CREDIT DERIVATES: CDS & CDOspidi2.iimb.ac.in/~networth/CCS/2005/477 CCS-CreditDerivatives.pdf ·...

Contemporary Concerns Study ________________________________________________________________________

CREDIT DERIVATES: CDS & CDO

Current Research, Global Trends & Indian Prospects

Final Report

INDIAN INSTITUTE OF MANAGEMENT BANGALORE

Presented to: Prof. Ashok Thampy

Submitted By –

Atul Malik 0511079 Mayank Jain 0511238

Post Graduate Programme 2005-07

Contemporary Concerns Study

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Acknowledgements

We would like to express our sincere gratitude to all those who were instrumental in the

completion of the project.

Our sincere thanks to our guide: Professor Ashok Thampy, for giving us this opportunity to

complete this project under his guidance. We would also like to thank him for his

continuous guidance and support during the course of the project.

Atul Malik Mayank Jain (0511079) (0511238)


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TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION TO CREDIT DERIVATIVES......................................................... 3

CHAPTER 2: CREDIT RISK FRAMEWORK .............................................................................. 9

SINGLE NAME CREDIT DERIVATIVE PRODUCTS..................................................... 15

MULTI NAME CREDIT DERIVATIVES...................................................................... 28

BASKET DEFAULT SWAPS ...................................................................................... 29

CHAPTER 3: COLLATERALIZED DEBT OBLIGATIONS .......................................................... 31

CHAPTER 4: CREDIT DEFAULT SWAPS ............................................................................... 43

CHAPTER 5: CONSTANT PROPORTION PORTFOLIO INSURANCE .......................................... 51

CHAPTER 6: CDO STRUCTURING – INDIAN CONTEXT........................................................ 59

THE WATERFALL STRUCTURE OF THE DEAL.......................................................... 60

CONCLUSION...................................................................................................................... 67


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CHAPTER 1: INTRODUCTION TO CREDIT DERIVATIVES

Until recently, credit risk was one of the major components of business risk for which no

tailored risk-management products existed. Credit risk management for the loan portfolio

manager meant a strategy of portfolio diversification backed by line limits, with an

occasional sale of positions in the secondary market. Derivative users traditionally relied

on purchasing insurance, letters of credit, or guarantees, or negotiating collateralized

mark- to-market credit enhancement provisions1. Companies either carried open positions

on key customers’ accounts receivables or resorted to means such as factoring or

forfaiting. However, these strategies were largely inefficient because they do not separate

the management of credit risk from the asset with which that risk is associated. For

example, a corporate bond, which represents a bundle of risks including duration,

convexity, callability, and credit risk (both the risk of default and volatility in credit

spreads). If the only way to adjust credit risk is to buy or sell that bond, affecting the

positioning across the entire bundle of risks, there is a clear inefficiency. It is with this

background that Credit Derivative products have proved to be a significant innovation in

the management of both types of credit risk.

2

While interest rate derivatives introduced the ability to manage duration, convexity, and

callability independently of bond positions, credit derivatives complete the process of risk

management by allowing the independent management of default or credit spread risk.

Formally, credit derivatives are bilateral financial contracts that isolate specific aspects of

credit risk from an underlying instrument and transfer that risk between two parties.3 In 1 Introduction to Credit Derivatives, Danilo Zanetti, Zurcher Kantonalbank, October 7/14 2004 2 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


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so doing, credit derivatives separate the ownership and management of credit risk from

other qualitative and quantitative aspects of ownership of financial assets. Thus, credit

derivatives possess the potential to achieve efficiency gains through a process of market

completion. By separating specific aspects of credit risk from other risks, credit

derivatives allow even the most illiquid credit exposures to be transferred from portfolios

that have but don’t want the risk to those that want but don’t have that risk, even when

the underlying asset itself could not have been transferred in the same way.

Credit derivatives have fundamentally changed the way banks price, manage, transact,

originate, distribute, and account for credit risk. Yet, in substance, the definition of a

credit derivative given above captures many credit instruments that have been used

routinely for years, including guarantees, letters of credit, and loan participations.

Essentially, it is the precision with which credit derivatives can isolate and transfer

certain aspects of credit risk that distinguishes them from more traditional credit

instruments. There are a number of distinct arguments which suggest that these products

should be increasingly used by institutions that routinely bear credit risk. These are:

1. Reference Entity Argument: The Reference Entity is the party whose credit risk

is being transferred. It does not need to be a party to or even be aware of the credit

derivative transaction. This confidentiality enables banks and corporate treasurers

to manage their credit risks discreetly without interfering with important customer

relationships. The absence of the Reference Entity at the negotiating table also

means that the terms, such as tenor, seniority and compensation structure, of the

credit derivative transaction can be customized to meet the needs of the buyer and

seller of risk, rather than the particular liquidity or term needs of a borrower4.

Moreover, because credit derivatives isolate credit risk from relationship and

other aspects of asset ownership, they introduce discipline to pricing decisions.

Credit derivatives provide an objective market pricing benchmark representing

the true opportunity cost of a transaction. Increasingly, as liquidity and pricing

3 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group 4 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group


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technology improve, credit derivatives are defining credit spread forward curves

and implied volatilities in a way that less liquid credit products never could. The

availability and discipline of visible market pricing enables institutions to make

pricing and relationship decisions more objectively5.

2. Market Efficiency Argument: Credit derivatives are the first mechanism via

which short sales of credit instruments can be executed with any reasonable

liquidity and without the risk of a short squeeze6. It is more or less impossible to

short-sell a bank loan, but the economics of a short position can be achieved

synthetically by purchasing credit protection using a credit derivative. This allows

the user to reverse the “skewed” profile of credit risk (whereby one earns a small

premium for the risk of a large loss) and instead pay a small premium for the

possibility of a large gain upon credit deterioration. Consequently, portfolio

managers can short specific credits or a broad index of credits, either as a hedge

of existing exposures or simply to profit from a negative credit view. Similarly,

the possibility of short sales opens up a wealth of arbitrage opportunities. Global

credit markets today display discrepancies in the pricing of the same credit risk

across different asset classes, maturities, rating cohorts, time zones, currencies,

and so on. These discrepancies persist because arbitrageurs have traditionally

been unable to purchase cheap obligations against shorting expensive ones to

extract arbitrage profits. As credit derivative liquidity improves, banks,

borrowers, and other credit players will exploit such opportunities. The natural

consequence of this is, of course, that credit pricing discrepancies will gradually

disappear as credit markets become more efficient7.

3. Flexibility & New Markets Argument: Credit derivatives, except when

embedded in structured notes, are Off-Balance Sheet instruments. As such, they

offer considerable flexibility in terms of leverage. In fact, the user can define the

required degree of leverage in a credit investment. The appeal of off- as opposed

to on-balance-sheet exposure will differ by institution: The more costly the

5 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group 6 An Introduction to Credit Derivatives, Moorad Choudhry, London Guildhall University, 12 June 2002 7 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets


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balance sheet, the greater the appeal of an off-balance-sheet alternative. To

illustrate, bank loans have not traditionally appealed as an asset class to hedge

funds and other non-bank institutional investors for at least two reasons: first,

because of the administrative burden of assigning and servicing loans; and

second, because of the absence of an adequately liquid repo market. Without the

ability to finance investments in bank loans on a secured basis via some form of

repo market, the return on capital offered by bank loans has been unattractive to

institutions that do not enjoy access to unsecured financing8. However, by taking

exposure to bank loans using credit derivatives, a hedge fund can both

synthetically finance the position (receiving under the swap the net proceeds of

the loan after financing) and avoid the administrative costs of direct ownership of

the asset, which are borne by the swap counterparty9. The degree of leverage

achieved will depend on the amount of up-front collateralization required.

Thus, as we have seen, credit derivatives are a means of transferring credit risk between

two parties by way of bilateral agreements. Contracts can refer to single credits or diverse

pools of credits (such as in synthetic Collateralized Debt Obligations, CDOs, which

transfer risk on entire credit portfolios). Credit derivative contracts are over-the-counter

(OTC) and can therefore be customized to individual requirements. However, in practice

the vast majority of transactions in the market are quite standardized.

Within an economy a broad variety of entities have a natural need to assume, reduce or

manage credit exposures. These include banks, insurance companies, fund managers,

hedge funds, securities companies, pension funds, government agencies and corporate

entities. Each type of player will have different economic or regulatory motives for

wishing to take positive or negative credit positions at particular times.

8 Introduction to Credit Derivatives, Danilo Zanetti, Zurcher Kantonalbank, October 7/14 2004 9 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets


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Credit derivatives enable users10 to:

- hedge and/or mitigate credit exposure;

- transfer credit risk;

- generate leverage or yield enhancement;

- decompose and separate risks embedded in securities (such as in convertible bond

arbitrage);

- synthetically create loan or bond substitutes for entities that have not issued in those

markets at chosen maturities;

- proactively manage credit risk on a portfolio basis;

- use as an alternative vehicle to equity derivatives (such as out-of-the-money equity

put options) for expressing a directional or volatility view on a company, and

- manage regulatory capital ratios.

Conventional credit instruments (such as bonds or loans) do not offer the same degree of

structural flexibility or range of applications as credit derivatives. A fundamental

structural characteristic of credit derivatives is that they de-couple credit risk from

funding. Thus players can radically alter their credit risk exposures without actually

buying or selling bonds or loans in the primary or secondary markets.

Credit default swaps (CDS) are developing into an increasingly standardized means of

transferring credit risk – not just between entities but between different markets for risk.

CDS are the most important and widely used product in the credit derivatives market

while the growth of synthetic-CDO type products remains strong. Although default swaps

are in many ways similar to insurance policies there are important differences. For

example, an insurance policy typically requires an underlying insurable interest and

actual loss whereas credit protection can be bought whether or not the buyer has an

underlying risk exposure which needs hedging. In most countries insurance companies

have regulatory constraints limiting direct usage of derivatives. For this reason, many of

10 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series


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the credit derivative transactions are structured into Credit Linked Notes (CLNs) or

principal protected notes, which are collateralized by zero coupon bonds11.

The development of a deep and relatively liquid credit derivative market has the potential

to play an important role in efficiently allocating credit risk within economies. Arguably,

the differing capital adequacy requirements of different types of credit investor can

distort this efficient credit allocation. If this is the case then an effective and standardized

market for credit risk may tend to promote “capital efficient” in addition to “efficient”

allocation of credit12.

Market Participants

In terms of the types of market participants in the CDS space, the largest participants in

the market are banks, insurance companies and securities companies. The insurance

sector stands out as the dominant net seller of protection, absorbing a significant amount

of credit risk from banks, hedge funds and securities companies. However, a significant

proportion of the credit risk transferred to insurance companies by banks is in the form of

senior or super-senior tranches of synthetic CDOs which represents low-risk low-return

assets.

