The Structured Credit Handbook - leseprobe.buch.de€¦ · Prerequisites for Credit Derivatives...
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The StructuredCredit
Handbook
ARVIND RAJANGLEN MCDERMOTT
RATUL ROY
John Wiley & Sons, Inc.
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The StructuredCredit
Handbook
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The StructuredCredit
Handbook
ARVIND RAJANGLEN MCDERMOTT
RATUL ROY
John Wiley & Sons, Inc.
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Copyright c 2007 by Arvind Rajan, Glen McDermott, and Ratul Roy. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
Wiley Bicentennial Logo: Richard J. Pacifico.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission.
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Library of Congress Cataloging-in-Publication Data:
Rajan, Arvind.The structured credit handbook / Arvind Rajan, Glen McDermott, Ratul Roy.
p. cm.(Wiley finance series)Includes bibliographical references and indexes.ISBN 978-0-471-74749-9 (cloth)1. Credit derivatives. 2. CreditManagement. 3. Default (Finance).
I. McDermott, Glen, 1968 II. Roy, Ratul, 1964 III. Title.HG6024.A3R35 2007332.7dc22
2006019227
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
www.wiley.com
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To the memory of my dad, V. Varadarajan (19212002),whose faith in my potential
still inspires me.A.R.
This book is dedicated to Gail B. McDermottand to the memory of
Maurice and Claire McDermottand John F. Brennan.
G.M.
To my parents, Tapan and Uma, for theirlove and faith in me.
R.R.
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Contents
Acknowledgments xix
About the Authors xxi
About the Contributors xxiii
Introduction: A Roadmap of the New World of Structured Credit 1How Structured Credit Completes Markets 2Enabling Technology 3Improved Liquidity, Transparency, and Customizability 3Growth of Structured Credit Markets 4
Asset Classes 4Products 4Participants 7
Core Uses of Structured Credit 8Nonrecourse Leverage 8Diversification 8Customization of Risk Profiles 9Separating Legal from Beneficial Ownership 9Separating Funding from Risk Transfer 9Isolating and Hedging Risk 10Representative Examples of Structured Credit Solutions 10
Who Should Read This Book? 11How This Book Is Organized 11
PART ONEIndex and Single-Name Products
CHAPTER 1A Primer on Credit Default Swaps 17
Arvind Rajan
The Market for Credit Default Swaps 17Transaction Terminology and Mechanics 22
vii
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viii CONTENTS
Prerequisites for Credit Derivatives Transactions 22What Happens in Case of a Credit Event? 23Unwinding Default Swap Transactions 25The DV01 of a Credit Default Swap 25The Default-Cash Basis 26
Some Uses of Default Swaps 26Buying a Note versus Selling Default Protection 26Freeing Up or Using Bank Credit Lines 27Filling a Maturity Gap 28Expressing Curve or Forward-Rate Views 28Barbell-Bullet Trade 29Taking Advantage of Tight Repo Levels
without Financing 29Case Study: Relative ValueCashing In on the Curve
Steepness in Telecoms 30How to Blend CDs and Cash in Long-Maturity-Curve
Trades 30Implementing Credit Curve FlattenersTwo Basic
Approaches 33Appendix: Equivalence of a Bond Spread and Default Swap
Premium 35Specialness of the Underlying 36Effect of Accrued Default Swap Premium 36Accrued Interest on the Underlying Risky Security 37Accrued Interest on the Underlying Risk-Free
Security 37
CHAPTER 2Credit Default Swaptions 39
Arvind Rajan and Terry Benzschawel
Payer Options 40ExampleWhen to Buy a Payer 41ExampleWhen to Sell a Payer 42
Receiver Options 42ExampleWhen to Buy a Receiver 43Effect of DV01 on Credit Swaption Payoffs 43ExampleWhen to Sell a Receiver 44
Credit Swaption Payoffs in Default 46Credit Swaption Implied Volatility 47
Conclusion 47
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Contents ix
Case Study: Are Tight Spreads Giving You Butterflies? 49Introduction 49Float Like a Butterfly, Sting Like a Bee 50Butterfly versus Payer 50Variations 54Details of Butterfly Construction 54Conclusion 54
CHAPTER 3Constant Maturity Credit Default Swaps 57
Olivier Renault and Ratul Roy
Basics of CMCDSs 57Participation Rate 58Behavior of CMCDSs 59
Impact of Spread Level 60Impact of Spread Volatility 64
Capped CMCDS 66Hedging CMCDSs 68Trading Strategies with CMCDSs 69
Selling CMCDS Protection 69Buying CMCDS Protection 70Combination Trades and Index CMCDSs 70
Conclusion 72Case Study: Taking Curve Views with CMCDSs 72
Features of CMCDSs 73Trade Ideas 73
Appendix: Computing the Participation Rate 76
CHAPTER 4Credit Derivatives Indexes 79
Jure Skarabot and Gaurav Bansal
Introduction 79Family of Credit Derivatives Indexes 80Structure of the CDX/iTraxx Index Family 81Administration of Indexes 83Basket of Credit Default Swaps 83
Trading ExampleThe Index 84Up-Front and Running Payments 84
Trading ExamplePremium Payments 85What Happens in Case of a Credit Event? 86
Trading ExampleCredit Event 87
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x CONTENTS
Settlement Process after Credit Event 87Physical Settlement (Indexes and Tranche Products) 88Cash Settlement (Tranche Product Only) 88
