Credit Derivatives 1

October 7/14, 2004

Danilo ZanettiDanilo ZanettiIHMIHM

IntroductionIntroduction to to Credit Credit DerivativesDerivatives

October 7/14, 20042

Single-name Credit Default Swaps (CDS), Preamble- Basic Terminology and Mechanics

Market OverviewCredit Risk FrameworkSingle-name Credit Default Swaps (CDS), Part 1

- Static Replication and Pricing- Unwind Valuation- Legal Issues

Measures of Spreads for BondsBond Pricing, Probability, Bond-Equivalent CDS SpreadSingle-name Credit Default Swaps (CDS), Part 2

- Default Swap Basis Single-name Credit Linked Notes (CLN)

ContentContent

October 7/14, 20043

CDS and CLN on Credit Indices- with emphasis on DJ iTraxx Europe Index Family

Credit Options- Credit-Spread Options/Warrants- Credit Default Swaptions

Correlation Products- First-to-Default (FtD) CDS- Tranched Credit-Index Products (Tranched DJ iTraxx)

OutlookReferences

ContentContent((cont'dcont'd))

October 7/14, 20044

SingleSingle--name name Credit Default Credit Default SwapsSwaps

(CDS)(CDS)

PreamblePreamble

Single-name CDS, Part 1Single-name CDS, Preamble

October 7/14, 20045

Basic Basic Terminology Terminology and and MechanicsMechanics

... Basics

October 7/14, 20046

SingleSingle--name name CDSCDSDescriptionDescription

The single-name CDS is the standard credit derivativeand the basic building block of the credit derivatives market

A CDS is a

- bilateral contract- enables an investor to buy protection against default of an asset issued by a specified reference entityreference entity typically a corporate, bank or sovereign issuer - upon a legally defined credit event, the buyer of protection receives a compensation payment for the loss on the investment- common to define triggering of credit event using a reference asset/reference obligation such that capital structure seniority of covered debt

is specified exactly- the loss protection is acheived through payment of a periodic fee to the protection seller- the protection fee can also be paid upfront (although not usual)- typically specified using confirmation document and definitions of the International Swap and Derivatives Association (ISDA)

October 7/14, 20047

SingleSingle--name name CDSCDSMechanicsMechanics

Between trade initiation and default or maturity (whichever first), the protection buyer makes regular payments to the protection seller:

Protection buyer sells credit risk to protection sellerProtection seller buys credit risk from protection buyer

Terminology: CDS spread, CDS premium, default swap spread

Protection sellerProtection seller

Reference EntityReference Entity

Protection buyerProtection buyer

Credit risk

CDS spread

October 7/14, 20048

Protection buyerProtection buyer Protection sellerProtection seller100 - Recovery

Cash settlement : Price of defaultet asset determined via dealer poll typically within less than 30 days after credit event such that the recovery value of the reference obligation is stabilized

Physical settlement : Delivery of cheapest to deliver obligation out of a basket of deliverables assets ranked pari passu to reference obligation

Protection buyerProtection buyer Protection sellerProtection seller100

BondBondConvertibleConvertible

CTD BondCTD Bond

SingleSingle--name name CDSCDSMechanics Mechanics ((cont'dcont'd))

October 7/14, 20049

SingleSingle--name name CDSCDSCashflow Cashflow representationrepresentation

Non default case:

CDS

CDS

T

0

CDS

Recovery100 −

CDST

τ0

Default case:

October 7/14, 200410

Market Market OverviewOverview

Market Overview

October 7/14, 200411

Market Market OverviewOverviewExplosive growth of Credit Explosive growth of Credit DerivativesDerivatives

Credit Derivatives Volumes Trades (US$ billions)

October 7/14, 200412

Market Market OverviewOverviewFactors contributing increased activityFactors contributing increased activity

Standardized documentation

Current documentation framework are the 2003 ISDA credit derivatives definitions

Further details in section on Legal Issues

Liquidity provider to cash market during market stress

"September 11" had a 3-fold increase in trading volumes but still consistent two-ways flows (stable share of protection bought vs protection sold)

Positioning of credit derivatives desk being typically long protection (short risk) is favourable for increased request for protection (desks sell their protection inventory)

October 7/14, 200413

Market Market OverviewOverviewFactors contributing increased activity Factors contributing increased activity ((cont'dcont'd))

"Enron's decline" After disclosure of Enron's off balance sheet liabilities spreads widened and

credit derivatives activity increased After downgrade of Enron's debt to junk liquidity in the cash market decreased

and credit derivatives desks sold their inventory of protection and/or unwinded existing contracts

Confidentiality vs credit referenceCustomization of transaction terms according to needs of protection

buyer/seller (tenor, seniority, currency,...)

Provider of increased liquidity to individual names under stress

Confidential isolation/transfer of credit risk

October 7/14, 200414

Market Market OverviewOverviewFactors contributing increased activity Factors contributing increased activity ((cont'dcont'd))

Long term repo for corporate bonds nearly impossible, same for short-selling of bank loans

Long protection in credit derivatives corresponds to synthetical creation of an (unfunded) short position in cash instrument

No funding costs, low administration costsStructured notes have funding costs

Efficient vehicle for shorting credit

Off-balance sheet instruments with leverage advantage wrt to cash instruments

Regulatory capital relief/economic risk reduction/portfolio diversification

October 7/14, 200415

Market Market OverviewOverviewFactors contributing increased activityFactors contributing increased activity ((cont'dcont'd))

Transition from lending to intermediationTransition among banks from traditional lending role to intermediator in

issuance and sale of bonds over the last decadeShift from loans to bonds

Increased amount of corporate credit risk in the market

Increased credit spread volatility

Loans not widely traded in the secondary market, accounted on an accrual basis and possibility of quiet negotiation with banks syndicate in case of credit problems

Bonds widely traded in the secondary market, accounted on a mark-to-market basis and traded on basis of publicly available information

October 7/14, 200416

Market Market OverviewOverviewEvolution of Market Evolution of Market ParticipantsParticipants

Evolution of Credit Derivatives Market

Bank Portfolio Managers Asset Managers

Life Insurance/P&C Insurers/Reinsurers/Monoliners Hedge Funds

October 7/14, 200417

Market Market OverviewOverviewDiversity Diversity of Market of Market ParticipantsParticipants

October 7/14, 200418

Market Market OverviewOverviewFuture Future ParticipantsParticipants: : CorporatesCorporates

Sources and traditional hedges of corporate credit risk

- Common sources of credit risk for a company are trade receivables, vendor financings, long-term contracts, outright loans, joint ventures, partnerships,...

- Hedge of credit risk is traditionally achieved via credit insurance, lettersof credit

- Insurers often retain the right to revoke coverage in the event of a rating downgrade and the coverage period is typically no longer than one year

- Securitisation programs remove most of credit risk from balance sheet but can be quite costly and are public

October 7/14, 200419

Obstacles for corporate to embrace credit derivatives

- Credit spreads peak in 2001 and 2002 not paralleled by a peak in premium charges by credit insurers

- Timing mismatches between credit event unter CDS contract and a default by the corporate's counterparty (different triggering mechanism)

- Fair value accounting (marking-to-market) produces potential earnings volatility

- Corporates may have exposure to credits not actively traded in the CDS market

Market Market OverviewOverviewFuture Future ParticipantsParticipants: : Corporates Corporates ((cont'dcont'd))

October 7/14, 200420

Market Market OverviewOverviewFuture Future ParticipantsParticipants: : Corporates Corporates ((cont'dcont'd))

October 7/14, 200421

Market Market OverviewOverviewConduit Conduit of Informationof Information

Bond market

Convertible market

Loan market

CDS market

Equity market

Credit Derivatives

Desk

In sourcing and selling generic credit risk the credit derivatives desk serves as a link between many different markets:

Example: - A corporation issues a convertible bond (CB)- CB funds look for cheap call options on the underlying equity- CB funds buy the bond + buy protection via CDS stripping out credit risk- CDS spreads will widen due to increase demand for

protection

October 7/14, 200422

Market Market OverviewOverviewGlobal Global Positions by Sector Positions by Sector

Banks and broker dealers are overall net buyers of protection, biggest provider of liquidity and most important intermediaries

Insurance industry and, in particular, financial guarantors are net protection sellers

Smaller regional banks where net sellers of protection as an additional channelfor originating credit

October 7/14, 200423

Market Market OverviewOverviewMarket Share Market Share by Productby Product

Market share figures recently skewed towards credit-index products due to introduction of iTraxx credit-index and sub-indices (portfolio products)

October 7/14, 200424

Market Market OverviewOverviewReference Entities Reference Entities

October 7/14, 200425

Market Market OverviewOverviewTop Top Counterparties Counterparties and Credit and Credit EventsEvents

Counterparty risk is heavily concentrated among the top 10 global banks and broker dealers.