Banks are the dominant market users, and have particularly large market share as buyers

of protection. While initially focused on regulatory capital relief and portfolio

transactions, the focus is now arguably migrating to economic capital relief and single

name transactions, becoming selective sellers of protection and using the process to

facilitate primary market syndications13.

11 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 12 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 13 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group


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CHAPTER 2: CREDIT RISK FRAMEWORK

The commoditization and transfer of credit risk has been one of the major achievements

of the credit derivatives market. However, to be able to do this, we need a framework for

valuing credit risk. It is clear that the compensation that an investor receives for assuming

a credit risk and the premium that a hedger would need to pay to remove a credit risk

must be linked to the size of the credit risk. This can be defined in terms of the likelihood

of default (Probability of Default) and the size of the payoff or loss following default

(Recovery Rate)14.

Taking the example of one-year zero coupon defaultable bonds, let us assume that the

probability that the bond will default over the next year is p. If the bond defaults, we

assume that it has a recovery rate R, which is a fixed percentage of the face value. We

further assume that this recovery is paid at the maturity date of the bond. This can be

modeled as a simple binomial tree, as shown.

Here the price of the bond rP isky is the expected payoff discounted off the risk-free curve

with r is the one-year risk-free rate.

( )( )r1P 100 1 100

1isky p R p

r= × × + − ×

+

14 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


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Generally the market uses the LIBOR swap curve as the risk-neutral default-free interest

rate; since that is the level at which most market participants fund their hedges.

It is possible to show that one can accurately approximate

the credit spread using the credit triangle15 formula,

shown in the figure, which states that the annualized

compensation for assuming a credit risk, the credit

spread, S, is equal to the probability of default (per

annum), P, times the loss in the event of a default. For a

par asset, the loss is par minus the recovery rate R. This

simple formula is very accurate, and is a very powerful formula for analyzing credit

spreads and what they imply about default probabilities and recovery rates, and vice-

versa. Within the credit derivatives market, understanding such a relationship is essential

when thinking about how to price instruments such as fixed recovery default swaps. It is

also a very useful formula for examining relative value within the capital structure of a

company. Since cross default provisions mean that it is almost always the case that all of

the debt of a company defaults together, the only thing that differentiates between senior

and subordinated debt is the expected recovery in the event of default. All of the

company’s bonds, therefore, have the same default probability. Using this fact, one can

use the Credit Triangle to derive an equation expressing the subordinated “fair-value”

spread as a function of the senior spread and the respective recovery rates of the senior

and subordinated bonds.

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SUBSUB SENIOR

SENIOR

RS SR−⎛ ⎞= ×⎜ ⎟−⎝ ⎠

For example, if RSENIOR = 50%, RSUB = 20% and the senior LIBOR spread SSENIOR = 50

bp, this implies that the subordinate spread should be 80 bp. One should qualify this

result by noting that the LIBOR spread of a security may contain other factors such as

liquidity and credit risk premia. Nevertheless, this simple relationship does provide a

useful starting point for analyzing relative value.



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Empirical Studies of Recovery Rates16

The market standard source for recovery rates in the US is Moody’s historical default rate

Study. It shows how the recovery rate of a defaulted asset depends on the level of

subordination. There is usually a very wide variation in the recovery rate, even for the

same level of seniority. The recovery rates are not the actual amounts received by the

bondholders following the workout process. Instead, they represent the price of the

defaulted asset as a fraction of par some 30 days after the default event.

Empirical Studies of Default Probabilities17

This is equal to the average probability that a bond starting with a given rating will

default the given time horizon. Thus, it is obvious that higher rated bonds should have a

lower cumulative default probability than lower-rated bonds.

Using the credit triangle approach, it is possible to estimate an implied cumulative default

probability from market spreads. Typically, this default probability is greater than that

implied by empirical analysis. There are a number of reasons why this should be so. First,

the credit spread of a bond will usually contain a liquidity component. After all, no bond

is as liquid as a Treasury bond or a LIBOR swap. Then, there may be a component to

account for regulatory capital effects. There will be a credit risk premium designed to

protect the bond holder against changes in the credit quality of the issuer. Finally, market

spreads are forward looking and asset specific, whereas this data is based on historical

defaults and is averaged over a large number of bonds within each rating class.

16 Credit Derivatives: A guide to Instruments and Applications, Janet M. Tavakoli, Wiley Finance 17 Credit Derivatives: A guide to Instruments and Applications, Janet M. Tavakoli, Wiley Finance


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Credit Curves18

Investors have different views about how the credit risk of a company will change over

time. This is manifested in the shape of the credit curve: the excess yield over some

benchmark interest rate of a credit as a function of the maturity of the credit exposure.

This excess yield, known as a credit spread, can be expressed in a variety of ways,

including the asset swap spread, the default swap spread, the par floater spread, and the

option-adjusted or zero-volatility spread. There are three main credit curve shapes, which

are shown in the figure below.

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Upward Sloping: Most credits exhibit an upward sloping credit curve. This can be

explained as expressing the view that within the short term, the quality of the credit is

expected to remain constant. However, the further into the future we look, the less we can

be certain that the credit will not deteriorate. The credit spread increases in order to

compensate the investor for this increased uncertainty.

Humped: This shape is commonly observed for credits that are viewed as likely to

worsen in the medium term—the chance of defaulting in the very short term is low. As

18 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 19 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


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the maturity increases, the credit spread then falls to reflect the view that should the credit

survive the medium term, it will be more likely to survive the long term.

Downward Sloping (Inverted): The inverted curve is usually associated with credits that

have experienced a significant deterioration to the extent that a default is probable. The

bonds begin to trade on a price basis —bonds of the same seniority trade with the same

price irrespective of their maturity and coupon. This has the effect of elevating short-

maturity spreads and inverting the spread curve.


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Credit Spreads

There are a number of different measures of credit spread used in the credit markets.

These may be real spreads associated with specific types of instrument or may be

measures of excess yield. However, these different credit spreads may include effects

other than pure credit risk. For example, Treasury credit spreads, which measure credit

risk versus the Treasury yield curve, may include effects of liquidity, coupon size, risk

premia, and the supply and demand for Treasury bonds. 20



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SINGLE NAME CREDIT DERIVATIVE PRODUCTS

Floating Rate Notes21

This instrument is not a credit derivative, yet it is included because of its importance as

an instrument whose pricing is driven almost entirely by credit. As such, it serves as a

benchmark for much of credit derivative pricing, and no discussion of credit derivatives

is complete without it.

A floating-rate note (FRN)22 is a bond that pays a coupon linked to a variable interest rate

index. This has the effect of eliminating most of the interest rate sensitivity of the note,

making it almost a pure credit instrument. As a result, the price action of a floating-rate

note is driven mostly by the changes in the market-perceived credit quality of the note

issuer. The variable interest rate index used is usually the LIBOR, Euribor or the Fed

Funds Rate. These indices, although different, are a measure of the rate at which the

highly rated commercial banks can borrow, and therefore reflect the credit quality of the

(roughly) AA-rated commercial banking sector. While the senior short-term floaters of

AA-rated banks pay a coupon close to LIBOR flat and trade at a price close to par, in the

credit markets, many floaters are issued by corporates with much lower credit ratings.

Also, many AA-rated banks issue floating-rate notes that are subordinate in the capital

structure. In either case, investors require a higher yield to compensate them for the

increased credit risk. At the same time, the coupons of the bond must be discounted at a

higher interest rate than LIBOR to take into account this higher credit risk. Therefore, in

order to issue the note at (or slightly below) par, the coupon on the floating-rate note

must be set at a fixed spread over LIBOR. In fact, it is easy to show that this fixed spread,

S, must be set equal to the spread over LIBOR at which the cash flows of the issuer are

discounted. This spread is known as the par floater spread, F. The par floater spread can

be thought of as a measure of the market-perceived credit risk of the note issuer. The

21 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 22 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series


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fixed spread of a floating-rate note therefore tells us the par floater spread and, hence, the

credit quality of its issuer when it was issued at par.

Floating-rate notes have much lower interest rate sensitivity than fixed-rate bonds. If

LIBOR interest rates increase, the resulting increase in the implied future LIBOR

coupons is almost exactly offset by the increase in the rate at which they are discounted.

Similarly, when LIBOR falls, the implied future coupons decrease in value, but this is

offset as they are discounted back to today at a lower rate of interest. As a result, the

interest rate sensitivity of a floating rate note is much less than that of a fixed-rate bond

of the same maturity.

In addition to the par floater spread, another convention for quoting the credit spread of

an FRN is to use the discount margin. This is a very similar idea to the par floater spread

but is defined slightly differently. It is based on a calculation that assumes a flat LIBOR

curve and so does not take into account the shape of the term structure of the LIBOR

curve on the present-valuing of future cash flows23. In practice, the difference between

the LIBOR spread and the par floater spread is very small, but not small enough to

ignore. It also means that the discount margin calculation differs from the approach used

in pricing credit derivatives that use the full shape of the LIBOR curve.

A large proportion of the floating-rate note market is issued by banks to satisfy their bank

capital requirements and may be fixed maturity or perpetual. Traditionally, perpetual

bonds have constituted a sizeable portion of the floating rate note market. The advantage

of a floating rate perpetual is that it has low interest rate duration despite having an

infinite maturity.

Asset Swap

An asset swap is a synthetic floating-rate note. This means that it is a specially created

package that enables an investor to buy a fixed-rate bond and then hedge out almost all of

the interest rate risk by swapping the fixed payments to floating. The investor takes on a

23 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group


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credit risk that is economically equivalent to buying a floating-rate note issued by the

issuer of the fixed-rate bond. For assuming this credit risk, the investor earns a

corresponding excess spread known as the asset swap spread. Asset swaps are a key

structure within the credit markets and are widely used as a reference for credit derivative

pricing.

There are several variations on the asset swap structure, with the most widely traded

being the par asset swap. In its simplest form, it can be treated as consisting of two

separate trades. In return for an up-front payment of par, the asset swap buyer:

− Receives a fixed rate bond from the asset swap seller. Typically the bond is trading

away from par.

− Enters into an interest rate swap to pay the asset swap seller a fixed coupon equal to

that of the asset. In return, the asset swap buyer receives regular floating rate

payments of LIBOR plus (or minus) an agreed fixed spread. The maturity of this

swap is the same as the maturity of the asset.


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24

The credit derivative pertinent aspect of asset swaps is that the asset swap buyer takes on

the credit risk of the bond. If the bond defaults, the asset swap buyer has to continue

paying the fixed side on the interest rate swap, while no longer receiving coupons from

the bond. The asset swap buyer also loses the redemption of the bond that was due to be

paid at maturity and is compensated with whatever recovery rate is paid by the issuer. As

a result, the asset swap buyer has a default contingent exposure to the mark-to-market on

the interest rate swap and to the redemption on the asset. In economic terms, the purpose

of the asset swap spread is to compensate the asset swap buyer for taking on these risks.

