Credit Derivatives

Credit Derivatives Copyright 2004 Deutsche Bank@
Credit Derivatives
Mike Pawley michael.pawley@db.com
Product Profitability High
Product Complexity Medium-High
1
Global Markets Training
Credit Derivatives

What will you get out of this material ?
Well, at the end of this session you should :
Understand the mechanics of credit default swaps
Understand the pricing of credit default swaps
Know the key users of default swaps
Be aware of the links between credit derivatives and synthetic CDO’s
Be able to explain constant maturity credit default swaps
Be able to explain equity default swaps
Be able to identify bond/default swap relative value opportunities

What you already need to know:
Basic bond maths
Simple repo applications.
2
Credit Derivatives
This session covers the main uses of credit default swaps, the key product in the credit
derivative market. In particular, we look at the applications of credit default swaps in
customised structured products : credit linked notes, repackaged notes, and synthetic
collateralised debt obligations.
In the appendix we have briefly covered other types of credit derivative : total return
swaps and credit spread options.
We start with an introduction to the basic credit default swap product and its uses.
Credit derivatives are bilateral contracts tied to the performance of an underlying

reference credit(s) or loan(s). They allow users to manage their credit exposure via the
isolation and transfer of credit risk.
The figure below shows the structure of a credit default swap. It is a contract whereby
one party (the protection seller) agrees to receive periodic payments (the CDS spread
or fee) in return for making a contingent payment to the protection buyer, following a
default on a specific security or loan.
Credit Default Swap Structure
Contingent Payment
Protection Protection
Buyer Seller
Periodic
Fee (bps), s.a. A/360
Reference
Entity/Security
(Bond/Loan)
The credit risk faced by the protection buyer as a result of holding the reference security
has been stripped off, and effectively trades separately.
So, what are the motives of the counterparties ?
Perhaps the protection seller is a bank that wants credit exposure to a particular sector
to which it does not have a have particularly strong presence. Alternatively, it could be
an investor seeking access to a particular credit that is not normally available in the
market.
The protection buyer may simply want to hedge the credit risk on the bond for a period
of time.
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If a credit event occurs the protection seller makes a payment to the protection buyer.
Payment is usually linked to the change in price of an agreed reference credit in order
to cover the loss. The most common method of payment is physical settlement, in which
the protection buyer exchanges the reference security for par. Settlement may also be
in cash, and is usually the difference between par and the market value of the defaulted
reference asset. The market value may be determined by a calculation agent or through
a dealer poll.
A credit default event would normally cover payment default, bankruptcy and
rescheduling/restructuring of debt. It must be a material and objectively measurable
default. In particular, note that ratings downgrades are not in themselves evidence of
default.
Users
Banks tend to be major users of CDS’s. They tend to use them to reduce credit line
usage with major counterparties. Increasingly, clients give mandates for high value-
added investment banking business (derivatives, FX etc) to those banks that are willing
and ready to offer deep credit lines. If credit lines are full, the CDS allows the bank to
free up line usage to carry on lending to the valued client. The alternative would be to
refuse to lend and subsequently to lose the chance to cross-sell other products.
Banks also use CDS’s to adjust portfolio concentration. Many banks tend not to be fully
diversified - their portfolio may be geographically concentrated or concentrated on a
particular sector. Credit default swaps therefore allow banks to manage assets and shift
credit risk.
One of the major advantages of credit default swaps is the ability to create maturity and
credit exposures that are not available in the underlying cash market. For example, if an
investor wants a four year maturity and duration to an issuer that only has two year and
seven year securities trading in the secondary market, then a four year credit default
swap can be created that suits the investor’s requirements. Alternatively, a credit linked
note (see below) could be created for the investor.
It’s important to recognise that credit derivatives are not one-shot static products. They
are dynamic products whose value changes as the risk of default on the underlying
changes. Their mark-to-market performance is therefore very closely related to changes
in credit spreads. They are therefore a very useful tool for hedging/speculating on
changes in credit.
Clearly, any negative sentiment on a corporate, or perhaps a negative outlook from the
rating agencies will tend to increase the credit protection bought in the market and a
subsequent increase in the default swap fee quoted for new business (see below). The
mark-to-market of existing default swaps will therefore change (the MTM value of the
CDS will go up in this case).
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Default Swaps As Dynamic Products
Contingent Payment
Investors CDS
Market
Increased Fee required by

CDS market for new default
swaps on XYZ
Corporate XYZ
(poor outlook)
For example, an investor could have sold protection on Ford in October 2002 at around
650bps and closed out the deal in January 2003 at 400bps, making 250bps (hindsight
is a wonderful thing – see figure below). This is effectively the same as buying Ford
bonds (but without the duration risk). Alternatively, an investor could have bought
protection on Ford around June 2002 at 200 bps and closed it out later in October 2002
at 650bps, a gain of 450bps. Buying protection is effectively the same as shorting the
credit, but with much less hassle.
Ford 5Y CDS Spread History

Ford Motor Credit
700
600
500
400
Ford Motor Credit 5Y CDS
300
200
100
0
04/01/2002
04/05/2003
04/11/2003
04/05/2004
04/09/2003
04/09/2001
04/07/2002
04/01/2003
04/03/2004
04/07/2004
04/11/2001
04/03/2002
04/05/2002
04/09/2002
04/11/2002
04/07/2003
04/01/2004
04/03/2003
The market can also be used for relative value trades. Relative value trades expressing
intra- or inter- industry views are more efficiently expressed using default swaps. They
can be used to isolate a credit view whilst limiting curve, rate and funding risk. They are
easier to execute as there are less components/instruments in the trade.
5
Here, for example, is an intra-sector trade idea : Ford/GM basis. When the Ford/GM
spreads diverge too much, sell Ford protection and buy GM protection in the
expectation that spreads will come back together. Alternatively, when the spreads are
too close to each other, buy Ford protection and sell GM protection.
Ford and GM 5Y CDS Spread History.
Ford Vs GM
350
300
250
200
Ford 5Y
GM 5Y
150
100
50
0
3
3
3
4
3
04
22 200
17 200
12 200
20 200
03 200
29 200
23 200
19 200
14 200
09 200
23 200
06 200
01 200
15 200
26 200
09 200
08 200
22 200
05 200
03 200
17 200
31 200
28 200
12 200
26 200
20
4/
5/
7/
9/
9/
0/
1/
1/
2/
2/
2/
1/
1/
2/
2/
3/
3/
4/
5/
5/
6/
6/
7/
8/
0/
8/
/0
/1
/1
/1
/1
/1
/0
/0
/0
/0
/0
/0
/0
/1
/1
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
08
So, the market has rapidly moved from using CDS as a static hedging instrument to one
that uses CDS to actively buy and sell credit risk.
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CDS Pricing
Credit default swap pricing tends to be driven by credit spreads in the cash markets and
by the financing costs of hedging the deal. The key parameters are the asset swap rate
and the repo rate.
If buying protection, we have the following figure :
Credit Default Swap Pricing : Buying Protection and Hedging, No Default
Asset Swap
Counterparty
Float (Libor + Asset Swap Spread)

Fixed
Contingent
Payment Cash
Repo
Protection Deutsche Repo interest
Counterparty
Seller Bank Libor - Spread
Periodic
Fee Eurobond
(28 bps)
Fixed
American
Express
Eurobond
Deutsche Bank buys an American Express Eurobond and finances it in the repo market.
The bank then buys credit default protection (via a CDS) and swaps the interest flows
on the bond from fixed to floating.
If there is no default, the two fixed rates cancel, the two libors cancel and the net
position is :
Net Position = Asset Swap Spread + Repo Spread – Fee
Cash Flows For Deutsche Bank (No Default)
CDS : Fixed
Interest Rate Swap : Libor + Asset Swap Spread – Fixed
Repo : -Libor-Repo Spread
Default Swap : -Fee
Net Position : Asset Swap Spread + Repo Spread - Fee
If we assume that the bank funds at libor (rather than Libor-spread) then the breakeven
CDS fee is the asset swap spread.
In reality, of course, banks do not fund at libor but somewhat below libor (ie the repo is
libor minus a spread).
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If there is a default, we have the following figure :
Buying Protection and Hedging, Default Occurs
Asset Swap
Counterparty
PV of Interest Rate Swap

Bond
Repo
Protection Deutsche
Counterparty
Seller Bank
Par
Par
American
Express
Eurobond
The protection seller pays DB par, DB delivers the bond, pays par in the repo and the
swap is closed at a mark-to-market loss or gain.
The net position is thus the PV of the interest rate swap.
Cash Flows For Deutsche Bank (Default Occurs)
CDS Bond Delivered at Par

Interest Rate Swap PV of Interest Rate Swap
Repo -Par
Net Position PV of Interest Rate Swap
If we assume that the bank funds at libor and the expected present value of the interest
rate swap is zero, then the breakeven CDS fee is the asset swap spread.
We will use the data in the table below to price up a CDS on American Express.
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American Express Pricing Information
USD Asset Default Breakeven Repo Repo

