The World of Credit

A chronology from 1999 to 2008

 Contacts 5

The world of credit:

a chronology from 1999 to 2008
Editor Natasha de Terán Pictures: Alamy, photolibrary, Corbis,
Eurex editorial adviser Byron Baldwin Reuters, Getty
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4 Contents

34 63
Contents
The World of Credit
A chronology from
1999 to 2008

70 94
 Contents 5

3
Forewords 24 Credit derivatives: 49 Regulatory intervention
8 The world of credit the basic instruments, the users By John Ferry
By Michael Peters, global head of sales, and the uses
member of the Eurex Executive Board By Hardeep Dhillon 54 Automation, transparency
and the aftermath of regulatory
12 Indexing for growth 28 Evolution of the credit intervention
By David Mark, chief executive, derivatives market By John Ferry
International Index Company By Hardeep Dhillon
58 The Bloomberg Pricing Model
15 Cataloging changes in the 34 iTraxx® Indexes – the global By Mirko Filippi, Bloomberg LP
credit markets benchmark for the credit markets
By Natasha De Terán, editor, By Tobias Spröhnle, 63 Eurex iTraxx® Credit Futures
The World of Credit International Index Company By Michael Hampden-Turner and
A chronology from 1999 to 2008 Michael Sandigursky, Citigroup
38 The upsides
The landscape By Natasha de Terán Case studies
18 The growth of the 70 Portfolio overlay strategy using
credit markets 42 The darker side of credit derivatives Eurex iTraxx® Credit Futures
By Hardeep Dhillon By John Ferry By Byron Baldwin, Eurex

131 78

74 Generating alpha – trading credit
versus equity and equity volatility
on exchange
By Byron Baldwin, Eurex
78 Credit futures: application
and strategies
By Jochen Felsenheimer,
HypoVereinsbank
82 Making the case for
credit derivatives
By Sarah Smart,
Standard Life Investments
85 A look back at May 2005: Did the
models cause the correlation crisis?
By Ammar Kherraz, Morgan Stanley
Investment Management
90 Credit indexes: an efficient route
to asset allocation
By Gareth Quantrill, Scottish Widows
Investment Partnership
94 Playing the spread dispersion
using index arbitrage
By Fabrice Jaudi and Alexandre
Stoessel, ADI Alternative Investments
97 Using iTraxx® across the
fund spectrum
Natasha de Terán interviews
Raphael Robelin from BlueBay
Asset Management Plc
99 Evaluating opportunities in the
credit markets
By Chetlur Ragavan, BlackRock
104 Making the most of new
credit opportunities
John Ferry interviews Graham Neilson
from Credaris
107 Using iTraxx® in exotic structures
Natasha de Terán interviews
Ryan Suleimann from
Fortis Investments
110 The use of iTraxx® in
structured credit
Natasha de Terán interviews
Igor Yalovenko from WestLB
114 CDS and iTraxx®: adding to the
fixed income manager’s armory
By Maria Ryan, Barclays
Global Investors
Contents 7
118 No free lunch, but a
good opportunity to
make money
By Riccardo Pedrazzo,
Banca IMI
122 The use of iTraxx®
Options in corporate
bond portfolios
By Stefan Sauerschell,
Union Investment
126 Opportunity funds:
the thinking investor’s CDO
By Dipankar Shewaram,
BlueBay Asset Management
131 The use of iTraxx®
Indexes in traditional euro
corporate portfolios
By Martine Wehlen-Bodé,
UBS Global Asset Management
Conclusion
134 Credit derivatives:
outlook, challenges and
perspectives
By Natasha de Terán
122
8 Foreword

The world
of credit
By Michael Peters
Global Head of Sales
Member of the Eurex Executive Board

I
nnovation and growth in the
credit markets have been
rampant since credit deriva-
tives first emerged. Many
investors have migrated to, or
been drawn to, credit and, as a
result, the market is now as
sophisticated as any of the longer-standing,
larger asset classes. Funds have poured into
the sector as investors that previously
shunned or ignored the market have waded
in. Even those that have remained on the
sidelines no longer can ignore it – they look
closely at movements in the credit area to

Innovation and growth in

the credit markets have been
rampant since credit
derivatives first emerged

identify possible trends and imminent shifts
that will affect their own markets.
As a result, credit derivatives have experi-
enced explosive growth. The notional volumes
of traded credit default swaps (CDS) had
risen from less than USD 1 trillion in 1996 to
more than USD 49 trillion by the end of
2006, according to rating agency Fitch. And
there is no evidence that it is slowing down.
The credit index market has enjoyed no less
spectacular a trajectory: having represented
just 9 percent of transaction turnover in
2004, they account today for nearly 50
percent of total volumes. Eurex is privileged
to be playing a part in the development of
this market and honored to be working with
Credit derivatives have
experienced explosive
growth.The notional
volumes of traded credit
default swaps had risen
from less than USD 1 trillion
in 1996 to more than USD
49 trillion by the end of 2006
the International Index Company (IIC), the
firm behind the benchmark iTraxx® Indexes.
In bringing the first-ever listed credit futures
contracts to the market, Europe’s largest
derivatives exchange will be working
together with the benchmark index provider.
The combination is undeniably compelling.
The IIC’s iTraxx® rules-based Indexes are
the most widely followed, the most
objective and the most transparent CDS
indexes in the European market. Eurex,
meanwhile, offers a broad range of interna-
tional benchmark products and operates the
most liquid fixed income markets in the
world, with open, equal, and low-cost elec-
tronic access. With market participants con-
Foreword 9
nected from 700 locations worldwide,
trading volume at Eurex exceeds 1.5 billion
contracts a year. The exchange already lists
the flagship European fixed income and
equity index futures contracts. The Euro-
Bund Futures are the world’s most heavily
traded bond futures and the benchmark for
the European yield curve. They are often
used as the standard reference by those
comparing and evaluating interest rates in
Europe and managing interest rate risk.
On behalf of everyone at Eurex, I hope
you will find this publication stimulating
and interesting – and the new Eurex iTraxx®
Credit Futures a useful addition to your
trading toolbox.
12 Foreword
Indexing for
growth
By David Mark
Chief Executive
International Index Company (IIC)
L
ooking back over the
emergence of credit as
an asset class, it is clear
that the pace of devel-
opment has been
meteoric. This holds as true
for the sell-side’s ingenuity
in devising new products
and structures as it does for investors’ fast-
grown appetite and for the establishment of
standardized, widely followed market indexes.
The emergence of credit indexes dates
back just a few years. It was early 2004; a
number of investment banks had packaged
some credits and called the result a credit
derivatives index. Some had even devised a
few basic rules to support their indexes, but
the indexes served mainly to provide easy
references for baskets of credits.
This was convenient for the sell-side, but
for obvious reasons it proved difficult for
buy-side institutions: the lack of standardi-
zation made it difficult to trade the products
with anyone other than the issuing bank. The
result was the same as it would be for any
market lacking standardized index products –
higher bid/offer spreads and lower volumes.
It became increasingly apparent that end
customers would be better served by a single,
transparent, objective set of market stan-
dards. Hosting this at an institution far
removed from a single bank’s trading floor
was another imperative. This did not mean
limiting the number or type of products, but
rather having only a single reference point,
such as an industry-wide accepted index.
The next steps involved convincing
investment banks that, despite having to
give up proprietary indexes, they would
both be able to retain control through index
governance and, ultimately, benefit from
that. Fortunately, the banks soon recognized

this, realizing that they were likely to see
greater trading volumes from increased
standardization.
And so the iTraxx® Index idea was born.
In the absence of credit derivatives being
publicly traded and there being no readily
available volume data, it was agreed that the
iTraxx® Indexes would be investable, reflecting
the most liquid traded credits, as measured by
data provided by the sell-side. Diversification
would be ensured through relevant rules,
designed to prevent concentration.
Even making allowance for the benign
credit environment of recent years, the
resulting volumes of index trades (and their
share of all credit derivatives trading) have
surpassed the most optimistic projections.
Such volumes prove that common, trans-
parent, objective standards and readily
available data build confidence and can be a
huge help in driving the development of
‘newer’ asset classes.
In addition to direct index trades, there has
been a proliferation of second and third gen-
eration products based on, or referring to,
It became increasingly
apparent that end
customers would be
better served by a single,
transparent, objective set
of market standards
the iTraxx® Indexes. These have been
developed by investment banks in response
to buy-side needs.
As an index company we serve the needs
of all market participants and thus continue
to see our role as multi-faceted. Naturally, we
will continue to update the current iTraxx®
Indexes and, from time to time – when
market conditions warrant – we will make
small changes to the index rules. At all times,
such changes will follow close consultation
with participants, ensuring that the indexes
reflect the market’s needs.
We will also continue to expand our index
family to include other, closely related asset
classes – for instance, we recently launched
the iTraxx® LevX® Indexes, extending our
coverage to leveraged loans. And in the
future we will doubtless broaden our geo-
graphical reach – entering newer or
emerging markets, such as the Eastern
European or CIS countries.
The principles governing iTraxx® will,
however, remain unchanged: to develop and
publish indexes that are independent,
Foreword 13
objective, transparent and accessible. As for
any new index, the primary goal will always
be to ensure that it is driven by the needs of
market participants, and becomes the
market-leading index in its field.
It is only by strictly adhering to these gov-
erning rules that iTraxx® has succeeded so far
– and, in particular, achieved its most notable
success: broadening credit’s appeal. While the
initial development of credit as an asset class
was largely focused on trading between the
‘street’ and hedge funds, more classical buy-
side institutions only increased their
involvement in the market once the indexes
had become more established.
The introduction of a wider range of index-
based products, such as the Eurex iTraxx®
Credit Futures, takes another step in this
direction. These futures will doubtless further
broaden participation in this asset class by
attracting those who do not wish, or do not
have the ability, to trade OTC derivatives. IIC is
delighted to have worked with Eurex to
produce the contracts and wishes the
exchange every success with the products.

W
riting about such
a fluid and fast-
moving subject as
the derivatives
business is rarely – if
ever – unexciting. But
trying to pin down such an
elusive quarry can be unusually challenging–
and putting together this book has proved to
be no exception.
Between inception and publication, sen-
timent in the credit markets has shifted dra-
matically. At the time of writing, it is impos-
sible to determine exactly how matters will
play out, but one thing is certain: the events
of recent months have underscored not only
the central position that the credit industry
now holds in the wider financial markets,
but also the pivotal role that the iTraxx®
Indexes now play in the credit markets.
The iTraxx® Indexes have become such
critical market indicators that they are no
longer followed just by dedicated credit pro-
Cataloging
changes in the
credit markets
By Natasha de Terán
Editor
The World of Credit
A chronology from 1999 to 2008
fessionals. Movements in the indexes have
been widely tracked throughout the last few
months, and their progress has been scruti-
nised and reported on by all sectors of the
media. The iTraxx® Crossover, HiVol and
Main Indexes were referenced no less than
32 times during July 2007 in The Financial
Times alone.
Market events have also demonstrated
just how important a liquid, transparent
and tradable benchmark credit instrument
is set to become. Credit is now firmly
established as an asset class, and credit
derivatives and credit index products are
the most widely used instruments within
the market. An exchange-traded credit
futures product, that can be used quickly,
efficiently and cheaply, could dramatically
improve the market. It could attract new
market users and generate even greater
trading volumes.
Thanks to central counterparty clearing,
there is no double credit risk in trading
Foreword 15
credit futures, enabling users to discount
their worries about counterparty credit risk
deterioration, as well as their concerns over
increased correlations between counterparty
credit risk and underlying credits. Such a
facility will always be a bonus, but in times
of stress, like those we have recently been
witnessing, these considerations come to
the fore.
Listed credit products, such as the Eurex
iTraxx® Credit Futures contracts, should also
serve to demystify the credit world, increase
transparency and allay fears about risk con-
centrations, over-the-counter trade backlogs
and legal documentation issues.
Those asset managers, analysts and traders
that have kindly contributed to this book
have been unambiguous in their regard for
these instruments. They welcome the emer-
gence of the first exchange-listed futures
products and look forward to using them
more extensively – and not just in times of
stress, but in the daily run of business.
 18 The landscape

The growth of the

credit markets
The development of the credit markets has transformed the European investment landscape.
Hardeep Dhillon looks back at the early evolution of the market

T
he European credit
markets have
undergone a par-
adigm shift since the
introduction of the
euro in 1999. Market
participants have now
grown accustomed to
viewing Europe’s credit market as being
much on a par with the U.S. – busy, buoyant,
liquid and integrated – and many may,
therefore, fail to recall the state of affairs
that existed before the European Economic
and Monetary Union (EMU).
When the London-based investment bank
S.G. Warburg & Co. pioneered the first
eurobond back in July 1963, a USD 15 million
deal launched by the Italian toll road
operator Autostrade, the stage was set for
the growth of the European credit markets;
but the markets failed to respond. For
decades after – indeed until EMU – they
The arrival of the single
European currency
lowered the costs of
issuing and investing in
bonds by eliminating
currency risk and reducing
transaction costs. It drove
supply and demand
remained fragmented, heterogeneous and,
because of the numerous currencies involved,
they also lacked the depth and breadth of
the dollar credit market.
The evolution of a pan-European fixed
income market was further hindered by cor-
porates borrowing in their local currency, and
by national laws that required insurance
companies and pension funds to invest large
portions of their assets in their local currency.
The euro
The euro was introduced to world financial
markets as an accounting currency on
January 1, 1999, and launched as physical
coins and banknotes in 2002. It replaced the
transitional European Currency Unit (ECU).
The arrival of the single European currency
lowered the costs of issuing and investing in
bonds by eliminating currency risk and
reducing transaction costs. It drove supply
and demand.
The
Case
landscape
studies 19
The European bond market, initially domi-
nated by a handful of top-tier banks and
financial issuers, has since undergone a
remarkable transformation. Today, it encom-
passes a broader quality range of issuers, and
a more eclectic representation of sectors, and
has effectively changed Europe’s ‘currency
culture’ into a ‘credit culture’.
How has this happened? Well, in part
because the trend of decreasing government
bond issuance and low interest rates on
these transactions forced many more
investors to look to corporate bonds for
enhanced yield. This provided the impetus for
an increased supply of investment-grade
bonds – with high credit quality and rela-
tively low risk of default – and high yield, or
so-called ‘junk’ bonds, which are rated below
investment grade at the time of purchase
and have a higher risk of default.
A shift in behavior away from unprofitable
bank financing was a major driver of bond
issuance. A similar trend had earlier shaped
the U.S. market, where reduced lending
margins and a deterioration in the credit
quality in bank lending books further
encouraged the growth of corporate bonds.
An increasing number of U.S. and interna-
tional issuers that entered the Eurobond
market in an attempt to diversify their
funding sources engendered further devel-
opment and variety. Meanwhile, the bursting
of the Dotcom bubble in 2000 and the
resultant underperformance of stock markets,
and the contraction of most European
economies, precipitated an auxiliary move by
local market participants away from equity-
financing towards bonds. Finally, the raft of
high-profile corporate bankruptcies that hit
the market around this point – not least
Enron, Global Crossing and WorldCom –

led banks to tighten their lending policies
still further.
The European corporate sector facilitated
this process of bank disintermediation by
loosening its ties with the commercial
banking sector and turning to the debt
capital markets for direct funding. As a result,
the bond market soon came to be regarded
as a more efficient and cheaper means of
financing than traditional bank lending.
Companies quickly recognized that it was
much more flexible and did not include
many of the restrictive financial covenants
of bank loans.
This, in turn, led to an increase in the
number of one-off borrowers, lesser known
and lower-rated companies, that had previ-
ously either been restricted to their local cur-
rency markets or had been dependent on
bank loans. By accessing the bond markets,
companies were not only able to diversify
their funding sources, but also their creditor
base, because bonds were syndicated over
many more investors in Europe and abroad.
The early years
In the aftermath of the euro’s introduction,
there was an initial period of major leveraging
by companies. Dominating corporate bond
supply were the telecom companies, which
piled more debt onto their balance sheets to
finance the cost of 3G licences, followed by
the auto industry and utility companies. A
low interest rate environment enabled the
refinancing of transactions at a lower cost,
while the pressure on firms to improve
returns and shareholder value, and the need
to address pension fund shortfalls, were also
factors in supporting issuance.
The pace of mergers and acquisition
(M&A) activity in Europe – which was pri-
Dominating corporate
bond supply were the
telecom companies, which
piled more debt onto their
balance sheets to finance the
cost of 3G licences, followed
by the auto industry and
utility companies
marily driven by large scale M&A deals in the
telecom, bank, industrial and energy sectors,
and by leveraged buyouts by private equity
firms – contributed substantially to keeping
the bond market buoyant.
Foreign companies also targeted the
European market as an alternative source of
financing. Those with European businesses
were able to capture potentially lower yields
in the euro market through transactions that
did not have to be swapped back into U.S.
dollars. Indeed, ever since Xerox and Gillette
launched debut EUR-denominated deals in
January 1999, there has been a steady flow
of transactions from other North American
and international corporates.
The increase in market liquidity, and the
development of a large and liquid pool of
assets, nurtured a growing number of
investors at a time when government bond
The landscape 21
issuance was falling sharply. Investors began
to acquire corporate bonds in ever-larger
numbers, due to the declining returns on
government bonds and a perceived yield pick-
up over traditional instruments.
Another development was the increase in
the number of institutional investors that had
become comfortable investing in bonds
further down the credit quality curve than
would have been imaginable even five years
ago. Institutional investors still have an over-
whelming demand for equities, but the
growth in demand from this sector strongly
supported the bond markets. To a large
extent, this is because some institutional
investors, mainly pension funds and insurance
companies, have long-term obligations and
need to match the tenors of their assets and
liabilities – a factor that committed them to
investing in the corporate bond market.
 22 The landscape

The primary and secondary markets
Bonds are sold first in the primary market,
also known as the new issue market. Here,
borrowers, banks and investors come
together to launch a transaction through a
book building process, which determines the
price and level of demand for the bonds.
The investment bank, also known as the
underwriter or book runner, assists the
issuer to structure the bond and prepares
the documentation.
Depending on the size and structure of the
transaction, either a sole underwriter or a
syndicate of underwriters can be involved.
The underwriter acts as an intermediary,
buying the bonds from the issuer and then
reselling them to investors. Most of the
money received from the sale of the primary
issue goes to the issuer. The investment
banks earn fees and can make a profit by
selling the bonds for more than they paid.
It is on the secondary market that bonds
are bought and sold following their original
sale. This trading is predominantly con-
ducted over-the-counter (OTC), either by
telephone or on electronic trading plat-
forms. The secondary market offers
investors some flexibility in the pricing and
timing of their bond trades, and investors
who sell bonds receive the profits, minus
any fees or commissions. The issuer of the
bonds plays no role in trading on the sec-
ondary market, nor receives any proceeds
from these transactions.
of institutional investors to buy and hold
bond assets, thereby further dampening both
trading activity and liquidity.
Certain segments, such as the gov-
ernment bond market, were more liquid
and relatively transparent, but the corpo-
rate bond segment continued to lack trans-
parency because of the absence of any
established central source of independent
data and pricing information. Banks were
the primary source of information for
industrial and lower-rated companies and
little attention was paid to the role of credit
analysis. Instead, investors simply focused
on higher-quality debt. Investment man-
dates also restricted many from investing
in lower-quality, high yield bonds.
At this time, obtaining data was often
cumbersome and even then it was expensive
to access and analyze. The lack of European-
The underwriter acts as
an intermediary, buying
the bonds from the
issuer and then reselling
them to investors
wide regulation or legislation, combined with
the relative immaturity of the market,
created a number of poor market practices,
including the lack of disclosure, timely docu-
mentation and adequate covenant protec-
tions in bond prospectuses.
To add insult to injury, investors could be
subject to declines in bond prices and had no
way to safeguard against this. Many investors
held bonds until maturity, so they would only
profit if the assets rose in value. Benefiting
from a decline in the price of a bond, or
shorting, was difficult because the associated
lending fees and transaction costs could
render it uneconomic. Finding matching
counterparties was also difficult, because the
bond market was far less concentrated than
the equity markets and, typically, each issuer
had several bonds outstanding with different
maturities and structures.

Teething problems
In the early years, poor liquidity in the sec-
ondary market for corporate bonds was a
major constraint on investors’ involvement,
because the trading in many issues was
small. Another hindrance was the tendency
24 The landscape

Hardeep Dhillon explores the early days of the credit derivatives

market – the basic instruments, their users and applications

Credit derivatives: the

basic instruments, the
users and the uses

T
he arrival on the
scene of credit deriva-
tives was to transform
the European credit
markets radically. The
instruments alleviated
many of the problems
discussed in the previous
chapter and fostered a dramatic surge in
investor interest.
Credit derivatives emerged from the secu-
ritization of mortgaged-backed securities in
the 1980s, when credit risk was hedged by
transferring the actual assets from the books
of bank lenders. The derivatives instruments
were first traded sporadically at the end of
the 1980s, but it was the 1990s that proved
to be decisive for the fledgling market.
The pioneers of credit derivatives were
those banks – prominent among them
JPMorgan, Merrill Lynch, Credit Suisse and
Bankers Trust – that had attempted to devise
Although a number of
European banks had been
analyzing how to structure
contracts, it was another U.S.
investment bank, JPMorgan,
which first set the European
market in motion
financing solutions that would provide
insurance against the risk that a bond or loan
would default. They subsequently began
marketing nascent forms of credit derivatives
to the wider markets, but it took a number of
years before a real market for the products
began to emerge.
The first deals
The U.S. investment bank Merrill Lynch is
credited with launching the first credit deriv-
ative, a USD 368 million contract, in 1991.
And the following year the International
Swaps & Derivatives Association (ISDA®)
first used the term ‘credit derivatives’ to
describe this new, exotic over-the-counter
(OTC) contract.
Although a number of European banks
had been analyzing how to structure con-
tracts, it was another U.S. investment bank,
JPMorgan, which first set the European
market in motion. Combining derivatives
The
Case
landscape
studies 25
with credit was still a novel and unproven
idea, but in 1994 JPMorgan’s London deriva-
tives desk structured a ‘first to default’ swap.
It was designed to insure against the default
risk of three European government bonds
and safeguard the bank against risks in its
growing government bond trading business.
A further defining moment came in 1997,
when JPMorgan launched its Broad Index
Secured Trust Offering (Bistro), a transaction
that transferred a significant amount of
diverse credit risk to an external company or
special purpose vehicle (SPV). By employing
credit derivatives to offload the risk on a
USD 9.7 billion corporate loan portfolio,
Bistro helped JPMorgan both to clean up its
balance sheet and manage its risk. The bank
quickly grasped its wider application and
began touting the solution to other firms
with ever-increasing success.
Credit derivatives steadily gained traction
thereafter, as banks’ derivatives and swaps
desks grew ever more involved. By 1995,
the market for contracts written on indi-
vidual companies, or single-name credit
default swaps (CDS), was flourishing. It
swelled further when more sophisticated
fixed income managers started to come
into the market in 1997.
By this time, there were estimated to be
up to 15 dealers that were willing to quote
prices in basic instruments in the U.S. market.
The old guard of banks – JPMorgan, Bankers
Trust, Merrill Lynch, Credit Suisse First Boston,
Chase Manhattan, Bear Stearns and CIBC
Wood Gundy – was now being supplemented
by newer entrants like Lehman Brothers,
Citibank and Bank of Montreal.
Despite the heavy involvement of North
American banks, by 2000, it was London
that emerged as the dominant center in the
 26 The landscape

global credit derivatives market. It boasted

about ten active Market Markers and a
much larger number of banks involved in
niche areas, together with the necessary
core of non-bank underwriters and inter-
dealer brokers.
Pivotal to the growth of the European
market was the imminent arrival of the New
Basel Accord and its capital adequacy rules.
These require banks to apply minimum
capital standards and hold a certain level of
reserves against assets, and played a funda-
mental role in forcing banks to improve the
risk profile of their balance sheets. Against
the backdrop of the incoming regulation,
banks saw credit derivatives as powerful
tools that could be used to isolate and lay
off unwanted credit risks. They realized they
could manage their loan and credit port-
folios better, if they protected themselves
against potential losses by transferring the
credit risk to another party, while keeping
the loans on their books.
The classic role of CDS in the early days
was, therefore, to hedge concentrations of
risk, improve the diversity of exposure and
reduce the amount of capital that banks
needed to allocate to their portfolios. Banks
also used CDS to reduce credit risk exposure
to counterparties, enabling them to continue
to offer loans without exceeding internal risk
concentration limits.
The emergence of credit as an asset class
had already highlighted the concomitant
hazards: investors appreciated that bonds
were far from risk free and were, therefore,
attracted to a form of credit protection
against so-called ‘event risks’. This base of
users, meanwhile, grew to include insurance
companies, hedge funds, corporates and
asset managers.
Source: Brian Eales Study, The Case for Exchange-based Credit Futures Contracts, 2007
The CDS product
Whereas bonds and loans are financial con-
tracts between a borrower and a lender,
credit derivatives – and specifically CDS con-
tracts – are contracts between two counter-
parties that reference a specific borrower.
In essence, the CDS is an OTC insurance
policy that transfers the credit risk of a par-
ticular corporation or government from one
party to another. A standard CDS contract is
a privately negotiated bilateral agreement
where one party, the protection buyer, pays a
periodic fee or premium to another, the pro-
tection seller. The contract is designed to
cover potential losses that could damage a
loan or bond as a result of unforeseen devel-
opments, or a credit event (see chart, above).
A credit event includes instances where
the reference entity on which the contract is
written is unable to pay its debts, such as a
bankruptcy or restructuring. If a credit event
is triggered, then the seller of protection will
make a payment to the buyer of the contract.
Buying credit protection is equivalent to
shorting the credit risk, while selling is
termed as ‘going long’ a reference entity.
The early issues
Although the credit derivatives market
expanded at a record pace, the instruments
faced resistance from many quarters and
experienced a number of teething problems.
Initial concerns related to banks’ increasing
counterparty exposure through their use of
credit derivatives, because these contracts
were only as robust as the counterparty to
the trade. Many potential users and outside
observers were wary about the product,
noting how it still had to be tested in a
serious downturn.
Some commentators were particularly
scathing. Among other things, credit deriva-
tives were labeled ‘fool’s gold’, and likened to
‘games of Russian roulette’: one influential
critic, no less than Berkshire Hathaway’s
investment magus, Warren Buffett, went so
far as to term them “financial weapons of
mass destruction”. Even the rating agency

Standard & Poor's is reported to have had its
reservations, initially refusing to rate credit
derivatives products.
One critical element in limiting the
expansion of CDS in the early stages was the
absence of any broadly accepted and stan-
dardized documentation that could clarify the
precise terms and conditions of contracts.
Liquidity was hampered because the Inter-
national Swaps and Derivatives Association
(ISDA®) had yet to finalize documentation for
basic credit derivatives structures or for
standard definitions of credit events.
ISDA® had published a standardized letter
confirmation – allowing dealers to transact
under the umbrella of an ISDA® Master
Agreement – in 1991, but it was not until
1999 that formalized guidelines for sovereign
and non-sovereign CDS contracts appeared.
Prior to this, contracts tended to be nego-
tiated on an ad hoc basis between buyers
and sellers of protection. Not only did this
routinely delay transactions, but it also
opened up the possibility of disputes when
credit events occurred.
As the Bank of International Settlements
(BIS) commented: “Risk shedders appear,
sometimes, to have been able to exploit the
terms of credit derivatives agreements at the
expense of risk takers, insofar as payments
under CDS contracts are not conditional on
actual losses.”
Another problem concerned the settlement
of CDS contracts and the issue of deliverable
bonds. In some circumstances, the physical
settlement option was not always available
since CDS were being used to hedge exposures
to assets that were not readily transferable, or
to create short positions for users who did not
own deliverable obligations.
In addition, the absence of insurance-spe-
The landscape 27
cific regulations addressing credit derivatives
prevented some insurance companies from
entering the market. There was also a lack of
clarity from regulators as to the impact of
credit derivatives on European banks’ credit-
related capital charges and the levels of
capital allocation required on a financial insti-
tution’s balance sheet against outstanding
credit derivatives contracts.
One more stumbling block to liquidity
was the absence of a balanced two-way
market – quite simply, there were more
hedgers looking to lay off credit risk than
there were buying it. As a result, initial deal
sizes remained limited to trades in the
region of EUR 25 to 50 million.
Pricing transactions was also a challenge
because there was no industry-standard
pricing model for credit. This meant that
traders were often obliged to analyze the
price of the underlying asset to provide an
indication of the levels at which a CDS
might be priced or traded. This was some-
what easier to gauge for more liquid bond
issues and for frequent borrowers, but the
test for many was to price credit derivatives
based on debt instruments for which there
was little available public information or no
credit rating.
Finally, risk management tools and quan-
titative models were still in development,
and many firms were in the early stages of
implementing credit value-at-risk or other
quantitative credit risk management
methodologies.
The combination of all these factors meant
that even though the issues did not actually
stall the CDS market, they served to unnerve
many of its participants and, in doing so,
hampered the develop-ment of next-gener-
ation credit products based on CDS.
 28 The landscape

Evolution of the credit

derivatives market
The credit derivatives market opened up a plethora of opportunities for investors.
Hardeep Dhillon assesses the impact they had on different corners of the credit world
 The
Case
landscape
studies 29

W
hen the British
Bankers’
Association (BBA)
first began collating
statistics on the credit
derivatives market in
1996, volumes totalled
some USD 180 billion. Five
years later, they had grown to USD 1
trillion, and the BBA’s most recent forecasts
suggest they will accelerate to USD 33
trillion by 2008, up from 2006’s figures of
USD 20 trillion.
The market’s rapid growth over the first
years of this century – as well as its sub-
sequent evolution – owes much to two
principal factors: the introduction of
standardized International Swaps &
Derivatives Association (ISDA®) documen-
tation and the arrival of the iTraxx®
Index family.
A dispute between
The legal documentation
The publication of the ISDA® Standard
Agreement in March 1999 was critical in
assisting the expansion of the market to a
wider investor base. The new Master
Agreement was developed in response to dis-
agreements between buyers and sellers in the
wake of the 1998 Russian default and, in
particular, whether the delay in payments on
the City of Moscow’s debt constituted a
credit event. The English courts ruled in favor
of the buyers, but doubts remained.
In response to ongoing market events,
ISDA® issued three supplements to the 1999
guidelines within the next two years. These
new definitions were soon put to test when,
in October 2000, the U.S. life insurer Conseco
extended the maturity profile on USD 2.8
billion worth of bonds and loans. Some par-
ticipants questioned whether such a restruc-
turing should constitute a credit event
because it did not inevitably lead to losses.
Others viewed it as being indisputably a neg-
ative credit development.
ISDA® responded in May 2001, with the
publication of a Restructuring Supplement
that provided counterparties with a selection
of four ‘modified restructuring clauses’.
The issue of successor events came to the
fore only a month later, when U.K. utility,
National Power, demerged into two com-
panies, thereby creating two successor
entities. This resulted in uncertainty over
which would be the new reference entity for
existing credit default swap (CDS) contracts
– at the time the ISDA® documents only
stipulated a successor assuming ‘all or sub-
stantially all of the obligations’. ISDA® subse-
quently published the Successors and Credit
Events Supplement in November, stating
that the new reference entity would hold 75
percent or more of the bonds or loans.
A dispute between Nomura and Credit
Suisse First Boston on deliverable bonds, in
the wake of the Railtrack default in October

Nomura and Credit 2001, prompted a further dispute. The U.K.

courts eventually ruled in February 2003, that

Suisse First Boston on Nomura, the protection buyer, was entitled to

deliver Railtrack convertible bonds as physical

deliverable bonds, in settlement. ISDA® responded by issuing the

Convertible, Exchangeable & Accreting
the wake of the Obligations Supplement.