However these exposures can be mitigated or reversed using other variations of the

standard par asset swap. Equally, one could use other traditional methods such as

collateral posting, netting, and credit triggers25.

The sensitivity of the bond price to parallel movements in the yield curve will be less

than the sensitivity of the fixed side of the swap to parallel shifts in the LIBOR curve. 24 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 25 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


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This is true only provided the issuer curve is above the LIBOR curve, which is typically

the case. The asset swap buyer, therefore, has a very small residual exposure to interest

rate movements, which only becomes apparent when LIBOR spreads widen significantly.

As such, they are a useful tool for banks, which are mostly floating rate based. Asset

swaps can be used to take advantage of mispricings in the floating rate note market26.

Using forward asset swaps, it is possible to go long a credit at some future date at a

spread fixed today. If the bond defaults before the forward date is reached, the forward

asset swap trade terminates at no cost. The investor does not take on the default risk until

the forward date27. Another variation, the cross-currency asset swap, enables investors to

buy a bond denominated in a foreign currency, paying for it in their base currency, pay on

the swap in the foreign currency, and receive the floating-rate payments in their base

currency. The cash flows are converted at some predefined exchange rate. In this case,

there is an exchange of principal at the end of the swap. This structure enables the

investors to gain exposure to a foreign currency denominated credit with minimal interest

rate and currency risk provided the asset does not default28.

Credit Linked Notes

For investors who wish to take exposure to the credit derivatives market and who require

a cash instrument, one possibility is to buy it in a funded credit linked note form. A

credit-linked note is a security issued by a corporate entity (bank or otherwise) agreed

upon by the investor and an investment bank29. The note pays a fixed- or floating-rate

coupon and has an embedded credit derivative. Unlike the SPV structure, the investors

retain an exposure to the note issuer: if the note issuer defaults, then the investors can

lose some or all of their coupon and principal.

26 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 27 Credit Derivatives & Synthetic Structures: A Guide to Instruments and Applications, Janet M. Tavakoli, Wiley Finance 28 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series 29 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


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30

The standard credit-linked note contains an embedded default swap. The investor pays

par to buy the note, which then pays LIBOR plus a spread equal to the default swap

spread of the reference asset plus a spread linked to the funding spread of the issuer. This

issuer funding spread compensates the investors for their credit exposure to the note

issuer. It will be less than the issuer spread to the note maturity to take into account the

fact that the credit event may cause the note to terminate early. The issuer will also

impose a certain cost for the administrative work. Like an asset swap, the credit-linked

note is really a synthetic par floater. If the reference asset defaults, the credit-linked note

accelerates, and the investor is delivered the defaulted asset. Unlike an asset swap, there

is no default contingent interest rate risk.

Advantages of CLNs3132

− Relative Value: CLNs give investors the opportunity to exploit anomalies in pricing

between cash and protection markets. In particular where the default swap basis

widens and the credit story remains acceptable to the investor, significant yield

enhancement can be achieved.

30 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 31 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 32 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series


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− Tailored Exposure: CLNs can be used to gain exposures to reference entities in a

variety of currencies, maturities and coupon structures that may not be available in

the cash market. They may also be used to gain greater leverage to credit risk.

− Maturity: As the protection period is not tied to any particular issue, it is possible to

synthetically create a maturity that is different from existing debt issues by the

reference entity. In particular, this means that investors who have lines for the credit

which are shorter than outstanding issues can use CLNs to shorten the maturity.

− Non-issuers: CLNs can be created by referencing credits which have not yet issued in

the bond market. This can help with portfolio construction and diversification.

− No Direct Derivatives Contract: Since the CLN itself contains embedded interest rate

and credit default swaps, there is no need for the investor itself to enter into either

contract.

− Counterparty Risk/Credit Line Usage – Investing in a CLN does not use up

counterparty credit limits relating to the sale of protection or the interest rate swap.

This feature is relevant for lower-rated investors, but also for those who are highly

correlated to the reference credit. Protection buyers are exposed to the credit risk of

the SPV collateral and not the CLN investor.

− Infrastructure: Selling protection via a funded purchase of a CLN will bypass the

need for infrastructure and pricing systems necessary for default swap trading.

− Listed: CLNs can be listed and are transferable in the same way as other bond issues.

Disadvantages of CLNs3334

− Liquidity: CLN issues are usually much smaller than corporate bond issues and do

not have plain vanilla credit structures – thus whilst freely transferable they will not

typically be liquid. CLNs with shorter maturities can to a certain extent mitigate this.

− Cheapest to Deliver: If a credit event does occur to the reference entity, physical

settlement of the default swap will likely consist of the lowest priced bond ranking

pari-passu with the reference obligation.

33 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 34 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series


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− Medium Term View: There are fixed costs (legal costs) associated with the creation

of the SPV and the various aspects of the CLN. These fixed costs are irrespective of

notional size or maturity, and will be reflected in the pricing of the issue. Thus it

would make more sense for a medium-term investment horizon rather than for short-

term trading purposes.

Special Purpose Vehicle (SPV)

An alternative to the credit-linked note is the special purpose vehicle or SPV. Unlike the

credit-linked note, an SPV is a legal trust or company that is bankruptcy remote from the

sponsor: any default by the sponsor does not affect payments on the issued note.

Therefore, the only credit exposure of the investor is to the underlying assets and/or

embedded derivatives. Where the SPV has entered into an interest rate swap, there is also

a potential exposure to the swap counterparty. Notes issued by an SPV can be rated and

can be listed on an exchange35. A classic illustration of the use of an SPV is in the

securitization of an asset swap.

36

If the asset in the SPV defaults, the interest rate swap is closed out, with the swap

counterparty usually having first recourse to the liquidation proceeds of the defaulted

35 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 36 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group


23

asset to cover any negative mark-to-market on the termination of the swap contract. The

investor receives the remaining value of the asset.

A simple extension of this concept is the SPV that converts an asset denominated in one

currency into the investors’ preferred currency. Since a cross-currency swap has to be

terminated in the event of a default, the investors are exposed to currency and interest rate

risk on the recovery amount.

As the assets in the SPV serve as collateral, they eliminate the counterparty exposure

between the note issuer and the investor by exposing the investor to the underlying

collateral. This broadens the range of investors who can participate in the default swap

market and opens it up to retail customers, making an illiquid asset more liquid37.

Principal Protected Structures

Investors who prefer to hold high-grade credits like to hold principal protected structures

that guarantee to return the investor's initial investment of par. The credit derivatives

market can be used to provide this protection to credit investors through a principal

protected credit-linked note. The note can be issued out of some highly rated entity.

Where necessary, it may be possible to get the principal protection feature of the note

rated by a rating agency and to use the BIS risk weighting of the issuing entity (20% for

an OECD bank), rather than that of the reference credit, which may be 100% risk-

weighted38.

The principal protected structure is a funded credit derivative similar to a credit linked

note. In a 100% principal protected note with an embedded default swap, the coupon of

the note terminates following a credit event. The note then redeems at par on its maturity

date. If a credit event occurs before the maturity of the note, some or part of all further

coupons terminates, and the investors wait until maturity to receive the full redemption.

37 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 38 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


24

The inclusion of a principal protected feature can significantly reduce the investors'

participation in the reference credit. For this reason, principal protected structures are best

suited to assets with very wide spreads, such as some emerging market sovereign assets,

low-grade corporate credits, or first-loss products such as default baskets. For higher

quality assets where principal protection is still a requirement, it is possible to increase

participation in the spread of the reference credit while still maintaining principal

protection by allowing the maturity of the note to extend if there is a credit event39.

Credit Spread Options

A Credit Spread Option is an option contract in which the decision to exercise is based on

the credit spread of the reference credit relative to some strike spread. This spread may be

the yield of a bond quoted relative to a Treasury or may be a LIBOR spread. In the latter

case, exercising the credit spread option can involve the physical delivery of an asset

swap, a floating-rate note, or a default swap. This reference asset may be either a floating

rate note or a fixed rate bond via an asset swap. As with standard options, one must

specify whether the option is a call or put, the expiry date of the option, the strike price or

strike spread, and whether the option exercise is European (single exercise date),

American (continuous exercise period), or Bermudan style (multiple exercise dates). The

option premium is usually paid up front, but can be converted into a schedule of regular

payments. A call on the spread (put on the bond price), expressing a negative view on the

credit, will usually be exercisable in the event of a default. In this case, it would be

expected to be at least as expensive as the corresponding default swap premium. For a put

on the spread (call on the bond price), expressing a positive view on the credit, the option

to exercise on default is worthless and, hence, irrelevant. The strike for a credit spread

option is normally quoted in terms of a spread to LIBOR. Credit spread options present

an unfunded way for investors to express a pure credit view4041.

39 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group 40 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group 41 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


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Total Return Swaps

A Total Return Swap is a contract that allows investors to receive the cash flow benefits

of owning an asset without actually holding the physical asset on their balance sheet.

As such, a total return swap is more a tool for balance sheet arbitrage than a credit

derivative. However, as a derivative contract with a credit dimension - the asset can

default - it usually falls within the remit of the credit derivatives trading desk of

investment banks and so becomes classified as a credit derivative.

42

At inception, one party, the total return receiver, agrees to make payments of LIBOR plus

a fixed spread to the other party, the total return payer, in return for the coupons paid by

some specified asset. At the end of the term of the total return swap, the total return payer

pays the difference between the final market price of the asset and the initial price of the

asset. If default occurs, this means that the total return receiver must then bear the loss.

The asset is delivered or sold and the price shortfall paid by the receiver. In some

42 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


26

instances, the total return swap may continue with the total return receiver posting the

necessary collateral.

The static hedge for the payer in a total return swap is to buy the asset at trade inception,

fund it on balance sheet, and then sell the asset at trade maturity. Indeed, one way the

holder of an asset can hedge oneself against changes in the price of the asset is to become

the payer in a total return swap. This means that the cost of the trade43 will depend mainly

on the funding cost of the total return payer and any regulatory capital charge incurred.

We can break out the total cost of a TRS into a number of components. First, there is the

actual funding cost of the position. This depends on the credit rating of the total return

payer that holds the bond on its balance sheet. If the asset can be repo’d, it depends on the

corresponding repo rate. If the total return payer is a bank, it also depends on the BIS risk

weight of the asset, with 20% for OECD bank debt and 100% for corporate debt. If the

total return payer is holding the asset, then the total return receiver has very little

counterparty exposure to the total return seller. However, the total return payer has a real

and potentially significant counterparty exposure to the total return receiver. This can be

reduced using collateral agreements or may be factored into the LIBOR spread coupon

paid44.