Credit events are concentrated within a limited universe of actively traded, fallen angel credits

The hedge fund industry is excluded from the survey

October 7/14, 200426

Market Market OverviewOverviewConcerns Concerns

Ultimate protection sellers may be less informed and knowledgeable about the credit than the originator (especially under physical settlement)

Informational asymmetries

Counterparty concentration

The market is concentrated among the top 10 global banks and broker dealers Withdrawal of such institutions from the market may produce negative effects

Moral hazard

Separation of loan underwriting/origination from credit ownership creates the potential for moral hazard

Source: Fitch 09/2003

October 7/14, 200427

Credit Risk FrameworkCredit Risk Framework

Credit Risk Framework

October 7/14, 200428

Credit Risk FrameworkCredit Risk FrameworkEmpirical Studies Empirical Studies of Recovery Ratesof Recovery Rates

Market standard source for recovery rates is Moody's historical default rate study (www.moodysqra.com)Recovery rates depend on subordination levelWide variation in recovery rate even for same subordination level

October 7/14, 200429

Credit Risk FrameworkCredit Risk FrameworkEmpirical Studies Empirical Studies of Default of Default ProbabilitiesProbabilities

Table shows average default probability of a bond starting with an initial rating and defaulting within the given time horizonHighly rated bonds have a lower cumulative default probability

October 7/14, 200430

Credit Risk FrameworkCredit Risk FrameworkCredit Credit CurvesCurves/Credit /Credit SpreadsSpreads

Credit Curve:

- Investors have different views about how the credit risk of a company can be measured

- It is customary to express credit risk in form of an excess yield over some benchmark interest rates as a function of the maturity of a credit exposure,

a so-called credit curve

Credit Spreads*:

- The excess yield is known as credit spread- There are various credit spread measures (CDS-Spread, Z-Spread, I-Spread, ASW-Spread, BE CDS-Spread)

* See sections Measures of Spreads for Bonds and Bond Pricing, Probability, BE CDS-Spread

October 7/14, 200431

Credit Risk FrameworkCredit Risk FrameworkCredit Credit CurvesCurves/Credit /Credit Spreads Spreads ((cont'dcont'd))

Maturity

Credit Spread

Upward sloping credit curve

Maturity

Credit Spread

Inverted credit curve

Maturity

Credit Spread

Humped credit curve

Upward sloping credit curve:- Common shape- Constant expected credit quality- Increased uncertainty with increasing maturity increases credit spread

Humped credit curve:- Observed for credits likely to worsen in the medium term with small change of defaulting in the short term- Survival over the medium term increases likelihood of survival in the long term thus lowering credit spreads

Inverted credit curve:- Significant deterioration of credit quality- High probability of a default

October 7/14, 200432


Source: JPMorgan ORBIT

CDS-Spreads credit curve dynamics for ABB International Finance Ltd:

October 7/14, 200433

Source: JPMorgan ORBIT

CDS-Spreads credit curve dynamics for FIAT Spa:


October 7/14, 200434


(CDS)(CDS)

Part 1Part 1

Single-name CDS, Part 1

October 7/14, 200435

Static Replication Static Replication and Pricingand Pricing

... Static Replication and Pricing

October 7/14, 200436

SingleSingle--name name CDSCDSFloatingFloating--rate rate note note (FRN)(FRN)

Description: - A FRN is a Bond that pays a coupon linked to a variable interest-rate index, usually Libor, Euribor,...- FRN have a very low interest-rate sensitivity, since in a rising interest-

rate environment, the rise in the Libor rates is compensated by a stronger discounting of the Libor payments. Similarly for a decreasing interest-

rate environment.Default-free FRN:

- Senior par floaters of AA rated issuers pay a coupon of Libor flat- We assume in the sequel Libor flat par FRN's to be default-free

default-free par FRN

T

0

100Libor

100

October 7/14, 200437

SingleSingle--name name CDSCDSFRN FRN cont'dcont'd

Defaultable FRN:- Subordinated par floaters of AA rated issuers pay a coupon higher

than Libor to compensate investors for the increased credit-risk- Par floaters of issuers rated lower than AA require also coupon payments higher than Libor for the increased credit-risk

defaultable par FRN

100

SpreadLibor +

T

0

100

Credit-risk: Coupons and face value are at risk

October 7/14, 200438

Idea: Set up a static hedge/replication, ie,

- find a portfolio of instruments that exactly offsets the cashflows of the CDS in every possible scenario- in particular, this must hold before and after default

Construction of a statically hedged portfolio for the protection buyer:

- buy protection for a notional of 100

SingleSingle--name name CDSCDSStatic hedgeStatic hedge//replicationreplication: Construction: Construction

Recovery100 −

Tτ

0

long CDS

CDS

T

0

October 7/14, 200439

- fund 100 cash at LIBOR flat (or equivalently short a default-free parFRN for initial cash of 100)

- invest the 100 cash into a defaultable par FRN

SingleSingle--name name CDSCDSStatic hedgeStatic hedge//replicationreplication: Construction (: Construction (cont'dcont'd))

long defaultable FRN

100

SpreadLibor +

T

0

100

Libor

short default-free FRN

T

0100

100

October 7/14, 200440

- hold the portfolio to maturity or default – depending on whichever comes first- if no default, unwind the hedge at maturity at no cost

SingleSingle--name name CDSCDSStatic hedgeStatic hedge//replicationreplication: Non : Non default scenariodefault scenario

Libor


T

0100

100


100

SpreadLibor +

T

0

100

long CDS

CDS

T

0

+ + = 0


October 7/14, 200441

- if default, deliver the defaulted FRN to the protection seller in return for 100 and use the proceeds to repay the funding loan (or default-free par FRN). The net cost is also zero.

SingleSingle--name name CDSCDSStatic hedgeStatic hedge//replicationreplication: Default : Default scenarioscenario

= 0+ +Libor


T

0100

100 τ


Recovery

SpreadLibor +

T

0

100τ


Recovery100 −

Tτ

0

long CDS

CDS

October 7/14, 200442

Pricing problem:

The static hedge portfolio has no initial costs and no close-out costs

Therefore pricing the default swap is equivalent to set the default swap spread equal to the par FRN spread:

SingleSingle--name name CDSCDSStatic hedgeStatic hedge//replicationreplication: Pricing: Pricing problem problem and Par CDS and Par CDS SpreadSpread

What default swap spread makes the net present value of the CDS equal to zero

?

Par CDS Par CDS SpreadSpread = Par FRN = Par FRN SpreadSpread

October 7/14, 200443

Construction of static hedge for protection seller:

- borrow a defaultable par FRN in the Repo market and short it for initial cash of 100- invest the 100 cash into a default-free par FRN- hold the portfolio to maturity or default – depending on whichever comes first- on default, sell the default-free par FRN, pay 100 to the protection

buyer in return for the defaulted FRN and cover the short FRN position

- at maturity, the 100 cash from the default-free par FRN are returned and used for the completion of the Repo contract

Difficult the borrow the reference asset on RepoStatic hedge usually not feasible

SingleSingle--name name CDSCDSStatic hedgeStatic hedge//replicationreplication forfor protection sellerprotection seller

October 7/14, 200444

Defaultable par FRN can be replaced by fixed-rate Bond of the same issuer provided it is of same seniority as the FRN (same recovery value upon default)

Repo specials: Costs for maintaining short FRN position until maturity of CDSincrease the level of the CDS spread when selling protection

Transaction costs increase bid-ask spreads for CDS

Accrued interest: buyer of protection must usually pay at default the CDS spread accrued since the last coupon date

Delivery option for protection buyer is usually not modelled: After default not all pari passu assets have the same recovery value and the protection buyer can choose to deliver the cheapest asset

Usual to assume constant recovery value of the reference asset

Customary to assume that counterparties are default-free

SingleSingle--name name CDSCDSMiscellaneous aspects Miscellaneous aspects

October 7/14, 200445

CDS is a par product: The default payment corresponds to difference between defaulted bond and face-value of the bond

Premium bond: Hedging credit risk of a premium bond with a CDS of same face-value underhedges the credit risk

Discount bond: Hedging credit risk of a discount bond with a CDS of same face-value overhedges the credit risk

SingleSingle--name name CDSCDSMiscellaneous aspects Miscellaneous aspects ((cont'dcont'd))

October 7/14, 200446

Unwind Unwind valuation valuation MarkingMarking--toto--MarketMarket

... Unwind Valuation

October 7/14, 200447

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: Motivation : Motivation

The trigger of a default swap to pay out is defined in terms of a credit event

On a mark-to-market basis the value of a default swap is changing in line with changes in the credit quality of the reference entity

Changes in the credit quality of the reference entity are reflected in changes in the market quotes of par CDS spreads

We will show that a default swap is sensitive to CDS spreads changes and thus is very much a credit spread product

October 7/14, 200448

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: Simple: Simple Example Example

The market par CDS spread for a reference entity is currently 100bpConsider entering the following 1-period short protection CDS position:

Short CDS

0

TCDS

100-Recovery

CDS spread payment

0

100 bp

60

Actual PV

100-Recovery

non default

default

( Interest rates flat @ 2.00%, Recovery @ 40% )

October 7/14, 200449

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: Simple : Simple Example Example ((cont'dcont'd) )

Payoff structure at maturity:- If there is no default, after 1-period a premium of 100bp will be realized- If there is a credit event a loss of 40=100-Recovery will be incurred

Credit deterioration:- Assume there is a simultaneous downgrade of the reference entity- Due to the credit deterioration of the reference entity the par CDS spread quoted on the market jumps from 100bp to 300bp

What is the current value of the short CDS position after credit deterioration assuming that expected recovery and interest rates remain unchanged

?

