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In the past week, I have spoken with many regulators and bankers on the proper role of intuition in the econometric estimation of credit models for the Federal Reserve’s Comprehensive Capital Analysis and Review 2015. In our review of best practices for stress testing , value at risk, and credit value at risk on October 20, 2014, there was no role for “intuition,” just for science. The same is true for our November 13, 2014 update of model validation procedures for CCAR 2015

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On October 20, we noted that the Federal Reserve’s decried banks’ reliance on poor risk models. The Fed’s comments were contained in the final rules for Comprehensive Capital Analysis and Review (“CCAR”) stress testing in 2015 and beyond in a document released Friday, October 17, 2014. In our October 20 note “ Best Practice Model Validation for Stress Testing, Value at Risk and Credit VAR,” we described the systematic best practice for model validation for these model types.

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Corporate bond trading activity on October 21 was led by Morgan Stanley (MS), the most heavily traded bond issuer on the day. Petrobras International Finance Company S.A. (PBR) had the two most actively traded bond issues. Alpha Natural Resources (ANR) led the credit spread ranking at 2156 basis points. Cliffs Natural Resources (CLF) (CLV) bonds dominated the lowest priced bond rankings. Credit spreads continue to be squeezed at maturities beyond 12 years, giving long-maturity minded corporate treasurers a unique opportunity to go long. The credit spread to default probability ratio generally declines as default risk rises, so high quality bond issuers dominate “best value” bond trades by this criterion. Finally, substantially all fixed rate corporate bond trading is taking place at the lowest default probability levels. As default probabilities rise, trading actively drops off dramatically. We present the analysis behind these findings in what follows.

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Last Friday, the Federal Reserve decried banks’ reliance on poor risk models as one of the major problems that has been exposed by the stress testing process under the Fed’s Comprehensive Capital Analysis and Review programs. The Fed’s comments were contained in the final rules for CCAR stress testing in 2015 and beyond in a document released Friday, October 17, 2014.

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Forward 1 month T-bill rates fell again this week, dropping sharply at all but the very shortest maturities. The fall in implied forward 1 month Treasury bill rates stems from a decrease of 0.11% to 0.20% in current U.S. Treasury yields in the 2 to 30 year maturities. Forward 1 month T-bill rates now rise steadily until reaching a peak at 3.11% in February, 2022, a peak 0.17% lower and eight months later than last week. The implied forecast also shows forward 10 year U.S. Treasury yields rising to 3.32% in 2024, down 0.13% from last week.

We also present three potential scenarios consistent with the implied forecast that represent alternative paths for interest rates. This kind of multi-factor scenario generation is essential for comprehensive asset and liability management at banks, insurance firms, pension funds, and endowments.

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