Designed for failure? Risk-return tradeoffs and risk management of structured investment vehicles

Research Seminars
Academic Areas Organisational Behaviour
Seoyoung Kim, Assistant Professor , Santa Clara University, Leavey School of Business
November 27, 2013 | 3:00 PM - 4:30 PM | Wednesday
AC 2, NMLT- L2, Hyderabad, India
For ISB Community

We model the design of a structured investment vehicle (SIV), specically, its capital structure, leverage risk controls, and the rollover frequency of senior debt, all of which determine the rating of the senior notes issued by the SIV. We show that inaccurately modeling re-sale discounts, i.e., the deadweight costs of defeasance, leads to fragile structures that are not designed to sustain inherent levels of risk or to ensure repayment of principal to senior note holders commensurate with a top quality credit rating. We  and that instead of providing safety, stringent risk management controls can accelerate the chances of failure, and the optimal risk management choices depend critically on the rollover horizon of the senior notes. Our analysis shows that senior-note ratings are very sensitive to leverage controls, oftentimes more so than to the riskiness of the collateral pool. We also and that the expected losses on senior notes become increasingly sensitive to pool risk (i.e., spread volatility) when leverage controls become more stringent, particularly under shorter roll-over horizons. We also proposed two possible avenues of mitigating senior note risk through contingent capital.

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