October 7/14, 200450

Assume to enter an offsetting long CDS position @ 300 bp to the existing short CDS position @ 100 bp - with maturity and reference entity being exactly the same

If a credit event occurs, the settlement received from the long CDS and short CDS position will exactly offset each other

Only the CDS spreads of the long CDS and short CDS differ

The unwind value (mark-to-market value) of the short CDS position can be computed as follows:

In numbers:

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: : Discounted Spreads Discounted Spreads ModelModel

( ) ( )444444 3444444 21

4434421

factordiscountrisky

newnewold

valueMtMspreadCDSrateInterest

spreadCDSspreadCDSvalueUnwind++

×−=1

1

( ) ( ) { 90.1100300%00.21

1300100 −=×++

×−=nominalvalueMtM

bpbpbpvalueUnwind

4434421

October 7/14, 200451

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: : JPMorgan JPMorgan Model (Model ( industry standardindustry standard))

The expected cash inflow for to the protection seller is

The expected cash outflow is

The default probability can be stripped out of the offsetting par CDS position quoted @ 300bp, since by definition of the par CDS spread the following musthold:

( )rateInterest

probDefaultRecoveryPV outcash +××−=

11100

( )RecoveryspreadCDSspreadCDSprobDefault

new

new

−+=

100

( ) incashPVrateInterest

probDefaultRecovery =+

××−1

1100

[ ] newoutcash spreadCDSrateInterest

probDefaultPV ×+

×−×=1

11100

=[ ] old

factor discountprob survival

incash spreadCDSrateInterest

probDefaultPV ×+

×−×=44 344 21

444 3444 21 111100

October 7/14, 200452

CDS spread payment

?

100 bp

60

Unwind value

100-Recovery

( Interest rates flat @ 2.00%, Recovery @ 40% )

( ) %76.4%40%100300

300=

−+=

bpbpprobDefault

( ) %24.951 =−= probDefaultprobSurvival

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: : JPMorgan JPMorgan Model (Model (cont'dcont'd))

The probabilities stripped out of the offsetting par CDS can be used to find out the unwind value of the original CDS position:

October 7/14, 200453

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: : JPMorgan JPMorgan Model (Model (cont'dcont'd))

The unwind value (mark-to-market value) of the short CDS position can be computed as follows:

93.0100%00.21

1%24.95100 =×+

××= bp PV incash

( ) 8.2%00.21

1%76.440100 =+

××−=outcashPV

- 87.18.293.0 −=−=4434421

valueMtM

valueUnwind

October 7/14, 200454

SingleSingle--name name CDSCDSUnwind Unwind valuationvaluation: : ExerciseExercise

Credit improvement:

- Assume there is a simultaneous upgrade of the reference entity

- Due to the credit improvement of the reference entity the par CDSspread quoted on the market tightens from 100bp to 50bp

Show that the unwind value with the cash differential method corresponds to:

Show that for the JPMorgan model the following holds:

49.0=4434421

valueMtM

valueUnwind

%83.0=probDefault

48.049.097.0 =−=4434421

valueMtM

valueUnwind

October 7/14, 200455

SingleSingle--name name CDSCDSUnwind Unwind valuation valuation in in BLOOMBERG'sBLOOMBERG's CDSW: CDSW: Discounted Spreads Discounted Spreads ModelModel

Input in the section Deal Information

- notional amount

- maturity

- deal spread of the CDS

- ...

Input into the Spreads section

- Recovery Rate

- Par CDS spreads (the current spread as a flat spread curve)

Select the model 'Disctd Spreads' in the Calculator section

In the Calculator section the Market Value (to the negative) corresponds to the unwind value of the short CDS position

October 7/14, 200456

SingleSingle--name name CDSCDSUnwind Unwind valuation valuation in in BLOOMBERG'sBLOOMBERG's CDSW: CDSW: Discounted Spreads Discounted Spreads Model Model ((cont'dcont'd))

newspreadCDS

Recovery

probDefault

notional of%90.1−

oldspreadCDS

CDSW for our example CDS:

October 7/14, 200457

SingleSingle--name name CDSCDSUnwind Unwind valuation valuation in in BLOOMBERG'sBLOOMBERG's CDSW: CDSW: JPMorgan JPMorgan ModelModel

Select the model 'JPMorgan' in the Calculator section – all the rest is analogous to the 'Disctd Spreads' model

newspreadCDS

Recovery

probDefault

notional of%90.1−

oldspreadCDS

October 7/14, 200458

SingleSingle--name name CDSCDSCDSW Default CDSW Default SettingsSettings......

October 7/14, 200459

SingleSingle--name name CDSCDSUnwind alternatives/Unwind alternatives/SummarySummary

The owner of a default swap position can monetize a change in the CDS spread by:

- terminating the transaction

- reassigning the default swap to another counterparty (novation)

- enter into an offsetting position with another counterparty

In all cases the unwind value or mark-to-market has to be negotiated between the counterparties

The industry standard for negotiation is the JPMorgan Model – and it is sufficient for the counterparties to agree upon

- the par CDS spread curve

- the recovery rate

(Notice that the unwind value is quite robust to various recovery assumptions)

October 7/14, 200460

Legal Legal Issues Issues

... Legal Issues

October 7/14, 200461

SingleSingle--name name CDSCDSStandardization Standardization of CDSof CDS ConfirmationConfirmation

Current documentation framework are the 2003 ISDA credit derivatives definitions

History to date...

- 1998 standard form of confirmation

- 1999 credit derivatives definitions

- Supplements (restructuring, successor* and credit events, convertibles)

- 2003 ISDA credit derivatives definitions

Standardized documentation led to dramatic growth of credit derivatives market

Investment Grade and High Yield North American confirmation based on the2003 ISDA credit derivatives definitions

Standard 2003 contracts began trading June 20, 2003

Contracts proved effective by Enron, Worldcom, ... defaults

Worldcom: close to 600 contracts outstanding, estimated over 7 billion in notional, no disputes or litigation and no mechanical settlement problems*For instance in case of a Reference Entity merger

October 7/14, 200462

SingleSingle--name name CDSCDSStandard Non Standard Non Emerging Emerging Market Corporate CDSMarket Corporate CDS

October 7/14, 200463

SingleSingle--name name CDSCDSTriggering Mechanism Triggering Mechanism of CDSof CDS

Watch : A predefined group of Obligations of the Reference Entity

Check: Has a Credit Event occured ?

Deliver: A predefined group of Deliverable Obligations in return for par

ObligationsObligations Credit Credit EventsEventsDeliverable Deliverable ObligationsObligations

Watch Check Deliver/Settle

October 7/14, 200464

SingleSingle--name name CDSCDSWatch ObligationsWatch Obligations

ObligationsObligations

Watch

Credit Credit EventsEventsDeliverable Deliverable ObligationsObligations

Check Deliver/Settle

Derivative Contracts General Creditors

Bonds Loans

"Payment"

"Borrowed Money"

Borrowed Money: bond, note, loan, commercial paper,money market accounts, savings accounts and reimbursements from letters of credit

October 7/14, 200465


Watch


Check

SingleSingle--name name CDSCDSCheck Credit Check Credit EventsEvents

Standard Credit Events unter ISDA

- Failure to Pay

- Bankruptcy

- Restructuring (soft credit event)

Emerging market and sovereign Reference Entities generally include Repudiation/Moratorium

High Yield CDS trade without Restructuring as a Credit Event

Bankruptcy deemed to have occurred only if the default occurs with respect to the Reference Entity, all other Credit Events are deemed to have occurred if default occurs on any obligation

Deliver/Settle

October 7/14, 200466


Watch


Check

SingleSingle--name name CDSCDSDeliverDeliver//Settle Deliverable ObligationsSettle Deliverable Obligations

Deliverable Obligations means any Bond, Loan, Convertible, Exchangeable,... satisfying the Deliverable Obligation Characteristics, ie, ranked senior or better in the capital structure (eg, senior unsecured)

Deliver/Settle

Protection buyerProtection buyer Protection sellerProtection seller100

ConvertibleConvertibleLoanLoan

BondBondCTD BondCTD Bond

October 7/14, 200467

SingleSingle--name name CDSCDSPhysical Settlement TimelinePhysical Settlement Timeline

October 7/14, 200468

SingleSingle--name name CDSCDSFirst First two two "major "major defaultsdefaults" in " in the the European CDS Market European CDS Market

On 30 September, 2001, Railtrack plc, the owner of UK railway infrastructure, was placed under administration

On 4 October, 2001, SAirGroup applied for a moratorium of debt enforcement

The credit events of Railtrack plc and SAirGroup clearly constitued a Bankruptcycredit event, given that both companies were either insolvent or in severe financial difficulty

A significant number of CDS have been "triggered"

The credit derivative market has worked well...

October 7/14, 200469

Measures Measures of of Spreads for Spreads for BondsBonds

Measures of Spreads for Bonds

October 7/14, 200470

Investors have different views about how the credit risk of a company can be measuredIt is customary to express credit risk in form of an excess yield over some benchmark interest rates, a so-called credit spread

Several ways for looking at credit spreads implied by bond prices:

- Z-Spread- I-Spread- Par ASW-Spread

Z-Spread, I-Spread and par ASW-Spread are all available on BLOOMBERG

Goal:

- introduce credit spreads concepts by examples- explain their relationship by examples

Measures Measures of of Spreads for Spreads for BondsBondsMotivation/Motivation/GoalGoal

October 7/14, 200471

Measures Measures of of Spreads for Spreads for BondsBondsYieldYield--toto--Maturity Maturity (YTM)(YTM)

Premium Bond:

Discount Bond:

Bond CashFlows

Swap ratesYear 0 Year 1 Year 2 Year 3

0.50% 1.00% 2.00%

-105 10 11010

Bond CashFlows


0.50% 1.00% 2.00%

-92.13 5 1055

%06.8)1(

105)1(

5)1(

513.92 32 =⇒+

++

++

= YTMYTMYTMYTM

%06.8)1(

110)1(

10)1(

10105 32 =⇒+

++

++

= YTMYTMYTMYTM

October 7/14, 200472

Measures Measures of of Spreads for Spreads for BondsBondsZZ--Spread Spread

Premium Bond:

Discount Bond:

Bond CashFlows


0.50% 1.00% 2.00%

-105 10 11010

Bond CashFlows


0.50% 1.00% 2.00%

-92.13 5 1055

%17.6)%00.21(

110)%00.11(

10)%50.01(

10105 32 =⇒++

+++

+++

= ZZZZ

%12.6)%00.21(

105)%00.11(

5)%50.01(

513.92 32 =⇒++

+++

+++

= ZZZZ

October 7/14, 200473

Measures Measures of of Spreads for Spreads for BondsBondsII--Spread Spread

Premium Bond:

Discount Bond:

Bond CashFlows


0.50% 1.00% 2.00%

-105 10 11010

Bond CashFlows


0.50% 1.00% 2.00%

-92.13 5 1055

%06.6%00.2%06.83 =−=−= YearSwap RateYTMSpreadI

%06.6%00.2%06.83 =−=−= YearSwap RateYTMSpreadI

October 7/14, 200474

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: Definition : Definition

Definition:

Package consisting of fixed cashflows of a bond, and an agreement to swap these fixed cashflows for a series of floating payments. These payments "float" with an index rate, normally LIBOR.

