Credit Derivatives 1

Introduction to
Credit Derivatives
October 7/14, 2004
Danilo Zanetti
IHM
Content
Single-name Credit Default Swaps (CDS), Preamble

- Basic Terminology and Mechanics
Market Overview
Credit Risk Framework
Single-name Credit Default Swaps (CDS), Part 1
- Static Replication and Pricing
- Unwind Valuation
- Legal Issues
Measures of Spreads for Bonds
Bond Pricing, Probability, Bond-Equivalent CDS Spread
Single-name Credit Default Swaps (CDS), Part 2
- Default Swap Basis
Single-name Credit Linked Notes (CLN)
2 October 7/14, 2004

Content
(cont'd)
CDS and CLN on Credit Indices

- with emphasis on DJ iTraxx Europe Index Family
Credit Options
- Credit-Spread Options/Warrants
- Credit Default Swaptions
Correlation Products
- First-to-Default (FtD) CDS
- Tranched Credit-Index Products (Tranched DJ iTraxx)
Outlook
References
3 October 7/14, 2004

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

Swaps
(CDS)
Preamble
4 October 7/14, 2004

... Basics
Basic Terminology and

Mechanics
5 October 7/14, 2004

Single-name CDS
Description
The single-name CDS is the standard credit derivative

and the basic building block of the credit derivatives market
A CDS is a
- bilateral contract
- enables an investor to buy protection against default of an asset issued
by a specified reference entity
- reference entity typically a corporate, bank or sovereign issuer
- upon a legally defined credit event, the buyer of protection receives a
compensation payment for the loss on the investment
- common to define triggering of credit event using a reference asset/
reference obligation such that capital structure seniority of covered debt
is specified exactly
- the loss protection is acheived through payment of a periodic fee to the
protection seller
- the protection fee can also be paid upfront (although not usual)
- typically specified using confirmation document and definitions of the
International Swap and Derivatives Association (ISDA)
6 October 7/14, 2004
Single-name CDS
Mechanics
Between trade initiation and default or maturity (whichever first), the protection
buyer makes regular payments to the protection seller:
Credit risk
Reference Entity
Protection buyer Protection seller

CDS spread
Protection buyer sells credit risk to protection seller

Protection seller buys credit risk from protection buyer
Terminology: CDS spread, CDS premium, default swap spread
7 October 7/14, 2004

Single-name CDS
Mechanics (cont'd)
Cash settlement : Price of defaultet asset determined via dealer poll typically
within less than 30 days after credit event such that the recovery value of the
reference obligation is stabilized
100 - Recovery
Physical settlement : Delivery of cheapest to deliver obligation out of a basket

of deliverables assets ranked pari passu to reference obligation
Bond
Convertible
CTD Bond
100
8 October 7/14, 2004

Single-name CDS
Cashflow representation
Non default case:

CDS
T
0
CDS
Default case:
CDS
100 − Recovery
0 T
CDS τ
9 October 7/14, 2004

Market Overview
Market Overview
10 October 7/14, 2004

Market Overview
Explosive growth of Credit Derivatives
Credit Derivatives Volumes Trades (US$ billions)
11 October 7/14, 2004

Market Overview
Factors contributing increased activity
Standardized documentation
Current documentation framework are the 2003 ISDA credit derivatives

definitions
Further details in section on Legal Issues
Liquidity provider to cash market during market stress
"September 11" had a 3-fold increase in trading volumes but still consistent
two-ways flows (stable share of protection bought vs protection sold)
Positioning of credit derivatives desk being typically long protection (short risk)
is favourable for increased request for protection (desks sell their protection
inventory)
12 October 7/14, 2004

Market Overview
Factors contributing increased activity (cont'd)
Provider of increased liquidity to individual names under stress
"Enron's decline"
After disclosure of Enron's off balance sheet liabilities spreads widened and
credit derivatives activity increased
After downgrade of Enron's debt to junk liquidity in the cash market decreased
and credit derivatives desks sold their inventory of protection and/or unwinded
existing contracts
Confidential isolation/transfer of credit risk
Confidentiality vs credit reference

Customization of transaction terms according to needs of protection
buyer/seller (tenor, seniority, currency,...)
13 October 7/14, 2004

Market Overview
Efficient vehicle for shorting credit
Long term repo for corporate bonds nearly impossible, same for short-selling of
bank loans
Long protection in credit derivatives corresponds to synthetical creation of an
(unfunded) short position in cash instrument
Off-balance sheet instruments with leverage advantage wrt to cash instruments
No funding costs, low administration costs

Structured notes have funding costs
Regulatory capital relief/economic risk reduction/portfolio diversification
14 October 7/14, 2004

Market Overview
Increased amount of corporate credit risk in the market
Transition from lending to intermediation

Transition among banks from traditional lending role to intermediator in
issuance and sale of bonds over the last decade
Shift from loans to bonds
Increased credit spread volatility
Loans not widely traded in the secondary market, accounted on an accrual

basis and possibility of quiet negotiation with banks syndicate in case of credit
problems
Bonds widely traded in the secondary market, accounted on a mark-to-market
basis and traded on basis of publicly available information
15 October 7/14, 2004

Market Overview
Evolution of Market Participants
Evolution of Credit Derivatives Market
Bank Portfolio Managers Asset Managers
Life Insurance/P&C Insurers/Reinsurers/Monoliners Hedge Funds
16 October 7/14, 2004

Market Overview
Diversity of Market Participants
17 October 7/14, 2004

Market Overview
Future Participants: Corporates
Sources and traditional hedges of corporate credit risk
- Common sources of credit risk for a company are trade receivables,

vendor financings, long-term contracts, outright loans, joint ventures,
partnerships,...
- Hedge of credit risk is traditionally achieved via credit insurance, letters

of credit
- Insurers often retain the right to revoke coverage in the event of a

rating downgrade and the coverage period is typically no longer than one year
- Securitisation programs remove most of credit risk from balance sheet

but can be quite costly and are public
18 October 7/14, 2004

Market Overview
Future Participants: Corporates (cont'd)
Obstacles for corporate to embrace credit derivatives
- Credit spreads peak in 2001 and 2002 not paralleled by a peak in

premium charges by credit insurers
- Timing mismatches between credit event unter CDS contract and a

default by the corporate's counterparty (different triggering mechanism)
- Fair value accounting (marking-to-market) produces potential earnings

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

CDS market
19 October 7/14, 2004

Market Overview
Future Participants: Corporates (cont'd)
20 October 7/14, 2004

Market Overview
Conduit of Information
In sourcing and selling generic credit risk the credit derivatives desk serves as
a link between many different markets:
Bond market
Convertible market
Credit Derivatives
CDS market Desk
Loan market
Equity market
Example: - A corporation issues a convertible bond (CB)

- CB funds look for cheap call options on the underlying equity
- CB funds buy the bond + buy protection via CDS stripping out
credit risk
- CDS spreads will widen due to increase demand for
protection
21 October 7/14, 2004
Market Overview
Global Positions by Sector
Banks and broker dealers are overall net buyers of protection, biggest provider
of liquidity and most important intermediaries
Insurance industry and, in particular, financial guarantors are net protection
sellers
Smaller regional banks where net sellers of protection as an additional channel
for originating credit
22 October 7/14, 2004

Market Overview
Market Share by Product
Market share figures recently skewed

towards credit-index products due to
introduction of iTraxx credit-index and
sub-indices (portfolio products)
23 October 7/14, 2004

Market Overview
Reference Entities
24 October 7/14, 2004

Market Overview
Top Counterparties and Credit Events
Counterparty risk is heavily concentrated among the top 10 global banks and
broker dealers.
Credit events are concentrated within a limited universe of actively traded,
fallen angel credits
The hedge fund industry is excluded from the survey
25 October 7/14, 2004
Market Overview
Concerns
Informational asymmetries
Ultimate protection sellers may be less informed and knowledgeable about the
credit than the originator (especially under physical settlement)
Counterparty concentration
The market is concentrated among the top 10 global banks and broker dealers
Withdrawal of such institutions from the market may produce negative effects
Moral hazard
Separation of loan underwriting/origination from credit ownership creates the

potential for moral hazard
Source: Fitch 09/2003
26 October 7/14, 2004

27 October 7/14, 2004

Empirical Studies of Recovery Rates
Market standard source for recovery rates is Moody's historical default rate
study (www.moodysqra.com)
Recovery rates depend on subordination level
Wide variation in recovery rate even for same subordination level
28 October 7/14, 2004

Empirical Studies of Default Probabilities
Table shows average default probability of a bond starting with an initial rating
and defaulting within the given time horizon
Highly rated bonds have a lower cumulative default probability
29 October 7/14, 2004