Railtrack default in An ISDA® working group studied the new

definitions and the latest version, the 2003

October 2001, ISDA® Credit Derivatives Definitions, came

into effect in June that year, incorporating all
prompted a three supplements.

further dispute The iTraxx® Indexes

Secondly, came the indexes. The first tradable
credit derivatives index emerged in 2000
when U.S. investment bank JPMorgan
 30 The landscape
launched the European Credit Swap Index,
quickly followed in 2001 by the High Yield
Debt Index, or HYDI, for the high yield
market. Morgan Stanley’s Synthetic Tracers
on U.S. bonds and JPMorgan’s European
Credit Derivatives Index (JECI) and Emerging
Markets Derivative Index (EMDI), were
launched the following year.
Further competition appeared in April
2003, when Morgan Stanley and JPMorgan
merged their proprietary indexes to form
Trac-x, prompting Deutsche Bank and ABN
Amro to launch the iBoxx® 100, as a rival
competitor for the European market. An
American version of iBoxx® was launched
later in the year, again going head-to-head
with Trac-x North America.
The indexes gained some traction, but by
2004 participants had become convinced
that the establishment of a single, stan-
dardized index would better serve the market.
That same year, iTraxx® was formed out of
the merger of iBoxx® and Trac-x and consti-
tuted the 125 most frequently traded credit
default swaps.
The market’s development
It is hard to overplay the effect of these two
events on the development of the credit
derivatives market. Following the intro-
duction of the standardized documents and
indexes, the market raced ahead: not only
did volumes in single-name CDS explode,
but index trades soared, new users poured
into the market and a plethora of new uses
was found for the products.
Investors already appreciated that credit
derivatives could be used for a multitude of
different applications – the products offered
an extremely flexible method of expressing a
variety of investment strategies with tailored
sizes, currency denomination and maturities.
And because credit derivatives enabled credit
risk to be separated from interest rate risk,
investors found the instruments could be
applied as a substitute for cash bond trades:
they did not necessarily need to buy or sell a
bond or loan to gain exposure to a desired
issuer, nor did there have to be a physical
bond outstanding.
Early uses of the instruments included
hedging individual or single-name credit
exposure, or managing the credit risk of a
total portfolio. Investors also employed them
to increase yield – leveraging the value of
credit derivatives and undertaking basis
strategies to exploit the difference between
cash bond and CDS prices. Credit derivatives
were further used to separate risks embedded
in certain instruments, such as convertible
bonds, and to help firms manage their regu-
latory or economic capital requirements.
Although single-name CDS
were for a long time the
most common instrument,
their dominance has
increasingly been
challenged by a growing
demand for index trades
The expanding product range
It was only after the iTraxx® and ISDA® ini-
tiatives that the credit derivatives product
range really began to expand and diversify.
And although single-name CDS were for a
long time the most common instrument,
their dominance has increasingly been chal-
lenged by a growing demand for index
trades. Indeed, the latest industry survey
from rating agency Fitch estimated that the
volume of index trades outpaced single-
name trades for the first time in 2006.
But combining the indexes did not simply
enhance liquidity in index-based trades
themselves, it enabled a raft of ever more
sophisticated products to be developed.
Some dealers, for instance, had previously
traded tranches based on the indexes
between themselves, but it was not until the
iTraxx® family had been formalized that a
standardized market of index tranches

emerged. Dealers began tranching the new
iTraxx® Indexes almost immediately after
their launch. More importantly, they agreed
to quote standard tranches on these port-
folios, ranging from equity or first loss
tranches (0–3 percent) to the most senior
9–12 percent tranches.
These new tranches not only shared the
same underlying portfolios, and the same
subordination and thickness, but the docu-
mentation supporting the trades was also
standardized, as all the Market Makers had
agreed to confirm with the same documents.
This meant that investors who had traded in
a tranche with one dealer could easily mark
their positions to market, or unwind their
trades with different Market Makers without
any transactional risk.
Standardized tranching also spawned a
host of new products. First-to-default stan-
dardized baskets and other tranched index
products began to appear in 2004, substan-
tially boosting the transparency and effi-
ciency of trading correlation.
Prior to the introduction of standardized
iTraxx® tranches, correlation desks had, to a
large extent, hedged their correlation posi-
tions by generating more client business.
Banks could hedge their market risk by
using the index, but not the entire corre-
lation risk unless they managed to place the
other parts of the capital structure. The
iTraxx® tranches completely changed this.
They permitted banks to create, market and
sell single-tranche structures in record time.
And at far lower cost than had previously
been possible.
Credit-linked notes, basket products and
credit spread options were the first more
structured tools to be used widely, but par-
tially-funded synthetic collateralized debt
obligations (CDOs) also rapidly grew in
importance. One of the most groundbreaking
of the new instruments, synthetic CDOs are
collateralized debt obligations that are
backed by pools of credit derivatives. The
synthetic CDO market soon eclipsed the cash
CDO market because of its greater opera-
tional simplicity. While tight spreads in the
cash market makes it difficult to source
underlying assets for traditional CDOs, syn-
thetic CDO transactions avoid this issue and
have the flexibility to reference credits from
different countries, as well as a range of
The landscape 31
credit assets including loans, mortgage- and
asset-backed securities, high-yield and
emerging market debt.
Volumes also quickly grew in equity-linked
credit products and swaptions, as well as
total return swaps that were developed to
sell customized exposures to investors
requiring a pick-up in yields on their port-
folios. An index option market meanwhile
developed alongside, enabling investors to
buy or sell a current standard iTraxx® CDS at
a future date and given price.
More recent developments have included
the expansion of the iTraxx® family. Since it
first debuted in 2004, dealers started writing
credit derivatives on other debt assets, such as
leveraged loans. iTraxx® expanded its family in
tandem with these developments, launching
its LevX® Leveraged Loan Index in 2006.
CDS have also formed the foundations
for two recent structured credit innovations:
constant proportion portfolio insurance
(CPPI) transactions and constant proportion
debt obligations (CPDO). Credit CPPI is a
leveraged capital-guaranteed deal that ref-
erences CDS portfolios and the iTraxx®
Indexes. There has been a flurry of deals
 32 The landscape
since ABN Amro launched Rente Booster,
the first credit CPPI deal in 2004. The Dutch
investment bank also pioneered CPDOs,
which combine CPPI and CDO technology to
generate returns of 200 basis points over
Libor by dynamically leveraging exposure to
a portfolio of CDS.
The users
As credit derivatives became increasingly
standardized, and these new trading and
investment tools arrived on the market, they
developed into indispensable tools for
investing in credit and managing credit risk.
Consequently, a larger number of traditional
asset managers entered the market. In fact,
by 2004–2005, the range of participants
had expanded to include mutual funds,
pension funds, corporate treasurers and
other investors, all of whom were looking to
transfer credit risk, or for extra yield on
their investments to compensate for the
narrowing returns on conventional cor-
porate and sovereign issues.
Banks, hedge funds and securities houses
nonetheless remained the biggest buyers of
CDS protection, while insurance companies
and monolines tended to be protection
sellers, absorbing much of the market’s
credit risk. Within this broad segregation
there were further divisions: larger com-
mercial banks tended to be protection
buyers, while smaller or regional entities,
such as German Landesbanks, were pro-
tection sellers. Corporates, government and
export credit agencies were net buyers,
while pension funds and mutual funds were
net sellers. Corporates, meanwhile, began to
use CDS to insure themselves against credit
exposures with risky commercial counter-
parties, such as customers or suppliers.
Banks, hedge funds and
securities houses
nonetheless remained the
biggest buyers of CDS
protection, while insurance
companies and monolines
tended to be protection
sellers, absorbing much of
the market’s credit risk
The infrastructure
The development of the market infra-
structure gathered momentum as the
market took off. The interdealer trading firm
Creditex, for instance, launched the first
electronic platform for trading index-based
credit derivatives in 2004. The emergence of
this, and other subsequent dealer-to-dealer
electronic platforms, facilitated greater
transparency and turnover in the interdealer
market, speeding up price dissemination and
market efficiency, thereby enhancing trans-
parency and liquidity, and making trading
easier for dealers.
This evolution highlighted the need for
independent pricing and valuation services
and less reliance on pricing based on dealers’
proprietary models. As a result, and in a
matter of just a few years, a dealer-owned
firm, Markit, emerged as the benchmark
provider of independent data and portfolio
valuations of credit derivatives. A raft of
other providers also entered the market, pro-
viding additional data sources, such as
Interactive Data, SuperDerivatives, Numerix,
Barra Credit and Credit Market Analysis.
The client or dealer-to-customer side of
the market did not, however, evolve so
rapidly. While a growing proportion of
dealer-to-dealer trades were conducted elec-
tronically, the few initiatives launched to
serve the client side of the market failed to
gain traction. Thus, the transparency, liquidity
and operational benefits of the electronic
markets were largely the preserve of the
giant dealer firms.
Nonetheless, the consensus at this time
was that the growing importance of CDS, the
exponential increase in volumes and
improving liquidity would continue apace,
while an ever-expanding pool of investors
would further enhance liquidity.
 34 The landscape
iTraxx® Indexes – the
global benchmark for
the credit markets
Standardized credit indexes are the backbone of the credit markets.
Tobias Spröhnle, from International Index Company (IIC), details how
the indexes are constructed and explains how they are used
I
n recent years, the credit
default swap market has experi-
enced exponential growth. A
major driver behind this has been
the development of a transparent
index market.
Standardized credit default
swap (CDS) indexes revolutionized
corporate credit trading, opening
the door to greater liquidity and trans-
parency, attracting new investors and cre-
ating important standardized vehicles for
the structured credit markets.
Credit indexes are easy and efficient to
trade. Investors can use them to trade
credit risk separately from interest rate
and/or currency risk, to express bullish or
bearish views on credit as an asset class
and to actively manage investment port-
folios – all the while benefiting from the
low transaction costs associated with
static portfolios.
The present
Credit has become a recognized asset class
and a source of risk. Most market partici-
pants have some form of credit exposure
that needs to be managed, measured and
priced, and first generation credit derivative
instruments enabled investors to do this, as
well as to trade this risk separately from
interest rate and/or currency risk.
The first-generation products were
quickly embraced by the market and, as a
result, the credit derivatives market grew
rapidly in its early years – but it was only
with the creation of the first standardized
indexes, the iTraxx® family, that the market
really began to take off.
The International Index Company (IIC)
manages and administers the iTraxx® Indexes
and sets the market standards for investing,
trading and hedging the iTraxx® Index family.
With the iTraxx® families, IIC not only covers
the European and Asia/Pacific CDS markets,
where it has rapidly become the benchmark,
but it also recently debuted in the European
leveraged loan CDS market with its iTraxx®
LevX® Indexes.
As an independent index supplier, IIC is
committed to open and transparent markets.
Setting the market standard to facilitate
investment, trading, hedging in the indexes
and helping to improve market liquidity in
tradable iTraxx® CDS Indexes, is an important
part of IIC’s business rationale. Its indexes are
objective, rules-based and dependable, and
adhere to the highest quality standards.
As a result of the growing standardi-
zation brought to the market by IIC, index
volumes have grown rapidly in recent years.
The British Bankers Association (BBA) esti-
mated that index trading had become the
second largest segment of the credit deriva-
tives market by the end of 2005. The
London-based association estimated that it
accounted for some 30 percent of total
 The landscape 35

Comprehensive European platform

Benchmark indexes Sector indexes Standard maturities
iTraxx® Europe iTraxx® Europe, HiVol
Non-Financials
Top 125 names in terms of 3
CDS volume traded in the six months 100 entities 5
prior to the roll 7
10

iTraxx® Europe HiVol Financials Senior

Top 30 highest spread names
25 entities
from iTraxx® Europe iTraxx® Crossover
5 and 10

iTraxx® Europe Crossover

Financials Sub
Exposure to 50 European iTraxx® Sector Indexes
sub-investment grade 25 entities
reference entities 5 and 10

First to Default baskests:

Autos, Consumer, Energy, Financial (sen/sub), Industrials, TMT, HiVol, Crossover, Diversified Source: IIC

volumes, only marginally less than the 33
percent share of single-name credit default
swaps. A more recent survey by the rating
agency Fitch has revealed that index trades
have since outpaced single-name trades.
Fitch estimates that index trades accounted
for some 44 percent of volumes at the end
of 2006, compared to the 40 percent of
total volumes driven by single-name CDS.
The purpose
Investors can use iTraxx® CDS Indexes to
trade large positions in credit names without
having to take on direct exposure to the
underlying securities, and managers can use
the indexes to manage the three separate
components of their portfolios: credit risk,
interest rate duration and relative value.
But the instruments also provide trading
opportunities for other participants, such as
speculators and arbitrageurs. For instance,
taking a short credit position in the iTraxx®
Europe (the main index of 125 equally-
weighted investment grade names) without
exposure to a cash bond position, offers
upside potential in the case of underlying
credit deterioration. Arbitrageurs can also
use the indexes to exploit spread differen-
tials between the CDS, equity and cash
markets. The additional liquidity provided by
trading desks, hedge funds and arbitrageurs
undertaking these strategies has greatly
influenced the index market, making it more
liquid and thus an easier and more efficient
means of gaining risk diversification and
market exposure.
Since the iTraxx® Indexes were introduced,
the basis between EUR-denominated cash
bonds and CDS has been greatly reduced.
This is because trading desks have increased
their trading activity substantially, and hedge
funds seeking to profit from price ineffi-
ciencies between the CDS and cash bond
markets have helped to tighten the
cash/synthetic gap.
As the index market has developed and
expanded, and liquidity in credit has
improved, it has become possible to trade
 36 The landscape
tighter ranges and higher volumes, and to
enter and exit relative value and curve trades
at lower cost. The liquidity and transparency
provided by the indexes has paved the way
for new products, such as standardized first-
to-default baskets, sector indexes and
iTraxx® tranches.
Short-biased managers and momentum
traders are now able to put on volatility
trades in sub-sector indexes, exploiting their
fundamental views on specific sectors. Index
baskets offer investors timing flexibility and
low-cost trading structures, allowing active
managers to implement credit duration
strategies largely independent from the
primary and secondary cash markets. The
iTraxx® tranches were initially created for
mark-to-market purposes and to help book
runners manage their P&L accounts, but
index tranches are now actively traded and
are also being used to trade and/or hedge
correlation risk. Because the underlying
portfolios and maturity dates are fixed,
iTraxx® Index Market Makers are also able to
quote a range of standard tranches from
equity or first-loss tranches, up to the most
senior tranches.
A particularly exciting by-product of the
increased liquidity and transparency in the
index market has been the very recent emer-
gence of exchange-traded futures contracts
based on the iTraxx® Indexes. It is early days
yet, but these contracts can provide a new
dimension for buy-side organizations to
manage credit risk.
The outlook
When the markets needed a benchmark for
managing credit risk, iTraxx® provided the
tool. It has also stimulated trading activity
and provided an efficient means of port-
folio hedging and established itself as a serve their changing needs. At the same
market standard. time, credit derivative products will likely
By adding liquidity and transparency to become more widely accepted. This will
the markets, the iTraxx® family also helped mean that those players still prevented from
establish credit risk as an asset class in its using the instruments by mandates or regu-
own right – an asset class that is now every lations will soon enter the market. Those
bit as complex as other more established using credit derivatives for the first time will
markets such as equity. likely use the standardized indexes or
This success could not have been achieved instruments based on them, such as the
without the goodwill and cooperation of new futures contracts.
investment banks, but especially not without All these factors will continue to drive the
the input of investment managers. Having credit derivatives market – and in particular,
identified the need for indexes and hedging the index market, fuelling volume and liq-
instruments and pushed for their devel- uidity. The International Index Company will
opment, this community played a pivotal remain at the forefront of activity, spear-
role in iTraxx®’s development. heading the market’s development with the
Investment managers will likely continue principles of independence, transparency
to press for products and opportunities to and objectivity at its core.
International Index Company Ltd. (IIC) is the market leader for fixed income and credit
derivatives data and indexes. Established in 2001, IIC calculates and publishes the inde-
pendent iBoxx® bond prices using multiple price contributors and rigorous quality controls.
The iBoxx® bond indexes set new standards in the investment community for transparency
and accessibility and have been adopted by the market for use as benchmarks, in research
and as the basis for financial products. The index families include the iBoxx® euro, British
pound, U.S. dollar, global inflation-linked, ABS and euro high yield bond indexes.
IIC also manages and administers the iTraxx® European and Asian Credit Derivatives
Indexes, and calculates and distributes the iBoxx® FX trade-weighted foreign exchange
indexes for ten major currencies. IIC is owned by ABN AMRO, Barclays Capital, BNP Paribas,
Deutsche Bank, Deutsche Börse, Dresdner Kleinwort, Goldman Sachs, HSBC, JPMorgan,
Morgan Stanley and UBS.
Tobias Spröhnle joined IIC in 2006, where he is head of derivatives. In this role he is respon-
sible for the global iTraxx® Credit Derivatives Index families. He holds a diploma in economics
and information management and is a chartered financial analyst (‘CFA’).
After starting his career in the German private banking industry, Tobias joined Eurex/
Deutsche Börse Group in 2000, where he occupied different roles in market supervision and
product design for fixed income derivatives. In his role as a product designer, he was project
manager for the iTraxx® Credit Futures products, the first exchange-traded credit derivatives in
the world.
 38 The landscape

The upsides
Credit derivatives rose from obscurity to become mainstream derivatives instruments in record time.
Natasha de Terán finds out how they have benefited the wider financial markets

T
he creation of credit
derivatives had
indeed transformed
the world of finance,
strengthening the
banking system and rein-
venting credit as a
streamlined asset class.
Historically, debt had financed much of
the world’s corporate activity, but credit
had been overshadowed by its headline-
grabbing cousin, equity, which was per-
ceived as a more exciting asset-class that
was easier to access and, in most cases,
offered higher returns.
The low-key perception of debt masked its
potential importance in global capital
markets. Few people outside Wall Street
could have predicted the impact that credit
would have on financial markets once the
smartest brains in finance had developed an
effective risk-transfer tool that was the
equivalent of turning tin into silver.
“Perhaps the most significant development
in financial markets in decades has been the
rapid development of credit derivatives,” the
As the credit derivatives
market grew unabated after
2000, it continued to face
more challenges because
low interest rates were
stoking an ever-increasing
appetite for debt
former Federal Reserve Chairman Alan
Greenspan told a gathering at the Bond
Market Association in New York last year.
Among other things, he said, “it has made
the banking sector more resilient”.
Greenspan’s best illustration of his thesis
was that between 1998 and 2000, the peak
of the Dotcom boom, the equivalent of USD
1 trillion of debt had been taken out by the
telecommunications industry, of which a sig-
nificant part went into default. Yet not a
single major U.S. financial institution ran into
difficulty because, when the Dotcom bubble
burst in 2000, the credit derivatives market
had played an effective role in defusing the
very major credit problems. The new market
had passed its first test.
The enhanced resilience of the banking
sector is the common thread that runs
through many of the comments made by
regulators and central bankers over the past
five years. Although, it must be noted that
they, as circumspect guardians of the
financial system, have also warned the world
of its darker side – but more of that in the
next chapter.
The
Case
landscape
studies 39
Mitigating risks
As the credit derivatives market grew
unabated after 2000, it continued to face
more challenges because low interest rates
were stoking an ever-increasing appetite for
debt, while rising energy and commodity
prices were testing the market’s tolerance
for risk.
The Reserve Bank of Australia’s deputy
governor, Glenn Stevens, noted in 2006: “A
striking feature over the past several years
has also been the way in which a succession
of events that might previously have trig-
gered a significant disturbance in financial
markets have been absorbed relatively easily.”
Two of the events to which Stevens may
have been referring were the twin credit
ratings downgrades to junk of the world's
two biggest car manufacturers and corporate
debtors, General Motors and Ford, and the
biggest hedge fund liquidation in history, that
of Connecticut-based, Amaranth Advisors.
Market practitioners were equally quick to
point out that the parallel existence of the
seemingly unflappable financial marketplace
and the growth of credit derivatives has not
been mere coincidence.
“We have been through several market
corrections in the past few years and in each
case, markets have recovered,” said Anshu
Jain, Deutsche Bank's head of global markets
and the chief architect of the German bank’s
reinvention as a global derivatives power-
house. “In retrospect, people think the market
has been characterized by calm, continuous
and even benign conditions. Derivatives are
a big part of explaining that phenomenon,”
he added.
The development of the interest rate swaps
market in the 1980s left bankers grappling to
find a tool to manage their other major risk –
 40 The landscape
Historically, banks’
lending practices had
been constrained by
their inability to dispose
of loan risks that they no
longer wanted to hold
credit. Historically, banks’ lending practices
had been constrained by their inability to
dispose of loan risks that they no longer
wanted to hold. In practice it was possible,
but it was a convoluted process. The market
for loan trading was illiquid and the borrower
had to be notified of the transfer, which
risked jeopardizing the entire banking rela-
tionship with the customer.
Moreover, in the case of an economic
downturn, banks were forced to cut the
amount of loans they issued, creating a
‘credit crunch’ effect. This typically led to
higher borrowing costs, and ultimately
defaults, which affected the wider economy.
Loans sat stagnating on banks’ balance
sheets, exposing them to potentially huge
losses in the event of a major default or
series of defaults.
Perversely, in some cases, banks would
actually increase the amount of loans to
healthier corporate sectors as a way of diver-
sifying their risk. Credit derivatives made the
process fluid, while keeping their core
business intact.
“Credit default swaps are transforming the
way banks operate in the market, and due to
credit portfolio management practices have
indeed profound implications for the banking
business model,” Jean-Claude Trichet, pres-
ident of the European Central Bank, told del-
egates at the International Swaps and
Derivatives conference in April 2007. “Banks
increasingly find credit default swaps a
highly attractive mechanism for reducing
exposure concentrations in their loan books,
while simultaneously allowing them to meet
the needs of their corporate customers.”
Minimizing costs
As this decade has progressed, the needs of
the customer have been met not only by the
availability of credit, but also in cheaper
funding costs. Credit derivatives cannot take
all of the plaudits, of course, because strong
economic growth, low interest rates and a
consumer boom since 2002 have kept default
rates near an all-time low.
Nevertheless, the banks’ growing use of
credit derivatives has freed up more capital
to make more loans and generate more fees,
without them having to set more capital
aside for regulatory purposes. Indeed, as
Trichet said in the same speech: “Some evi-
dence from the United States, based on indi-
vidual loan data, supports the idea that
banks are increasing the supply of credit as
they obtain additional credit protection
through credit derivatives.”
The increased agility of the banking system
has also led to a reassessment of what is
suitable credit risk, and this has reinforced
the already low default rates, which has
brought wider implications for the economy
as a whole.
The changing shape of business banking
and risk management was further stream-
lined by the rapid growth of so-called syn-
thetic collateralized debt obligations (CDO).
These ingenious examples of financial engi-
neering enable banks to bundle together
groups of credit default swaps (CDS), dividing
them into parcels of varying risk, before
selling them on to investors.
Synthetic CDO volumes surged from 2004
after banks created credit derivatives indexes,
which became the building blocks for CDOs
and other products, enabling banks to further
slice-and-dice risk according to their view of
the financial health of companies. Investors
benefited from gaining exposure to a group
of companies of their choice, without having
to source the individual underlying bonds.
The first CDOs had been composed of
corporate bonds, which took many months
to bring together. The market accelerated
with the onset of credit derivatives, and CDS
indexes in particular, because banks could
package them together much more swiftly –
in some cases, in one day.
The proliferation of synthetic CDOs led
directly to a compression of credit risk pre-
miums. The CDO market now stands at
USD 1.5 trillion, having grown by more
than USD 500 billion last year, according to
Morgan Stanley. Although just a fraction of
the overall size of the credit derivatives

market of USD 34.5 trillion, the
market’s impact on credit spreads has
been significant.
As banks built the CDOs, typically they
would hedge their positions by selling CDS
in the market. At a time when investors and
banks were less concerned about company
defaults, there was less demand to buy CDS
and credit risk premiums fell to near record
lows as a result. According to Standard &
Poor’s Leveraged Commentary & Data unit,
for instance, U.S. junk-rated companies now
pay an average spread of 2.38 percentage
points more than LIBOR, a record low, com-
pared with more than 4 percentage points
in 2003.
To illustrate the benefits of this large-scale
dispersion of credit risk, consider the example
of Eastman Kodak, the world’s largest pho-
tography company. By mid-2005, the once
blue chip company had reported losses
totalling USD 1.6 billion over six consecutive
quarters and its credit rating had been cut
three times by Moody’s. In a world without
credit derivatives, banks might have balked at
the prospect of lending further to the
company. Yet Kodak was still able to borrow
USD 2.7 billion at 0.75 basis points less than
it had three years earlier. That may have been
due to its CDS being contained in more than
150 CDOs, according to data from bond
research firm, CreditSights. Eastman Kodak
duly secured the funding it needed to fight
another day.
In this case, the CDS market had helped
avoid the possibility of a default and the
prospect of thousands of job losses.
Attracting new investors
As with all asset classes, the premise of
CDS rests on its effectiveness as a risk
The landscape 41
management tool, or in common trader
parlance, the ability to ‘go short’. For gener-
ations, corporate debt investors had been
hamstrung by their inability to hedge bond
portfolios; when credit conditions worsened,
risk premiums rose and companies started
defaulting on their bonds. For many fund
managers it represented a critical barrier
to entry.
And for those involved in the debt markets,
the choices were few: they either bought
more bonds to diversify or became forced
sellers. In practice this was time consuming,
inefficient and expensive. Restocking the
portfolio made things even more expensive.
The introduction of the iTraxx® Indexes in
2004 made life a whole lot easier. Soon,
much credit derivatives trading activity was
based on the indexes, making the difference
between the buy and sell rates (or the bid/
offer spread) small and the cost of hedging a
bond portfolio significantly cheaper, in turn,
making the process much faster.
It is also arguable that the increased use of
credit derivatives by fund managers after
2004 contributed to a reduction in corporate
risk premiums. In the past, investors had
demanded what was known as a ‘liquidity
premium’. They wanted to be rewarded suffi-
ciently to compensate for transactional risks,
and, as a result, borrowing rates were artifi-
cially higher than they should have been.
Borrowers were attracted to the longer-term
funding that the bond market provided, not
to the lending margins they were offered.
The adoption of credit derivatives as a
more effective way of hedging their bond
portfolios gave investors more flexibility, or,
as one private equity manager recently put it,
meant that there had “never been a cheaper
time to go to the bond market”.
 42 The landscape

The darker side of

credit derivatives
The rapid expansion of the credit derivatives market came at a price.
John Ferry exposes the flaws and teething problems
 The
Case
landscape
studies 43

T
he emergence of the
credit derivatives
market clearly pro-
duced some well-docu-
mented benefits for
both the individual
buyers and sellers of
credit risk, and for the
financial system as a whole. But as the
market for credit default swaps (CDS) and
other forms of credit risk transfer continued
to expand exponentially and become more
established – and as the structured credit
products that referenced these instruments
continued to grow – so negatives, as well as
positives, emerged.
The regulators were not unaware of the
issues. Financial regulators often talk pub-
licly about the development of the over-
the-counter (OTC) derivatives market and
their associated concerns. But during the
early years of this century they increasingly
turned their attention to credit derivatives.
Their worries centered on how banks were
processing credit derivatives contracts in
their back offices, as well as how legal,
counterparty, liquidity, concentration and
other risks might be casting a shadow over
the growing market.
Nearly all the risks were highlighted in
an October 2004 report produced by the
Financial Stability Forum (FSF). The FSF had
requested its Joint Forum’s Working Group
on Risk Assessment and Capital undertake a
review of credit risk transfer (CRT) activity.
The report was based on a number of inter-
views and discussions with market partici-
pants and noted the importance of consid-
ering the financial stability issues that
could be associated with CRT activity. It
highlighted several key risk management
risks associated with CRT: operational risk,
counterparty credit risk, legal risk and liq-
uidity risk.
Processing issues and operational risk
Ironically, in view of the sophistication of
the market’s tools and techniques, the infra-
structure that supported credit derivatives
operations was based on old-fashioned
systems and outdated technology.
All OTC derivatives are cumbersome to
confirm, but operational advances over the
years had eased the processes for many
product types. Credit derivatives, by com-
parison, did not enjoy the same levels of
operational streamlining.
Credit derivatives have some peculiar fea-
tures that mean the back-office paperwork
is hugely important. Unlike more established
and standardized interest rate and equity
derivatives, credit derivatives trades have to
be supported by lengthy documentation
outlining the terms of the deal. The com-
plexity of the instruments and the rapid
growth in volumes only exacerbated the
associated paperwork burden and the oper-
ational shortfall.
Back-office controls are particularly
important for the credit derivatives market
because when two parties agree a sale they
are effectively transferring the risk of default
on a bond, or group of bonds. But the con-
tract does not become valid until all the