Construction: - buy the bond to be asset swapped- pay a swap, arranged so that the fixed leg of the swap exactly offsets the coupon payments of the bond- adjust the floating leg of the swap so that the net present value of the package is par

Main purpose: - enable a credit investor to take exposure to credit quality of a fixed-rate bond - without taking interest rate risk

October 7/14, 200475

=

Bond

Swap

+

Asset Swap

= FRN with Price of Par

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: : Package Package

October 7/14, 200476

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: Par Asset : Par Asset Swap Spread Swap Spread (Par ASW)(Par ASW)

Par ASW)()( receivedPVpaidPV =

)(100)( BondValueFairpaidPV +=

)()(

AnnuityPVpriceDirtyBondValueFairASWPar −

=

)(),()(100

AnnuityPVASWParParLiborPVpriceDirtyreceivedPV ×++=44 344 21

Swap +

-

October 7/14, 200477

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: : ObservationsObservations

Interpretation: par ASW spread is an annuity that compensates the bond holder for the difference between the riskless price of the bond and its market price

Credit risk: the buyer of the asset swap still owns the bond with the associated credit risk

Interest rate risk: the buyer does not retain the bond's coupons (hence does not take the associated interest rate risk )

Counterparty default risk: when the bond is trading at a discount, the assets swap buyer has immediate credit risk vs the seller equal to par minus the bond price. For premium bonds the opposite holds.

Default contingent exposure to mark-to-market value of swap: the bond is credit-linked, but the swap is usually not and does not terminate upon default, but can be at its market value.

Clean asset swap: an asset swap package with a credit-linked swap. The par ASW spread will be different than for a normal asset swap package.

October 7/14, 200478

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: Par ASW : Par ASW Example Example

Premium Bond:

Discount Bond:

Bond CashFlows


0.50% 1.00% 2.00%

-105 10 11010

Bond CashFlows


0.50% 1.00% 2.00%

-92.13 5 1055

( ) ( ) ( ) ( )( ) ( ) ( ) ( )

%31.692.2

10541.123

%00.211

%00.111

%50.01192.2

%00.21110

%00.1110

%50.011041.123

32

32

=−

=⇒

++

++

+==

++

++

+==

ASWParAnnuityPV

BondValueFair

( ) ( ) ( ) ( )( ) ( ) ( ) ( )

%72.592.2

13.9282.108

%00.211

%00.111

%50.01192.2

%00.21105

%00.115

%50.01582.108

32

32

=−

=⇒

++

++

+==

++

++

+==

ASWParAnnuityPV

BondValueFair

October 7/14, 200479

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: : ExerciseExercise

What is the default contingent risk assumed by the asset swap buyer

- if the bond defaults immediately

- in case of the premium and in case of the discount bond

- assuming a bond recovery price of 40% ?

What is the immediate counterparty credit risk

- before and after bond default ?

Premium bond default (buyer's view):

Value at inception

Value after default

Loss

+105

+ 40

- 65

- 5

- 5

0

+100

+35

- 65

Bond Swap Total

does not terminate upon

default

immediate counterparty credit risk of asset swap

seller

October 7/14, 200480

Discount bond default (buyer's view):

Value at inception

Value after default

Loss

+ 95

+ 40

- 55

+ 5

+ 5

0

+100

+45

- 55

Bond Swap Total

does not terminate upon

default

Measures Measures of of Spreads for Spreads for BondsBondsAsset Asset SwapSwap: : Exercise Exercise ((cont'dcont'd))

immediate counterparty credit risk of asset swap

buyer

October 7/14, 200481

Measures Measures of of Spreads for Spreads for BondsBondsSummary Summary of of examplesexamples

Premium Bond

Discount Bond Description

YTM 8.06% 8.06%

Z-Spread 6.17% 6.12% Best measure of comparable bond value as adjusts for shape of Swap curve

I-Spread 6.06% 6.06% Not as good as Z-Spread (ignores shape of Swap curve)

Good approximation for high grade bonds

Par ASW 6.31% 5.72% A tradable value

Not a good value measure for bonds far from par

October 7/14, 200482

Measures Measures of of Spreads for Spreads for BondsBondsGeneral General relationships relationships

Z-Spread vs I-Spread:

- For upward-sloping yieldcurve the Z-Spread is higher than the I-Spread

- For a flat yieldcurve Z-Spread and I-Spread are equal

The relations hold for par, premium and discount bonds.

SpreadZSpreadI <

SpreadZSpreadI =

October 7/14, 200483

Measures Measures of of Spreads for Spreads for BondsBondsGeneral General relationships relationships ((cont'dcont'd) )

Z-Spread, I-Spread vs par ASW for premium bond:

- For upward-sloping yieldcurve Z-Spread and I-Spread will be lowerthan the ASW spread

- For a flat yieldcurve similarly

ASWParSpreadZSpreadI <<

ASWParSpreadZSpreadI <=

Z-Spread, I-Spread vs par ASW for discount bond:

- For upward-sloping yieldcurve Z-Spread and I-Spread will be higher than the ASW spread

- For a flat yieldcurve similarly

ASWParSpreadISpreadZ >>

ASWParSpreadISpreadZ >=

October 7/14, 200484

Measures Measures of of Spreads for Spreads for BondsBondsGeneral General relationships relationships ((cont'dcont'd) )

Why is the par ASW spread higher than the Z-Spread for a premium bond ?

- For a premium bond and a flat yield curve the Coupon is by definition higher than Libor + Z-Spread- In an asset swap package with a swap paying the Coupon and receiving Libor + Z-Spread, the swap value will be negative after a default- To compensate for the additional risk of having a swap not terminating on default, the swap must pay a higher spread than the Z-Spread- ... and therefore

ASWParSpreadZSpreadI <=

- In a so-called clean asset swap package the swap terminated upon default and therefore the clean par ASW spread would correspond to

the Z-Spread

October 7/14, 200485

Bond Bond PricingPricing, , ProbabilityProbability, , BondBond--Equivalent Equivalent CDSCDS--SpreadSpread

(BE CDS(BE CDS--SpreadSpread))

Bond Pricing, Probability, BE CDS-Spread

October 7/14, 200486

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadFrameworkFramework

100

106

40

Actual Price

Cash at maturity

Expected Recovery if default

Survival probability

Default probability

( Interest rates flat @ 2.00% )

October 7/14, 200487

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadBootstrapping ProbabilitiesBootstrapping Probabilities

( )eryRecovprobDefaultCashprobSurvivalfactorDiscountpriceMarket ×+××=

Bond pricing equation:

( ) ⎟⎟

⎠

⎞

⎜⎜

⎝

⎛×−+××

+=

=

401106%00.21

1100444 3444 21

probDefault

probSurvivalprobSurvival

Bootstrapping probabilities:

%94.93=probSurvival

%06.6=probDefault

October 7/14, 200488

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadFilling Filling in in ProbabilitiesProbabilities

100

106

40

Actual Price

Cash at maturity

Expected Recovery if default

93.94%

6.06%

( Interest rates flat @ 2.00% )

October 7/14, 200489

100

106

40

93.94%

6.06%

?