There are several reasons45 why an investor would wish to use such a total return

structure:

Funding/Leverage

− Total return swaps make it possible to take a leveraged exposure to a credit.

− They enable investors to obtain off-balance-sheet exposure to assets to which they

might otherwise be precluded for tax, political, or other reasons.

Trading/Investing

43 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 44 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 45 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


27

− Total return swaps make it possible to short an asset without actually selling the asset.

This may be useful from a point of view of temporarily hedging the risk of the credit,

deferring a payment of capital gains tax, or simply gaining confidentiality regarding

investment decisions.

− Total return swaps can be used to create a new synthetic asset with the required

maturity. Credit maturity gaps in a portfolio may, therefore, be filled.


29

BASKET DEFAULT SWAPS

A basket default swap is similar to a default swap in which the credit event is the default

of some combination of the credits in a specified basket of credits48. In the particular case

of a first-to-default basket, it is the first credit in a basket of reference credits, the default

of which triggers a payment to the protection buyer. This payment may be cash settled or

more commonly, it can involve physical delivery of the defaulted asset in return for a

payment of the par amount in cash. First-to-default baskets have grown in popularity

lately, given that they enable investors to leverage their credit risk and earn a higher yield

while being exposed to well-known, good-quality names.

In return for protection against the first-to-default, the protection buyer pays a basket

spread to the protection seller as a set of regular accruing cash flows. As with a default

swap, these payments terminate following the first credit event. The advantage of the

basket structure is that it enables investors, who sell first to default protection, to leverage

their credit risk without increasing their downside risk. The most that the investors can

lose is par minus the recovery of the first asset to default, which is the same as they

would have lost had they simply purchased this asset in the first place. However, the

advantage is that the basket spread paid can be a multiple of the spread paid by the

individual assets in the basket. More risk-averse investors can use default baskets to

construct low risk assets: second-to-default baskets trigger a credit event after two or

more assets have defaulted. As such, they are lower-risk second-loss exposure products

that may pay a higher return than other similar risk assets49.

Baskets are essentially a default correlation product. This means that the basket spread

depends on the tendency of the reference assets in the basket to default together. It is

natural to assume that assets issued by companies within the same country and industrial

sector would have a higher default correlation than those within different industrial

sectors. They share the same market and the same interest rates and are exposed to the

48 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 49 An Introduction to Credit Derivatives, Moorad Choudhry, London Guildhall University, 12 June 2002


30

same costs. There is also an argument that within the same industry sector, the default

correlation can actually be negative since the default of one company can take out

capacity and so strengthen the remaining players. However, the systemic sector risks far

outweigh this possibility so that default correlation is always positive50.

A second-to-default basket is a simple extension of the first-to-default structure in which

the triggering credit event is the default of two of the assets in the basket. Following this

credit event, it is the second asset to default that is delivered in return for a payment of

par. Second-to-default baskets are part of a class of credit derivative known as second-

loss products. Because they require two or more defaults to trigger a credit loss, for small

baskets they are usually considered to be much less risky than standard single credit

products and so appeal to investors who wish to buy high quality assets that return a

higher yield than other equally high quality assets5152.

50 An Introduction to Credit Derivatives, Moorad Choudhry, London Guildhall University, 12 June 2002 51 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 52 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group


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CHAPTER 3: COLLATERALIZED DEBT OBLIGATIONS

The concept on which the structure and development of CDOs is founded is extremely

simple. The advancement of any form of credit should be based upon the ability of the

borrower to repay – or on the collateral, security or compensation in the event of default

that a borrower is able to provide. The instrument is simply a “promissory note backed by

collateral or security”53.

In the market for COs, that security can be taken from a very wide spectrum of

alternative financial instruments, such as bonds (collateralized bond obligations, or

CBOs), loans (collateralized loan obligations, or CLOs), funds (collateralized fund

obligations, or CFOs), mortgages (collateralized mortgage obligations, or CMOs) and

others. They can (and frequently do) source their collateral from a combination of two or

more of these asset classes. Collectively, these instruments are popularly referred to as

CDOs54, which are bond-like instruments that use the cash flows from their assets to pass

coupon payments on to their investors. In a technique known as tranching (slicing up),

those payments are made on a sequential basis, depending on the seniority of investors

within the capital structure of the CDO.

The market for CDOs55 is generally believed to date back to the late 1980s and the

repackaging and redistribution in the US of portfolios of high-yield bonds and loans.

Prior to those transactions, however, a market for CMOs – the forerunner of modern

CDOs – was taking shape in the US market by the early 1980s. In 1983, for example, the

Federal Home Loan Mortgage Corporation pioneered structures that built on existing

mortgage securitization templates by creating so-called paythrough structures. These

divided cash flows up into a number of tranches to suit investor preferences, and by the

late 1980s these securities remained the only form of COs familiar to market participants.

53 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 54 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 55 Merrill Lynch Fixed Income Strategy Introduction to CDO Investments: CDO Basics in Plain English, 2 October 2003


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By the late 1990s, the structure of the international market for COs of all kinds was

becoming characterized by a number of conspicuous and interrelated trends56. First,

issuance volume was rising exponentially, as was understanding and acceptance of the

CDO technique. Second, cross-border investment flows into CDOs were rising steeply.

Another trend that had become conspicuous by 1999 and, more strikingly, 2000 was the

speed with which the concept of the CO was being popularized across continental

Europe. By the late 1990s, changes to legislation and regulation were emerging as

important sources of support for new issuance in the CDO market in some pockets of

Europe.

By 2000 and 2001, the most important determinant of increasing volumes in the CDO

market globally, however, was the explosive growth in the market for credit derivatives

in general, and for credit default swaps (CDS) in particular. That growth paved the way

for an equally explosive expansion of the market for synthetic CDOs, which had made

their first appearance in Europe at the end of 1997. In 2003, 92% of all European CDOs

rated by Moody’s were accounted for by synthetic structures, up from 88% in 200257.

The initial reason for collateralization of debt was the same as that for any securitization;

to free up more of the banks’ balance sheets. But since the mid-1990s CDOs have

become a way for originating firms to arbitrage rating inefficiencies. Against a backdrop

of falling returns from government, supranational, agency and other top-rated assets, the

structure of the CDO market is such that it can offer much more attractive yields for

comparably rated securities. Returns in the CDO market are also considerably higher than

in other securitized instruments with longer track records58. According to research

published in 2003 by Barclays Capital, AAA rated tranches of CDOs have spreads as

high as three times wider than credit card-backed deals.

56 Merrill Lynch Fixed Income Strategy Introduction to CDO Investments: CDO Basics in Plain English, 2 October 2003 57 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 58 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


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Part of the complexity associated with the CDO market arises from the fact that

originators can and do have different reasons for issuing CDOs. The very different

motives for issuing are one pivotal difference between the two fundamental forms of all

COs, which are known either as balance-sheet or arbitrage instruments. In the most basic

terms, a balance-sheet CDO is issued by a bank almost out of necessity, or as a means of

addressing an existing problem or challenge. An arbitrage obligation, by contrast, will

generally be issued by an asset management company as a strategic means of exploiting

latent opportunities arising from perceived market inefficiencies59. It was the issuance of

balance-sheet CLOs by commercial banks that formed the basis for the growth of the

broader CDO market in the mid to late 1990s. A balance sheet CLO is a form of

securitization in which assets (in this instance, loans) are removed from a bank’s balance

sheet and repackaged into marketable securities that are then sold on a private placement

basis to investors.

60

In the 1990s, at least three influences combined to fuel the expansion in banks’ issuance

of balance-sheet CLOs61.

1. The first and comfortably the most important of these can be traced back to the

Basel Capital Accord of 1988, which laid down the first, universally accepted 59 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group 60 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 61 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets


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framework for calculating bank capital for regulatory purposes. Securitization in

general, and the use of the fast developing CLO market in particular, allowed

banks to transfer the risk associated with their loan portfolios to third parties via

the capital market, which in turn qualified them for regulatory capital relief and

removed or reduced constraints on fresh lending capacities.

2. A second, related influence on the growth of the CLO market in the 1990s was the

increasing emphasis that banks were forced to place on the delivery of enhanced

shareholder value and improved return on equity (ROE), which in continental

Europe were especially low. For a variety of reasons, feeble ROEs in the banking

sector in Europe had not much mattered in the 1980s and early 1990s. In many

countries, banking industries remained sheltered within a cocoon of local

protectionism and regulation that discouraged competition among largely state

owned banks and was unwelcoming to foreign financial services providers. But as

privatization, liberalization, deregulation and – ultimately – consolidation all

gathered momentum in Europe in the 1990s, banks were forced to focus more

intensely on their profitability. Securitization rapidly emerged as one important

tool to help in the process. Issuance of CLOs in the US market was also motivated

in large measure by banks’ need to make more efficient use of capital and to

bolster ROE levels.

3. A third, albeit less important, driver for increased issuance in the CLO market in

the 1990s was the recognition among commercial lenders that institutional

investors were probably much more proficient at pricing and managing credit risk

than the banks were. In Europe (as it had been many years before in the US), the

development of securitization was part of a broader transformation in the

corporate finance landscape.

While the majority of balance-sheet CDOs originated by commercial banks have been

motivated by regulatory capital considerations, some issuers have had alternative

objectives. In the case of the CDOs launched by Banco di Roma in 2000, for example,


35

the bank’s stated goal was to support the development of the broader Italian corporate

bond market rather than to achieve capital relief62.

By the late 1990s an active, liquid and increasingly well understood market for balance-

sheet CDOs originated by banks had taken shape in Europe, but it was not until 1999 that

the other basic form of CO, the arbitrage CDO, took its bow in the European market. The

motives for issuing arbitrage CDOs are radically different from those prompting the

launch of balance-sheet instruments, with the market driven by asset management

companies using the CDO technique principally as a means of increasing their assets

under management. In a nutshell, in an arbitrage CDO, the originator’s objective is to

take advantage of the yield differential between the assets within a CDO portfolio and the

cost of funding the CDO through the sale to investors of securities. A key difference

between a balance-sheet and an arbitrage CDO is that in the case of a balance-sheet

instrument the issuer will be securitizing assets that it already owns, whereas in an

arbitrage CDO the issuer will generally buy new assets in the market earmarked as

collateral for a new CDO issue63. This explains why, in the US markets in particular,

arbitrage CDOs are often identified as important sources of demand in the new issue

market for investment-grade and high-yield bonds as well as in the syndicated loans

market.

