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Scenario simulation methods

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The first type measures the sensitivities of portfolio value to some particular market variables. Usually, a portfolio’s risk profile can be described by a large number of those sensitivities. The second type is more comprehensive as it calculates the probability distribution of the portfolio value at a given horizon. This then provides com¬mon risk measures that summarise the portfolio risk, such as value at risk (VaR).

Among the commonly applied methods to estimate VaR, the simplest is “delta approximation”. The method, however, depends on two assumptions: the normality assumption of portfolio value, and the linearity assumption of the relationship between transactions’ prices and market variables. For most portfolios, especially for portfolios with options and/or embedded options, Monte Carlo simulation is an appropriate method. The difficulty with the Monte Carlo approach is its computational burden.

The scenario simulation method described here is a computationally efficient alternative to conventional Monte Carlo for multicurrency fixed-income portfolios.

Scenario simulation provides the entire distribution of future portfolio returns. From this, not only VaR, but standard deviation and other measures of risk, such as the “coherent mea¬sures of risk”, can be computed. The scenario simulation model can be applied in estimating a portfolio’s overall risk profile of joint market and credit risks.

The scenario simulation method makes the simulation computationally practical for very large multicurrency portfolios of fixed-income securities and derivatives.

Applications to Value-at-Risk estimation and stress testing
The scenario simulation model provides an effective alternative to the delta approximation method and the traditional Monte Carlo method. We can directly apply the model by valuing each transaction and obtain the portfolio’s profit and loss distribution, and with it, the portfolio risk exposure statistics.

The scenario simulation model can also be applied to perform stress testing. VaR analysis is usually supplemented by stress testing, using the data from extraordinary historical market events. It is also important to stress test the assumptions of VaR mod¬els such as volatilities and correlations. Because of its computational efficiency, scenario simulation method is particularly suitable for such testing. In particular, the method allows risk managers to examine a portfolio’s risk exposures within the tail of a given distribution and to identify specific stress scenarios under which the portfolio may become vulnerable.

Applications to portfolio’s credit risk exposure estimation
There are three basic ingredients that go into estimating a portfolio’s potential credit risk:
1) market value of bonds and transactions for each issuer/counterparty;
2) the probability distribution of issuer or counterparty defaults;
3) the recovery rate distribution.

A portfolio will suffer a credit loss if an issuer or a counterparty defaults, the market value of the portfolio with respect to the issuer or the counterparty is positive, and the recovery rate is less than 100 percent.

Estimating credit risk is related to, but more complicated than, market risk estimation. All the above three ingredients are random, and they are usually correlated with each other. Unlike market risk management where the horizon is usually short credit risk management looks at much longer horizons, often the entire life of a transaction.

The scenario simulation model can be applied to estimate a portfolio’s credit risk exposure as well as its joint market and credit risk exposure.

This article is an edited version of
an entry in the “Encyclopedia of Quantitative Risk Analysis and
Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by
permission.

www.wiley.com

Default risk

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The assessment of default risk is also critical in the valuation of corporate bonds and credit derivatives such as basket-default swaps.

There is an important distinction between default risk under the actual probability measure and that under the risk-neutral probability measure. Typically, a decision to lend would be assessed using the former, where risk is assessed in terms of the probabilities of actual default occurrences. Decisions relating to pricing would be assessed under the latter.

Credit ratings
Ratings are based on factors such as the agency’s assessments of the firm. It will then go through public information and meet with the debt issuer to obtain further information. Ratings might be carried out independently of the firm, with ratings revealed on a confidential basis to the agency’s clients.

Recently, institutions have developed their own risk rating systems. These produce estimates of the probability of loan default. Many also produce estimates of the loss given default. Combined with information about exposure at default, this allows a bank to estimate the expected loss on a loan.

Contingent claims approaches
Some approaches to default risk utilise the contingent claim approaches that build on the limited liability rule that allows shareholders to default on their obligations provided that all the firm’s assets are handed over to creditors.
The firm’s liabilities are contingent claims issued against its assets. Default occurs at maturity when the value of the firm’s assets falls short of the value of its liabilities. Such default risk can be modelled using regular option pricing methods.

