Editor’s Letter

The ability to evaluate evolving credit risk from market prices rather than waiting for rating agency announcements is crucial to superior portfolio performance generation. In this issue of The Journal of Fixed Income, we begin with an article by Evert Vrugt concerning the credit risk of sovereign debt. The framework simultaneously extracts the term structure of default probabilities and the recovery value from sovereign bond prices. The application of the model to Greece in 2010 provides a useful case study. In the next article, Terry Benzschawel, Adoito Haroon, and Tuohua Wu provide an in-depth analysis of the determinants of recovery value given default. Their model includes position of debt in the firm’s capital structure, effect of the business cycle, industry sector, credit quality just prior to default, and place of legal jurisdiction. The model is used to simulate distributions of recovery rates for default-risky firms. Next, Hans Byström provides a methodology for estimating asset values from equity prices and the credit default swap market for bond prices. The methodology is applied to the estimation of asset correlations for credit risk models and a set of important European banks in an EU-wide stress test.

Bank regulation played a significant role in the recent financial crisis. Tobias Berg, Bernhard Gehra, and Michael Kunisch empirically demonstrate that regulatory arbitrage opportunities between the trading business and the loan business existed under the Basel I and Basel II framework and are likely to subsist under the Basel III regime. Essentially, banks will focus on areas where capital requirements are low relative to true risk weights and, hence, create a more fragile banking system.

The financial crisis began in the housing market, and mortgage modifications have been tried as a hopeful remedy. In their article, Laurie Goodman, Roger Ashworth, Brian Landy, and Lidan Yang provide evidence and recommendations on the success of mortgage modifications. They demonstrate that principal reduction, substantial pay relief, and modifying early in the delinquency cycle are major contributors to modification success.

Finally, Roland Füss and Olena Nikitina employ a factor-augmented vector autoregression technology in order to explain yield curve dynamics. They demonstrate that the level and slope of the term structure are best forecasted by using latent macroeconomic factors that incorporate inflation and the forces behind the business cycle, respectively.

We hope you enjoy this issue of the Journal of Fixed Income.Your continued support of the Journal is greatly appreciated.

Stanley J. Kon

Editor

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