Libor Swap Swap Funding Rate Spread
Spread Premium Rate
Bid Protection 5% 17 bps 28 bps 4.89% 4.8% - 20 bps
Offer Protection 5% 28 bps 42 bps 4.86% 4.75% - 25 bps
Source : DB Global Markets Research “Credit Derivatives and Structured Credit” August 30th 2000
In the figure below Deutsche Bank buys an American Express Eurobond and finances it
in the repo market. The bank then buys credit default protection (via a CDS) and swaps
the interest flows on the bond from fixed to floating.
Deutsche Bank finances the purchase of the bond at a cost of 4.8% (Libor–20),
receives 5.17% (Libor+17) in the asset swap market (difference = 37 basis points) and
buys credit protection for 28 basis points. There is therefore 9 bps of positive carry for
the bank. Alternatively, we can use the expression above :
Net Position = Asset Swap Spread + Repo Spread - Fee
= 17 + 20 – 28 = 9 (positive carry)
The breakeven financing cost is just the difference between the asset swap yield
(5.17%) and the default swap premium (28 bps), which gives 4.89%. As the repo rate is
below this, the bank earns positive carry (as mentioned above).
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Credit Default Swap Pricing : DB Buys Protection and Hedges, No Default
Asset Swap
Counterparty
Float (L+17= 5.17%)

Fixed
Contingent
Payment Cash
Repo
Protection Deutsche Repo interest
Counterparty
Seller Bank L-20=4.80%
Periodic
Fee Eurobond
(28 bps)
Fixed
American
Express
Eurobond
If bond spreads tighten then the hedge will cost more for the dealer, and the dealer will
push down the amount paid for protection. Similarly, if repo rates rise the hedge will cost
more and the amount the dealer is willing to pay for protection will fall. Finally, if the
asset swap spread tightens the hedge will also cost more and the fee quoted on default
swaps will go down.
All of these factors will drive down the credit default swap fee (see table below).
Impact On Pricing
Event Default Swap Fee

Credit Spread Tightens : Down
Repo Spread Falls : Down
Asset Swap Tightens : Down
Credit Spread Widens : Up

Repo Rate Falls : Up
Asset Swap Widens : Up
Alternatively, Deutsche Bank could sell credit protection. In the figure below, Deutsche
Bank sells the Eurobond via the repo market, sells credit protection on the bond and
receives fixed in the asset swap. [NB remember that in a repo the original seller of the
bond receives the coupon back from the buyer of the bond].
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Credit Default Swap Pricing : DB Sells Protection and Hedges, No Default
Asset Swap
Counterparty
Float (L+Asset Swap Spread)

Fixed
Contingent Cash Proceeds
Payment
CDS Reverse
Protection Deutsche Repo Interest Repo
(L-Repo Spread)
Buyer Bank Counterparty
Periodic Fixed
Fee
(42 bps)
Eurobond Eurobond
Sale by DB
Counterparty
The two fixed rates cancel each other out, as do the libors, and the bank is left with the
following position :
Net Position = Fee – Asset Swap Spread - Repo Spread
Cash Flows For Deutsche Bank (No Default)
Default Swap : Fee

Interest Rate Swap : Fixed – Libor – Asset Swap spread
Reverse Repo : Libor – Repo spread - Fixed
Net Position : Fee – Asset Swap Spread - Repo Spread
If we assume that the bank funds at libor then the breakeven CDS fee is the asset swap
spread.
Now, let’s look at this again using the American Express example.
On the credit protection offer side Deutsche Bank sells American express (having
reverse repo’d it in at a cost of 4.75% or L–25), pays out libor plus 28 bps on the asset
swap (5.28%) and receives 42 basis points for selling credit protection.
Alternatively, we could calculate it as :
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Net Position = Fee – Asset Swap Spread - Repo Spread
= 42 – 28 - 25 = (11) negative carry
The breakeven financing rate is simply the difference between the asset swap level
(5.28%) and the credit default swap fee (42 bps) which gives 4.86%. Note the repo rate
is below the breakeven rate, so the dealer earns a negative carry.
Credit Default Swap Pricing : DB Sells Credit Protection, No Default
Asset Swap
Counterparty
Float (L+28 = 5.28%)

Fixed
Contingent Cash Proceeds
Payment
CDS
Repo
Protection Deutsche Repo Interest
L-25=4.75% Counterparty
Buyer Bank
Periodic Fixed
Fee
(42 bps)
Eurobond Eurobond
Sale by DB
Counterparty
If bond spreads tighten the hedge will cost less for the dealer. The dealer will be willing
to accept a lower default swap fee.
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Credit Default Swap Pricing Using Swap Methodology
It is also possible to use swap market techniques to price credit default swaps. A good
analogy is with interest rate swap pricing. In practice, CDS spreads are known from the
market and are used to derive default probabilities. Pricing credit derivatives thus
follows the principles of no-arbitrage pricing and dynamic hedging. Therefore, the
pricing benchmarks are prices of traded instruments and not historical data.
Market CDS spreads reflect survival/default probabilities and the potential recovery
value of the bond in default. Typically, the default curve and probabilities of default are
bootstrapped from CDS market quotes for a number of maturities (using an assumption
about recovery rates).
Calculating Default Probabilities from CDS

CDS PV PV Probability PV Fixed - Cumulative Survival
Maturity Spreads Pvf Recovery (R) Fixed Float of Default (P) 1-P 1-R PV Float P Probability
1 0.52% 0.985512959 40% 0.508% 0.508% 0.8592% 99.1408% 60% 0.00% 0.8592% 99.1408%
2 0.97% 0.959923999 40% 1.849% 1.849% 2.3487% 97.6513% 60% 0.00% 3.1877% 96.8123%
3 1.38% 0.92368145 40% 3.820% 3.820% 3.6723% 96.328% 60% 0.00% 6.7430% 93.2570%
4 1.70% 0.882572087 40% 6.041% 6.041% 4.4993% 95.501% 60% 0.00% 10.9389% 89.0611%
5 1.90% 0.839314814 40% 8.107% 8.107% 4.6056% 95.394% 60% 0.00% 15.0407% 84.9593%
6 1.96% 0.793244796 40% 9.634% 9.634% 3.7764% 96.224% 60% 0.00% 18.2491% 81.7509%
7 2.03% 0.753861716 40% 11.177% 11.177% 4.1727% 95.827% 60% 0.00% 21.6603% 78.3397%
8 2.07% 0.714914121 40% 12.511% 12.511% 3.9685% 96.032% 60% 0.00% 24.7692% 75.2308%
9 2.11% 0.676963455 40% 13.782% 13.782% 4.1618% 95.838% 60% 0.00% 27.9001% 72.0999%
10 2.16% 0.64128122 40% 15.061% 15.061% 4.6109% 95.389% 60% 0.00% 31.2246% 68.7754%
The table above shows how default probabilities can be calculated from market CDS
spreads (in this case, the Ford CDS curve).
Think of CDS pricing like swap pricing – there are two legs, fixed (the spread) and
floating (the contingent payment). For a swap to be fairly priced at inception the present
value (using PV factors from the USD swap curve) of the two legs should be equal :
PV Floating (contingent payment) Leg =
60% x [(Prob of Default1 x PVF1) + (Survival Prob1 x Prob of Default2 x PVf2) +

(Survival Prob2 x Prob of Default3 x PVf3) +….]
PV Fixed Leg = CDS Spread x [ (Survival Prob1 x PVf1) + (Survival Prob2 x Pvf2) +…]
PV Fixed Leg = PV Float
So, solve for probability of default given that the two legs must be equal
Now, we know the CDS spread from the market, and assuming a particular recovery
rate we can solve for the probability of default given that the two legs must be equal.
In the excel spreadsheet we use the solver function to find the probability of default.
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 Go to spreadsheet ‘Credit Derivatives‘ – Default Probs’ to see the
calculations.
14
CDS Basis Trades
It is potentially profitable for bond investors to pay attention to what is known in the
credit derivative market as ‘basis’. This refers to the pickup that can be achieved by
selling protection via a credit default swap rather than buying the cash bonds on an
asset swapped basis.
More formally, the basis is shown below :
Basis = Protection Bid – Bond Offer
The choice is fairly simple : the investor should choose to take on credit risk in
whichever way is most efficient (see below).
Taking on Credit Risk : Choices
Sell Protection Buy Bonds

(Take on (Take on
OR
credit risk, bid credit risk,
side) offer side)
Works when basis is wide (positive)

Basis = Protection Bid – Bond Offer
The table below shows some recent examples of the basis or protection pick-up.
Protection Pickup For Various Credits
Protection Cash Bond Asset Protection

Swapped Pickup
Daimler Chrysler 69 35 34
Rolls Royce 44 12 32
Allianz 21 0 21
Five year protection for Daimler Chrysler has a positive basis of 34 basis points. The
default swap could also be done in funded form as a credit linked note, although this
would reduce the spread by a few basis points.
Switch Trade
Alternatively, if an investor already owns the bond a switch trade could be done by
selling the bond and replacing it by selling protection (see figure below).
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Taking on Credit Risk : Switch
Sell Protection Bond

(Take on (Sell Bond
To
credit risk, Bid already
Replace
Side) owned, Bid
Side)
Works when basis is wide (positive)

Basis = Protection Bid – Bond Bid
Selling a bond and replacing it by selling protection will result in a smaller pick-up due to
the bid-ask spread. In the CIT case, the basis would be the bid side of the protection
level (95 bps) and the bid side of the bond spread (82 bps), giving a pickup of 13 basis
points.
If the basis is negative ie asset swapped cash bonds trade wider than default swaps,
then it makes sense to buy bonds and also buy protection. In other words, it is possible
to both buy the bond and buy protection and lock in a positive spread (see below).
Buying Bond And Hedging Credit Risk
Buy Buy Bond

Protection (Take on
(Hedge credit AND credit risk,
risk, offer offer side)
side)
Works when basis is negative