Credit migration approaches
Some classes of models are built on a credit migration or transition matrix. This examines the probabilities of any given credit rating changing to any other over the horizon period. These probabilities are assessed from historical default data and will suggest whether a firm with any given rating is likely to retain that rating by the end of the horizon period.

The best-known migration model, the CreditMetrics model, considers the forward value of a loan at the end of the horizon period for each possible end-horizon credit rating. Values are found by discounting the loan’s cash flows at a rate equal to the risk-free end-horizon forward rate, with an estimate of the credit spread for that rating. The combination of transition probabilities and end-horizon loan values enables the modeller to apply value-at-risk (VaR) analysis and obtain the credit VaR as the loan value minus the relevant quantile of the distribution of forward loan values.

Default and migration probabilities are unlikely to remain constant over time and there is a need for an underlying structural model to tie these to more fundamental economic variables. CreditMetrics uses the Merton model to tackle this, making simplifications to obtain probabilities from the joint distribution of the equity returns of obligor firms. An alternative solution is offered by the CreditPortfolioView model, which relates probabilities to macroeconomic variables.

Intensity models of default risk
This system models default as an exogenous process that occurs randomly in accordance with a fitted intensity or hazard function. These models are empirical and don’t embody any economic theory of default. They make no attempt to relate default risk to capital structure or make assumptions of the causes of default.

Since intensity-based models are based on debt prices, they can reflect complex default term structures better than some other approaches. However, corporate bond markets can prove illiquid, making pricing data inaccurate.

General problems and future objectives in default risk modeling
All models of default risk have their weaknesses, particularly their exposure to model risk. It can be difficult to discriminate between models, making it impossible to determine which model is the “best”. Even within the confines of a model there exists the parameter risk, which is calibrated rather than estimated. As calibration requires judgement, it introduces error. Evidence suggests estimates of default probabilities are also likely to be sensitive to key parameter values, such as volatilities and correlations.

The recent financial crisis has exposed the weaknesses of credit models in the starkest possible terms. Their sensitivity to key parameters and their failure to take adequate account of market conditions have been shown to be very serious problems indeed.

This article is an edited version of
an entry in the “Encyclopedia of Quantitative Risk Analysis and
Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by
permission.

www.wiley.com

Resolution plans cash call to fund AXA deal

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Acquisitions vehicle Resolution said it would fund its planned takeover
of French insurer AXA’s British life operations by raising £2bn
($2.91bn) in a rights issue.

The acquisition would cost a total
of £2.75bn, Resolution said, adding that it hoped to announce a deal by
the end of June.

The company, founded by insurance tycoon Clive
Cowdery, aims to buy and merge at least three British insurers or asset
managers before floating or selling the combined group in 2012.

Resolution confirmed that it was discussing a takeover of most of AXA’s
British operations in what would rank as its second acquisition after
the £1.8bn purchase of British life insurer Friends Provident last year.

“This acquisition would build strong momentum in Resolution’s
life assurance consolidation project, and provides a range of options
for further activity,” Resolution Chief Executive John Tiner said in a
statement.

Under the deal, AXA, Europe’s second-biggest
insurer, would sell its British protection, annuities and group pensions
business to Resolution, but would keep its wealth management and direct
protection operations in the UK.

“This potential transaction
does not call into question in any way the AXA Group’s continuing
long-term commitment to the UK market,” AXA said in a statement.

AXA said the disposal would result in a Ä1.4bn ($1.7bn) one-off
writedown in 2010, but would generate net cash proceeds of Ä1.7bn and
boost its capital strength.

Resolution said it had requested a
suspension of its shares as the deal would be classified as a reverse
takeover under stock market rules.

Spain says has not, will not make EU aid request

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Spain’s economy ministry has said it had not made a request for economic aid from the EU, after a newspaper report that the EU was preparing to activate a package in case Madrid asked for it.

“This is lie. There’s no rescue. There’s nothing asked for, nor will there be, nothing, but nothing. I don’t know where they got this from,” an economy ministry spokesperson told reporters. Without citing sources, the FT Deutschland said the EU was preparing for an aid application in the months ahead for access to the fund set up to lend to eurozone countries that run into Greek-style payments problems.

Specifically, Spain might need the aid if the problems at the Spanish banking sector get worse, the report said.

However, it also cited an unnamed European Commission spokesman as saying there were no signs of a Spanish aid request at the moment.

