The financial crisis proved that macro expectations are the main moving factors driving credit risk markets. Market prices reflect expectations about macroeconomic growth and market volatility and understanding underlying assumptions behind prices and quantifying sensitivity of asset price movements to economic shocks could give valuable information on current and future market price changes.
After the Lehman collapse credit markets have tumbled and subsequently recovered significantly. This was driven by high leverage, which made credit markets more sensitive to changes to macroeconomic expectations and our new model is able to track down and explain these swings on the market by connecting macro environment to company level performance.
In our view credit research and fundamental modelling has a long way to go to establish fair value of credit instruments as it needs to consider all relevant credit driving factors, most importantly prevailing macroeconomic expectations and enterprise value volatility. To understand and measure credit risk future cash flow generation of the borrower needs to be tested under different macroeconomic scenarios. This way fair value of credit can be established on current macro environment and vulnerability of credit prices to future macroeconomic shocks can be measured.
To see how this approach has been put into practice please visit RISKAWARE/Methodology, where the methodology of the new credit pricing tool is detailed.