houses ->the credit spread of the mortgages went up as the creditworthiness of borrowers came into question due to collapse in the prices of the house which served as collateral to mortgages ->the credit spread of the Mortgage backed securities(and other riskier securities) went up as the credit spread of the mortgages went up(credit quality down) which served as collateral to Mortgage backed securities
The credit spread essentially captures the default risk of the security,higher the default risk of the security the higher the credit spread and vise versa, as the default risk of the mortgages increased, the creditworthiness of Mortgage backed securities went down or the default risk of Mortgage backed securities went up thereby increasing the credit spread of these securities.These soon spread to other securities.

 

[hhao]

Thank you! I understand now.

 

[hhao]

What exactly is a market return? I understand that a risk-free return is the return you'd expect to get from investing in something with no risk, a portfolio return is the return you get from a particular portfolio, is the market return the average (weighted or not) of everything available in the market? In is this calculated in the real world?

 

[ShaktiRathore]

Market return is the return you get from the market as S&P index or any index representing the broad market.

According to Capm,

Stock return=Risk free rate+Beta*(Market return-Risk free rate)

where we take Market return as return on the index its almost impossible to calculate real world market portfolio return representing all the economy exactly.Risk free rate is the rate of return when the cash flows to be received in the future are certain.Beta represents the systematic risk of the stock.

Market portfolio(real world) is the representative of all the sectors of the economy that is the market portfolio is hypothetical its the assumption of CAPM that Market portfolio should be a true representative of all the economy comprising of all the economic sectors.We generally take the S&P index return as Market portfolio which is only an approximation to the real world Market portfolio.I think the real world market portfolio is not actually calculated we generally take S&P index as proxy for Market portfolio.

Thus

Stock return-Risk free rate=Risk free rate-Risk free rate+Beta*(Market return-Risk free rate)

Stock return-Risk free rate=Beta*(Market return-Risk free rate)

(Stock return-Risk free rate)/Beta=(Beta/Beta)*(Market return-Risk free rate)

(Stock return-Risk free rate)/Beta=Market return-Risk free rate

(Stock return-Risk free rate)/Beta +Risk free rate=Market return-Risk free rate+Risk free rate

(Stock return-Risk free rate)/Beta +Risk free rate=Market return

Market return=(Stock return-Risk free rate)/Beta + Risk free rate

Mathematically Market return is the excess return of the Stock wrt Risk free rate divided by Beta plus the Risk free rate.

If Beta=1,Market return=(Stock return-Risk free rate)/1+ Risk free rate

Market return=Stock return-Risk free rate+ Risk free rate

Market return=Stock return therefore the Market return is the stock return if the beta of the stock is equal to 1.

Thanks