Spain has suffered from fears that a debt crisis contagion will sweep the eurozone, particularly affecting the bloc’s weaker southern members, after Greece needed to be bailed out by the EU because of its debt problems.

But Spain saw solid demand for a new three year benchmark bond on June 10, a positive sign for the Treasury ahead of a 16.2-billion-euro ($19.50bn) redemption in July.

Spain’s unpopular minority Socialist government is having a difficult time pushing through austerity measures and reforms aimed at restoring the economy back to health and is in the midst of a massive restructuring of its banking sector.

An austerity package aimed at slashing a deficit of 11.2 percent of GDP to three percent of GDP by 2013 passed parliament by just one vote in May.

South Korean FX controls loom

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South Korea’s government, alarmed by the wild swings of the won in turbulent markets, is close to slapping new controls on currency trading, though a news report that banks will get two years to comply calmed investors nerves.

As Europe’s debt crisis unfolded, the won’s gyrations exceeded swings of most other currencies and officials in Seoul have made it plain they would act to limit volatility that was hurting the world’s ninth-biggest exporter.

Bank of Korea Governor Kim Choong-soo threw his weight behind the plan saying it would not run counter to Seoul’s commitment to opening up its economy.

“We have never retreated in terms of liberalisation, market-opening and international regulations and have been praised for that,” he told reporters after the central bank kept interest rates unchanged.

Kim indicated it was getting ready to counter growing inflationary pressures and start lifting rates from their record low. He also said the bank was considering controls on domestic bank lending in foreign currencies to South Korean companies to limit market volatility, but did not elaborate.

Given that the won is one of Asia’s most actively and freely traded currencies and short-term debt makes up a large part of its foreign liabilities, South Korea feels particularly exposed to market movements.

In the course of one week in May, the won dropped 6.5 percent from the end of the previous week before turning to rally nine percent.

Improved stability
A senior government official told reporters that the new steps would include limits on banks’ dollar/won forward trades linked to their equity capital.

The official largely confirmed what has been mooted in the media. The limits would be set at 50 percent of equity capital for domestic banks and 250 percent for foreign bank branches to level the playing field, given they tend to have much lower capital.

“This is not aimed at imposing direct restrictions on foreign bank branches but at improving the medium- to long-term stability of our financial system,” EDaily quoted an unidentified finance ministry official as saying.

“Therefore, existing positions that they have will not be affected right away.”

The new policy was likely to include foreign currency liquidity risk controls for foreign bank branches and the authorities were considering a three-month grace period before the new rules came into force, officials told reporters.

No discrimination
The proposed rules appeared to address concerns before details of the plan emerged that any appearance that discriminated against foreign banks could hit South Korea’s standing in the eyes of foreign investors.

The EDaily also reported that the authorities would also tighten restrictions on companies’ forward trades that were announced last November alongside other regulations and came into force early this year.

It said the cap on such trades would be lowered to an equivalent of the volume of the company’s physical foreign trade transactions, down from initially imposed 125 percent.

Bankers say limits on bank’s own exposure to forward trades may help reduce somewhat South Korea’s high short-term foreign debt, but were sceptical whether it would achieve its main goal and mitigate sharp won swings.

Some economists also questioned the wisdom of implementing new controls so soon after the latest batch.

“It’s not a good sign to have to bring in a new set of rules just seven months after the last set. If the November 2009 regulations didn’t address the causes of KRW volatility, how confident can we be about another round?” said Sean Callow, currency strategist at Westpac in Sydney.

Germany, France press EU over ban on short selling

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German Chancellor Angela Merkel and French President Nicolas Sarkozy
have urged European Commission President Jose Manuel Barroso to consider
an EU-wide ban on short selling of shares and state bonds.

In a
letter published by the German government on June 9, the pair said the
Commission should step up efforts to introduce tougher controls for
credit default swaps on sovereign bonds and short selling, and present
measures in the next few weeks.

“In particular we think it’s
imperative to improve the transparency of short selling positions on
shares and bonds, particularly sovereign bonds,” the two said.

“The work of the European Commission should also extend to the
possibility of an EU-wide ban of naked short-selling of all or certain
shares and sovereign bonds as well as all or certain naked CDS on
sovereign bonds,” they added.

