Presented At The 11 th International Congress on Insurance: Mathematics & Economics

1. Estimation of Stock Return Distress Costs Associated with Downgradesusing Regime-Switching Models* Presented At The 11th International Congress on Insurance: Mathematics & Economics Athens, Greece, July 10-12, 2007 by Andreas Milidonis, Ph.D. Manchester Business School Shaun Wang, Ph.D., F.C.A.S., A.S.A * Project funded by CKER & AERF (Society of Actuaries)

2. Outline • Motivation – Bond Ratings & Info Arrival. • Data Uniqueness • Methodology • Results • Summary • Future Research Milidonis & Wang (2007)

3. 1. Motivation - Market Timing Egan Jones Moody’s Milidonis & Wang (2007)

4. 2. Data - Sample Selection • Final set of “Timely Downgrades” satisfied the following criteria: • a downgrade by one rating company, • later verified by the second company • to the same eventual rating. • Exclusions: • Reversals Milidonis & Wang (2007)

5. 3.1 Lognormal Distribution & Structural Breaks Milidonis & Wang (2007)

6. 3.2 Methodology – Regime Switching Models Log-returns switch between 2 states: • Low-Volatility (Un-Distressed) • High-Volatility (Distressed ) Milidonis & Wang (2007)

7. 3.3 Lognormal vs. Regime Switching Model Milidonis & Wang (2007)

8. 3.4 Methodology –Regime Switching Model Cost Estimation from Regime Switching Model: • Adjust returns for each regime using Market Price of Risk, l : • R1 Risk adjusted: • R2 Risk adjusted: , but • Cost for day “t” = = , where : Milidonis & Wang (2007)

9. 4.1 Results – Different Means between Regimes Milidonis & Wang (2007)

10. 4.1 Results – Equal Means in two Regimes Milidonis & Wang (2007)

11. 4.1 Results - Prob-Vol Measure Estimates Milidonis & Wang (2007)

12. 5. Summary Used properties of Regime Switching Models to • Perform a dynamic (endogenous) event study. • Quantify the change in market capitalization from structural breaks in stock returns. • Measure the duration of each regime. • Relate the timing of a RS with the timing of an external event (downgrade). Milidonis & Wang (2007)

13. 6.1 Other Results & Future Research • Relate the timing of a RS with the timing of an external event (downgrade) • Observe and Measure the duration of each regime • Propose an extension to regime switching models to the bi-variate case with a common shock. Milidonis & Wang (2007)

14. 6.2 Future Research Questions Corporate Finance • Is the smaller rating company just following the market or does its analysis of public information provide new information to the market? • Is there a conflict of interest for Moody’s selling ratings and other credit risk management software? • How close to a downgrade (and for which downgrade) does a regime-shifting take place? • What is the value added by the earlier rating action if any? • Do a Cross-sectional analysis of implied probabilities of default from Moody’s and Egan Jones ratings. Quantitative Finance • How can we use the RS model to explain risk in portfolios? • Does a regime switching model offer a different perception towards risk than other comparable market risk measures? • Estimation of the time-series loss from downgrades and covariance with bond prices? Milidonis & Wang (2007)

15. 6.2 Future Research Questions Credit Risk • Forecasting power compared to Merton Model of default (implied probabilities of default) • Bi-variate Case to be compared with the Merton Model to do out-of-sample forecasting. • Pricing Implications for Volatility derivatives. Milidonis & Wang (2007)