Credit Default Swap Info

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CBOT Credit DefaultSwap Index Futures

RefeRence Guide


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IntroductIon 5

Background 6

contract BenefIts 7

Short Lifespan

Rate Up, Price Up

Buy Futures Buy Protection. Sell Futures Sell Protection.

key BenefIts 9Position Scalability

Administrative Convenience and Low Operational Cost

Transparency

High-Grade Credit Exposure

Capital Efficiency

Off-Exchange Trading

the cdr lIquId 50 Index: composItIon and structure 11

Index Series and Futures Expiries

Selection of Index Components

Maximum Running Spread and Other Index Parameters

the cdr lIquId 50 Index: some sylIzed facts 14

Financials: CDR Liquid 50 versus CDX

synthetIc corporate Bond portfolIos 17

Long Corporates Long IRS Futures + Short CDS Index Futures

Short Corporates Short IRS Futures + Long CDS Index Futures

prIcIng cds Index futures: spot versus forward 23

Spot Forward, Generally

Exceptions Depend on the Hazard Rate

Rolling Down the Curve

appendIx 1 cdS ix ftrs cotrat Spatos 29

appendIx 2 cdS ix ftrs cotrat Rls 30

appendIx 3 cdR Lq 50 nAiG ix costrto a Mata Prors 32

appendIx 4 cMA a cMA dataVso 37

Table of Contents


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IntroductionSince the birth of financial futures, market practitioners have exhorted exchanges to list corporate bond futures.

What they envision, typically, are contracts that would be traded and transparently priced on a regulated

exchange, and that would be guaranteed by a centralized clearing house, and that would (by whatever means)

furnish a generic proxy for the price exposure of investment grade corporate bonds.

Chicago Board of Trade Credit Default Swap (CDS) Index futures meet this need.

CDS Index futures give institutional portfolio managers a simple means of acquiring or laying off

standardized investment grade corporate bond price exposure.

For many users, CDS Index futures should result in lower administrative costs relative to over-the-counter

(OTC) alternatives.

As with all CBOT futures, the guarantee furnished by the Exchanges clearing services provider

consolidates and virtually eliminates counterparty credit risk, permitting contract users to easily adjust their

asset exposures without tying up credit lines.

Used in conjunction with CBOT Interest Rate Swap (IRS) futures, CDS Index futures give market

practitioners a simple, flexible means to create and trade synthetic investment grade corporate

bond portfolios.

This reference guide reviews the key features and benefits of CDS Index futures. It then discusses the structure of

the contracts underlying reference, the CDR Liquid 50TM North America Investment Grade Index (hereafter, CDR

Liquid 50TM) and describes some of the indexs empirical features. It explores in detail how traders and investors

can combine CDS Index futures with CBOT 5-Year IRS futures to achieve an operationally clean and flexible proxy

for generic investment grade corporate bond exposure. It concludes with a discussion of the relationship between

spot values of the CDR Liquid 50 index and the forward values reflected in CDS Index futures prices.

Appendices present a summary of the terms of the CDS Index futures contract, the CBOT Rulebook chapter thatformally defines the contract, the guide to index construction and maintenance procedures for the CDR Liquid 50

index, and an overview of CMA DataVisionTM, the price data source for the CDR Liquid 50 index.


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6

The dramatic growth of credit default swaps marks

one of the great milestones in the saga of financialderivatives. In the short span from year-end 2004 to

year-end 2006, outstanding notional amounts of US

dollar-denominated credit default swaps burgeoned

from around $6.5 trillion to nearly $29 trillion, clocking

growth of 110 percent per annum. The share of this

total that represents index-related (multi-name) credit

default swaps has risen yet faster, from 20 percent in

2004 to nearly 35 percent in 2006. See Exhibit 1.

This achievement has not come without growing

pains. In recent years, regulators have become

increasingly troubled by the inability of dealers

back offices to keep pace with timely capture,confirmation, and booking of credit derivative

transactions. Matters came to a head in September

2005, when the Federal Reserve Bank of New York

convened the first of a series of meetings with major

derivatives market participants and regulators. The

action plan that emerged from these gatherings hasaccomplished much, including marked reduction

in the backlog of outstanding unconfirmed trades,

clarification of procedures for trade assignment and

novation, and widespread acceptance and adoption

of more rigorous protocols for the settlement of credit

derivatives when credit events actually occur. (See,

e.g., Federal Reserve Bank of New York, Statement

Regarding Progress in Credit Derivatives Markets, 27

September 2006, www.frb.ny.org.)

Despite these efforts or perhaps because of them

the operational costs of trading and managing OTC

credit derivative positions have soared in league withthe scale of market activity. This underscores the

need for exchange-listed contracts to assist market

participants in managing their risk exposures. CBOT

CDS Index futures are ideally suited to play this role.

Background

Exhibit 1

Outstanding Notional

Amounts of OTC US Dollar

Credit Default Swaps

Data Source:Bank for International Settlements

0

10

20

30

Dec 04 Jun 05 Dec 05 Jun 06 Dec 06

Total

Multi-Name


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CBOT CDS Index futures expire quarterly, in March,

June, September, and December. The last trading

day for expiring contracts is the so-called IMM

Monday, the Monday before the third Wednesday

of the expiry month.

The underlying reference for CDS Index futures is

the CDR Liquid 50 North America Investment Grade

Index, maintained and published daily by Credit

Derivatives Research LLC (CDR LLC). The CDR Liquid

50 index is simply an arithmetic average of 5-year

credit default swap spreads quoted on each of the 50

most active names in the US investment grade credit

default swap market.

CDS Index futures are quoted as an average credit

spread, directly in terms of the CDR Liquid 50 index,in basis points and hundredths of basis points. Each

basis point of contract price is worth $500. Each

hundredth of a basis point, the contracts minimum

trading increment, is worth $5.

At expiration the CDS Index futures contract settles

to the value of the CDR Liquid 50 index on the

contracts last trading day. Importantly, each futures

expiry references a distinct index series. This means,

for example, that a September CDS Index futures

contract will expire with reference to a CDR Liquid 50

index series that may differ in composition from the

index series that serves as the underlying reference

for the futures contract that expires the following

December. (How this relationship works, and why it is

so, is explained in detail below. See The CDR Liquid

50 Index: Composition and Structure on page 11.)

CDS Index futures expire by cash settlement. There

is no physical delivery. CDR LLC will publish the value

of the pertinent CDR Liquid 50 index series for the

last day of trading, on the next morning. This index

value becomes the expiring contracts final settlement

price. The Exchanges clearing services provider uses

this final settlement price to determine a final mark to

market (versus the futures contracts daily settlement

price on the last day of trading).

Two differences between CDS Index futures and

other CBOT financial futures deserve emphasis:

s li

One is that a CDS Index futures contract has an

unusually abbreviated lifespan, roughly three and a

half months from listing to expiration. A newly listed

contract begins trading on the business day after

the CDR Liquid 50 index series that corresponds to

it has been constituted and announced. The newly

listed contract then coexists with the previously

listed contract for approximately two weeks, until the

previously listed contract expires.

Example:Consider a hypothetical March 2007 CDS

Index futures contract. Its underlying reference

would be the CDR Liquid 50 index series

constituted on the last business day of November

2006 (Thursday, 30 November). The contract wouldbegin trading on the first business day of December

2006 (Friday, 1 December) and would expire on

IMM Monday in March 2007 (Monday, 19 March).

It would trade alongside the (likewise hypothetical)

December 2006 contract from Friday, 1 December,

through Monday, 18 December, the last trading

Contract Features


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day in the December 2006 contract. During this

time, strategic open interest holders would be able

to roll their positions from the December 2006

contract to the March 2007 contract. Among the

many considerations they would take into account

when pricing the roll spread are the differences in

composition, if any, between the two CDR Liquid

50 index series 064 and 071, respectively -- thatcorrespond to the December 2006 and March

2007 contracts.

This listing/expiry timetable strikes a judicious balance

between two goals. One is to allow each newly listed

CDS Index futures contract to run in tandem with the

previously listed contract, long enough to let market

participants roll in orderly fashion from one expiry to

the next.

The other is to permit the CDR Liquid 50 index to do

what it is designed to do. The futures contracts short

lifespan enables a comparably short lifespan for the

index series that serves as its underlying reference.

The single-name credit default swaps selected as

index components will have been chosen on the basis

of their trading activity. However, one of the realities of

both the corporate bond and OTC credit derivatives

markets is that liquidity can, and often does, migrate

abruptly from one corporate reference to another. In

view of this, the brief lifespan of the futures contract

and its companion index series is intended to increase

the chances that the 50 names in the index series

might remain active through contract expiration.

r u, pi u

The other distinction is that CDS Index futures are

priced with direct reference to an interest rate spread

to be precise, a forward-starting credit spread.

This means that when credit spreads widen generally,

the contract price is likely to rise in value. Conversely,

when credit spreads become narrow generally, the

contract is likely to fall.