The age of the atom

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One of the founding principles of traditional economic theory, is that
when making economic decisions, we are independent. Like self-contained
atoms in a gas, we only interact by bumping up against each other in the
marketplace.

In the 19th century, neoclassical economists such
as William Stanley Jevons and Léon Walras were directly inspired by the
atomic theory of physics. Individuals or firms were equated with atoms.

Later,
economists would compare the apparent random walk of the marketplace
with the so-called Brownian motion of tiny particles of dust or pollen
as they are buffeted around by colliding atoms. The ultimate realisation
of this atomic vision of the economy was Eugene Fama’s efficient market
hypothesis, which asserted that the actions of independent investors
would drive prices to their optimal level.

Today, risk models
used by companies and banks implicitly assume that economic decisions
are taken independently. In economic terms, we are still in the age of
the atom. But thanks to input from other areas of science – including
physics – that is beginning to change. Economics is entering the age of
the network.

It has long been known by physicists that atoms or
molecules are capable of organising themselves into connected networks,
with a dramatic effect on the material’s properties. For example, when
water freezes, large clusters of molecules spontaneously align
themselves into the highly ordered network known as ice.

In the
late 1950s, mathematicians gained insight into such phase changes
through their study of randomly connected networks. As connections are
randomly added to a large enough collection of nodes, at first most of
the connected groups will only consist of two individuals. As more
connections are added, larger clusters slowly begin to form. And at a
certain threshold the group suddenly gels into a cohesive whole, like
water freezing.

Random networks have the advantage of being
mathematically tractable, but they are a rather coarse model of society,
which – being made up of people instead of atoms or molecules – is not
like the random disorder of a gas, or the pure order of a solid, but
shows a richer and more complex structure.

This was illustrated
in the 1960s by Harvard psychologist Stanley Milgram, who performed
experiments in which he mailed out a number of letters to randomly
selected people in the US. Each letter gave information about a target
person, and asked the recipient to forward the letter to a personal
acquaintance who they thought would be likely to know that person.
Milgram was amazed to find that, although some letters never made it to
their destination, others did in just a couple of mailings, and the
median number of mailings was only six.

Thus was born the idea
of “six degrees of separation.” This became the title for a 1990 play by
John Guare, the title of the film adaptation, and eventually a cliché.

Attractive
as the “six degrees” notion is – it’s nice to think that we’re all part
of one big family – scientists have since questioned its accuracy. In
Milgram’s experiments, less than 30 percent of the letters reached their
destination, and the rest were omitted from the results. As psychology
professor Judith S. Kleinfeld wrote, the empirical evidence suggests
that the world is not uniformly connected, but more “like a bowl of
lumpy oatmeal,” with some of us well-connected, and others much less so.

While
it may be debatable to say that human society is what scientists call a
small world network, it is certainly getting smaller all the time – at
least for some things. The rapid spread of diseases such as SARS or the
recent swine flu is evidence of that. The existence of fast transport
links between countries means that diseases can spread around the world
in a couple of days.

So what relevance does this have for the
economy? Well, network scientists have recently shifted their attention
to studying financial networks – and their findings are in some respects
alarming. In recent decades, the world financial system has become
increasingly connected.

The figures below, from a Bank of
England report, show the cross-border stocks of external assets and
liabilities in 18 countries, in the years 1985 and 2005. Node size is
proportional to total external financial stocks, and the thickness of
the links is proportional to bilateral external financial stocks
relative to GDP.

Over those two decades, the node sizes have
increased by about a factor 14, and links by a factor six. As the
report’s author Andrew Haldane notes, “The network has become markedly
more dense and complex. And what is true between countries is also
likely to have been true between institutions within countries.”

Instead
of six degrees of separation, the average path length between larger
countries is now more like 1.4. This isn’t a small world – it’s a
crowded bar. Information propagates rapidly, but – as shown by the
recent crisis – so do problems. If anyone gets a cold, everyone gets it;
and a credit freeze can turn the entire network to ice. Robust
networks, such as those found in healthy ecosystems, tend to be built up
from smaller, weakly-connected subnetworks.

A first step
towards making the financial system more robust is therefore to
introduce a degree of modularity. Some ideas being floated include:
separating investment banks from commercial operations; breaking up the
largest institutions along regional lines; or introducing a Tobin tax
(or variant thereof) on financial transactions that would slow the
global flow of money.