Basis = Protection Offer – Bond Offer
Normally, the protection market trades wider than the asset swapped level of the
underlying cash bond. As a result, buying protection as a hedge of a bond position
usually results in negative carry after taking the bid/ask spreads into account – ie the
cost of protection exceeds the carry on the bond that is available to pay the protection
fee.
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The table below shows examples where it would be worthwhile buying bonds and
buying protection.
Negative Basis For Various Credits

Protection Offer Cash Bond Asset Swapped Basis
HVB Group 31 52 -21
Michelin 34 53 -19
ING 15 33 -18
Market Dynamics : The Loan Market And Credit Default Swaps
Feedback mechanisms between the loan markets and the credit derivative markets can
often be seen. In the figure below a strong bid for protection emerges from banks soon
after signing off on a large syndicated loan. The increased demand to buy protection on
the part of the banks means that credit default swap spreads will widen.
So, the basis will widen to accommodate the new demand for protection.
Syndicated Loans And Impact On Default Swap Fee

Contingent Payment
Banks CDS
Market
Fee
Large
Syndicated Loan
Corporate
This means that potential investors in the corporate’s bonds may be able to buy
exposure at a discount to the cash bond market by selling protection instead (as
mentioned above).
A good example of this is the AT&T $25billion syndicated loan facility in November
2000. This led to heightened demand amongst banks for one year protection, causing
the default swap curve to flatten versus cash. This led to attractive levels for investors
wanting to take on credit risk by selling protection either via a CDS or a credit linked
note (see below).
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AT&T Default Swaps Vs Cash Bonds
Cash Bond CDS

1 Year L+35 65
5 Year L+95 110
It would be expected that the AT&T default swap curve would move back in line with the
cash market as banks involved in the syndication are able to acquire the protection that
they need.
As the credit default swap market grows, feedback mechanisms of this kind between
the loan and protection markets will become more prevalent and developed.
Market Dynamics : Bond Issuance And Default Swaps
It may also be the case that heavy new supply of bond issuance has an impact on the
basis.
Market Dynamics : Negative Sentiment
Bond Investors
Market
Heavy New Supply,
Spreads Widen,
Basis May Tighten
A good example of the relationship between cash market spreads and default spreads
occurred in April 2001 in the European telecoms market. Telecom spreads widened
considerably on supply fears (expectation that telecoms companies would need to issue
more paper to fund 3G licenses) and also lower expectations that telecoms would be
able to sell off assets to fund license purchases.
Default swap spreads for telecoms also widened, but by less than in the cash market,
causing the basis to reduce. The protection pick-up (difference between selling
protection and buying cash bonds on an asset-swapped basis) fell by between 5-21
basis points.
The protection market still remained relatively cheap to the cash market, with Deutsche
Telecom at 64 bp and France telecom and KPN both over 50bp.
This is partly explained by the fact that many of these issues have a high name
recognition and have an unnaturally strong retail bid pushing down spreads (particularly
in short maturity paper). Even CLN’s on telecoms offered pick-ups of 50 basis points or
more in the telecom sector in March 2001.
It is also possible for the protection market sometimes to take a different view to the
cash market. The protection market might take a more prudent view and push up
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protection levels faster than cash credit spreads rise, leading to a stronger basis. (ie
protection trading above the cash asset swap level).
Market Dynamics : Creating Credit Derivatives From Convertible Bonds
Convertible bonds, in simple terms, are made up of a bond and an equity call option. It
is possible to strip out the various elements embedded in the convertible to create credit
derivatives.
In the figure below the investor has created an arbitrage between the value of the
embedded equity option in the CB and the value of the equity option in the equity
derivatives market. The investor is benefiting from a higher implied vol in the equity
derivative market than in the convertible market.
CB Stripping
Swap
(DB)
Fixed Float
Contingent Option
Payment Premium
Equity
Default Investor Derivatives
Swap (DB)
Desk (DB)
Buyer
Periodic CB
Fee (bps) Equity
Option
Convertible
Bond
The investor sells an equity call option to Deutsche Bank. At the same time, the investor
strips out the credit risk in the CB by buying default protection from Deutsche Bank in
the form of a credit default swap. Finally, the investor has hedged the interest rate risk
in the CB by swapping the fixed coupon to a floating coupon.
All that the investor is left with is the arbitrage profit (once taking into account the
floating return from the swap, the cost of funding the CB, the fee paid to Deutsche for
protection and the premium earned on the sale of the equity derivative).
The only way that the trade can work for the investor is if the equity option value in the
equity derivative market is large enough for the investor to cover the cost of carrying the
convertible, paying to buy credit protection, and still providing enough left over to make
an arbitrage profit.
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Consider two large convertible issues from November 2000, Corning (GLW) and Tyco
International (TYC) (see table below).
Cash, CDS and Stripped Converts (Offer Side)
Issue Rating Maturity Cash CDS Stripped

Bond Convert
GLW 0% 2015 A2/A 5 Yr L+40 120 L+140
TYC 0% 2020 Baa1/A- 3 Yr L+50 115 L+140
Notice that the cash bond levels of GLW and TYC are around the L+40 and Libor+50
area, but the same credit can be obtained through a stripped convertible with a spread
of Libor+140.
The implied vol on the equity call option embedded within the GLW issue traded in the
52%-54% range around issue (November 2000), whereas equity 6-month vol in the
OTC options market was around 80% at the time.
These large arbitrage gains mean that hedge funds are able to pay a premium for
protection if necessary (and still make money), driving up default swap spreads.
The level of liquidity in the credit derivatives market will also have an impact on CDS
levels. The protection market typically trades in blocks of $5-$20million, whereas these
were large convertible trades ($2.7 billion and $4.05 billion respectively) that added
significant demand to the CDS market. Given that dealers will want to buy protection to
hedge their long positions this will add upward pressure to the CDS market.
In addition, the investor base for stripped convertibles and credit linked notes is still
fairly limited, making it difficult for dealers to place large long positions in GLW and TYC
protection.
The stripped convertible market can have an impact on credit default swap spreads. It
may be the case, for example, that a large issue by a corporate on generous terms
leads to hedge fund arbitrage activity. As noted before, the hedge fund sells the equity
option premium and hedges the credit risk by buying a credit default swap.
This can cause credit default swap spreads to widen in the market off the back of heavy
demand for protection. This, in turn, can lead to cheap opportunities for investors to
gain credit exposure to a corporate through the credit default swap (either by selling
protection as a substitute for buying the bonds or as a switch trade ie selling the bonds
and then selling protection). This is because the basis has widened.
Note that the wider default swap spreads in this example result from a technical
situation and are not credit related. The wider spreads are related to the increased
demand to purchase protection from convertible arbitrage funds, which are interested
primarily in the equity option component.
Of course, it is also possible to see the opposite situation, where investor demand for
convertibles is relatively high. In these situations issuers and lead managers try to
capitalise on strong demand for converts by pricing issues more aggressively. The
spread between the implied vol in the equity market and the CB market will then tend to
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tighten. This can mean that the equity arbitrage for hedge funds disappears and
stripping becomes unattractive. So, hedge fund asset swap bids (ie hedge funds paying
fixed) tighten, creating tighter asset swap levels for fixed income investors.
Tighter asset swap levels will lead to cheaper credit default swaps.
Moreover, hedge funds will buy less credit protection if they are not arbitraging the
convert market and protection costs will see downward pressure.
For arbitrage to occur again either equity volatility has to increase or recently issued
convertibles have to cheapen.
See the Convertible Bond Asset Swaps session for more detail.
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Credit Default Swaps and Synthetic CDO’s
Credit default swap levels can be significantly affected by activity in the CDO synthetic
arbitrage market. In these deals the notional portfolio is made up of single name default
swaps rather than bonds (see figure below). Investors in the different tranches of the
transaction sell credit protection and receive a corresponding fee as part of their return.
It is often possible to create structures where the all-in cost of buying protection in the
tranched portfolio form is less than the weighted average cost of the default swaps that
make up the portfolio. This can be achieved even though the spreads on the tranches
are substantially wider than on comparably rated corporate bonds.
In putting the portfolio together, the sponsor buys protection in tranched form from
investors and then sells single name protection to dealers. This creates significant
supply of protection in the market, leaving dealers long protection and looking to sell
protection. This can have a downward effect on protection levels and can in fact drive
the basis negative.
This, of course, will tend to make it attractive to buy protection (which is not normally the
case). Investors can buy bonds, buy protection and lock in a positive spread.
Synthetic CDO
Tranched
Single
Portfolio of
Default
Default Swaps
Swaps Default
Protection
CDS
Counterparty Default
1 Protection
Fee Class A
Default
CDS
Protection Fee
CDS Sponsor
Counterparty Default
2 Protection
Fee Class B
CDS
Default
Protection Fee
CDS
Counterparty
3 Threshold Amount
(First Loss)
Fee
Note, once again, that these are technical factors impacting on the CDS market. They
do not reflect changes in credit outlook.
22
Deutsche Bank Funding Spread
The DB ‘Funding Spread’ metric aims to provide a better measure of relative and
absolute richness/cheapness of bonds versus CDS than either asset swap spreads or
Z-Spreads versus CDS.
The funding spread calculates a theoretical bond price, taking into account recovery
rates and survival probabilities computed from the CDS curve. The theoretical bond
Price is calculated like this :
PV Bond Cash Flows x Survival Probability + PV Recovery Cash Flows x Default

