Extreme Events in Finance

Chapter 14Extreme Value Theory and Credit Spreads

Wesley Phoa

Capital Fixed Income Investors, The Capital Group Companies, Inc., Los Angeles, CA, USA

While the use of extreme value theory (EVT) in risk management for financial assets became well developed in the 1990s (Embrechts et al., 1997), its applications to modeling credit risk and credit spreads came somewhat later (e.g., Phoa, 1999; Campbell and Huisman, 2003). Interest in this area intensified because of the extraordinary behavior of debt securities during the global financial crisis of 2008, and the apparent breakdown of risk models that did not explicitly incorporate heavy tails (see Chavez-Demoulin and Embrechts, 2011).

This chapter is a practical introduction to the use of EVT in modeling and managing credit portfolios. It is aimed at investment professionals rather than researchers, so all technical details and proofs are omitted. Some knowledge of EVT, as described in the earlier chapters of this book, is assumed.

The focus of this chapter is on credit spreads for corporate bonds and for credit default swaps (CDS), which refer to corporate bonds. We also refer to spreads on index products based on a basket of issuers, such as the MarkIt CDX indices. We omit discussion of other credit markets such as bank loans (which are now frequently traded) and emerging market debt.

14.1 Preliminaries

A cursory look at the data suggests that EVT should be of great utility in modeling the behavior of credit spreads. For example, ...