These might make the system less efficient
in the short term, but they should also make it more robust. After all,
when it comes to deadly viruses or credit crises, “It’s a small world,
isn’t it?” is the last cliché you want to hear.

New budget highlights Pakistan’s survival mode

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The budget announced on June 5 underscores how hard it will be for the government to appease frustrated Pakistanis hit by food inflation, unemployment and tax hikes seen as helping fuel an Islamist insurgency and discrediting civilian authorities.

The government’s predictions for a lower budget deficit of four percent of GDP may also be simply too ambitious, putting off hard decisions on spending and revenues for later, as well as almost guaranteeing a continued unpopular IMF bailout.

“To be honest, I think this government is surviving not so much because of its popularity but more so by default, ” said Rashid Rehman, editor of the Daily Times newspaper.

“The government’s hands are tied and one must not forget, given the fact that we’re in the IMF programme, that there is little fiscal space for the government to manoeuvre. It’s in survival mode.”

President Asif Ali Zardari’s Pakistan People’s Party formed a coalition government after defeating former President Pervez Musharraf’s supporters in a 2008 election, but an economic downturn and political infighting quickly made it unpopular.

On the brink of default, Pakistan turned to the IMF in November 2008 for a $10.66bn loan package to help put its economy back on track. It received the fifth tranche of $1.13bn in May.

The budget raised taxes on sectors such as capital gains, increased a sales tax and slashed some subsidies on energy and food, while trying to provide some social relief for the roughly third of the 170 million population that lives in poverty.

“The government now has very few levers to provide relief,” said Asad Sayeed, director at Collective for Social Science Research.

Between a rock and a stone
Key to meeting IMF conditions is cutting the deficit, targeted at 5.1 percent this year and seen as posing a serious inflation risk and hurting the economy just as it tentatively recovers from its lowest growth rate in decades.

“The tax collection target is grossly over-ambitious,” said Ashfaque Hasan Khan, dean of Islamabad’s NUST Business School.

Pakistan’s tax-to-GDP ratio which is around 9.5 percent, is one of the lowest in the world.

“A country like Pakistan, where fiscal indiscipline is all around, then it should be in an IMF programme to learn discipline,” he said, adding the government would have to go back to the IMF for more money this year.

But continued IMF assistance could become politically unpopular if it is associated with austerity and may fuel further resentment in Pakistan against perceived Western meddling.

“People here sometimes portray the IMF as if its holding a baseball bat and making the country do whatever it wants,” Finance Minister Abdul Hafeez Shaikh told reporters.

Meanwhile, the government raised defence spending by 17 percent, a sign of the military’s influence in politics.

Commentators questioned why an increase was needed, given the army’s battle against militants in the northwest was mostly funded by the US.

The country’s main stock exchange was unfazed by the budget as analysts said all the measures had been priced in and there were no surprises and the uncertainty was over.

The government has targeted 1.778 billion rupees in tax revenue, which is almost 21 percent higher than the current fiscal year’s target, one that is likely to be unmet as well.

Pakistan collected 1.026 billion rupees in the first ten months of the 2009/10 fiscal year.

Pakistan is also aiming to generate more than 51 billion rupees, which would be 0.3 percent of GDP, from an auction of 3G spectrum licences that analysts said was unlikely to materialise.

The inflation target of 9.5 percent for fiscal year 2010/11 was unlikely to be met if there were slippages in the fiscal target, analysts said.

“Considering we will probably not meet the tax collection target for the current fiscal year, we will definitely see fiscal slippages in the next fiscal year,” said Asif Qureshi, director at Invisor Securities Ltd.

Cameron says Britain must heed Greek warning

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Prime Minister David Cameron has told Britons the scale of the country’s budget problems is even worse than he had anticipated and cited crisis-hit Greece as an example of the risk of failing to act.

Cameron painted a bleak backdrop two weeks ahead of an emergency budget in which his coalition government will give more details of measures to cut a deficit running at 11 percent of national output.

Giving few details of where cuts will come, he attacked the previous Labour government for economic mistakes over the past decade that he said had left the legacy of a debt crisis.

“Greece stands as a warning of what happens to countries that lose their credibility, or whose governments pretend that difficult decisions can somehow be avoided,” Cameron said in a speech in Milton Keynes, central England.