Probability
The basis is then the difference between the theoretical bond price and the market
price.
The funding spread is then the parallel shift to the swap curve required to make the
theoretical and market bond prices equal.
For as positive basis (bond rich to CDS, credit spread lower than CDS spread) – the
swap curve needs to be shifted downwards, meaning a negative funding spread.
For a negative basis (bond cheap to CDS, credit spread higher than CDS spread) – the
swap curve needs to be shifted upwards, meaning a positive funding spread.
Trading the Basis – Negative Basis Trades
If the basis is negative the bond is cheap to CDS, the credit spread is higher than the
CDS spread, and the funding spread is positive. The trade is then : Buy bond, buy
protection, if you expect one of following :
1. Bond richens (bond price rises, credit spread falls), long bond position profitable.
2. CDS spread widens, protection resold at profitable level.
3. Both events happen, profits made.
4. Bond richens more than CDS (bond price rises, bond credit spreads fall, and by
more than fall in CDS spreads), gain on long bond more than offsets CDS loss.
5. CDS spread widens more than bond cheapens (bond price falls, bond credit spreads
rise, but less than rise in CDS spreads), gain on CDS more than offsets loss on bond.
All of these events push the funding spread lower, ie bond richens relative to CDS.
Interest rate risk is typically hedged with an asset swap, the bond financed with a repo,
so you can replace ‘Credit Spread’ with ‘asset swap spread’ above, also corporate
bonds on special are good for this trade (positive carry).
23
Trading the Basis – Positive Basis Trades
If the basis is positive, the bond is rich to CDS, the credit spread lower than the CDS
spread and the funding spread is negative. The trade is then: Short bond, sell
protection, expecting one of the following :
1. Bond cheapens (bond price falls, credit spread rises), short bond position profitable.
2. CDS spread tightens, protection bought back at profitable level
3. Both events happen, profits made.
4. Bond cheapens more than CDS (bond price falls, credit spread rises, and credit
spread rises by more than CDS spreads), gain on short bond more than offsets CDS
loss.
5. CDS spread tightens more than bond richens (bond price rises, credit spread falls,
but less than fall in CDS spreads), gain on CDS more than offsets loss on bond.
All of these events push the funding spread more positive ie the bond cheapens relative
to CDS. The interest rate risk is typically hedged with an asset swap, the bond financed
with a repo, so you can replace ‘credit spread’ with ‘asset swap spread’ above, also
corporate bonds on special are bad for this trade (negative carry), although investors
who own bonds can sell them, invest the proceeds at Libor and sell protection,
enhancing the yield on their portfolios until the positive basis disappears.
The return from basis trading comes in three parts :
– Carry
– P&L on unwind, assuming no default
– Payoff on default
For a face value hedge the CDS and bond notionals are set equal. For an expected
recovery hedge the CDS notional N is set such that the payoff in default is zero
ie N (1-R) – P + R = 0.
Let’s concentrate on a negative basis trade. The carry is :
Carry = Proceeds of bond x (ASW+Repo Spread) – Notional on CDS x CDS spread
24
Carry on Negative Basis Trade
ASW
Coupon Proceeds of bond x Libor + ASW
Protection Investor
Seller Proceeds of Repo
Bond x Libor –
CDS Repo Spread
Notional x Coupon
Spread
Bond
For buyers of protection higher CDS notional leads to lower carry, all other things equal,
therefore the expected recovery hedge has highest carry if the bond is below par, the
face value hedge has the greatest carry for bonds above par.
For the P&L on Unwind, assuming no default, and assuming the basis hits zero at the
unwind date (bond becomes richer and CDS curve remains constant) : for a buyer of
protection higher CDS notional leads to lower P&L (same result as for carry), all other
things equal, therefore expected recovery hedge has highest P&L if bond below par,
face value hedge has greatest P&L for bonds above par).
P&L on Negative Basis Trade
ASW
Coupon Proceeds of bond x Libor + ASW
Protection Investor
Seller Proceeds of Repo
Bond x Libor –
CDS Repo Spread
Coupon
Notional x
Spread
(Nets Off)
Bond
For the payoff on default : Payoff on default = N(1-R) – P + R

N = CDS Notional, 1 = Bond Face Value, R = Recovery Rate, P = Initial Bond Proceeds
25
Payoff on Default for Negative Basis Trade
ASW
ASW Unwind
N(1– R) P + Repo Rate

Protection
Investor Repo
Seller
Defaulted
Bond
As most bonds are currently above par and defaults not generally expected, face value
hedges are likely to be more prevalent, see the figure below.
Hedge Rankings for Negative Basis Trades
Scenario Best Hedge Justification
Full Price Below Par, Default Not Expected Expected Recovery Hedge Highest carry and P&L on unwind
Full Price Below Par, Default Expected Face Value Hedge Highest payoff when default occurs
Full Price Above Par, Default Not Expected Face Value Hedge Highest carry and P&L on unwind
Full Price Above Par, Default Expected Expected Recovery Hedge Lowest loss when default occurs
Source : Global Markets, Quantitative Credit Strategy, 25 August 2004

Market Value Hedges are are also possible, where CDS notional is the same as bond proceeds, but these are always
outperformed by either face value or expected recovery hedges).
26
Hedge Rankings for Positive Basis Trades
Scenario Best Hedge Justification
Full Price Below Par, Default Not Expected Face Value Hedge Highest carry and P&L on unwind
Full Price Below Par, Default Expected Expected Recovery Hedge Highest payoff when default occurs
Full Price Above Par, Default Not Expected Expected Recovery Hedge Highest carry and P&L on unwind
Full Price Above Par, Default Expected Face Value Hedge Lowest loss when default occurs
Source : Global Markets, Quantitative Credit Strategy, 25 August 2004
27
CDS Forwards and Options
It is also possible to create forward CDS curves from spot CDS curves, analogous to
the way in which forward interest rates are created from yield curve data. We can then
compare the forward curve for a credit with the generic forward curve for the same
credit rating to see if there is a difference and if there might be trading opportunities.
The forward CDS Spread can be calculated as follows :
(CDS Spread2 x Risky PV012),- (CDS Spread1 x RiskyPV011)

Risky PV012 – Risky PV011
Where :
Risky PVf : Product of Riskless PVf and Survival Probability

Risky PV01 : Cumulative PVf
The table below shows the forwards calculated from the formula above.
Forward CDS Spreads

USD Swap Survival Risky Risky CDS Forward 1Y Forward 2Y Forward 3Y Forward 4Y Forward 5Y Forward 6Y Forward 7Y Forward 8Y Forward 9Y
Maturity Rates PVf Probability PVf PV01 Curve Maturities Maturities Maturities Maturities Maturities Maturities Maturities Maturities Maturities
0 1
1 1.47% 0.985513 99.14% 0.9770 0.9770 52
2 2.06% 0.959924 96.81% 0.9293 1.9064 97 144
3 2.66% 0.923681 93.26% 0.8614 2.7678 138 229 185
4 3.13% 0.882572 89.06% 0.7860 3.5538 170 283 254 215
5 3.50% 0.839315 84.96% 0.7131 4.2669 190 290 286 265 231
6 3.84% 0.793245 81.75% 0.6485 4.9154 196 235 264 271 259 232
7 4.01% 0.753862 78.34% 0.5906 5.5059 203 261 248 263 269 259 236
8 4.16% 0.714914 75.23% 0.5378 6.0438 207 248 255 248 260 265 258 237
9 4.29% 0.676963 72.10% 0.4881 6.5319 211 261 254 257 251 260 265 258 239
10 4.39% 0.641281 68.78% 0.4410 6.9729 216 290 275 265 264 257 264 267 261 243
 Go to spreadsheet ‘Credit Derivatives – Forward CDS‘ to see the
calculations.
The question the trader has to ask is this : Do I believe the evolution of the forward
curve ?
A pure forward trade would be to buy protection at one maturity and sell protection at
another using equal notionals. For example, buy 3Y protection, sell 5Y protection
synthetically creates selling two year protection starting in three years. For years 1-3
receive difference between 5Y and 3Y CDS spreads (carry). For years 4-5 pay 5Y CDS,
but expect to unwind before then.
Outright forwards are possible in some markets, but there are often liquidity problems.
Also, there can be wide bid-offers, around 5bps for 5Y CDS, and 10bps or more for
other maturities, meaning that significant curve changes would be necessary for the
trade to make money.
28
It is possible to trade the shape of the curve, as opposed to a specific forward rate. If
the curve is too steep then buy three year protection and sell five year protection. The
notionals of each leg should be weighted such that the trade is immunised against
parallel shifts in the credit curve. For example, the three year leg should be weighted
by the relative risky PV01’s of the three and five year legs, 4.2576/2.7668 = 1.54 (these
data come from the forward table explained in more detail below). This gives PV01
neutral two year short protection stating in three years.
Note that the forward CDS spread depends on the level and slope of the CDS curve. A
steeper and/or higher spot CDS spread will result in a higher forward CDS spread.
Credit Spread Options
A ‘Payer’ Swaption is the right to buy protection on an index or credit. It can be thought
of as a put on the forward credit price or a call on the forward CDS spread.
Other features are : European exercise, premium is paid/received upfront, maturities

tend to be 3-6 months, strikes are often at-the-money although others are possible,
physical delivery upon exercise. Upon exercise parties enter into a standard default
swap on index or single name. Index options allow for exercise if credit events occur
before expiry, whilst single name options knock out if a credit event occurs prior to
expiry.
Payer Swaption
payout
Forward
CDS
Spread
A ‘Receiver’ option is the right to sell protection on an index or credit. It can be thought
of as a call on the forward credit price or a put on the forward CDS spread.
Receiver Swaption
payout
Forward CDS
Spread
29
The market for trading volatility on credit spreads has been developing rapidly, with
markets now existing in trading options on credit indices, and a focus on options to
express volatility views as well as directional credit bets.
So, here’s a simple model to price CDS swaptions. It is basically the Black model for
pricing options on forward prices. Here is the VBA code for pricing it :
Function Swaption(ForwardSwap, Strike, Volatility, PVfSum, ValueDate, ExpiryDate, PayOrReceive)