Arbitrage deals are now the main motor of expansion in the CDO market in Europe. A

more recent contribution made by Axa to innovation in the CDO market was its launch of

Overture, which at $3.5 billion was the largest CDO ever structured in the European

market. More important than its size, however, was the way in which it was distributed.

In that sense, the Overture deal was distributed like a conventional public bond, rather

than as a private placement, which is very good for liquidity. The fact that the deal was

bought by 96 institutions – more than in any previous CDO – attests to the success of the

62 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 63 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations


36

syndication method64. The growth of the market for arbitrage CDOs in Europe was

characterized in 2001 and 2002 by the emergence of increasingly specialized and liquid

CDOs.

Synthetics

Balance-sheet and arbitrage CDOs can be structured as cash flow or synthetic

instruments, although an increasingly popular formula among originators is to combine

the two into so-called hybrid CDOs. The cash flow CDO, which formed the bread and

butter of the market in its formative years, is a structure in which CDO notes are

collateralized by a portfolio of cash assets purchased by the originator. In other words, in

this classical structure the CDO owns the physical bond, loan or other security referenced

by the instrument. In a synthetic CDO, no legal or economic transfer of bonds or loans

takes place, with the underlying reference pool of assets remaining on the balance sheet

of the originator. Instead, the CDO gains exposure to credit risk by selling protection to

others through a CDS, which functions very much like an insurance contract..

65

64 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 65 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations


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The volume of traditional cash flow CDOs has been eclipsed in recent years by synthetic

products, sometimes referred to as collateralized synthetic obligations66. From the

perspective of originators, there are a number of clear benefits associated with synthetic

CDOs. One of these is that risk transfer via synthetic structures allows bank originators in

the CDO market to ensure that client relationships are not jeopardized. That is an

especially relevant consideration in the market for CLOs, given that deal documentation

in the syndicated lending market often prevents the transfer of loan ownership. Even

where loan transfer is permitted, CDOs would often need, in theory, to secure the written

permission of each borrower in order to construct a cash flow, which would amount to an

impractical burden. Synthetic structures are also attractive for originators securitizing

multi-jurisdictional portfolios or loans made in countries where the local legal framework

either does not allow for the so-called ‘true sale’ of assets or, more probably, where the

local tax system makes the transfer of legal title of assets uneconomic67.

The market for synthetic CDOs owes its dramatic growth in recent years to the explosive

expansion in the market for CDS68. A CDS is a privately negotiated bilateral agreement

in which one party, variously known as the protection buyer or risk shedder, pays a

premium to another, generally referred to as the protection seller or risk taker, in order to

secure protection against any losses that may be incurred through exposure to an

investment as a result of an unforeseen development (or ‘credit event’).

For investors there are a number of important attractions associated with exposure to the

CDS market rather than to cash bonds. CDOs made up of CDS allow investors to buy

‘pure’ credit because the structure separates the credit risk component of from the other

asset’s risks, such as interest rate and currency risk. The explosion of liquidity in the CDS

market has had a beneficial knock-on effect on the market for synthetic CDOs at a

66 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series 67 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 68 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


38

number of levels. For one, it has allowed for portfolios of default swaps to be assembled

(or ramped up) much more quickly than those of cash instruments.

Synthetic CDOs began to appear for the first time in the European market in 1997, with

JP Morgan’s Bistro (Broad Index Secured Trust Offering), launched in December of

1997, one of the first instruments of its kind to transfer the risks embedded in a portfolio

of loans to the capital market, and hence reduce regulatory capital requirements.

Synthetic CDOs were much slower to catch on in the Asian market, which was attributed

by some market commentators to reluctance among Asian investors to buy bonds that are

not backed by physical, tangible assets, which in turn explained why the broader CDS

market was slower to develop in Asia than in Europe. Since 2001, however, issuance of

synthetic products has been rapidly gaining in popularity in Asia69.

The structure of a synthetic CDO70

In the so-called unfunded portion of a synthetic CDO, the risk embedded in a portfolio of

assets (as opposed to the assets themselves) is transferred directly to a ‘super-senior

counterparty’ via a super-senior CDS. In this instance, the CDO acts as the protection

buyer, by agreeing to pay a premium to the counterparty (the protection seller) in return

for a commitment from the counterparty to pay compensation to the CDO in the event of

any defaults in the reference portfolio. The super-senior swap is a vital driver behind the

economics of a synthetic CLO and the key reason underlying the compelling cost benefits

of these structures for originators. Within a synthetic structure, the super-senior swap will

typically account for at least 80% of the CLO’s capital structure, and will generally be

provided by a highly rated bank or insurance company. Those super-senior buyers or

sellers of credit protection are attracted by the security of the instrument, which is often

referred to as a ‘quasi quadruple-A’ or triple-A-plus tranche, and is therefore, presumably

69 Deutsche Bank Research, Current Issues, 9 June 2004; Credit derivatives: effects on the stability of financial markets 70 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


39

a more solid credit than the US government or the World Bank71, which of course is not

possible. Nevertheless, it is broadly accepted that the risk embedded in the super-senior

tranche of a synthetic CLO referencing a pool of investment-grade assets is remote in the

extreme. This is because even if a super-senior swap accounts for as much as 90% of a

CDO’s capital structure (which is not uncommon), more than 10% of the assets within

the reference pool would have to default for losses to be sustained by the most senior

tranche – an improbably high default rate for investment-grade bonds when the historical

norm has been for a default rate of about 0.3%. Because the perceived risk associated

with the super-senior swap is so low, the investor in this tranche is typically paid a

premium that is no more than 8 basis points to 10bp of the CDO’s notional size, which is

considerably below what an investor in the most senior tranche of cash CDO would

demand72.

There are very compelling cost benefits associated with synthetic CDOs as compared to

their traditional cash counterparts73. Consider a hypothetical CDO with a notional value

of $1 billion, as compared to a cash product. The collateral pool for both CDOs is

investment-grade credits. But in the synthetic transaction, no cash is paid upfront for

physical bonds, whereas in the cash CDO the entire liability structure is used to fund the

physical purchase of the collateral. In the synthetic CDO, 89% of the capital structure is

accounted for by the super-senior swap, for which the CDO is paying just 8bp. The result

is that the weighted average cost of liabilities for the whole capital structure is 20bp. This

compares with a weighted average cost of 66bp for comparable cash CDO in which 85%

of the capital structure is accounted for by triple-A Class A notes, 10% by A3 Class B

notes and the remaining 5% by junior-most equity74.

71 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 72 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 73 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 74 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series


40

Static vs. Managed CDOs75

In the formative stages of the development of the market, CDOs were generally

categorized as ‘static’ or ‘passive’ products, meaning that the original composition of

their underlying portfolios remains unchanged. The obvious advantage associated with

this structure is that it calls for minimal resources in terms of management expertise and

time, and reduces the costs involved in trading or ‘churning’76 a portfolio. The drawback

with the static structure, obviously, is that it lacks maneuverability. As credit quality

begins to deteriorate, investors in static CDOs find themselves holding instruments that

are declining in value and, worse, are unable to do anything to reverse that decline. The

result is that actively managed CDOs, in particular managed synthetic products, are

rapidly gaining in popularity. The growth of managed products, however, was also

helped by the growing maturity of the CDO market, and by the increasing number of

managers with proven experience in managing credit in general and credit derivatives in

particular. With the expansion of managed CDOs at the expense of more traditional static

products, asset managers (or collateral managers) have become increasingly important

protagonists in the CDO world. They will generally hold some of the equity in their CDO

so as to ensure that they have a vested interest in the success of the business.

Tranching

A common characteristic of all specifications, including CDO collateralizations, is the so-

called tranching, i.e. the structuring of the product into a number of different classes of

notes ranked by the seniority of investors’ claims on the instrument’s assets and cash

flows77. A CDO is structured to have creditors with varying degrees of seniority. The

more senior the creditor, the less risky the investment and hence the less they will be paid

in interest. The way it works is frequently referred to as a ‘waterfall’ or cascade of cash

flows, because in bankruptcy the proceeds from liquidating a CDO assets will first be 75 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 76 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 77 The J.P. Morgan Guide to Credit Derivatives, published in collaboration with the RiskMetrics Group


41

used to repay the most senior creditors, the senior debt tranche, and only then, if there is

remaining money, the next most senior tranche.

The most senior note is rated triple-A, with the tranche below this generally referred to as

the mezzanine notes, which are usually rated from high triple-B to low single-B. These

can be in fixed- or floating-rate form and pay note-holders a regular coupon. As such

each individual tranche is very much like a bond. In addition to being senior to the

subordinated debt and the equity holders, the most senior tranches can be given an added

degree of protection in the form of guarantees from insurance companies. The final

tranche within the CDO structure, in terms of seniority of sequential payment claims, is

the equity portion, and it is this junior position in the capital structure that explains why

the equity is also described as the ‘first-loss’ piece. Also sometimes known as junior

subordinated notes, preferred stock and secured income notes, the equity tranche is

generally unrated and can account for anything between 2% and 15% of a CDO’s total

capital structure. Unsurprisingly, the equity tranches of CDOs have historically delivered

the highest returns but also exposed investors to the highest risks; in just the same way as

investing in the equity of any public company is associated with higher risks and rewards

than investing in its debt78.

Over-Collateralization

Over-Collateralization (OC) is one of a broader range of structural features of CDOs,

collectively known as credit enhancement, which allows for higher-quality debt to be

issued relative to lower-rated underlying collateral. The concept of over-collateralization

is pivotal to all forms of securitization, and refers to the excess of the par amount of

collateral available to secure one or more of the note classes over the par amount of those

notes. To illustrate how the level of OC is determined, consider an example79 where a

cash flow transaction is involving the issuance of $80 million of rated senior debt

supported by a collateral pool with a total par value of $100 million. This is therefore

78 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 79 An Introduction to Credit Derivatives, Moorad Choudhry, London Guildhall University, 12 June 2002


42

known as an ‘80/20’ liability structure consisting of 80% of rated senior debt and 20% of

unrated supporting debt or equity. The level of over-collateralization is 125%, which

equals the ratio of assets over liabilities. The tests to ensure that the OC level is

maintained (OC tests) fall into two categories.

The first is the par value test8081, which requires that the value of the rated notes is equal

to a minimum percentage of the underlying collateral. The higher the ranking of the note

in the capital structure, the higher this is required to be. In other words, the par value test

may call for 115% coverage in the case of the senior notes and for 105% in the case of

the mezzanine tranche.

The second OC test is known as the interest coverage test8283. This is designed to ensure

that interest income earned by the collateral is sufficient to cover potential losses and to

maintain interest payments to senior note-holders, with the difference between the two

referred to as the excess spread. In the event of a breach of the OC test, managers will

need to remedy the situation usually within two to 10 days by, for example, purchasing

additional collateral with any available excess interest.