Credit Curves/Credit Spreads
Credit Curve:
- Investors have different views about how the credit risk of a company
can be measured
- It is customary to express credit risk in form of an excess yield over
some benchmark interest rates as a function of the maturity of a credit exposure,
a so-called credit curve
Credit Spreads*:
- The excess yield is known as credit spread

- There are various credit spread measures (CDS-Spread, Z-Spread,
I-Spread, ASW-Spread, BE CDS-Spread)
* See sections Measures of Spreads for Bonds and Bond Pricing, Probability, BE CDS-Spread
30 October 7/14, 2004

Credit Curves/Credit Spreads (cont'd)
Upward sloping credit curve:

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

- Observed for credits likely to worsen in Humped credit curve
the medium term with small change of

Credit
defaulting in the short term Spread
- Survival over the medium term increases Maturity
likelihood of survival in the long term thus
lowering credit spreads
Inverted credit curve
Inverted credit curve:
- Significant deterioration of credit quality Credit
Spread
- High probability of a default
Maturity
31 October 7/14, 2004

CDS-Spreads credit curve dynamics for ABB International Finance Ltd:
Source: JPMorgan ORBIT
32 October 7/14, 2004

CDS-Spreads credit curve dynamics for FIAT Spa:
Source: JPMorgan ORBIT
33 October 7/14, 2004

Single-name CDS, Part 1

Swaps
(CDS)
Part 1
34 October 7/14, 2004

... Static Replication and Pricing
Static Replication and Pricing
35 October 7/14, 2004

Single-name CDS
Floating-rate note (FRN)
Description:
- A FRN is a Bond that pays a coupon linked to a variable interest-rate
index, usually Libor, Euribor,...
- FRN have a very low interest-rate sensitivity, since in a rising interest-
rate environment, the rise in the Libor rates is compensated by a stronger
discounting of the Libor payments. Similarly for a decreasing interest-
rate environment.
Default-free FRN:
- Senior par floaters of AA rated issuers pay a coupon of Libor flat
- We assume in the sequel Libor flat par FRN's to be default-free
default-free par FRN
Libor 100
100
36 October 7/14, 2004

Single-name CDS
FRN cont'd
Defaultable FRN:
- Subordinated par floaters of AA rated issuers pay a coupon higher
than Libor to compensate investors for the increased credit-risk
- Par floaters of issuers rated lower than AA require also coupon
payments higher than Libor for the increased credit-risk
defaultable par FRN
Libor + Spread
100
0
T Credit-risk:
100 Coupons and face
value are at risk
37 October 7/14, 2004

Single-name CDS
Static hedge/replication: Construction
Idea: Set up a static hedge/replication, ie,
- find a portfolio of instruments that exactly offsets the cashflows of the

CDS in every possible scenario
- in particular, this must hold before and after default
Construction of a statically hedged portfolio for the protection buyer:
- buy protection for a notional of 100
long CDS
T
100 − Recovery
0
CDS
0 T
τ
38 October 7/14, 2004

Single-name CDS
Static hedge/replication: Construction (cont'd)
- fund 100 cash at LIBOR flat (or equivalently short a default-free par
FRN for initial cash of 100)
short default-free FRN
100
T
0
Libor 100
- invest the 100 cash into a defaultable par FRN

Libor + Spread
100
0
T
100
long defaultable FRN
39 October 7/14, 2004

Single-name CDS
Static hedge/replication: Non default scenario
- hold the portfolio to maturity or default – depending on whichever

comes first
- if no default, unwind the hedge at maturity at no cost
100
T
0
long CDS
Libor 100
+ + T =0
Libor + Spread 0
100 CDS
0
T
100 Reference Entity
40 October 7/14, 2004

Single-name CDS
Static hedge/replication: Default scenario
- if default, deliver the defaulted FRN to the protection seller in return for
100 and use the proceeds to repay the funding loan (or default-free par
FRN). The net cost is also zero.
100
τ T
long CDS
0
Libor 100
100 − Recovery
+ + =0
Libor + Spread 0 T
CDS τ
0 Recovery
τ T
100 Reference Entity
41 October 7/14, 2004

Single-name CDS
Static hedge/replication: Pricing problem and Par CDS Spread
Pricing problem:
What default swap spread makes the net present value of the CDS equal to
zero
?
The static hedge portfolio has no initial costs and no close-out costs
Therefore pricing the default swap is equivalent to set the default swap spread
equal to the par FRN spread:
Par CDS Spread = Par FRN Spread
42 October 7/14, 2004

Single-name CDS
Static hedge/replication for protection seller
Construction of static hedge for protection seller:
- borrow a defaultable par FRN in the Repo market and short it for initial
cash of 100
- invest the 100 cash into a default-free par FRN
- hold the portfolio to maturity or default – depending on whichever
comes first
- on default, sell the default-free par FRN, pay 100 to the protection
buyer in return for the defaulted FRN and cover the short FRN
position
- at maturity, the 100 cash from the default-free par FRN are returned
and used for the completion of the Repo contract
Difficult the borrow the reference asset on Repo

Static hedge usually not feasible
43 October 7/14, 2004

Single-name CDS
Miscellaneous aspects
Defaultable par FRN can be replaced by fixed-rate Bond of the same issuer
provided it is of same seniority as the FRN (same recovery value upon default)
Repo specials: Costs for maintaining short FRN position until maturity of CDS
increase the level of the CDS spread when selling protection
Transaction costs increase bid-ask spreads for CDS
Accrued interest: buyer of protection must usually pay at default the CDS
spread accrued since the last coupon date
Delivery option for protection buyer is usually not modelled: After default not all
pari passu assets have the same recovery value and the protection buyer can
choose to deliver the cheapest asset
Usual to assume constant recovery value of the reference asset
Customary to assume that counterparties are default-free

44 October 7/14, 2004
Single-name CDS
Miscellaneous aspects (cont'd)
CDS is a par product: The default payment corresponds to difference between

defaulted bond and face-value of the bond
Premium bond: Hedging credit risk of a premium bond with a CDS of same
face-value underhedges the credit risk
Discount bond: Hedging credit risk of a discount bond with a CDS of same
face-value overhedges the credit risk
45 October 7/14, 2004

... Unwind Valuation
Unwind valuation
Marking-to-Market
46 October 7/14, 2004

Single-name CDS
Unwind valuation: Motivation
The trigger of a default swap to pay out is defined in terms of a credit event
On a mark-to-market basis the value of a default swap is changing in line with

changes in the credit quality of the reference entity
Changes in the credit quality of the reference entity are reflected in changes in
the market quotes of par CDS spreads
We will show that a default swap is sensitive to CDS spreads changes and
thus is very much a credit spread product
47 October 7/14, 2004

Single-name CDS
Unwind valuation: Simple Example
The market par CDS spread for a reference entity is currently 100bp
Consider entering the following 1-period short protection CDS position:
Short CDS
T
CDS
0 100-Recovery
non default
100 bp CDS spread payment
Actual PV 0
60 100-Recovery
default
( Interest rates flat @ 2.00%, Recovery @ 40% )
48 October 7/14, 2004

Single-name CDS
Unwind valuation: Simple Example (cont'd)
Payoff structure at maturity:

- If there is no default, after 1-period a premium of 100bp will be realized
- If there is a credit event a loss of 40=100-Recovery will be incurred
Credit deterioration:
- Assume there is a simultaneous downgrade of the reference entity
- Due to the credit deterioration of the reference entity the par CDS
spread quoted on the market jumps from 100bp to 300bp
What is the current value of the short CDS position after credit deterioration
assuming that expected recovery and interest rates remain unchanged
?
49 October 7/14, 2004

Single-name CDS
Unwind valuation: Discounted Spreads Model
Assume to enter an offsetting long CDS position @ 300 bp to the existing short
CDS position @ 100 bp - with maturity and reference entity being exactly the
same
If a credit event occurs, the settlement received from the long CDS and short
CDS position will exactly offset each other
Only the CDS spreads of the long CDS and short CDS differ
The unwind value (mark-to-market value) of the short CDS position can be
computed as follows:
Unwind value = (CDS spreadold − CDS spread new )×

1
144244
MtM value
3 (1 + Interest rate + CDS spreadnew3)
14444442444444
risky discount factor
In numbers:
Unwind value = (100bp − 300bp )×

1
× 100
{ = −1.90
144244 3
MtM value
(1 + 2.00% + 300bp ) nominal
50 October 7/14, 2004

Single-name CDS
Unwind valuation: JPMorgan Model (Æ industry standard)
The expected cash inflow for to the protection seller is
PVcash in = 100 × [1 − Default prob]×

