Fitch Ratings announced last week the launch of its Nth-to-Default Model now available for those seeking a tool to evaluate risks related to Nth-to-Default trades. Nth-to-Default trades are synthetic transactions where a credit event is triggered upon the first, second, third or Nth reference entity to default in a portfolio, Fitch explained in its announcement.
Essentially, the Nth-to-Default Model can assess how a possible credit event related to one bond defaulting can affect other bonds defaulting in the same portfolio, whether within the same industry or across industries," said Richard Hrvatin, managing director in Fitch's credit products group. "Monte Carlo simulation is a convenient way to assess such risks when there is no finite solution," he said.
To that end, Fitch has based the Nth-to-Default Model off the same simulation engine as the Fitch Default VECTOR Model - Fitch's CDO portfolio default risk tool. "The Nth-to-Default Model is an offshoot of Fitch's Default VECTOR Model, Fitch's primary tool for analyzing CDO portfolios. The difference being, with VECTOR, you get a distribution of all possible default events, whereas the Nth-to-Default Model returns a very specific default probability," Hrvatin said.
Indeed, the new model comes at a good time for the Nth-to Default market, as it becomes more liquid and transparent, and as standardized indexes are taking shape, Hrvatin said. The new model will help market players more effectively buy or sell protection on trades, Hrvatin explained. "This is a tool that adds to the transparency," he added.
"The credit derivatives marketplace continues to add liquidity and create innovative structured products. Fitch's new Nth-to-Default Model allows investors to gauge the level of default risk taken on these trades," noted Fitch managing director Roger Merritt, in the announcement.
The correlation module is at the heart of the new Nth-to-Default Model, Hrvatin said. Users can tailor their default analysis by comparing results using sector correlations, user-defined correlations, or a range of pairwise correlations, all of which are consistent with the VECTOR Model. "[The] main model outputs are the probabilities of Nth reference entities experiencing a credit event under various correlation scenarios," Fitch added in its release.
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