The previous Value at Risk (VaR) methodology Pfizer employed relied solely on credit default swap (CDS) data, which in a number of cases suffered from either a lack of available quoted rates or data of questionable accuracy owing to the illiquidity in the CDS market.
Bank of America Merrill Lynch’s (BofAML) Lighthouse approach to analysing a portfolio and calculating credit VaR did not support sovereign or short-term securities such as commercial paper. Pfizer worked with the BofAML team to adapt Lighthouse to incorporate sovereign securities and to use a proxy measure for short-term security risk.
Lighthouse builds upon the standard Merton model, using equity option pricing, capital structure and equity market valuation of individual counterparties to inform the calculation of credit risk, while also accounting for the diversification benefit within the portfolio. Pfizer’s implementation of Lighthouse also uses the benefits of CDS data for sovereign issuers, where liquidity is strong, while using the credit option adjusted spread (COAS) approach of Lighthouse which incorporates equity market valuations, credit spreads, capital structure and option pricing to assess the credit risk of corporate counterparties.
The equity price underlying the fixed income security is a mainstay of Lighthouse analytics. While this works well for analysing corporate bonds it does not directly work for sovereign issuers who do not have an equity component underlying their bond issuances. This posed a problem for Pfizer since a large portion of its portfolio is exposed to sovereign risk.
“Rather than leave these exposures outside of our analysis we use a risk mapping approach. We start by summing the exposures of each sovereign counterparty and calculate a money-weighted average maturity for each. We input each sovereign into Lighthouse along with its respective weighted-average maturity date. Lighthouse then uses the CDS data to calculate the risk associated with these sovereign positions,” explains Barry McKernan, Credit Analyst.
“Additionally Lighthouse does not recognise short-term securities, such as commercial paper. To overcome this hurdle we input our position in these securities into Lighthouse by equating them to a BofAML high-grade (AAA-A) short-term corporate credit index as a proxy. This index was selected because it best reflected the risk profile of Pfizer’s exposures,” adds McKernan.
Best practice and innovation
As Pfizer searched the market for a solution that met its credit risk needs it became apparent that there were many ‘traditional’ credit risk solutions on offer. These varied widely in terms of type of methodology, sophistication of analytics and ease of use. This project undertook the difficult task of analysing several of these products across the spectrum of their needs. It evaluated Credit Metrics, Moody’s Credit Edge, Credit Suisse’s Portfolio Risk Plus as well as BofAML’s Lighthouse.
The in-depth analysis Pfizer performed on each of these products before making its selection makes this project unique. Over a period of three months, the treasury team met with the vendors repeatedly, dug deep into their analytics, uploaded their sample portfolio into their systems to get a feel for ease of use and finally summarised and debated the findings before making their final decision.