This is in contrast to other CBOT financial futures,

such as Treasuries, Interest Rate Swaps, or 30-Day

Fed Funds. Because those contracts trade in terms of

notional asset price, rather than notional interest rate

or interest rate spread, their prices tend to fall when

interest rates rise, and vice versa.

Several examples given below will dramatize the

importance of keeping this distinction clear when

constructing and trading spreads between CDS

Index futures and other CBOT financial futures. (SeeSynthetic Corporate Bond Portfolios on page 17.)

B f B pis f s pi

For those familiar with OTC credit default swaps,

a convenient rule of thumb is that owning a long

position in CDS Index futures is similar to owning

protection. Given a general widening of credit

spreads, a CDS Index futures contract price will tend

to rise, and contract longs should benefit. If instead

there is a general narrowing of credit spreads, then

CDS Index futures prices will tend to fall, and contract

longs will have to pay variation margin on the ensuing

marks to market. Obviously the converse holds too:

A seller of CDS Index futures assumes exposure

broadly similar to a protection sellers position in

OTC credit default swaps.


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Users of CBOT CDS Index futures gain several

important benefits from the contract design.

pii sbii CDS Index futures offer

a convenient and standardized means to obtainexposure, long or short, to a generic investment

grade corporate credit spread, without having to

own either an OTC credit default swap or a spread

position between, e.g., corporate bonds and plain-

vanilla interest rate swaps. Unlike OTC credit default

swaps, positions in CDS Index futures can be entered

or liquidated, scaled up or down, without extensive

contractual documentation and without leaving

behind a book of non-nettable or non-offsetting

OTC swap contracts.

aiii ci l

oi c Using CDS Index futures

eliminates the administrative (e.g., accounting,

manpower, record-keeping) costs frequently required

in maintaining a book of OTC credit derivatives.

Moreover, cash settlement means there are no trailing

contractual obligations after contract expiration. The

financial obligations entailed in CDS Index futures

expire with the contract, after the final mark to

market. For this reason, among others, CDS Index

futures make synthetic credit spread exposure readily

available to market participants who cannot be, or

who would prefer not to be, directly involved in OTC

credit derivative transactions.

t By their nature and structure,

futures markets allow participants with differing

information sets and outlooks to discover the

equilibrium price of the moment. By making price

information available for all to see, CDS Index futures

furnish a useful reference point and a daily mark to

market with unmatched transparency.

hi g ci eThe credit

guarantee of the CBOT clearing services provider

makes CDS Index futures comparable to the

strongest counterparty credits in the OTC market.

Among its many benefits, this obviates the needfor entering into potentially cumbersome bilateral

collateralization arrangements to alleviate

counterparty credit exposure.

ci eii Besides virtually eliminating

credit risk, the clearing house guarantee means that

futures position holders need not reserve significant

amounts of capital against the risk of adverse moves

in credit spreads. That is, by using CDS Index

futures portfolio managers and credit spread traders

may substitute (inexpensive) risk management for

(expensive) capital.

o-e ti CDS Index futures are

eligible for a wide variety of bilaterally negotiated

off-exchange transactions. These include:

Wholesale trades in which a buyer and seller

can bilaterally trade a block of CDS Index

futures at a mutually agreeable price, as long

as the scale of the block transaction is large

enough to qualify. The minimum admissible

size for block trades in CDS Index futures

is 100 contracts.

Exchange-for-Physical (EFP) trades inwhich a buyer acquires CDS Index futures

from a seller at a mutually agreeable price.

At the same time, the futures buyer sells (and

the futures seller buys) an equivalent amount

of a credit spread position in cash securities,

for which the credit spread dynamics are

reasonably correlated with the price dynamics

of the CDS Index futures.

Key Benefits


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Example: The buyer of CDS Index futures might

simultaneously sell a comparably scaled Treasury-

Agency spread, by selling 10-year Treasury notes

and buying 10-year Agency debentures. The seller

of the CDS Index futures would take the other side

of the cash transaction as buyer of the 10-year

Treasuries and seller of the 10-year Agencies.

Example:The CDS Index futures buyer might

simultaneously sell a comparably sized exposure

in the Swap-Corporate yield spread, by buying

corporate bonds and taking the fixed-payer side of

an OTC plain-vanilla swap. The seller of the CDS

Index futures would take the other side of the cash

transaction, as the fixed-rate receiver on the plain-

vanilla interest rate swap and as the seller of the

corporate bonds.

Exchange-for-Swap (EFS) trades, which

are similar to EFP trades, except that the

buyer of CDS Index futures enters into a

comparably scaled OTC credit default swap as

the protection seller. Conversely, the seller of

the CDS Index futures position takes the other

side of the OTC credit default swap, as the

protection buyer.Exchange-for-Risk (EFR) trades, which are

similar to EFS trades, except that the buyer of

CDS Index futures enters into an OTC option

position with a delta that is negatively related to

the level of credit default swap spreads. That is,

he is either the purchaser of a put on protection

or the seller of a call on protection. Conversely,

the seller of the CDS Index futures takes the

other side of the OTC option transaction: She

is either the buyer of a call on protection or the

seller of a put on protection. The DV01 of the

CDS Index futures position is approximately

the same size as the delta of the OTC

option position.

The Chicago Board of Trade Rules and Regulations

are the authoritative source regarding permissible

off-exchange transactions. Regulation 331.05

covers wholesale trades. Regulation 331.08 governs

EFP, EFR, and EFS transactions. The Rules and

Regulations are found on the CBOT website at

www.cbot.com.


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As noted earlier, the underlying reference for CBOTCDS Index futures is the CDR Liquid 50 North America

Investment Grade Index, maintained and published by

Credit Derivatives Research LLC.

In broad overview, the index mechanism is delightfully

simple: an arithmetic average of standard 5-year

single-name credit default swap spreads, quoted on

each of the 50 corporate names represented in the

index. Index components are selected on the basis of

their credit quality -- all must be issuers of investment

grade debt and on the basis of trading activity in the

single-name credit default swaps that reference them.

I si f eii

The CDR Liquid 50 index is reconstituted quarterly,

such that each index series corresponds to an

individual futures contract expiry. (For details, see

Sections 2 and 3 of Appendix 3.)

Example: Consider a hypothetical December 2008

CDS Index futures contract. Its underlying reference

would be the 084 series of the CDR Liquid 50

index (where 084 refers to the fourth, or December,

quarter of 2008). Index components of the 084

series would be chosen and published after close ofbusiness on the last business day of August (Friday,

29 August 2008). The next business day (Tuesday,

2 September) would be both the index roll date and

the first day of trading in December 2008 futures.

This pairing December 2008 futures and the084 index series -- would briefly coexist with the

(hypothetical) September 2008 futures and the

corresponding 083 index series. Since the last

trading day in September 2008 futures would be

Monday, 15 September, the overlap would be just

under two weeks.

The composition of the two index series, 083 and

084, may differ, but this would have no direct

bearing upon the expiry value of the September

2008 futures. The underlying reference for that

contract would be the 083 index series, and no

other. Similarly, the expiry value of December 2008

futures would rely solely upon the 084 index series,

and no other.

si I c

For each new CDR Liquid 50 index series, the

50 components are selected from the universe

of standard credit default swap spreads, where

standard means any on-the-run credit default swap

with 5 years to maturity, denominated in US dollars,

referencing taxable bonds that are rated BBB/Baa2

or higher and that are issued by a North American

corporation. (For details, see Sections 1, 4, and5 of Appendix 3.)

The CDR Liquid 50 Index:Composition and Structure


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Sidenote: The rating standard requirement

Standard & Poors BBB and Moodys Baa2 -- is

more stringent than the requirements that apply

to many other investment grade credit default

swap indexes. For example, to be considered

for admission to the well-known CDX.NA.IG

(the CDX North America investment grade

credit default swap index) a credit default swapmay reference securities rated anywhere within

the investment grade spectrum. (See Index

Methodology for the CDX Indices, 22 May 2007,

www.markit.com.) This means that a debt issuer

rated as low as BBB-/Baa3 might be eligible

to become a component of the CDX.NA.IG

index, whereas the same debt issuer would be

automatically ruled out for inclusion in the CDR

Liquid 50 index. The index managers at CDR

LLC have incorporated this tighter definition of

investment grade into their index design in

order to lend stability to the indexs composition

i.e., to reduce the rate of turnover among indexcomponents -- from one index series to another.

The CDR index managers then rank all elements of

the universe by trading activity, measured in terms of

frequency of actionable bid-offer quotes, during the

three months preceding the index roll date. The more

quoting activity, the higher the rank. The quote data

that CDR LLC employs in determining this ranking are

furnished by CMA through its DataVision service. (For

a description of CMA DataVision and an overview of

its framework for data collection and preparation, see

Appendix 4.) Broadly speaking, the 50 highest-rankedelements of the universe become the components of

the new index series.

mi ri s

o I p

To assemble these components into a new index

series, the CDR index managers begin by computing

index component DV01s. Each index component

DV01 is the dollar value of a 1 basis point change in

one of the single-name credit default swap spreads

serving as an index component, with the notional

amount of the credit default swap assumed to be

$1. The key inputs in computing this collection of

parameters are the levels of credit default swap

spreads for each of the 50 index components, and thelevel of the 5-year plain-vanilla swap rate, at the time

the index series is constituted.