Dim Time As Single
Dim D1 As Single
Dim D2 As Single
Dim OptVal As Single
Time = (ExpiryDate - ValueDate) / 365
D1 = (Application.Ln(ForwardSwap / Strike) + (Volatility ^ 2 * Time / 2)) / (Volatility * Sqr(Time))
D2 = D1 - Volatility * Sqr(Time)
OptVal = PayOrReceive * ForwardSwap * Application.NormSDist(PayOrReceive * D1) - PayOrReceive
* Strike * Application.NormSDist(PayOrReceive * D2)
Swaption = OptVal * PVfSum
End Function
Here we price up 1 year into 5 year payers and receivers swaption (ie the right in one
year’s time to enter into a five year CDS) on Ford. These knockout if there is a credit
event before expiry of the option. So, payers and receivers swaptions would be 2.67%
(note they are the same price because the strike is at-the-money).
Forward CDS Spread 231.67

Strike 232
Volatility 75%
PV01 3.9443214
Value Date 28/09/2004
Option Expiry Date 28/09/2005
Option to Buy Protection : Payer Swaption 267

Option to Sell Protection : Receiver Swaption 267
 Go to spreadsheet ‘Credit Derivatives‘ – CDS Swaptions’ to see the
calculations.
30
In theory, a knockout payer swaption should be delta hedged with a short protection
CDS to the final maturity of the underlying CDS and a long protection CDS to the
default swaption expiry date. This produces a synthetic forward CDS that knocks out at
default before the expiry date. However, CDS with short maturities tend to still have low
liquidity, so swaptions with expiry of one year or less (the majority) are hedged only with
CDS to final maturity (as mentioned earlier, there are also liquidity issues with outright
forwards).
The market for trading volatility on credit spreads has been developing rapidly, with
active markets in trading of options on credit indices and a focus on options to express
volatility views (see the straddles in the figure below) as well as directional credit bets.
The liquidity of the credit volatility market has benefited from several factors : increased
liquidity in the underlying product, i.e. single name CDS and index products; better
understanding of credit spread volatility and modelling approach; the increased demand
for credit options as part of an integrated credit trading strategy.
Straddle on Index, Long Vol Straddle on Index, Short Vol
Buy Buy
Receiver Payer
Sell Sell
Receiver Payer
Constant Maturity Credit Default Swaps (CMCDS)
The premium in the first year is X% of the 5 year spot CDS spread, subsequent
premiums are reset at a pre-determined frequency (quarterly, semi-annually), to X% of
the then spot 5 year spread.
X% is known as the ‘participation rate’ and stays constant.
Selling CMCDS protection provides spread income plus the upside to spread
widening/curve steepening (whilst still taking default risk ie long credit) – the best
analogy is fixed bonds versus FRN’s, CDS versus CMCDS.
CMCDS should be used when spreads are tight, there are flat curves and vol is low
ie Now !
CMCDS generally provide higher spread income than short-dated risk and lower MTM
volatility compared to a plain vanilla CDS. Note that the maturity of the contract and the
maturity of the CMCDS reference rate need not be the same.
31
CMCDS Spread Setting Process
Constant 5 Year CDS maturity set every period

bps
18 months forward
12 months forward
6 months forward
Spot CDS Curve
1 5
Maturity (years)
Consider the example of Ford Motor Company (F):

Investor View
Is it likely that F will default within the next 5 years? NO
Is it likely that F CDS spreads tighten further relative to historical levels? NO
Is it likely that F CDS spreads will widen within the next year or so? YES
The investor can sell CMCDS protection on F at 74% of the 5yr spread = 230bps * 0.74
= 171bps.
By selling CMCDS protection the investor benefits from potential future spread widening
through spread reset.
32
Ford CDS Curve Vs Forwards

CDS Curve Vs Forwards
300
250
200
CDS Curve
bps
150
Constant Maturity 5Y
100
50
0
1 2 3 4 5 6 7 8 9 10 11
Years
Pricing a CMCDS means finding the fair participation rate. The payoff on the loss leg of
a CMCDS is identical to the payoff on the loss leg of a plain vanilla CDS, so the spread
legs on both instruments must be equal too :
CMCDS Spread Leg x Participation rate = CDS Fixed leg
Let’s assume the CMCDS spread leg can be priced using the forwards, then the
participation rate becomes :
Participation Rate = CDS Spread

Average of Forward CDS Spreads
If the CDS curve is flat, the forwards equal spot and the participation rate will equal 1.
If the CDS curve is upward sloping, the forwards will be higher than spot and the
participation rate will be lower than 1.
If the CDS curve is downward sloping, the forwards will be lower than spot and the
participation rate will be higher than 1.
CDS Forward 5Y 1 x 5 CMCDS 2 x 5 CMCDS 3 x 5 CMCDS 4 x 5 CMCDS 5 x 5 CMCDS

Maturity Curve CDS Spread Participation Participation Participation Participation Participation
0
1 52 190 0.27 0.46 0.61 0.72 0.79
2 97 232
3 138 259 1st Year 1st Year 1st Year 1st Year 1st Year
4 170 265 Spread Earned Spread Earned Spread Earned Spread Earned Spread Earned
5 190 260 52 87 116 137 150
6 196
7 203
8 207
9 211
10 216
33
 Go to spreadsheet ‘Credit Derivatives‘ – CMCDS’ to see the calculations.
The participation in the CMCDS depends on the shape of the curve. Steeper curves
typically have lower participation levels whilst inverted curves typically imply a
participation greater than 100%. For example, the figures below show the CDS curves
for Lafarge and Corus and their participation levels.
Lafarge Credit Curve (5y Lafarge CMCDS: 60%)
0.7%
0.6%
0.5%
0.4%
0.3%
0.2%
0.1%
0 2 4 6 8 10 12 14
Corus Credit Curve (5y Corus CMCDS: 102%)
8.1%
7.1%
6.1%
5.1%
4.1%
3.1%
2.1%
1.1%
0.1%
0 2 4 6 8 10 12 14
For views solely on credit spreads widening and/or steepening the trade would be to
sell CMCDS protection, buy CDS protection, which gets rid of default risk.
The CMCDS technology can be applied to the entire continuum of credit derivative
products, single name credits, capped CMCDS, first-to-default baskets, credit indices,
credit portfolios.
34
Credit Indices
The Dow Jones Indices have become the de facto indicators for the synthetic credit
default swap market. The DJ indices represent the merger of two leading indices in
June 2004 (iBoxx and DJ TRAC-X). Here are (some) of the indices available :
CDX.NA.IG 125 US names

iTraxx Europe 125 names
iTraxx Asia (ex Japan) 30 names (plus sub-indices for Korea, Greater China and
other countries) The Dow Jones iTraxx Indices have become the de facto indictor
for the synthetic credit default swap market. Represents the merger of two
leading indices in June 2004 (iBoxx and DJ TRAC-X).
iTraxx Japan 50 names
iTraxx Australia 25 names
The figure below shows the main users of the indices.
Who’s Using the Indices?
Asset Managers Hedge Funds Bank Prop Desks

 Quick credit  Relative value  Relative value
exposure trades trades
 Liquidity  Efficient tool for  Efficient tool for
Management tool directional trading directional trading
Bank Portfolio Correlation Corporate Insurance

Managers Trading Desks Treasury Companies
 Suitable for  Suitable for  Easy access to  Proxy hedge
portfolio balancing portfolio hedging diversified US risk against senior
CDO credit
 Credit  Easy ramp-up
portfolio
diversification tool
For investors that do not have the credit resources to fully research a large number of
names one approach would be to sell protection on one of the broad indices and
concentrate credit analysis on sectors or names that might offer the prospect of superior
returns, such as the high yield sector.
The DJ indices allow investors to trade sector exposure in large size. This could include
strategies where single name risk is hedged out to create specific baskets. For
example, an investor could sell protection on the HVOL index and buy protection on
names that are deemed to be above a particular level of risk (or those names marked
down as ‘underweight’ by DB research. In addition, investors could sell extra protection
on names which are expected to outperform (eg those which DB research has placed
on an ‘overweight’ recommendation) in order to generate extra spread income.
Some traders take views on the indices according to the difference between the fair
value spread and the actual spread on the index (known as the index basis). The fair
value spread is that implied by the spread on the underlying names (calculate the NPV
for each CDS in the index, add them up and reverse out one spread that equates to the
aggregate NPV – DB research also makes an adjustment for the ‘no restructuring’
clause of an index by taking 5% off the spread, and adjusting for maturity mismatch of
around 1bp per quarter).
35
The basis between the index and the underlying names is taken as an indicator of
relative richness/cheapness of the index. If the basis (index spread – fair value spread)
is positive the index is cheap to the underlying names. A negative basis means that the
index is rich relative to the underlying names. The basis itself is rarely traded because
of the difficulty of trading 125 names given the liquidity and transactions costs.
Generally a directional position is simply taken in one of the indices.
First-to-Default Basket Default Swaps
Basket default swaps can be used to buy and sell protection on baskets of securities or
portfolios of assets, where default protection is traded on each of the constituent
securities or loans in the portfolio. In the figure below Deutsche Bank makes periodic
payments for default protection on a basket of four securities and receives a contingent
payment when any reference credit in the basket experiences a credit event, at which
point the swap terminates.
First-to-Default Basket Default Swap Structure
Security 1
Security 2
Contingent
payment
Deutsche
Seller Security 3
Bank
(Buyer)
Fee
Security 4
The seller gains higher payments than on a single security of the same credit quality but
the seller’s risk is limited to the market loss that follows a credit event on a single
security in the basket. First-to-Default baskets are considered in more detail in the CDO
materials as they are basically correlation products. The figure below shows how first,
second and third to default baskets are priced in relation to varying correlation between
the names in the baskets.
Correlation Versus Pricing for Default Baskets