Credit derivatives parties sign the documents, or confirm it

electronically. The hypercharged expansion of

trades have to the market meant that the dealers' ability to

process such trades was severely tested and
be supported it is probable that all participants fell behind

by lengthy in confirming the often-complex terms

involved in transactions. The Joint Forum

documentation Report said: “CRT activity also gives rise to

operational risks. Most significantly, the OTC

outlining the derivatives market generally has struggled to

develop transactions processing and set-
terms of the deal tlement mechanisms that reduce operational
and settlement risks. The relevant issues
include backlogs of unsigned master agree-
 44 The landscape
Controversy arose in 2000
with the restructuring of
loans to Conseco, when
banks agreed to extend the
maturity of the company’s
senior secured loans in
return for higher coupon
and collateral payments
ments and unsigned confirmations, as well as
the prevalence of manual systems and the
risk that they break down with increased
volume. In the CDS market, especially, market
participants recognize that the problem of
unsigned confirmations had reached
excessive proportions, with some transac-
tions going unconfirmed for months.”
Legal risk
In terms of legal risks, the Joint Forum sum-
marized the issue as follows: “Market partici-
pants agreed on the paramount importance
of legal certainty in these types of transac-
tions, but emphasized that this requires sig-
nificant work to ensure it is achieved.”
Legal or contract risk had, indeed, been a
perennial issue in the credit derivatives
market since its inception. As bilateral OTC
deals, CDS require close legal scrutiny by
those signing the contracts, which is why
many credit derivatives desks often have
lawyers sitting nearby.
Jean-Claude Trichet, president of the
European Central Bank, returned to the theme
of legal risk in an address to the International
Swaps and Derivatives Association’s (ISDA®)
annual general meeting in April 2007: “It is
important that market participants clearly
understand the precise rights and obligations
which they assume when entering into credit
derivatives transactions, as standardized con-
tracts do not always work out in the way that
contracting parties anticipate,” he said. “Also,
in some cases, case law has demonstrated
that the courts can take divergent views
regarding the meaning of ISDA®’s definitions
of credit derivatives.”
In the most basic of instances there has
been confusion between the buyer and seller
of CDS regarding the specific legal entity on
which the CDS was written. In other cases,
market participants entered into contracts on
the wrong legal entity. But over the years
other issues emerged, such as CDS dealers
arguing over the wording of contracts, or
whether a default had actually occurred.
Further difficulties arose out of restruc-
turing events. The 1999 ISDA® definitions
included debt restructuring – such as low-
ering a coupon or extending maturity – as a
designated credit event that would trigger
repayment on a CDS. Controversy arose in
2000 with the restructuring of loans to
Conseco, when banks agreed to extend the
maturity of the company’s senior secured
loans in return for higher coupon and col-
lateral payments. This triggered protection on
about USD 2 billion of CDS.
David Mengle, ISDA®’s head of research,
noted in his paper, Credit Derivatives: An
Overview, that: “Protection buyers then took
advantage of an embedded ‘cheapest to
deliver’ option in CDS by delivering longer-
dated senior unsecured bonds, which were
deeply discounted – worth about 40 cents on
the dollar – relative to the restructured loans,
which were worth over 90 cents on the dollar.
Protection sellers ended up absorbing losses
that were greater than those incurred by pro-
tection buyers, which led many sellers to
question the workability of including restruc-
turing.” The result was a modification to the
definition of restructuring that placed some
limits on deliverable bond maturity and,
therefore, on the cheapest–to–deliver option.
ISDA® had published standardized credit
derivatives definitions in 1999, as a basic
framework for documentation. These
underwent various modifications and were
then updated in 2003 in response to the
many problems that had emerged, high-
lighting legal risks to market participants.
But even so, legal doubts remained.
In 2006, for example, Aon Financial
Products and Société Générale engaged in a
court battle over a CDS on the Republic of
 The landscape 45

the Philippines. Aon had sold protection to so rapid, there is particular reason to be protection provided by CRT instruments and
Bear Stearns on a Philippine corporate aware of them.” CSA agreements – concerns the potential
backed by a government agency. It then The Joint Forum noted how market par- correlation that can exist between an
bought sovereign protection on the ticipants manage this counterparty credit underlying reference entity and the pro-
Philippines from the French bank. Market risk in various ways. One of the most tection seller. For example, if the CDS pro-
observers assumed this was done to hedge common methods is by way of a collateral tection seller’s credit risk is highly correlated
the contract Aon had sold. The Philippine support agreement (CSA) that accompanies with the credit risk referenced in the CDS
agency subsequently withdrew backing for the ISDA® trade documentation and that itself, the extent of credit risk reduction for
the Philippine corporate triggering default requires lesser counterparties to post addi- the protection buyer is much less than if the
on the contract Aon had sold. This event tional collateral against their trades. CSAs protection seller were largely uncorrelated
did not, however, trigger a payout on the are, however, operationally burdensome. To to the reference entity.
Aon-Société Générale contract, and so a work effectively, they require constant over- Some OTC market participants set up
dispute emerged. A U.S. court ultimately sight and administration with periodic Special Purpose Vehicles (SPV) and ran their
upheld the content of both buy-and-sell marking-to-market and margin and col- derivatives trades through them. The SPVs
contracts, with the result that Aon was lateral adjustments as pre-agreed thresholds stood in the middle of the deals becoming
obliged to honor its payout to Bear Stearns are breached. the trade counterparty to both sides. While
but did not receive compensation from An additional complication that can arise this removed the counterparty risk element,
Société Générale. – both in regard to the evaluation of coun- it added extra layers of complexity, expense
terparty credit risk and the value of credit and organizational difficulty.
Counterparty credit risk
As bilateral OTC derivatives trades, CDS nec-
essarily entail credit risk exposures, namely
the credit risk of the counterparty to the
trade. For instance, a bank that buys pro-
Although banks and
tection against a reference entity through a
CDS will rid itself of that particular credit risk,
other institutions
but at the same time it will take on the risk generally have strict
that the counterparty selling the protection
might not be able to pay out. Likewise, a pro-
procedures for checking
tection seller takes on counterparty risk
because the seller will lose expected premium
and evaluating
income if the buyer defaults. counterparties,
Although banks and other institutions
generally have strict procedures for checking counterparty risk
and evaluating counterparties, counterparty
risk will always remain. Lars Nyberg, deputy
will always remain
governor of the Swedish Central Bank, drew
attention to this risk in a speech earlier this
year, saying: “Counterparty risks exist in
most financial agreements, but as the credit
derivatives market is so young and growth is
 46 The landscape
Liquidity risk
Related to the issue of counterparty risk is
liquidity risk. The CDS market is heavily con-
centrated among a limited number of dealing
banks, while the real ‘liquidity’ is centered on
a relatively small amount of reference
entities: less well-known ‘names’ are traded
only infrequently, and many structured deals
have no real liquidity at all. Given the lack of
transparency in the market, it is impossible to
predict how the market will cope under
extreme circumstances.
This issue was raised by the Joint Forum,
has repeatedly been revisited by regulators,
and was aired again in May this year when
Donald Kohn, vice chairman of the board of
governors of the U.S. Federal Reserve, spoke
at a conference in Atlanta. There he warned
that the credit risk transfer markets are
dependent on a small set of key intermedi-
aries, and that, in the extreme, “price varia-
tions and other adverse developments could
call into question the viability of these inter-
mediaries, threatening a larger cumulative
real effect”.
Concentration risk
Related to the above two risks are concen-
tration risks. These were highlighted in
several Fitch reports – most particularly the
rating agency’s 2002 study: Liquidity in the
Credit Default Swap Market: Too Little Too
Late? and a 2003 report, Global Credit
Derivatives: Risk Management or Risk? The
2002 study found on the one hand that liq-
uidity (even in commonly traded names)
tended to dry up in times of stress, after
rating agency downgrades and in high
volatility periods. The 2003 study, mean-
while, highlighted the dominance of just a
few dealers – as measured by the gross
amount of protection sold, the top 30 global
banks and broker dealers held approximately
98 percent of positions. Worse, counterparty
“The market for credit
default swaps is quite
opaque. Because
swaps are structured
as OTC derivatives,
they are largely
unregulated”
risk was concentrated among just the top- service for credit derivatives generally,” stated
ten global banks and broker dealers. Partnoy and Skeel in their paper.
To a limited extent, centralized pricing
Opacity risk services do currently exist (though these are
The general opacity of the market is another non-obligatory), but highly esoteric credit
issue that cannot be ignored. In the OTC derivatives and CDS written on less liquid
markets, buyers and sellers of risk are not names are another matter. For complex, or
obliged to disclose details of particular CDS bespoke products – ‘nth-to-default’ deriva-
deals. As recently as 2006, Frank Partnoy and tives on a basket of credit exposures, for
David Skeel of the University of Pennsylvania example – pricing can be highly subjective.
Law School noted in their paper, The Promise Such derivatives are generally marked to
and Perils of Credit Derivatives: “The market model rather than marked to market, which
for Credit Default Swaps is quite opaque. means the pricing is only as good as the
Because swaps are structured as OTC deriva- veracity of the underlying quantitative model
tives, they are largely unregulated.” used, as well as the inputs to that model.
Increasing liquidity in the CDS market
helped improve pricing transparency for the Advances
most liquid credit derivatives, but this has The Joint Forum report then remains as
not stopped some market observers from important today as it was when it was first
calling for formal moves to be made on OTC published. Although considerable advances
deal and pricing information. “Although there have since been made – many of them in
is some price transparency in certain seg- direct response to the report’s findings –
ments of the credit default swaps market, we the significance of the issues raised has
believe there should be a centralized pricing not diminished.

Regulatory
intervention
Though regulators largely welcomed the advent of credit derivatives, they soon realized
that there were abundant flaws in the systems that supported the products. John Ferry
explores the lead-up to regulatory intervention
I
n February 2005, the U.K.
Financial Services Authority (FSA)
was prompted (perhaps by the
Joint Forum’s report) to write to the
largest players in the market. The
FSA warned them that it was con-
cerned about the levels of unsigned
confirmations in existence and the
risks these posed to market efficiency
and confidence. The regulator said it felt
that the backlogs in confirmations of deriv-
atives contracts and unauthorized assign-
The backlogs in confirmations
of derivatives contracts and
unauthorized assignments
undermined the effectiveness
of the market as a whole
ments undermined the effectiveness of the
market as a whole.
Unauthorized assignments, it said, posed
the risk that participants might not be sure
who their counterparties were and raised the
question as to what extent they could rely
on the credit derivatives they had written or
bought. If a credit event occurred, then the
buyer of protection would not necessarily be
able to find the entity responsible in order to
settle the contract.
The ‘Dear CEO’ letter from the FSA was
The landscape 49
followed by a report, published in July that
year, by the Counterparty Risk Management
Policy Group (CRMPG), an influential industry
organization. The CRMPG had concluded that
there was a need for “urgent industry-wide
efforts” to cope with serious back-office and
potential settlement problems in the credit
default swaps (CDS) market. It also called on
the industry to put a stop to the practice
whereby some market participants were
assigning their side of a trade to another
institution without the consent of the
original trade counterpart.
“Among other things, this practice has the
potential to distort the ability of individual
institutions to effectively monitor and
control their counterparty credit exposures,”
noted Gerald Corrigan, managing director at
Goldman Sachs and chairman of the CRMPG,
at the time.
In August 2005, the Federal Reserve Bank
of New York took up the baton. President
 50 The landscape
Timothy Geithner summoned 14 major
credit derivatives dealers to attend a meet-
ing. The topic under discussion was going to
be an ugly one: operational issues in the
CDS market.
The Fed meeting took place in September
that year and the outcome was a concerted
effort by the world’s major derivatives dealers
to improve credit derivatives processing, red-
uce backlogs and a commitment to report on
progress regularly. To a large extent, these
efforts have been successful, but what had
led to the difficulties in the first place?
The simple explanation is that credit deriv-
atives volumes had increased at such a rapid
pace, with intermediation on credit deriva-
tives deals being handled by a relatively small
number of key dealers, that middle and back
office teams simply could not keep up with
what their front offices were doing. But to
leave it at that would be too simplistic. The
difficulties experienced by the market did
not, in fact, stem purely from exploding
volumes. To gain a thorough understanding
of the issue requires us to delve a little
deeper and to go back to fundamentals.
Novations
Over-the-counter (OTC) derivatives, which by
definition trade synthetically, do not involve
a transfer of ownership, as cash securities
trading does, but rather a transfer or pay-
ment of mark-to-market value, which can be
offset or cancelled in three different ways.
The two parties to an OTC trade can agree
a termination, or a so-called tear-up,
whereby they agree to cancel the original
obligation following a payment. Alternatively,
one side of a deal can choose to enter an
offsetting transaction. In this scenario, the
original deal is left in place but its economic
Hedge funds generally prefer
to unwind through novations
rather than offsets, because
they are reluctant to incur
additional credit exposure in
the form of offsetting swaps
effects become mute. In the third option, one
of the parties can enter into a novation –
also referred to as an assignment – whereby
the rights and obligations of the derivatives
are transferred to a third party in exchange
for a payment.
In the latter case, the OTC market’s stan-
dard template for conducting derivatives
deals, the International Swaps and Derivatives
Association (ISDA®) Master Agreement,
requires a transferor to obtain prior written
consent from the remaining party before a
novation takes place.
Such novations were used relatively infre-
quently until the CDS market began to take
off. The usual method of exiting a deal was
through an offsetting transaction. But as
hedge funds became more active in CDS, so
novations became increasingly common.
Hedge funds generally prefer to unwind
through novations rather than offsets,
because they are reluctant to incur additional
credit exposure in the form of offsetting
swaps. They also, generally, prefer novations
to terminations because terminations can
limit unwind possibilities and have the
potential to reveal the trading strategies
being used.
In the wake of mounting hedge fund
involvement in the CDS market and the
emergence of index trading, the use of
novations increased considerably. Indeed,
the CRMPG in its 2005 report estimated
that novations constituted 40 percent of
trade volume.
“Novations became a problem because of
participants’ failure to follow established pro-
cedure,” explained David Mengle, ISDA®’s
head of research, speaking at a financial
markets conference held in Atlanta this May.
This was because some investors who wished
to step out of transactions via novations
were not obtaining prior consent from the
remaining party. Sometimes the transferee
was not verifying that the transferor had
obtained clearance, while in other cases the
remaining party, which might not have
known of the novation until the first pay-
ment date, would simply back-date its books
to the novation date and change the coun-
terparty name.
The finger pointing went further, according
to Mengle: “When dealers complained that
investors failed to obtain consent, investors
countered that remaining parties might have
given consent but failed to transmit the

By 2005, it was clear that
the volume of outstanding
credit derivatives contracts
could far exceed that of the
bonds available for delivery
The
Case
landscape
studies 51
necessary information to the back office in a
timely manner.” Either way, the situation pre-
sented significant operational problems in
the form of confirmation backlogs.
Settlements
There was another issue surrounding the
treatment of credit events. When a company
files for bankruptcy protection, any CDS con-
tracts on its name need to be fully or par-
tially settled. The original CDS contracts re-
quired that the buyer of default protection
hand over the company's bonds to the seller
of protection. However, by 2005, it was clear
that the volume of outstanding credit deriva-
tives contracts could far exceed that of the
bonds available for delivery.
 52 The landscape
In the adopted process,
dealer auctions set a
notional cash price for the
bonds of a bankrupt
company.The offsetting
trades are then cancelled,
leaving only the net
positions to be settled
This was certainly the case when U.S.
car parts manufacturer, Delphi, filed for
bankruptcy in October 2005. The volume of
CDS contracts outstanding was larger than
the volume of bonds by a factor of ten. The
International Monetary Fund noted in its
2005 Financial Stability Report, that contract
settlement following a default could thus
become a source of ‘market vulnerability’.
To address the shortage of bonds and to
simplify the settlement of contracts, dealers,
together with the ISDA®, developed a cash-
only settlement mechanism that market par-
ticipants can choose to adopt on an ad hoc
basis. In the adopted process, dealer auctions
set a notional cash price for the bonds of a
bankrupt company. The offsetting trades are
then cancelled, leaving only the net positions
to be settled. The market can adhere to this
as an alternative to physical delivery, thereby
eliminating any problems arising from a
shortage of deliverables. ISDA® intends to
include this methodology as the primary
means of settlement in its next set of credit
definitions, and has already included a
variant of it in its recently issued loan CDS
documentation. ISDA®’s revised definitions
are due out later in 2007 or in early 2008.
Confirmations
Like any other OTC instrument, credit deriva-
tives are traded on the basis of two parties
transacting directly or via some form of
intermediary. Each party will typically capture
the trade in its internal systems for post-
trade processing and risk management.
Sometimes counterparties will add an addi-
tional step in the process, known as the
affirmation stage, a process whereby the
two parties verify the key economic details
of the trade. The final stage of transacting
involves the two parties reviewing and
putting together the full terms of the trade
in a confirmation.
Ideally, these confirmations should be
processed very shortly after a trade is done.
In the case of the credit derivatives market,
however, this was far from the case. In fact,
by 2004 the average confirmation backlog
for large dealers represented more than 23
trading days. By mid-2005 it was taking
major banks an average of 44 days to
confirm a standard plain vanilla credit deriv-
ative, and double that for more complex,
exotic trades. In September of that year there
were over 150,000 unconfirmed credit deriv-
atives transactions, 98,000 of which were
more than 30-days old. The difficulties and
uncertainties surrounding novations, which
often meant that those buying and selling
credit derivatives could not be sure of the
identity of their counterparty, only exacer-
bated the backlog of unconfirmed trades.
Even though in many jurisdictions verbal
contracts are enforceable by law, the absence
of written deal confirmations was clearly a
major problem. The lack of documented
transactions not only disrupted the flow of
information within firms, and increased the
chances of errors going undetected, but
there were also doubts as to whether parties
would be able to prove the details of any dis-
puted trades. Ultimately, this could have led
to inaccurate measurement and manage-
ment of credit and market risks. Meanwhile,
backlogs could – and doubtless did – lead to
margin and payments breaks, disrupting the
trade cycle.
The confirmations issue, as it came to be
known, was a problem – but it was the
sheer number of unconfirmed trades in cir-
culation that really worried regulators. As
the FSA’s director of wholesale firms

division, Thomas Huertas, noted in a speech
that he gave in April 2006 in London. He
said: “Backlogs in confirmations of credit
derivatives trades pose similar risks as those
posed by unauthorized assignments. With-
out a valid confirmation in place, there is no
way of being certain that the two counter-
parties to the deal agree that there is in fact
a deal, or that they agree on the terms of
the deal.”
Without valid confirmations in place,
Huertas expressed that it was doubtful
whether firms, or the marketplace in
general, could truly gain the benefits
promised by the credit derivatives market.
He said: “It is questionable, at least from
this regulator's perspective, as to whether
firms can include unconfirmed transactions
in their calculations of exposures under
netting agreements, and whether firms can
give effect to unconfirmed transactions in
calculating counterparty exposures under
“Without a valid confirmation
in place, there is no way of
being certain that the two
counterparties to the deal
agree that there is in fact
a deal, or that they agree
on the terms of the deal”
The landscape 53
netting agreements, or in calculating large
exposures and capital requirements for
credits ‘protected’ by unconfirmed deriva-
tives transactions”.
Huertas was far from alone in his con-
cerns. The then Federal Reserve chairman,
Alan Greenspan, for instance, berated dealers
for “using 19th-century methods of dealing
with 21st-century financial instruments”.
At the end of the day the regulators felt
they had to bring the world’s major deriva-
tives dealers to account and serve them an
ultimatum: clean up the market in which
you are the major participants, or we will
step in and sort it out for you. Dealers, of
course, disliked the thought of having to
endure even more regulatory intervention
than they were already subject to. They
therefore wasted no time in putting in
place a plan of action to attempt to sort
out the operational problems in the credit
derivatives market.
 54 The landscape

Automation,transparency
and the aftermath of
regulatory intervention
John Ferry recalls how the market responded to the regulators’
scrutiny, by launching the OTC derivatives market’s largest clean-up
 The
Case
landscape
studies 55

T
he moves instigated
by the regulators to
sort out the opera-
tional deficiencies in the
credit derivatives market
were unavoidable. If the
dealing houses did not
clean up the market, then
the regulators were tacitly threatening to
intervene. The moves were also decisive, in
that they were put in place rapidly. As a
result, the fears of regulators and those oper-
ating in the market were much alleviated.
Here, we consider how the industry came
together to take practical steps to solve
the problem.
When the 141 key credit derivatives dealers
got together at the behest of the New York
Federal Reserve in September 2005, they
agreed a crucial plan to sort out the opera-
tional mess.
Working with the International Swaps and
Derivatives Association (ISDA®), these firms
agreed to implement the trade organization’s
Novations Protocol. They also promised that
by the end of January the following year, the
number of confirmations outstanding by
more than 30 days would be reduced by 30
percent, compared to the levels that existed
at the end of September 2005, with further
cuts to be made by the end of the following
March. The dealers also pledged to provide
regulators with monthly figures for trade
volumes, confirmations, settlements and fails.
In February 2006, the Fed formally said
that the industry group had fulfilled the
commitments outlined the previous year.
Specifically, it was happy that the 14 dealers
had implemented ISDA®’s Novations
Protocol; that there was increased use of
electronic processing of confirmations; a
reduction in the backlog of trades that were
unconfirmed; and that the industry had
worked well towards improving the credit
default swap (CDS) settlement process.
“All 14 major dealers have met the January
31, 2006 commitment to reduce by 30
percent the number of confirmations out-
standing by more than 30 days. As a group, a
54 percent reduction was achieved by the
end of January,” said the Fed. “Separately, vir-
tually all active clients have been added to an
industry-accepted electronic confirmation
platform. This has facilitated an increase of
total trade volume that is electronically con-
firmed from 46 percent in September, to 62
percent in January.”
The protocol
A key element in the improvement was
ISDA®’s Novation Protocol, which stan-
dardized the process by which participants
to a novation agree or provide consent to a
transfer. The protocol specifies a set of
explicit duties to which the parties to a
novation have to adhere.
Under the protocol, a party wishing to act
as a transferee has to obtain prior consent
but can do so electronically. If the remaining
party provides consent before 18:00 New
York time, then the novation is complete and
the remaining party can respond by e-mail. If
the remaining party does not provide
consent by this time, then the transferor and

In February 2006 the Fed transferee enter an offsetting deal that gives
a similar economic result to the novation.
formally said that the The idea is that a participant in the credit
derivatives market that wishes to assign its
industry group had fulfilled obligations to a third party should quickly get

the commitments outlined a response from the other counterparty to

the original deal. Market participants were

the previous year given a deadline to sign up to the new pro-

tocol, and dealers agreed to stop trading with
parties that did not comply with it. The result
was that the dealers were largely successful
1
Bank of America, N.A., Barclays Capital, Bear, Stearns & Co., Citigroup, Credit Suisse, in seeing the protocol adopted throughout
Deutsche Bank AG, Goldman Sachs & Co., HSBC Group, JPMorgan Chase, Lehman Brothers, the market.
Merrill Lynch & Co., Morgan Stanley, UBS AG, Wachovia Bank, N.A. “By the end of 2005, over 2,000 firms,
including practically all frequent participants
 56 The landscape
The clean-up in credit
derivatives processing
showed that light
pressure from regulators
is often enough to make
the dealing industry sort
out collective problems
in the credit derivatives market, had signed
the Novation Protocol, and the major banks
had implemented the necessary procedures
to assure that they could give prompt
responses to assignment requests,” reported
Thomas Huertas, the Financial Services
Authority’s (FSA) director of wholesale firms
division at the end of April 2006.
Eradicating the backlogs
Banks, meanwhile, committed additional
resources to working through the vast
numbers of confirmation backlogs. Firms
put in place so-called SWAT teams – either
external consultants, or staff that had been
redeployed from other back office opera-
tions – to attack the problem. Banks also
conducted ‘lock-ins’ with each other: the
ops teams of the two institutions staying in
a room with each other until they had
cleared away all the trades between them
that awaited confirmation.
As a result of these efforts, the total
number of unconfirmed trades had declined
to 74,000 at end of March 2006, a reduction
of over 50 percent from the figure in
September 2005. Trades unconfirmed after
30 days fell to 29,000, a decline of over
70 percent.
Getting rid of existing backlogs solved only
part of the problem, however. The aforemen-
tioned responses were no more than fire
fighting. What the industry really had to do
was to put in place long-term solutions –
processes that would ensure that such high
levels of backlogs never appeared again.
To move towards achieving this goal, the
major players worked to bring almost all the
most frequent traders onto electronic confir-
mation platforms. This entailed a com-
mitment to make full use of the Depository
Trust & Clearing Corporation’s (DTCC)
Deriv/SERV – an automated matching and
confirmation platform that the DTCC had
debuted in late 2003.
Again, the efforts seemed to work. By
September 2006, the Fed reported that the
14 largest dealers had reduced the number
of all confirmations outstanding by 70
percent, and of confirmations outstanding
past 30 days by 85 percent. Meanwhile, the
dealers had doubled the share of trades con-
firmed electronically to 80 percent of total
trade volume and the DTCC began working
on a trade information warehouse. The
warehouse is essentially an over-the-counter
(OTC) derivatives trade database and a
central support infrastructure designed to
facilitate automation and centralized pro-
cessing of post-trade events, such as cash
flows, novations and terminations.
The clean-up in credit derivatives pro-
cessing showed that light pressure from reg-
ulators is often enough to make the dealing
industry sort out collective problems. But why
did it take regulatory intervention, and why
was the problem allowed to escalate to such
a large extent in the first place?
Speaking in May 2007, ISDA®’s head of
research, David Mengle, related the situation
to game theory and the classic prisoner’s
dilemma – each participant in the market
would have benefited from adhering to
proper procedures but there was no way of
knowing if the other parties would do
likewise. The result was no change and
increases in confirmation backlogs.
“On the one hand, dealers were aware of
the problem and would benefit if all parties
to novations followed established procedures.
But on the other hand, refusing to agree to
novations if procedures were not followed
would lead to losing potentially profitable
business to those dealers that did not insist
on proper procedures,” Mengle said.
Competitive considerations also made
dealers reluctant to exert pressure on their
most active clients. “It was not until regu-
latory intervention that there was sufficient

cover for dealers to insist on adherence by
their clients. In this case, a relatively light
touch by a regulator was sufficient to bring
about a solution,” added Mengle.
No end in sight
Looking ahead, it seems clear that the
industry will not be able sit back and enjoy
the fruits of its 2005/2006 efforts, but rather
it will need to invest in further improvements.
Indeed, though regulators have been quick to
applaud the efforts completed to date, they
have been equally swift to point out that
further action is needed.
Automation, for instance, is not yet as
ingrained as it should be and so far only
incorporates plain vanilla transactions.
Moreover, only 31 percent of CDS trades are
confirmed on the same day, and error and
re-booking rates in CDS transactions are still
among the highest of all OTC transactions.
The challenge is now to improve on and
extend the automation processes, to stan-
dardize the complex products and, where
possible, to move these to electronic confir-
mation systems.
Over the past year, regulators have
stressed repeatedly the importance of con-
tinuing progress in these areas. Indeed, as
John Tiner, then chief executive officer of
the U.K.’s FSA, noted in his address at
ISDA®’s annual general meeting in Boston:
“There is still a need for continued vigilance
on everyone’s part and the submission of
credit derivative confirmation metrics to
regulators still plays an important part in
this respect.”
In a May 2007 paper from Harvard Law
School (Credit Derivatives, Settlement and
Other Operational Issues), the author,
Alexandre Richa, pointed out that with the
backlog in confirmations largely solved, the
emergence of the issue revealed a problem of
information processing, not only between
those trading in the market but also between
the market and regulators.
“Before 2005, the authorities did not seem
to have a clear view of what the financial
institutions were doing in the credit deriva-
tives market. It is unclear to what extent the
situation has improved,” noted Richa. “We
should pursue the efforts to improve the
information flow between the major market
participants and the supervisory authorities.
The existing meetings to assess the progress
made in the reduction of the backlog are a
first step in the right direction.”
As the OTC credit derivatives market con-
tinues to expand exponentially, there will
always be the risk that operational problems
could return to haunt it. Moreover, the rise
of CDS trading and credit risk transfer has
As the OTC credit
derivatives market
continues to expand
exponentially, there will
always be the risk that
operational problems
could return to haunt it
The landscape 57
largely taken place in the context of a
benign credit environment. Strong global
growth with low inflation and reasonably
predictable monetary policies, as well as
solid corporate performance in terms of
profits, have been the order of the day. If
and when the environment changes for the
worse, which many believe is now inevitable,
the fear is that operational difficulties will
again return to the OTC credit derivatives
market. As Tiner concluded in his ISDA®
speech: “Now that the immediate risk of
operational backlogs and unauthorized
assignments in credit derivatives is largely
mitigated, it is right that the industry’s
attention is now on potential operational
risks that would arise in a more volatile
credit market. You could say we have had a
long dry summer in which to get the
groundwork done, but now it is time to get
the roof on before winter comes around.”
 58 The landscape

The Bloomberg
Pricing Model
Bloomberg’s Mirko Filippi explains the Bloomberg Pricing Model for
CDSW/FCDS screens and Bloomberg defaults in CDSD/SWDF
 The
Case
landscape
studies 59

B
loomberg models
have benchmark
status in the credit
default swaps (CDS)
space; Market Makers
and institutional
investors communicate
price, trade and mark-
to-market information on CDS transactions
using the popular Bloomberg CDSW function.
CDSW is also popularly used to evaluate
contracts based on CDS indexes, such as the
iTraxx® Indexes and tranches, and the facility
has been recently expanded to price the
Eurex iTraxx® Credit Futures contracts.
The first part of this chapter will describe
the analytics behind the CDS Bloomberg pendent of changes in the default free generated by CDSW from the user inputs for
Model, while the second part will focus on yield curve. the maturity dates and other conventions.
how to set up the different variables (interest The last assumption allows us to perform any The discount function, which takes the date
rates, CDS curves, etc.) in order to replicate discounting with the current default-free as input and returns a discount factor, uses
the futures contract’s final settlement prices discount factors, without assuming that standard interest rate market conventions, and
or its intraday levels. interest rates are deterministic. can be configured to different underlying
The CDS pricer takes as inputs the instruments through the SWDF function (as
1 Bloomberg Model for CDS pricing schedule, a default probability function and a explained in section two).
The Bloomberg Model is available on the discount function. As an output it produces The default probability function is gen-
CDSW screen along with other models, such the present value of the default leg (also erated from an input CDS curve (also fully
as JPM and Hull-White. It prices a credit known as the protection leg) for a unit loss- configurable, as described in section three) by
default swap as a function of its maturity, given default as well as the present value of the default probability curve stripper.
the deal spread, the CDS and yield curves and a flow of a unit premium until the earlier of Symbolically, we can express the present
the notional amount in question. The model default and maturity. value of the premium leg as shown in the
consists of two main components: a default The model value of the CDS is determined equation below. Where:
probability ‘stripper’ and a CDS pricer. The by multiplying the default leg by the notional c is the annualized deal spread
conventions, assumptions and auxiliary amount of currency times one, minus the N is the notional amount
market data used in both components assumed recovery rate, and subtracting from P(t) is the discount function
are identical. this the contractual deal spread (premium Q(t) is the default probability function, giving
The key assumptions employed in the rate) times the notional amount of currency. the cumulative default probability to time t;
Bloomberg Model are: The required payment schedule is then And t measures time with time 0 being the
I constant recovery as a fraction of par
I piecewise constant risk-neutral
hazard rates
I default events being statistically inde- Equation expressing the present value of the premium leg
 60 The landscape
present and T = the time to maturity of
the deal. denotes the fractional
year between successive premium payment
dates, and the function measures
the length of time over which premium has
accrued since the last premium payment
date, both measured in the relevant day-
count convention.
The present value of the default leg can
similarly be expressed as:
Where R is the assumed fractional
recovery of par in case of default.
As shown in the CDSW screen, the par
spread for a CDS is determined as the
spread that equates the present value of the
premium leg with the present value of the
default leg. Therefore, the principal of the
transaction will be zero.
The pricer screen also produces two risk
measures: the spread and interest rate
(DV01), which represent the number of cur-
rency units that the value of the transaction
will change by as a result of a parallel shift of
one basis point in the CDS curve or interest
rate forward curve.
On implementation the integrals above are
evaluated piecewise, each piece being no
longer than three months and small enough
to justify locally flat hazard rates and
forward interest rates.
The curve stripper takes a set of standard
maturity CDS as inputs, along with their
associated schedules, a yield curve and a
recovery rate. A set of risk-neutral default
probabilities for future dates is produced by a
bootstrapping algorithm, which starts from
the shortest maturity and progresses recur-
sively over the input maturities.
The specific assumption on default proba-
bility function is that it has the shape:
for . Then, is determined so
that the CDS pricer will match the par spread
of the first input CDS. Given , is
found, the CDS pricer will correctly price the
second input CDS, and so on. The value of
Q to each input CDS maturity is presented in
the CSDW screen under the heading
‘Default Prob’.
2 Interest rate curve settings
Interest rate curve settings affect CDS
pricing, as they determine the discounting
rates that are applied to the instruments’
cashflows. They can be changed through the
SWDF <go> function.
The three indispensable settings are:
1) The curve type (which determines
how the interest rate curve is built).
We advise it should be built on
‘Standard Rates’, under selection
number one.
2) The pricing source (the rate source for
each curve). For a list of choices, move
your cursor to any of the highlighted
fields. The sources are used in order of
preference; if the first choice is not
available, the second choice is selected,
and so on. NOTE: If you do not select a
contributor, SWDF defaults to Bloom-
berg composite pricing. For consistent
intraday and historical CDS futures
pricing, use the Bloomberg Composite

(‘CMPL’) and London trading hours (‘L’).
3) The interpolation method (the method
used to interpolate values between
maturity points on the swap curve). The
interpolation method can be changed in
SWDF, under ‘User Defaults’ and should
be set to ‘Smooth Forward/Piecewise
quadratic’.
3 CDS curve settings
The standard Bloomberg CDS Curve Spread
Defaults settings that Eurex uses for the
Bloomberg CDS Pricing Models to calculate
the credit futures settlement prices should
be changed via the Bloomberg function
CDSD <go>
These are as follows:
1) Set the ‘IMM Override’ field (reference
dates for the Par-CDS-Curve). The
setting should be number 2 ‘IMM
Maturities’.
2) Set the ‘CDSW default Date Generation
Method’ (choosing number 2 ‘IMM’, the
CDS cashflow dates are generated with
IMM defaults).
4 Set the pricing model
Set the ‘Bloomberg’ Model as the default
pricing model (‘CDS Default Model’).
5 Set the pricing source for the under-
lying iTraxx® Indexes to ‘CBIL’
Change your settings from the CDSD
function (number 12: Indexes) for the
indexes underlying the futures contract.
6 CDS futures contracts in Bloomberg:
how to find them?
The CDS futures contracts are retrievable
under the following tickers:
The landscape 61
A set of risk-neutral default
probabilities for future
dates is produced by a
bootstrapping algorithm,
which starts from the
shortest maturity and
progresses recursively over
the input maturities
I FEAU7 Index In the ticker symbols:
iTraxx® Europe 5-year Index Futures I ‘F’ stands for ‘Future’;
(active contract) I ‘E’, ‘H’ and ‘X’ relate respectively to ‘iTraxx®
I FEBU7 Index Europe’, ‘iTraxx® HiVol’ and ‘iTraxx®
iTraxx® Europe 5-year Index Futures Crossover’;
(defaulted contract)1 I ‘A’ means ‘Active’ (which will be the con-
tract with the lowest factor, the contract
I FHAU7 Index containing no defaults);
iTraxx® Europe HiVol 5-year Index Futures I ‘B’, ‘C’, etc: these sequential letters of the
(active contract)
1
alphabet describe indexes that contain ‘1’,
I FHBU7 Index ‘2’ and increasing number of defaults; (i.e.
iTraxx® Europe HiVol 5-year Index Futures B=1 default, C=2 defaults and so on)
(defaulted contract) I ‘U7’ indicates the September 2007 expiry.
I FXAU7 Index The futures can also be accessed via:
iTraxx® Europe Crossover 5-year Index I CEM EUX <go>; which is the contract
Futures (active contract) exchange menu for Eurex Deutschland;
I FXBU7 Index I CTM CDS <go>; which is the contract
iTraxx® Europe Crossover 5-year Index table menu for all futures contracts on CDS-
Futures (defaulted contract)1 single-name and CDS indexes.
1
If and when a default situation occurs.
 62 The landscape

7 CDS futures contracts on Bloomberg: function: FCDS <go>.

how to calculate the fair price?
Once the settings are properly organized,
users can calculate the future fair price
(intraday, at settlement, also for historical
dates) through a new analytical Bloomberg
FCDS can be launched in two ways:
I either from the Description Page (DES) of
the future;
I or by typing, for instance, FEAU7 Index
FCDS <go>.