Using these 50 index component DV01s, CDR

LLC will then compute and publish various

index parameters:

the index DV01, the arithmetic average of the

50 index component DV01s. Like the index

component DV01s, the index DV01 presumes

a $1 notional amount.

the

notional size of the credit default swapexposure embodied in the corresponding CDS

Index futures contract. This is equal to the

futures contract DV01, always $500 per basis

point, divided by the index DV01.

the standard recoveryrate that the index

managers will employ in all subsequent index

calculations. The standard recovery rate may

vary from one CDR Liquid 50 index series to

another, depending upon what is deemed to be

market convention at the time the index series

is constituted. (The recovery rate that market

participants regard as customary has varied in

recent years between 0.3 and 0.4, i.e., 30 to

40 percent of notional.) Setting the standard

recovery rate is left to the sole discretion of

CDR LLC. Once the standard recovery rate

for an index series has been set, however, it

remains fixed for the life of that index series.


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Perhaps most important is the maximum

running spread, which functions as an upper

bound on the values that index components

may take. The maximum running spread is

computed as1

Maximum Running Spread =

(1 Standard Recovery Rate) / Index DV01.

For definitions and detailed explanations, see Section

6 of Appendix 3.

Imposing the maximum running spread as an upper

bound on index inputs might appear to be arbitrary.

In fact, it is not. It plays a natural role in ensuring the

stability, continuity, and responsiveness of the CDR

Liquid 50 index

Stability. Suppose a credit event overtakes, or

threatens to overtake, one of the 50 corporate entities

in the index. Market quotes on credit default swap

spreads referencing that entity are apt to widen,

possibly to extreme levels, relative to credit default

swap spreads for other index components. Cappingthe index inputs at the maximum running spread

permits the distressed outlier to enter the index, while

simultaneously preventing it from exerting undue

outlier influence upon the index average.

Continuity. Whenever a corporate entity becomes

distressed, or threatens to become distressed, liquidity

commonly gets patchy in single-name credit default

swaps referencing that entity. Conversely, whenever

market quote activity dries up in single-name credit

default swaps for a given corporate debt issuer, the

likeliest explanation is market apprehension that the

issuer is under imminent threat of a credit event.

Against this backdrop, the maximum running spread

serves as a reasonable place-holder, enabling the

index managers to assign plausible values to all

index components, and thus to publish a valid and

methodologically consistent index value each day,

irrespective of discontinuities in market quote traffic.

Responsiveness. Imposing a structural limit upon

admissible values of index components enables the

index to rely solely upon market rates as inputs.

Importantly, this means index evaluation requires noarbitrary or ad hoc decisions, or speculation, on the

part of the index managers as to whether a credit

event may have occurred or might be imminent.

Thus, paradoxically, the maximum running spread

mechanism makes the CDR Liquid 50 index more

directly responsive to market rates, prices, and

expectations.

1 To appreciate the conceptual role of the maximum running spread, readers familiar with credit derivatives will want to recall the iron triangle of

credit default swap valuation:

Hazard Rate = Credit Default Swap Spread / ( 1 Recovery Rate )

In this framework, the maximum running spread identifies the threshold at which the implied credit event hazard rate equals the basis point value

of a $1 change in the value of the index portfolio.


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Exhibit 2 shows daily readings of CDR Liquid 50

index series from late March 2006 through early June

2007. It juxtaposes them with daily values for the three

coeval series of the CDX.NA.IG, widely acknowledged

to be the benchmark in the US credit derivatives

index arena.

The two time series plots obviously mimic each

others broad trends and low frequency swings. Just

as clearly, however, they are far from identical. The

correlation between their daily changes is a modest

0.67. Given the differences in their index composition

procedures rule-based selection on the basis of

trading activity in the case of CDR Liquid 50, versus

an elaborate dealer polling procedure in the case

of CDX.NA.IG such behavioral differences are

unsurprising.

Exhibits 3 and 4 demonstrate these compositional

differences via comparison of on-the-run index series

as of June 2007 specifically the CDR Liquid 50

series 072, and the CDX.NA.IG Series 8 Version

1. At least three features of the comparison are

worth pointing out. First, the CDR Liquid 50 index

places notably more weight upon the Financial and

Communications & Technology sectors. Second, its

emphasis upon the liquidity of its index constituents

leads it, in this example at least, to concentrate nearly

The CDR Liquid 50 Index:Some Stylized Facts

Exhibit 2

CDR Liquid 50 and CDX,

Daily, 21 March 2006 to

11 June 2007

Data Sources: CDR LLC, CMA,

Markit Group Ltd.

Notes: CDX.NA.IG index components

are as given by Markit Group Ltd.

CDX.NA.IG index values are

computed with single-name credit

default swap spread data furnished

by CMA.25

35

45

CDR 062 CDR 063 CDR 064 CDR 071 CDR 072

CDX 6 CDX 7 CDX 8

IndexCreditSpr

ead(Bps)

21-M

ar-06

2-Ma

y-06

13-Jun-06

25-Jul-0

6

5-Se

p-06

17-O

ct-06

28-N

ov-06

9-Jan-07

20-Apr-

07

3-Ap

r-07

15-M

ay-07


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all of its sectoral exposure in just four sectors: Consumer Cyclicals and Noncyclicals, in addition to Financials and

Communication & Technology. Third, for the same reason, the CDR Liquid 50 index accords relatively little or no

weight to Industrials, Materials, Energy, Utilities, and Government (i.e., Fannie Mae and Freddie Mac).

Exhibit 3

Sector Composition as

Percent of Index Weight:

CDR Liquid 50 versus CDX

(CDR Liquid 50 Series 072

and CDX.NA.IG Series 8Version 1, Maturing 20

June 2012)

Data Sources: CDR LLC, Markit

Group Ltd

Among sectors that dominate the CDR Liquid 50 index make-up, the degree of overlap with corresponding

sectors in the CDX.NA.IG is generally high. For example, as Exhibit 4 shows, of 14 corporate names from the

Consumer Cyclicals sector that serve as CDR Liquid 50 index components, 11 also stand as CDX.NA.IG index

components. As a general rule, approximately three quarters of each sectors weight in the CDR Liquid 50 index

signifies overlap with the CDX.NA.IG. The one glaring exception is the Financials sector.

Exhibit 4

Index Overlap Between

CDR Liquid 50 and

CDX: Numbers of Index

Components

(CDR Liquid 50 Series 072

and CDX.NA.IG Series 8

Version 1, Maturing 20June 2012)

Data Sources: CDR LLC, Markit

Group Ltd

18

22

14

1211

9

6

5

2 2

30

28

24

14

2 2

Financial Cons

Cyclical

Comm +

Tech

Cons

Noncyclical

Industrial Materials Utilities Energy Govt Other

CDX

CDR Liquid 50

4

119

5

CDR Liquid 50 NAIG Index, Series 072:

30 of 50 index components also appear in

CDX.NA.IG expiring 20 June 2012

CDR Liquid 50 NAIG

Sector Totals

Overlap with C DX .NA.I G

CDX.NA.IG

Sector Totals

27

23

17

15

14

11

8

6

2 2

1 1

7

12

1415

Financial

ConsCynical

Comm+Tech

ConsNoncyclical

Industrial

Materials

Utilities

Energy

Govt

Other


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fii: cdr lii 50 cdx

The sharp divergence between the two indexes in their

emphasis on Financials arises directly from the CDX.

NA.IG index constitution procedures. The composition

of the CDX indexes is decided collectively by the

consortium of 16 credit derivative dealers who support

the CDX family. This roster includes ABN AMRO,

Bank of America, Barclays Capital, Bear Stearns,BNP Paribas, Citigroup, Credit Suisse First Boston,

Deutsche Bank, Goldman Sachs, HSBC, JPMorgan,

Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS,

and Wachovia. (Source: Markit Ltd.)

Not only do these dealers decide CDX index

composition, they also serve as the main price-makers

and liquidity-providers for the vast OTC derivatives

market that has grown up around the CDX indexes.

Potential conflict of interest considerations dictate that

no consortium member should be eligible for inclusion

as a CDX index component. Because the consortiummembership encompasses most of the leading issuers

of investment grade US financial corporate debt, this

means the CDX.NA.IG index is thus structurally tilted

toward under-representation of Financials.

The CDR Liquid 50 index is not so encumbered,

because its composition, maintenance, and data

sourcing are performed by neutral parties (namely

CDR LLC and CMA). Insofar as its representation of

the Financials sector is unconstrained, the CDR Liquid

50 makes a potentially closer match for the sector

mix held by many corporate bond portfolio managers.