Recent Defaults in CDX Indexes 88Index versus Intrinsics 90Investment Strategies with Credit Derivatives Indexes 91
Investors 92Index-Related Structured Credit Products 92Issues and Concerns 93
Conclusion 93Case Study: DJ CDX HY and DJ CDX EMConversion of
Price Level into a Spread Level 94Case Study: Using iTraxx to Replicate Bond Portfolios 94
Motivation 94Typical Portfolio Risks 95Replicating Interest Rate Risks 96Using iTraxx to Replicate Broad Credit Market Risk 96Adjusting for Single-Name Risk through Default Swaps 99Performance 100Conclusion 104
Appendix: Description of the Roll Process 106Risky PV01 of a CDS Contract 106Calculation of Intrinsic Spread of the Index 107Risky PV01 of an Index 108Mark-to-Market Estimation of an Index Position 108
CHAPTER 5The Added Dimensions of CreditA Guide to Relative Value Trading 111
Matt King and Michael Sandigursky
Overview of Curve Trades 111Learning Curves 112Drivers of Curve Steepness 113
Putting on a Curve Trade 115Cross-Currency Trades 116
Cross-Currency Opportunities in Bonds 117Cross-Currency Trades in CDSs 117
Basis Trades 118Back to Basis 118Drivers of Basis 122Why CDSs and Bonds Are Two Sides of the Same Coin 122Trading the Basis 126
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Contents xi
A New Spread Measure: C-Spread 129Debt-Equity Trades 129
Meet the Models 129The Debt-Equity Cycle 130A Practical Hurdle or Two 131Debt-Equity Trading in PracticeArbitrage or Mirage? 132Deciding What to Trade 133A Recovery Trade 134
iTraxx Credit Indexes 134Truly Global 135Youve Got to Roll with It 136iTraxx Intrinsics 137What Happens When a Name Defaults? 139Equiweighted or Not 139Second-Generation Products: iTraxx Tranches 139
Credit Options 140Its a Knockout 140Effect of Convexity on Credit Option Payoffs 141Delta-Exchange 143Why Sell an Option (Riskier Strategy) Rather
Than Buy One? 143Option Strategies 144
PART TWOPortfolio Credit Derivatives
CHAPTER 6Single-Tranche CDOs 149
Jure Skarabot, Ratul Roy, and Ji-Hoon Ryu
Overview of Single-Tranche CDOs 149Advantages of Single-Tranche CDOs 150Key Features of Single-Tranche CDO Transaction 150Description of the Product and Basic Structure 151Main Decision Steps for Investors 153Key Issues in Modeling and Valuation 155Single-Tranche CDO Risk Measures and Hedging 158Substitution of Credits 164Single-Tranche CDO Market 166Investment Strategies 167
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xii CONTENTS
Case Study: Dispersion Trades and Tranches 180Traditional Bull-Bear Trade 180Not Just Another Bull-Bear Tranche Trade 181Whos Afraid of Blowups? 181Buy Protection on 10-Year 3 to 7 Percent CDX IG
Tranche, Sell Protection on 5-Year 10 to 15 PercentCDX IG Tranche 183
Effect of Blowups in CDX IG on the Dispersion Trade 184Trade Sensitivity Analysis 184How to Choose the Most Efficient Tranches 187Conclusions 190
Case Study: Attractions of Hedged Mezzanines 190Motivation 191The Trade 191Comparing Delta-Hedged Equity and Mezzanines 192Time-Decay Profile 194Conclusion 195
CHAPTER 7Trading Credit Tranches: Taking Default Correlationout of the Black Box 197
Ratul Roy
The Credit Tranche Market 197Importance of Default Correlation in Tranches 199Problems with Traditional Correlation Measure 199
Skew in Default Correlation 201Further Flaws in Tranche Correlation 201Correlation Skew Is Like a Volatility Surface 201Skew Is Markets Risk Preference 204Investor Risk Appetite May Scale Across Markets 207Greeks: Managing Correlation and Delta Risk 209In Summary: Why Skew Is a Better Model 213
Trading Opportunities for Investors 214Tranche Correlation Can Still Provide Insight 214Pricing Off-Market Tranches 217
Conclusion and Future Agenda 219Case Study: Curve Trades in Tranche Markets 220
Curve Trades, Tranche Markets, and Technicals 220Trade Recommendation 221Market Drivers for the Tranche Curve Trades 221Base Correlation Analysis and Market Technicals 223
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Contents xiii
Technicals Driving the Flattening of Tranche Curves 224Analysis of Investment Strategy 225
CHAPTER 8Understanding CDO-Squareds 229
Ratul Roy and Matt King
CDOs versus CDO2 230Value of CDO2s Derives Broadly from Inner CDOs 232CDO2 versus Inner CDO 234Like Mezzanine, but with Tails 235CDO2 versus Master CDO 236Economic Value versus Rating Quality 238Uses of CDO2: Long, Short, and Correlation! 239Structures: Good, Bad, and Ugly 239
Inner CDO Tranche Seniority and Thinness 240Overlap of Credits 242Nonuniformity of Portfolios 243Fungible and Tradable Subordination 244
How Managers Can Add Value 246Not Just Credit Selection 246Manage to the Structure 248
Conclusion 249Case Study: Term Sheet 249
CHAPTER 9CPPI: Leveraging and Deleveraging Credit 253
Olivier Renault
Product Mechanics 253Managed CPPIs 256
When Is CPPI Suitable? 257Choice of Trading Strategies 257
Case Study: Performance Comparison of Strategies 258Baseline: Unlevered Strategies 258Simulations 258Results 259Performance Comparison in CPPI Setup 263Other Strategies 264
Appendix: Our Methodology 265Our Estimations and Simulations 265