101

40

93.94%

6.06%

Bond A Bond B

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadComputing the Computing the Fair Value of Fair Value of another bondanother bond

Bond pricing equation:

( )40%06.6101%94.93%00.21

140.95 ×+××+

=

Idea: Compute the Fair Value of another bond with different coupon, but of same seniority, based on the probabilities determined for the first bond

95.40

October 7/14, 200490

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadInvestment Investment strategies strategies Contingent PayoffsContingent Payoffs

Invest 1000 CHF into Bond A or Bond B:

Bond A Bond B

Price 100% 95.40%

# purchased 10 10.482

Cash at maturity 106 CHF 101 CHF

Expected Recovery 40% 40%

Payoff if no default 1060 CHF 1058.68 CHF

Payoff if default 400 CHF 419.28 CHF CHF

Compute contingent payoffs:

October 7/14, 200491

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadInvestment Investment strategies strategies Expected valuesExpected values

Weighted payoff if no default 1060 CHF x 93.94% 1058.68 CHF x 93.94%

Weighted payoff if default 400 CHF x 6.06% 419.28 CHF x 6.06%

Compute expected values:

Expected value 1020 CHF 1020 CHF

+ +

= =

Bond A Bond B

October 7/14, 200492

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadYTM, ZYTM, Z--SpreadSpread, Par ASW, Par ASW

First compute spread measures for Bonds A and B:

Bond A Bond B Formula

YTM 600 bp 587 bp ( )YTMmaturity at CashPrice

+=

1

Z-Spread/I-Spread 400 bp 387 bp ( )ZLibormaturity at CashPrice

++=

1

Par ASW 400 bp 370 bp ( )

( )Libor1

PriceLibor1maturity at Cash

ASWarP

+

−+= 1

( Libor @ 2.00% )

October 7/14, 200493

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadBE CDSBE CDS--SpreadSpread

Bonds A and B have equal issuer and same seniorityBonds A and B are w.r.t credit risk of equal value (same expected recovery,

same default probability)Goal: Introduce a metric telling that A and B are of equal value w.r.t credit risk

Idea: - Sell protection against default of Bonds A and B via a Credit Default Swap contract- Use the default probability/survival probability derived from the Bonds prices to value the Credit Default Swap contract- Determine the CDS Spread such that the Credit Default Swap

contracts has a value of zero Bond Equivalent (BE) CDS Spread

Interpretation of BE CDS Spread: Answers the question

If Bond A or Bond B were a CDS contract, what would the CDS spread be ?

October 7/14, 200494

BE CDS)()( receivedPVpaidPV =

Credit Default Swap

0 T

CDS

100-Recovery

+

-

( ) CDSprobSurvivalfactorDiscountreceivedPV ××=

( ) ( ) ( )RecoveryprobSurvivalfactorDiscountpaidPV −×−×= 1001

( ) ( )probSurvival

RecoveryprobSurvivalCDSBE −×−=

1001

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadBE CDSBE CDS--Spread Spread ((cont'dcont'd))

BE CDS for the 1-period situation:

October 7/14, 200495

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadBE CDSBE CDS--Spread Spread ((cont'dcont'd))

Bond A Bond B Formula

YTM 600 bp 587 bp ( )YTMmaturity at CashPrice

+=

1

Z-Spread/I-Spread 400 bp 387 bp ( )ZLibormaturity at CashPrice

++=

1

Par ASW 400 bp 370 bp ( )

( )Libor1


ASWarP

+

−+= 1

( Libor @ 2.00% )

BE CDS 387 bp 387 bp( ) ( )

probSurvivalRecoveryprobSurvivalCDSBE −×−

=1001

BE CDS is robust to the price of the bond (same for premium, par or discount bond) and also to the shape of the interest-rate curve

October 7/14, 200496

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadGeneral General relationshipsrelationships

Z-Spread, I-Spread vs par ASW and BE CDS for premium bond:

ASWParSpreadZSpreadICDSBE <≤<

ASWParSpreadISpreadZCDSBE >≥>

Z-Spread, I-Spread, par ASW and BE CDS for discount bond:

The best overall proxy for the BE CDS spread is the Z-Spread !

October 7/14, 200497

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadExerciseExercise

Compute all the credit spread measures for the following deep discount bond:

October 7/14, 200498

Bond Bond PricingPricing, , ProbabilityProbability, BE CDS, BE CDS--SpreadSpreadExerciseExercise ((cont'dcont'd))

Deep Discount bond Formula

( Libor @ 2.00%, Survival prob = 78.50% )

YTM 17.78 % ( )YTMmaturity at CashPrice

+=

1

Z-Spread/I-Spread 15.78 % ( )ZLibormaturity at CashPrice

++=

1

Par ASW 14.20 % ( )

( )Libor1


ASWarP

+

−+= 1

BE CDS 16.43 % ( ) ( )probSurvival

RecoveryprobSurvivalCDSBE −×−=

1001

October 7/14, 200499


(CDS)(CDS)

Part 2Part 2

Single-name CDS, Part 2

October 7/14, 2004100

SingleSingle--name name CDSCDSThe The Default Default SwapSwap Basis: Definition / Basis: Definition / CalculationCalculation

Definition: The basis in credit markets is the difference between the pricing of an individual (or a group of) bonds in the cash market and the pricing of the same issuer (or same group of issuers) using the CDS market

Terminology: Commonly referred to as default swap basis

Calculation (sophisticated):

Calculations (practical):

SpreadCDSBESpreadCDSBasisSwapDefault −=

SpreadASWSpreadCDSBasisSwapDefault −=

SpreadZSpreadCDSBasisSwapDefault −=

October 7/14, 2004101

Source: JPMorgan Credit Navigator

SingleSingle--name name CDSCDSThe The Default Default SwapSwap Basis: Basis: ExampleExample

Default Swap Basis for ABB International Finance Ltd:

October 7/14, 2004102

SingleSingle--name name CDSCDSThe The Default Default SwapSwap Basis: Basis: Example Example ((cont'dcont'd))

ABB Intl Finance 11.5£ May 2009 has currently negative basis (coupon stepsdown if ABB investment grade)

- Par 5Y CDS is currently trading at mid 140 bp- Z-Spread is 250 bp, Par ASW-Spread is 271 bp- Z-Basis is –110 bp, ASW-Basis is –131 bp

SpreadZ

SpreadASWPar

October 7/14, 2004103

SingleSingle--name name CDSCDSDrivers behind Drivers behind Default Default Swap Swap BasisBasis

Fundamental factors:

Technical factors:

(CDOs issuance)

October 7/14, 2004104

SingleSingle--name name CDSCDSTrade Trade strategiesstrategies

Positive basis:

- CDS is cheaper than Bond- Short Bond and sell protection (buy credit risk) via CDS- Position is credit-risk neutral- Investigate why cash and derivatives market price same risk differently

Negative basis:

- Bond is cheaper than CDS- Buy Bond and buy protection (sell credit risk) via CDS- Position is credit-risk neutral- Investigate why cash and derivatives market price same risk differently

October 7/14, 2004105

SingleSingle--name name CreditCredit--Linked Linked NotesNotes(CLN)(CLN)

Single-name CLN

October 7/14, 2004106

SingleSingle--name name CLNCLNDescriptionDescription

Motivation: - Investor wishes to take exposure to the credit derivatives market but requires a cash instrument (plan restrictions, regulatory constraints)- Investor does not have an ISDA master agreement in place- Investor wants to capture the relative value offered by the credit

derivatives market (eg, positive basis)

A funded Credit Linked Note (CLN) is - a security - paying a fixed or floating-rate coupon - having an embedded credit derivative (coupons and principal repayment are dependent upon the financial well being of a reference entity)- sometimes having principal protection

Two forms are common- CLN issued by corporate entity (bank or otherwise), unrated, unlisted- CLN issued by Special Purpose Vehicles (SPV), rated/unrated, listed

October 7/14, 2004107

SingleSingle--name name CLNCLNCLN CLN issued by corporate entityissued by corporate entity: : MechanicsMechanics

Investor pays par to buy the noteIssuer invests the proceeds receiving Libor+CDS spread+funding spreadIssuer pays Libor+CDS spread+funding spread less administrative fees and correction for possibility of early termination in case of a credit event

InvestorInvestor


IssuerIssuer

Credit risk

Credit Credit Derivatives DeskDerivatives Desk

ParPar

Credit Linked Coupons


October 7/14, 2004108

Cash settlement : Price of defaultet asset determined via dealer poll

Physical settlement : Delivery of cheapest to deliver obligation out of a basket of deliverables assets ranked pari passu to reference obligation

SingleSingle--name name CLNCLNCLNCLN issued by corporate entityissued by corporate entity:: MechanicsMechanics ((cont'dcont'd))

InvestorInvestorIssuerIssuerCredit Credit

Derivatives DeskDerivatives Desk100-Recovery



100-Recovery


CTD BondCTD Bond


Derivatives DeskDerivatives Desk




CTD BondCTD Bond

October 7/14, 2004109

SingleSingle--name name CLNCLNCLN CLN issued by issued by SPV: SPV: MechanicsMechanics

Investor pays par to buy the noteIssuer invests the proceeds into AAA collateral and enters into a swap transaction receving Libor+CDS spread in exchange for the fixed couponsIssuer pays Libor+CDS spread less administrative fees and correction for possibility of early termination in case of a credit event

InvestorInvestor


Credit risk

Credit Credit Derivatives DeskDerivatives Desk

ParFixed Rate

LIBOR + CDS spread LIBOR+CDS spread

Fixed Fixed Rate AssetRate Asset((CollateralCollateral))

Fixed Rate Par

IssuerIssuer

Securitization of credit-linked asset swap

October 7/14, 2004110

Cash settlement : Liquidation of collateral, price of defaultet asset determined via dealer poll

SingleSingle--name name CLNCLNCLNCLN issued byissued by SPV: SPV: MechanicsMechanics ((cont'dcont'd))


Derivatives DeskDerivatives Desk100-Recovery

LIBOR+CDS spread LIBOR + CDS spread

Recovery

Fixed Fixed Rate AssetRate Asset((CollateralCollateral))

Fixed Rate 100

(Market value of Collateral assumed to be 100)

Physical settlement : see above...

October 7/14, 2004111

CDS and CLN on CreditCDS and CLN on Credit--IndicesIndices((withwith emphasisemphasis on DJ on DJ iTraxxiTraxx Europe Index Europe Index FamilyFamily))

CDS and CLN on Credit-Indices (DJ iTraxx Europe)

October 7/14, 2004112

June 21, 2004: iBoxx Ltd and TRAC-X LCC are merging their European tradable CDS indices thereby creating Dow Jones iTraxx Europe (DJ iTraxx Europe)

The DJ iTraxx platform will offer one benchmark for all credit investorsPredecessors: JECI1, JECI2, DJ TRAC-X Europe 1, DJ TRAC-X Europe 2,...