1
× CDS spread old
144 42444 3 1 + Interest rate
survival prob 1442443
discount factor
The expected cash outflow is
PVcash out = (100 − Recovery )× Default prob ×

1
1 + Interest rate
The default probability can be stripped out of the offsetting par CDS position
quoted @ 300bp, since by definition of the par CDS spread the following must
hold:
PVcash out = 100 × [1 − Default prob]×
1
× CDS spread new
1 + Interest rate
= CDS spread new
Default prob =
CDS spread new + (100 − Recovery )
(100 − Recovery )× Default prob ×

1
= PVcash in
1 + Interest rate
51 October 7/14, 2004

Single-name CDS
Unwind valuation: JPMorgan Model (cont'd)
The probabilities stripped out of the offsetting par CDS can be used to find out
the unwind value of the original CDS position:
Survival prob = (1 − Default prob ) = 95.24%
100 bp CDS spread payment
Unwind value ?
60 100-Recovery
300bp
Default prob = = 4.76%
300bp + (100% − 40% )
( Interest rates flat @ 2.00%, Recovery @ 40% )
52 October 7/14, 2004

Single-name CDS
Unwind valuation: JPMorgan Model (cont'd)
The unwind value (mark-to-market value) of the short CDS position can be
computed as follows:
1
PVcash in = 100 × 95.24% × ×100bp = 0.93
1 + 2.00%
- Unwind value = 0.93 − 2.8 = −1.87

144244 3
MtM value
PVcash out = (100 − 40 )× 4.76% ×

1
= 2.8
1 + 2.00%
53 October 7/14, 2004

Single-name CDS
Unwind valuation: Exercise
Credit improvement:
- Assume there is a simultaneous upgrade of the reference entity
- Due to the credit improvement of the reference entity the par CDS
spread quoted on the market tightens from 100bp to 50bp
Show that the unwind value with the cash differential method corresponds to:
Unwind value = 0.49

144244 3
MtM value
Show that for the JPMorgan model the following holds:
Default prob = 0.83%
Unwind value = 0.97 − 0.49 = 0.48

144244 3
MtM value
54 October 7/14, 2004

Single-name CDS
Unwind valuation in BLOOMBERG's CDSW: Discounted Spreads Model
Input in the section Deal Information

- notional amount
- maturity
- deal spread of the CDS
- ...
Input into the Spreads section
- Recovery Rate
- Par CDS spreads (the current spread as a flat spread curve)
Select the model 'Disctd Spreads' in the Calculator section
In the Calculator section the Market Value (to the negative) corresponds to the
unwind value of the short CDS position
55 October 7/14, 2004

Single-name CDS
Unwind valuation in BLOOMBERG's CDSW: Discounted Spreads Model
(cont'd)
CDSW for our example CDS:
CDS spread new
CDS spread old
Default prob
Recovery
− 1.90% of notional
56 October 7/14, 2004

Single-name CDS
Unwind valuation in BLOOMBERG's CDSW: JPMorgan Model
Select the model 'JPMorgan' in the Calculator section – all the rest is analogous
to the 'Disctd Spreads' model
CDS spread new
CDS spread old
Default prob
Recovery
− 1.90% of notional
57 October 7/14, 2004

Single-name CDS
CDSW Default Settings...
58 October 7/14, 2004

Single-name CDS
Unwind alternatives/Summary
The owner of a default swap position can monetize a change in the CDS
spread by:
- terminating the transaction
- reassigning the default swap to another counterparty (novation)
- enter into an offsetting position with another counterparty
In all cases the unwind value or mark-to-market has to be negotiated between

the counterparties
The industry standard for negotiation is the JPMorgan Model – and it is

sufficient for the counterparties to agree upon
- the par CDS spread curve

- the recovery rate
(Notice that the unwind value is quite robust to various recovery assumptions)
59 October 7/14, 2004
... Legal Issues
Legal Issues
60 October 7/14, 2004

Single-name CDS
Standardization of CDS Confirmation
Current documentation framework are the 2003 ISDA credit derivatives

definitions
History to date...
- 1998 standard form of confirmation
- 1999 credit derivatives definitions
- Supplements (restructuring, successor* and credit events, convertibles)
- 2003 ISDA credit derivatives definitions
Standardized documentation led to dramatic growth of credit derivatives market
Investment Grade and High Yield North American confirmation based on the
2003 ISDA credit derivatives definitions
Standard 2003 contracts began trading June 20, 2003
Contracts proved effective by Enron, Worldcom, ... defaults
Worldcom: close to 600 contracts outstanding, estimated over 7 billion in
notional, no disputes or litigation and no mechanical settlement problems
*For instance in case of a Reference Entity merger
61 October 7/14, 2004

Single-name CDS
Standard Non Emerging Market Corporate CDS
62 October 7/14, 2004

Single-name CDS
Triggering Mechanism of CDS
Watch Check Deliver/Settl

e
Deliverable
Obligations Credit Events
Obligations
Watch : A predefined group of Obligations of the Reference Entity

Check: Has a Credit Event occured ?
Deliver: A predefined group of Deliverable Obligations in return for par
63 October 7/14, 2004

Single-name CDS
Watch Obligations

e
Deliverable
Obligations
Borrowed Money: bond, note, loan, commercial paper,money market accounts,

savings accounts and reimbursements from letters of credit
"Payment"
Derivative Contracts General Creditors
Bonds "Borrowed Money" Loans
64 October 7/14, 2004

Single-name CDS
Check Credit Events

e
Deliverable
Obligations
Standard Credit Events unter ISDA

- Failure to Pay
- Bankruptcy
- Restructuring (soft credit event)
Emerging market and sovereign Reference Entities generally include
Repudiation/Moratorium
High Yield CDS trade without Restructuring as a Credit Event
Bankruptcy deemed to have occurred only if the default occurs with respect to
the Reference Entity, all other Credit Events are deemed to have occurred if
default occurs on any obligation
65 October 7/14, 2004

Single-name CDS
Deliver/Settle Deliverable Obligations

e
Deliverable
Obligations
Deliverable Obligations means any Bond, Loan, Convertible, Exchangeable,...

satisfying the Deliverable Obligation Characteristics, ie, ranked senior or better in
the capital structure (eg, senior unsecured)
Convertible
Loan
Bond
CTD Bond
100
66 October 7/14, 2004

Single-name CDS
Physical Settlement Timeline
67 October 7/14, 2004

Single-name CDS
First two "major defaults" in the European CDS Market
On 30 September, 2001, Railtrack plc, the owner of UK railway infrastructure,

was placed under administration
On 4 October, 2001, SAirGroup applied for a moratorium of debt enforcement
The credit events of Railtrack plc and SAirGroup clearly constitued a Bankruptcy
credit event, given that both companies were either insolvent or in severe financial
difficulty
A significant number of CDS have been "triggered"
The credit derivative market has worked well...
68 October 7/14, 2004

69 October 7/14, 2004

Motivation/Goal
Investors have different views about how the credit risk of a company can be
measured
It is customary to express credit risk in form of an excess yield over some
benchmark interest rates, a so-called credit spread
Several ways for looking at credit spreads implied by bond prices:
- Z-Spread
- I-Spread
- Par ASW-Spread
Z-Spread, I-Spread and par ASW-Spread are all available on BLOOMBERG
Goal:
- introduce credit spreads concepts by examples

- explain their relationship by examples
70 October 7/14, 2004

Yield-to-Maturity (YTM)
Premium Bond:
Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond -105 10 10 110
CashFlows
10 10 110
105 = + + ⇒ YTM = 8.06%
(1 + YTM ) (1 + YTM ) 2 (1 + YTM )3
Discount Bond:
Swap rates 0.50% 1.00% 2.00%
Bond -92.13 5 5 105
CashFlows
5 5 105
92.13 = + + ⇒ YTM = 8.06%
(1 + YTM ) (1 + YTM ) 2 (1 + YTM )3
71 October 7/14, 2004

Z-Spread
Premium Bond:

Swap rates 0.50% 1.00% 2.00%
Bond -105 10 10 110
CashFlows
10 10 110
105 = + + ⇒ Z = 6.17%
(1 + 0.50% + Z ) (1 + 1.00% + Z ) 2 (1 + 2.00% + Z )3
Discount Bond:
Swap rates 0.50% 1.00% 2.00%
Bond -92.13 5 5 105
CashFlows
5 5 105
92.13 = + + ⇒ Z = 6.12%
(1 + 0.50% + Z ) (1 + 1.00% + Z ) 2 (1 + 2.00% + Z )3
72 October 7/14, 2004

I-Spread
Premium Bond:

Swap rates 0.50% 1.00% 2.00%
Bond -105 10 10 110
CashFlows
I Spread = YTM − Swap RateYear 3 = 8.06% − 2.00% = 6.06%
Discount Bond:
Swap rates 0.50% 1.00% 2.00%
Bond -92.13 5 5 105
CashFlows
I Spread = YTM − Swap RateYear 3 = 8.06% − 2.00% = 6.06%
73 October 7/14, 2004

Asset Swap: Definition
Definition:
Package consisting of fixed cashflows of a bond, and an agreement to swap

these fixed cashflows for a series of floating payments. These payments "float"
with an index rate, normally LIBOR.
Construction:
- buy the bond to be asset swapped
- pay a swap, arranged so that the fixed leg of the swap exactly offsets
the coupon payments of the bond
- adjust the floating leg of the swap so that the net present value of the
package is par
Main purpose:
- enable a credit investor to take exposure to credit quality of a fixed-rate
bond
- without taking interest rate risk
74 October 7/14, 2004

Asset Swap: Package
Bond
Asset Swap
= FRN with Price of
Par
+ =
Swap
75 October 7/14, 2004

Asset Swap: Par Asset Swap Spread (Par ASW)
Swap +
PV ( paid ) = PV (received )
Par ASW
-
PV ( paid ) = 100 + Fair Value( Bond )
PV (received ) = Dirty price + PV ( Libor , Par ) + Par ASW × PV ( Annuity )

1442443
100
Fair Value( Bond ) − Dirty price

Par ASW =
PV ( Annuity)
76 October 7/14, 2004

Asset Swap: Observations
Interpretation: par ASW spread is an annuity that compensates the bond holder
for the difference between the riskless price of the bond and its market price
Credit risk: the buyer of the asset swap still owns the bond with the associated
credit risk
Interest rate risk: the buyer does not retain the bond's coupons (hence does not
take the associated interest rate risk )
Counterparty default risk: when the bond is trading at a discount, the assets
swap buyer has immediate credit risk vs the seller equal to par minus the bond
price. For premium bonds the opposite holds.
Default contingent exposure to mark-to-market value of swap: the bond is
credit-linked, but the swap is usually not and does not terminate upon default, but
can be at its market value.
Clean asset swap: an asset swap package with a credit-linked swap. The par
ASW spread will be different than for a normal asset swap package.
77 October 7/14, 2004

Asset Swap: Par ASW Example
Premium Bond:
Swap rates 0.50% 1.00% 2.00%
Bond -105 10 10 110
CashFlows
Fair Value(Bond ) = 123.41 =
10 10 110
+ +
(1 + 0.50% ) (1 + 1.00% ) (1 + 2.00% )3
2
⇒ Par ASW =
123.41 − 105
= 6.31%
PV ( Annuity ) = 2.92 =
1 1 1 2.92
+ +
(1 + 0.50% ) (1 + 1.00% )2 (1 + 2.00% )3
Discount Bond:
Swap rates 0.50% 1.00% 2.00%
Bond -92.13 5 5 105
CashFlows
Fair Value(Bond ) = 108.82 =
5 5 105
+ +
(1 + 0.50% ) (1 + 1.00% ) (1 + 2.00% )3
2
⇒ Par ASW =
108.82 − 92.13
= 5.72%
PV ( Annuity ) = 2.92 =
1 1 1 2.92
+ +
(1 + 0.50% ) (1 + 1.00% )2 (1 + 2.00% )3
78 October 7/14, 2004
Asset Swap: Exercise
What is the default contingent risk assumed by the asset swap buyer
- if the bond defaults immediately
- in case of the premium and in case of the discount bond
- assuming a bond recovery price of 40% ?
What is the immediate counterparty credit risk
- before and after bond default ?
Premium bond default (buyer's view):

Bond Swap Total
Value at inception +105 -5 +100

Value after default + 40 -5 +35
Loss - 65 0 - 65
does not immediate counterparty

terminate upon credit risk of asset swap
default seller
79 October 7/14, 2004

Asset Swap: Exercise (cont'd)
Discount bond default (buyer's view):
Bond Swap Total
Value at inception + 95 +5 +100

Value after default + 40 +5 +45
Loss - 55 0 - 55
does not immediate counterparty

terminate upon credit risk of asset swap
default buyer
80 October 7/14, 2004

Summary of examples
Premium Discount Bond Description

Bond
YTM 8.06% 8.06%
Z-Spread 6.17% 6.12% Best measure of comparable

bond value as adjusts for
shape of Swap curve
I-Spread 6.06% 6.06% Not as good as Z-Spread

(ignores shape of Swap
curve)
Good approximation for high
grade bonds
Par ASW 6.31% 5.72% A tradable value
Not a good value measure for
bonds far from par
81 October 7/14, 2004

General relationships
Z-Spread vs I-Spread:
- For upward-sloping yieldcurve the Z-Spread is higher than the I-

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

I Spread = Z Spread
The relations hold for par, premium and discount bonds.
82 October 7/14, 2004

General relationships (cont'd)
Z-Spread, I-Spread vs par ASW for premium bond:
- For upward-sloping yieldcurve Z-Spread and I-Spread will be lower

than the ASW spread
I Spread < Z Spread < Par ASW
- For a flat yieldcurve similarly

I Spread = Z Spread < Par ASW
Z-Spread, I-Spread vs par ASW for discount bond:
- For upward-sloping yieldcurve Z-Spread and I-Spread will be higher than

the ASW spread
Z Spread > I Spread > Par ASW
- For a flat yieldcurve similarly

Z Spread = I Spread > Par ASW
83 October 7/14, 2004

General relationships (cont'd)
Why is the par ASW spread higher than the Z-Spread for a premium bond ?
- For a premium bond and a flat yield curve the Coupon is by definition
higher than Libor + Z-Spread
- In an asset swap package with a swap paying the Coupon and
receiving Libor + Z-Spread, the swap value will be negative after a
default
- To compensate for the additional risk of having a swap not terminating
on default, the swap must pay a higher spread than the Z-Spread
- ... and therefore
I Spread = Z Spread < Par ASW
- In a so-called clean asset swap package the swap terminated upon

default and therefore the clean par ASW spread would correspond to
the Z-Spread
84 October 7/14, 2004

Bond Pricing, Probability, BE CDS-Spread
Bond Pricing, Probability,

Bond-Equivalent CDS-Spread
(BE CDS-Spread)
85 October 7/14, 2004

Framework
Survival
probability
106 Cash at maturity
Actual Price 100
Expected
40
Recovery if default
Default
probability
( Interest rates flat @ 2.00% )
86 October 7/14, 2004

Bootstrapping Probabilities
Bond pricing equation:
Market price = Discount factor × (Survival prob × Cash + Default prob × Recovery )
Bootstrapping probabilities:
⎛ ⎞
× Survival prob × 106 + (1 − Survival prob )× 40 ⎟
⎜
1
100 =
1 + 2.00% ⎜ 144 42444 3 ⎟
⎝ = Default prob ⎠
Survival prob = 93.94%
Default prob = 6.06%
87 October 7/14, 2004

Filling in Probabilities
93.94%
106 Cash at maturity
Actual Price 100
Expected
40
Recovery if default
6.06%
( Interest rates flat @ 2.00% )
88 October 7/14, 2004

Computing the Fair Value of another bond
Idea: Compute the Fair Value of another bond with different coupon, but of
same seniority, based on the probabilities determined for the first bond
Bond A Bond B
93.94% 93.94%
106 101
100 95.40?
6.06% 40 6.06% 40
Bond pricing equation:
× (93.94% × 101 + 6.06% × 40 )

1
95.40 =
1 + 2.00%
89 October 7/14, 2004

Investment strategies Æ Contingent Payoffs
Invest 1000 CHF into Bond A or Bond B:
Bond A Bond B
Price 100% 95.40%
# purchased 10 10.482
Cash at maturity 106 CHF 101 CHF
Expected Recovery 40% 40%
Compute contingent payoffs:
Payoff if no default 1060 CHF 1058.68 CHF
Payoff if default 400 CHF 419.28 CHF

CHF
90 October 7/14, 2004

Investment strategies Æ Expected values
Compute expected values:
Bond A Bond B
Weighted payoff if no default 1060 CHF x 93.94% 1058.68 CHF x 93.94%
+ +
Weighted payoff if default 400 CHF x 6.06% 419.28 CHF x 6.06%
= =
Expected value 1020 CHF 1020 CHF
91 October 7/14, 2004

YTM, Z-Spread, Par ASW
First compute spread measures for Bonds A and B:
Bond A Bond B Formula