Exhibit 5 suggests as much, via comparison of theCDR Liquid 50 and CDX.NA.IG indexes with the

Lehman Brothers US Corporate Index.

Sidenote:A popular proverb in market folklore

holds that, for any index of credit default swap

spreads, the more weight the index accords

to Financials, the less volatile the index should

be. The time series data portrayed in Exhibit 2,

however, reveal just the opposite: The median

of absolute values of daily changes in the CDR

Liquid 50 index is 0.44 basis points versus 0.38

basis points for the CDX.NA.IG index.

Exhibit 5

Sector Composition as

Percent of Index Weight:

Lehman Brothers US

Corp, CDR Liquid 50,

and CDX

(Lehman Brothers US

Corporate Index, 31 Dec

2006, CDR Liquid 50 Series

072, and CDX.NA.IG Series

8 Version 1)

Data Sources: CDR LLC, Lehman

Brothers Inc, Markit Group Ltd

47

70

30

74

18

62

43

10

Industrials Financial Utilities Govt

Lehman US Corporate CDR Liquid 50 CDX


17/40

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By combining appropriate numbers of CBOT CDS Index futures with CBOT 5-Year IRS futures, an investor or

trader can assemble a futures position that mimics the price exposure of a generic portfolio of liquid investmentgrade US corporate bonds. This synthetic portfolio is both simple and flexible in terms of the mechanics of futures

position management and pricing. The two component contracts cease trading on the same day and at the same

time. Both contracts expire by cash settlement. At contract expiry, the underlying references for both contracts

signify maturity exposure of 5 years.

Moreover, toggling back and forth between contract price exposure and implied yield exposure is unusually

straightforward. The 5-Year IRS futures contract is designed so that there is a one-to-one mapping from its price

to the implied forward-starting plain-vanilla swap rate2. CDS Index futures are priced with direct reference to a

forward-starting market-average 5-year credit default swap spread, quoted as a yield spread versus the 5-year

plain-vanilla swap rate. Thus, the implied forward-starting yield for the synthetic portfolio is the sum of (a) the

implied yield for 5-Year IRS futures and (b) the CDS Index futures price. Exhibit 6 shows the resultant implied

corporate bond portfolio yields, daily from late March 2006 to early June 2007, and how they compare with theMoodys Aaa Industrial/Utility average and the Moodys Baa average.

Synthetic CorporateBond Portfolios

Exhibit 6

CBOT Synthetic Corporate

Bond Yields vs Moodys

Aaa Industrial/Utility and

Baa Averages

(CBOT synthetic corporate

bond yield equals (a) the

forward-starting swap

rate implied by the nearby

5-Year IRS futures priceplus (b) the average credit

spread reflected in the CDR

Liquid 50 index.)

Data Sources: Board of Governors of

the Federal Reserve System, CBOT,

CDR LLC

5

6

7

CBOT Synthetic Corporate M oody's Aaa Ind&Utility M oody's Baa

Yield(Percent)

21-Mar-06

2-May06

13-Jun-06

25-Jul-06

5-Sep-06

17-Oct-06

28-Nov-06

9-Jan-07

20-Feb-07

3-Apr-07

15-May-07

2 Translation from price to yield in CBOT IRS futures is facilitated by lookup tables furnished by the Exchange at www.cbot.com/swaps.


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18

As the scatter plots in Exhibit 7 suggest, daily changes in the CBOT synthetic corporate bond yield are reasonably

well correlated with these market averages: 0.87 for the Moodys Aaa Industrial/Utility, 0.89 for the Moodys

Baa. By no means is either a perfect fit. But given the absence of any other exchange-listed contract or contract

spread that might be remotely suitable for hedging or replicating corporate bond exposure, the CBOT synthetic

portfolio makes an attractive and useful addition to any credit product traders risk-management toolkit.

Exhibit 7

Daily Yield Changes:

CBOT Synthetic Corporate

Bond Portfolio, Moodys

Aaa Industrial/Utility,

and Moodys Baa

(21 March 2006 to

11 June 2007)

Data Sources: Board of Governors of

the Federal Reserve System, CBOT,

CDR LLC

-20

-15

-10

-5

0

5

10

15

20

-20 -15 -10 -5 0 5 10 15 20

Daily Changes in CBOT Synthetic Bond Yield (Bps)

Baa Corr = 0.89

Aaa Corr = 0.87

DailyChan

gesinMoodysBondYields(Bps)


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l c l Irs f + s cds I f

A few examples should make this concrete. To begin, consider a portfolio manager who anticipates buying

$1 billion of 5-year Aaa corporate bonds. Between now and when she actually acquires the bonds, she faces

two primary sources of yield risk:

changes in the 5-year benchmark yield (here, the 5-year plain-vanilla swap rate) and

changes in the corporate credit spread, the spread between the 5-year benchmark yield and 5-year corporate

bond yields.

To manage this exposure, she creates a synthetic place-holder portfolio by combining CBOT CDS Index futuresand 5-Year IRS futures. Properly structured, this should serve adequately both as an anticipatory hedge and as

a means of avoiding cash drag on the portfolios returns. If market conditions are as shown in Exhibit 8, then the

appropriate DV01-weighted hedge should consist of two components:

Long 9,798 5-Year IRS futures = $430,897/($43.98 per contract)

Short 862 CDS Index futures = $430,897/($500 per contract)

Exhibit 8

Market Conditions on Day 1

pi yi dv01

5-Year Aaa Corporate Bonds $1 billion (par) 5.60 $430,897

CBOT 5-Year IRS Futures 102-19/32nds 5.401 $43.98/contract

CBOT CDS Index Futures 36.00 bps 0.36 $500/contract

Note that the long position in the synthetic portfolio comprises along position in IRS futures (which references a

notional asset price) and ashort position in CDS Index futures (which references a notional interest rate spread).

Now suppose market interest rates fall 50 bps, with credit spreads holding steady. Exhibit 9 summarizes the

change in market conditions.

Exhibit 9Change in Market Conditions from Day 1 to Day 2

Day 1 Day 2

pi yi pi yi prie change ($)

5-Year Aaa Corporates $1 billion (par) 5.60 $1,021,823,737 5.10 21,823,737

Long 9,798 5-Year IRS Futures 102-19/32nds 5.401 104-26.5/32nds 4.901 21,892,406

Short 862 CDS Index Futures 36.00 bps 0.36 36.00 bps 0.36 Zero


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20

Bonds that would have cost $1 billion to purchase at par previously are now $21.8 million more expensive. The

anticipatory hedge has generated sufficient proceeds, however, for the portfolio manager to keep up with market

valuations. Specifically, the 50 bps drop in yields translates into a jump of 2 points and 7.5/32nds in the price of

5-Year IRS futures. The corresponding mark to market on that portion of the hedge structure is:

$21,892,406.25 = 71.5/32nds x $31.25 per 32nd per contract x 9,798 contracts

Now, suppose instead that benchmark market rates hold steady, but that investment grade corporate creditspreads narrow by 5 bps. Exhibit 10 details the change in market conditions.

Exhibit 10

Change in Market Conditions from Day 1 to Day 2

Day 1 Day 2


5-Year Aaa Corporates $1 billion (par) 5.60 $1,002,157,249 5.55 2,157,249

Long 9,798 5-Year IRS Futures 102-19/32nds 5.40 102-19/32nds 5.40 Zero

Short 862 CDS Index Futures 36.00 bps 0.36 36.00 bps 0.31 2,155,000

As before, the rise in bond prices might compel the portfolio manager to chase after the market. Without the

protection afforded by her anticipatory hedge structure, she would find herself paying nearly $2.2 million more

for the same bonds today than she would have paid previously. However, the protection seller exposure to

corporate credit spreads that she established by selling CDS Index futures keeps her overall portfolio in synch

with market conditions. The mark to market on the CDS Index futures component of her hedge structure comes

reasonably close to matching the move in bond prices:

$2,155,000 = -5 bps x $500 per bp per contract x -862 contracts


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s c s Irs f + l cds I f

The same strategy applies to more elaborate hedge structures. Thus, consider another portfolio manager who

intends to sell $1 billion of 8-year Baa corporate bonds. Rather than exiting the position abruptly, he decides to

hedge his exposure by selling a synthetic corporate bond portfolio consisting of CBOT futures.

