Credit Derivatives Handbook - Acting Man

1 Corporate Quantitative Research New York, London December, 2006. Credit Derivatives Handbook Detailing Credit default swap products, markets and trading strategies About this Handbook This Handbook reviews both the basic concepts and more advanced Corporate Quantitative Research trading strategies made possible by the Credit Derivatives market. Readers seeking an overview should consider Sections - , and Eric Beinstein AC. (1-212) 834-4211. There are four parts to this Handbook : Andrew Scott, CFA. Part I: Credit default swap fundamentals 5 (1-212) 834-3843. Part I introduces the CDS market, its participants, and the mechanics of the Credit default swap.

2 This section provides intuition about the CDS Ben Graves, CFA. (1-212) 622-4195. valuation theory and reviews how CDS is valued in practice. Nuances of the standard ISDA documentation are discussed, as are developments in documentation to facilitate settlement following Credit events. Alex Sbityakov (1-212) 834-3896. Part II: Valuation and trading strategies 43. Katy Le Part II provides a comparison of bonds and Credit default swaps and (1-212) 834-4276. discusses why CDS to bond basis exists. The theory behind CDS curve trading is analyzed, and equal-notional, duration-weighted, and carry- neutral trading strategies are reviewed.

3 Credit versus equity trading European Credit Derivatives Research strategies, including stock and CDS, and equity Derivatives and CDS, are analyzed. Jonny Goulden (44-20) 7325-9582. Part III: Index products 111 The CDX and iTraxx products are introduced, valued and analyzed. Dirk Muench (44-20) 7325-5966. Options on these products are explained, as well as trading strategies. Tranche products, including CDOs, CDX and iTraxx tranches, Tranchlets, options on Tranches, and Zero Coupon equity are reviewed. Saul Doctor (44-20) 7325-3699. Part IV: Other CDS products 149. Andrew Granger Part IV covers loan CDS, preferred CDS, Recovery Locks, Digital default (44-20) 7777-1025.

4 Swaps, Credit -linked notes, constant maturity CDS, and first to default baskets. Yasemin Saltuk (44-20) 7777-1261. JPMorgan publishes daily reports that analyze the Credit derivative Peter S Allen markets. To receive electronic copies of these reports, please contact a (44-20) 7325-4114. Credit Derivatives research professional or your salesperson. These reports are also available on The certifying analyst(s) is indicated by a superscript AC. See last page of the report for analyst certification and important legal and regulatory disclosures. Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research Credit Derivatives Handbook December, 2006.

5 Andrew Scott, CFA (1-212) 834-3843. Part I: Credit default swap fundamentals ..5. 1. 2. The Credit default swap ..8. Credit Settlement following Credit events ..10. Monetizing CDS Counterparty considerations ..12. Accounting for CDS ..12. 3. Marking CDS to market: CDSW ..13. 4. Valuation theory and Credit curves ..15. Default probabilities and CDS The Shape of Credit Forwards in Risky Annuities and Risky Durations (DV01) ..23. 5. The ISDA Agreement ..24. Standardized The new CDS settlement CDX Note settlement procedures ..32. Old-fashioned CDS settlement procedures.

6 33. Succession events ..34. 6. The importance of Credit 7. Market participants ..40. Part II: Valuation and trading Decomposing risk in a bond ..44. Par-equivalent Credit default swap spread ..46. Methodology for isolating Credit risk in bonds with embedded 9. Basis Understanding the difference between bonds and Credit default swap spreads ..55. Trading the 10. Trading Credit Curves ..62. Drivers of P+L in curve Curve trading strategies ..70. 1. Equal-Notional Strategies: 2. Duration-weighted strategies ..76. 3. Carry-neutral Different ways of calculating slide ..82.

7 Calculating The Horizon Effect ..86. Changing Risky Annuities over the Trade A worked Horizon Effect Conclusion ..89. 2. Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research Credit Derivatives Handbook December, 2006. Andrew Scott, CFA (1-212) 834-3843. 11. Recovery rate and curve shape impact on CDS valuation ..90. Intuition ..90. CDS curve shape Recovery rate impact ..92. Assumptions at contract Worked examples ..94. 12. Trading Credit versus equity ..97. Relationships in equity and Credit markets ..97. Finding trade A worked trade 13. Trading CDS against equity Part III: Index products.

8 111. Introduction ..112. Mechanics of the CDX and iTraxx Basis to Comparing on-the-run and off-the-run basis ..114. Credit CDX and iTraxx indices ..116. History of US CDS 15. CDX and iTraxx Product description ..121. Basic option strategy payoff Using options to express a spread view ..122. Using options to express a volatility view ..122. Combining spread and volatility views ..123. Option trading The practical side to trading 16. Trading Credit volatility ..130. Defining Delta-hedging ..131. The returns from delta-hedging in Credit ..132. Historical Option 17. Tranche products.

9 136. What is a tranche?..136. Why are synthetic tranches traded? ..139. The mechanics of trading tranche The role of correlation ..142. Pricing tranches ..143. Other products ..145. Part IV: Other CDS products ..149. Overview ..150. Comparing CDS contracts across asset classes ..150. Similarities and differences between CDS and Participants ..154. Settlement following a Credit event ..154. Modifications to LSTA transfer documents ..156. 3. Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research Credit Derivatives Handbook December, 2006. Andrew Scott, CFA (1-212) 834-3843.

10 Rating agency approach to LCDS in structured Credit ..156. Spread relationship between loans and 19. Preferred Overview ..158. Preferred stock CDS contracts differ from the standard CDS PCDS versus CDS ..160. Overview of preferred stock issuance and 20. Profiting from views on recovery rates ..162. Recovery Rate Lock ..162. Digital Default 21. Other Credit default swap Credit linked Constant maturity Credit default swaps (CMCDS) and Credit spread swaps (CSS)..169. First-to-default baskets ..170. Conclusion ..171. Appendix I: JPMorgan CDSW Example Calculations Appendix II: How to get CDX and iTraxx data.