NB – implicit ceiling on price of baskets : dealers unwilling to
pay more than about 85% of the sum of spreads)
100%
Basket
Spread as First-toDefault
% of Sum
of Spreads
Second-to-Default
Third-toDefault
0%
0% Training Correlation 36 100%

Global Markets
A good way of thinking about FTD baskets and correlation is to compare them with the
various tranches on a CDO. The equity is similar to first-to-default, mezzanine like
second to default, and senior like third to default (in simple, relative terms). You can
immediately see that the figure above is very similar to the figure in the right hand
corner below.
With low correlation the assets are more or less independent and there is a low
probability of large losses, low probability of zero losses – spread on senior tranche
(third, fourth, fifth to default etc) is small, spread on equity tranche (first-to-default) is
large.
For medium correlation the assets are more likely to default together and the
distribution of the tail is longer – more risk in senior tranche, larger senior spread
(third,fourth, fifth to default etc) than before; probability of zero losses has increased,
equity less risky and equity spread (first-to-default) smaller than before.
Finally, for high correlation the portfolio behaves like one asset with zero diversification,
the names either all default or all survive. The probability of a large number of losses is
significant, the spread required to hold the senior tranches (third, fourth, fifth to default
etc) is relatively large; probability of zero losses is very high so equity spread (first-to-
default) is small.
Medium correlation lower equity
Low correlation, high equity returns,
returns, higher senior returns
low senior returns 35.00%
20%
Probability
Probability
Probability
18% 30.00%
Probability
16%
Probability
25.00%
14%
12% 20.00%
10%
15.00%
8%
6% 10.00%
4%
5.00%
2%
0% 0.00%
0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% 44% 48% 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% 44% 48%
Portfolio Loss (%)
Portfolio Loss (%)
Correlation and Tranche Spreads

High correlation, lowest equity returns,
highest senior returns 25.00%
80.00%
70.00% 20.00%
Probability
60.00%
Spreads (%)
15.00% Equity
50.00%
Mezzanine
40.00% Senior
10.00%
30.00%
20.00% 5.00%
10.00%
0.00%
0.00% 10% 20% 30% 40% 50% 60% 70% 80%
0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% 44% 48%
Default Correlation
Portfolio Loss (%)
37
Implied correlations for standardised baskets as of September 2004 are given in the
table below for comparative purposes.
Basket Correlation (1/09/04)

Consumer 28%
Industrial 24%
Financial 51%
Energy 38%
TMT 34%
HVOL 23%
Standardised FTD baskets are a new development to the market (summer 2004).
Sixteen dealers have undertaken to make markets in the standardised US baskets
listed above. Each basket has five corporate names in it, and average bid-offers at DB
are 25bp (a lot tighter than before the standardisation came about). For credit views
investors can buy/sell straight FTD protection (there will still be a correlation element
here, but it can be said that the credit view dominates). For correlation views investors
can buy/sell FTD protection and delta hedge (this eliminates default risk and
concentrates on the correlation element). Here are some relationships/terminology to
remember :
Buy FTD and delta hedge : short correlation (expect correlation to fall)
Sell FTD protection and delta hedge : long correlation (expect correlation to rise)
For correlation trades the key drivers are idiosyncratic single name credit spread
movements (lower correlation) and economy/industry wide risks (higher correlation).
Here’s a good example of correlation trading with FTD baskets. In July 2003, Sears sold
its credit card unit and Sears spreads subsequently tightened on the market relief. At
the same time, Altria, also in the Consumer basket of five names, suddenly faced
litigation threats, leading to a big widening of Altria spreads. Spread correlation for the
basket fell (see the figure below). These are ‘idiosyncratic’ risks that reduce correlation.
Consumer FTD basket Spread Correlation
Spread Correlation
40%
Consumer FTD Basket

30%
20%
10%
0%
Jul03 Nov03 Apr04
38
Equity Default Swaps (EDS)
EDS offer the opportunity to trade/invest in a credit-like instrument without the need to
deal with the complexities of the ISDA credit derivatives conventions (this can be
especially attractive for retail investors and equity derivatives investors) as EDS are
documented under ISDA 2002 Equity Derivative definitions rather than ISDA Credit
Derivative definitions.
An EDS trigger even” is based on the performance of the underlying share price,
typically a 70% fall in the share price. An EDS has fixed recovery in the case of a trigger
event, usually 50% of notional.
For fixed-income investors, EDS enable access to an entirely new segment of the
continuum of corporate risk, in a familiar CDS format.
For equity investors, EDS provides the ability to tap into a part of the volatility surface
that previously did not trade with any material liquidity
In particular, EDS offer a wide range of opportunities to extract value from the equity
versus credit market.
In the figure below you can see that a buyer of EDS protection pays a running premium
on the notional to protect against the occurrence of a trigger event. The seller of EDS
protection pays 0% if there is no trigger event or [Par - Recovery] if there is a trigger
event. A trigger event occurs if the stock price of the underlying reference entity ever
closes below the barrier level set at the inception of the contract.
Equity Default Swap Mechanics
Contingent
Payment on
Trigger Event
Buyer of EDS protection Seller of EDS protection
Running
Premium
The tables below show a comparison between a CDS on siemens and an EDS on
siemens. Clearly, EDS spreads are a lot higher, reflecting the higher probability of the
share price dropping by 70% compared to the probability of default.
39
Siemens Credit Default Swap

Reference Entity : Siemens AG
Reference Notional : EUR [10,000,000]
Scheduled Maturity : 5 years
Spread : 26 bp
Trigger : (1) Bankruptcy

(2) Default
(3) Restructuring
Redemption : 100% (ie EUR10m) or Recovery Value
Siemens Equity Default Swap
Reference Entity : Siemens AG
Reference Notional : EUR [10,000,000]
Scheduled Maturity : 5 years
Spread : 102 bp
Trigger : 70% drop in the Share Price
Redemption : 100% or 50% (ie EUR10m or EUR5m)
EDS are available in note format and in first-to-default or nth-to-default contracts. For
some investors, simple relative-value trades are becoming popular :
Sell EDS protection and

Buy CDS protection
For a broad universe of names, this is a massively positive carry position where the
investor is “proxy-hedging” the EDS exposure with CDS protection.
If the investor believes that credit spreads and equity prices are negatively correlated,
then if equity prices go down the investor will lose money on the EDS but make some of
it back through the CDS (on a MTM basis). The CDS protection can be purchased on a
larger notional than the EDS protection sold, due to the large EDS-CDS basis, and still
allow for a positive carry.
For the Siemens EDS/CDS positions above, the positive carry would be 102bp - 26bp =
76bp. Net Payment should the equity price collapse by more than 70% would be EUR
5,000,000 - (Value of CDS)
Let’s assume a recovery assumption for the CDS of 30% (Trader receives EUR 7m if
Siemens AG triggers a credit event).
40
The maximum gain: Should Siemens AG default, then the Trader would make :
(EUR5 m) + EUR 7m = EUR 2m
The maximum loss: Should the CDS not be worth anything the trader would lose :
(EUR 5m) + EUR 0m = (EUR 5m)
Credit Linked Notes
This section explains how credit linked notes (CLN’s) are structured and their attraction
to investors. CLN’s are typically issued by corporates or banks, often through a medium
term note or structured note programme. A CLN is a structured note that combines a
debt product and an embedded credit derivative (typically a credit default swap).
In the figure below the investor in the CLN receives interest that is enhanced by the
default premium received for selling credit protection. If a credit event occurs on the
reference asset, the note typically matures immediately and the investor takes a loss of
principal based on the loss on the reference asset.
Credit Linked Note (Embedded Credit Default Swap)
Contingent Payment Proceeds
Default Issuer CLN

Swap (DB) Investor
Buyer
Periodic Fee (bps) Interest, Default Premium
Interest Rate
Swap, Currency
Swap etc (DB)
The issuer is simply trying to reduce its cost of funds. It does this by buying the default
protection embedded in the note and then selling that protection to Deutsche Bank. The
difference between the value of the credit default swap embedded in the note and the
credit default swap sold to Deutsche creates the reduced cost of funding for the issuer.
The notes are typically issued by highly rated corporates or banks, with an embedded
default swap on another (typically lower rated) reference entity.
A variety of investors simply are not allowed to enter into credit derivatives or other off-
balance sheet products. CLN’s are on-balance sheet instruments and therefore tend not
to be caught by these restrictions. These investors can therefore gain access to the
credit derivative markets via CLN’s (an anomaly, certainly, but the sort of anomaly that
drives many markets).
CLN’s, like plain credit default swaps, can also be customised such that they create
maturities and credit features that may not otherwise be available in other markets.
41
CLN’s may be rated by one of the agencies. The rating is based on the embedded
default swap and the credit of the CLN issuer.
Some investors are wary of buying CLN’s directly because of the counterparty credit
risk involved. They therefore prefer to buy credit linked notes structured by banks via
bankruptcy-remote special purpose vehicles (SPV’s – see repackaging below).
Insurance companies and retail investors tend to buy Credit Linked Notes in the form of
Principal Protected CLN’s. With these, there is a guaranteed full return of principal. If a
credit event occurs in relation to the reference security, the CLN remains outstanding
until its maturity date but stops paying interest. At maturity the CLN investor receives
the principal amount.
The investor is therefore partly protected from default under the reference security, but
still has the risk of principal loss if the issuer of the CLN defaults.
CLNs offer structural characteristics similar to cash instruments :
Notes can be structured with DB as the host asset (DB CD or MTN) via a shelf
program or with third-party collateral (AAA ABS) via an SPV or Trust
Return of principal is contingent upon a Credit Event of the Reference Entity or

the default of the host asset
Notes can pay a fixed or floating coupon, quarterly or semiannually
Notes are DTC/Euroclear eligible and generally 144A
Notes can be rated for an additional cost
42
How to create a tailored structured note :
Does client want exposure to a single name or a customized index or basket?