“I want to set out for the country… why the overall scale of the problem is even worse than we thought,” he said, adding that the structural nature of the debt meant “a return to (economic) growth will not sort it out”.

Cameron said the public sector had grown too large under Labour. If no action were taken, within five years its debt-servicing costs would be more than it spends on schools in England, climate change and transport combined.

“Based on the calculations of the last government, in five years’ time the interest we are paying on our debt, the interest alone is predicted to be around £70bn ($101bn). That is a simply staggering amount.”

G20 support
Cameron said the summit in South Korea of the Group of 20 leading economies had endorsed the steps taken by Britain. The government, which took office in May, has already trimmed £6bn in costs to start to reduce a deficit that reached £156bn in the financial year to April.

In opposition, Labour has warned that cuts planned by the coalition risks killing off a fragile economic recovery and throwing Britain into a double-dip recession.

Cameron acknowledged the cuts to come would hurt a government still enjoying something of a honeymoon with voters.

“This is fraught with danger. This is a very, very difficult thing we are trying to do,” he said in answer to questions at distance learning institute the Open University.

Cameron heads Britain’s first coalition government since 1945, his centre-right Conservatives having teamed up with the smaller Liberal Democrats after the recent election.

Flanked by Lib Dem Treasury minister Danny Alexander, Cameron said the coalition would make it easier to win over the public, saying there were “two parties together facing up to the British people.”

Economist Alan Clarke of BNP Paribas said it was natural for a new government to lay the blame for ills at the door of its predecessor and that the message for the budget was clear.

“Fiscal tightening, spending cuts and tax increases are going to bear down on growth and disposable income. It’s going to hold back growth which is going to hold back inflation. It’s not going to be pleasant for anyone,” Clarke said.

The Treasury is expected to consult on the spending review with the private sector, voluntary organisations, trade unions and the general public.

Hungary govt plans steps to improve economy

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The Hungarian government’s economic action plan to be published after a release of its report on the budget will contain steps to improve the financial situation and structural changes, Prime Minister Viktor Orban has announced.

“It cannot be about…an adjustment, about patching up (the economy)…measures aimed at improving the financial situation must be linked with deep structural changes,” Orban told TV2 television over the phone from Brussels.

BREAKING NEWS: Orban ready to restucture

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The Hungarian government’s economic action plan to be published after a release of its report on the budget will contain steps to improve the financial situation and structural changes, Prime Minister Viktor Orban said recently.

“It cannot be about…an adjustment, about patching up (the economy)…measures aimed at improving the financial situation must be linked with deep structural changes,” Orban told TV2 television over the phone from Brussels.

Trustees: use protection

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To avoid finding themselves personally liable for costs which are likely to be substantial, trustees must know how to effectively manage disputes.

Trustees’ fundamental duties are to preserve and protect the fund which may include enforcing causes of action for damages or defending the trust against adverse claims. These duties are owed to the beneficiaries. They are not absolute duties but require trustees to exercise reasonable care.

Communicating with the beneficiaries to establish their views is essential. If nothing else, this will considerably reduce the risk of a claim against the trustees being brought by the beneficiaries down the line.

There may be a clause in the trust document which provides that the trustee is entitled to be reimbursed out of the fund for all litigation costs unless it is proved that such costs were incurred dishonestly or a clause that the trustee need not take any action unless it is first indemnified and/or provided with security to its satisfaction.

Do the beneficiaries have the rights of action in respect of any claims?
Statute or the transaction documents may provide that the beneficiaries can pursue or defend proceedings in their own right. Under the Trust Indenture Act 1939, if a US bondholder’s right to receive payment is impinged on without his consent, that bondholder has the right to take direct action against the third party responsible. The US bond trustee (unlike its English equivalent) is not given a wide discretion to act on the bondholders’ behalf.

Court action and the costs involved
Trustees need to know the merits of their case and familiarise themselves with the costs regime of the jurisdiction in which the court action will be conducted. In many jurisdictions (such as England and Wales), costs follow the event which means an award of costs will generally flow with the result of litigation; the successful party being entitled to an order for costs against the unsuccessful party. However, in other jurisdictions, there is no fee shifting. In the US, each party to civil litigation is responsible for its own legal costs regardless of which party prevails; this is the “American Rule”.

