AC402 Financial Risk Analysis

This is an optional module in which I have chosen to write a dissertation instead. Just submitted my paper today...so I guess that's the end of my 10 months at LSE, well, i.e., if I pass.
Spent about a week or so working on the dissertation, so I have to say it's not a great piece of work. But I've learnt quite a bit on my topic (credit spread puzzle), read at least a dozen journal articles, though my final paper did not have much original contribution.

Exactly a week from now, I'll be starting work. I'm sure there'll be more exciting posts to follow (only if you find IB and quant work exciting). Since I will be blogging on my internship experiences here, I'm thinking I might as well write for eFinancialCareers too, maybe I can pocket some extra money (I'm poor and London is way too expensive).

Riskless curve

I read this paper by Longstaff, Mithal and Neis (2004) in which they find the choice of the riskless curve has a big impact on determining the components of credit spreads. Academics typically use US Government Treasury securities as the benchmark riskless rate, however, Longstaff et al. (2004) use the swap curve instead. They find, in contrast to many previous studies, that default risk in fact explains most of the variation in spreads.

Now this is interesting as it casts doubt on previous results. It could potentially be that previous studies, using swaps rate instead of Treasury rates, might find that default risk is the major determinant instead.

The question is, why is the swap curve a better proxy for the riskless curve? Hull et al. (2004) provide an argument, but I am not thoroughly convinced (at least not intuitively clear) that is the case. They also mention that practitioners also use the swap curve as the benchmark.

Credit spreads

I'm currently working on my dissertation on the credit spread puzzle. Basically, there is a wide gap between corporate bond yields and expected default losses, which imply that default risks can only explain a small proportion of the spread. This is commonly known as the credit spread puzzle.

Well, I've been reading several recent research papers to summarize what the answers to this puzzle could be. This isn't the difficult part, what is difficult is being able to criticize the papers, undermine their models and justify my arguments. In a theoretical dissertation, we're supposed to select 8-12 journal articles and present them. Firstly, these articles have a certain level of technical sophistication, and I am unable to completely comprehend the modelling details. How am I going to succinctly criticize the models or suggest ways to improve them? Secondly, my knowledge on credit risk is probably close to nothing, and it'll take a huge effort to produce something outstanding (yeah, I know I should have started a few months back). And lastly, I have only a week left to finish it...

Anyway, in case you're interested in this area, which is still a major current research theme, I can provide you with a good reference list that I've been collecting for some time. A good paper to look at is Hull, Predescu and White (2004), where they mention the possible answers as tax and liqudity factors, risk premium, traders' expectations, nondiversifiable risks and diversifiable risks.