There are no predetermined parameters dictating how many tranches an individual CDO

can contain, although there is usually a minimum of three. Nor are there any governing

the optimum weighting of any class of note within the overall structure. Indeed, one of

the principal attractions of CDOs is the flexibility of their capital structure, which can

create scores of different risk profiles by adjusting the structure of the instrument and the

credit quality of its collateral.

80 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 81 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 82 The Deutsche Bank and Application Networks’ The ABC of CDO: The credit guide to collateralized debt obligations 83 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


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CHAPTER 4: CREDIT DEFAULT SWAPS

The Credit Default Swap, also known as Protection, is a bilateral financial contract in

which one counterparty (the Protection Buyer) pays a periodic fee, typically expressed in

basis points per annum, paid on the notional amount, in return for a Contingent Payment

by the Protection Seller following a Credit Event with respect to a Reference Entity84.

85

The definitions of a Credit Event, the relevant Obligations and the settlement mechanism

used to determine the Contingent Payment are flexible and determined by negotiation

between the counterparties at the inception of the transaction. However, the evolution of

increasingly standardized terms in the credit derivatives market has been a major

development because it has reduced legal uncertainty that, at least in the early stages,

hampered the market’s growth. This uncertainty originally arose because credit

derivatives are frequently triggered by a defined (and fairly unlikely) event rather than a

defined price or rate move, making the importance of watertight legal documentation for

such transactions greater.

Under a typical default swap the buyer of protection pays to the seller a regular premium

(usually quarterly), which is specified at the beginning of the transaction. If no Credit

Event, such as default, occurs during the life of the swap, these premium payments are

the only cash flows. Like many other swaps there is no exchange of underlying principal.

Following a Credit Event the protection seller makes a payment to the protection buyer.

Typically this payment takes the form of a physical exchange between the buyer and

seller. The protection buyer provides the seller any qualifying debt instrument (known as

Deliverable Obligation) of the Reference Entity in return for a cash payment amounting

to its full aggregate notional amount (i.e. par). The protection buyer stops paying the

regular premium following the Credit Event. The net loss to the protection seller is

84 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 85 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


44

therefore par less the recovery value on the delivered obligation. Just because a Credit

Event has occurred it does not necessarily mean that the claim on the Reference Entity

will be worthless. Credit default contracts are structured to effectively replicate the

experience of a cash market holder of an obligation of the Reference Entity. At least

some payments may be made to creditors even if the company is wound up. As recovery

values (or the market value of debt following default) are typically at a deep discount to

par, the default swap buyer has effectively received protection on this price deterioration.

The transaction described above involves physical settlement86. The market convention is

for such physical settlement although it is possible to cash settle. In such cases, following

a credit event, the protection seller would provide a single cash payment reflecting the

extent to which a market valuation of a specified debt obligation of the reference entity

has fallen in value.

Valuation Factors

In terms of cash flow profile, a credit default swap is most readily comparable with a par

floating rate note funded at Libor or an asset swapped fixed-rate bond financed in the

repo market. Though default protection should logically trade at a spread relative to a

risk-free asset, in practice it trades at a level that is benchmarked to the asset swap

market. Most banks look at their funding costs relative to LIBOR and calculate the net

spread they can earn on an asset relative to their funding costs87. LIBOR represents the

rate at which AA-rated banks fund each other in the interbank market for a period of 3-6

months. Although this is a useful pricing benchmark it is not a risk free rate88.

Intuitively, the price of a credit default swap will reflect several factors. The key inputs89

would include the following:

- probability of default of the reference entity and protection seller;

86 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 87 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 88 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series 89 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


45

- correlation between the reference entity and protection seller;

- joint probability of default of the reference entity and protection seller;

- maturity of the swap; and

- expected recovery value of the reference asset.

Though several sophisticated pricing models exist in the market, default swaps are

primarily valued relative to asset swap levels. This assumes that an investor would be

satisfied with the same spread on a credit default swap as the spread earned by investing

the cash in the asset (taking into account the funding cost of the institution for the

particular asset).

Default Probability Models90

In practice, supply and demand as well as the arbitrage relationship with asset swaps

tends to be the dominant factor driving pricing of default swaps. Technical models for

pricing default swaps tend to be used more for exotic structures and off-market default

swap valuation (unwinds, for example). These models calculate the implied default

probability of the reference entity as a means of discounting the cash flows in a default

swap. While the mathematics of such models is involved, the essential inputs, Spread and

Recovery Rate, are used to interpolate (‘bootstrap’) a time-series of Survival Probabilities

of the reference entity. A typical recovery rate assumption in the default swap market for

senior unsecured contracts is 35%91.

A default swap consists of two legs. The buyer of protection pays quarterly payments to

the protection seller until the earlier of a credit event or maturity of the contract. This is

called the Fixed Leg. The seller of protection pays the difference between par and the

recovery value of the delivered obligation should a credit event occur during the contract.

90 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 91 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001


46

This is called the Floating Leg. These flows are shown below for a default swap at

100bp.

At the inception of a default swap, the Risky PV of the Fixed Leg must equal the risky

PV of the Floating Leg. i.e., on-market default swaps have zero net present value.

Pricing Conventions9293

Capital-at-Risk

The relative value comparison between asset swapped par bonds and credit default swaps

is quite straightforward. When the bond is trading significantly away from par, an

additional level of risk is introduced. The capital-at-risk for a bond investor is the market

price paid for that bond whilst the default swap seller is effectively exposed to the par

value of debt. More precisely, following a credit event the protection seller will expect to

lose the difference between the notional size of the contract and the recovery value on the

cheapest to deliver obligation of the reference entity.

92 Lehman Brothers Structured Credit Research, Credit Derivatives Explained: Market, Products, and Regulations, March 2001 93 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series


47

Other things being equal therefore, selling protection should be most attractive where

cash market instruments are trading above par and less attractive versus bonds trading at

a discount. Thus the positive bases that are typical for deteriorating credits have

fundamental justification as well as technical drivers. As the credit situation deteriorates

further and investors perceive a real risk of default occurring, the market value of cash

bonds fall and tend to converge towards the expected recovery value of the asset class. As

premiums on credit default swaps push upwards towards 1000bps sellers of protection

tend to melt away, notwithstanding the very high current yields in comparison with the

cash market. This behaviour reflects:

- Huge comparative capital exposure. If for example, a bond is trading at 60c and the

expected recovery value is 50c the expected loss following default would be 10c.

With a default swap the capital at risk would be 50c.

- Following a credit event and settlement the default swap would be terminated, and

no cash flows from the high running yield would be payable. Thus for a 1000bps

premium the first quarterly payment of 250bps would not be received for 3 months.

Points-Upfront9495

Credits that are viewed as very high risk tend to trade on a "points-upfront" basis in the

default swap market. According to this convention, dealers quote default in two parts:

1. lump sum in bond points paid or received upfront; and

2. quarterly running premium in bp.

The upfront points and the running yield are together equivalent to a conventional default

premium, i.e., the risky PV of the cash flow streams should be identical. The points paid

upfront by a protection buyer are analogous to the discount on the equivalent bond. Once

the lump sum payment is made, the default swap position becomes economically

identical to a basic CDS with an off-market spread. Dealers who sell protection on a

distressed credit use the points-upfront convention to receive the equivalent bond

94 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003 95 Credit Derivatives: A guide to Instruments and Applications, Janet M. Tavakoli, Wiley Finance


48

discount on the settlement date. In other words, they receive a significant portion of the

conventional premium upfront and a smaller running premium (relative to the

conventional premium) on a quarterly basis.

One feature of the points-upfront CDS is the reduced exposure to spread movements:

spread tightening will provide a smaller mark-to-market gain than a position that only

pays a running premium, while spread widening will result in a smaller loss.

Unwinding Default Swaps96

When entering into credit default swaps, the well established arbitrage relationship with

the cash market is typically the relative value starting point. The procedure for unwinding

default swap trades though is a key difference between cash and synthetic credit markets.

Comparing Cash and Default Products97

1. Default Swaps are ‘Spread’ Products: While the payouts on credit default swaps

are dependent upon the occurrence of pre-defined credit events, default swaps can

nonetheless be thought of as credit ‘spread’ instruments whose premiums move in

relation to the changing credit quality of the underlying reference entity. As a

result, the mark-to-market value of an existing default swap will move as its

default swap premium moves over the course of time.

2. Unwinding Cash Market Positions: Unwinding a holding in the cash market is

straightforward, simply involving selling the bond. Following this transaction

there should be no residual flows or contractual obligations between the investor

and its counterparty, and with the exception of unwinding any interest rate hedges

the P&L is essentially defined by the change in price of the bond.

96 Credit derivatives instruments, applications, and pricing, mark j.p. anson, frank j. fabozzi, moorad choudhry, ren-raw chen, John Wiley’s The Frank J. Fabozzi Series 97 Credit Derivatives: A guide to Instruments and Applications, Janet M. Tavakoli, Wiley Finance


49

Ways to Unwind a Default Swap98

An investor with a long or short position in an existing default swap can monetize a

change in the default swap premium, and realize P&L, in three ways:

1. Agreeing An Unwind Payment with the Original Default Swap Counterparty in

Termination of the Transaction

The investor receives/pays the current mark-to-market value of the existing default swap

from/to the current default swap counterparty. One of the benefits of terminating (or

‘tearing up’) an existing trade is that all future cash flow streams are cancelled and

ongoing legal risk (i.e. possible disputes over deliverable obligations) is removed. This

method also has potentially advantageous capital treatment.

2. Assignment to Another Counterparty

Default swaps can also be assigned to a new counterparty that simply ‘replaces’ the

investor in the default swap. In this case, the investor receives/pays the current mark-to-

market value from/to the new counterparty. The original counterparty and the new

counterparty become parties to the CDS contract, with the investor ending its

involvement

98 The Merrill Lynch Credit Derivative Handbook 2003, 16 April 2003


50

Assignment will also be subject to the protection buyer agreeing to take on the

counterparty risk of the protection seller. Again this may reduce legal/capital risk for the

investor who has closed its position.

3. Entering into an Offsetting Transaction

The final alternative is to enter into an offsetting long or short protection position with

counterparty. Offsetting transactions are not as popular with end investors as they require

the signing of further documentation and added legal risk. Nonetheless, unwinding with

another counterparty may be the most desirable option for holders of illiquid positions

where better unwind terms may be available away from the original counterparty and

where an assignment is not possible.


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CHAPTER 5: CONSTANT PROPORTION PORTFOLIO INSURANCE

Constant Proportion Portfolio Insurance (CPPI) products, conceptually first introduced by

Perold in 1986 and Black and Jones in 1987, are leveraged principal-protected

investments whose return depends on the performance of an underlying trading strategy.