What maturity fits the client’s risk profile?
What are the client’s spread target/benchmark and investment guidelines?
Does client want exposure to a particular industry or set of industries?
Does client want exposure to a particular geographical region?
Does client have a rating requirement for credits in which it invests?
Does client need note rated by S&P and/or Moody’s?
Does client want a fixed or floating note? LIBOR or other base?
USD or foreign currency exposure?
How else can we customize the note to meet the needs of client – e.g. Can add
interest rate or FX overlay?
43
Appendix 1 : ISDA 1999 and 2003 Credit Derivative Definitions
The introduction of the 1999 ISDA Credit Derivative Definitions led to a reduction in
legal risk, greater standardisation of terms, faster execution and confirmation and
enhanced market liquidity and transparency for credit derivative market participants.
Further modifications have been made to the definitions in a number of Supplements,

following specific market events (notably the Conseco restructuring and the Railtrack
default).
The 2003 Definitions have adopted the various Supplements and also introduced new
terms and conditions that are a further step in the evolution of the credit derivative
market.
Notice of Physical Settlement
Protection buyers must notify the protection seller of the bond/loan it will deliver to settle
a triggered default swap contract. The provision also sets out explicit steps to be taken
if the buyer changes the deliverable, or is unable to deliver as scheduled. The overall
effect is to clarify that a protection contract is not subject to cancellation if timely delivery
cannot be made.
Business Day Convention
If a business day convention is not specified in the confirmation, the fallback will be
‘following’ instead of ‘modified following’. Under ‘following’ if a date falls on a non-
business day, an adjustment is made to the first following business day. Under ‘modified
following’ an adjustment is made to the first following business day unless that day falls
in the next calendar month, in which case it is adjusted to the first preceding business
day.
Quarterly Roll Date
Default swaps will generally have standardised matuirty dates falling on 20th March,
June, September and December, and the maturity date will roll over quarterly.
Effective Date
The effective date for a default swap is now the day following the trade date (T+1)
instead of the previous T+3 convention.
Restructuring
Market participants can choose Full Restructuring, where a reference obligation is

restructured so as to reduce the interest or principal due, delay interest payments or
extend the maturity date, become subordinated to another obligation. The multiple
holder obligation is standard, unless the counterparties agree to waive this provision.
Under the multiple holder requirement, an obligation must be held by at least four
unaffiliated holders and holders representing at least two-thirds of the principal balance
must consent to trigger a credit event.
44
The intention here is to exclude restructurings in connection with bilateral loans. Note
that a bilateral loan is still capable of being delivered, even if its restructuring cannot
trigger a restructuring credit event.
Supplementary definitions and provisions to the 1999 Definitions have been made in the
‘Restructuring Supplement’ to the 1999 ISDA Credit Derivatives Definitions,
subsequently adopted in the 2003 Definitions after full restructuring proved problematic.
These were constructed in the light of market dissatisfaction with the situation in the
Conseco case. In the Conseco situation, buyers of protection could deliver long-dated
bonds that were considerably cheaper than short-dated bonds. They therefore gained
significantly from the ‘cheapest to deliver’ option, even though they were not materially
worse off after the restructuring.
In the US, dealers started to charge a premium (10% to 15%) for CDS with restructuring
compared to CDS without restructuring. In Europe dealers continued to include
restructuring as a standard event.
In the Restructuring Supplement the guidelines for deliverable obligations following a

restructuring are as follows :
Restructuring Maturity Limitation (‘Modified Restructuring’ or ‘Mod-R’) – If

physical settlement and ‘Restructuring Maturity Limitation Applicable’ are specified in
the confirmation, and restructuring is the only credit event specified in a credit event
notice delivered by the buyer, then the maturity of the deliverable obligation is limited to
the earlier of the restructuring date plus thirty months, or the maturity of the restructured
obligations, subject to a general provision that the maturity limitation cannot be earlier
than the termination date of the default swap or later than thirty months following the
termination date.
The maximum maturity date is thus at a minimum the termination date, and may extend
to the earlier of the restructuring date plus thirty months or the termination date plus
thirty months.
Under the 2003 Definitions, mod-r is selected by choosing ‘Restructuring Maturity

Limitation and Fully Transferable Obligation : Applicable’
The changes are intended to prevent delivery of long-dated obligations that might be
trading at prices well below short-dated obligations. The idea is that the maturity of the
deliverable obligation should be consistent with the term of the protection contract.
Sellers can therefore reduce their exposure to the cheapest to deliver option that can
arise when the reference obligations of an entity have many different maturities and
hence many different values.
Furthermore, the selected delivered obligation must be freely transferable,

meaning that it is not subject to restrictions on who can hold it or to approvals from an
original lender before it can be transferred.
NB the restructuring definitions do not take into account statutory or regulatory

restrictions such as banking regulations that prohibit certain types of entities from
holding loans and/or bonds.
45
Mod-R proved to be too restrictive for many European banks, leading to the introduction
of so-called Modified Modified Restructuring, or ‘Mod Mod-r’. This eases mod-R in two
ways. The maximum maturity for deliverable restructured obligations is extended to the
earlier of the restructuring date plus sixty months or the termination date plus sixty
months. Non-restructured obligations are also deliverable but are subject to the thirty
month rule of Mod-R. In both cases the minimum maturity is the termination date of the
default swap contract.
Deliverable obligations can be conditionally transferable to banks and other entities that
make or invest in loans, with the stipulation that borrower consent for novation,
assignment, or transfer cannot be unreasonably withheld or delayed.
Under the 2003 Definitions, mod mod-r is selected by choosing ‘Modified Restructuring
Maturity Limitation and Conditionally Transferable Obligation: Applicable.’
It is of course possible to choose no restructuring (restructuring is not chosen as a

credit event) and credit events are then generally limited to failure to pay and
bankruptcy.
The US, Australia and New Zealand are expected to select mod-R with the multiple
holder obligation standard, Europe mod mod-R with the multiple holder standard, Japan
and Asia full restructuring without the multiple holder standard, Emerging Markets (ex-
asia) full restructuring including the multiple holder standard.
Credit Event Notice Upon Restructuring – parties may elect to partially

exercise credit protection following a restructuring credit event. In effect, more than one
credit event notice can be delivered.
eg a protection seller may have sold protection to two or more entities, and then hedged
the exposure by buying protection from a single seller. If some buyers do not trigger
upon restructuring, the seller would not have deliverable obligations to deliver under its
hedge without this provision.
However, if the credit event is not a restructuring event then the exercise amount must
be equal to the floating rate payer calculation amount (and not a portion thereof).
Pari Passu Ranking – any reference obligation in the context of a restructuring

will have its seniority determined as of the trade date or the date on which the obligation
was issued, without regard to any changes in seniority.
The objective here is to ensure that should a reference obligation be subordinated in a

restructuring the protection buyer can only deliver the reference obligation and not
some other subordinated security or loan.
Supplement Relating to Successor and Credit events to the 1999 ISDA Credit
Derivatives Definitions
ISDA has used this supplement to develop cutoff levels to determine how CDS
contracts should be allocated in a successor situation (merger, demerger, consolidation,
amalgamation, transfer). The Supplement has been adopted in the 2003 Definitions.
46
The original 1999 Definitions expected that successor events would result in an entity
that ‘assumes all or substantially all’ of the obligations of the original reference entity. It
did not anticipate a situation where a corporate might break itself up, as happened with
National Power (a UK utility company that split into Innogy Holding Plc and International
Power Plc).
The initial test will be 75%. If one entity succeeds to 75% or more of the relevant
obligations of the reference entity that are outstanding immediately prior to the
succession event, then that entity will be the sole successor.
If no entity meets the 75% test, then a ‘more than 25%’ test will be used.
If only one of the surviving entities succeeds to more than 25% of the relevant
obligations, this entity will be the sole successor.
If one or more entities succeeds to more than 25% of the relevant obligations then the
transaction will be divided into separate transactions for each of these entities and the
notional amount evenly divided among them. The division will be done evenly between
the contracts to avoid odd-sized contracts and disputes as to exact proportions.
If no successor meets the 25% test then the G6 committee recommends turning to the
original reference entity. If the original reference entity remains in existence, regardless
of the amount of the relevant obligations it has succeeded to, then there will be no
successor and the transaction will not change.
If the original reference entity no longer exists and no entity succeeds to 25% of the
relevant obligations then the entity that succeeds to the greatest percentage of bonds
and loans of the original reference entity will become the sole successor. If, however,
two entities succeed to equal portions of the bonds and loans then the one that
succeeds to the greatest percentage of obligations will be the sole successor.
It is still possible for an investor to reference a specific obligation as deliverable in the