Cash at maturity
Price =
YTM 600 bp 587 bp (1 + YTM )
Cash at maturity
Price =
Z-Spread/I-Spread 400 bp 387 bp (1 + Libor + Z )
Cash at maturity
− Price
Par ASW 400 bp 370 bp Par ASW =
(1 + Libor )
1
(1 + Libor )
( Libor @ 2.00% )
92 October 7/14, 2004
BE CDS-Spread
Bonds A and B have equal issuer and same seniority

Bonds A and B are w.r.t credit risk of equal value (same expected recovery,
same default probability)
Goal: Introduce a metric telling that A and B are of equal value w.r.t credit risk
Idea:
- Sell protection against default of Bonds A and B via a Credit Default
Swap contract
- Use the default probability/survival probability derived from the Bonds
prices to value the Credit Default Swap contract
- Determine the CDS Spread such that the Credit Default Swap
contracts has a value of zero Æ Bond Equivalent (BE) CDS Spread
Interpretation of BE CDS Spread: Answers the question
If Bond A or Bond B were a CDS contract, what would the CDS spread
be ?
93 October 7/14, 2004

BE CDS-Spread (cont'd)
Credit Default Swap
CDS +
0 T
- PV ( paid ) = PV (received )
BE CDS
100-Recovery
BE CDS for the 1-period situation:

PV ( paid ) = Discount factor × (1 − Survival prob )× (100 − Recovery )
PV (received ) = Discount factor × Survival prob × CDS
BE CDS =
(1 − Survival prob)× (100 − Recovery)
Survival prob
94 October 7/14, 2004

BE CDS-Spread (cont'd)
Bond A Bond B Formula

Cash at maturity
Price =
YTM 600 bp 587 bp (1 + YTM )
Cash at maturity
Price =
Z-Spread/I-Spread 400 bp 387 bp (1 + Libor + Z )
Cash at maturity
− Price
Par ASW 400 bp 370 bp Par ASW =
(1 + Libor )
1
(1 + Libor )
BE CDS =
BE CDS 387 bp 387 bp
Survival prob
( Libor @ 2.00% )
BE CDS is robust to the price of the bond (same for premium, par or discount
bond) and also to the shape of the interest-rate curve
95 October 7/14, 2004

General relationships
Z-Spread, I-Spread vs par ASW and BE CDS for premium bond:
BE CDS < I Spread ≤ Z Spread < Par ASW
Z-Spread, I-Spread, par ASW and BE CDS for discount bond:
BE CDS > Z Spread ≥ I Spread > Par ASW
The best overall proxy for the BE CDS spread is the Z-Spread !
96 October 7/14, 2004

Exercise
Compute all the credit spread measures for the following deep discount bond:
97 October 7/14, 2004

Exercise (cont'd)
Deep Discount bond Formula

Cash at maturity
Price =
YTM 17.78 % (1 + YTM )
Cash at maturity
Price =
Z-Spread/I-Spread 15.78 % (1 + Libor + Z )
Cash at maturity
− Price
Par ASW 14.20 % Par ASW =
(1 + Libor )
1
(1 + Libor )
BE CDS 16.43 % BE CDS =

Survival prob
( Libor @ 2.00%, Survival prob = 78.50% )
98 October 7/14, 2004

Single-name CDS, Part 2

Swaps
(CDS)
Part 2
99 October 7/14, 2004

Single-name CDS
The Default Swap Basis: Definition / Calculation
Definition: The basis in credit markets is the difference between the pricing of
an individual (or a group of) bonds in the cash market and the pricing of the same
issuer (or same group of issuers) using the CDS market
Terminology: Commonly referred to as default swap basis
Calculation (sophisticated):
Default Swap Basis = CDS Spread − BE CDS Spread
Calculations (practical):
Default Swap Basis = CDS Spread − Z Spread
Default Swap Basis = CDS Spread − ASW Spread
100 October 7/14, 2004

Single-name CDS
The Default Swap Basis: Example
Default Swap Basis for ABB International Finance Ltd:
Source: JPMorgan Credit

Navigator
101 October 7/14, 2004
Single-name CDS
The Default Swap Basis: Example (cont'd)
ABB Intl Finance 11.5£ May 2009 has currently negative basis (coupon steps
down if ABB investment grade)
- Par 5Y CDS is currently trading at mid 140 bp
- Z-Spread is 250 bp, Par ASW-Spread is 271 bp
- Z-Basis is –110 bp, ASW-Basis is –131 bp
Z Spread
Par ASW Spread
102 October 7/14, 2004

Single-name CDS
Drivers behind Default Swap Basis
Fundamental factors:
Technical factors:
(CDOs issuance)
103 October 7/14, 2004

Single-name CDS
Trade strategies
Positive basis:
- CDS is cheaper than Bond

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

- Buy Bond and buy protection (sell credit risk) via CDS
- Position is credit-risk neutral
- Investigate why cash and derivatives market price same risk differently
104 October 7/14, 2004

Single-name CLN
Single-name Credit-Linked Notes

(CLN)
105 October 7/14, 2004

Single-name CLN
Description
Motivation:
- Investor wishes to take exposure to the credit derivatives market but
requires a cash instrument (plan restrictions, regulatory constraints)
- Investor does not have an ISDA master agreement in place
- Investor wants to capture the relative value offered by the credit
derivatives market (eg, positive basis)
A funded Credit Linked Note (CLN) is

- a security
- paying a fixed or floating-rate coupon
- having an embedded credit derivative (coupons and principal repayment
are dependent upon the financial well being of a reference entity)
- sometimes having principal protection
Two forms are common

- CLN issued by corporate entity (bank or otherwise), unrated, unlisted
- CLN issued by Special Purpose Vehicles (SPV), rated/unrated, listed
106 October 7/14, 2004

Single-name CLN
CLN issued by corporate entity: Mechanics
Investor pays par to buy the note

Issuer invests the proceeds receiving Libor+CDS spread+funding spread
Issuer pays Libor+CDS spread+funding spread less administrative fees and
correction for possibility of early termination in case of a credit event
Credit risk
Reference Entity
Credit Linked Credit Linked
Credit
Coupons Issuer Coupons Investor
Derivatives Desk
Par Par
107 October 7/14, 2004

Single-name CLN
CLN issued by corporate entity: Mechanics (cont'd)
Cash settlement : Price of defaultet asset determined via dealer poll

Credit
Derivatives Desk
100-Recovery 100-Recovery
Physical settlement : Delivery of cheapest to deliver obligation out of a basket

of deliverables assets ranked pari passu to reference obligation

Credit
Derivatives Desk
Bond Bond
Convertible Convertible
CTD Bond CTD Bond
108 October 7/14, 2004

Single-name CLN
CLN issued by SPV: Mechanics
Investor pays par to buy the note

Issuer invests the proceeds into AAA collateral and enters into a swap
transaction receving Libor+CDS spread in exchange for the fixed coupons
Issuer pays Libor+CDS spread less administrative fees and correction for
possibility of early termination in case of a credit event
Credit risk
Reference Entity
LIBOR + CDS spread LIBOR+CDS spread
Credit
Issuer Investor
Derivatives Desk
Fixed Rate Par
Fixed Rate Par
Fixed Rate Asset

(Collateral) Securitization of credit-linked asset swap
109 October 7/14, 2004

Single-name CLN
CLN issued by SPV: Mechanics (cont'd)
Cash settlement : Liquidation of collateral, price of defaultet asset determined

via dealer poll
LIBOR+CDS spread LIBOR + CDS spread

Credit
Issuer Investor
Derivatives Desk
100-Recovery Recovery
Fixed Rate 100
Fixed Rate Asset

(Collateral)
(Market value of Collateral assumed to be 100)
Physical settlement : see above...
110 October 7/14, 2004

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

(with emphasis on DJ iTraxx Europe Index Family)
111 October 7/14, 2004

CDS/CLN on Credit-Indices
Brief history
June 21, 2004: iBoxx Ltd and TRAC-X LCC are merging their European
tradable CDS indices thereby creating Dow Jones iTraxx Europe (DJ iTraxx
Europe)
The DJ iTraxx platform will offer one benchmark for all credit investors
Predecessors: JECI1, JECI2, DJ TRAC-X Europe 1, DJ TRAC-X Europe 2,...
Infos under www.iboxx.com. Most material is drawn from there...