Infos under www.iboxx.com. Most material is drawn from there...

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesBrief Brief historyhistory

October 7/14, 2004113

Liquidity and Standardisation:- 20 market makers brought together into DJ iTraxx Europe platform

- Portfolio composition rules bring together most liquid reference entities- Standardised documentation for all DJ iTraxx notes (CLN) and swaps (CDS)

Transparency:- One benchmark credit index- Portfolio inclusion rules

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesOverviewOverview

October 7/14, 2004114

Diversification:- Cost efficient and timely access to the credit markets via CDS and

CLN on DJ iTraxx Europe

Independency, Track History:- International Index Company (IIC) as independent index supplier and administrator- IIC manages the indices and carries out the rebalancing process on behalf of Dow Jones Indices - IIC includes the former management team from iBoxx Ltd

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesOverview Overview ((cont'dcont'd))

October 7/14, 2004115

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Index Europe Index FamilyFamily

October 7/14, 2004116

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Product DescriptionsProduct Descriptions

October 7/14, 2004117

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Product Descriptions Product Descriptions ((cont'dcont'd))

October 7/14, 2004118


October 7/14, 2004119


October 7/14, 2004120

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Inclusion RulesInclusion Rules

October 7/14, 2004121

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Inclusion Rules Inclusion Rules ((cont'dcont'd))

October 7/14, 2004122

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Inclusion Rules Inclusion Rules ((cont'dcont'd))

October 7/14, 2004123

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Reference Reference Portfolio Portfolio ExampleExample

October 7/14, 2004124

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Mechanics Mechanics and Credit and Credit EventsEvents: : Unfunded Unfunded CDS FormCDS Form

Consider buying protection of €10 MM on the DJ iTraxx Europe main index in unfunded CDS form with maturity 09/2009

The running CDS premium is 45bp p.a.The current market quote is a par CDS premium of 42.50bp/43bp (JPMorgan

quote under BLOOMBERGs JITX:

The CDS is executed at 45bp p.a.The present value difference between 45bp and the bid of 42.5bp inclusive the

accrued interest is paid by the protection seller to the protection buyer

October 7/14, 2004125

The upfront payment of €17,861 is settled on T+3 days and calculated via BLOOMBERGs CDSW*:

*The current market standard is to model the CDS Index as a single-name CDS contract with a hypothetical reference entity. For more details see section on unwind valuation of single-name CDS.

curveCDSparflat

recovery assumed

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Mechanics Mechanics and Credit and Credit EventsEvents: : Unfunded Unfunded CDS Form (CDS Form (cont'dcont'd))

model JPMorgan

October 7/14, 2004126

Protection sellerProtection seller

DJ DJ iTraxx iTraxx EuropeEurope


Credit risk

45 bp p.a = €45,000

€17,861


The protection buyer receives the upfront premium and pays to protection seller 45bp p.a. quarterly on €10 MM until maturity

No Credit Event

October 7/14, 2004127


Defaultet Reference Entity has a weighting of 0.80% (=1/125)Protection buyer delivers €80,000 nominal face value of Deliverable Obligations

of the Reference Entity in exchange for €80,000n (=0.80% of €10 MM)Notional amount on which premium is paid reduces by €80,000 to €9,92 MM

resulting in a premim of €44,640Each subsequent credit event will result in a further reduction of the nominal by

€80,000 (=1/125)

Credit Event on a single Reference Entity – Physical Settlement

45bp p.a. = €44,640


Credit risk

Protection sellerProtection sellerProtection buyerProtection buyer

€80,000

€80,000 nominal in bonds/loans

October 7/14, 2004128

Consider an investor buying €10 MM DJ iTraxx Europe Note (CLN) with maturity 09/2009

The investor pays at launch 100 for the Note and receives Euribor+45bp p.a., quarterly

Without Credit Events, the investor continues to receive the coupon on the original notional invested until maturity

At maturity, the Note will redeem at par

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Mechanics Mechanics and Credit and Credit EventsEvents: : FundedFunded CLN Form CLN Form

No Credit Event

InvestorInvestor

DJDJ iTraxxiTraxx EuropeEurope

Credit risk

Par

EURIBOR+CDS spreadIssuerIssuer

October 7/14, 2004129

Credit Event on a single Reference Entity – Cash Settlement

Defaultet Reference Entity has a weighting of 0.80% (=1/125) and final recovery value of 40%

Issuer pays to the investor the Cash Settlement amount of €32,000 =0.80%*€10 MM*40%

Redemption amount of the Note reduces from €10 MM to € 9,92 MM = 99.2%*€10 MM and Coupons of Euribor+45bp are paid on € 9,92 MM subject to any further credit events

InvestorInvestor


Credit risk

€32,000

IssuerIssuer EURIBOR+CDS spread

€9,92 MM

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesDJ DJ iTraxx iTraxx Europe Europe Mechanics Mechanics and Credit and Credit EventsEvents: : FundedFunded CLN Form (CLN Form (cont'dcont'd) )

October 7/14, 2004130

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesAppendix: Appendix: Computing the Intrinsic SpreadComputing the Intrinsic Spread

What is the on-market coupon for a CDS on a Credit-Index?We will show that the on-market coupon can be approximated by

- the weighted average of the par CDS spreads of the names in the index

- where the weights are the risky DV01's for each name*

The approximation of the on-market coupon can also be used as a device for a replication of the Credit-Index CDS with single-name CDS on the underlying names.

The on-market coupon is called the intrinsic spread for the Credit-Index CDS.

* The risky DV01 si the change in value of the CDS for a 1bp widening in the spread. When using BLOOMBERGs CDSW the risky DV01 is displayed as 'Sprd DV01'.

October 7/14, 2004131

CDS/CLN on CreditCDS/CLN on Credit--IndicesIndicesAppendix: Appendix: Computing the Intrinsic Spread Computing the Intrinsic Spread ((cont'dcont'd))

Step 1 (Intrinsic Upfront Payment)

- Use CDSW on each component of the credit index

- then sum up

Step 2 (Market Upfront Payment)

- Use the market convention of modelling the credit index as a single fictitious entity trading at a flat spread curve with recovery 40%:

( ) nameSingleIndexnameSinglenameSingle DVSprdSpreadDealSpreadCDSParpaymentUpfront 01×−=

( )∑∑ ×−=N

nameSingleIndexnameSinglenameSingle DVSprdSpreadDealSpreadCDSParpaymentUpfront 01

( ) EntityFictitiousIndexEntityFictitiousconventionMarket DVSprdSpreadDealSpreadCDSParpaymentUpfront 01×−=

October 7/14, 2004132


Step 3 (Intrinsic Spread):

- Equate the upfront payments and back out the intrinsic spread

Step 4 (Approximation of Intrinsic Spread)

- Substitute the Sprd DV01 of the fictitious entity by the average of the index components Sprd DV01's:

( )∑∑ ×−=N

nameSingleIndexnameSingle

N

nameSingle DVSprdSpreadDealSpreadCDSParN

paymentUpfrontN

0111

( ) EntityFictitiousIndexEntityFictitiousconventionMarket DVSprdSpreadDealSpreadCDSParpaymentUpfront 01×−=

∑≈N

nameSingleEntityFictitious DVSprdN

DVSprd 01101

October 7/14, 2004133


- The upfront payment equations then become

- and the intrinsic spread can be easily computed as follows:

( )∑∑ ×−=N

nameSingleIndexnameSingle

N

nameSingle DVSprdSpreadDealSpreadCDSParN

paymentUpfrontN

0111

( ) nameSingleIndexEntityFictitious

N

conventionMarket DVSprdSpreadDealSpreadCDSParN

paymentUpfront 011×−= ∑

∑

∑ ×≈ N

nameSingle

N

nameSinglenameSingle

SpreadCDSPar

DVSprdSpreadCDSParspreadIntrinsic

01

October 7/14, 2004134


Simple average vs intrinsic spread:

In general, the intrinsic spread is lower than the simple average because the higher spreads have lower 'Sprd DV01' and therefore lower weights.

The difference between the simple average and the intrinsic spread is called the intrinsic basis.

N

spreadnameSinglespreadIntrinsic

N

ii

AverageSimple

∑== 1

∑

∑ ×≈ N

nameSingle

N

nameSinglenameSingle

SpreadCDSPar

DVSprdSpreadCDSParspreadIntrinsic

01

spreadIntrinsic AverageSimplespreadIntrinsic<

October 7/14, 2004135

Credit Credit OptionsOptionsCreditCredit--Spread OptionsSpread Options/Warrants/Warrants

CreditCredit--Default Default SwaptionsSwaptions

Credit Options

October 7/14, 2004136

Credit Credit OptionsOptionsOverview Overview

Substantial growth in activity in 2003 - bond and spread optionsoptions on single-name CDS- options on index-linked CDS

Increased liquidity in the CDS market is expected to boost the market for options on CDS

Main growth expected to come from index-linked trades ( DJ iTraxx)

Hedge bond inventory, Volatility TradingBanks

Yield Enhancement, Liability management (Casino's credit spread warrants)

Corporate Issuers

Benchmark Outperformance, Relative Valuation, Yield Enhancement (Covered Call Writing)

Money Managers

Leverage, Debt-Equity Strategies, Relative Valuation, typically Buyers of Volatility

Hedge Funds

Hedge of Liabilities, Yield EnhancementInsurance Companies

ApplicationMarket Participant

October 7/14, 2004137

Credit Credit OptionsOptionsBond and Bond and Spread OptionsSpread Options: Bond : Bond Options Options (Price (Price OptionsOptions))

The Option Buyer pays a premium to the Option Seller for the right (not the obligation) to buy or sell a Reference Asset at a predetermined Strike Price on a predetermined future Expiration Date.

