Journal of Risk

Philippe Jorion

University of California at Irvine

Like the previous issue, this issue of The Journal of Risk reflects current developments in credit risk, with three papers on credit risk. The fourth paper deals with a very timely issue in market risk measurement, which is at the root of the recent mutual fund scandals.

In “The Effect of Taxes on the Pricing of Defaultable Debt”, Lim, Song and Warachka extend the reduced-form credit-risk model from Janosi, Jarrow and Yildirim (2002) previously published in the Journal of Risk (Fall 2002) to account for taxes. Recent literature has indicated that credit yield spreads reflect not only the actuarial credit risk but also a risk premium and tax effects. The new model considers a default intensity that depends on taxes in addition to market variables. The authors show that their model fits corporate bond prices as well as the Janosi et al. model but is more parsimonious, with fewer parameters.

The second paper by Akutsu, Kijima and Komoribayashi, “A Portfolio Optimization Model for Corporate Bonds Subject to Credit Risk”, tackles the problem of optimization of credit-sensitive bond portfolios. It shows how to integrate the Jarrow–Lando–Turnbull methodology into an optimization framework with correlated changes in credit ratings. Such portfolios cannot be characterized by normal distributions due to the nature of default events. An application is presented, with results compared to the traditional mean–variance approach.

In “Credit Default Swap Valuation with Counterparty Default Risk and Market Risk”, Kim and Kim present simulation results for the valuation of credit default swaps based on the structural model approach. The innovation is the modeling of correlation between market risk and reference credit risk(s), as well as between counterparty credit risk and reference credit risk. The authors show that ignoring these correlations can significantly affect the pricing of credit default swaps.

Finally, the paper by Audrino and Bühlmann, “Synchronizing Multivariate Financial Time Series” proposes a new method for synchronizing multiple time series. This is an important issue for the measurement of risk for portfolios that contain assets whose prices are measured at the close of different time zones. With positive true correlations between series, for example, unsynchronized data will appear to have correlations that are too low. As a result, the portfolio will have lower risk than is actually the case. The authors propose an adjustment based on a multivariate Garch process, which, as they show, significantly improves the measurement of risk. The market timing scandals affecting many mutual funds attest to the relevance of risk management. Some forms of market timing could occur because of the use of nonsynchronous, or “stale”, prices for assets in different time zones (for international mutual funds) or illiquid assets (for example, for high-yield funds). The Securities and Exchange Commission is now encouraging mutual funds to quote net asset values from estimated synchronous prices.

The mission of The Journal of Risk is to further our understanding of risk management. Contributions to the journal are welcome from academics, practitioners, and regulators in the field. With this in mind, authors are encouraged to submit full-length papers.