Bloomberg LP’s founding vision in 1981 was to create an information-services, news and media company that provides business and
financial professionals with the tools and data they need on a single, all-inclusive platform. The success of Bloomberg is due to the con-
stant innovation of its products, unrivaled dedication to customer service and the unique way in which it constantly adapts to an ever-
changing marketplace. The New York-based company employs more than 9,000 people in more than 125 offices around the world.
Bloomberg is about information: accessing it, reporting it, analyzing it and distributing it, faster and more accurately than any other
organization. The BLOOMBERG PROFESSIONAL service, the company's core product, is the fastest-growing real-time financial infor-
mation network in the world.

Mirko Filippi is a business manager in charge of fixed income and inflation derivatives, structured notes and property derivatives. Mirko
joined the business side of Bloomberg two years ago, having covered those asset classes as sales specialist for three years. Mirko previ-
ously worked as a quantitative analyst at the capital modeling department of BoE and CNB focusing in particular on STIRS and exotic
options. Mirko terminated his post-graduate studies with a masters degree in financial engineering in the U.K. An Italian native, Mirko
now manages the business from London and less frequently from New York.

Eurex iTraxx®
Credit Futures
All about Eurex iTraxx® Credit Futures – reprinted from a March 7, 2007
research report by Michael Hampden-Turner and Michael Sandigursky. With
grateful thanks to Citigroup Corporate and Investment Banking
T
he new 5-year iTraxx®
Investment Grade, HiVol and
Crossover Index Futures were
launched on March 27, 2007.
For credit default swap (CDS)
indexes this marks the final
stage of a remarkable three-year
evolution from exotic over-the-
counter (OTC) credit derivative to
exchange-traded security. The British Bankers
Association estimates that index credit deriv-
atives such as CDX and iTraxx® make up at
Another advantage of
trading on exchange is the
degree of confidence that the
market has in a product that
is completely standardized
least 30 percent of the USD 26 trillion credit
derivatives market.
Futures on these indexes will build on this
success by making index credit derivatives
accessible to a much broader audience than
could have used the OTC contract. The future
has an identical risk profile to the index
credit default swap but the fact that it is
margined has a significant impact.
I No credit lines are required for futures,
which is a significant advantage for
investors who have high demands on
The landscape 63
their capital or limited access to credit.
I No ISDA®s have to be in place between
counterparties, which removes a signif-
icant administrative burden.
I Margined products have no counterparty
risk. The cost of trading futures is,
therefore, considerably lower as counter-
party risk costs money in terms of capital
usage and administration costs.
I Index credit default swaps require a
sophisticated booking and risk man-
agement system. CDS are typically closed
out with an offsetting CDS with another
party, which means that over time a CDS
book can grow to be quite large.
I Futures are completely fungible; with the
result that managing them can be done on
a net basis.
Another advantage of trading on exchange
is the degree of confidence that the market
has in a product that is completely stan-
dardized. The underlying OTC index CDS is
 64 The landscape
also standardized but for many investors
the simplicity of a futures contract will
prove popular.
I iTraxx® Futures trade on a price basis
(which means convexity does not play a
part) and daily P&L can potentially be cal-
culated without a calculator. Ticks move x
contracts x tick value. This suits ‘futures
orientated’ investors, while investors who
prefer a spread-based product can
convert the price to spread and view the
contract in this way.
I Exchange-traded contracts have complete
order book and trade transparency which
helps to give investors confidence.
Futures trade on a contract size of EUR
100,000 notional which is a much smaller
granularity than is available for the OTC con-
tract, again opening up trading to a whole
new potential category of small investors.
Contract mechanics
So how has Eurex managed to commoditize
an OTC credit derivative?
Eurex has chosen to reference the most
liquid index CDSs, the front or on-the-run
contracts. There are three active six-month
futures trading on the Investment Grade,
HiVol and Crossover Indexes. At the rolls
there is a brief period (five exchange days)
of futures overlap when both the vintage
and new indexes trade together to enable
market participants to roll into the new
future before the old one expires.
The CDS contract has been transformed
into a bond, the future trades on that bond
price, i.e. essentially on the PV of the CDS.
To clarify this it is helpful to think of it in
four components:
I Par is 100 at inception for all the indexes
and will reduce proportionally as defaults
Exchange-traded contracts
have complete order book
and trade transparency
which helps to give
investors confidence
occur in the underlying index. It will
reduce by 1/n for each default, where ‘n’ is
a number of equally weighted constituents
in the reference index. For example, if a
default were to occur in the iTraxx®
Investment Grade Index, the par value
would drop to: 100 - 1/125 = 99.2. This
mirrors the change of notional in the OTC
index CDS.
I PV of the underlying spread change
reflects the change in the market’s view on
credit quality of the reference basket since
the inception of the index. Each new series
of iTraxx® Indexes have a standard coupon.
This coupon is roughly equal to an average
spread of the index basket at a time of
issuance. In order to standardize trading,
this coupon is fixed and does not change
with credit quality of the underlying
basket. The current series (S6) of iTraxx®
Europe was issued with 30 bps coupon,
while a current market quote is around
24 bps. Therefore the protection buyer
needs to be compensated by the seller for
this 6 bps in the PV of the contract. More
formally for a protection buyer:
01DV bp PV • Δ= ,
where bpΔ ≈ contractual coupon –
current spread and DV01 is the present
value of a single basis point (DV01 is a
non-linear function, a model is required
for accurate pricing, by convention the
market uses the model on the CDSW, but
Eurex will have their own model for this
calculation.)
I Accrued coupon represents a portion of
the iTraxx® Index coupon due to the pro-
tection seller, similar to the ‘dirty price’ of
a bond. The accrual is based on fixed
coupon paid by the underlying index CDS.
It is calculated as a daily ‘straight-line’
accrual on an ACT/360 basis. Unlike OTC
indexes, which pay coupon quarterly,
future coupon will only be settled at
maturity. For example, the accrued coupon
on a future with a contractual coupon of
30 bps on the October 10, 2007 would be
20 days/360 x 30 bps x Par = 0.0167
I There is a default component: if a credit in
the index defaults then the future may
contain a component that is equal to the
recovery value of the defaulted name(s) in
the index. In the case of a default, a new
index will spawn and there will be two
indexes – one with a default component
and a clean one.
 The
Case
landscape
studies 65

Once each future starts trading, iTraxx®

If spreads tighten, the spreads will change from the inception

level and the future will trade away from

future will trade above par to reflect the value of the upfront
payment now embedded into the price. If

par, while the opposite is
true when spreads widen
spreads tighten, the future will trade above
par, while the opposite is true when spreads
widen. This closely resembles price behavior
of a fixed coupon bond. In fact, thinking of
the future as a bond is useful to under-
standing it in terms of risk, dirty/clean
prices and its relationship to the OTC
index CDS.
Since futures prices are observable and
the P&L of a future is a simple function of
the number of ticks made and the number
of contracts held, no model is required.
 66 The landscape
The success of the
iTraxx® Futures will
largely depend on it
gaining enough
liquidity to become a
mainstream method of
taking a credit view
However, it is inevitable that market
participants will want to break the futures
price into its constituent parts and to know
what iTraxx® spread is implied by a given
futures price. Also, at expiry Eurex will cash
settle futures using a ‘closing’ iTraxx® spread.
For both of these purposes a model is
required to be able to move between futures
price and index spreads.
Treatment of defaults
When it comes to treatment of defaults,
iTraxx® Futures mimics the OTC index con-
tract. In case of an anticipated credit event,
International Index Company (IIC), which
oversees the administration of iTraxx®
Indexes, may publish a separate version of
the index that excludes a name that is on the
edge of bankruptcy. In case of iTraxx®
Investment Grade, this means a 124-name
basket. If this occurs, Eurex will also list a
124-name future, which will trade without
the defaulted credit and whose par com-
ponent will be 99.2. Both 125- and 124-
name futures will trade until future expiry or
until another credit event occurs.
The announcement of a CDS protocol
will be used as a sole trigger of an actual
trigger event. The following day, the par of
the contract will be reduced by 1/n. At this
stage, calculations for both the accrued
premium and PV of spread change are
based on the reduced par. Additionally, the
price of the future will contain ‘expected
recovery’ of the defaulted name. For
instance, 40 percent expected recovery
would contribute 0.32 (40 percent times 0.8
units of par).
Actual recoveries are determined by an
ISDA® recovery auction and until that day
the recovery component remains variable.
This allows investors to create a synthetic
recovery swap by trading the 125-name
future versus the 124-name future. A single
complication arises when recovery auction is
scheduled after the expiry of the future.
When recovery is still not fixed at expiry of
the future, the 125-name future will be split.
The non-defaulted part will be settled based
on 124-name contract, while a recovery
component will continue trading as a single
name future until the auction date.
Next steps
The success of the iTraxx® Futures will
largely depend on it gaining enough liq-
uidity to become a mainstream method of
taking a credit view. Market Makers have
few incentives to entice investors to stick
with OTC markets, as bid/offer spreads are
already quite tight and the operational
costs of maintaining a large CDS book rela-
tively high.
We see futures extending into longer
maturities. A one-year future referencing
static 5-year index will help investors to
express their views on credit transition more
efficiently. The next logical step will be to
trade exchange-traded options on futures.
Liquid OTM options will satisfy a current
demand for cheap ‘crisis’ hedge attracting
more investors’ interest than the moribund
OTC swaption market.
 The landscape 67

Contract Specifications
Contract Standards

Contract Product ID Underlying Currency Bloomberg Code

iTraxx® Europe 5-year Index Futures F5E0 The current iTraxx® Europe EUR FEAA
5-year Index Series
iTraxx® Europe HiVol 5-year Index Futures F5H0 The current iTraxx® Europe EUR FHAA
HiVol 5-year Index Series
iTraxx® Europe Crossover 5-year Index Futures F5C0 The current iTraxx® EUR FXAA
Europe Crossover 5-year
Index Series

Contract value
EUR 100,000
Settlement
Cash settlement, payable on the first
exchange day following the Final
Settlement Day.
Price quotation
In percentage, with three decimal places for
the iTraxx® Europe 5-year Index Futures and
with two decimal places for the iTraxx®
Europe HiVol and iTraxx® Europe Crossover
5-year Index Futures as the sum of
I the basis, determined as the ni, whereby
ni represents the weight of the i’th ref-
erence entity in the underlying index
series, which has not experienced an actual
credit event (basis = 100, as long as no
credit event has occured);
I the present value change calculated on
the basis;
I the accrued premium since the effective
date of the underlying index series based
on the coupon fixed for the underlying
index series;
I and, if applicable, the proportional
recovery rate of the i’th reference entity in
The Daily Settlement Price
for the current maturity
month is determined during
the closing auction of the
respective futures contract
the underlying index series which experi-
enced an actual credit event.
Minimum price change
iTraxx® Europe 5-year Index Futures
The Minimum Price Change is 0.005 percent,
equivalent to a value of EUR 5.
iTraxx® Europe HiVol 5-year Index Futures
and iTraxx® Europe Crossover 5-year Index
Futures
The Minimum Price Change is 0.01 percent,
equivalent to a value of EUR 10.
Contract months
The nearest semi-annual month of the March
and September cycle will be available for
trading; trading in the back month contract
starts on the 20th calendar day if this is an
exchange trading day; otherwise on the next
exchange trading day.
Last Trading Day
The fifth exchange day following the 20th
of the respective contract month.
Daily Settlement Price
The Daily Settlement Price for the current
maturity month is determined during
the closing auction of the respective
futures contract.
 68 The landscape
For the remaining maturity month the
Daily Settlement Price for a contract is deter-
mined based on the average bid/ask spread
of the combination order book. Further
details are available in the clearing conditions
on www.eurexchange.com.
Final Settlement Price
The Final Settlement Price is established at
17:00 CET on the Last Trading Day in percent,
as the sum of:
I the basis determined as the ni, whereby
ni represents the weight of the i’th ref-
erence entity in the underlying index
series, which has not experienced an actual
credit event (basis = 100, as long as no
credit event has occured);
I the present value change of the underlying
index series resulting from the change of
the credit spread in relation to the basis.
The present value calculation on the final
settlement day is based on the official
iTraxx® Index levels as published by IIC at
17:00 CET and the deal spread (coupon) of
the underlying index. The mid-spread
reflecting the mid-point between the bid
and ask spreads of the official iTraxx®
Index levels are considered for the present
value calculation.
I the accrued premium calculated from the
effective date of the underlying index
series based on the coupon fixed for the
underlying index series;
I and, if applicable, the proportional
recovery rate of the reference entity in the
underlying index series, which experienced
an actual credit event; The calculated Final
Settlement Price will be determined with
four decimal places and rounded to the
next possible price interval (0.0005; 0.001
or a multiple thereof).
Upon occurrence of a credit
event, the credit futures
contract will continue to
trade in its original form
Trading hours will list a futures contract based on the new
08:30 – 17:30 CET. On the Last Trading Day version of the underlying index (for example,
trading ceases at 17:00 CET. 124 reference entities).
Occurrence of a Credit Event For all details regarding the handling of a
Upon occurrence of a credit event, the credit credit event as well as the determination of
futures contract will continue to trade in its Final Settlement Prices, please refer to the
original form, including the reference entity full contract specifications published on
subject to the credit event. In addition, Eurex www.eurexchange.com.
Citi's Credit Product Strategy Group, headed by Matt King, provides advice and research
on credit portfolio management, from the latest views on CDOs and exotic structured credit
to the euro and British pound cash markets. The team was ranked number one in 2004, 2005
and 2006 for credit strategy and number one for credit derivatives by Euromoney in 2006. Citi
is the largest financial institution in the world and a global force in corporate and structured
credit markets.
Michael Hampden-Turner is a director in Citi's Credit Products Strategy Group in London.
Within this global research and strategy group he focusses on European cash CDOs, CLOs and
synthetic structured products. He has worked in similar research roles in structured credit at
the Royal Bank of Scotland, interest rate derivatives at WestLB and equities Smith New Court
Merrill Lynch. Michael studied economics and history at Trinity College Cambridge and
Harvard University.
Michael Sandigursky, CFA is a vice president in the credit derivatives structuring team of
Citigroup, based in London. Before moving to structuring, he specialized in quantitative ele-
ments of credit derivatives and structured credit in his role within credit strategy. Previously,
Michael worked for several years in Citigroup Corporate Bank in London and Russia. Michael
holds an MBA from London Business School, and degrees from the University of Economics
and Finance and the University of Electronics in St. Petersburg, Russia.
 Case studies 69

Case studies
 70 Case studies

Portfolio overlay
strategy using Eurex
iTraxx® Credit Futures
Eurex’s Byron Baldwin explains how the new iTraxx® Credit
Futures introduce more options in European fund management
 Case studies 71

W
ith the introduction Diagram 2: Synthetic iTraxx® Credit Future and Eurex Euro-Bobl Future
of the Eurex iTraxx®
Europe, HiVol and
Crossover Credit Futures
contracts on March 27,
2007, the world’s first
exchange-traded credit
derivatives1 began trading.
Combined with Eurex’s existing benchmark
fixed income futures contracts of Euro-
Schatz, Euro-Bobl, Euro-Bund and Euro-
Buxl®, the iTraxx® Credit Futures contracts
introduce greater opportunities in European
fixed income fund management. Source: Eurex and IIC Ltd. CFE1 Future is the synthetic iTraxx® Credit Future,
The benefit of introducing credit as an OE1 is the front month Eurex Euro-Bobl Future
asset class within fixed income fund man-
agement is underlined in a recent paper by
Brian Eales2. Using data from the September The analysis demonstrated
to December 2006 period, Eales looked at the
benefits of incorporating credit into a
that the inclusion of credit
European government bond portfolio. In his
study, credit exposure was introduced
into a bond portfolio reduced
through the iTraxx® Europe Index, while
Bloomberg/EFFAS Euro Market 3-5 Year Bond
risk and increased return
Index was considered as the proxy for a

Diagram 1: Efficient Frontier: Euro Market Tracker 3-5 Year Bloomberg/EFFAS Bond Index short-term maturity European government
bond holding, (see diagram 1, left).
The analysis demonstrated that the
inclusion of credit into a bond portfolio
reduced risk and increased return. The results
showed that a 10 percent inclusion of iTraxx®
reduced risk by 0.19 percent and increased
return by 1.63 percent, while a 20 percent
holding increased risk by only 0.10 percent
but increased return by 3.27 percent. The
attraction of augmenting credit within fixed
income portfolio management is underlined
in diagram 2 (above), which looks at the
Sources: B. Eales The Case for Exchange-based Credit Futures Contracts, history of a synthetic iTraxx® Credit Future
Bloomberg LP and data from IIC Ltd. and the Eurex Euro-Bobl Future. There has
 72 Case studies
Diagram 3: Bloomberg DLV Screen
Used with permission of Bloomberg LP
also been a study carried out by Hans
Byström, Lund University, on the relationship
between iTraxx® CDS Index and equity prices3.
Consider the situation of a European fixed
income fund manager, who manages a EUR
500 million short maturity European gov-
ernment bond portfolio that has a (modified)
duration of 4.5 years. The fund manager
decides to switch 20 percent of the European
bond exposure to a European credit exposure
using the Eurex Euro-Bobl and iTraxx®
Europe Credit Futures contracts.
Steps
1. Calculate Portfolio Basis Point Value (BPV is
the price value of an 0.01 change in yield):
Portfolio BPV = Portfolio Modified
Duration x Portfolio Value x 0.0001 =
4.5 x EUR 500 million x 0.0001 =
EUR 225,000
2. Calculate the BPV of the Eurex Euro-Bobl
Futures contract using the Bloomberg
DLV and DUR function. (See diagram 3,
above.) BPV of the Eurex Euro-Bobl Future
= BPVCTD/CFCTD
Where BPVCTD is the BPV of the cheapest-
to-deliver bond and CFCTD is the con-
version factor of the cheapest-to-deliver
bond. Alternatively, the BPV of a futures
contract can be generated very quickly
using the Bloomberg FRSK function (i.e.
for the September 2007 Euro-Bobl
Futures contract it is
OEU7<cmdty>FRSK<go>, which gives
0.04807 in price terms, 9.614 futures ticks
or EUR 48.07 in monetary terms).
3. Calculate the appropriate number of
Eurex Euro-Bobl Futures to sell to
synthetically reduce the fund managers’
European government bond exposure by
20 percent: Number of Euro-Bobl
Futures to sell = (EUR 225,000/EUR 48.07)
x 0.20 = 936
4. Calculate the Eurex Euro-Bobl
Futures/Eurex iTraxx® Europe Credit
Diagram 4: Bloomberg FCDS Screen
Futures ratio. The BPV of the Euro-Bobl
Future is EUR 48.07 (see step 2). The
price value of a basis point change in
the CDS curve in terms of the iTraxx®
Europe Credit Future is EUR 45.25,
which can be generated using the
Bloomberg FCDS4 screen. Type
FEAA<index>FCDS<go> and go to
SprdDV01 (there is a small interest rate
exposure being long credit futures, but
the exposure is minimal, see IR DV01).
(See diagram 4, below.) Therefore, the
ratio is: 1 Eurex Euro-Bobl Futures con-
tract/1.06 Eurex iTraxx® Credit Futures.
The fund manager sells 936 Eurex Euro-
Bobl Futures and buys 992 Eurex iTraxx®
Europe Credit Futures to synthetically
switch 20 percent of his European bond
exposure to a European credit exposure.
By way of this portfolio overlay strategy,
the fund manager can quickly switch
part of his European bond exposure to a
European credit exposure, while leaving
his existing portfolio intact5.
Used with permission from Bloomberg LP

Diagram 5: Using iTraxx® Credit Futures in portfolio overlay
Initial Portfolio
Long
European
Government
Bond
Exposure
Sell Eurex
Euro-Bobl
Futures
Portfolio Overlay
Diagram 6: Eurex OTC Block Trade Facility
Contract
iTraxx® Europe Index Futures
iTraxx® HiVol Index Futures
iTraxx® Crossover Index Futures
Euro-Schatz Futures
Euro-Bobl Futures
Euro-Bund Futures
Euro-Buxl® Futures
5. When the fund manager feels the out-
performance of credit has run its course,
he can unwind the short Euro-Bobl/long
iTraxx® Europe Credit Futures spread
position. Diagram 5 (above, top) outlines
portfolio overlay using Eurex Euro-Bobl
and iTraxx® Credit Futures contracts.
The Eurex OTC Block Trade Facility (BTF) is
extended to iTraxx® Credit Futures and pro-
motes maximum liquidity and trading flexi-
bility for a fund manager initiating portfolio
overlay strategies across European credit and
Case studies 73
rupting the underlying portfolio. The recent
New Synthetic launch of the Eurex iTraxx® Credit Futures
Portfolio
contracts introduces a new asset class for
this strategy. The iTraxx® Credit Futures
Long contracts offer fund managers a highly
Buy Eurex European leveraged (0.29 percent of underlying
iTraxx® Government margin required for iTraxx® Europe Index
Credit Bond Futures; 0.55 percent for iTraxx® HiVol
Futures Exposure
Index Futures and 2.0 percent for iTraxx®
Crossover Index Futures) and cheap (exchange
fees of EUR 0.40 per EUR 100,000) access to
Long European credit market ‘beta’7,8.
Credit Exposure
Further reading
1
Eurex, Credit Derivatives – Always…
Making Fresh iTraxx®. See the Eurex web site:
http://www.eurexchange.com/documents/
publications/crd_en.html
OTC Block Trade – Eurex, Eurex iTraxx® Credit Futures: Building
minimum amount of contracts
on the Market Benchmark, Eurex Xpand,
2,500 April 2007 edition.
1,500 2
B. Eales, London Metropolitan University,
1,000 The Case for Exchange-based Credit Futures
4,000 Contracts.
3,000 3
H. Byström, Lund University, Credit Default
2,000 Swaps and Equity Prices: The iTraxx® CDS
500 Index Market.
4
M. Filippi, Bloomberg, Eurex CDS
bonds. The BTF6 allows market participants, Futures in Bloomberg.
trading either for their own account or on 5
B. Baldwin, Derivatives: a tool for efficient
behalf of customers, to enter off-exchange fund management, Pensions Week,
transactions in Eurex futures and options December 2004.
contracts and yet still have the transactions 6
Eurex OTC Block Trade Facility. Eurex website
cleared by Eurex Clearing AG, the Eurex link: http://www.eurexchange.com/trading/
Clearing House, (see diagram 6, above). market_model/wholesale/block_trades_en.
html
Conclusion 7
B. Baldwin, Successful Portable Alpha
Using derivatives in portfolio overlay Investing with exchange traded derivatives,
increases the efficiency of fund management Pensions Week, December 2005.
by allowing fund managers to move quickly 8
Eurex, Complete Your Picture in Fixed
from one asset class to another, without dis- Income Fund Management.
 74 Case studies

Generating alpha –
trading credit versus
equity and equity
volatility on exchange
Byron Baldwin describes how the Eurex iTraxx® Credit Futures
have introduced new alpha generation opportunities in Europe

E
urex’s recent
launch of the
a
world’s first
exchange-traded
credit derivatives con-
tracts has opened up a
wealth of new opportu-
nities to generate alpha
across European asset classes.
Eurex, Europe’s largest derivatives exchange,
already lists benchmark derivatives for the
European equity, fixed income and volatility
markets. The introduction of iTraxx® Europe,
Crossover and HiVol CDS Index Futures has
expanded the exchange’s range of products to
the credit markets, opening up opportunities
to generate alpha across the range of Euro-
pean financial asset classes. Crucially, the
exchange-traded credit derivatives products
offer advantages over and above their over-
the-counter (OTC) counterparts – particularly
as regards transparency, the introduction of a
central clearing house, reduced counterparty
risk and independent daily valuations.
The causality between credit spreads, the
equity market and equity volatility (including
the option volatility skew) can be attributed
to ‘the leverage effect’ – a fall in equity
prices increases a company’s leverage,
thereby increasing the risk to equity holders,
and increasing equity volatility. John C. Hull
in Options, Futures & Other Derivatives, out-
lined the causality as follows: “As a com-
pany’s equity declines in value, the com-
pany’s leverage increases. This means that
the equity becomes more risky and its
volatility increases. As a company’s equity
increases in value, leverage decreases. The
equity then becomes less risky and its
volatility decreases. This argument shows
that we can expect the volatility of equity to
Diagram 1: iTraxx® Crossover Series 6 synthetic future & Eurex DAX® Future
be a decreasing function of price”. Therefore,
one would expect an inverse relationship
between equity prices and credit spreads – or
a positive relationship between the iTraxx®
CDS Index/Eurex iTraxx® CDS Index Future
and equity (see diagram 1), and a positive
relationship between credit spreads and
equity volatility. However, there could be sit-
uations (i.e. LBO and M&A activity), which
would result in a breakdown of the inverse
relationship and actually result in increasing
equity prices with increasing credit spreads.
An increase in the option volatility put skew
is known to reflect the markets’ expectations
of an increasing downside risk in equity
prices : therefore, one would also expect a
b
positive relationship between the option
volatility, put skew and credit spreads .
1
Hans Byström in Credit Default Swaps and
Equity Prices: The iTraxx® CDS Index Market c
looked at the empirical relationship between
the iTraxx® CDS Index market and the
equity market and made the following
empirical findings : 2
I There is a clear empirical link between
the iTraxx® CDS Index market and the
equity market.
I There is a tendency for European sectoral
iTraxx® CDS Indexes to narrow when stock
Case studies 75
prices rise and vice versa.
I Firm specific information is imbedded into
equity stock prices before it becomes
imbedded into CDS spreads – the equity
market leads the CDS market.
I Stock price volatility is significantly corre-
lated with CDS spreads – spreads are
found to increase when stock price
volatility increases and vice versa.
I And finally, there is significant autocorre-
lation in the iTraxx® market.
In diagram 1 (above) the statistical historical
relationship between iTraxx® Crossover Series
6 Index synthetic future and the Eurex DAX®
Future is illustrated.
Such a close correlation between iTraxx®
Crossover and the Eurex DAX® Future – a R2
of 0.97 would suggest that, should there be a
divergence between the two variables, a con-
vergence trade, taking a view on the re-estab-
lishment of the historical relationship between
two markets, can be established. With the
recent launch of the Eurex iTraxx® CDS
Futures contracts, such a relative value/cross
asset class position can now be established on
exchange, with the added benefits of trans-
parency, independent mark-to-market valu-
ation and a central clearing house.
 76 Case studies
How can such relative value/cross asset
class positions be structured? One method
would be to structure such strategies in
terms of the ratio of the monetary value of
each of the respective contracts’ risk posi-
tions based on historical price volatility.
For example, structuring a Eurex iTraxx®
Crossover Index/DAX® position, typing
GXU7<index>HVT<go> on Bloomberg will
generate historical price volatility data for
the Eurex DAX® Future, and typing
FXAU7<index>HVT<go> will generate his-
torical price volatility data for the Eurex
iTraxx® CDS Crossover Index Future.
Taking the 30-day historical price volatility
measures for both contracts:
Eurex DAX® Future
8,105.50 (DAX® Future price) x 18.553
percent (30-day historical price volatility) =
1,503.81 index points = EUR 37,595.
Eurex iTraxx® CDS Crossover Index Future
99.15 (iTraxx® CDS Crossover Future price) x
6.698 percent (30-day historical price
volatility) = 6.641 index points = EUR 6,641.
The monetary value of each of the
respective contracts’ risk positions (based on
the 30-day historical price volatility) would
suggest we should structure a Eurex DAX®
Future: Eurex iTraxx® CDS Crossover Index
Future relative value strategy in a 1: 5.66
ratio. (Though obviously, as the relative price
volatilities change, then the ratio of DAX®
Futures to iTraxx® CDS Crossover Futures
would need to be adjusted.)
The attraction of generating alpha across
European asset classes are further under-
lined in diagram 2 (top, right), which looks
at the index price history of the Eurex Dow
Jones EURO STOXX 50® Index Future price
and a synthetic iTraxx® CDS Europe Index
Future price.
Again, one approach to structuring a Eurex
Dow Jones EURO STOXX 50® Index Future/
Eurex iTraxx® CDS Europe Index Future rel-
ative value strategy, would be to ratio the
respective contracts’ monetary value of the
risk position based on historical price volatility:
Eurex Dow Jones EURO STOXX 50®
Index Future
4,538 (Dow Jones EURO STOXX 50® Index
Future price) x 14.079 percent (30-day his-
torical price volatility) = 638.90 index points
= EUR 6,389.
Eurex iTraxx® CDS Europe Index Future
100.07 (iTraxx® CDS Europe Index Future
Diagram 2: Eurex Dow Jones EURO STOXX 50® Index Future and synthetic iTraxx® CDS Europe Future
Diagram 3: Eurex OTC Block Trade Facility
Contract
iTraxx® Europe Index Futures
iTraxx® HiVol Index Futures
iTraxx® Crossover Index Futures
Euro-Bobl Futures
Dow Jones EURO STOXX 50® Index Futures
Dow Jones EURO STOXX 50® Index Options
DAX® Futures
VSTOXX® Volatility Index Futures
VDAX-NEW® Volatility Index Futures
VSMI® Volatility Index Futures
price) x 0.742 percent (30-day historical price
volatility) = 0.7425 = EUR 742.50.
Therefore, based on the 30-day historical
price volatilities for the two contracts, the
ratio to structure a Eurex Dow Jones EURO
STOXX 50® Index Future/Eurex iTraxx® CDS
Europe Index Future relative value strategy
would need to be initiated in a 1 Dow Jones
EURO STOXX 50® Index: 8.6047 iTraxx® CDS
Europe Index Future ratio (1:8.6047).
Such cross asset/relative value strategies
can be extended to initiate Eurex iTraxx®
Credit Index Futures versus European Equity
volatility plays, using the Eurex VSTOXX®,
OTC Block Trade –
minimum amount of contracts
2,500
1,500
1,000
3,000
1,000
1,000
250
100
100
100
 Case studies 77

VDAX-NEW® and VSMI® equity volatility

index contracts, and to European Credit
versus European equity volatility skew posi-
tions, using the Eurex Dow Jones EURO
STOXX 50® Index Option contracts3.
The Eurex OTC Block Trade Facility (BTF)
d
enables the initiation of such relative value/
cross asset class strategies in Eurex futures
and options products off-exchange, while
maintaining the benefits of having a position
in exchange-traded derivatives products,
Further reading
a
Eurex, Credit Derivatives – Always…Making Fresh iTraxx® See the Eurex website:
http://www.eurexchange.com/documents/publications/crd_en.html
a
Eurex, Eurex iTraxx® Credit Futures: Building on the Market Benchmark, Eurex Xpand,
April 2007 edition.
b
A number of articles have been written on the predictive power of the option volatility skew, namely,
B. Mizrach, Did option prices predict the ERM Crisis?, R. Cont, Beyond implied volatility: Extracting
information from option prices, G. Murphy, When option prices meet the volatility smile and
M. Rubenstein, Implied Binomial Trees, to name just a few.
H. Byström, Lund University, Credit Default Swaps and Equity Prices: The iTraxx CDS Index Market.
c

cleared by the Eurex clearing house. d

Diagram 3 (bottom, left) outlines the
minimum amount of contracts that can be
traded under the BTF.
Conclusion
The recent launch of the Eurex iTraxx®
CDS Futures has greatly extended the
possibilities of generating alpha through
various relative value strategies across
European asset classes with the benefits of
substantially reduced counterparty risk, a
central clearing house and independent
mark-to-market valuation.
Eurex OTC Block Trade Facility. Eurex web site link:
http://www.eurexchange.com/trading/market_model/wholesale/block_trades_en.html
1
Merton in On the Pricing of Corporate Debt: The Risk Structure of Interest Rates produced an
equity based credit model taking asset values and volatilities from equity prices producing
a firm credit default probability. Riskmetrics adapted the Merton model and produced CreditGrade
which produces a company’s default calculations based on a firm’s equity volatility and
leverage ratio.
2
Norden and Weber in The co movement of credit default swap, bond and stock markets; an empirical
analysis made similar findings.
3
Such relative value positions are not only limited to European equity. Using the Eurex Euro-Bobl
Futures contract with the Eurex iTraxx® Credit Futures contracts, European credit/European fixed
income cross asset positions can be initiated. See B. Baldwin, Portfolio Overlay using Europe iTraxx®
Credit Futures – Introducing more options in European Fund Management for a discussion of the
Euro-Bobl Future: iTraxx® Credit Future ratio.