Exhibit 11

Market Conditions on Day 1

pi yi dv01

8-Year Aaa Corporate Bonds $1 billion (par) 6.50 $616,218CBOT 5-Year IRS Futures 102-19/32nds 5.401 $43.98/contract

CBOT 10-Year IRS Futures 103-24.5/32nds 5.505 $77.88/contract

CBOT CDS Index Futures 36.00 bps 0.36 $500/contract

Assume market conditions are as in Exhibit 11. Because the portfolio manager is concerned about adverse

portfolio impacts from both increases in the outright level of benchmark yields and changes in the slope of

the yield curve, he decides to combine a short position in an IRS futures barbell with a long protection buyer

position in CDS Index futures. Using conventional DV01 weights to set the wings of his IRS futures barbell3, he

determines that the benchmark yield component of his hedge structure should consist of 48 percent 5-Year IRS

futures and 52 percent 10-Year IRS futures. Thus his hedge structure is:

Short 6,720 5-Year IRS futures

Short 4,118 10-Year IRS futures

Long 1,232 CDS Index futures = $616,218/($500 per contract)

As before, note the mix of long and short contract positions: The short synthetic portfolio comprises a

shortposition in the IRS futures barbell and along position in CDS Index futures.

Now, suppose a sudden burst of buoyant economic conditions pushes the yield curve into inversion, with rising

short- and intermediate-term yields pivoting around unchanged long-term yields: 5-year swap rates increase 40

bps, 8-year swap rates gain 16 bps, and 10-year swap rates hold steady. Suppose moreover that corporate

credit spreads across the curve narrow by 5 basis points. The combined impact is an 11 bps rise in 8-year

corporate yields (16 bps increase in benchmark 8-year yields, minus 5 bps decline in credit spreads).

Exhibit 12 summarizes.

3 Let D10, D5, and D, respectively, represent DV01s for a 10-Year IRS futures contract, a 5-Year IRS futures contract, and $100,000 face

value of the cash 8-year corporate bonds, and note that a $1 billion par position in corporate bonds contains 10,000 units of $100,000 par value.

Then the 5-Year IRS futures wing of the butterfly is computed as

10,000 x (D/D5) x (D10 D)/(D10 D5)

The (D10 D)/(D10 D5) term, which plays the principal role in shaping the wing, takes the value of 0.48 in the example above.

Similarly, the 10-Year IRS futures wing of the butterfly is equal to

10,000 x (D/D10) x (D D5)/(D10 D5)

The (D D5)/(D10 D5) term, which shapes this wing, equals 0.52 in the example above.


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22

Exhibit 12

Change in Market Conditions from Day 1 to Day 2

Day 1 Day 2


8-Year Baa Corporates $1 billion (par) 6.50 $993,249,765 6.61 -6,750,235

Short 6,720 5-Year IRS Futures 102-19/32nds 5.401 100-27.5/32nds 5.801 11,655,000Short 4,118 10-Year IRS Futures 103-24.5/32nds 5.505 103-24.5/32nds 5.505 Zero

Long 1,232 CDS Index Futures 36.00 bps 0.36 31.00 bps 0.31 -3,080,000

Hedge Total 8,575,000

The updraft in short- and intermediate-term yields

hands the portfolio manager a $6.8 million loss on his

core bond position. Fortunately, the hedge affords

more than enough protection, generating proceeds of

nearly $8.6 million, for a net gain of $1.8 million.

Three remarks warrant mention. The first is simply tonote the relative accuracy that the portfolio manager

achieves by using an IRS futures barbell to hedge

his benchmark interest rate exposure. If instead he

had used a DV01-equivalent number of 10-Year IRS

futures alone (7,912 contracts in this case), he would

have found himself underhedged and consequently

nursing a $9.8 million net loss (comprising the $6.75

million loss on the core bond position and the $3.1

million margin payout on the CDS Index futures

position).

Had he used a DV01-equivalent number of 5-YearIRS futures alone (here, 14,011 contracts), he would

have been lavishly overhedged. Gains on his hedge

position would have exceeded triple the loss on his

core bond position ($21.2 million, comprising $24.3

million margin collects on 5-Year IRS futures, less

$3.08 million in margin pays on CDS Index futures).

Thats a gratifying outcome, at least in this case, but

any market practitioner who takes risk management

seriously would warn that such an imbalanced hedge

(in essence, the yield curve exposure between 5-year

and 8-year swap rates) might just as easily hurt you as

help you.

Second, the CDS Index futures hedge ratios in

the examples above are set on the rudimentaryassumption that the credit spread exposure in the

hedge target and the CDS Index futures price move

in lockstep, basis point for basis point. Generally,

this presumption would be unrealistic. A more

refined approach might incorporate the credit spread

analogue to stock index betas. That is, in setting the

credit spread component of the hedge structure,

the portfolio manager might take explicit account of

systematic differences in volatility between the CDS

Index futures contract price and the hedge targets

credit spread.

Third, at first blush, the sizes of the futures

transactions in the examples above may appear

imprudently large. In fact, given that both IRS futures

and CDS Index futures are eligible for a wide array of

bilaterally negotiated off-exchange trades, including

block trades, such magnitudes are neither unrealistic

nor infeasible. (See Off-Exchange Trading on pages

9 and 10.)


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Each day CDR LLC publishes the spot value of the

CDR Liquid 50 index. As noted earlier, this is theaverage of on-the-run 5-year single-name credit

default swap spreads quoted that day, for spot

settlement, for each of the 50 index components. In

contrast, the index value reflected in the price of the

companion CBOT CDS Index contract is a forward

value, the market expectation of the pertinent CDR

Liquid 50 index series on the contracts last day of

trading.

s f, g

As with any other pair of spot and forward market

rates or prices, these two will seldom be identical,except when the futures contract expires. In practice,

however, the difference between spot and forward

typically will be negligible. To make this clear, consider

the three primary linkages in the pricing of a credit

default swap:

The recovery rate, the percentage of face

value that a bond holder would expect to

recover from the bond issuer in the event

that the issuer defaults, enters bankruptcy, or

suffers some other credit event that impairs

timely payments to his debt holders.

The hazard rate (or, when cumulated,

the survival function) which determines the

probability per unit of time that the bond issuer

will suffer a credit event.

The credit default spread essentially the

price of the credit default swap itself -- whichdictates the amount, measured in basis points

per annum, that the protection buyer pays to

the protection seller to guarantee coverage of

the portion of asset exposure not covered by

the recovery rate.

In a world where the yield curve is flat and the hazard

rate is constant, these three elements form the well-

known iron triangle of credit default swap pricing:

Credit Default Spread =

(1 Recovery Rate) x Hazard Rate

Example:Assume the representative average

member of the CDR Liquid 50 index features a

credit default swap spread of 39 basis points.

Assume as well a standard recovery rate of 40

percent and a hazard rate of 0.65 percent per year.

Then the iron triangle takes shape as: 39 bps =

0.0039 percent = ( 1 - 0.40 ) x 0.0065

Given the assumptions underpinning the iron triangle

flat yield curve and flat survival function -- spot and

forward-starting credit default swap spreads should be

identical. More generally, even though yield curves are

seldom flat, and the hazard rate is seldom constant,

spot and forward-starting credit spread values will

tend to be quite close, if not indistinguishable.

Pricing CDS Index Futures:Spot versus Forward


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24

ei d h r

On those occasions when spot and forward do deviate significantly, the most likely cause is apt to be a non-

constant hazard rate. To see this, consider the pricing of 5-year protection on the CDR Liquid 50 index portfolio,

and assume the following hypothetical market conditions

Arbitrarily, today is 18 June 2003.

Spot rates quoted today are for T+2 settlement on 20 June 2003. (In fact, this signifies standard

settlement for interest rate swaps, but skip day settlement for credit default swaps.)

The LIBOR/plain-vanilla interest rate swap curve is flat at 5 percent

The assumed standard recovery rate is 40 percent.

For spot settlement, market participants value protection on the CDR Liquid 50 index portfolio at 100 bps

per annum.

If the hazard rate were constant, then given these market conditions, the iron triangle would imply a hazard rate of

1.666 percent for the representative average member of the index portfolio:

100 bps = 0.01 percent = ( 1 - 0.40 ) x 0.01666

Assume instead that market participants believe (a) that the average hazard rate will be zero over the coming year

-- reflecting perhaps the very strong presumption of a benign credit environment -- and (b) that the hazard rate

will run thereafter at a constant 2.156 percent per annum. The two far left-hand columns of Exhibit 13 summarize

this set-up.

The two main panels Exhibit 13 il lustrate, on the left, the valuation of a hypothetical 5-year credit default swap for

spot settlement on 20 June 2003 and, on the right, the valuation of forward-starting 5-year credit default swap

that is constructed to mimic a hypothetical September 2003 CDS Index futures contract. The settlement date for

this hypothetical forward-starting swap is IMM Wednesday, 17 September 2003.