CDS, making it a ‘single stock trade’.
The 2003 Definitions also now include spin-off as a succession event.
The Successor Supplement also clarified the currency of payment definitions. In the
original 1999 Definitions, any currency switch would trigger a restructuring event.
Now, any change in the currency or composition of any payment of interest or principal
to any currency that is not a Permitted Currency will be defined as a restructuring.
Permitted Currency is defined as a currency from a G7 member country or that of a
country that has a long-term debt rating equal to or more favourable than AAA from
S&P, Aaa from Moody’s, and AAA from Fitch IBCA. These currencies are sufficiently
liquid to be interchangeable without causing a credit event.
The Obligation Default has largely fallen into disuse by the market (it captures default
situations other than failure to pay, where an obligation is in technical default, eg
perhaps due to a violation of covenants).
47
Obligation Acceleration refers to situations where an obligation has been accelerated for
technical reasons other than bankruptcy or non-payment (eg violation of covenants).
Typically, loans or obligations are rarely accelerated unless default is close.
The US market currently tends to exclude both Obligation Default and Obligation
Acceleration, whereas the European market tends to include Obligation Acceleration.
ISDA is taking this stance because Obligation Default and Obligation Acceleration can
be triggered even though the reference entity has the ability and willingness to meet the
original terms of the obligation. ISDA is therefore trying to exclude from the definitions
events that are some distance away from outright default.
The Successor definitions are widely used globally.
Supplement to the 1999 ISDA Credit Derivatives Definitions Relating to

Convertible, Exchangeable or Accreting Obligations.
Issues arose in the credit derivative market following the placing of Railtrack into
Administration in October 2001 (Railtrack is the infrastructure owner of Great Britain’s
railway system).
Protection buyers delivered the 3.5% 2009 convertible as it was the cheapest to deliver
(trading at around a 15 point discount to other Railtrack obligations). The CB was
trading at a discount because the government had announced that it was cutting off
equity holders, resulting in the CB trading at its bond floor, whilst the government
continued to service straight Railtrack debt. With a 3.5% coupon, the CB was at a large
discount to straight Railtrack bonds once the equity conversion option had been taken
away.
Protection sellers pointed out that the 1999 definitions disallowed ‘contingent securities’
as deliverable obligations and therefore questioned the ability of buyers of protection to
deliver CB’s. In the Supplement on convertibles, adopted in the 2003 Definitions, ISDA
indicated that convertibles, along with exchangeable, or accreting bonds, could be
delivered into CDS even if the ‘Not Contingent’ condition had been specified. ie
convertibles do not count as ‘contingent securities’ and are deliverable obligations. The
key point is that the convertible/exchangeable feature must be solely at the investor’s
discretion, and that it not have been exercised.
Emerging Markets
Repudiation/Moratorium – the 1999 definitions have been expanded to clarify that a

repudiation/moratorium must be declared by an authorised officer of the reference entity
or appropriate government authority and it must be accompanied by a failure to pay or
restructuring.
48
Appendix 2 : Total Return Swaps and Credit Spread Options
Total Return Swaps
Total Return Swaps (TRS) allow investors to exchange the total economic returns of an
asset for fixed or floating interest payments or vice versa. They provide a synthetic
method to access off balance sheet assets or manage portfolio risk more efficiently.
Total return swaps give clients exposure to particular sectors without incurring the costs
of ownership and administration of the underlying assets. They optimise the efficiency
of capital by achieving exposure to market and credit risk with reduced transaction,
administrative and taxation costs.
In many markets TRS can lock in term financing costs more efficiently than repos. It
also allows the investor to finance an asset for which there is no traditional repo market.
Total Return Loan Swap Structure
Libor + Spread
Coupon +
Funding Deutsche Appreciation Investor
Source Bank
Libor-spread
Depreciation
Total
Return
Bond/Loan
The TRS gives protection against the risk of portfolio assets without removing them
from the balance sheet. Of course, the return payer need not hold the asset on its
balance sheet to enter into a TRS - the TRS then allows the payer to short the asset.
In a TRS there is no exchange of principal or exchange of ownership. TRS can be

settled for cash or by physical delivery. If it is to be cash settled the market value is
established by polling a group of dealers.
Credit Spread Options
Options on credit spreads allow investors to isolate credit risk from market risk and to
express a view about an asset’s credit risk profile in the future. They can be used to
49
earn premium income to profit from spread tightening or widening and to buy securities
on a forward basis at favourable prices.
Credit spread options are normally written on bonds. The spread or yield differential
represents the risk premium the market demands for holding the issuer’s bonds.
Spread calls make money from decreasing spreads (bond values rise if yields fall).
Spread puts make money from widening spreads (bond values fall if yields rise).
Maturities are usually between six months and two years and are settled in cash or
through delivery of the bond.
Essential Reading :
Credit Derivatives and Structured Credit, Deutsche Bank Global Markets Research,
August 30 2001.
2003 ISDA Credit Definitions, Deutsche Bank Global Markets Research, June 13th 2003
‘Trading Forward Spreads : Where is the Value ?’ DB Global Markets Research, July
2004
CMCDS : The Path to Floating Credit Spread Products’ DB Global Markets Research,
March 2004
‘Trading the CDS-Bond Basis’ DB Global Markets Research, August 2004
‘Equity Default Swaps : A Primer’ DB Global Markets Research, February 2004
50
☺
That’s the end of the session (at last !) You should now :
Understand the mechanics of credit default swaps
Understand the pricing of credit default swaps
Know the key users of default swaps
Be aware of the links between credit derivatives and synthetic CDO’s
Be able to explain constant maturity credit default swaps
Be able to explain equity default swaps
Be able to identify bond/default swap relative value opportunities
Confused ? email Mike Pawley at michael.pawley@db.com
This publication is for internal use only by Deutsche Bank Global Markets employees. The material
(including formulae and spreadsheets) is provided for education purposes only and should under no
circumstances be used for client pricing. Examples, case studies, exercises and solutions may use
simplifying assumptions that do not apply in practice, and may differ from Deutsche Bank proprietary
models actually used. The publication is provided to you solely for information purposes and is not intended
as an offer or solicitation for the purchase or sale of any financial instrument or product. The information
contained herein has been obtained from sources believed to be reliable, but is not necessarily complete
and its accuracy cannot be guaranteed.
51

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Product Profitability High

Product Complexity Medium-High

Well, at the end of this session you should :

Understand the mechanics of credit default swaps

Understand the pricing of credit default swaps

Know the key users of default swaps

Be aware of the links between credit derivatives and synthetic CDO’s

Be able to explain constant maturity credit default swaps

Be able to explain equity default swaps

Be able to identify bond/default swap relative value opportunities

Basic bond maths

Simple repo applications.

Credit derivatives are bilateral contracts tied to the performance of an underlying

Credit Default Swap Structure

So, what are the motives of the counterparties ?

Default Swaps As Dynamic Products

Increased Fee required by

Ford 5Y CDS Spread History

Ford Motor Credit 5Y CDS

Ford and GM 5Y CDS Spread History.

If buying protection, we have the following figure :

Credit Default Swap Pricing : Buying Protection and Hedging, No Default

Float (Libor + Asset Swap Spread)

Net Position = Asset Swap Spread + Repo Spread – Fee

Cash Flows For Deutsche Bank (No Default)

If there is a default, we have the following figure :

Buying Protection and Hedging, Default Occurs

PV of Interest Rate Swap

The net position is thus the PV of the interest rate swap.

Cash Flows For Deutsche Bank (Default Occurs)

CDS Bond Delivered at Par

American Express Pricing Information

USD Asset Default Breakeven Repo Repo

Net Position = Asset Swap Spread + Repo Spread - Fee

Credit Default Swap Pricing : DB Buys Protection and Hedges, No Default

Float (L+17= 5.17%)

Event Default Swap Fee

Credit Spread Widens : Up

Credit Default Swap Pricing : DB Sells Protection and Hedges, No Default

Float (L+Asset Swap Spread)

Net Position = Fee – Asset Swap Spread - Repo Spread

Cash Flows For Deutsche Bank (No Default)

Default Swap : Fee

Alternatively, we could calculate it as :

Net Position = Fee – Asset Swap Spread - Repo Spread

= 42 – 28 - 25 = (11) negative carry

Credit Default Swap Pricing : DB Sells Credit Protection, No Default

Float (L+28 = 5.28%)

Credit Default Swap Pricing Using Swap Methodology

Calculating Default Probabilities from CDS

PV Floating (contingent payment) Leg =

60% x [(Prob of Default1 x PVF1) + (Survival Prob1 x Prob of Default2 x PVf2) +

PV Fixed Leg = PV Float

 Go to spreadsheet ‘Credit Derivatives‘ – Default Probs’ to see the

CDS Basis Trades

More formally, the basis is shown below :

Basis = Protection Bid – Bond Offer

Taking on Credit Risk : Choices

Sell Protection Buy Bonds

Works when basis is wide (positive)

Protection Pickup For Various Credits

Protection Cash Bond Asset Protection