Eurex is a leading derivatives exchange. One of Eurex’s key strengths is the open, low-cost electronic access to the global exchange network.
Eurex provides access to a broad range of global benchmark products, including the most liquid fixed income markets worldwide. Every day, par-
ticipants trade more than seven million contracts, from around 700 different locations. Alongside the fully-computerized trading platform, Eurex
also operates an automated and integrated clearing house. Acting as a central counterparty, Eurex Clearing AG guarantees the performance of
all trades entered into at the Eurex exchanges. The same guarantee is extended to cover Eurex Bonds, Eurex Repo, and all cash securities listed at
the Frankfurt Stock Exchange (Xetra® and floor) or at the Irish Stock Exchange (ISE).

Byron Baldwin is a member of the institutional investor sales team at Eurex. Byron has over 25 years of experience in derivatives working with
hedge funds, central banks, fund management companies and corporations. He has written a number of articles on the use of derivatives in
fund management – he recently wrote an article for Pensions Week, Is Portable Alpha Investing the answer for Pension Funds?, as well as two
articles, Derivatives: a tool for efficient fund management and Complete Your Picture in Fixed Income Investment Management for Eurex, and
has lectured on derivatives at the London Metropolitan University. Byron read monetary economics at the London School of Economics for his
BSc economics degree and finance for his MSc degree at the University of Leicester Management Centre.
 78 Case studies

Credit futures:
application and
strategies
HypoVereinsbank’s Jochen Felsenheimer describes some of the different ways in which
the Eurex iTraxx® Credit Futures can be put to work

T
he innovative power
of credit market prac-
titioners remains as
strong as ever. During
the last few years, a
wide range of new
instruments have been
developed – new collater-
alized dedt obligation (CDO) structures,
credit default swaptions, and standardized
tranches being some of the most popular
examples. The growing standardization of
the instruments and the legal documen-
tation supporting them have facilitated this
trend, fuelling liquidity and transparency in
the credit derivatives market and triggering
enormous growth rates. According to the
British Bankers Association, the outstanding
amount of credit derivatives exceeded USD
34 trillion at the end of 2006 – around six
times the outstanding balance of over-the-
counter (OTC) equity derivatives. During the
last five years, credit derivatives have been
the fastest growing segment of all estab-
lished asset classes.
The iTraxx® Index products are among
the most liquidly traded instruments in the
credit market – the iTraxx® Europe, HiVol,
and Crossover Indexes being the flagship
products with the highest turnover and
Futures should facilitate the
credit portfolio management
process and the development
of standardized cross-asset
trading strategies
greatest levels of popularity. Once these
indexes had been established, and taken off,
the obvious next step towards the market’s
completion was, of course, the listing of
credit futures contracts. Futures should
facilitate the credit portfolio management
process and the development of stan-
dardized cross-asset trading strategies.
The Eurex iTraxx® Credit Futures contracts
were the first exchange-traded credit deriva-
tives contracts, though similar contracts have
since launched in the U.S. The first and most
important fact about the iTraxx® Futures
contract is that, in contrast to its name, it is
not a futures contract in a strict sense, as it
does not have a forward payoff profile.
Instead, it can be viewed as a standardized
exchange-traded total return index on an
unfunded underlying. In contrast to a
forward CDS contract, the Eurex iTraxx®
Credit Futures contract involves premium
payments (not as real cash-flows, but as
accruals), and default risk (forward CDS are
usually knock-out-on-default contracts)
during the holding period. Moreover, in con-
trast to the underlying OTC iTraxx® swap
contracts (which are quoted in basis point
spreads), the Eurex iTraxx® Credit Futures
contracts are quoted in price terms.
Furthermore, the quoted prices are dirty
Case studies 79
prices, reflecting the accrued premium
(referring to the deal spread of the under-
lying swap contract), changes in value in the
underlying iTraxx® swap contract (due to
spread changes), and losses arising from
credit events (including the recovery rates).
From a credit portfolio management per-
spective, futures contracts can be used to
implement cost-efficient hedging and overlay
management strategies. Liquid exchange-
traded futures contracts also provide a par-
ticularly cost-efficient alternative to OTC
swap contracts for immunizing European
credit portfolios against systematic risks.
And they can be used to implement core-
satellite strategies. In such cases credit
futures will be the core investment, while
the alpha-generation, curve positioning
trades and so forth will be managed via
satellite CDS or cash trades. Finally, many
market participants may choose to use the
Eurex iTraxx® Credit Futures contract as an
attractive alternative to the underlying swap
contract, or to actively manage cross-asset
portfolios. In all cases the users will benefit
from the contract size and regulatory
advantages, as well as from using stan-
dardized instruments from a single toolbox.
Strategic cross-asset management strate-
gies will likely gain traction, as cost-efficient
overlay strategies can now be implemented
by combining liquid instruments – for instan-
ce, by using the Eurex iTraxx® Credit Futures
contract in conjunction with well-established
instruments, such as the DAX® Futures. The
consistent construction principles behind the
Eurex futures contracts make these ideal
instruments to use in cross-asset strategies,
as the complexity of delta-adjustments is
negligible (via the tick value of the contracts),
while beta remains the major challenge.
 80 Case studies
Three trading strategies:
credit versus equity, versus volatility,
and versus rates
Credit versus equity
Debt-equity trades on indexes are not ‘real’
capital structure arbitrage trades, but index
futures can be used to express general views
on the relative attractiveness of debt versus
equity. An increasing number of accounts are
already implementing such trading positions,
for instance, by playing the MDAX® Future
versus the iTraxx® Crossover Index in swap
format. This trade can now be easily imple-
mented using the futures, as the DV01 of the
index swap is transferred into a ‘tick value’
(as is the case with the MDAX® Futures) and
correlation can be easily calculated using
Eurex iTraxx® Crossover Futures quotes,
instead of spread levels. Moreover, the pos-
sible introduction of listed credit options will
allow investors to trade implied volatilities in
the credit market versus implied volatilities in
the equity market.
Inter-market vega-trades can be seen as
a further step in the cross-asset trading uni-
verse. From a strategic perspective, we
would prefer equity versus debt (owing to
LBO and M&A risks, as well as the renais-
sance of shareholder-friendly measures),
which translates, for example, into a long
position in the Dow Jones EURO STOXX 50®
Future and a short position in credit futures
(HiVol or Europe).
Credit versus rates
Interest rates and spreads are linked.
However, there are two basic theories that
suggest exactly the opposite. Fundamental
investors will argue that rising rates reflect
an improving economic environment, which
From the well-known
Merton-model we know
that there is a fundamental
relationship between the
implied volatility of a
company’s stock price
and its credit risk
translates into lower default rates and conse-
quently, lower spreads. In this case, the credit
return is negatively correlated to the curve
return. The opposite is true according to so-
called spread-yield aficionados, who will
argue that declining yields force yield
hunters into spread products (triggering
tighter spreads), hence spread and curve
returns are positively correlated. Regardless
of one’s viewpoint, such ideas can easily be
implemented using credit futures and, for
example, the Bund Future (which is still the
most liquid derivative instrument worldwide).
Trading credit versus volatility
From the well-known Merton-model we
know that there is a fundamental rela-
tionship between the implied volatility of a
company’s stock price and its credit risk. This
relationship stems from the fact that a
company’s stock can be viewed as a call
option on the company's assets (with the
strike being related to the leverage, i.e. the
equity/debt ratio), and its credit risk as a cor-
responding put option. However, in this
approach one would need to know the
asset’s volatility, which is usually implied
from equity volatility. There is also another,
more technical relationship, as credit risk has
a similar payoff profile to a far-out-of-the-
money put option. In the case of a credit
event, not only will credit investors suffer,
but the stock will also drop dramatically, trig-
gering a payoff in the put options. In this
respect, equity portfolio managers use out-
of-the-money put options to hedge against
large drops in their investment. Hence, the
implied volatility of such options usually has
a high correlation to credit spreads. However,
as liquid instruments for trading credit

(iTraxx® Future) and volatility (VDAX-NEW®
Future) are now available, such strategies can
be generalized to index levels. As an example,
a long credit risk position in the iTraxx®
Future, can be hedged via a long volatility
position in the VDAX®.
Product outlook
Following the successful launch of the
first credit futures, we expect that further
exchange-based credit products will be
listed on exchanges, including option-
related payoffs.
The most obvious enhancement is the
introduction of futures contracts on other
maturities within the liquid iTraxx® universe.
In addition to the existing 5-year futures
contracts, the iTraxx® Europe Index can also
be liquidly traded in 3-year, 7-year, and 10-
year formats in the OTC market, while a
liquid 10-year index swap market also exists
for the HiVol and the Crossover Indexes. The
introduction of a wide range of maturities to
the futures offering will allow investors to
put on curve positions on the indexes, imple-
menting so-called ‘calendar spread’ trades. In
addition, futures based on other index swaps
within the iTraxx® universe – for instance,
the iTraxx® financials senior and subordi-
nated sub-indexes, might also be introduced.
Another very interesting innovation
might be the introduction of options refer-
encing the Eurex iTraxx® Credit Futures
The futures contract will likely
be used as an underlying
reference for performance
certificates and notes
contracts. Although the credit default
swaption market has become quite liquid,
the lack of transparency and ongoing con-
cerns over the underlying modelling
framework have been deterring real money
accounts from using credit default swap-
tions for hedging purposes, or to build up
exposure to spread volatility. The intro-
duction of Eurex-listed standardized
credit options should thus be of
particular interest and benefit to market
participants.
The futures contract will likely be used as
an underlying reference for performance
certificates and notes. Total return certifi-
cates that reference the iTraxx® Future
could also be attractive products, even for
retail clients. In addition, exchange-traded
funds could potentially be based on the
future, with the added advantage of daily
price settlement.
Other likely developments include:
I Index-linked structures, such as constant
proportion debt obligations (CPDOs), will
switch from the swap to the futures con-
tract, once liquidity in the futures market
surpasses that in the OTC market.
I Hybrid and cross-asset products will likely
be linked to the futures, rather than to
swap contracts, owing to the benefits and
the high standardization of Eurex-traded
futures contracts.
Case studies 81
Bayerische Hypo- und Vereinsbank AG
(HypoVereinsbank) is one of the three
largest banks in Germany. Its roots
reach back to the 18th century. As an
internationally operating institution,
domiciled in Munich, it offers customers
the entire range of products of services
of a modern financial services provider.
HypoVereinsbank has a network of
nearly 700 branch offices in Germany,
and sees itself as a bank for private cus-
tomers and small and midsized busi-
nesses. Its competitive advantage lies in
its in-depth knowledge of regional
markets and in close, intensive cus-
tomer relationships. In addition,
HypoVereinsbank offers all the advan-
tages of an ‘integrated universal bank.’
Since 2005 it has been of member of
UniCredit Group, a banking group with
over 140,000 employees serving cus-
tomers in 19 countries in Europe.
Jochen Felsenheimer heads the credit
strategy and structured credit team of
UniCredit MIB's global research
department and is responsible for
quantitative and qualitative credit
strategy, including credit derivatives,
structured credits, relative value
analysis, and credit portfolio opti-
mization. He is a co-author of Active
Credit Portfolio Management (Wiley
2005) and he holds a PhD in eco-
nomics from Ludwig Maximilians
University in Munich.
 82 Case studies

Making the case for

credit derivatives
Standard Life Investments’ Sarah Smart makes the case for using credit derivatives and
explains how the instruments can usefully complement traditional case-based
investment strategies

O
ver the last few years,
investors have
realized that
whatever they
measure is what
will get managed.
For instance, if they
assess a manager’s per-
formance against a market
benchmark on a quarterly basis, their
manager will keep close to the benchmark.
The manager will also avoid putting on posi-
tions – however potentially profitable these
might be – if the return expectations cannot
be guaranteed within the quarterly meas-
urement period.
As a result of this realization, there has
been an increasing willingness on the part of
investors to give managers the ability to take
longer-term views. Combined with a growing
appetite for absolute returns, this is good
news for fund managers. And, it is particu-
larly good news for managers looking to
generate absolute returns from dynamic
exposure to areas of market risk. Why?
Because even if managers have a strong view
that a particular area of the market is over-
valued, it is difficult for them to identify
exactly when that overvaluation will be cor-
rected. Longer measurement timescales
enable the absolute return manager to invest
in views that he believes will be rewarded at
some unidentified point over the next 18–24
months, for example.
But it is not all good news. Putting on a
trade and waiting for it to deliver can be a
painful process if you have to pay for the
carry while waiting for your view of the
market to be realized. This lesson was very
clearly demonstrated by Long Term Capital
Management: the fund’s view did come good
in the end, but unfortunately it ran out of
money waiting for this to occur. What is
useful, in such a scenario, is to execute a
trade that covers the cost of the carry and
also has a low exposure to market direction.
In the following example, we consider such a
scenario when seeking to gain exposure to
the credit market.
Making positions pay for themselves
In this scenario, our fund manager holds the
view that there is a correction due in the
credit market. He believes there will be spread
widening at some point in the near future,
but he is not sure when. He is running an
absolute return fund with a cash benchmark,
so any position he takes needs to deliver
returns relative to cash. Were he managing a
long-only fund and unable to use derivatives,
he would be restricted from shorting the
credit market and would not be able to get
any benefit in his portfolio from any potential
spread widening.
Fortunately, the fund rules allow the fund
manager to use derivatives. He is, therefore,
able to implement this view by buying credit
Case studies 83
default swaps (CDS). By holding these instru-
ments, the fund is short credit risk and will
benefit from spreads widening. Using the
recently launched iTraxx® Credit Futures
provides further advantages as the manager
is able to quickly trade in these transparent
instruments with a central counterparty,
without having to go through administration
and legal processes such as the ISDA® set up.
However, the fund has to pay carry to
execute this trade. As the fund manager does
not know when the widening will happen,
the fund will lose money while he waits for
his view to play out. The manager, therefore,
looks for a ‘payer position’ to help neutralize
the cost. Ideally the payer position will have
the following characteristics:
I Be market neutral, (i.e. it will not make or
lose significant value as the market rises
and falls).
I Have a positive carry.
I Be exposed to risks that are diversified
with the core position, (i.e. a situation in
which this trade loses money will be less
of a concern, as the core position will be
making money in the same scenario.)
Source: Bloomberg
 84 Case studies
Position construction free. The position will lose money if the
To implement his view that credit spreads will curve flattens between the 5- and 10-year
widen, the manager executes the following: points. We consider that the risk of a capital
loss due to curve flattening is mitigated by
Instrument iTraxx® Crossover 5-year the following:
Trade direction Long I The trade will steepen naturally as it slips
Size of trade EUR 10,000,000 down the curve.
Cost of carry EUR 204,000 pa I The curve is currently quite flat at this
point and there appears to be little room
DV01 4,300 left for further flattening.
Breakeven 47.44 bps I The trade is executed in the Crossover
rather than the Investment Grade market.
If spreads widen to 280 bps, this position We consider that the higher level of CDO
will deliver EUR 326,800. However, if this activity in the Investment Grade market
widening occurs twelve months after the makes it more susceptible to being com-
trade is executed, the return is reduced by pressed by the hedging of structural
62 percent to EUR 122,800, due to the cost credit risk.
of carry. By holding this position, the fund is also net
To cover this cost, the manager also exe- long default risk and will lose money if a
cutes the following payer position: bond in the index defaults. We believe the
Instrument iTraxx® Crossover 5-year iTraxx® Crossover 10-year
Trade direction Short Long
Relative duration 6.62/4.3 = 1.54 A
Relative spread 303/204 = 1.49 B
A>B, therefore trade will pay per EUR 1 million of trade: 1,107 pa
Size of trade required (EUR million) 283.83 184.36
Expected payment EUR 204,000 pa
It can be seen that, assuming the curve market is overcompensating for the default
remains unchanged, the payoff from this risk being assumed within this trade. In the
trade will cover the carry requirements of environment of an overall increase in default
the core position. In reality, if the trade rates, we expect the core position to deliver
were left on for a period of time we would strong returns to the fund and outweigh any
expect a higher return as the position loss in value in the payer position.
slipped down the curve. This example demonstrates how, over a
The payer position is not, however, risk- longer period, fund managers are able to
implement strategies in cases where they
are confident about the investment, but
less sure about timing.
The use of derivatives enables the
fund manager to express views he might oth-
erwise not be able to express in a long only
fund, and enables him to put in place ‘payer
positions’ that help to cover the cost of carry
while he waits for his strategy to deliver.
Standard Life Investments was
launched in 1998 and is a wholly-owned
subsidiary of Standard Life Investments
(Holdings) Limited, which in turn is a
wholly-owned subsidiary of Standard
Life plc. It is a leading asset man-
agement company, with GBP 135 billion
of assets under management (as at
March 31, 2007). This includes over GBP
49 billion in bonds. Standard Life
Investments has an international
presence in Hong Kong, the U.S., Canada,
India and China to ensure that it forms
a truly global investment outlook.
Sarah Smart trained as a chartered
accountant with Coopers & Lybrand,
and joined Standard Life Investments
in 1999, where she worked on a variety
of new product developments in mul-
tiple asset classes, including equities,
real estate and absolute return funds.
Sarah joined the strategic solutions
unit of Standard Life in September
2004, where she is responsible for the
development and management of tai-
lored liability driven solutions for insti-
tutional investors.

A look back at May 2005:
Did the models cause the
correlation crisis?
Morgan Stanley Investment Management’s Ammar Kherraz examines the limits of delta
hedging and correlation models
T
he credit derivatives
market has seen
phenomenal growth
in liquidity, volumes,
and sophistication. By
mid 2005, the time of
the events under
scrutiny in this note, the
traded volume of the credit derivatives
market had reached USD 12.43 trillion,
May 2005 was a testing
month for correlation
trading and, to date, the
most volatile period in the
young life of this market
dwarfing the USD 4.83 trillion of the once
derivatives markets leader, equity deriva-
tives. The market size is now estimated to
have grown to around USD 30 trillion,
making credit the fastest expanding class of
financial derivatives. While credit default
swaps (CDS) are the basic building block of
the credit derivatives space, a lot of the
growth has been driven by activity in the
so-called correlation market, essentially the
Case studies 85
market for tranches on CDS portfolios.
May 2005 was a testing month for corre-
lation trading and, to date, the most volatile
period in the young life of this market.
Following a ruthless and surprisingly timed
downgrading of the car makers GM and Ford
by the rating agency S&P on May 5, 2005,
the financial equivalent of a hurricane hit
credit spreads. A sharp rise in idiosyncratic
risk took place, with CDS spreads widening
to record levels and reaching their peak on
May 17. The correlation market saw a
violent move in the relative pricing of CDS
index tranches. Crucially, those relative
price moves were at odds, not only in mag-
nitude but also in the arithmetic sign, with
what traders understood the mathematical
models had suggested. Although, even-
tually, CDS spreads generally returned to
their pre-May levels (see figure 1, following
page), the correlation market sustained
some lasting damage.
 86 Case studies

Figure 1: iTraxx® Europe 5-year CDS Indexes (Main and Crossover) in mid 2005. Index levels are par spreads in basis points

The relative valuation of tranches never Consider a CDS portfolio, referencing the n where is the standard normal distri-
went back to its pre-crisis levels. The financial credit entities C1,…, Cn . Let the default, up bution function, and Pi is the probability of
press called the events a ‘correlation crisis’, to some fixed time horizon T, of each credit Ci defaulting (by time T).1 Furthermore, the
and it was. Ci be modelled by the random variable Xi. one-factor Gaussian copula models each Xi
Press reports talking of banks’ correlation More specifically, we determine a ‘barrier’ by:
desks and hedge funds suffering multi- level bi, such that Ci defaults (by time T) if
million-dollar trading losses attracted neg- and only if Xi < bi. In the Gaussian copula
ative publicity for the market. Crucially, ques- framework, the Xi s are standard normal, and where M and the i s are mutually inde-
tions were raised over the reliability of the bi is given by: pendent standard normal random variables
mathematical modelling machinery that had and
become the industry standard for modeling
credit correlation.
The one-factor Gaussian
The mathematical modelling
The mathematical model in question is the copula rapidly climbed up
one-factor Gaussian copula. This was first
introduced to credit by Li (2000), for the case
in popularity, becoming
of two entities in a portfolio, and then gene-
ralized to the case of n entities by Gregory
the ‘Black-Scholes’ of the
and Laurent (2003). Other authors later put correlation market
forward several modifications and implemen-
tation methods for the model and its varia-
tions. The one-factor Gaussian copula rapidly
climbed up in popularity, becoming the
‘Black-Scholes’ of the correlation market.
Here, we will give a very brief description of
the modelling process.

M is called the market (or common) factor
(and since there is only one market factor
here, the setup is called a one-factor model),
while i is called the idiosyncratic factor.
The i are (naturally enough) called the
s was very popular in the
betas; they are the sensitivities of each
credit to the market factor. Notice how this
determines the correlation structure of the
credits involved;
cor
A common further assumption is to let all
betas be equal – denote that then by . The
correlation structure then boils down to a
single number .
Observe how the n default processes are
‘conditionally independent’; fix a value for
the market factor and the Xi s become inde-
pendent. This is a valuable feature in terms
of computationally estimating the joint dis-
tribution of the n loss distribution and even-
tually pricing tranches on the portfolio.
Numerical integration methods (such as
Gaussian quadrature) allow the easy imple-
mentation of the model.
The crisis
By May 2005, GM and Ford had already been
keeping the credit market nervous for
months. The financial troubles of the two car
makers were a threat to their credit ratings
and, potentially, their ability to honor their
debt obligations. On May 4, 2005, billionaire
Kirk Kerkorian injected GM shares with their
biggest one-day gain in more than 40 years
by offering an USD 870 million investment in
the company. Suddenly, there was hope for
the embattled car maker. The following day
that hope was dashed. On May 5, 2005, the
rating agency S&P downgraded GM and
Ford, sending their respective USD 292 billion
and USD 163 billion debts to junk. The timing
A correlation trade that
run-up to May 2005 was
the ‘equity vs mezz’ trade
.
of that decision, coming only one day after
Kerkorian's announcement, took the market
off guard.
A correlation trade that was very popular
in the run-up to May 2005 was the ‘equity vs
mezz’ trade. This involves going long (i.e.
selling protection on) an equity tranche (such
as the 0–3 percent) and ‘hedging’2 that by
going short (i.e. buying protection on) a mez-
zanine tranche (e.g. the 3–6 percent).
Let us explore the appeal of this trade at
Table 1: Traded upfront (as percent of notional), spread (in basis points), and delta for the two
tranches in the ‘equity vs mezz’ trade on the iTraxx® Main 5-year basket, as of May 4, 2005
Upfront
iTraxx® 0–3% 29%
iTraxx® 3–6% 0%
Case studies 87
the time. Table 1 (below) gives the prices for
the 0–3 percent and 3–6 percent pieces of
the iTraxx® Europe Index on May 4, 2005, the
day before the crisis.
The delta of a tranche (on an index) is
the sensitivity of its PV to the PV of the
underlying index3. It is also the hedge ratio:
showing how much protection you need to
buy on the index to hedge a long position
(of a notional 1) on the tranche. Traders
took these deltas one step further. The
Spread Delta
500 17
168 6
1
pi is directly deducible from the
CDS market.
2
So traders thought at the time.
3
It is the first derivative of the tranche PV
with respect to the index PV.
 88 Case studies

Table 2: Levels, during May 2005, of the 5-year iTraxx® equity and junior mezzanine tranches,
quoted as traded upfront (as percent of the notional) for the equity tranche and par spread in
basis points for the mezzanine tranche. In addition to the traded upfront, the equity tranche
pays an annualized spread equal to 500 bps

4 May 5 May 6 May 17 May 26 May

iTraxx® 0–3% 29% 30% 31% 49% 34%
iTraxx® 3–6% 168 158 165 170 120

ratios of two tranche deltas are frequently
used as the ratio of the needed notionals
of those two tranches so that they ‘hedge’
each other. Let us apply this to the example
in Table 1 (page 87): The trader:
1. Sells protection on EUR 10 million of the
0-3 percent tranche, therefore receiving
EUR 2.9 million (= 29 percent of 10
million) upfront, plus an annual EUR 0.5
million (= 500 bps of 10 million) in carry
(i.e. in coupon spread).
2. Buys protection on approx. EUR 28
million of the 3-6 percent tranche (so
the mezzanine tranche’s notional multi-
plied by its delta equals the equity
tranche’s notional multiplied by its delta).
This leads to paying about EUR 0.47
million (= 168 bps of 28 million) in carry.
The net position, considered by the trader
‘delta-neutral’, receives the sizeable upfront of
EUR 2.9 million, in addition to an annual EUR
0.03 million (= 0.5 million – 0.47 million) of
positive carry – a seemingly irresistible trade.
The trouble with this trade is that, as the
eventful May 2005 unravelled, both legs of
the position moved in an unfavorable direc-
tion; the equity tranche widened and the
mezzanine piece tightened (see table 2,
above). The ‘hedge’ was a double-disaster. To
this day, the relative pricing of equity and
mezzanine tranches have never returned to
the levels everybody took for granted before
May 2005. The financial press termed this the
‘correlation breakdown’. Many traders felt
they had been misled by the models and, in
particular, that the model's deltas had turned
out to be worthless.
May 2005 left market participants
polarized over whether the models were
to blame. Some argued that the crisis had
exposed the one-factor Gaussian copula as
totally inadequate, while others came to the

Many traders felt they had

been misled by the models
and, in particular, that the
model's deltas had turned
out to be worthless
 Case studies 89

defence of the industry-standard model,

saying that it was the traders, not the mod-
ellers, who had got it wrong. So was it the
mathematical models or the trading strategy
that inflicted all those losses of May 2005?
Put bluntly, who was to blame: the traders
or the modellers?
The verdict
There is no doubt that the industry-standard
modelling framework suffers from several
shortcomings. For example:
1. The normal distribution is known to
underestimate, compared to the ‘real
world’, the probability of (joint) extreme
events (the so-called lack of tail
dependence).
2. Reducing the correlation matrix to a
single number (simply referred to as the
correlation) is an oversimplification that
is bound to backfire.
3. There are several other (potentially dan-
gerous) simplifying assumptions: recov-
eries upon default are assumed to be
known in advance, betas are assumed to
be deterministic, and there is no
imposed consistency between portfolio
loss distributions corresponding to dif-
ferent time horizons.
Was it the mathematical
models or the trading
strategy that inflicted all
those losses of May 2005?
However, the direct reason for the breakdown
of the ‘equity vs mezz’ trade is that the
traders had taken deltas too far. A delta is
mathematically a first derivative, that will
work as a hedge ratio as long as the under-
lying remains close to the value on which the
delta was originally calculated. A simple
Taylor expansion will show that the first order
derivative does not account for all the risk.
What happened to the tranche space in May
2005 was a redistribution of the risk across
the capital structure, that would almost cer-
tainly have occurred regardless of which
model was established as industry standard.
The May 2005 events, however painful for
some, proved a valuable educational oppor-
tunity. Traders learnt, albeit the hard way, the
limitation of a delta hedge – among other
things. Modellers have also had to reflect
upon the limitations of the model, such as
the ones highlighted above.
The search for better correlation models
will continue. While the tractability of the
Gaussian copula is difficult to beat, a trade-
off between computational convenience and
practicality continues to be the center of a
huge amount of research and reflection.
References:
Gregory J., Laurent J-P. (2003): I will survive,
Risk magazine, June.
Li D.X. (2000): On default correlation: a
copula function approach, Journal of fixed
income, 9:43-54.

Morgan Stanley Investment Management (MSIM) is the asset management division of Morgan Stanley & Co., the global financial services
firm. MSIM specializes in managing assets for a range of institutional clients. MSIM manages USD 483 billion of assets, and services a wide
client spectrum with over 50 globally-diversified investment products.