112 October 7/14, 2004
Overview
Liquidity and Standardisation:

- 20 market makers brought together into DJ iTraxx Europe platform
- Portfolio composition rules bring together most liquid reference entities

- Standardised documentation for all DJ iTraxx notes (CLN) and swaps
(CDS)
Transparency:
- One benchmark credit index
- Portfolio inclusion rules
113 October 7/14, 2004

Overview (cont'd)
Diversification:
- Cost efficient and timely access to the credit markets via CDS and
CLN on DJ iTraxx Europe
Independency, Track History:

- International Index Company (IIC) as independent index supplier and
administrator
- IIC manages the indices and carries out the rebalancing process on
behalf of Dow Jones Indices
- IIC includes the former management team from iBoxx Ltd
114 October 7/14, 2004

DJ iTraxx Europe Index Family
115 October 7/14, 2004

DJ iTraxx Europe Product Descriptions
116 October 7/14, 2004

DJ iTraxx Europe Product Descriptions (cont'd)
117 October 7/14, 2004

118 October 7/14, 2004

119 October 7/14, 2004

DJ iTraxx Europe Inclusion Rules
120 October 7/14, 2004

DJ iTraxx Europe Inclusion Rules (cont'd)
121 October 7/14, 2004

DJ iTraxx Europe Inclusion Rules (cont'd)
122 October 7/14, 2004

DJ iTraxx Europe Reference Portfolio Example
123 October 7/14, 2004

DJ iTraxx Europe Mechanics and Credit Events: Unfunded CDS Form
Consider buying protection of €10 MM on the DJ iTraxx Europe main index in

unfunded CDS form with maturity 09/2009
The running CDS premium is 45bp p.a.
The current market quote is a par CDS premium of 42.50bp/43bp (JPMorgan
quote under BLOOMBERGs JITX:
The CDS is executed at 45bp p.a.

The present value difference between 45bp and the bid of 42.5bp inclusive the
accrued interest is paid by the protection seller to the protection buyer
124 October 7/14, 2004

DJ iTraxx Europe Mechanics and Credit Events: Unfunded CDS Form (cont'd)
The upfront payment of €17,861 is settled on T+3 days and calculated via
BLOOMBERGs CDSW*:
flat par CDS curve

JPMorgan model
assumed recovery
*The current market standard is to model the CDS Index as a single-name CDS contract with a hypothetical reference
entity. For more details see section on unwind valuation of single-name CDS.
125 October 7/14, 2004

No Credit Event
Credit risk
DJ iTraxx Europe
45 bp p.a = €45,000
€17,861
The protection buyer receives the upfront premium and pays to protection seller
45bp p.a. quarterly on €10 MM until maturity
126 October 7/14, 2004

Credit Event on a single Reference Entity – Physical Settlement
Credit risk
DJ iTraxx Europe
€80,000
Protection buyer €80,000 nominal in Protection seller

bonds/loans
45bp p.a. = €44,640
Defaultet Reference Entity has a weighting of 0.80% (=1/125)

Protection buyer delivers €80,000 nominal face value of Deliverable Obligations
of the Reference Entity in exchange for €80,000n (=0.80% of €10 MM)
Notional amount on which premium is paid reduces by €80,000 to €9,92 MM
resulting in a premim of €44,640
Each subsequent credit event will result in a further reduction of the nominal by
€80,000 (=1/125)
127 October 7/14, 2004
DJ iTraxx Europe Mechanics and Credit Events: Funded CLN Form
Consider an investor buying €10 MM DJ iTraxx Europe Note (CLN) with

maturity 09/2009
The investor pays at launch 100 for the Note and receives Euribor+45bp p.a.,
quarterly
No Credit Event
Credit risk
DJ iTraxx Europe
EURIBOR+CDS spread
Issuer Investor
Par
Without Credit Events, the investor continues to receive the coupon on the
original notional invested until maturity
At maturity, the Note will redeem at par
128 October 7/14, 2004

DJ iTraxx Europe Mechanics and Credit Events: Funded CLN Form (cont'd)
Credit Event on a single Reference Entity – Cash Settlement
Credit risk
DJ iTraxx Europe
€32,000
EURIBOR+CDS spread
Issuer Investor
€9,92 MM
Defaultet Reference Entity has a weighting of 0.80% (=1/125) and final

recovery value of 40%
Issuer pays to the investor the Cash Settlement amount of €32,000 =
0.80%*€10 MM*40%
Redemption amount of the Note reduces from €10 MM to € 9,92 MM =
99.2%*€10 MM and Coupons of Euribor+45bp are paid on € 9,92 MM subject to
any further credit events
129 October 7/14, 2004
Appendix: Computing the Intrinsic Spread
What is the on-market coupon for a CDS on a Credit-Index?

We will show that the on-market coupon can be approximated by
- the weighted average of the par CDS spreads of the names in the
index
- where the weights are the risky DV01's for each name*
The approximation of the on-market coupon can also be used as a device for a
replication of the Credit-Index CDS with single-name CDS on the underlying
names.
The on-market coupon is called the intrinsic spread for the Credit-Index CDS.
* The risky DV01 si the change in value of the CDS for a 1bp widening in the spread. When using BLOOMBERGs CDSW
the risky DV01 is displayed as 'Sprd DV01'.
130 October 7/14, 2004

Appendix: Computing the Intrinsic Spread (cont'd)
Step 1 (Intrinsic Upfront Payment)
- Use CDSW on each component of the credit index
Upfront payment Single name = (Par CDS Spread Single name − Deal Spread Index )× Sprd DV 01Single name
- then sum up
= ∑ (Par CDS Spread Single name − Deal Spread Index )× Sprd DV 01Single name
N
∑ Upfront payment Single name
Step 2 (Market Upfront Payment)
- Use the market convention of modelling the credit index as a single

fictitious entity trading at a flat spread curve with recovery 40%:
Upfront payment Market convention = (Par CDS Spread Fictitious Entity − Deal Spread Index )× Sprd DV 01Fictitious Entity
131 October 7/14, 2004

Step 3 (Intrinsic Spread):
- Equate the upfront payments and back out the intrinsic spread
∑ (Par CDS Spread − Deal Spread Index )× Sprd DV 01Single name

N N
1 1
N
∑Upfront payment Single name =
N
Single name
Upfront payment Market convention = (Par CDS Spread Fictitious Entity − Deal Spread Index )× Sprd DV 01Fictitious Entity
Step 4 (Approximation of Intrinsic Spread)
- Substitute the Sprd DV01 of the fictitious entity by the average of the
index components Sprd DV01's:
N
1
Sprd DV 01Fictitious Entity ≈
N
∑ Sprd DV 01 Single name
132 October 7/14, 2004

- The upfront payment equations then become

N N
1 1
N
∑Upfront payment Single name =
N
Single name

N
1
Upfront payment Market convention = Fictitious Entity
N
- and the intrinsic spread can be easily computed as follows:
∑ Par CDS Spread Single name × Sprd DV 01Single name

Intrinsic spread ≈ N
∑ Par CDS Spread Single name
133 October 7/14, 2004

Simple average vs intrinsic spread:
∑ Single name spread i

Intrinsic spread Simple Average = i =1
N
∑ Par CDS Spread Single name × Sprd DV 01Single name

Intrinsic spread ≈ N
∑ Par CDS Spread Single name
Intrinsic spread < Intrinsic spread Simple Average
In general, the intrinsic spread is lower than the simple average because the
higher spreads have lower 'Sprd DV01' and therefore lower weights.
The difference between the simple average and the intrinsic spread is called
the intrinsic basis.
134 October 7/14, 2004
Credit Options
Credit Options
Credit-Spread Options/Warrants
Credit-Default Swaptions
135 October 7/14, 2004

Credit Options
Overview
Substantial growth in activity in 2003

- bond and spread options
- options on single-name CDS
- options on index-linked CDS
Increased liquidity in the CDS market is expected to boost the market for
options on CDS
Main growth expected to come from index-linked trades (Æ DJ iTraxx)
Market Participant Application
Insurance Hedge of Liabilities, Yield Enhancement
Companies
Hedge Funds Leverage, Debt-Equity Strategies, Relative Valuation, typically Buyers of
Volatility
Banks Hedge bond inventory, Volatility Trading
Money Managers Benchmark Outperformance, Relative Valuation, Yield Enhancement

(Covered Call Writing)
Corporate Issuers Yield Enhancement, Liability management (Casino's credit spread

warrants)
136 October 7/14, 2004

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

Premium
Option Option
Seller Buyer
Right to purchase the

Reference Asset at the Strike Price
Expiration Date
If the Price > Strike Price If the Price < Strike Price
The Buyer buys the Reference The Buyer does nothing
Asset at the Strike Price
Strike
Price
Option Option Option Option
Seller Buyer Seller Buyer
Reference
Asset
137 October 7/14, 2004

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

Premium
Option Option
Seller Buyer
Right to purchase the

Reference Asset at the Strike Spread
Expiration Date
If the Spread < Strike Spread If the Spread > Strike Spread
The Buyer purchases the Reference The Buyer does nothing
Asset at the Strike Spread
Price given
Strike
Option Spread Option Option Option
Seller Buyer Seller Buyer
Reference
Asset
138 October 7/14, 2004

Credit Options
Bond and Spread Options Application: Casino's Spread Warrants
Source:
Dresdner Kleinwort
Wasserstein
139 October 7/14, 2004
Credit Options
Bond and Spread Options Application: Casino's Spread Warrants (cont'd)
Source:
Dresdner Kleinwort
Wasserstein
140 October 7/14, 2004
Credit Options
CDS Swaptions / Options on CDS
Definition:
- Option on Credit Default Swap spread of a credit
- Underlying = forward starting CDS (at Option Expiry)
- Traded as European options, only exercisable at Expiry Date
- 3 to 9 month options on ATM 5 year CDS are most common
Terminology:
- Payer: Option to buy protection (short credit risk Æ "put on credit")
- Receiver: Option to sell protection (long credit risk Æ "call on credit")
- Physically settled (enter into underlying CDS) or cash settled (MtM at
option expiry)
What happens if before the Option Expiry there is a Credit Event ?

