Sep 02

ABX pricing factors (Learning outcomes “in the news”)

by David Harper, CFA, FRM, CIPM

FRM |

abx

BIS just released a study on the controversial subprime index called the ABX (The ABX: how do the markets price subprime mortgage risk?). Against the oldest vintage ABX (as the dependent variable), the authors regressed several independent variables:

  • Macroeconomic variables; e.g., new home sales,
  • ABX-specific  data; i.e., delinquencies and downgrades among constituent MBS bonds in the ABX indices,
  • Financial variables: one-year U.S. swap rate for the interest rate; difference between 10-year and three-month Treasury yield for the yield curve slope,
  • A proxy for investor risk appetite. The VIX volatility ratio: the ratio of the VIX (derived from option prices on the S&P 500 equity index) and realized S&P volatility over a leading 20-day window, “where higher readings of the VIX ratio (i.e., positive forecast errors of the VIX relative to realized volatility) correspond to declining risk appetite.”
  • and proxies for liquidity: the CDX bid-ask spread and the US dollar 10-year swap spread which “is known to contain a liquidity premium, along with a premium reflecting the default risk embedded in the LIBOR rate”

The authors could only explain 20% of the variation in ABX prices (coefficient of determination, R^2, was about 20%). The findings continue to fuel criticism of the ABX as “not a good predictor of likely losses on subprime-backed mortgage backed securities” and as an inadequate gauge of subprime losses.

Some of the criticism mistakenly assumes the ABX is meant to be pricing input. As Christopher Finger has explained, it is merely a useful valuation benchmark. The positive finding in the BIS study is: systemic financial factors were (on average) just as explanatory as fundamental drivers (housing market). Says the study,

“These results underline the well established view that risk premia are important components of observed prices for default-risky products, and that the relative importance of non-default-related risk factors [i.e., risk appetite, liquidity] will tend to increase in periods of strong repricing of risk.  This suggests that theoretical pricing models that do not sufficiently account  for these factors may be inappropriate, particularly in periods of heightened market pressure.”

Role in the FRM

The ABX shows up in our excellent reading Understanding the Securitization of Subprime Mortgage Credit (2008 FRM assigned under credit risk). Arguably, this reading is a withering critique of the rating agencies. The ABX has a specific role in this reading: to help establish that in early 2007, it was “certainly possible” that the credit rating agencies were “long overdue for downgrades.” They echo criticism that the ABX started to hint at trouble at the beginning of 2007, about six months before the bulk of the downgrades:

“In response to the historic rating action on subprime ABS during the week of 9 July 2007, the rating agencies were heavily criticized in the press about the timing.  In particular, investors pointed to the fact that the ABX had been trading at very high implied spreads since February”

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