Ammar Kherraz is a structured products strategist at Morgan Stanley Investment Management. He joined Morgan Stanley in 2007, with five
years’ investment industry experience. He holds a PhD in mathematical finance, in addition to an MSc with distinction in mathematics and
finance and is a visiting mathematical and computational finance lecturer at Imperial College London. He is also a member of Chatham House
(Royal Institute of International Affairs).
 90 Case studies

Credit indexes: an
efficient route to
asset allocation
Scottish Widows Investment Partnership’s Gareth Quantrill demonstrates how iTraxx® Indexes
and Futures contracts offer fund managers an efficient means of reshaping their portfolios

A
sset allocation imple-
ments our views about
the expected returns
from a variety of asset
classes. For instance,
if we believe invest-
ment grade cor-
porate bonds will
provide superior returns to high-yielding
bonds, we will allocate a higher proportion of
our portfolios to investment grade assets.
Sector and stock selection may be reliant
on a positive or negative move in the under-
lying market, but we find that it is more
often market neutral. For example, we are
currently overweight in the telecom sector
because it is undervalued due to an overhang
of bonds. And we recently sold all of our
exposure to Wm Morrison, after speculation
about an impending corporate restructuring
and the possibility of a bond buy-back
resulted in spreads tightening to unsus-
tainable levels. In both cases the strategy
will be successful if we get the sector and
stock decision right, not because of a
general move.
Historically, all of these activities have
been implemented through cash bonds.
However, the introduction of single-name
and index-based credit derivatives has
delivered a significant degree of extra flexi-
bility to asset managers.
The indexes
The three most frequently traded European
credit index products are listed below:
I iTraxx® Europe (Main)
This index comprises the 125 investment
grade rated European entities with the
highest credit default swap (CDS) trading
volume over the previous six months. It is
constructed by selecting the highest-
ranking entities in each of the following
sectors: automobiles (10 entities); con-
sumers (30); energy (20); industrials (20);
TMT (20); financials (25).
I iTraxx® HiVol
This index comprises the 30 entities with
the widest 5-year CDS spreads from the
iTraxx® Europe Non-Financials Index.
I iTraxx® Crossover (X-over)
This comprises the 50 European non-
financial entities with the highest CDS
trading volume over the previous six
months. To qualify for inclusion, entities:
I must have more than EUR 100
million of publicly traded debt;
I rated BBB-/Baa3/BBB- or higher,
(Fitch/Moody’s/S&P) are excluded;
I must have a spread of at least
twice the average spread of
the constituents of the iTraxx®
The introduction of
single-name and
index-based credit
derivatives has delivered
a significant degree of
extra flexibility to
asset managers
Case studies 91
Non-Financial Index, with a
maximum of 1,250 bps or upfront
of 35 percent;
I must be equally weighted in
all indexes.
Asset allocation
The iTraxx® suite of indexes is very liquid.
Average trade sizes for Main, HiVol and
Crossover are EUR 100 million, EUR 50
million and EUR 25 million respectively.
Outstanding contracts on the current series,
across the three, amount to approximately
EUR 5 trillion. These trading volumes are sig-
nificantly higher than turnover in the cash
bonds of the reference companies.
Consequently, the spread between the price
of buying or selling the indexes (i.e. trading
costs) is much lower than in funded index
products or in cash bonds.
The liquidity and low transaction costs of
 92 Case studies
Table 1
Index Normal Bid/offer
market size spread
EUR million (basis points)
Main 100 0.25
HiVol 50 0.5
Crossover 25 1 B-rated HY
index derivatives have a number of important
implications for asset managers like our-
selves, and our clients.
Firstly, they allow strategic asset alloca-
tions to or from the credit markets to be
implemented quickly – and with minimal
market disturbance. The manager then has
the option of unwinding the derivative
position over time as he or she buys or sells
cash bonds. This can be particularly helpful
in the high-yield market where investing a
significant allocation in the cash market
can take several days, or even weeks – in
contrast, the equivalent market exposure
can be gained through the iTraxx® Cross-
over Index in significant size in a matter
of minutes.
Secondly, and because of the lower trans-
action costs involved, the indexes present a
greater number of asset allocation opportu-
nities, in which the manager’s expected
return after transaction costs is sufficient to
implement the trade.
Thirdly, the ability to use a derivative (or an
unfunded) product significantly increases our
ability to manage fund inflows and outflows
efficiently. For example, if we know that we
have money coming into a fund and we
believe the current level of credit spreads to
be attractive, then we can sell protection on
the index in advance of the cash arriving, and
‘lock in’ the current attractive level.
Equivalent Normal Bid/offer
bond market size spread
EUR million (basis points)
A-rated Bank 10 4 twelve-month period – during which the
BBB-rated 5 4
Telecom
3 10
bond
Preserving the alpha opportunity
Perhaps most pertinent today, given the
recent rise in credit market volatility, iTraxx®
Index products allow us to hedge market
exposure (beta), while preserving the sector
and stock selection (alpha) opportunities.
Historically, when we chose to allocate
away from credit, we sold a portion of our
cash bonds. This had the effect of incurring
significant trading costs, tying up portfolio
managers’ time and reducing the impact of
the sector and stock selection in our port-
folios. By using index derivatives, we can
swiftly make asset allocation decisions
without touching our underlying portfolio
positions, at a lower cost, and without signif-
icant portfolio management intervention.
For example, if we wanted to reduce our
allocation to high yield by 10 percent we
could do this in either of two ways:
1) By selling 10 percent of all holdings in
the portfolio.
Action: sell EUR 50 million of high-yield
bonds with a 20 bps bid/offer spread (for size).
Transaction costs = EUR 315,000.
2) By selling EUR 50 million iTraxx® Crossover.
Action: sell EUR 50 million of iTraxx® Cross-
over with a 1.5 bps bid/offer spread (for size).
Transaction costs = EUR 31,124.
If we use the Crossover Index in option
two, not only does this reduce our trans-
action costs, but we also preserve the
underlying sector and stock positions on the
total portfolio. Furthermore, if we assume
that the asset allocation sale occurred at
the start of the year and was held for a
portfolio manager achieved his 100 bps
outperformance target – then we would
preserve the EUR 500,000 benefit of
the outperformance.
In this example the benefit of using option
two over option one is:
Table 2
I Lower transaction costs
E315,000 – E31,124 = E283,876
I Preserved alpha
100 bps alpha x E50 million = E500,000
= E783,876
Option two also has another significant
benefit: namely, that the reduction in market
risk can be implemented in a matter of
minutes, whereas option one could poten-
tially occupy the portfolio managers for
several days. With the arrival of exchange-
traded credit futures, option two is now
available to a large number of clients who
are unable or unwilling to use over-the-
counter derivatives.
Expanding the alpha opportunity
The introduction of credit index derivatives
allows us to express views beyond the limita-
tions of the benchmark, and to target more
accurately those elements of the market on
which we have a view.
For example, at the moment we see the
main risks to credit spreads coming from
the high levels of leverage in the financial
system, the impact of private equity, M&A
 Case studies 93

and corporate re-leveraging. Traditionally,
we would have expressed such a view by
being underweight relative to the
benchmark in those particular companies
that we felt were especially vulnerable to
such risks. However, this approach would
have limited our ability to be underweight
to only those companies that appear in the
index, and we could only have gone under-
weight to them, to the extent of their
weight in the index.
The HiVol Index has a concentrated
exposure to a number of companies that we
perceive as being vulnerable to M&A, private
equity or re-leveraging. By buying protection
on this index, we can create a larger
underweight position than could be achieved
by traditional methods. For example,
Cadbury Schweppes, Compass, Kingfisher,
Marks & Spencer and Tate & Lyle are all
underweighted in our cash bond funds.
However, while their collective index weight
is only 0.55 percent, they constitute 17
percent of the Series 7 HiVol Index. This index
also contains several other names about
which we have concerns.
Conclusion
The introduction of index-based derivatives
provides a useful degree of flexibility,
allowing bond fund managers to reshape
their portfolios more quickly for strategic or
tactical purposes. Access to these instru-
ments can only increase with the advent of
exchange-traded credit index futures.
Furthermore, the greater liquidity and lower
trading costs of these instruments should
produce better outcomes for clients.

Access to these instruments

can only increase with the
advent of exchange-traded
credit index futures
Scottish Widows Investment Partnership (SWIP) is one of the U.K.'s largest asset management companies, with GBP 98 billion*
invested across all major asset classes - including U.K. and international equities, property, bonds and cash. SWIP manages a diverse range
of specialist funds for U.K. and international clients, including pension schemes, charities and local government authorities as well as life
assurance, pension and investment funds for the parent company Lloyds TSB . The company manages over GBP 41 billion* (in fixed interest
and cash assets and offers a range of strategies with different risk/return profiles to suit a variety of client needs.

Gareth Quantrill is head of bond product at SWIP, where he is responsible for aggregate bond mandates and the development of the
firm’s structured credit business. He has over 15 years of investment experience, having started his career at Norwich Union in 1991. In
2000, he joined SWIP as credit portfolio manager and was made head of credit in 2004. Gareth moved to Henderson Global Investors as
head of credit in 2005, before rejoining SWIP in 2007.
*Source: SWIP, as at June 30, 2007
 94 Case studies

Playing the spread

dispersion using
index arbitrage
ADI Alternative Investments’
Fabrice Jaudi and Alexandre
Stoessel describe how credit
futures can be used in
spread dispersion trades

W
ith the for investors’ risk aversion, these strategies can
launch of be used as efficient and low-cost tools for
credit futures portfolio diversification, hedging or arbitrage.
on March 27, There is no universal mathematical defi-
2007 – the first nition of credit spread dispersion. For a
exchange-traded sample of issuers, the standard deviation
credit derivatives normalized by the average spread is an
worldwide – Eurex acceptable measure, able to reflect the real
not only extended the range of tradable market spread dispersion. While such a
credit instruments, but also paved the way measure is quite hard to replicate in a port-
to the introduction of new and innovative folio, it allows us to observe the link between
trading strategies. dispersion and the credit market.
This article describes how credit futures In chart 1, we can see that an increase in
can be used to replicate credit spreads. As dispersion occurred during the main spread-
spread dispersion is often also a good proxy widening periods of the last three years.
Indeed, it appears logical for a wider market
to be more dispersed and a tighter market
less dispersed. However, that rule is not sys-
tematic because various other factors affect
dispersion, such as activity in the structured
credit market or rumors about leveraged
buyouts (LBOs). Such factors can affect the
dispersion independently of market direction.
Analyzing dispersion
Spread dispersion is a useful indicator of
market participants’ risk aversion. When risk
aversion is high, investors shift their invest-
ments to the higher part of the ratings curve
and reduce their exposure to lower rated
 Case studies 95

Chart 1: Cumulative iTraxx® Europe & Crossover Indexes universe: historical dispersion and average spread

issuers. In such a scenario, spread dispersion
naturally increases.
On the other hand, when investors are
risk takers, they seek to increase their carry
by reducing their portfolio’s credit quality,
causing a decrease in dispersion.
Of note is the violent spread compression
over the last quarter of 2006. That com-
pression demonstrated the effects of inves-
tors’ quest for higher yields in a tighter
market. Eventually, following the spread
widening in March 2007, the market made
an equally violent turnaround and dispersion
drastically increased.
whereas the iTraxx® Europe 5-year Index
includes issuers with average ratings of
BBB+. Chart 3 (next page) illustrates there is
a relatively good correlation between the
iTraxx® Europe Crossover/iTraxx® Europe and
our dispersion indicator. Replicating an index
ratio means selling one index and buying
another, ending up with a neutral position,
not in nominal terms, but on a spread-
Chart 2: Average spread
Large dispersion
adjusted basis. The strategy is carry neutral,
avoids negative time decay and allows
investors to be more patient.
Example of strategy using the iTraxx®
Credit Futures
Let us suppose that on January 2, 2007, the
Eurex iTraxx® Europe 5-year Index Futures
and the iTraxx® Europe Crossover 5-year

Replicating dispersion through indexes AAA AA A BBB BB B CCC

If spread dispersion reflects an investor’s 20 bps 800 bps

positioning on the ratings curve, then it is Low dispersion

possible to approximate it with a simple ratio
between two qualifying indexes. For instance, AAA AA A BBB BB B CCC

10 bps 400 bps

the iTraxx® Europe Crossover 5-year Index
contains names with a BB average rating
 96 Case studies

Index Futures are respectively quoted at
100.33 and 102.71, implying credit spreads of
22.75 bps and 215 bps and a spread ratio of
9.45. Let us suppose we buy a notional EUR
10 million of the Crossover contract at 102.71
and sell EUR 94 million notional of the
Europe contract at 100.33.
On February 21, 2007, the contracts
respectively trade at 100.34 and 104.34,
implying credit spreads of 22.25 bps and 175
bps – or a spread ratio of 7.86.
markets with high dispersion as well as Furthermore, in some market contexts, it can
bearish markets with low dispersion. This is also be a low cost directional macro-hedge
due to the numerous factors affecting dis- (with neutral carry).
persion: the level of default rates, significant The launch of the Eurex iTraxx® Credit
structured products activity, idiosyncratic risk Futures on the three main indexes introduces
(LBO’s, re-leveraging, and so on). Regardless, arbitrage opportunities to the credit markets
the replication of dispersion as a diversifi- that have long been successfully deployed in
cation tool in a credit portfolio is attractive. the equity market.
Chart 3: iTraxx® Europe & Crossover Indexes: dispersion and spread ratio

The result of the strategy is the following:

P/L = 10,000,000 x (104.34% – 102.71%) –
94,000,000 x (100.34% – 100.33%)
= EUR 153,600.

Conclusion
Spread dispersion is a variable on its own
and does not necessarily replicate market
performance. Indeed as shown in chart 1,
in the past there have been some bullish

ADI Alternative Investments is an alternative investment manager specializing in convertible arbitrage, credit arbitrage, high yield, merger
arbitrage and fixed income. The credit arbitrage desk at ADI was set up in 2003. The team consists of eight staff, whose mission is to develop
quantitative and qualitative strategies using credit derivatives instruments.

Fabrice Jaudi is a senior portfolio manager within the credit arbitrage team. He joined ADI in early 2003 to develop the credit arbitrage funds,
having begun his career at Dexia Asset Management as a fund manager. At Dexia he participated actively in the development of the con-
vertible bond arbitrage and credit arbitrage funds from 1996 to 2003 and, from 2001 onwards, he developed and was in charge of credit deriv-
atives activity. Fabrice graduated as a financial analyst from the European Federation of Financial Analysts, and holds a masters degree in
economics and a postgraduate specialization in finance from Université Paris II – Panthéon Assas.

Alexandre Stoessel is a senior portfolio manager in the credit arbitrage team. He joined ADI in March 2002 to take responsibility of cash man-
agement within the portfolio management team. After the successful launch of ADI EONIA, he was appointed senior portfolio manager within
the credit and volatility team in 2004. He started his career in 1996 at Société Générale Capital Markets, working as a programmer analyst. In
1998 he joined Cardif Asset Management where he held a post as portfolio manager on cash enhanced money market funds. From 2001 to
2002, he worked at Commerzbank as a proprietary trader. Alexandre is a graduate of ENSIMAG (Ecole Nationale Supérieure d’Informatique et
Mathématiques Appliquées de Grenoble).

Using iTraxx® across
the fund spectrum
Raphael Robelin talks to editor Natasha de Terán about
how BlueBay funds utilize the iTraxx® Indexes
R
aphael, can you
explain how your
investment teams
are set up at
BlueBay?
Investment teams at
BlueBay are structured
in such a way that each
group is headed by a long-only and a long-
short specialist. This allows for a good mix of
disciplines – one specialist tries to outperform
an index, while the other aims to generate
absolute returns. We have structured the teams
in this way, as we believe that the two skill-
sets are complementary and the investment
process seeks to get the best of both.
What do you use the iTraxx® Indexes for
and why?
We use the iTraxx® credit default swaps (CDS)
Indexes across all of our funds, primarily to
adjust credit beta at the overall portfolio level.
This highly liquid instrument gives us good
diversification (the underlying exposure is
split equally between up to 125 issuers) and is
highly correlated to the overall credit market.
Therefore, it offers, in our opinion, the best
way to implement our top-down view on
credit spreads in our funds.
What did you use before the arrival of
the iTraxx® product?
When I started at BlueBay in 2003, the CDX
product was already established in the U.S.,
but the iTraxx® group had not yet been
formed in Europe – instead, two rival CDS
index families were competing. At this point,
we did not believe that the indexes were
transparent enough. They were also much
more technically driven – which made them
quite risky to use – and liquidity was scant.
As a result, we were somewhat restricted.
For instance, if there was a conflict
between our top-down and bottom-up
Case studies 97
views, we had to examine which was the
stronger and compromise accordingly. We
implemented this by either doing nothing, or
by selling a part of the portfolio. The launch
of the iTraxx® Index family has meant that
we can move efficiently. When we need to
adjust risk, we can do it at much lower cost
through the iTraxx®, so its establishment has
been an enormous benefit.
What are the key advantages of the
iTraxx® Indexes over and above single-
name CDS?
The problem with trading single-name bonds
or CDS is that the bid/offer spreads are still
very wide, therefore, trading in and out of
positions can be very costly. In contrast, the
indexes are now so liquid and widely traded
that bid/offer spreads are much narrower
and we can use them to quickly re-adjust our
risk with very limited transaction costs. So,
for us, it is the instrument of choice as a
 98 Case studies

credit beta overlay – we do not have to get
rid of single-name exposures, but can use the
indexes to adjust our overall risk.
For instance, let us say we have a port-
folio of 100 names that we really like and
think will outperform the index. While
holding this position, there will be times
when we may feel the market is due for a
modest widening in spreads or that credit
could underperform in the short-term. In
other words, we think we have too much
beta-adjusted risk. Without iTraxx®, we
would have to sell out of the selected
single-names. This is not ideal for two
reasons. Firstly, we research the credits in
great depth before putting on these single-
name trades and want to retain our long
term exposure to them and, secondly, the
bid/offer spread, even in the more liquid
single-name CDS that make up the main
index, is around 5 bps. If we use the index
instead, we can keep the exposure to the
names we are happy with, still generating
alpha through those bottom-up bets, even
while adjusting the credit risk at the beta
level. An additional benefit comes from the
considerably lower transaction costs – the
bid/offer spread on the main iTraxx® Index
is usually 0.25-0.5 bp – well below the 5
bps for the single-name CDS.
Which iTraxx® instruments do you use
and how frequently do you trade them?
For the long-only funds, we use the main
iTraxx® Index, but we also use the HiVol and
Crossover Indexes, depending on what we
are hedging and the portfolio holdings.
We trade the indexes quite regularly –
not just when our top-down view changes
as already described, but also when we
change our views on a particular credit, and
when we receive new inflows to the fund.
For instance, if we decide that an indi-
vidual bond has reached its top, we will sell
our position and substitute the iTraxx®
Index to keep our risk exposure the same
until we are ready to reinvest on a single-
name basis. In this way, we are able to keep
the overall amount of credit risk in line
with our top-down view on spreads at all
times – whatever our view on particular
credits. Similarly, we usually invest fund
inflows in index format in a first stage,
before transferring the risk into the less
liquid single-names that we believe are
attractive. Using the index as a first step
allows us to wait for more attractive
pricing, new issues and so forth.
What are you views on the Eurex iTraxx®
Credit Futures?
The futures should, in theory, have a
number of advantages for us – the main
ones being the reduced amount of docu-
mentation and back-office work they
involve, along with the lower bid/offer
spreads usually available in the exchange-
traded markets. If the contracts were liquid
we could do a very large amount of business
through them, as the back-office con-
straints would be much lighter. At the
moment we have two people dedicated to
managing our novations (the exchange of
new debts or obligations for older existing
ones). These staff could be redeployed if
we were able to use the futures instead of
the OTC instruments to open and close out
our positions.

BlueBay Asset Management Plc was founded in 2001, and is one of the largest independent managers of fixed income credit funds
and products in Europe, with assets under management of approximately USD 13.1 billion (as at June 30, 2007). Based in London, with
offices in Tokyo and New York, it provides investment management services to institutions and high-net-worth individuals globally.
BlueBay provides long-only, long/short and structured products across emerging market, high yield and investment grade credit. The
company, which was admitted to the official list of the U.K. Listing Authority and to trading on the main market of the London Stock
Exchange in November 2006, also manages segregated mandates on behalf of large institutional investors.

Raphael Robelin is the senior portfolio manager for the investment grade bond fund at BlueBay. He joined the company in August 2003
from Invesco where he was a portfolio manager for investment grade funds. Prior to that, Raphael was a portfolio manager with BNP
Group and Saudi International Bank. He holds a degree in engineering (IT) and applied mathematics from EFREI as well as a masters
degree in management and international finance from the Sorbonne.
 Case studies 99

Evaluating opportunities
in the credit markets
BlackRock’s Chetlur Ragavan details how credit derivatives and credit indexes are helping
organizations manage their exposures and generate excess returns

T
he dramatic growth in greater transparency and price discovery and exit from relative value trades, and
of the credit deriva- within the credit markets. to do these in size, than it was just a few
tives market over the At the portfolio level, the recent advances years ago.
past few years has in technology and analytics are enabling This enhanced ability to look for relative
ushered in a new era of investors to easily tailor their exposure to value opportunities is even more crucial in a
credit investing and specific risk slices of the market, at appro- benign market environment. Chart 1 (below)
attracted a fresh gener- priate levels of risk premium. It is much illustrates the extent to which credit risk pre-
ation of investors. easier now for credit investors to enter into miums narrowed over the past few years.
No longer constrained by the illiquidity in
cash bonds, investors are not forced to play Chart 1: Option-adjusted spreads to treasuries of global aggregate and euro aggregate corporate indexes
the market only from the long side. Prior to
the ascendancy of credit derivatives, they
would simply not own a credit they did not
like, as most were unable to short bonds in
their portfolios; now, they can easily buy
credit protection as a means of taking a neg-
Source: Lehman Brothers

ative stance on a credit.

The expanded toolbox afforded by credit
derivatives is clearly enabling investors to
look for relative value opportunities wherever
they exist, from both the long and the short
sides of the market. This, in turn, has resulted
 100 Case studies
On the surface, the tightening of credit
spreads has been supported by robust cor-
porate earnings, generous free cash flows and
healthy corporate balance sheets. Corporate
default rates are at an historically low level,
even for the high yield sector. The trailing
twelve-month global corporate speculative-
grade default rate fell to a mere 1.2 percent in
May, 2007, well below its long-term average
of 4.48 percent, according to Standard &
Poor’s. The rating agency also noted how the
twelve-month rolling downgrade ratio (ratings
downgrades to total rating actions) was at 62
percent, close to the lowest level observed in
recent years. These compelling dynamics, com-
bined with the global quest for higher yields
and surplus liquidity, kept credit spreads tight
over the past few years.
Beneath the surface, however, credit con-
ditions appear to be deteriorating. Corporate
leverage has been rising (albeit from its low
level) with ever increasing levels of leveraged
buyout (LBO) activity. Moreover, there has
been a general easing of bond and loan
covenants that are meant to protect lenders,
increasing instances of pay-in-kind (PIK)
coupon features, and debt financings pri-
marily to fund share buybacks and/or deliver
larger dividends to shareholders. Most
importantly, there has been a discernible
Corporate default rates
are at an historically
low level, even for the
high yield sector
deterioration in the credit quality of the bor-
rowers tapping the market. Almost one-third
of all new high yield issuance in the first five
months of 2007 was rated CCC+ or lower. In
some ways, these conditions are not dis-
similar to the conditions that prevailed in
the subprime mortgage market in the U.S.
only recently. Weak borrowers, unsustainable
levels of debt and poor underwriting stan-
dards all set the stage for the precipitous fall
in subprime valuations.
While the outcome for credit markets
remains uncertain, it is tempting for inves-
tors to seek relative value opportunities
without taking any outright exposure to the
credit market. An array of credit derivatives
products, such as single-name credit default
swaps (CDS), CDS index baskets and tranches
and bespoke collateralized debt obligation
(CDO) structures, allow investors to alter their
exposures and tailor their portfolios in spe-
cific ways to establish optimal positions
within the credit markets.
In this article, we will highlight a market
neutral relative value strategy - an index
arbitrage strategy. Index arbitrage involves
exploiting valuation differences between a
credit derivative basket (such as the iTraxx®
Crossover Index) versus its components.
Theoretically, a credit derivatives basket
should track closely the valuation of its com-
ponents. In practice, however, demand and
supply factors will determine the valuation of
the basket. This is somewhat analogous to
the pricing of a closed-end mutual fund,
where the traded price is based on the
demand and supply dynamics of the fund
and not the underlying securities.
Arbitrage opportunities in the index
markets generally arise as a result of large
flows in the underlying credit derivatives
market. For instance, when the demand for
protection on specific single-name CDS rises
or falls because of CDO demand, the index
may not keep pace with all of its con-
stituents. Conversely, when several macro
hedge funds trade large volumes of credit
derivatives baskets, the potential for indi-
vidual CDS to fall out of line with the value
of the basket becomes pronounced.
To exploit this anomaly, investors need
quick and efficient methods for evaluating
credit derivatives baskets and their con-
stituents. In the following example (chart 2),
we will show how BlackRock uses AnSer®,
BlackRock Solutions’ analytic calculator, to
discern and exploit relative value opportu-
nities between the iTraxx® Index and its con-
stituent members.
The index highlighted is the iTraxx®
Crossover 5-year Index (ITRAXX XO.7). It is
one of several standard credit derivatives
indexes that provide default protection on a
basket of issuers – in this case 50 European
Crossover names1. Using AnSer®, we compute
the breakeven spread for the iTraxx® Index.
The breakeven spread (displayed as BE CDS
Spread) is equivalent to the spread that one
would pay for protection today, given a CDS
contract of the same maturity and terms (i.e.
the spread at which an at-the-money XO.7

5-year would trade today). In this case, it is
approximately 239 bps, as of March 28, 2007.
Within AnSer®, we can also look at the
individual CDS that make up the iTraxx®
Crossover Index. The screen in chart 3 (fol-
lowing page) displays each name, current
face amount, default date/recovery rate (for
defaulted names) and other relevant
indicative data and valuation assumptions.
(Note: XO.7 has had no defaults).
AnSer®’s portfolio analyzer tool allows us
to analyze the basket as an intrinsic portfolio,
wherein each constituent is valued separately
as a single-name CDS, using the index prop-
erties (including maturity, document clause,
Chart 2: Breakeven CDS spread computed in AnSer®
Note: BlackRock’s main source for market CDS spreads is Mark-it Partners, and represents a composite of daily quotes from several dealers.
tier and coupon – 230 bps for XO.7). The
report can also display the CDS spread and
recovery rate assumptions used to value each
constituent member of the iTraxx® Crossover
Index. The breakeven spread for the portfolio
computed as a collection of individual CDS, is
approximately 206 bps.
In the example illustrated in chart 4,
the ‘basis’2, which reflects the difference
between the breakeven CDS spread of the
index versus its components, is 33 bps (239
bps less 206 bps), illustrating the fact that
the index was trading cheap relative to the
intrinsic portfolio as of March 28, 2007.
Portfolio managers can capture this basis by
Case studies 101
‘buying’3 the cheaper asset (selling index
protection) and ‘selling’ the richer asset
(buying protection on all of the underlying
constituent members). Conversely, if the
‘basis’ is negative, the trade can be reversed
to lock in the excess spread.
An important caveat for the portfolio
manager is that he must be cognizant that
indexes can be more liquid than the under-
lying names, particularly in the high yield
sector. This could result in the ‘basis’ remaining
positive (or negative) over an extended period.
It is important to track the basis over a period
of time, using simple statistical measures
such as ‘z-scores’ (the number of standard
 102 Case studies
Chart 3: Analysis of basket constituents in AnSer®
deviations of the current basis from its his-
torical average) to ascertain the relative
richness or cheapness of the different assets.
Another risk to this strategy is cash-flow
related, owing to the potential differences
between par swaps in the single-name CDS
market and off-market swaps within the
indexes. (All single-names in the iTraxx®
Crossover Index are struck at the same level
as the index, which is 230 bps, while indi-
vidual CDS contracts are struck at the pre-
vailing market premium). Furthermore, trans-
action costs incurred by trading a basket of
single-name CDS against the index also need
to be considered before deploying this
strategy. Index arbitrage is by no means a
‘risk-free’ arbitrage. Nevertheless, index arbi-
trage can be profitable, enabling portfolio
managers to generate alpha without taking
an outright exposure to the credit market.
The above strategy is just one example of
how credit derivatives and credit indexes are
helping organizations manage their expo-
sures and generate excess returns in these
challenging times. The use of credit deriva-
tives has grown exponentially and the end-
user base has broadened rapidly. Transaction
volumes are large, providing the necessary
liquidity and transparency to investors. These
conditions enable credit investors to manage
their exposures efficiently and exploit relative
value trading opportunities.
Crossover bonds are corporate bonds
1
that have less credit risk than most
junk bonds and higher yields than most
investment grade bonds. They are typi-
cally rated at the lowest level of
investment grade or at the highest level
of non-investment grade.
This basis is different from the cash
2
bond versus CDS basis.
Buying in this context is analogous
3
to going long credit risk (i.e. selling
protection).
 Case studies 103

Chart 4: Breakeven CDS spread computed in AnSer®

Note: The BE CDS spread of the portfolio is the average of constituent BE CDS spreads weighted by their standalone CDS Sprd DV01. This adjusts for spread dispersion within
the index; higher spread names have a lower duration and would contribute less to the average. Another way of thinking about this, is that higher spread names are expected
to default sooner, leaving tighter names that would reduce the average spread. This expectation is priced into today’s index spread.

BlackRock® is a premier provider of global investment management, risk management and advisory services. With 36 offices located in 18
countries around the globe, BlackRock serves clients in over 50 countries. Its client base includes public and private pension funds, insurance
companies, third-party distributors, corporations, banks, official institutions, charities and individuals. In Europe, BlackRock has been a trusted
investment partner of its clients for many decades.

Chetlur Ragavan, CFA, CLU, is a managing director and member of the Portfolio Analytics Group within BlackRock Solutions. Chetlur's service
to the firm dates back to 1980, including his years with Merrill Lynch Investment Managers, which merged with BlackRock in 2006. At MLIM,
Chetlur was most recently the global head of fixed income research. Prior to that, he served as senior risk manager for fixed income. Chetlur
earned a BA degree in operations research from the University of Madurai, an MBA in finance from Madras University, and an MS degree in
computer sciences from New Jersey Institute of Technology.
 104 Case studies

Making the most of new

credit opportunities
Credaris’ chief investment strategist and portfolio manager, Graham Neilson, describes to John Ferry
how credit derivatives technologies have transformed the credit investment landscape

Credaris was established in 2003, just as
the structured credit market, or at least
the synthetic structured credit market,
was really starting to take off. How did
the market’s evolution tie in with the
establishment and development of
Credaris’ business?
The financial market events that occurred
between 1999 and 2003, in the equity and
bond markets, gave pension fund, asset and
liability managers, as well as the predomi-
nantly long-biased investment community at
large, a very big wake-up call. Not only had
equities undergone one of the biggest bear
markets in 70-odd years, but bonds and
equities hadn’t always behaved in the way
most textbooks suggested they would do.
That meant that the old model of having a
diversified portfolio of equities and bonds
was definitely challenged. Credit was usually
included in there somewhere, but it was gen-
erally just part of the bond portfolio.
Suddenly people had more of an incentive to
look for alternatives to the traditional mix.
What I think credit derivatives demon-
strated – and this is one reason why we’re in
the business – is that they can be used to
create products that have a low correlation to
Credit markets and products
have witnessed some
phenomenal periods of
volatility in recent years
traditional asset classes, and offer different
methods of providing the ultimate nirvana of
an improved risk-adjusted return profile.
Also, if we look at the evolution of credit
over the last five or six years, two important
things have occurred. Firstly, the broader
credit market has changed radically. The
spread available on credit products has
imploded. Secondly, instruments have
evolved very rapidly. The standardization of
credit derivatives language has played a large
part in this growth, and that standardization
has brought about an increase in tradable
instruments. These factors have combined to
push credit closer to the forefront of the
asset class mix. Credit markets and products
have witnessed some phenomenal periods of
volatility in recent years but, I think, emerged
stronger as a result.
What types of products are you
offering today?
We manage funds and products based
around two types of credit assets: asset
backed securities (ABS) and corporate
credit. Each fund is a long/short fund with
a target of attractive risk-adjusted total
returns. For example, we manage a
Case studies 105
long/short structured ABS fund called the
secured finance fund. This fund has con-
tinued to create positive returns, thanks to
its ability to take both long and short
exposure to structured ABS products. This
makes it stand out hugely compared with
other long-biased funds in the structured
ABS arena, which have not been so for-
tunate. One of our main corporate credit
offerings is a long/short structured credit
fund, which generates attractive double-digit
returns through active management of deriv-
ative-based structured credit assets, such as
collateralized debt obligations (CDOs) and
constant proportion portfolio insurance
(CPPI) products. Again, these are defined by
the underlying assets, whether these be
structured ABS products or corporate credits.
The corporate credit-based products include
a principle protected version of our
long/short structured credit fund, and a prin-
ciple protected single-name credit default
swap (CDS) product, which is uniquely credit
spread market neutral.
Tell us about your investment and
structuring approach.
Our corporate credit business approach is
centered on singling out three key risk com-
ponents – single-name risk, market spread
risk and default correlation risk. A lot of
credit funds out there today have tended to
drift into becoming multi-strategy credit
funds, with the manager trading anything
available – tranches, options, single-name
CDS, indexes, debt-equity trades, convertibles,
and so on. Now this is certainly an approach
that can work, but given the growing com-
plexity of instruments, our bias is to keep
things simple by isolating key building blocks.
Take single-name risk in a portfolio
 106 Case studies
context first. If you have selected a portfolio
of 100 names, then the fundamental
analysis behind these names clearly needs
to be thorough. Through the use of credit
derivatives you can manage that single-
name risk appropriately, either via hedging
or through substitution activity. Certainly, the
advantages of having the correct approach
to managing single-name exposures became
very evident in the second-quarter of 2005,
during the so-called correlation meltdown.
You mean when Ford and General Motors
(GM) were downgraded?
That’s right. But it should also be remem-
bered that, as well as these two names
blowing out in April that year, the vast
majority of investors arrived at the second-
quarter 2005 party very long credit. This
highlighted the single-name risk in a struc-
tured portfolio context – if you had a port-
folio of 100 names, including GM and Ford
at that point, then this obviously had strong
implications for risk management. Another
major risk component, highlighted during
that episode, is that of general market
spread risk. Funds and products have dif-
fering degrees of exposure and flexibility to
manage market spread risk exposure. Credit
spreads can widen or tighten for credit-
based reasons or for external reasons
related to macro market volatility. We
believe that a broader view of the credit
market, and credit spread movements, taken
from a macro perspective, is a critical
element to successful credit fund and
product management.
The third factor is correlation risk. If you
have a portfolio of 100 names, then some of
the names will be more closely correlated
than others in terms of their default proba-
bility. Default probability is determined by
issues such as spread level, sector and geo-
graphic concentration. Once again, Ford and
GM were a classic case in point during the
second-quarter of 2005. That period high-
lighted how single-name risk can have a
knock-on effect on the general level of
overall credit market spread risk and
direction, as well as how the correlation
market prices risk across tranches.
What was the fallout from that episode
for structured credit players?
From our point of view it did two things. It
told us that our approach to managing the
risk was right, and it created a huge amount
of value in the market. The irony was that the
most profitable trade you could put in place
after the dislocation happened, was the trade
that got everyone in trouble. We took the
opportunity to begin our long/short
structured credit fund, which has provided
extremely attractive returns ever since.
How do you use the credit derivatives
market to manage your three key
risk factors?
We will use single-name CDS up and down
all the maturity curves. For managing market
spread risk we can use standard index
products, and for correlation risks we can
utilize the standardized tranche markets.
How do you view the emergence of credit
futures, and how do you see the credit
derivatives market progressing from here?
It will take time, but I think listed futures,
such as the Eurex iTraxx® Credit Futures,
could become part of the risk architecture
of the credit market. They could potentially
bring more players to the market. Not
having to go through the ISDA® documen-
tation routine is an advantage and may
speed up some approval processes, and we
could potentially see retail players enter the
market, as well as more direct investment
through pension vehicles.
More generally, I think credit derivatives
techniques are moving into other underlying
assets. We’re seeing the extension of credit
derivatives technologies to the asset backed
and the loan worlds, including the devel-
opment and growth of tranches on related
indexes. The underlying instruments, and the
underlying fundamentals driving those instru-
ments, will encounter their own problems
going forward, but they will provide lots of
opportunity for people like us, whether we’re
buying, selling or creating products, to extract
value from the markets.
Credaris is a credit-specialist asset
manager based in London and operating
in the global secured, unsecured and
structured credit markets. With EUR 1.4
billion of capital, the firm offers tailored
solutions in the form of funds, structured
products and separate mandates.
Graham Neilson is a portfolio manager
and leads Credaris' investment strategy.
He has wide experience in trading and
strategy across a diverse range of asset
classes from Asian equity and foreign
exchange markets to global credit and
bond markets. Prior to joining Credaris,
Graham was global head of credit
strategy at ABN Amro. He holds a
master’s degree in economics from
St. Andrew’s University, Scotland.