- Payer : Traded with or without knock-out *
- Receiver : Credit Event not relevant, since option would be out-of-the-
money short before Credit Event
* Knock-out: Exercise is not possible in case of Credit Event in the issuer or guarantor of the CDS Reference Entity.
Reason for knock-out is that hedging instruments are eg forward starting CDS that will expire worthless should a default
occur prior to expiry date.
141 October 7/14, 2004

Credit Options
CDS Swaptions / Options on CDS: Payer
Payer CDS Swaption
Premium
Option Option
Seller Buyer
Right to buy Protection

at the Strike CDS Spread
Expiration Date
Cash Settlement Physical Settlement

If the par CDS spread > Strike CDS spread If the par CDS spread > Strike CDS spread
The Seller pays the MtM The Buyer enters a CDS position If the par CDS spread < Strike CDS spread
of the CDS position to the Buyer at the Strike CDS spread The Buyer does nothing
MtM of Payer
Option CDS Option Option CDS Option Option Option
Seller Buyer Seller Buyer Seller Buyer
142 October 7/14, 2004

Credit Options
CDS Swaptions / Options on CDS: Receiver
Receiver CDS Swaption
Premium
Option Option
Seller Buyer
Right to sell Protection

at the Strike CDS Spread
Expiration Date
Cash Settlement Physical Settlement

If the par CDS spread < Strike CDS spread If the par CDS spread < Strike CDS spread
The Seller pays the MtM The Buyer enters a CDS position If the par CDS spread > Strike CDS spread
of the CDS position to the Buyer at the Strike CDS spread The Buyer does nothing
MtM of Payer
Option CDS Option Option CDS Option Option Option
Seller Buyer Seller Buyer Seller Buyer
143 October 7/14, 2004

Credit Options
CDS Swaptions on iTraxx
Options on iTraxx Main Series 1 6 Aug 8:51 am
Sep 04 Expiry
strike ---> 40 42.5 45 47.5 50
tenor v bid/ask delta bid/ask delta bid/ask delta bid/ask delta bid/ask delta
Payer 18 / 21 -81% 10 / 14 -62% 4/8 -42% 1/5 -25% 0/3 -14%
Receiver 1/5 19% 5/9 37% 11 / 15 58% 19 / 23 75% 30 / 33 86%
Dec 04 Expiry
strike ---> 40 42.5 45 47.5 50
tenor v bid/ask delta bid/ask delta bid/ask delta bid/ask delta bid/ask delta
Payer 29 / 35 -80% 22 / 28 -70% 16 / 22 -59% 11 / 18 -49% 8 / 14 -39%
Receiver 3/8 20% 6 / 12 30% 11 / 17 41% 17 / 24 51% 25 / 31 61%
All exchanging spot delta at 42.5

Options don't KO on default
Prices in cents of notional, payable upfront
Payers are options to buy protection (=pay fixed)
Receivers are options to sell protection (=receive fixed)
A positive delta means buyer of option buys CDS in the exchange
A negative delta means buyer of option sells CDS in the exchange
Closest strike to:

ATM spot
ATM forward
Example: If you buy €100 MM @ strike 45 Dec04 Payer, you pay €220,000
upfront and you have the right to buy 5 years protection on DJ iTraxx Europe @
45 on Dec 22, 2004
144 October 7/14, 2004

First-to-Default (FtD) CDS
Tranched Credit-Index Products
(Tranched DJ iTraxx)
145 October 7/14, 2004

FtD CDS: Mechanics
FtD basket CDS are simple products allowing investors to take advantage of
both
- their views on default probability of companies
- the correlation between those defaults
The protection buyer in a FtD CDS is protected against only the first default
Typical basket consists of 5-6 reference entities
Similar to single-name CDS
No Credit Event
Reference Entity Credit risk

Reference Entity
Reference Entity
Reference Entity
Reference Entity

CDS spread
146 October 7/14, 2004

FtD CDS: Mechanics (cont'd)
Credit Event: First Reference Entity Default

After first Credit Event the FtD CDS is terminated
The protection buyer delivers a Deliverable Obligation of the defaulted
Reference Entity
The protection seller pays par
Reference Entity
Reference Entity
Convertible
Reference Entity
Reference Entity Loan
Defaulted Reference Entity Bond
CTD Bond

100
147 October 7/14, 2004

FtD CDS: Rules-of-thumb
Upper bound (0% default correlation):

- An FtD CDS offers only partial protection against the first defaulting
Reference Entity,
- therefore the sum of the individual premiums should define an upper
bound to the FtD CDS premium:
FtD CDS Spread < ∑ Single name CDS Spread
- When the correlation between defaults is 0%, the FtD CDS premium
corresponds to the sum of the individual CDS premiums
Lower bound (100% default correlation):

- Assuming the correlation between the defaults is 100%, the riskiest
credit in the basket will always be the first to default,
- therefore the maximum of the individual CDS premiums defines a
lower bound for the FtD CDS premium:
Maximal Single name CDS Spread < FtD CDS Spread
148 October 7/14, 2004

FtD CDS: Rules-of-thumb (cont'd)
Basic relationship Spread-Correlation:
Market FtD CDS Spreads:

- Range typically from 60% to 80% of total spread
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FtD CDS: JPM Standard FtD Baskets
JPMorgan introduced 'standard' FtD Baskets

Basket composition is rules-based and draws on the DJ iTraxx subindices
150 October 7/14, 2004

FtD CDS: JPM Standard FtD Baskets (cont'd)
FtD Implied Spread and Underlying CDS levels:
151 October 7/14, 2004

FtD CDS: JPM Standard FtD Baskets (cont'd)
FtD Implied Spread and Underlying CDS levels:
Sample Market
Quotes
152 October 7/14, 2004

Tranched DJ iTraxx: Description
DJ tranched iTraxx is a synthetic CDO on a static portfolio

The portfolio of Reference Entities corresponds to the DJ iTraxx Reference
Entities
Tranches:
- Equity Tranche bears the first 3% of losses of the static portfolio

- Second-Loss Tranche bears the second 3% of losses
- ...
3%, 6%, 9%, 12%, 22% are called attachement/detachement points or
lower/upper subordination levels
Contractually
tranched
DJ iTraxx Europe
12-
12-22% Tranche
Portfolio of 125
9-12% Tranche
Credit Default Swaps
6-9% Tranche
3-6% Tranche
First-loss
0-3% Tranche Tranche
Equity Tranche
153 October 7/14, 2004
Tranched DJ iTraxx: Mechanics for Equity Tranche
Consider an investor selling protection for €10 MM on the Equity Tranche with
maturity 09/2009
Assume that the DJ tranched iTraxx 0-3% Tranche trades at 500bp
The periodic premium received by the investor is €500,000 (=5% of €10 MM)
No Credit Event
Credit risk
(First 3% of
Losses)
DJ iTraxx Europe
€500,000
Protection buyer Investor
Without Credit Events, the investor continues to receive the premium on the
original notional until maturity
154 October 7/14, 2004
Tranched DJ iTraxx: Mechanics for Equity Tranche (cont'd)
Credit Event: One Reference Entity defaults @ 40% Recovery

The 60% loss on the Reference Entity translates into a 0.48% (=60%/125) loss
on the 125-name portfolio
The investor would lose the entire notional for a loss of 3%
A loss of 0.48% corresponds therefore to a 16% (=0.48%/3%) loss of notional
The investor pays €1.6 MM (=16% of €10 MM) to the protection buyer
The new notional is €8.4 MM(= €10 MM - €1.6 MM)
The investor receives 500bp on €8.4 MM contingent on any further credit event
Credit risk
(First 3% of
Losses)
DJ iTraxx Europe
€1,6 MM