Credit CPPIs are relatively new to credit space: they combine principal protection with a

credit-linked investment that leverages up or leverages down depending on the

performance of a credit trading strategy99.

The basic premise of CPPI is fairly simple. CPPI products offer a principal protected and

a target return over Libor by investing the present value of the interest in levered

strategies. These products usually have a relatively long maturity (7 to 10 years). In order

to protect 100 of principal at maturity, the present value of the principal, say 70 is

invested in a high-quality zero-coupon bond. This amount is called the "bond floor," and

tends to increase as maturity approaches. The remaining 30, known as the cushion and

defined as the excess of the portfolio value over the floor, is then invested in a credit

strategy according to a rule that increases the leverage when the underlying investment is

performing well and deleverages when the investment return is negative. This degree of

leverage remains constant over the investment horizon, thus giving rise to the name

"constant proportion." The investor shifts asset allocation between the risk-free asset and

risky assets over his investment horizon. The risky exposure is also subject to some

borrowing constraints, so the overall leverage is often limited to a certain level100.

This structure means CPPIs have dynamic leverage, compared with other levered

strategies with principal protection. Investors in CPPI can see the size of their exposure to

the trading strategy increase when the P&L is positive, and can benefit from more

leverage and more return if the strategy keeps performing well. By contrast, should the

trading strategy under perform, the CPPI could return sub-Libor performance or, in

extreme situations, pay back only the principal at maturity.

99 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 100 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005


52

Obviously, the higher the leverage is the higher potential upside would be. However, high

leverage increases the risk that the value of the risky exposure declines too fast for the

investor to readjust his asset allocation. Indeed, the portfolio value could fall below the

bond floor, albeit with a relatively low probability. Hence, the strategy is not a "locked-

in" hedge, and the name "insurance" does not describe its nature precisely. In contrast, a

static portfolio hedge refers to a strategy that calls for initially investing a portion of the

portfolio in the risk-free, zero-coupon bond to ensure that the desired amount is available

at maturity for certain. The static approach is equivalent to purchasing a European put

option on the portfolio101.

However, it may be more costly when the risk-free interest rate is relatively low, because

the relatively high bond floor limits the amount that can be invested in risky, higher

yielding assets.

Many credit CPPIs take a hybrid format. In a credit CPPI, the main sources of risk are

default losses and spread widening, which lowers the value of the risky exposure. This

risk can be sourced in an "unfunded" CDS form, which allows large leverage.

Alternatively, the risk can be sourced in a single-tranche CDO, such as the equity tranche

of the CDS index. While the risk-free portion of the portfolio earns the risk-free return,

the credit portion earns collateral return plus protection premium (i.e., spread) based on

the notional amount of credit exposure102103.

Some of the important terms104 used in CPPIs are:

− The reserve (R) is the difference between the value of the note and the value of the

principal protection. Initially, it is simply the difference (30 in the above example)

between the notional value of the investment and the value of the principal protection.

As time goes by, the value of the note will reflect the P&L of the trading strategy and

the value of the reserve will fluctuate up or down accordingly.

101 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005 102 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 103 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005 104 Standard & Poor’s CDO Spotlight: CPPI Jostling to Become Structured Credit Market’s Next Big Thing


53

− The target leverage (TL) is set at the inception of the CPPI note. It measures how

many times the reserve amount is invested in the risky strategy. For example, a TL of

20 would lead to an initial notional investment of 600 in the example.

− The portfolio notional (PN) is defined as the market value of the levered strategy

while the target notional (TN) is the target leverage times the value of the reserve

(600).

− The rebalancing multiplier (RM) determines how frequently changes in leverage will

occur. A high RM implies less frequent changes in leverage; a low RM implies more

frequent changes.

The following figure shows the general dynamics of the CPPI structure

105

The trade’s P&L determines the leverage of the strategy. If the trade is performing well

(positive P&L) and to such an extent that the portfolio notional deviates substantially

from the target notional, the leverage is increased. To be more precise, no rebalancing

takes place if the portfolio notional is within (RM x R) of the target notional. If PN > TN

+ RM x R, then the trade is levered up, while if PN < TN - RM x R, the leverage is

105 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005


54

lowered. At the leverage reset, the new portfolio notional is set to PN = TM x R. As

mentioned previously, it is clear that the higher the RM, the less frequent would be the

changes in leverage. If the P&L becomes sufficiently negative to reach the unwind

threshold (for example 5% of the initial reserve), then the trade is unwound and the note

is replaced with a zero-coupon bond.

One of the drawbacks of conventional CPPI strategies is the fact that once the cushion

vanishes due to adverse market conditions, the investor is locked at the floor and left

basically with a risk free money market account until maturity. This perspective clearly

has discouraged many medium to long term investors in recent years from using CPPI

strategies to gain exposure to risky asset classes106.

To overcome these disadvantages the so called minimum exposure CPPI strategies have

been developed in recent years. In these strategies the investor always carries a minimum

exposure to the risky asset without giving up partial or full capital protection at maturity.

Minimum exposure strategies are motivated by the simple observation that a CPPI

strategy is obviously equivalent to a dynamically allocated portfolio. However, building a

minimum exposure into the allocation scheme means that the targeted partial or full

capital protection can no longer be achieved by the allocation scheme alone. Therefore a

protective put on the CPPI strategy has to be bought to compensate for this. The

protective put is relatively cheap and thus highly attractive to investors107108.

Because a minimum exposure CPPI involves both a traditional dynamic allocation

scheme together with the static use of a protective put it is an example of a new

generation of hybrid approaches to portfolio insurance.

106 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 107 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005 108 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005


55

Credit-Linked CPPI Variations109

The CPPI technique, although more commonly used in the hedge fund/equity market

context, is now being increasingly used in the context of credit risk have begun to appear.

Credit linked notes referencing the tranches of the CDS indexes are now very popular.

Moreover, an actively managed portfolio of CDS and corporate bonds can also be used to

source risk. Some programs combine the CPPI mechanism with constant maturity CDS

(CMCDS), as a defensive strategy against general spread widening. Another possible

variation is addition of some up-side potential based on the stock market or an equity

tranche of synthetic CDOs. Some programs include an "explicit" principal guarantee by

the sponsor, while others provide an implicit protection (i.e., "protective mechanism")

where the investor is exposed to possible losses of principal. The following table

summarizes some credit CPPI structures:

110

109 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 110 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005


56

Factors that affect the performance of a CPPI111112113114

Credit CPPIs require arrangers, managers and investors to take views on the following:

− Structural risk: Credit CPPIs can express any number of investment strategies, and

the rules governing those strategies are bespoke to each structure. The nature of the

strategy, the investment guidelines and rebalancing rules driving the strategy, and the

extent to which the manager can invest outside those rules are primary concerns.

− Leverage: Credit CPPIs can seek leverage via the multiplier, even to the extent that

the exposure to risky assets exceeds the total portfolio value. The extent of leverage

can have an impact on the structure’s ability to react to other risk factors. For a given

level of bond floor, the higher the gearing factor is, the larger the amount invested in

the risky asset is. Structures with upper or lower limits on leverage, or dynamic

multipliers that react to market conditions, can lead to increased or decreased

leverage.

− Credit risk: Credit CPPIs are exposed to both the likelihood and timing of defaults

and erosion in credit quality. All else being equal, a significant spike in defaults (i.e.,

real default correlation) or a systemic drop in credit quality (rating transitions) could

lead to lower-than-expected returns, or losses.

− Market risk: Market value triggers drive the asset allocation in credit CPPIs. It is

also rules driven, and therefore the ability to “ride out” temporary swings in prices

can be limited. A central aspect of analyzing a given structure’s ability to provide

expected returns - or promised principal protection - is its ability to withstand large

jumps in the market value of the risky portfolio.

− Interest rate risk: The risk-free portion of the portfolio adds to the market risk of the

portfolio, in that a decline in the return on risk-free investments can trigger a

rebalancing away from the risky asset. In addition, the analysis would have to ensure

111 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 112 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005 113 HVB Corporates & Markets, Global Markets Research Euro Credit Strategy; Credit CPPI: The Rising Star in 2006 114 Standard & Poor’s CDO Spotlight: CPPI Jostling to Become Structured Credit Market’s Next Big Thing


57

that the risk-free yield can actually be achieved from available investments in various

stress scenarios.

− Performance risk: Being dynamic structures, credit CPPIs must rely on the ability of

the manager to implement a given strategy. They also rely on the quality of the data

and the systems used to monitor risk in the portfolio.

− Gap Risk: In a CPPI, the most important risk is the possibility that the market

conditions deteriorate so rapidly (i.e., market "gapping") that asset allocation cannot

be readjusted fast enough. In that case, the portfolio value can drop below the bond

floor, causing the principal protection to fail. If the principal protection is explicit,

however, the "gap" risk is shouldered by the sponsor of a CPPI.

Additional factors115116 that may affect the performance of a CPPI include:

1. the amount of protected principal, and

2. the frequency of dynamic hedge adjustments.

The lower the protected amount, the more the CPPI portfolio behaves like the pure risky

asset. Volatility would be higher, but the average terminal value would be also higher.

An explicit principal guarantee significantly reduces the risk of poor performance to the

investor. When the deal sponsor explicitly guarantees the principal payment, the risk

exposure may be directly linked to the credit quality of the sponsor117.

If the CPPI portfolio is adjusted less frequently, it would arguably increase the "gap risk,"

as the portfolio value can drop past the bond floor before the asset allocation can be

shifted. If a portfolio manager is employed, the gap risk may be significantly mitigated,

because a deteriorating credit may be taken out before the portfolio value actually drops

after credit spreads widen or default losses occur. The portfolio manager may

dynamically adjust the level of leverage, instead of keeping the gearing factor constant.118

115 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 116 HVB Corporates & Markets, Global Markets Research Euro Credit Strategy; Credit CPPI: The Rising Star in 2006 117 Standard & Poor’s CDO Spotlight: CPPI Jostling to Become Structured Credit Market’s Next Big Thing 118 Nomura Fixed Income Research, Anatomy of Credit CPPI, September 8, 2005


58

The "adjustable" gearing factor would allow faster adjustment of the risky exposure to

keep up with a rapid market rally and sell-off. The sponsor of a credit CPPI often bears

the gap risk by explicitly guaranteeing the principal, but in other cases the risk is born by

the investor119120.

119 Citigroup Structured Credit Products, Credit CPPI, May 27, 2005 120 Standard & Poor’s CDO Spotlight: CPPI Jostling to Become Structured Credit Market’s Next Big Thing


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CHAPTER 6: CDO STRUCTURING – INDIAN CONTEXT

ICICI Bank came out with a CLO offering in 2004, which involved the securitization and

subsequent disbursement of corporate loan assets. The offer document states that 19

corporate loans of a total value of Rs. 975,300,000 were securitized. The CLO was

structured such that investors in the offering had the option to invest in either of two

tranches. The senior Tranche A offered 5.9%, with an Outstanding Principal Value of Rs.