Using iTraxx® in
exotic structures
Fortis Investments’ Ryan Suleimann describes to editor Natasha de Terán
how his firm uses iTraxx® Indexes within its exotic credit products
How and where do you use iTraxx®?
Within our collateralized debt obligation
(CDO) and CDO squared products we only
use single-name credit default swaps (CDS),
but we have been actively using the indexes
since December 2005, when we launched our
first constant proportion portfolio insurance
(CPPI) product, Matisse, together with Credit
Suisse as arranger.
“The idea behind the deal is
to take advantage of the
increased variety and
liquidity in index-based
credit instruments”
Tell us about your CPPI products?
The first CPPI is an absolute return fund that
takes positions on correlation in the stan-
dardized synthetic CDO market by going
long equity tranches, and short mezzanine
tranches of the iTraxx® and DJ CDX Indexes.
We enter into long equity/short mezzanine
tranche trades in the iTraxx® and CDX
Indexes, and use single-name swaps to
Case studies 107
cancel out names we consider to be at risk.
The idea is to take advantage of the
increased variety and liquidity in index-based
credit instruments and to benefit from both
spread widening and tightening scenarios. In
other words it is a convex strategy, (i.e. a
strategy that is relatively market neutral and
benefits from spread decompression, as well
as spread compression).
We also use iTraxx® extensively in our
two other credit CPPI products: Cézanne
and Delacroix.
Cézanne was launched in May 2006 and
arranged by UBS. It is essentially a market
spread compression or decompression
strategy, that goes long the Main iTraxx® and
CDX and short the iTraxx® and CDX HiVol
Indexes. The deal is structured to offer
investors exposure to a senior layer of risk in
the high triple-B/single-A area, by going long
the iTraxx® and CDX Main Indexes and short
the HiVol Index on both the iTraxx® and CDX.
 108 Case studies
“Our style of management
on these products is not
hedge fund-like – we do
not engage in frequent or
daily trading”
If we are really bearish on spreads, we
employ a hedge ratio of 1:1, while if we are
very bullish on spreads we would go long
four times on the Main iTraxx® and one time
short on the HiVol.
This strategy benefits from spread
widening on more volatile names, while
leaving investors exposed to idiosyncratic risk
on higher rated names. A key part of our role
is to manage that idiosyncratic risk by
hedging with single-name CDS.
Our third CPPI deal, Delacroix, was
arranged by JPMorgan in November 2006. In
this deal, the portfolio references flexible
long/short positions on the credit indexes,
tranches of the indexes and single-name CDS
risks. Typically, 50 percent of the portfolio is
dedicated to long/short trades on any two of
the tranches, and 50 percent to long/short
positions on the indexes – the Main and
HiVol Indexes, for example. The rationale here
is that the tranches are more representative
of idiosyncratic risk and the indexes rep-
resent the systemic risk, so we can at times
be short one and long the other, long both or
short both. By dynamically managing and
adjusting these positions with different
hedges, the product should be able to benefit
investors during each part of the credit cycle.
How often do you trade the indexes?
Our style of management on these products
is not hedge fund-like – we do not engage in
frequent or daily trading or look for short
term gains. Instead we put on strategic
trades, generally adjusting our position just
three to four times a year. Where we obvi-
ously intervene more often is on the hedging
side, adjusting our hedges once or twice a
month, either using the iTraxx® and CDX
Indexes or single-name CDS, depending on
the strategy. That said, index liquidity is enor-
mously important to us and is a key consid-
eration in using the indexes, for, once the
credit cycle changes, we will obviously need
to trade far more often.
How important are the iTraxx® and other
standard indexes to your strategies?
Very – if we did not have the iTraxx® and DJ
CDX Indexes, we would have to do multiple
single-name trades to hedge our positions.
This would entail a lot of back-office work
and, because the names would need to be
very liquid and tradable in size, it would also
require considerable back-end credit
analysis to identify suitable credits, espe-
cially for those illiquid credits that trade
rarely. The indexes have proved to be enor-
mously useful for going long and short
credit risk, though it is almost impossible to
quantify the savings.
How important has the introduction of
standardized tranching technologies been?
Enormously important. It would have been
next to impossible to put these deals
together before the arrival of the stan-
dardized iTraxx® tranches. Instead, we
would have had to use tranches from
bespoke CDOs, which would have been
completely illiquid and difficult to trade.
Furthermore, they would have been very
costly to trade as you are typically limited
to transacting with the bank behind the
CDO, and the bid/offer spreads on such
tranches tend to be very wide.
In short, it would have been nigh on
impossible – or as good as impossible – to
put these CPPI deals together without the
standardized tranches.
 Case studies 109

How could you envisage using the new
Eurex iTraxx® Credit Futures?
The futures could be very interesting new
instruments. In a leveraged buy-out (LBO)
context, for instance, we could use them to
bet or hedge against a name being taken out
by an LBO, using the iTraxx® Futures in con-
junction with a single-name CDS – going
long one and short the other, depending on
the bet. Alternatively, we could use them for
basis strategies: going long the index using
futures and short the actual index, in order
to benefit from negative or positive basis
moves between the names and the actual
traded level of the future.
Neither of these strategies would be eligible
within our existing CPPIs, so we would have to
create another product or would need to
amend the documentation of one or more of
our existing products to allow us to use them
– but these are obvious strategies to consider
as the futures contracts gain in liquidity.
What effects will the futures contracts
have on the market?
Counterparty credit risk, back office, clearing,
confirmations and transparency risks are
important considerations for us – and the
futures will likely introduce considerable ben-
efits on all sides. They should help remove
the ‘black box’ worries that surround credit
derivatives and should help the market and
the regulatory authorities to be more com-
fortable with the instruments. Furthermore,
they should help introduce a better and more
robust legal framework, encouraging more
funds into the market and helping CDS to
really become the flagship instruments of the
credit markets. Already CDS are nearly there
– spreads in the cash bond market are fol-
lowing the CDS market’s lead, but there is
still more to be done and a liquid futures
contract will definitely help by increasing
liquidity and transparency in the market.
The idea is extremely appealing.

“A liquid futures contract

will definitely help
by increasing liquidity and
transparency in the market”

Fortis Investments is the global asset management arm of the Fortis group. With some EUR 125 billion assets under management, it
manages investments on behalf of institutional, retail and private clients. Fortis has EUR 26 billion invested in structured finance products,
ranging from plain vanilla CDOs to CDO squared and CPPI products.

Ryan Suleimann is a senior fund manager at Fortis Investments in Paris. He is responsible for managing exotic structures – particularly
long/short strategies within CDOs, CDO squared and CPPI products.
 110 Case studies

The use of iTraxx® in

structured credit
Editor Natasha de Terán discusses the role that the iTraxx® Indexes have played in
the development of structured credit products with WestLB’s Igor Yalovenko

Firstly, could you outline the benefits of
structured credit, and explain why
investors might be motivated to invest in
the market?
The short answer is that structured credit is
worthy of exploration, because it expands the
investment universe and gives investors
much more tailored exposure to credit than
they would otherwise get. But this deserves
some more explanation.
Prior to the development of securitization
and structuring techniques, most institu-
tional and private investors would have
gone into the credit asset class by buying
cash loans or bonds. The drawback with
such a strategy is that the pay-off on these
cash investments is very asymmetrical:
investors get some upside return if things
go well, but they stand to lose the majority
of their investment if things go badly. Broad
diversification is, therefore, the key for
smoothing these asymmetric returns.
Private and smaller investors face a par-
ticular problem, in that it is as good as
impossible for them to build up a well-
diversified credit portfolio: they would need
to buy literally hundreds of bonds from dif-
ferent regions and market segments to
achieve the proper diversification, but would
not readily find sellers of such small lots.
Investing in a typical bond fund, meanwhile,
offers only limited flexibility, as far as the
debt classes and interest rate exposures are
concerned, plus it can involve significant
transaction costs.
In contrast, structured products and credit
indexes can offer investors simple, clean
paths around these issues. Through synthetic
index trades, all sorts of investors – both
large and small – can quickly and economi-
cally build up diversified credit exposures.
Structured credit can
be instrumental in
capturing the different
drivers of credit
portfolio performance
Meanwhile, collateralized debt obligation
(CDO) tranching techniques can be used to
create very particular risk/return profiles. We
can tranche portfolios of high yield loans to
create safe investments with AAA ratings, or
tranche portfolios of low-yielding
investment grade bonds to create high-
yielding equity investments. In this way,
structured credit broadens the investment
universe: expanding available debt classes
for investors who are either restricted from
investing below a certain rating level or
looking for additional sources of return.
Thus, tranching is used both for risk
reduction and yield enhancement purposes.
In addition, structured credit can be
instrumental in capturing the different
drivers of credit portfolio performance. Cash
credit portfolios give investors exposure to
both alpha and beta factors – the credit per-
formance of a particular debt class repre-
senting the beta factor, and the manager’s
bond or loan selection representing the alpha
component. These two will jointly dictate
how the portfolio performs – and in a cash
Case studies 111
credit investment there is no way of sepa-
rating the two. In contrast, CDO tranching
techniques allow us to separate those two
components: we can create alpha-orientated
investments by putting together equity or
junior tranches, with all the upsides of good
portfolio management; or we can create
beta-orientated investments with mezzanine
and more senior tranches, which, being less
dependent on portfolio selection, give broader
exposure to the debt class in question.
How has the structured credit market
evolved since the establishment of the
iTraxx® Indexes? What were the previous
alternatives?
The first CDOs were securitizations of cash
bond and loan portfolios. These products had
very useful applications, but were unwieldy
and costly to construct. When a bank puts
together a cashflow CDO comprised of bonds
or loans, it typically has to go out and source
all that collateral, warehouse it and carry the
risk if the transaction fails to materialize or is
delayed. Building up such a portfolio can
 112 Case studies
take months, depending on the issuance level
of the desired assets and their liquidity.
As soon as a liquid credit default swaps
(CDS) market emerged, CDO structurers were
able to put together so-called ‘Synthetic
CDOs’ – CDOs based on portfolios of CDS.
Banks arranging synthetic CDOs can go out
and transact 100 (or more) CDS trades with
homogeneous features in a single day,
gaining exposure to the same portfolio of
credits that they could take months to build
up in the cash markets. By the end of 2003,
some USD 50 billion of synthetic CDOs had
been issued, but the real jump in synthetic
issuance took place with the introduction of
the iTraxx® Indexes.
The reason for this is that the indexes
make synthetic CDO structuring hedging and
trading much easier. Using an index contract
further simplifies portfolio size adjustments,
because there is less need to trade individual
CDS. The products can also be structured and
sold on a single-tranche basis, as standard
index tranches are quoted by dealers daily.
This allows banks to issue, say, A-rated single
The products can also be
structured and sold on a
single-tranche basis, as
standard index tranches are
quoted by dealers daily
mezzanine tranches with a Euribor spread of
some 100 bps, without having to sell the
senior and junior parts of the capital
structure. In such cases, the issued tranches
are hedged out with delta and correlation
hedging techniques using the indexes and
standard index tranches. This is a major
advantage, because marketing full capital
structure CDOs requires arranging banks to
find investors for each tranche – a process
that can be convoluted and lengthy.
Because synthetic CDOs are often privately
placed transactions, they are difficult to track,
but the estimates for 2006 issuance range
from USD 100 to 300 billion, depending on
the source and methodology. We know for
certain, however, that virtually all of the cor-
porate credit CDOs being issued now are syn-
thetic structures, while other debt classes,
such as ABS and leveraged loans, dominate
the issuance of cashflow CDOs.
Various investors, including CDO managers,
have directly benefited from the iTraxx®
Indexes as well. This is because the indexes
have lower transaction costs, and give
investors far greater flexibility and trans-
parency in determining CDO features, such as
tranche subordination, maturity, thickness,
and ratings. Investors can also be sure that
desired portfolios are constructed quickly as
the ramp-up periods are much shorter for
synthetic deals, and there is far less uncer-
tainty over portfolio composition than there
is with normal cash-based CDOs. Professional
investors can calibrate portfolio default prob-
abilities to the market spreads of the portfolio
names, and the correlations between them to
the implied correlation from the quoted
iTraxx® tranches (base correlation skew),
making it much easier to do model-based
pricing. Finally, investors that buy single-
tranche deals avoid the conflicts of interest
that sometimes arise in full capital structure
CDOs with the holders of other tranches.
How have the iTraxx® Indexes facilitated
structured credit investment?
Enormously – but differently for distinct user
types. iTraxx® gives more sophisticated
investors the opportunity to put on delta
neutral trades – taking views on changes in
the correlation of underlying portfolios. They
can do this by going long or short standard
iTraxx® tranches, and delta-hedging these with
the indexes: if the correlation changes in the
desired direction they will profit accordingly –
independently of how the portfolio credit
spread moves. Also, because standard iTraxx®
tranches are actively quoted on a daily basis,
investors can easily benefit from the trends by
trading the relative value of different tranches
– doing so-called ‘relative value trading’
between different parts of the capital
structure. For instance, towards the end of
2005 many investors switched out of mez-
zanine tranches into super senior risk, because
 Case studies 113

Banks are now also able to use iTraxx® to

hedge their corporate loan portfolios far
More recently, historically more simply and economically than they

low default expectations were able to previously. Instead of doing

multiple CDS trades to hedge out individual

encouraged a trend toward risks, they can hedge out their overall port-
folio exposure by doing so-called macro

the equity tranches hedges through the index or sub-indexes.

For instance, if they think that credit risk
will worsen or spreads widen, they can buy
protection via an iTraxx® swap – a very
effective and low-cost way of ‘macro-
hedging’ their portfolios.

they saw more value there. More recently, his-
torically low default expectations encouraged
a trend toward the equity tranches.
Finally, because the iTraxx® Indexes are
quoted and traded across several maturities,
investors can use the indexes to do relative
value trades on the credit curve: trading
5-year exposures against 7- or 10-year expo-
sures. They can go long and short different
maturities and benefit from the change in
the shape of the credit curve, much as they
would do from interest rate flattener or
steepener trades.
What about the more traditional buy-
and-hold investors and banks?
These investors have been able to use the
iTraxx® Indexes to get diversified exposure
to the corporate credit universe and to
leverage or de-leverage that exposure to
particular rating or risk profiles. The sudden
rise and importance of innovative struc-
tured products, such as constant proportion
debt obligations (CPDO), which can pay
Euribor spreads of over 100 bps for a AAA-
rated note, would be impossible without
liquid credit indexes. For banks, this is par-
ticularly important because the introduction
of the Basel II regime will allow for much
more refined regulatory treatment of
investment grade structured credit invest-
ments, reducing risk weightings from 100
percent to 20 percent or below for AAA-
rated tranches.
How do the Eurex iTraxx® Credit Futures
complement the iTraxx® family?
Credit futures are particularly well-suited for
investors that are not advanced enough to
get involved in the over-the-counter (OTC)
market directly, whose business is not large
enough to justify the necessary infrastruc-
tural investment to do so, or who wish to
deal in small-sized trades that the major OTC
dealers do not cater for. Larger and more
sophisticated investors are already used to
trading in the OTC markets. However, if liq-
uidity in the Eurex iTraxx® Credit Futures
increases, they may well start using them as
alternatives to the OTC products, as there will
potentially be some overlap, and even some
arbitrage opportunities between the two.

WestLB is a leading German bank with a strong international presence. It is involved in credit origination, securitization, structuring and
trading and acts regularly as an arranger of structured transactions tailored for German saving banks, as well as for private, institutional
and international investors.

Igor Yalovenko is an executive director in the fixed income analysis group within WestLB’s research unit. He provides research coverage
for the whole range of structured credit products and his particular focus is on portfolio optimization.
 114 Case studies

CDS and iTraxx®: adding

to the fixed income
manager’s armory
Barclays Global Investors’ Maria Ryan describes how credit default swaps and the
iTraxx® Indexes can be gainfully deployed in fixed income portfolios
 Case studies 115

I
n June 2007, the iTraxx® Index
responded to the increased nerv-
ousness in the market caused
by the sub-prime mortgage
market turmoil in the U.S. Over
the month, spreads on the iTraxx®
credit default swap (CDS) Index in
Europe expanded by 4 bps, from 20
to 24. What may be a little surprising
is that over the same period, corporate bond
market spreads ended the month unchanged
at 22 bps.
Chart 1 (below) shows spreads on the The CDS and bond
iTraxx® Index versus the single A-rated com-
ponent of the European corporate bond markets have tended to
index (iBoxx®). There are some very valid
reasons why these markets can dislocate,
have different investor
demonstrating that some structural differ-
ences between them can make arbitrage
bases, with varying
very difficult. constraints
Chart 1
 116 Case studies
Different markets, different investors,
different values
The CDS and bond markets have tended to
have different investor bases, with varying
constraints. Asset management mandates
often preclude investors from using the CDS
markets, or stop them from taking short
positions, but hedge funds have been active
in the CDS market for some time. The distinct
investor profiles can result in different
behavior affecting the markets, with one
market reacting to events over a longer
investment horizon than the other.
Even fund managers who use these instru-
ments tend to have different investment
styles and use them in different ways to
hedge funds. Asset managers are often
measured against corporate bond bench-
marks, so they have a natural bias towards
holding a substantial number of physical cor-
porate bonds. If they have a fundamental
view on the credit of an individual company,
they may take an overweight or an under-
weight position in that issuer versus its
weight in the benchmark. This can be done
either through physical corporate bonds or
by trading individual CDS contracts. However,
asset managers have increasingly chosen to
maintain their physical corporate bond posi-
tions, using CDS indexes to reduce or
increase their overall credit risk as their views
dictate. The main reasons for this are that
CDS indexes tend to be far more liquid and
much cheaper to trade than corporate bonds.
Table 1
iBoxx® Europe Corporate Universe
Total
With duration between 3 and 7
Notional over EUR 750 million
Notional over EUR 1 billion
Difficulties with arbitrage
Hedging a CDS index with a portfolio of
bonds is particularly difficult due to the
diverse nature of the bond market. The
iTraxx® Europe Index is made up of 125 of
the most liquid names in the CDS market,
with 5- and 10-year tenures. In order to
execute a perfect arbitrage strategy, indi-
vidual physical securities, matching each
constituent of the index, would need to be
readily available in the bond market. This is
not always the case, as some issuers in the
index do not even have bonds outstanding
that can be used for a perfect match. Some
of the other difficulties that investors
encounter in finding perfectly matched secu-
rities are listed below:
I Liquidity – The bond market may not be
liquid enough to provide access to the
required securities at a reasonable size and
price. Some index components will have
no bonds that can be used, so access to
the loan market may be required. In table
1 (below) you can see that there are only
47 issuers or 72 bonds that are over
EUR 1 billion in size, highlighting the liq-
uidity difficulties that could arise when
accessing some of the smaller securities.
I Maturity – Matching maturity profiles of
all components of the index is also dif-
ficult. The iTraxx® Indexes are 5- and 10-
year instruments, but the maturity of cor-
porate bonds varies across the curve.
Thomson is an example, where matching
Number of issuers
304
254
137
47
issuer and maturity is problematic. It is a
component of the iTraxx® Europe Index,
but the only corporate bond that could be
a match is a perpetual bond, which is
callable in 2015. Therefore, to match this
component of the iTraxx® investors would
need to choose between matching the
issuer risk or the maturity/curve risk, but
they could not match both.
I Covenants and seniority level – Some
bonds have covenants and seniority prop-
erties that can materially affect their value
and, hence, performance. Valeo is an auto-
mobile components company and a com-
ponent of the iTraxx® Index. It has two
bonds within the vicinity of the 5-year
tenor of the iTraxx® Index, maturing in
2013 and 2011. The 2011 bond, however, is
a convertible, so it is not really a suitable
match. The better selection would be the
2013 bond, but it has a change of control
covenant, meaning that the bond would
be bought back at 100 in the event of a
leveraged buyout or mergers and acquisi-
tions activity. As this bond currently trades
at a price of 92.7, it would outperform sig-
nificantly in such an event, while its corre-
sponding CDS within the iTraxx® Index
might be expected to perform badly. Thus,
if investors want to hedge the exposure to
Valeo within the iTraxx® Index, they would
need to accept this risk.
I Event risk (default) – In the case of a
default, the buyer of protection in the CDS
Number of bonds
906
523
271
72

The iTraxx® Indexes
are 5- and 10-year
instruments, but the
maturity of corporate
bonds varies
across the curve
market can choose between a set of bonds
that could be delivered, typically selecting
the bond that would be the cheapest to
deliver. On default, an arbitrageur that has
sold a bond, and sold protection on the
issuer’s corresponding CDS single-name
component of the index, may find the
bond delivered to them differs from the
bond they sold. As the buyer of protection
is always likely to choose the cheapest-to-
deliver security, this discrepancy is unlikely
to be in the arbitrageur’s favor. The value
of this option can go some way toward
explaining the dislocation between bond
and CDS markets.
Dislocation between the two markets can
persist as long as the cost of implemen-
tation is greater than the arbitrage oppor-
tunity. In current market conditions we
estimate that the dislocation would need to
be at least 10 bps for it to make a rea-
sonable investment proposition when taking
account of current transaction and repo
costs (i.e. the cost of borrowing securities to
take short positions). With the current
spread at just over 2 bps, it is hard to
imagine a dislocation this wide.
Conclusion
CDS are an important addition to the fixed
income manager’s armory. The rapid growth
of CDS volumes in recent years, and the
development of new instruments based on
CDS-type technologies, attests to the
instrument’s usefulness. However, in order to
use them efficiently, it is crucial to under-
stand the differences that can exist between
CDS and the underlying physical securities.
In particular, differences in risk character-
istics between physical bonds and CDS that
cannot be hedged, can result in valuation
differences between both single-name and
index CDS, and their associated physical
securities. Efficient use of CDS in a portfolio
requires a precise understanding of the dif-
fering sources of risk, and of their potential
impact on risk in a portfolio.
Case studies 117
Barclays Global Investors (BGI) was
established over 30 years ago, and is
is the world's largest fund manager.
A subsidiary of Barclays Plc, the
company has a 3,369-strong workforce
worldwide and manages EUR 1,399
billion of assets for 2,903 clients globally.
BGI offers funds focusing on active,
index and asset allocation strategies, as
well as services including liability
driven investment, currency strategies,
cash management, securities lending,
hedging strategies, transitions and
commodities trading. BGI is the global
leader in the ETF business by assets
under management, via the
iShares range. BGI pioneered the first
index strategy in the 1970s and
continues to research and analyze
innovative ways to deliver risk-con-
trolled, cost-effective investment returns
for its clients.
Maria Ryan is a strategist in the
fixed income team, responsible for
relationships with fixed income clients
and investment consultants. She
joined BGI in September 2006, having
previously worked at Henderson
Global Investors as an investment
director responsible for U.K. pension
funds and at JPMorgan Investment
Management as a global fixed income
portfolio manager and client advisor.
Maria graduated from the University
of Limerick in 1990 with a Bachelors
degree in business studies, majoring
in economics and accounting.
 118 Case studies

No free lunch, but a

good opportunity to
make money
Banca IMI’s Riccardo Pedrazzo explains the ‘skew’ in iTraxx® Indexes and showcases
some simple strategies that can be used to exploit it

The skew trade: the basics
A skew trade is simply an index-versus-con-
stituents arbitrage trade. To lock in the dif-
ference between the fair spread of an index
and the spread of its constituents, one would
buy or sell protection on the index while
buying or selling protection on its con-
stituents. The origin of the term ‘skew trade’
comes from the market practice of calling
the difference between the fair value and the
market price of the index the ‘skew’.
Skew trade opportunities arise across
the whole iTraxx® spectrum. For example,
the iTraxx® Main has 125 constituents,
each with a weighting of 0.8 percent. You
would expect that the price of the index
would equal the average of the constituent
spreads – but as we will see it is somewhat
different. Liquidity in the iTraxx® Main is
now very strong, and the bid/offer spread
is usually as low as 0.25 bp. Let us presume
that the constituents’ bid/offer spreads are
approximately 2 bps, so that the average
bid of constituents is 22 bps and the
average offer is 24 bps. You would expect
to find iTraxx®’s value somewhere around
The fair value of the index
is approximately the
weighted average of the
constituents’ spread, with
the weights being the risky
DV01 of the constituents
23 bps, otherwise an arbitrage opportunity
would arise.
When you see an arbitrage opportunity
you have to ask yourself: how is this pos-
sible? The answer is typically down to liq-
uidity, market segmentation and trade exe-
cution issues. Liquidity in the iTraxx® Index is
very strong, so moves in the constituent
credit default swap (CDS) names usually lag
index movements, especially in fast-moving
or high-volume market conditions.
There are many different investors in the
iTraxx® Indexes. For example, there are flows
from macro traders, flows from structured
products desks, flows from the tranche
market, and flows that come from single-
name traders. All these traders and investors
are looking for different opportunities and
focus on different factors, thereby creating
the arbitrage opportunities.
As a result, if you look at the skew in the
most liquid iTraxx® Indexes (Main, Crossover
and HiVol), you will find that there is a pos-
itive correlation between the skew in dif-
ferent indexes: when flows arrive they hit all
the iTraxx® Indexes.
Case studies 119
Defining the ‘fair spread’
There are three points in the calculation of
the fair spread. If you compare the simple
average of the constituents with the index
(as we did earlier), you are not using the fair
spread of the index because of cashflow mis-
matches at the point of default. In fact, you
are trading an index at a flat value of, say, 23
bps for each name, with 125 names at dif-
ferent values. To better understand this
effect, think of an index with only two
names, one trading at 50 bps and the other
at 150 bps. Is the correct value of the index
with only these two names the simple
average 100 bps? No. In fact, if one name
defaults, let us say the 150 bps name, you
will receive 50 bps from the ‘good’ name,
whereas you will pay 100 bps on the index. It
follows, therefore, that the fair spread must
have something to do with the level of
spreads and the probability of default of
each constituent. Indeed, the fair value of
the index is approximately the weighted
average of the constituents’ spread, with
the weights being the risky DV01 of the
constituents. You are, therefore, going to
weight names with high spreads (high prob-
ability of default) less, meaning that in a
replication strategy you are going to sell a
lower amount of names with higher
spreads, to compensate for the loss from
the cashflow mismatch at default.
The second point is the maturity mismatch
that appears in the three months when
single-name CDS roll and the index does not.
You usually have only 3-, 5-, 7- and 10-year
CDS prices, so you have to estimate the value
of constituents with the same index maturity.
The third point is the ‘quotation bias’ that
arises from the market practice of having
indexes with fixed initial spread levels
 120 Case studies
(though this point is negligible in market
conditions, where the coupons and traded
levels are roughly equivalent).
From theory to practice
Execution plays a large role in skew trades.
It is difficult to lock-in the theoretical skew
for two reasons: the first is the operational
risk at the point of execution; the second
is that you need good firm prices from
several counterparties.
When you are confident with the level of
skew that you are going to lock-in, you have
to call a number of counterparties and try to
organize the trade. As the single-name is the
less liquid leg of the trade you have to start
with this, sending a list of bid/offer wanted
in competition (B/OWIC), to your counter-
parties. This quotation process can be quite
time-consuming for traders, so you can
expect to wait at least 15–20 minutes to
receive your quotes back.
Let us say, for example, that you called
your counterparties at 11:00 and asked them
to give you prices, from 11:30 for two
minutes. At 11:30 the first lists may arrive,
but you may not receive the remainder until
after 11:32, by which time the other offers
will have expired.
You now have to make your decision. You
have to compare the lists, pick the best
prices, check them against the index price to
ensure the level of skew is still good, and
then decide if you are prepared to omit
some of the names for which you did not
get good prices. The bad news is that you
have to do this very quickly – you have to
ask your counterparties to quote you prices
for a finite period and, of course, the longer
that period, the worse the prices. Depending
on the number of counterparties, as well as
Large skews often arise
in periods of market
volatility, which of
course brings further
execution issues
the level of ‘last looks’ that you are com-
fortable with, the whole process can take
anything from two to ten minutes. While
sending your ‘done files’ on the single-name
trades, you have to try to get best execution
on the indexes.
‘Pure arbitrage’ versus ‘directional
cheap option’
The skew trade can be done for two main
purposes: either for ‘pure arbitrage’, or for
what is known as a ‘directional cheap option’.
Of course, you can also trade only a subset of
single-names versus the whole index, but
this is more of a ‘statistical arbitrage’ trade,
which we are not exploring in this instance.
The ‘pure arbitrage’ approach
In a ‘pure arbitrage’ trade you lock-in the dif-
ference between the fair value of the index
and constituents, receiving a positive carry.
You would like to minimize the P&L volatility,
by putting the trade on at a historically large
level of skew, thereby maximizing the chance
of being able to unwind the trade at a profit.
In a ‘pure arbitrage’ trade you have to wait
for a large skew, but growing competition for
these trades can make timing difficult.
Furthermore, large skews often arise in
periods of market volatility which of course
brings further execution issues.
In a ‘pure arbitrage’ trade you will
probably hold the trade for a while, in fact
your goal is to secure a positive carry
without any real risk (to do this, of course,
you have to hedge the mismatch of cash
flows at default with a ‘delta-hedge’). You
have to pay attention to the real level of
skew, as you cannot use the simple average
of constituents, but you have to look at the
fair value of the index. So you receive money
(the positive carry) for the mark-to-market
losses at inception and are exposed to P&L
volatility. But you have to bear in mind that
the P&L volatility can be very painful in
extreme market moves. In the second week
of July 2007, for example, the skew in the
Crossover Index rose to 20 bps compared to
 Case studies 121

a maximum of 10 bps just a week earlier. If
you locked the skew at 10 bps in the
Crossover (and this is a quite heroic
assumption), with EUR 5 million in each
name and EUR 200 million for the index, the
loss could be as high as EUR 1 million.
Some mathematics on the calculation of the index fair spread
Denoting with:
= the day-count fraction (ti - ti-1);
= the discount factor from time ti up to the evaluation date;

The ‘directional cheap option’ approach = the survival probability at the time ti as seen at the evaluation date.
Another way to exploit the skew is through
what we can call a ‘directional cheap option’. The PV of the premium leg of a single CDS is:
There is a positive correlation between the
indexes and skew. In a spread-tightening envi-
ronment we would expect the skew to be
more negative: many flows arrive on the index
and single-name CDS lag this movement. The PV of an index of m single CDS is:
Otherwise, in a spread-widening environment
we would expect the skew to become more
positive: this is what we saw in the second-
week of July 2007 in the Crossover Index.
You can take advantage of the skew with The PV of an index of m single CDS must be equal to
the ‘directional cheap option’ approach either the sum of m PV of the very same m single CDS
by executing a ‘plain vanilla’ trade, or by
buying or selling different amounts of the
indexes. For example, if the skew is negative,
you would expect to make money in a
widening environment because the skew We can find the spread S that solves the equation
would become more positive. So you can buy
less of the index and, if the skew becomes
more positive, you will close the trade flat or
with a moderate gain. Or, if the skew remains
at the level that you locked in, you can earn As demonstrated, on coupon payment dates, all are almost the same, while on the
a more positive carry than you would have other dates the first is smaller. The equation can thus be seen as the weighted average of
done on the ‘plain vanilla’ trade. the constituents’ spread with the weights being the risky DVO1 of the constituents.