Option Seller

Option Buyer

Premium

Right to purchase the Reference Asset at the Strike Price

Option Seller

Option Buyer

Strike Price

Reference Asset

If the Price > Strike Price The Buyer buys the Reference

Asset at the Strike Price

Option Seller

Option Buyer

If the Price < Strike Price The Buyer does nothing

Expiration Date

Price Option ( Call )

October 7/14, 2004138

Expiration Date

Spread Option ( Call )

Option Buyer

Option Seller

Premium

Right to purchase the Reference Asset at the Strike Spread

Option Buyer

Option Seller

If the Spread > Strike Spread The Buyer does nothing

Option Buyer

Option Seller

Price given Strike Spread

Reference Asset

If the Spread < Strike Spread The Buyer purchases the Reference

Asset at the Strike Spread

The Option Buyer pays a premium to the Option Seller for the right (not the obligation) to buy or sell a Reference Asset at a predetermined Strike Spread on a predetermined future Expiration Date.

Credit Credit OptionsOptionsBond and Bond and Spread OptionsSpread Options: : Spread OptionsSpread Options

October 7/14, 2004139

Credit Credit OptionsOptionsBond and Bond and Spread OptionsSpread Options ApplicationApplication: : Casino's Spread Casino's Spread WarrantsWarrants

Source:

Dresdner Kleinwort Wasserstein

October 7/14, 2004140

Credit Credit OptionsOptionsBond and Bond and Spread OptionsSpread Options ApplicationApplication: : Casino's Spread Casino's Spread Warrants (Warrants (cont'dcont'd))

Source:

Dresdner Kleinwort Wasserstein

October 7/14, 2004141

Credit Credit OptionsOptionsCDS CDS Swaptions Swaptions // OptionsOptions on CDS on CDS

Definition: - Option on Credit Default Swap spread of a credit- Underlying = forward starting CDS (at Option Expiry)- Traded as European options, only exercisable at Expiry Date- 3 to 9 month options on ATM 5 year CDS are most common

Terminology:- Payer: Option to buy protection (short credit risk "put on credit")- Receiver: Option to sell protection (long credit risk "call on credit")- Physically settled (enter into underlying CDS) or cash settled (MtM at option expiry)

What happens if before the Option Expiry there is a Credit Event ?- Payer : Traded with or without knock-out *- Receiver : Credit Event not relevant, since option would be out-of-the-money short before Credit Event

* Knock-out: Exercise is not possible in case of Credit Event in the issuer or guarantor of the CDS Reference Entity. Reason for knock-out is that hedging instruments are eg forward starting CDS that will expire worthless should a default occur prior to expiry date.

October 7/14, 2004142

Expiration Date

Payer CDS Swaption

Option Seller

Option Buyer

MtM of CDS

If the par CDS spread > Strike CDS spread The Seller pays the MtM

of the CDS position to the Buyer

Option Seller

Option Buyer

Payer CDS

If the par CDS spread > Strike CDS spread The Buyer enters a CDS position

at the Strike CDS spread

Option Seller

Option Buyer

If the par CDS spread < Strike CDS spreadThe Buyer does nothing

Option Seller

Option Buyer

Premium

Right to buy Protection at the Strike CDS Spread

Cash Settlement Physical Settlement

Credit Credit OptionsOptionsCDSCDS SwaptionsSwaptions // OptionsOptions on CDS: Payeron CDS: Payer

October 7/14, 2004143

Expiration Date

Receiver CDS Swaption

Option Seller

Option Buyer

MtM of CDS

If the par CDS spread < Strike CDS spread The Seller pays the MtM

of the CDS position to the Buyer

Option Seller

Option Buyer

Payer CDS

If the par CDS spread < Strike CDS spread The Buyer enters a CDS position

at the Strike CDS spread

Option Seller

Option Buyer

If the par CDS spread > Strike CDS spreadThe Buyer does nothing

Option Seller

Option Buyer

Premium

Right to sell Protection at the Strike CDS Spread

Cash Settlement Physical Settlement

Credit Credit OptionsOptionsCDSCDS SwaptionsSwaptions // OptionsOptions on CDS: Receiveron CDS: Receiver

October 7/14, 2004144

Options on iTraxx Main Series 1 6 Aug 8:51 am

Sep 04 Expirystrike ---> 40 42.5 45 47.5 50tenor v bid/ask delta bid/ask delta bid/ask delta bid/ask delta bid/ask delta

Payer 18 / 21 -81% 10 / 14 -62% 4 / 8 -42% 1 / 5 -25% 0 / 3 -14%Receiver 1 / 5 19% 5 / 9 37% 11 / 15 58% 19 / 23 75% 30 / 33 86%

Dec 04 Expirystrike ---> 40 42.5 45 47.5 50tenor v bid/ask delta bid/ask delta bid/ask delta bid/ask delta bid/ask delta

Payer 29 / 35 -80% 22 / 28 -70% 16 / 22 -59% 11 / 18 -49% 8 / 14 -39%Receiver 3 / 8 20% 6 / 12 30% 11 / 17 41% 17 / 24 51% 25 / 31 61%

All exchanging spot delta at 42.5Options don't KO on defaultPrices in cents of notional, payable upfrontPayers are options to buy protection (=pay fixed)Receivers are options to sell protection (=receive fixed)A positive delta means buyer of option buys CDS in the exchangeA negative delta means buyer of option sells CDS in the exchange

Closest strike to:ATM spot

ATM forward

Credit Credit OptionsOptionsCDS CDS SwaptionsSwaptions on on iTraxx iTraxx

Example: If you buy €100 MM @ strike 45 Dec04 Payer, you pay €220,000 upfront and you have the right to buy 5 years protection on DJ iTraxx Europe @ 45 on Dec 22, 2004

October 7/14, 2004145

Correlation ProductsCorrelation ProductsFirstFirst--toto--Default (Default (FtDFtD) CDS) CDS

TranchedTranched CreditCredit--Index Index ProductsProducts((Tranched Tranched DJ DJ iTraxxiTraxx))

Correlation Products

October 7/14, 2004146

Correlation ProductsCorrelation ProductsFtDFtD CDS: CDS: MechanicsMechanics

FtD basket CDS are simple products allowing investors to take advantage of both

- their views on default probability of companies- the correlation between those defaults

The protection buyer in a FtD CDS is protected against only the first defaultTypical basket consists of 5-6 reference entitiesSimilar to single-name CDS



Reference EntityReference EntityReference EntityReference Entity


Protection sellerProtection sellerProtection buyerProtection buyerCDS spread

Credit risk

No Credit Event

October 7/14, 2004147

Correlation ProductsCorrelation ProductsFtDFtD CDS: CDS: MechanicsMechanics ((cont'dcont'd))

Credit Event: First Reference Entity DefaultAfter first Credit Event the FtD CDS is terminatedThe protection buyer delivers a Deliverable Obligation of the defaulted

Reference EntityThe protection seller pays par



Reference EntityReference EntityReference EntityReference Entity

Defaulted Reference EntityDefaulted Reference Entity

Protection buyerProtection buyer Protection sellerProtection seller

100

ConvertibleConvertibleLoanLoan

BondBondCTD BondCTD Bond

October 7/14, 2004148

Correlation ProductsCorrelation ProductsFtDFtD CDS: CDS: RulesRules--ofof--thumbthumb

Upper bound (0% default correlation):- An FtD CDS offers only partial protection against the first defaulting Reference Entity,- therefore the sum of the individual premiums should define an upper bound to the FtD CDS premium:

- When the correlation between defaults is 0%, the FtD CDS premium corresponds to the sum of the individual CDS premiums

∑< SpreadCDSnameSingleSpreadCDSFtD

Lower bound (100% default correlation):- Assuming the correlation between the defaults is 100%, the riskiest credit in the basket will always be the first to default,- therefore the maximum of the individual CDS premiums defines a

lower bound for the FtD CDS premium:

SpreadCDSFtDSpreadCDSnameSingleMaximal <

October 7/14, 2004149

Correlation ProductsCorrelation ProductsFtDFtD CDS: CDS: RulesRules--ofof--thumb thumb ((cont'dcont'd))

Basic relationship Spread-Correlation:

Market FtD CDS Spreads:- Range typically from 60% to 80% of total spread

October 7/14, 2004150

Correlation ProductsCorrelation ProductsFtDFtD CDS: JPM Standard CDS: JPM Standard FtD BasketsFtD Baskets

JPMorgan introduced 'standard' FtD Baskets Basket composition is rules-based and draws on the DJ iTraxx subindices

October 7/14, 2004151

Correlation ProductsCorrelation ProductsFtDFtD CDS: JPM Standard CDS: JPM Standard FtD Baskets FtD Baskets ((cont'dcont'd))

FtD Implied Spread and Underlying CDS levels:

October 7/14, 2004152

Correlation ProductsCorrelation ProductsFtDFtD CDS: JPM Standard CDS: JPM Standard FtD Baskets FtD Baskets ((cont'dcont'd))

FtD Implied Spread and Underlying CDS levels:

Sample Market Quotes

October 7/14, 2004153

Correlation ProductsCorrelation ProductsTranched Tranched DJ DJ iTraxxiTraxx: : Description Description

DJ tranched iTraxx is a synthetic CDO on a static portfolioThe portfolio of Reference Entities corresponds to the DJ iTraxx Reference

EntitiesTranches:

- Equity Tranche bears the first 3% of losses of the static portfolio- Second-Loss Tranche bears the second 3% of losses- ...