Alternatives to court action
The Civil Procedure Rules 1998 and Practice Directions in England and Wales specifically state that starting proceedings should usually be a last resort. The parties should consider whether some form of alternative dispute resolution might enable them to settle the matter without starting proceedings.

Weigh up the options
Trustees need to weigh up all the options before adopting the course of action which in their view is in the best long-term interests of the trust.

How to protect against the costs of any court action
Under English law, trustees can apply to the court for directions (otherwise known as a Beddoe application) as to whether or not proceedings should be conducted on behalf of the trust. Similar relief to that provided by the English courts is likely to be available in other jurisdictions where trusts are recognised and available.

The principles of Beddoe proceedings were first laid out in the nineteenth English case of Re Beddoe, Downes v Cottam [1893] 1 CH 547. In 2003, the principles were incorporated into the Civil Procedure Rules 1998 and Practice Directions at Part 64B.

Beddoe applications take the form of a separate action and are heard by a different judge to the main proceedings. They must be supported by evidence including the advice of an appropriately qualified lawyer as to the prospects of success and the beneficiaries’ views. Save in exceptional circumstances, Beddoe applications should be dealt with on paper and ideally they should be made before taking any steps in the main proceedings.

Beddoe proceedings offer trustees a means of complete protection from any future claims by the beneficiaries. Further, if litigation is pursued with the court’s approval, the trustees’ costs incurred in the litigation will be recoverable against the trust fund whatever the eventual outcome of the litigation. It is a myth to think that trustees are safe by simply following the advice of their counsel.

Trustees should consider obtaining a written agreement from all the beneficiaries that any litigation costs would be met out of the trust fund. Where there are numerous beneficiaries and trustees do not know who or where they all are, this approach is not feasible.

As an alternative, the trustees could seek to obtain an indemnity for the litigation costs from one or more of the beneficiaries, provided that they are not aware that other beneficiaries are against the litigation being conducted.

Prospective costs order
Under English law, trustees may apply for a prospective costs order. The English courts will order that one side will pay the other side’s costs whatever the result of the litigation. Prospective costs orders are generally only sought in administrative proceedings and are only made in very strong cases where the judge hearing the application is satisfied that the trial judge would make the same costs order.

Insurance
Trustees may be able to get indemnity or “after the event” insurance for the costs of conducting litigation which later turns out to be unsuccessful.

Final thoughts
If trustees have to conduct expensive litigation the outcome of which is not clear, trustees should always use protection. Under English law, the best protection afforded is by making a Beddoe application and obtaining the court’s approval in the form of directions for a proposed course of action. Ultimately, this gives trustees their most valuable benefit – protection against becoming personally liable for any costs incurred in pursuing or defending the litigation. As Lord Justice Lindley advocated in Re Beddoe, Downes v Cottam: “A trustee who, without the sanction of the court, commences an action or defends an action unsuccessfully, does so at his own risks as regards the costs, even if he acts on counsel’s opinion.”

David Allen (Partner) and Julie Bowring (Senior Associate), are lawyers in the Litigation and Dispute Resolution Group of the London Office of Mayer Brown International LLP

Apple overtakes Microsoft as biggest tech company

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Apple’s shares rose as much as 2.8 percent on the Nasdaq, as Microsoft shares floundered, briefly pushing its market value above $229bn, ahead of its longtime rival.

Both stocks ended down after a late-day sell-off, but Apple emerged ahead with a market value of about $222bn, compared with Microsoft’s $219bn, according to data.

Apple shares closed down 0.4 percent at $244.11 on the Nasdaq, while Microsoft fell four percent to a seven-month low of $25.01.

Shares of Apple are worth more than 10 times what they were 10 years ago, as it has profited from revolutionising consumer electronics with its stylish, easy to use products such as the iPod, iPhone and MacBook laptops.

The last time Apple had a higher market value than Microsoft was December 19, 1989, according to Thomson Reuters Datastream.

Microsoft, whose operating system runs on more than 90 percent of the world’s personal computers, has not been able to match growth rates from its hey-day 1990s. Its stock is down 20 percent from 10 years ago.

