AA Credit using market cap volatility, solving for Distance to Default
(d2 in Black Scholes)
The input for a stochastic analysis of AA credit is the volatility of the SP500, specifically the one year realized volatility (240 N):
The SP 500 volatility is transformed via simultaneous equation into asset volatility, using the equity value for the SP500 and the debt to arrive at a market cap (Vola below) or the volatility of the market cap (debt and equity) is derived:
Vole = [N(d1) X V X Vola] / E
The asset volatility derived:
Asset Vol of the SP500 is scatterplot to AA spreads, provides deeper insight of a stochastic analysis of credit.
While the above scatter of log of SP500 levels versus log of AA spread suggests that AA spreads might even be wide and may tighten, SP500 asset vol scatter to AA spread shows the opposite, despite SP500 trading up the last few sessions:
The asset volatility is the sigmaa, or vol of the underlying entire capital structure of the SP500, in a standard Black Scholes formula to find the d2. We do not solve for price, just d2, as the price asymtopes along the x axis and while correct theoretical is of little use for trading and risk management.
The d2 formula is well known:
The d2 depicts in units of volatility years (Brownian scaling of time) how far the underlying credit is from default given the current asset volatility, for a certain time period (we use 5 years) and for a certain interest rate or rho (we use 3%). The d2 is called, when using a Merton formula, the “distance to default”, or D2D. D2D us plotted over time and while the SP500 has sold off and traded back of late, the D2D of the SP500 has crashed and has lost 1/2 the peak value during the low sub 10% volatility period before Feb 2018 this year. Note the D2D does not track the SP500 direction in level, but the volatility increase in the SP500. Currently D2D for the AA credit is 5.2186209 and a year ago D2D was 14.121979 : This is one of the larger plunges in D2D in decades, almost a 2/3 drop.
The above D2D is scatterplot against AA spread.
AA spread currently ( December 21 2018 close ) can explode upwards, doubling towards 150 to 175, whether SP500 trades back up or lower. Since this is based upon volatility the characteristics of vol changes, long dated vol, it will change to reflect the large regime shift of volatility of of the last 6 weeks, whether or not the SP500 goes up or down. Volatility does not move in a discrete fashion like SP500 price. Almost all mistakenly price credit spreads to qualitative or accounting based metrics - credit in the end always moves to regime changes in volatility. AA credit spread are now trading extremely rich/tight - about the richest and most tight in last 2 decades.
A closeup of the above larger scale scatter is given, which gives greater detail. AA will double spread :
It is likely that AA credit spreads, unless long dated volatility of the SP500 drops again to levels of 2017, will go much wider. This may surprise as it will widen while the SP500 is trading upwards or downwards.