Valuation is elementary and, to market practitioners active in credit derivatives, quite familiar. The present value

of the swaps premium leg (the stream of fixed protection payments weighted by the cumulative probability

that there is no credit event) must equal the present value of the swaps recovery leg (the probability that the

protection seller will be obliged to pay the protection buyer if a credit event occurs):

pi l r l

Spread x [ai x zi x (1-pi)] = (1 Recovery) x [zi x (pi -pi-1)]


25/40

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Spread is the credit default swap spread, in interest rate percentage points per annum

Recovery is the recovery rate, assumed to be 40 percent, or 0.40

ai are daycount terms. Any ai represents the interval from payment date i-1 to payment date i, measured in

actual/360 terms, and it determines exactly how the credit default swap spread is apportioned to quarterly

protection payments.

zi are present value discount factors, bootstrapped from the plain-vanilla interest rate swap curve. Note that in

the left-hand panel of the table, these are spot discount factors, denoting present value as of the spot settlement

date (20 June 2003) of one dollar on date i. In the right-hand panel, they are forward discount factors, giving thearbitrage-free present value as of the forward settlement date (17 September 2003) of one dollar on date i.

pi represent the survival function. Each pi signifies the probability that a credit event occurs prior to date i.

Exhibit 13

Spot versus Futures-Equivalent Forward Settlement: How the Hazard Function Matters

s s 20 J 2003 f s 17 s 2003

pi l pi l pi l pi l

Spot Spread Recovery Rate Spot Spread Recovery Rate

100 bps 0.4 107 bps 0.4

Spot Spot Forward ForwardDate p a z a *z*(1-pi) (1-0.4)*z*(pi - pi-1) a z a *z*(1-pi) (1-0.4)*z*(pi - pi-1)

20-Jun-0317-Sep-03 0.9878

22-Sep-03 0.0000 0.26 0.9871 0.2577 0.0000 0.01 0.9993 0.0139 0.000022-Dec-03 0.0000 0.25 0.9749 0.2464 0.0000 0.25 0.9870 0.2495 0.000022-Mar-04 0.0000 0.25 0.9631 0.2434 0.0000 0.25 0.9750 0.2465 0.0000

21-Jun-04 0.0000 0.25 0.9517 0.2406 0.0000 0.25 0.9635 0.2435 0.000020-Sep-04 0.0054 0.25 0.9401 0.2363 0.0031 0.25 0.9517 0.2393 0.003120-Dec-04 0.0108 0.25 0.9286 0.2322 0.0030 0.25 0.9401 0.2351 0.0030

21-Mar-05 0.0162 0.25 0.9172 0.2281 0.0030 0.25 0.9286 0.2309 0.003020-Jun-05 0.0216 0.25 0.9060 0.2241 0.0029 0.25 0.9172 0.2268 0.002920-Sep-05 0.0269 0.26 0.8948 0.2225 0.0029 0.26 0.9058 0.2253 0.0029

20-Dec-05 0.0322 0.25 0.8839 0.2162 0.0028 0.25 0.8948 0.2189 0.002820-Mar-06 0.0374 0.25 0.8731 0.2101 0.0027 0.25 0.8839 0.2127 0.0028

20-Jun-06 0.0427 0.26 0.8623 0.2110 0.0027 0.26 0.8730 0.2136 0.002820-Sep-06 0.0480 0.26 0.8517 0.2072 0.0027 0.26 0.8622 0.2098 0.002720-Dec-06 0.0531 0.25 0.8413 0.2014 0.0026 0.25 0.8517 0.2038 0.002620-Mar-07 0.0582 0.25 0.8311 0.1957 0.0025 0.25 0.8413 0.1981 0.0026

20-Jun-07 0.0634 0.26 0.8208 0.1964 0.0025 0.26 0.8309 0.1989 0.002620-Sep-07 0.0686 0.26 0.8106 0.1930 0.0025 0.26 0.8206 0.1953 0.002520-Dec-07 0.0736 0.25 0.8007 0.1875 0.0024 0.25 0.8106 0.1898 0.0025

20-Mar-08 0.0786 0.25 0.7910 0.1842 0.0024 0.25 0.8007 0.1865 0.002420-Jun-08 0.0837 0.26 0.7812 0.1829 0.0024 0.26 0.7909 0.1852 0.002422-Sep-08 0.0888 0.26 0.7809 0.1858 0.0024


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If one knew everything about the market landscape

except the credit default spread itself, one could then

use the framework above to solve for it4:

Spread = { (1 Recovery) x [zi x (pi -pi-1)] }

[ai x zi x (1-pi)]

Exhibit 13 does precisely this. That is, to get the credit

default swap spread for spot settlement, in the left-

hand panel of table one would divide the sum of the

Protection Leg column by the sum of the Premium

Leg column. Similarly, to obtain the forward-starting

credit default swap spread, in the right-hand panel

one would divide the sum of the Protection Leg

column by the sum of the Premium Leg column.

Unlike the spot spread, which is fairly valued at 100

bps, the forward-starting spread is fairly valued at 107

bps. Intuitively, this is because the level of credit event

insurance furnished by the forward-starting swap isgreater than the coverage provided by the spot swap:

Given the survival functions shape, the 5-year

interval spanned by the spot credit default

swap comprises relatively more moments when

the probability of a credit event is presumed to

be zero.

Conversely, the 5-year interval spanned by the

forward-starting credit default swap comprises

relatively more moments when credit events

might occur.

In short, the shape of the hazard rate function in this

example dictates that the spread for the forward-

starting credit default swap should have higher fair

value than for the spot swap. With the passage

of time, the two must converge, so that on 15

September 2003 they will be identical. That is, given

our maintained assumption of a T+2 timetable for

spot settlement, both the forward-starting swap and

a spot swap quoted on Monday, 15 September,

would be intended for settlement on Wednesday,17 September5. Moreover, if the other assumptions

above regarding market conditions were to remain

static, then convergence would be achieved through

a gradual increase in the spot spread, until it reaches

107 bps on Monday, 15 September.

ri d c

On occasion, market practitioners may observe

discontinuities in the time series plots of spot values

for individual CDR Liquid 50 index series. Such

discontinuities, when they occur, are apt to coincide

with the standard quarterly payment dates in the OTCsingle-name credit default swap market (i.e., on or

just after the 20th of March, June, September, and

December).

Example: Consider the hypothetical credit default

swap sketched in the main left-hand panel of Exhibit

13. It corresponds to the hypothetical 032 series

of the CDR Liquid 50 index, which would have

been constituted on Friday, 28 February 2003. (The

equally hypothetical companion CDS Index futures

would have been the June 2003 contract, listed for

trading on Monday, 3 March 2003.)

Between 3 March and 18 March, the on-the-run

credit default swap spreads that CDR LLC uses

4 Students of the credit derivatives market will recognize that this computation incorporates not merely the assumption of a flat hazard rate

function, but also the assumption of a stationary copula scheme governing the manner in which credit events occurring among the 50 index

components might, or might not, occur in bunches.

5 This clarifies precisely how the forward-starting swap corresponds to the hypothetical September 2003 CDS Index futures contract: Monday,

15 September, would also be the last day of trading in futures.


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to evaluate the index would be quoted for spot

settlement, with 5-year term to maturity extending

to 20 March 2008. That is, the indexs inputs would

be swap spreads with terms to maturity that are

actually close to 5 years.

By contrast, from 19 March through 16 June 2003

(the last day of trading in the June 2003 futures),

CDR LLC would evaluate the index components

with quotes for on-the-run spot-settled credit default

swaps that mature on 20 June 2008. Note that, atthe outset of this interval, the indexs inputs abruptly

become swap spreads with terms to maturity of

approximately 5.25 years.

Now suppose the hazard rate function is not

constant. That is, suppose the survival function is

either upward sloping or downward sloping. The

switch in data for index evaluation that occurs on

19 March -- from on-the-run quotes with 5 years

to maturity, to on-the-run quotes with 5.25 year to

maturity may produce a corresponding break in

the time series of spot index values. Whether the

break is up or down, large or small, will depend

upon the slope and pitch of the term structure of

the survival function.

Users of CDS Index futures may note with relief that

there should be no such valuation notch in the daily

progression of futures prices, because fair valuation of

the futures contract is independent of the mechanics

of spot index valuation.

Thus, in the example above, market participants

would assess fair value in June 2003 CDS Index

futures on the presumption that, at contract expiry, theunderlying CDR Liquid 50 index would be evaluated

with market quote data for credit default swaps that

mature in June 2008. Moreover, they would knowingly

entertain this presumption throughout the entire

interval from first day of trading in June 2003 futures

until contract expiration.


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28


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Underlying The corresponding series of the CDR Liquid 50TM North American InvestmentGrade Index

Index Methodology Average of the five-year single-name credit default swap spreads of the 50 mostactively traded corporate names in the North American investment grade creditdefault swap market. Initially all index components are equally weighted(i.e., 2 percent index weight per component).

Contract Multiplier $500 per one basis point

Contract Value The index value in basis points multiplied by the contract multiplier

Price Quotation The index value in basis points and hundredths (1/100) of basis points. For example,a futures price quotation of 38.10 implies an index value of 38.10 basis points.

Minimum Trading

1 tick = 0.01 basis points = $5Increment

Expiration Months Generally, the nearest month in the March-June-September-December quarterly cycle

Last Trading Day The IMM Monday of the contract expiration month (i.e., the second Londonbusiness day preceding the third Wednesday of the contract expiration month)

Final Settlement Day The business day following the last trading day.