3%, 6%, 9%, 12%, 22% are called attachement/detachement points or lower/upper subordination levels


Portfolio of 125Portfolio of 125

Credit Default Credit Default Swaps Swaps

1212--22% Tranche22% Tranche





Contractually tranched

First-loss Tranche

Equity Tranche

October 7/14, 2004154

Correlation ProductsCorrelation ProductsTranched Tranched DJ DJ iTraxxiTraxx: : Mechanics for Equity Mechanics for Equity TrancheTranche

Consider an investor selling protection for €10 MM on the Equity Tranche with maturity 09/2009

Assume that the DJ tranched iTraxx 0-3% Tranche trades at 500bpThe periodic premium received by the investor is €500,000 (=5% of €10 MM)

Without Credit Events, the investor continues to receive the premium on the original notional until maturity

No Credit Event

InvestorInvestor


Credit risk

(First 3% of Losses)

€500,000Protection buyerProtection buyer

October 7/14, 2004155

Credit Event: One Reference Entity defaults @ 40% RecoveryThe 60% loss on the Reference Entity translates into a 0.48% (=60%/125) loss

on the 125-name portfolioThe investor would lose the entire notional for a loss of 3%A loss of 0.48% corresponds therefore to a 16% (=0.48%/3%) loss of notionalThe investor pays €1.6 MM (=16% of €10 MM) to the protection buyerThe new notional is €8.4 MM(= €10 MM - €1.6 MM)The investor receives 500bp on €8.4 MM contingent on any further credit event

For a vanilla Credit-Index CDS the payment of the investor would be €48,000 and the new notional would be €9,92 MM (for a much lower premium !)

Correlation ProductsCorrelation ProductsTranched Tranched DJ DJ iTraxxiTraxx: : Mechanics for Equity Mechanics for Equity Tranche (Tranche (cont'dcont'd))

InvestorInvestor

DJDJ iTraxxiTraxx EuropeEurope€1,6 MM

Protection buyerProtection buyer€420,000

Credit risk

(First 3% of Losses)

October 7/14, 2004156

Credit Event: 7 Reference Entities default each @ 40% RecoveryThe total loss on the Reference Entities (420%) translates into a 3.36%

(=420%/125) loss on the 125-name portfolioThe investor would lose the entire notional for a loss of 3%A loss of 3.36% corresponds therefore the loss of the full notionalThe investor pays €10 MM to the protection buyerThe protection buyer stops paying the spreadThe loss portion exceeding 3% (0.36%) triggers settlement cashflows for

buyers and sellers of the 3-6% tranche

Correlation ProductsCorrelation ProductsTranched Tranched DJ DJ iTraxxiTraxx: : Mechanics for Equity Mechanics for Equity Tranche (Tranche (cont'dcont'd))

InvestorInvestor

DJDJ iTraxxiTraxx EuropeEurope€10 MM


October 7/14, 2004157

Correlation ProductsCorrelation ProductsTranched Tranched DJ DJ iTraxxiTraxx: Sample Market : Sample Market QuotesQuotes

October 7/14, 2004158

Outlook...Outlook...

Total Return Total Return Swaps Swaps

(TRS)(TRS)

Equity Equity Default Default SwapsSwaps

(EDS)(EDS)

ConstantConstant--Maturity Maturity CDSCDS

(CMCDS)(CMCDS)

Digital Default CDSDigital Default CDS

(DDS)(DDS) Recovery Recovery SwapsSwaps

(RCDS)(RCDS)

Spread Spread CDSCDS

(SCDS)(SCDS)

................

Outlook...

October 7/14, 2004159

• The J.P. Morgan Guide to Credit Derivatives, JPMorgan / RISK, 2000• Credit Derivatives and Structured Credit, Bowler T and Tierney J.F., Deutsche Bank, August 2000• Credit Derivatives Explained, O'Kane D, Lehman Brothers, March 2001• Global Credit Derivatives: Risk Management or Risk?, Special Report FitchRatings, March 2003• Kreditderivate: Implikationen für die Kreditmärkte, Effenberger D, Deutsche Bank, June 2003• Global Credit Derivatives: A Qualified Success, Special Report, FitchRatings, September 2003• Credit Derivatives: A Case of Mixed Signals?, Credit Market Research, FitchRatings, December 2003• Kreditderivate: Wirkung auf die Stabilität der Finanzmärkte, Effenberger D, Deutsche Bank, April 2004• The Lehman Brothers Guide to Exotic Credit Derivatives, Lehman Brothers, 2004• Corporate use of credit derivatives: next stop in risk management, Morgan Stanley / RISK, May 2004• Credit Derivatives: An Overview of Market Participants & Activity, Benison T, JPMorgan, 2004

ReferencesReferencesGeneralGeneral

October 7/14, 2004160

• Credit Risk Modelling and Credit Derivatives, Schönbucher P J, Dissertation, Bonn 2000• Valuing Credit Default Swaps I: No Counterparty Default Risk, Hull J C and White A, The Journal of Derivatives, Fall 2000• Credit: The Complete Guide to Pricing, Hedging and Risk Management, Arvanitis A and Gregory J, RISK Books, 2001• Price and probability, Martin R, Thompson K and Browne C, RISK, January 2001• Credit Swap Valuation, Duffie D, Financial Analysts Journal 55(1), 1999, reprinted in Credit 2001•Valuing Default Swaps Under Market and Credit Risk Correlation, Jarrow R A and Yildirim Y,The Journal of Fixed Income, March 2002• Credit Derivatives Pricing Models, Schönbucher P.J., John Wiley & Sons, June 2003

References References TheoreticalTheoretical

October 7/14, 2004161

• Asset Swaps, Tim Frost, JPMorgan, December 1995• Railtrack and SAirGroup, Harvey R and Adams J, JPMorgan, October 2001• Unwind valuation of Credit Default Swaps, Goldman Sachs, December 2001• Fundamentals of the Default Swap Market, Corey J and Poprik B, Deutsche Bank, December2001• Credit Linked Notes – The Mechanics, Palmer A et al, JPMorgan, August 2002• Understanding the basis, Van den Bok A, ABN AMRO, January 2003• Fitch Examines Effect of 2003 Credit Derivatives Definitions, Special Report, FitchRatings, March 2003• Introduction to Credit Derivatives, Mettler B, JPMorgan Credit Derivatives Conference, 2004• Credit Derivatives Pricing and Research, Beinstein E, JPMorgan Credit Derivatives Conference, 2004• Credit Derivatives Documentation, Thompson D, JPMorgan Credit Derivatives Conference, 2004• Bond spreads as a proxy for credit default swap spreads, Davies M and Pugachevsky D, Bear Stearns / RISK, 2004

References References SingleSingle--name name CDS/CLNCDS/CLN

October 7/14, 2004162

• Dow Jones TRAC-X, Mettler B, JPMorgan Credit Derivatives Conference, 2004• Introducing DJ iTraxx Europe Series 1, Due J et al, JPMorgan, June 2004• Dow Jones iTraxx CDS Indices Europe, www.iboxx.com, June 2004• Computing Intrinsic Spreads of Portfolio Credit Default Swaps, Baheti P and Naldi M, Lehman Brothers, July 2004• Pricing and hedging credit default swaps on indices, Davies M and Pugachevsky D, Bear Stearns / RISK, 2004• Basic CDS Index Analytics, Derivatives Week, June 2004

References References Credit Index CDS/CLNCredit Index CDS/CLN

October 7/14, 2004163

• Corporate Bond Options, Kakodkar A and Francis C, Merrill Lynch, June 2003• An Introduction to Credit Options, Spinner A, Derivatives Week, May 2004• Credit option trading comes of age, Macaskill J, RISK, May 2004• Credit spread warrants, Park S, Dresdner Kleinwort Wasserstein, 2004• Index Monitor: Credit Spread Warrants, Stangl G and Schon C, Dresdner Kleinwort Wasserstein, May 2004• Credit Options Primer, Lehman Brothers, June 2004• Bets on for credit spread warrants, RISK, July 2004• Covered Credit Spread Warrants, Introducing credit options to corporate bond investors, Nevstad H, Dresdner Keinwort Wasserstein, July 2004

References References Credit Credit OptionsOptions

October 7/14, 2004164

• First to Default Basket Swaps, Tierney J.F., Deutsche Bank, February 2002• Introducing Dow Jones Tranched TRAC-X, McGinty L et al, JPMorgan, November 2003• Introduction to Correlation Products, Mazur B and Mettler B, JPMorgan Credit DerivativesConference, 2004• Credit Correlation: A Guide, McGinty et al, JPMorgan, March 2004• Introducing Base Correlations, McGinty et al, JPMorgan, March 2004• A Model for Base Correlation Calculation, McGinty L and Ahluwalia R, JPMorgan, May 2004• Introducing Standard First to Default Baskets, McGinty L, Harris M and Due J, JPMorgan, July2004• A Model for First to Default Implied Correlation Calculation, McGinty L et al, JPMorgan, July2004• The Bank of America Guide to Advanced Correlation Products, Bank of America, 2004

References References Correlation ProductsCorrelation Products

Documents

Credit Derivatives 1