Apple, which struggled for many years to get its products into the mainstream, resorted to a $150m investment from the much larger Microsoft in 1997 in order to keep it afloat. At that time, Microsoft’s market value was more than five times that of Apple.

Microsoft still leads Apple in sales. In the latest quarter, Microsoft reported $14.5bn in revenue compared with Apple’s $13.5bn.

Cupertino, California-based Apple is now the second-largest company on the Standard & Poor’s 500 index by market value, behind energy behemoth Exxon Mobil Corp.

UK firms’ foreign takeovers hit record low in Q1

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The number of foreign firms bought by British companies fell to its lowest in more than 20 years in the first three months of 2010, official data shows.

The Office for National Statistics said spending by UK firms on foreign acquisitions fell to £192m in the three months to March, the lowest since records began in 1987.

There were only 10 acquisitions abroad by UK companies with values of £1m or more, also the lowest since records began.

Foreign takeovers of British companies also fell, to £14.3bn from £15.1bn in the previous quarter, but came in higher than in preceding quarters.

The largest transaction was the acquisition of Cadbury Plc by Kraft Foods Inc, which sparked a wave of negative publicity in the British press.

A fall in the value of the pound over the past two years has made British companies a more attractive proposition for overseas firms.

Britain’s new coalition government is looking to see whether rules governing takeovers of UK companies need tightening and has launched a wide-ranging review of the independent Takeover Panel.

The Liberal Democrats, the smaller party in the coalition, have argued that there is a case for reinstating a public interest veto to prevent short-term speculators damaging domestic interests.

Credit value at risk

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Consider a credit portfolio that consists of default-sensitive instru¬ments such as lines of credit, corporate bonds, and government bonds. The corresponding credit value-at-risk (VaR), is the minimum loss of next year if the worst 0.03 percent event happens. In another words, 99.97 percent of the time the loss will not be greater than VaR. Note that the credit VaR is measured at the time span of one year and is different from the 10-day convention adopted by market VaR. 0.03 percent is chosen because it is a rating agency standard of granting an AA credit rating.

Single instrument
The loss of a single instrument can be decomposed into three components: the default probability of the obligor (PD), the loss given default (LGD), and the exposure at default (EAD). For the sake of simplicity, EAD is assumed to be non-random in the subsequent discussion.

LGD is the portion of EAD that gives negative impact in case of default. LGD is usually less than one because many default obligors are originally backed by securities.

The magnitude of the recovery rate is tied to the collateral properties during or after default. The recovery rate depends on the nature of the instrument: only the loss on principal can be claimed, not the loss on coupon interest.
PD and LGD are positively correlated, meaning PD and the recovery rate are negatively correlated.

Portfolio
The main issue in computing VaR for a credit portfolio is that the joint default probability for two obligors does not follow the law of independence. Companies in the same sector tend to default together. This is known as credit concentration.

Stress testing
Stress testing is the procedure of checking the robustness of VaR under different hypothetical changes. Examples include perturbation of the model parameters, economic downturn of the region, deterioration of the industry environment, or the downgrade of specific obligors’ credit profiles. Another equivalent way is to fix VaR and observe how the tail area of L is affected. A systematic account can be found in the Bank of International Settlement document of “Stress testing at major financial institutions: survey results and practice”.

Implementation details
Some hints on the real complexity of VaR:
• Although many banks have a strong desire to apply credit VaR to both trading and loan books in an integrated manner, some of the cumbersome barriers are the differences in accounting treatment, variation of technology platforms, and illiquidity factors (relating to traditional loans). The banks may involve fundamental changes in organisational structure in order to implement consistent integrated risk management systems.

• Some of the companies involved in a portfolio could have become public very recently and the equity return may not be available before IPO. Statistical techniques, such as EM algorithm of Dempster et al. and data augmentation algorithm of Tanner and Wong, can be employed to impute the missing values and estimate the model parameters.

• Similar to market VaR, backtesting is one of the goals to be achieved in addition to stress testing. However, the time span of credit VaR is typically one year and it is hopeless to collect enough historic credit loss data for validation purpose. Lopez and Saidenberg suggest backtesting by cross-sectional simulation, which is essentially a variation of bootstrap, ie, evaluation based upon resampled data.

This article is an edited version of
an entry in the “Encyclopedia of Quantitative Risk Analysis and
Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by
permission.

www.wiley.com