Final Settlement The index value, measured in basis points and hundredths (1/100) of basis points,Price evaluated with single-name credit default swap spread quotes, as of close of

business on the last trading day, as furnished by CMA through CMA DataVisionTM

Settlement Cash settlement based on the final settlement price

Trading Hours 6:02 pm to 4 pm Chicago time, Sunday through Friday

Wholesale Trading Minimum wholesale transaction is 100 contracts. Permissible hours for wholesaletransactions are 7 am to 4 pm Chicago time, Monday through Friday. Consultwww.cbot.com for wholesale trading procedures.

Ticker Symbol CX

Appendix 1CDS Index Futures Contract Specifications


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30

For the current and authoritative version of the CBOT

Rulebook, visit the CBOT website at www.cbot.com

c 61

Credit Default Swap Index Futures

c61 ti cii

6101.01 Authority- Trading in Credit Default Swap

Index futures may be conducted under such terms

and conditions as may be prescribed by regulation.

6102.01 Application of Regulations - Credit Default

Swap Index futures shall be referenced hereafter as

CDS Index futures. Transactions in CDS Index futures

shall be subject to the general rules of the Exchange

as far as applicable and shall also be subject to

the regulations contained in this chapter, which

are exclusively applicable to trading in CDS Index

futures. CDS Index futures are listed for trading by the

Exchange pursuant to Commodity Futures Trading

Commission exchange certification procedures.

6104.01 Unit of Trading - The unit of trading shall be

the Contract Reference Index. The Contract Reference

Index shall be referenced hereafter as CRI. CRI shall

be constituted and maintained by the Exchanges

designated index provider.

The designated index provider shall constitute and

maintain a distinct CRI for each distinct CDS Index

futures contract month.

CRI shall be an arithmetic average of interest rate

credit default spreads, as reflected in prices of over-

the-counter credit default swap contracts with five (5)

years to expiry as of the CDS Index futures contracts

last day of trading. Each interest rate credit default

swap spread that serves as a CRI component shall

reference senior, unsecured, taxable, investment

grade debt securities that are denominated in US

dollars and that are issued by a firm domiciled inthe US.

6105.01 Months Traded In - Trading in CDS

Index futures may be scheduled in such months as

determined by the Exchange.

6106.01 Price Basis - The price of CDS Index futures

contracts shall be quoted in interest rate basis points

and hundredths (1/100) of basis points. One basis

point shall equal $500. The minimum price fluctuation

shall be one one-hundredth (1/100) of one basis point

($5 per contract). Contracts shall not be made on any

other price basis.

Appendix 2CDS Index Futures Rules


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6107.01 Hours of Trading - The hours of trading

in CDS Index futures shall be determined by the

Exchange. Trading in an expiring CDS Index futures

contract shall cease at 4:00 pm Chicago time on the

last day of trading in said futures contract.

6109.01 Last Day of Trading - The last day of

trading day in a CDS Index futures contract shall be

the second London business day before the third

Wednesday of the contracts delivery month.

6109.02 Liquidation During the Delivery Month

- After trading has ceased in expiring contracts (in

accordance with Regulation 6109.01 of this chapter),

outstanding contracts shall be liquidated by cash

settlement as prescribed in Regulation 6142.01.

6110.01 Margin Requirements - (See Regulation

431.03.)

6112.01 Position Limits and Reportable Positions

- (See Regulation 425.01 and Appendix 4C.)

c61 di p

6136.01 Standards - The contract grade shall be the

final settlement value of the Unit of Trading (as defined

in Regulation 6104.01) for the Last Day of Trading

(as defined in Regulation 6109.01), as determined

and furnished to the Exchange by the Exchanges

designated index provider. The value of the CRI

shall be represented in interest rate basis points and

hundredths (1/100) of basis points.

If the Exchanges designated index provider fails to

report a value for the CRI for the Last Day of Trading,

then the contract final settlement price shall be based

upon the value of the CRI for the first preceding US

business day for which a value has been reported by

the Exchanges designated index provider.

6142.01 Delivery on Futures Contracts - Delivery

against expiring CDS Index futures shall be made

by cash settlement through the Clearing Services

Provider following normal variation margin procedures.

The final settlement price shall be $500 times the

final settlement value of the CRI for the Last Day of

Trading, as furnished by the Exchanges designated

index provider.

The final settlement price for an expiring CDS Indexfutures contract shall be determined on the business

day following the Last Day of Trading. For exceptions

to this schedule, see Regulation 6136.01.

6147.01 Payment - (See Regulation 1049.04.)


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32

The CDR Liquid 50 North America Investment Grade

Index (the Index) is an arithmetic average of 5-year

credit default swap (CDS) spreads for the 50 most

actively traded names in the North American CDS

market.

1 I cIndex components are based upon CDSspreads with the following characteristics --

1.1 CDS reference securities: Taxable bond issuesof North American corporations

1.2 Priority of CDS reference securities: Senior,unsecured

1.3 Maturity of CDS contracts: Five years

1.4 Type of restructuring of CDS contracts:Modified restructuring

1.5 Currency denomination of CDS contracts: USdollar

2 I r dFirst business day of March, June, September,

or December

3 I r pThe Index will be reconstituted each quarter.The components of each new constitutionof the Index, as well as various Indexcharacteristics (6.1), will be publicly announcedfollowing close of business on the businessday preceding the Roll Date (i.e., on the lastbusiness day of the month preceding themonth of the Roll Date).

4 eiibii cii Ic

4.1 Eligibility Evaluation Period: The three-monthinterval immediately preceding the Roll Date.

4.2 Data Universe: Actionable bid-offers on five-year CDS spreads delivered by dealers directlyto their customers or to inter-dealer brokersduring the Eligibility Evaluation Period.

4.3 Credit Rating Filter: Reference securitiesmust be rated BBB/Baa2 or higher by two ofthe three primary US Nationally RecognizedStatistical Rating Organizations throughout theEligibility Evaluation Period.

5 si I cThe following procedure will govern theselection of Index Components for anyreconstitution of the Index.

5.1 Names that satisfy the Eligibility Criteria forIndex Components, given in Section 4, will formthe pool of eligible names (the eligible pool).

5.2 For each business day during the EligibilityEvaluation Period (4.1), for each eligible name,compute the number of actionable bid-offerquotes (4.2).

5.3 For each business day during the EligibilityEvaluation Period (4.1), rank all eligible namesin descending order according to each namesnumber of actionable bid-offer quotes (5.2).

Appendix 3PROPRIETARY INFORMATION OF CREDIT DERIVATIVES RESEARCH LLC. REPRODUCTION WITHOUT EXPRESSWRITTEN CONSENT OF CREDIT DERIVATIVES RESEARCH LLC IS PROHIBITED.

CDR Liquid 50

TM

NAIG Index Construction andMaintenance Procedures


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5.4 Compute the top-50 count for each eligiblename. For any eligible name, the top-50 countis defined as the number of days during theEligibility Evaluation Period (4.1) on which thatname appears among the 50 highest-rankedeligible names, as determined in 5.3.

5.5 Rank all eligible names in descending orderaccording to their top-50 counts (5.4).

5.6 Eligible names that share a parent corporateentity (sibling names) are filtered from the

ranking determined in 5.5 as follows:5.6.1 If an eligible name serves as an Index

Component in the previous Index constitution,it will remain in the eligible pool for the newIndex constitution, and all of its other siblingnames will be eliminated from the eligible pool.

5.6.2 If, within a group of sibling names, noneappears as an Index Component in theprevious Index constitution, then the siblingname with the highest top-50 count within saidgroup of sibling names will remain in the eligiblepool for the new Index constitution, and all ofthe other sibling names in said group will be

eliminated from the eligible pool.5.6.3 If, within a group of sibling names, more

than one appears as an Index Componentin the previous Index constitution, then theComponent sibling name with the highesttop-50 count among said Component siblingnames will remain in the eligible pool for thenew Index constitution, and all of the otherComponent sibling names will be eliminatedfrom the eligible pool.

5.7 If the resultant eligible pool has fewer than60 names, then proceed directly to 5.8. If theresultant eligible pool has 60 or more eligible

names, then reduce it to those 60 names withthe highest top-50 counts, as determined in5.5 and 5.6.

5.8 Of the remaining names in the eligible pool, the40 names with the highest top-50 counts shallbe automatically selected for inclusion as IndexComponents in the new Index constitution.

5.9 Of the remaining names in the eligible pool,those names that appear as members in theprevious Index constitution shall be admittedas Index Components in the new Indexconstitution, in descending order of their top-50 counts. If and when 50 Index Componentshave been identified, then the new Indexconstitution is complete. Proceed to Section 6.

If fewer than 50 Index Components have beenidentified, then proceed to 5.10.

5.10 Admit remaining names in the eligible poolas Index Components in the new Indexconstitution, in descending order of their top-50counts, until 50 Index Components have beenidentified.

