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Lessons from the recent credit market turmoil

If it’s too good to be true, it probably isn’t true

When a new asset class is securitised, what is the historical data for

Default probability?

Recovery rate? Etc?

Sub-prime mortgages could not realistically be modelled using existing data

Importance of liquidity

Liquidity is essentially subjective

i.e. it can change with market perceptions

Usually straightforward to ESTIMATE relatively

i.e. a UST is more liquid than a AAA

and AAA more liquid than BBB etc

There are also rules of thumb:

Size of issue

Age of issue

Number of traders (the 2” rule)

BUT there can be unexpected (and unpredictable) effects

e.g. interbank liquidity

Note : LIBOR became illiquid, but not EONIA

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