Intesa Sanpaolo is among the top banking groups in the Eurozone, with a market capitalization of EUR 70 billion (as of August 31,
2007). It is the leader in Italy, with an average market share of more than 20 percent in all business areas (retail, corporate and wealth
management). With a network of more than 6,200 branches distributed throughout the country, and market shares above 15 percent
in most Italian regions, the group offers its services to about 10.5 million customers.

Riccardo Pedrazzo works on the credit derivatives desk at Banca IMI (Intesa Sanpaolo).
 122 Case studies

The use of iTraxx®

Options in corporate
bond portfolios
Union Investment’s Stefan Sauerschell explains how iTraxx® Options can be used in
relative value trades and hedging strategies
 Case studies 123

I
nvestment companies through- index option is exercised, settlement is At present, iTraxx® Crossover Options have
out Europe have increasingly made physically. the highest volume of liquidity. However,
been using iTraxx® Index con- Index option buyers receive a short (in with the further growth of the credit deriva-
tracts and iTraxx® Index Options to the case of a receiver) or long (in the case tives market, it is expected that there will be
actively manage systematic credit of a payer) protection position in the more liquidity in the iTraxx® Main and
risks in corporate bond portfolios. respective index contract from the option iTraxx® HiVol Options.
As these investment companies writer. In the event of a credit default, the To properly use credit index options, it is
generally have a credit risk position in iTraxx® Option continues to be traded vital to know the empirical facts of the credit
their benchmark portfolios, it is natural for without the defaulted name. If, for options market and, above all, the behavior
them to use credit derivatives instruments example, payer buyers exercise this type of of implied volatility. A modified Black-Scholes
for hedging. However, the use of credit index option, they receive a long protection index model is used to price credit index options:
options also allows additional active and risk- position from the payer writer. The payer the implied credit spread volatility, and the
adjusted portfolio management strategies. In buyer also receives a long protection forward spread levels, are the key factors that
addition to new option-based relative value position in the name subject to the credit impact on the option price.
strategies as a further alpha source, spread event from the payer writer. The difference between implied and
volatility can also be actively used as a new The options with the tightest bid/offer realized credit spread volatility, the so-called
asset class. spreads are the at-the-money index options. volatility risk premium, is comparatively large
There are two types of credit index
options: payers and receivers. A payer is the
right to buy a specific spread level protection
for a credit index. In other words, an investor
It is vital to know the
who has bought a payer has a put position in empirical facts of
corporate bonds and expects the credit
spread to expand. A receiver is the right to the credit options
sell a specific spread level protection for a
credit index. An investor or a trader who has
market and, above
bought a receiver has a call position in cor-
porate bonds, and expects the credit spread
all, the behavior of
to narrow. implied volatility
The maturities of the liquid index options
are between one and six months and are
based on the current 5-year iTraxx® Index
contracts. The final maturity of the liquid
iTraxx® Options is, in each case, the 20th of
March, June, September or December.
iTraxx® Options are European options, (i.e.,
they can only be exercised upon maturity).
As a rule, prices are listed in cents or as a
percentage of the nominal value of the
option1. Option buyers must pay the writer
an upfront premium. If an in-the-money 1
One cent is 0.01 percent of the notional.
 124 Case studies
Chart 1
in normal credit market situations. Chart 1
(above) shows the difference between the
implied and realized spread volatility of the
iTraxx® Main in the period from April 2005
to June 2007.
In periods of stress, such as that experi-
enced in the credit market in the April–May
2005 period, the implied volatility of iTraxx®
Main Options increases and the volatility
risk premium falls. The implied credit spread
volatility is, therefore, directional. If the
credit spread widens, both the implied and
historical spread volatility will increase. If
the spread narrows, they will fall. These
empirical correlations also apply for iTraxx®
HiVol and iTraxx® Crossover Options.
The volatility risk premium in the credit
market is high compared with other
financial markets, such as the equities
market. The large difference between the
implied and realized spread volatility can
largely be explained by the imbalance
between supply and demand: whereas
options traders at banks and brokers act as
net writers of volatility, most credit
investors are net buyers of volatility.
Source: JPMorgan, Union Investment
In the credit market, the volatility skew, or
the curve of the implied volatilities of the
individual strike spreads, is comparatively flat.
However, when the strike spread increases,
there is a tendency for implied volatility to
rise. Chart 2 (below) illustrates the correlation
for the iTraxx® Main Index.
As a rule, implied volatility increases with
the remaining maturity of the index option.
Inversions may result in periods of stress in
the credit market. In this case, credit index
options with a shorter maturity will have
higher implied volatilities.
Chart 2
The use of index options affords managers
far greater flexibility in determining the
opportunity/risk profile of their top-down
credit strategies. For portfolio managers, the
use of iTraxx® Options is primarily of interest
to hedge against an imminent or possible
widening in credit spreads. Individual
strategies can also be tailored to the needs of
particular credit portfolios through a careful
combination of long and short positions in
payers and receivers.
For instance, a risk reversal or bearish
cylinder can be set up as an optional alter-
native strategy to buying credit protection. In
this trade, an out-of-the-money receiver is
written and an out-of-the-money payer is
bought. The trick is for the written option
position to mostly finance the payer, or the
credit put buy. This approach protects
investors from strong increases in the spread,
however, they must accept a loss in the
option position if the spread narrows further.
Chart 3 (top, right) shows the oppor-
tunity/risk structure at maturity for a
bearish cylinder position on the iTraxx®
Main S7.
The position entails writing a receiver
with a strike at 21 at 5 bps. A payer with a
Source: Union Investment
 Case studies 125

Chart 3 This cylinder strategy shows just one way

strike at 25 at 6 bps is bought with on the
same notional. The spot spread of the
iTraxx® Main was almost 22.5 when the
position was opened, and the volatility
skew between the two strike spreads was
comparatively steep at 4 volatility points.
The cost of this hedging strategy would
have been lower if the volatility spread had
been less steep.
If the iTraxx® Main Index remains between
the two strike spreads of 21 and 25 at
maturity, the position costs 1 bp. Breakeven
for the entire position is the iTraxx® Main S7
at 25.25. That means that hedging would
start at this index level. If the spread widens
to 30 in the iTraxx® Main S7 by September
20, 2007, the position would enjoy a profit
of 20.5 bps based on the notional of the
payer position. Conversely, the position
would suffer a loss below spread levels of 21
for the iTraxx® Main, and at an index of 17
on maturity, the entire position would have
made a loss of 18 bps based on the notional
of the receiver.
Compared to the outright sale of pro-
tection on the iTraxx® Main Index, less carry
has to be paid. If the index is between the
two strikes upon the options’ maturity, the
investor suffers a loss of 1 bp from the
option position. However, the investor can
collect the carry premium from the cor-
porate bond portfolio.
in which index options can be used to make
hedging strategies more flexible. In addition
to traditional hedging strategies, investors in
the credit options market can benefit from
higher volatility premia by writing volatility
using straddles or strangles. A multitude of
relative value strategies can also be deployed
with options – for example, volatility skew
steepening or flattening positions are
examples of relative value strategies. In stress
situations with rapid spread increases, the
volatility skew may flatten off in the credit
option market, with increasing implied
volatilities. This is due to institutional
investors’ high demand for at-the-money
payer options. In this situation, a portfolio
manager can benefit from a volatility flat-
tening position by buying a payer option
with a higher strike spread and selling
another with a lower strike spread.
As liquidity continues to increase in the
credit derivatives market, there will doubtless
be a reduction in the volatility risk premium
for iTraxx® Options. This will lead to a
reduction in the profitability of volatility
option strategies and some relative value
option strategies, however, the increased liq-
uidity and standardization will also allow a
much wider group of investors to efficiently
hedge their corporate bond portfolios.

Union Investment was founded in 1956 and ranks among the three leading German fund managers by market share. Its principal share-
holders include German co-operative banks and highly respected international private financial institutions. Assets under management
totalled over EUR 130 billion as of May 2006.

Stefan Sauerschell studied economics at Johann Wolfgang Goethe-University in Frankfurt, where he focused on finance and statistics. In
July 1999 he joined Union Investment as an FX portfolio manager. In 2001 he became fixed income portfolio manager and since October
2002 he has also been responsible for producing credit research on brokerages and U.S. banks.
126 Case studies

Opportunity funds:
the thinking
investor’s CDO
BlueBay Asset Management’s Dipankar Shewaram presents
the case for opportunity funds

L
ate last year the col-
lateralized debt obli-
gation (CDO) market
breached the USD 1
trillion mark; a major
milestone for a market
that was worth under
USD 100 billion just six
years ago. In the wake of the record down-
grades and defaults of 2001/2002 the CDO
market was about as popular as a mosquito
at a barbeque. Thanks to the 2003 credit rally
and significant improvements in the credit
environment, as well as innovation by deal
structurers, the CDO market has been gaining
acceptance across an ever-widening range of
investors. Today, the CDO space is one of the
most rapidly growing segments of global
derivatives markets. And investors’ appetite
for CDO-type structures shows no sign of
abating. CDOs might be flavor of the day but
they are not without limitations. With few
viable alternatives available, investors have
been willing to overlook some of their struc-
tural flaws. But a new breed of structures is
emerging – in particular, there is a growing
interest in opportunity funds, or ‘hybrid
CDOs’ as they are sometimes known.
The CDO challenge
The CDO market, as we know it today, has its
origins in the collateralized bond obligation
(CBO) market that began to develop in the
mid-to-late 1990s. Investors sought to take
advantage of some kind of arbitrage in the
market (hence typical CDOs are also known
as arbitrage CDOs), essentially by buying a
cheap asset and locking in the relative value
over a period of time. The logic is that as the
asset quality improves, the overall value of
the investment improves. This is attractive to
investors because both the financing cost
and leverage are fixed. Of course, this does
require a certain element of market timing –
CDOs are all about doing the right deal at the
right time. The ideal period for issuing CDOs
being at the bottom of the credit cycle when
investors are able to lock–in cheap assets.
Today, arbitrage deals are the main driver
of growth in the European CDO market. But
CDO issuance has become less about doing
the right deal at the right time and more
about doing all deals in all market conditions.
This was precisely why some investors got
their fingers burnt during the 1999–2001
period – asset managers then were issuing
CDOs as a product for all seasons. What we
are seeing now is not dissimilar. The chal-
lenge to CDO managers is that, as specialists,
they need to continue to issue and replenish
these vehicles. They have limited options or
incentives to return capital and if their only
business is to manage CDOs, they are likely to
be motivated to keep issuing them. What
they are essentially saying is that they are
CDO issuance has
become less about
doing the right deal at
the right time and more
about doing all deals in
all market conditions
Case studies 127
going to leverage high-yielding assets on a
term basis, regardless of market conditions
and necessarily over the course of a credit
cycle – as most transactions have a term of
twelve or more years.
Provided you can take advantage of market
conditions you believe in, and you have
enough time to buy the assets without being
forced to buy the market, opportunistic CDO
issuance is a good thing. But programmed
issuance is not – it necessarily implies that
some of the CDOs may underperform.
CDOs – know their limits
While under certain market conditions CDOs
clearly have their advantages, they do have a
number of structural shortcomings. They are
very much an asset class play. A typical CDO
structure is backed by a single asset class –
usually leveraged loans or asset backed secu-
rities (ABS) – and has little flexibility to invest
in different parts of the capital structure.
Traditional cash CDOs are also highly
leveraged – often ten to twelve times at a
 128 Case studies
fixed level for a 12- to 15-year term. This
time period is necessarily going to include a
credit cycle; but with little flexibility on the
asset composition front and no control over
leverage, CDOs are consequently challenging
to manage through the cycle.
Another major drawback is that they
offer investors limited liquidity – CDO
tranches are typically traded as instruments
and redemption options are very limited.
A typical CDO leads a somewhat schizo-
phrenic existence – it is regulated, in a sense,
by the rating agencies; they look at the sta-
tistical default probabilities of the underlying
collateral and impose constraints that limit
the managers’ flexibility to manage the port-
folio. The ultimate aim being to protect the
debt which provides the leverage to the port-
folio. CDO equity investors, meanwhile, are
looking for attractive total returns from the
manager. Yet that manager is being con-
strained – and regulated on a day-to-day
basis – by parties that have no interest in
high returns for the equity tranche.
So, in a credit downturn it becomes much
more difficult for the manager to actively
manage risk. It also means that managers may
face a conflict of interest in managing the
portfolio for both debt and equity investors.
One other thing for investors to consider is
that they run the risk of buying into a
bubble. Lured by the instant gratification of
accumulating significant assets under man-
agement (AUM) very quickly, everybody and
his brother are launching a CDO/CLO.
Yet some managers are entering the
market without experience in the asset class,
the instruments or even the structural
framework. In addition, the overlap between
collateral pools in CDOs of a given asset
class may be very high between transactions
Lured by the instant
gratification of accumulating
significant assets under
management very quickly,
everybody and his brother
are launching a CDO/CLO
of similar vintage, leaving very little flexi-
bility to react to a downturn. When things
do go wrong, CDOs/CLOs will be subject to
some of the limitations we mentioned. And
within each asset class they will likely be
very correlated.
Opportunity funds: lots of advantages,
less limitations
Luckily, the structured products area is con-
stantly evolving to suit more types of assets
and different market conditions. Opportunity
funds combine some of the main benefits of
traditional CDOs and hedge funds, while
minimizing many of their limitations.
So, what are opportunity funds?
Essentially, these are low leverage structures
in which the manager has considerable flexi-
bility in portfolio construction, the ability to
go short (generally) and controls financial
leverage (typically without the involvement
of rating agencies).
Opportunity funds are actively managed,
and have the flexibility to invest in different
parts of the capital structure. Like a conven-
tional CDO, opportunity funds use financial
leverage to enhance total returns. But
leverage is modest and it is not the whole
story – these structures use a combination of
financial leverage and active management to
generate returns. What is more, it tends to be
the more stable, less risky assets in the
capital structure that are leveraged.
Opportunity funds have a number of
structural advantages. CDOs are relatively
inflexible trading vehicles – they tend to be
individual deals that have a single closing
and, therefore, their performance is highly
tied to the market conditions in which they
are closed or traded.
Opportunity funds, by contrast, are open-
ended and scalable. And that is very attractive
to investors – while CDOs are all about
finding the right manager with the right deal
at the right time, investors in an opportunity
fund can invest on their own timescale. What
is more, CDOs do not tend to have a self-
repair mechanism for leveraged investors.
So, once a certain level of losses occurs in
a CDO, cash flows are triggered away from
the equity holders to pay down the debt
holders. In a time of crisis, excess income in

the structure is taken away and used to pay
down the investors that, in a sense, need it
the least – i.e. the debt holders at the top
who already have the subordination pro-
tecting them.
There are typically no such triggers in
opportunity funds – even if there is a default
in the portfolio, investors in the equity por-
tion continue to receive the income stream
coming from the portfolio and, therefore, still
have the opportunity, over time, to recover
the total return of their investment.
It is all about the manager
Given the importance of alpha in an oppor-
tunity fund structure, the choice of asset
manager is absolutely crucial. A CDO/CLO will
generate returns in the presence of a manag-
er that does not trade – they could just pick
and hold assets to maturity as it is primarily
financial leverage of high income that gen-
erates the return. In an opportunity fund
structure, a significant part of the total return
will come from alpha generation and will
depend on the credit selection, trading capa-
bilities and sector skill of the asset manager.
Investors should, therefore, be looking for
a manager who has been managing the asset
class through the credit cycle and has been
managing the various components of the
portfolio for an extensive period of time.
Fundamentally, the manager needs to have a
short capability to manage the beta risk;
however, going short in any market can be
expensive if you cannot extract value
because it reduces returns to investors.
Stable returns throughout the credit cycle
An opportunity fund is a unique structure
designed to deliver capital preservation and
alpha generation throughout the credit cycle.
Case studies 129
A varied and flexible toolbox enables the
portfolio manager to take what is essentially
a ‘best of asset class’ view on the portfolio
construction, irrespective of market condi-
tions. The manager can proactively and
dynamically manage the asset mix across the
capital structure from stable assets to stres-
sed and distressed assets. The assets can be
either fixed or floating, cash or synthetic.
Once the manager has constructed the
optimal portfolio for the prevailing market on
the long side, he also has the opportunity to
use a large short bucket to stabilize the port-
folio as required.
An opportunity fund is also a lightly
leveraged vehicle with the flexibility to adjust
overall leverage on the fund, as well as on
individual assets, depending on prevailing
market conditions. In summary, portfolio
construction is in the hands of the manager.
A hedge fund/long-only hybrid
While this is a new product in the market,
the asset classes and techniques it employs
are not. An opportunity fund strikes a
balance between hedge fund and long–only
investment types. It employs many of the
tools and techniques used in both invest-
ment strategies – leveraging these skills and
tools and applying them in a different ratio.
Opportunity funds embody many of the key
elements of a long-only fund – for instance,
they are often EU-domiciled, may be listed
and typically publish weekly NAVs and offer
significant transparency in terms of the asset
holdings. There are typically sector and issuer
constraints, albeit broad-based ones, and asset
bucket constraints in terms of minimum and
maximum allocations (unlike a hedge fund in
which there are no limitations). But by the
same token they do have some hedge fund-
 130 Case studies

CDOs clearly have their

benefits at the right time
and the right place

like characteristics – most opportunity funds
have a very sizable short bucket as well as the
ability to invest across asset classes, unlike a
traditional long–only fund.
Opportunity knocks
It is still early days for opportunity funds and
they remain the contrarian trade, primarily
because the market is awash with CDOs and
this is what institutional investors are buying.
There is nothing wrong with CDO technology
per se, but it is subject to some of the limita-
tions we have outlined above.
Given the numerous attractive features of
the opportunity fund-type structure, it seems
inevitable that these will evolve at the
expense of CDOs/CLOs.
Opportunity funds are also evolving as an
alternative to traditional hedge funds –
investors who cannot invest in hedge funds
because of their domicile or lack of trans-
parency or their fee structures can incor-
porate opportunity funds into their asset
bucket; this is a ‘long plus’ or a ‘regulated
hedge fund’-type strategy for those investors.
The long-only world is evolving in this way
because there is a distinct need to become
more flexible and open-minded in terms of
types of assets and the allocation to alterna-
tives investors are considering.
Up until now, opportunity fund struc-
tures have been primarily used in the high
yield and leveraged loan domain. But the
same concept can work equally well with
other asset classes – emerging market debt
lends itself particularly well to this type
of structure .
CDOs clearly have their benefits at the
right time and the right place; they are par-
ticularly suited to market conditions that do
not require active management. With the
credit environment beginning to look
decidedly less friendly, the advantages of
opportunity funds are clearly beginning to
outweigh those of traditional CDOs.

BlueBay Asset Management Plc was founded in 2001. It is one of the largest independent managers of fixed income credit funds and
products in Europe, with assets under management of approximately USD 13.1 billion (as at June 30, 2007). Based in London, with offices in
Tokyo and New York, it provides investment management services to institutions and high net worth individuals globally. BlueBay provides
long-only, long/short and structured products across emerging market, high yield and investment grade credit. The company, which was
admitted to the official list of the U.K. Listing Authority and to trading on the main market of the London Stock Exchange in November 2006,
also manages segregated mandates on behalf of large institutional investors.

Dipankar Shewaram is a senior portfolio manager at BlueBay. He joined the firm in March 2002 from ING Barings, where he worked as a
proprietary trader responsible for emerging market exposure. He previously spent two years at BNP Paribas as a senior emerging market
strategist focusing on the European and Middle Eastern markets, and two-and-a-half years at Deutsche Asset Management as a portfolio
manager. Dipankar holds a BSc in economics from University College London and an MSc in finance and economics from the London
School of Economics.
 Case studies 131

The use of iTraxx® Indexes

in traditional euro
corporate portfolios
UBS Global Asset Management.’s Martine Wehlen-Bodé
makes the case for using iTraxx® Indexes within
traditional euro corporate bond portfolios

T
he birth of the credit use of iTraxx® Indexes in euro corporate Firstly, we will look at the investment phi-
derivatives market has mandates at UBS Global Asset Management, losophy and process for traditional cash
transformed the cor- putting particular focus on the required bond mandates. Then, we will examine how
porate bond market, as adjustments to our investment philosophy integrating iTraxx® Indexes into the invest-
well as the investment and process when shifting from traditional ment universe impacts on the manager’s phi-
approach of traditional cash bond portfolio management to a losophy and investment process.
portfolio managers. This combination of cash bonds and credit
case study analyzes the index derivatives. Investment philosophy for traditional cash
bond mandates
UBS Global Asset Management’s investment

Input to our process comes philosophy is based on three layers of

decision and sources of out-performance:

from our fundamental ‘market alpha’, which reflects the overall

mandate beta exposure relative to the index,
buy-side credit research ‘sector alpha’, which represents industry,

and from our quantitative rating and subordination strategies relative

to the index, and ‘issuer alpha’, which corre-

modelling techniques sponds to the selection of issuer and matu-

rities within a sector.
As shown in the graph, on the following
page, the three levels interact in a building-
block fashion.
 132 Case studies

be significant with cash bonds. Using the

iTraxx® Indexes instead, we can significantly
MARKET ALPHA reduce our transaction costs and speed up

Relative Market Beta our reaction times, making short-term tac-

tical moves more interesting. So, while we
are not really creating new sources of alpha

SECTOR ALPHA through the index transactions, we are gen-

erating important efficiency gains and
Industry Rating Subordination
Source: UBS Global Asset Management

ISSUER
ALPHA
Issuer Maturity
Investment process for traditional cash bonds. Additionally, the indexes allow market
bond mandates views to be implemented in a timely manner.
Input to our process comes from our funda- Because of these advantages, we use the
mental buy-side credit research and from iTraxx® Indexes for our daily portfolio man-
our quantitative modelling techniques. agement activities.
These are the central starting points for our
investment decisions. Our team-based Impact on investment philosophy
approach combines the input of the quanti- As cash bond investors, we can adjust our
tative research and credit analyst groups beta exposure with cash bonds, meaning
with portfolio management views, while that we can use cash bonds to go long and
qualitative considerations help us to imple- short beta versus a corporate bond bench-
ment our strategy at the most advanta- mark. However, costs and speed issues can
geous price.
shorter-term opportunities.
From an investment philosophy point of
view, however, there are two considerations:
1. Does the absolute out-performance
target require adjustment?
2. Does the split in performance contri-
bution from the ‘market alpha’, ‘sector
alpha’ and ‘issuer alpha’ change?
Given the efficiency gains that can be made
from using iTraxx® Indexes, the level of
expected out-performance should be raised.
To evaluate the impact, we looked at the
track record of a euro corporate investment
grade portfolio with a maximum derivatives
allocation of 15 percent. Without leverage,
the potential out-performance increased
by 15 bps.
As far as the performance contribution
from the various different sources of alpha
goes, our performance attribution model
demonstrates that about 60 percent of out-

Use of iTraxx® Indexes and the impact on

our investment process and philosophy
Indexes allow market views
By using the iTraxx® Indexes, the market beta
and, to a certain extent, the sector beta can
to be implemented in a
be easily altered. This allows an efficient timely manner
implementation of long or short beta posi-
tions versus a corporate bond benchmark.
Index transactions can be realized in large
volume without great market impact and at
significantly lower transaction cost than cash
 Case studies 133

investment concept, however, it does

The market is no longer introduce additional considerations into the

investment philosophy and process.

solely influenced by cash Furthermore, this case study demonstrates

that the investment philosophy and processes
bond buyers, but also by cannot be static, but have to be reviewed and

derivatives buyers adjusted to changes in market structure and

available instruments. The incorporation of
single issuer CDS into the investment universe
warrants the same considerations.

performance is generated by the ‘issuer
alpha’ and 40 percent is generated by the
‘market alpha’ and ‘sector alpha’. Using the
iTraxx® Indexes, speed and size are no longer
issues. Moreover, the indexes even allow us
to profit from smaller market movements, as
our breakeven costs are much lower. Thus,
the ‘market alpha’ and ‘sector alpha’ should
gain in importance using iTraxx®, and we
should expect their performance contri-
bution to increase accordingly. In short, we
should expect 50 percent of the alpha to be
generated by the ‘issuer alpha’ part and 50
percent by the ‘market alpha’ and ‘sector
alpha’ strategies.
Impact on the investment process
Trading in the EUR-denominated corporate
bond market has increasingly concentrated
on the derivatives side. This has meant that
the market is no longer solely influenced by
cash bond buyers, but also by derivatives
buyers such as financial companies or hedge
funds. The increasing concentration of
volumes on the synthetic side of the market
has also meant that sentiment is much more
visible here than in the cash market.
The impact of derivatives activity is cap-
tured in the qualitative part of our investment
process, where we study two technical
factors on a daily basis. Firstly, we look at the
skew – this being the difference between the
index spread and the underlying CDS. A pos-
itive skew (in which the spread of the index
is higher than the intrinsic spread of the
underlying CDS) is a good indication of a
high level of protection buyers, and vice
versa. Secondly, we look at the implied
volatility of the credit default swaptions,
which give a good indication of market nerv-
ousness. These two factors complement our
qualitative data.
On the credit research side, we have to
decide whether we want to research all the
index components before entering an
iTraxx® transaction. Because the index is
well-diversified and represents systematic
risk, issuer-specific risk does not warrant
individual coverage. This is especially true
for the iTraxx® Main Index, which consists
of 125 equally-weighted components.
Anyway, the iTraxx® universe has a high
level of research coverage at UBS Global
Asset Management.
Conclusion
We can say that the use of credit deriva-
tives indexes does not change the broad
UBS Global Asset Management is
one of the world's leading
investment managers, providing
traditional, alternative and real estate
investment solutions to private, insti-
tutional and corporate clients, both
directly and through financial inter-
mediaries. The group offers a wide
range of innovative investment
products and services through a
global structure. Its approach com-
bines the expertise of investment pro-
fessionals with sophisticated risk
management processes and systems.
The investment areas comprise
equities, fixed income, alternative and
quantitative investments, global real
estate, global investment solutions
and infrastructure.
Martine Wehlen-Bodé heads the
euro corporate strategy team within
UBS Global Asset Management. The
team sets the strategy and manages
various investment funds and client
mandates in the EUR-denominated
corporate investment grade area.
 134 Conclusion
Credit derivatives:
outlook, challenges
and perspectives
"The market turbulence has provided the exchanges with a golden opportunity to challenge the much larger market in over-the-counter, or private
bilateral deals, as investors reassess counterparty risk and seek the advantages of centralised clearing … The exchanges also provide the certainty of
valuations from assets marked-to-market one or more times a day, unlike the more opaque OTC markets."
Doug Cameron, Financial Times, August 28, 2007
T
he year 2007 was indelibly
marked by the subprime
mortgage collapse that shook
the credit markets. It is too
early to predict the exact
outcome of this so-called
‘credit crunch’, but we can safely
say that much will change in the wider credit
markets as a result.
The credit derivatives markets have by no
means been immune from the market
turmoil but, in some significant areas, they
have more than proved their worth – most
notably by their resilience. When liquidity
dried up in the cash credit markets and
trading came to a standstill, the credit deriv-
atives markets – in particular, the benchmark
iTraxx® Indexes – remained liquid. In fact,
iTraxx® volumes exceeded all expectations.
This not only provided hedgers and investors
with a vital route for trading in and out of
the credit market, but also supplied them
with the all-important pricing data with
which to value their positions.
The fact that liquidity largely remained
buoyant in the credit derivatives markets,
while the cash markets faltered, only served
to further underscore the pivotal position of
derivatives instruments within the credit
spectrum. But the dramatic volume surge
took its toll on back and middle offices. The
operational teams that support the all-
important trade affirmation, confirmation and
booking process struggled to keep pace with
the rise in ticket numbers. The delays in doc-
umentation and settlement led to an increase
in trade backlogs, valuation difficulties and
additional risk. At the same time counterparty
credit risk deteriorated quite dramatically.
Combined, these factors resulted in dealers
and buyside firms being left with uncon-
firmed trades, unquantified exposures and no
precise means of gauging the amount of
counterparty credit risk that they faced. All at
a critical juncture.
According to data published by infor-
mation provider, Markit, the amount of out-
standing confirmations rose sharply during
the summer period. Even worse, the amount
of outstanding credit derivatives confirma-
tions aged over 30 days rose to their highest
level since 2006. As a result dealers’ risk
By Natasha de Terán
management groups, buyside firms and
regulators will now all be seeking reas-
surance that operational improvements
are underway.
Among others the likely outcome of the
current turmoil is increased regulation –
though again it would be premature to try
and predict what shape this may take.
Another is an increased focus on the need
for accurate, independent valuation data
based on reliable, realtime transparent
market information. Those involved in the
credit derivatives market – and those still
poised on the fringes – will meanwhile
place a greater importance on liquidity and
on mitigating counterparty credit risk.
All of these issues play to the strengths
of exchange-listed, centrally cleared
products. Listed instruments offer definite
benefits to market participants in the form
of transparent mark-to-market valuation
and substantially reduced counterparty risk.
Thus, once the dust settles and investors
start to return to the credit markets, they
should go some way to help ensure greater
market stability.