754,100,000.00, with an inbuilt Credit Enhancement of Rs. 168,900,000.00. The junior

Tranche B had a coupon rate of 7.5%, with Outstanding Principal Value and Credit

Enhancement of 221,200,000.00 and 95,300,000.00 respectively.

Loan Input Data

Loan No: Outstanding Principal TTM (Months) Interest Rate

1 48,000,000.00 38 8.75% 2 57,000,000.00 34 9.50% 3 44,000,000.00 33 9.75% 4 51,000,000.00 37 9.25% 5 63,000,000.00 39 10% 6 46,000,000.00 31 8.50% 7 36,500,000.00 36 8.50% 8 48,500,000.00 36 8% 9 37,000,000.00 34 8.25% 10 69,000,000.00 31 9.25% 11 59,500,000.00 38 9.50% 12 76,500,000.00 35 9.50% 13 67,500,000.00 33 9.75% 14 71,000,000.00 29 10% 15 29,000,000.00 36 9% 16 54,300,000.00 37 9% 17 32,000,000.00 38 8.25% 18 42,000,000.00 36 8.75% 19 43,500,000.00 32 9.50%

Total 975,300,000.00 We have done the aggregate loan calculations to find the cash inflows from the loan pool.

These inflows are used to make principal and interest payment to the 2 tranches. The data

on the tranches is as follows:


60

Securitized Tranche Data

Tranche A Tranche B

Interest Rate 5.90% 7.50% Credit Enhancement 168,900,000.00 95,300,000.00 Outstanding Principal 754,100,000.00 221,200,000.00

Assuming base values of 1.5% per month Prepayment Rate, 0.5% per month Default Rate

and 50% Recovery Rate, the Principal and Interest Inflows for individual loans were

calculated and aggregated over the pool. These inflows were then used to make payments

to Note-A and Note-B investors in the order of priority as mentioned in the waterfall

structure, with the Principal and Interest payments been considered separately.

The Waterfall Structure of the Deal

The order of priority of Principal and Interest payments among the two tranches is as

follows-

Credit Enhancement

Issue Structure

Receivables Purchase

Consideration

Collections

Contributors Series A1& A2

Subscription to Certificates

Trust

Borrowers

Gross Payouts

ICICI Bank (Originator)

Cash Collateral Series A1

Cash Collateral Series A2

Facility


61

Principal Payments: First the principal of tranche A will be repaid back and then tranche

B. In the event of Default, the Credit Enhancements provided to the 2 tranches will be

used to pay for it. If the default loss exceeds the given protection then the excess loss will

have to be born by the investors. After all the Principal to tranche A has been paid, the

Credit Enhancement balance that is left will be paid back to ICICI bank. A similar rule

will be adopted for tranche B.

Interest Payments: First the interest due to Tranche A, then the interest arrears due to

Tranche A will be paid, then similarly the due interest and interest arrears to tranche B

will be paid out of the interest collections. The remaining balance will go to ICICI as

residual interest.

So the total inflows to the bank are the residual interest, the release of credit enhancement

of tranche A, the release of credit enhancement of tranche B and the risk free interest on

the total credit enhancement provided. Finally the cash outflows (comprising of principal

and interest payments) to the 2 tranches were found and the NPV and Macaulay Duration

were calculated. In order to asses the risk faced by the note investors as well as the bank

for default and prepayment rates, a scenario analysis was done with the assumptions as

shown below: To see the effect of changes in interest rate in the economy on the risk faced by the 2 tranches and the Bank:- Assume a relation between interest rates and prepayment rates: 1. For every 0.5% decrease in interest rate, the Prepayment Rate will increase by 0.4% 2. For every 0.5% increase in interest rate, the Prepayment Rate will decrease by 0.1% Scenarios Considered:

Interest Rate Prepayment Rate Default Rate Scenarios 5.50% 1.50% 0.50% 5.00% 1.90% 0.25% 4.50% 2.30% 0.75% 4.00% 2.70% 1.00% 3.50% 3.10% 1.50% 3.00% 3.50% 2.00% 6.00% 1.40% 5.00% 6.50% 1.30% 8.00% 7.00% 1.20% 10.00%

12.00%


62

The Results of the various Scenarios was as follows:

For a Default Rate of 0.5% and Recovery Rate of 50%

Tranche A Tranche B

Interest

Rate NPV (Rs.)

Duration

(months) NPV (Rs.)

Duration

(months)

Residual NPV

(Rs.)

3.00% 0.00 8.06 0.00 23.96 409,573.03

3.50% 0.00 8.45 0.00 24.53 447,630.27

4.00% 0.00 8.88 0.00 25.09 497,918.39

4.50% 0.00 9.35 0.00 26.35 562,453.85

5.00% 0.00 9.86 0.00 26.21 643,165.58

5.50% 0.00 10.41 0.00 26.75 741,846.91

6.00% 0.00 10.56 0.00 26.87 772,536.47

6.50% 0.00 10.71 0.00 27.00 803,458.21

7.00% 0.00 10.86 0.00 27.13 834,611.22

For a Prepayment Rate of 1.5% and Recovery Rate of 50%

Tranche A Tranche B

Default

Rate NPV (Rs.)

Duration

(months) NPV (Rs.)

Duration

(months)

Residual NPV

(Rs.)

0.25% 0.00 10.79 0.00 27.07 17,677,747.60

5.50% 0.00 10.41 0.00 26.75 741,846.91

0.75% 0.00 10.06 0.00 26.40 -15,352,799.06

1.00% 0.00 9.72 0.00 26.07 -30,634,699.40

1.50% 0.00 9.11 0.00 25.38 -59,030,830.18

2.00% 0.00 8.55 0.00 24.67 -84,757,439.24

5.00% 0.00 6.20 0.00 20.54 -202,566,783.51

8.00% 0.00 4.84 -29,009,306.04 16.64 -242,041,173.84

10.00% 0.00 4.22 -56,353,556.02 15.05 -245,504,635.55

12.00% -4,316,166.81 3.73 -72,369,002.91 13.75 -248,829,345.50


63

The NPV calculation discounted at the prevailing interest rates: For a Default Rate of 0.5% and Recovery Rate of 50%

Tranche A Tranche B

Interest

Rate NPV (Rs.)

Duration

(months) NPV (Rs.)

Duration

(months)

Residual NPV

(Rs.)

3.00% 14,833,184.06 8.06 20,782,971.36 23.96 11,130,845.58

3.50% 12,850,324.43 8.45 18,818,854.75 24.53 8,606,640.40

4.00% 10,664,736.19 8.88 16,762,372.90 25.09 6,012,129.00

4.50% 8,250,526.88 9.35 14,613,051.40 25.65 3,355,025.49

5.00% 5,577,387.43 9.86 12,372,782.35 26.21 643,165.58

5.50% 2,610,685.57 10.41 10,045,545.67 26.75 -2,115,507.19

6.00% -659,889.68 10.56 7,522,952.77 26.87 -4,902,384.43

6.50% -4,002,753.62 10.71 5,008,187.92 27.00 -7,649,805.42

7.00% -7,418,174.64 10.86 2,500,716.31 27.13 -10,358,325.20

A graphical representation of the variation of NPV and duration of the 2 tranches and the

residual NPV for variations in default and interest rates is shown below:

1. Variation of Tranche-A Duration Vs Interest Rate:

Tranche A Duration Vs Interest Rate

7.00

8.00

9.00

10.00

11.00

12.00

3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%Interest Rate

Duration (months)


64

2. Variation of Tranche-B Duration Vs Interest Rate:

Tranche-B Duration Vs Interest Rate

22.0023.0024.0025.0026.0027.0028.00

3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%

Interest Rate (per month)

Duration (months)

3. Variation of Residual NPV Vs Interest Rate:

Residual NPV Vs Interest Rate

400,000.00500,000.00600,000.00700,000.00800,000.00900,000.00

3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%

Interest Rate

Residual NPV (Rs.)

4. Variation of Tranche-A NPV Vs Default Rate:

Tranche-A NPV Vs Default Rate

-5,000,000.00-4,000,000.00-3,000,000.00-2,000,000.00-1,000,000.00

0.001,000,000.00

0.25% 5.50% 0.75% 1.00% 1.50% 2.00% 5.00% 8.00% 10.00% 12.00%

Default Rate (per month)

Tranche-A NPV (Rs.)


65

5. Variation of Tranche-B NPV Vs Default Rate:

Tranche-B NPV Vs Default Rate

-80,000,000.00-70,000,000.00-60,000,000.00-50,000,000.00-40,000,000.00-30,000,000.00-20,000,000.00-10,000,000.00

0.0010,000,000.00

0.25% 5.50% 0.75% 1.00% 1.50% 2.00% 5.00% 8.00% 10.00% 12.00%


Tranche-B NPV (Rs.)

6. Variation of Residual NPV Vs Default Rate:

Residual NPV Vs Default Rate

-280,000,000.00-240,000,000.00-200,000,000.00-160,000,000.00-120,000,000.00-80,000,000.00-40,000,000.00

0.0040,000,000.00

0.25% 5.50% 0.75% 1.00% 1.50% 2.00% 5.00% 8.00% 10.00% 12.00%


Residual NPV (Rs.)

7. Variation of Tranche-A Vs Default Rate:

Tranche-A Duration Vs Default Rate

3.004.005.006.007.008.009.00

10.0011.00

0.25% 5.50% 0.75% 1.00% 1.50% 2.00% 5.00% 8.00% 10.00% 12.00%


Duration (months)


66

8. Variation of Tranche-B Duration Vs Default Rate:

Tranche-B Duration Vs Default Rate

12.0014.0016.0018.0020.0022.0024.0026.0028.00

0.25% 5.50% 0.75% 1.00% 1.50% 2.00% 5.00% 8.00% 10.00% 12.00%


Duration (months)


67

CONCLUSION

We have studied in detail credit derivatives, first from an introductory point of view to its

requirements, implications, structuring and pricing. We have analyzed and presented all

the major credit derivatives present in the markets today, and in particular have dealt with

Credit Default Swaps and Collateralized Debt Obligations in a fair amount of detail.

Further, we have looked at the 2004 ICICI Collateralized Loan Obligation Offering, and

have conceptualized and developed a spreadsheet model for the same. We have presented

our findings in the report. Further, we have endeavoured to ascertain the risks faced by

the investor tranches and the bank due to variations in market interest rates, prepayment

rates and default rates, and have shown the requisite graphs for the same. We hope that

the outcome of the study is meaningful in the understanding and future developments of

the credit derivative market in India.

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