6 I ci

6.1 At the time a new Index is constituted, thefollowing Index characteristics and parametersshall be published:

6.1.1 Standard Recovery Rate: A parameterwith value between zero and unity thatis set arbitrarily by the Index manager,at his sole discretion, at the time of eachIndex constitution, and shall be used in thecalculation of all other Index characteristicspertaining to the new Index constitution. TheIndex manager, at his sole discretion, maychange the value of the Standard RecoveryRate from one Index reconstitution to the next,in accord with changes in prevailing marketpractice and/or market conditions.

For any given Index constitution, the value ofthe Standard Recovery Rate that the Indexmanager sets shall (a) remain fixed throughoutthe lifespan of that Index constitution and(b) serve as the only value of the Standard

Recovery Rate that the Index manager employsin maintaining that Index constitution.


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34

6.1.2 Index DV01: The arithmetic average of Index Component DV01s, based on $1 notional. The Index DV01will be computed using the following approximation for Index Component DV01s:

The Index DV01 and all Index Component DV01s shall be rounded to seven decimal places, with halfincrements in the eighth decimal place rounded up.

6.1.2.1 Example: Assume that the 5-year plain-vanilla swap rate is 5 percent, that the on-the-run CDS spreadfor the ith Index Component is 65 basis points, and that the Standard Recovery Rate has been set at 40percent. Then:

6.1.3 Contract Value of a Basis Point: The dollar value of a one basis point change in the price of a CBOT CDSIndex futures contract. Note that this remains constant from one Index Construction date to the next. TheContract Value of a Basis Point should not be confused with the Index DV01.

6.1.4 Implied CDS Notional: The notional underlying value of the CBOT CDS Index futures contract implied jointlyby the Index DV01 and the Contract Value of a Basis Point. The Implied CDS Notional shall be rounded tothe nearest dollar, with half-dollars rounded up to the nearest dollar:

6.1.4.1 Example, contd: Assume the Index DV01 is $0.0004311/bp. By definition the Contract Value of a BasisPoint is $500/bp. Then:

6.1.5 Maximum Running Spread: The maximum admissible value for any Index Component, through the life ofthe Index. The Maximum Running Spread shall be established at the time of Index constitution as:

( )( )

( )0004311.0

010833.005.0

5*010833.005.0exp1

000,10

1DV01ComponentIndex

010833.00.4-1

0.0065

i

=+

+=

==i

( )( )( )

RateRecoveryStandard-1

iComponentIndexforSpreadCDSYear-5Run-the-On

RateSwapVanilla-PlainDollarYear US-5

years5

*exp1

000,10

1DV01ComponentIndex

DV01ComponentIndex50

1DV01Index

i

i

50

1

i

=

=

=

+

+=

= =

r

T

r

Tr

i

i

i

/bp500$01.0

5$

SizeTick

ValueTickPointBasisaofValueContract ===

bp

1$DV01Index

PointBasisaofValueContractNotionalCDSImplied =

824,159,1$1$/bp0004311.$0

$500/bpNotionalCDSImplied ==


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The Maximum Running Spread shall be rounded to the nearest one one-hundredth (1/100) of one basispoint, with half-hundredths rounded up to the nearest hundredth of one basis point.

In any subsequent computation of the Index Value (6.4), any Index Component that exceeds the MaximumRunning Spread shall be replaced by the Maximum Running Spread.

6.1.5.1 Example, contd: Assume as in 6.1.4.1 that the Standard Recovery Rate is 40 percent and that the ImpliedCDS Notional is $1,159,824. Then the Maximum Running Spread will be:

6.2 Index Component Weight: At the time of Index constitution, each Index Component shall be assignedindex weight of one fiftieth (1/50), i.e., a 0.02 share of the Index composition.

6.3 Index Component Spread: The value that the Index manager assigns to each individual Index Componentin computing the Index Value (6.4). The Index Component Spread will depend upon whether single-nameCDS contracts that reference the corresponding Index Component name trade running or trade upfront.

An Index Component shall be identified, at the sole discretion of the Index manager, as to whether ittrades upfront or trades running, according to the conventions by which bid-offer prices are quoted for thecorresponding single-name CDS contracts.

6.3.1 Index Components that trade running: For any Index Component that trades running, the midpoint ofeach bid-offer quote for the corresponding CDS will be used in computing the Index Value, subject to theconstraint that the Index Component Spread must be less than or equal to the Maximum Running Spread(6.1.5).

6.3.2 Index Components that trade upfront: For any Index Component that trades upfront, the sum of therunning spread and the converted upfront percentage will be used in computing the Index Value, subjectto the constraint that the Index Component Spread must be less than or equal to the Maximum RunningSpread (6.1.5). The upfront percentage will be converted to an equivalent spread by multiplying the upfrontpercentage by the Implied CDS Notional and dividing by the Contract Value of a Basis Point.

6.3.2.1 Example, contd: Assume that the Implied CDS Notional is $1,159,824, and that the Maximum RunningSpread is 1,391.79 bps. Assume further that a particular Index Component trades at 18 percent upfront,500 bps running. Then the provisional estimate of the corresponding Index Component is:

Because this provisional estimate is less than the Maximum Running Spread, the Index Component valueshall be set at 917.54 bps.

6.3.3 Index Components that have ceased to trade: For any Index Component that ceases to trade, in the sensethat actionable bid and offer prices cease to be quoted for the corresponding CDS contracts, the IndexComponent Spread shall be set at the Maximum Running Spread.

6.3.4 Each Index Component Spread shall be rounded to the nearest one one-hundredth (1/100) of one basispoint, with half-hundredths rounded up to the nearest hundredth of one basis point.

( )PointBasisaofValueContract

NotionalCDSImplied*RateRecoveryStandard1

SpreadRunningMaximum

=

bps79.1391$500/bps

824,159,1$*)4.01(SpreadRunningMaximum =

=

bps54.917$500/bps

824,159,1$*18.0

500bpsSpreadComponent =+=


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6.4 Index Value: The Index Value is the sum of the products of each Index Component Weight (6.2) and itscorresponding Index Component Spread (6.3):

N is the number of Index Components. At the time of Index constitution, N equals 50, and each IndexComponent Weight is 0.02.

The Index Value, so computed, shall be rounded to the nearest one one-hundredth (1/100) of one basispoint, with half-hundredths rounded up to the nearest hundredth of one basis point.

7 t si e fi I cii

7.1 If, subsequent to an Index constitution, the corporate debt issuer referenced by a given Index Componentis superseded by successor corporate entities, then the original Index Component shall be removed fromthe Index, and the successors shall be added as Index Components, regardless of the credit ratings (4.3)that pertain to them. The Index Component Weights assigned to the successors shall sum to the IndexComponent Weight that applied to the original Index Component that the successors shall supersede.

7.2 The Index Component Weight that shall be assigned to each successor shall be set equal to the productof (a) the Index Component Weight that applied to the original Index Component, prior to the successionevent, and (b) the percentage share of the notional amount of the original single-name CDS that isassigned to each successor. The Index Component Weights that shall be assigned to the successors shall

be calculated to six decimal places, with half increments in the seventh decimal place rounded up.7.2.1 Example: Assume Alltel Corp (AT) is an Index Component. On 17 July 2006 Alltel Corp (AT) spins off

Windstream Corp (WIN). Each successor (AT and WIN) is assigned half of the notional value of single-name CDS contracts that referenced the original Index Component (AT). In accommodating thissuccession event, the Index manager makes the following modifications to the Index: the number of IndexComponents rises from 50 to 51; the Index Component Weight that had been assigned to AT is reducedfrom 0.02 to 0.01; and WIN is added as an Index Component with an Index Component Weight of 0.01.

7.3 In the event that the Index Component Weights assigned to the successors, so calculated, fail to sumto the Index weight that applies to the original Index Component, then the successors shall be sortedalphabetically by name, and the weight of the alphabetical first successor shall be adjusted so that thesuccessors Index Component Index weights sum to the Index Component Weight that applied to theoriginal Index Component.

7.3.1 Example: Assume that XYZ Corp is an Index Component, with an Index Component Weight of 0.02.

Assume, moreover, that it has been determined that XYZ Corp will be succeeded by ABC Corp, DEFCorp, and GHI Corp. The Index manager accommodates this succession event by making the followingmodifications to the Index: The number of Index Components rises from 50 to 52; XYZ Corp is removedfrom the Index; ABC Corp is added as an Index Component with Index Component Weight of 0.006666;DEF Corp and GHI Corp are each added as Index Components with Index Component Weights of0.006667 each. Note that the sum of the successor Index Component Weights (0.00666 + 0.006667+0.006667) is identically equal to the Index Component Weight (0.02) that had applied to the originalIndex Component.

=

=N

1i

ii SpreadComponentIndexWeightComponentIndexValueIndex


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a c-B pii si

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Documents

Credit Default Swap Info