€420,000
For a vanilla Credit-Index CDS the payment of the investor would be €48,000
and the new notional would be €9,92 MM (for a much lower premium !)
155 October 7/14, 2004
Tranched DJ iTraxx: Mechanics for Equity Tranche (cont'd)
Credit Event: 7 Reference Entities default each @ 40% Recovery

The total loss on the Reference Entities (420%) translates into a 3.36%
(=420%/125) loss on the 125-name portfolio
The investor would lose the entire notional for a loss of 3%
A loss of 3.36% corresponds therefore the loss of the full notional
The investor pays €10 MM to the protection buyer
The protection buyer stops paying the spread
The loss portion exceeding 3% (0.36%) triggers settlement cashflows for
buyers and sellers of the 3-6% tranche
DJ iTraxx Europe
€10 MM
156 October 7/14, 2004

Tranched DJ iTraxx: Sample Market Quotes
157 October 7/14, 2004

Outlook...
Outlook...
Constant-Maturity CDS
(CMCDS) Spread CDS
(SCDS)
Equity Default Swaps

Total Return Swaps
(EDS)
(TRS) ........
Digital Default CDS

Recovery Swaps
(DDS)
(RCDS)
158 October 7/14, 2004

References
General
• The J.P. Morgan Guide to Credit Derivatives, JPMorgan / RISK, 2000
• Credit Derivatives and Structured Credit, Bowler T and Tierney J.F., Deutsche Bank, August
2000
• Credit Derivatives Explained, O'Kane D, Lehman Brothers, March 2001
• Global Credit Derivatives: Risk Management or Risk?, Special Report FitchRatings, March 2003
• Kreditderivate: Implikationen für die Kreditmärkte, Effenberger D, Deutsche Bank, June 2003
• Global Credit Derivatives: A Qualified Success, Special Report, FitchRatings, September 2003
• Credit Derivatives: A Case of Mixed Signals?, Credit Market Research, FitchRatings, December
2003
• Kreditderivate: Wirkung auf die Stabilität der Finanzmärkte, Effenberger D, Deutsche Bank,
April 2004
• The Lehman Brothers Guide to Exotic Credit Derivatives, Lehman Brothers, 2004
• Corporate use of credit derivatives: next stop in risk management, Morgan Stanley / RISK, May
2004
• Credit Derivatives: An Overview of Market Participants & Activity, Benison T, JPMorgan, 2004
159 October 7/14, 2004

References
Theoretical
• Credit Risk Modelling and Credit Derivatives, Schönbucher P J, Dissertation, Bonn 2000
• Valuing Credit Default Swaps I: No Counterparty Default Risk, Hull J C and White A, The
Journal of Derivatives, Fall 2000
• Credit: The Complete Guide to Pricing, Hedging and Risk Management, Arvanitis A and
Gregory J, RISK Books, 2001
• Price and probability, Martin R, Thompson K and Browne C, RISK, January 2001
• Credit Swap Valuation, Duffie D, Financial Analysts Journal 55(1), 1999, reprinted in Credit
2001
•Valuing Default Swaps Under Market and Credit Risk Correlation, Jarrow R A and Yildirim Y,
The Journal of Fixed Income, March 2002
• Credit Derivatives Pricing Models, Schönbucher P.J., John Wiley & Sons, June 2003
160 October 7/14, 2004

References
Single-name CDS/CLN
• Asset Swaps, Tim Frost, JPMorgan, December 1995
• Railtrack and SAirGroup, Harvey R and Adams J, JPMorgan, October 2001
• Unwind valuation of Credit Default Swaps, Goldman Sachs, December 2001
• Fundamentals of the Default Swap Market, Corey J and Poprik B, Deutsche Bank, December
2001
• Credit Linked Notes – The Mechanics, Palmer A et al, JPMorgan, August 2002
• Understanding the basis, Van den Bok A, ABN AMRO, January 2003
• Fitch Examines Effect of 2003 Credit Derivatives Definitions, Special Report, FitchRatings,
March 2003
• Introduction to Credit Derivatives, Mettler B, JPMorgan Credit Derivatives Conference, 2004
• Credit Derivatives Pricing and Research, Beinstein E, JPMorgan Credit Derivatives Conference,
2004
• Credit Derivatives Documentation, Thompson D, JPMorgan Credit Derivatives Conference,
2004
• Bond spreads as a proxy for credit default swap spreads, Davies M and Pugachevsky D, Bear
Stearns / RISK, 2004
161 October 7/14, 2004

References
Credit Index CDS/CLN
• Dow Jones TRAC-X, Mettler B, JPMorgan Credit Derivatives Conference, 2004
• Introducing DJ iTraxx Europe Series 1, Due J et al, JPMorgan, June 2004
• Dow Jones iTraxx CDS Indices Europe, www.iboxx.com, June 2004
• Computing Intrinsic Spreads of Portfolio Credit Default Swaps, Baheti P and Naldi M, Lehman
Brothers, July 2004
• Pricing and hedging credit default swaps on indices, Davies M and Pugachevsky D, Bear
Stearns / RISK, 2004
• Basic CDS Index Analytics, Derivatives Week, June 2004
162 October 7/14, 2004

References
Credit Options
• Corporate Bond Options, Kakodkar A and Francis C, Merrill Lynch, June 2003
• An Introduction to Credit Options, Spinner A, Derivatives Week, May 2004
• Credit option trading comes of age, Macaskill J, RISK, May 2004
• Credit spread warrants, Park S, Dresdner Kleinwort Wasserstein, 2004
• Index Monitor: Credit Spread Warrants, Stangl G and Schon C, Dresdner Kleinwort
Wasserstein, May 2004
• Credit Options Primer, Lehman Brothers, June 2004
• Bets on for credit spread warrants, RISK, July 2004
• Covered Credit Spread Warrants, Introducing credit options to corporate bond investors,
Nevstad H, Dresdner Keinwort Wasserstein, July 2004
163 October 7/14, 2004

References
• First to Default Basket Swaps, Tierney J.F., Deutsche Bank, February 2002
• Introducing Dow Jones Tranched TRAC-X, McGinty L et al, JPMorgan, November 2003
• Introduction to Correlation Products, Mazur B and Mettler B, JPMorgan Credit Derivatives
Conference, 2004
• Credit Correlation: A Guide, McGinty et al, JPMorgan, March 2004
• Introducing Base Correlations, McGinty et al, JPMorgan, March 2004
• A Model for Base Correlation Calculation, McGinty L and Ahluwalia R, JPMorgan, May 2004
• Introducing Standard First to Default Baskets, McGinty L, Harris M and Due J, JPMorgan, July
2004
• A Model for First to Default Implied Correlation Calculation, McGinty L et al, JPMorgan, July
2004
• The Bank of America Guide to Advanced Correlation Products, Bank of America, 2004
164 October 7/14, 2004

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Introduction to

October 7/14, 2004

Single-name Credit Default Swaps (CDS), Preamble

2 October 7/14, 2004

CDS and CLN on Credit Indices

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Single-name Credit Default

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Basic Terminology and

5 October 7/14, 2004

The single-name CDS is the standard credit derivative

Protection buyer Protection seller

Protection buyer sells credit risk to protection seller

Terminology: CDS spread, CDS premium, default swap spread

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Physical settlement : Delivery of cheapest to deliver obligation out of a basket

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Non default case:

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10 October 7/14, 2004

Credit Derivatives Volumes Trades (US$ billions)

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Current documentation framework are the 2003 ISDA credit derivatives

Liquidity provider to cash market during market stress

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Provider of increased liquidity to individual names under stress

Confidential isolation/transfer of credit risk

Confidentiality vs credit reference

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Efficient vehicle for shorting credit

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

No funding costs, low administration costs

Regulatory capital relief/economic risk reduction/portfolio diversification

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Increased amount of corporate credit risk in the market

Transition from lending to intermediation

Increased credit spread volatility

Loans not widely traded in the secondary market, accounted on an accrual

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Evolution of Credit Derivatives Market

Bank Portfolio Managers Asset Managers

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

16 October 7/14, 2004

17 October 7/14, 2004

Sources and traditional hedges of corporate credit risk

- Common sources of credit risk for a company are trade receivables,

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

- Insurers often retain the right to revoke coverage in the event of a

- Securitisation programs remove most of credit risk from balance sheet

18 October 7/14, 2004

Obstacles for corporate to embrace credit derivatives

- Credit spreads peak in 2001 and 2002 not paralleled by a peak in

- Timing mismatches between credit event unter CDS contract and a

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

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

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Example: - A corporation issues a convertible bond (CB)

22 October 7/14, 2004

Market share figures recently skewed

23 October 7/14, 2004

24 October 7/14, 2004

Separation of loan underwriting/origination from credit ownership creates the