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Credit Derivatives Handbook Corporate Quantitative Research New York, London December, 2006 Credit Derivatives Handbook Detailing credit default swap products, markets and trading strategies About this handbook This handbook reviews both the basic concepts and more advanced Corporate Quantitative Research trading strategies made possible by the credit derivatives market. Readers AC seeking an overview should consider Sections 1.1 - 1.3, and 8.1. Eric Beinstein (1-212) 834-4211 There are four parts to this handbook: [email protected] Andrew Scott, CFA Part I: Credit default swap fundamentals 5 (1-212) 834-3843 [email protected] Part I introduces the CDS market, its participants, and the mechanics of the credit default swap. This section provides intuition about the CDS Ben Graves, CFA valuation theory and reviews how CDS is valued in practice. Nuances of (1-212) 622-4195 [email protected] the standard ISDA documentation are discussed, as are developments in documentation to facilitate settlement following credit events. Alex Sbityakov (1-212) 834-3896 Part II: Valuation and trading strategies 43 [email protected] Katy Le Part II provides a comparison of bonds and credit default swaps and (1-212) 834-4276 discusses why CDS to bond basis exists. The theory behind CDS curve [email protected] trading is analyzed, and equal-notional, duration-weighted, and carry- neutral trading strategies are reviewed. Credit versus equity trading European Credit Derivatives Research strategies, including stock and CDS, and equity derivatives and CDS, are analyzed. Jonny Goulden (44-20) 7325-9582 Part III: Index products 111 [email protected] The CDX and iTraxx products are introduced, valued and analyzed. Dirk Muench Options on these products are explained, as well as trading strategies. (44-20) 7325-5966 [email protected] Tranche products, including CDOs, CDX and iTraxx tranches, Tranchlets, options on Tranches, and Zero Coupon equity are reviewed. Saul Doctor (44-20) 7325-3699 Part IV: Other CDS products 149 [email protected] Part IV covers loan CDS, preferred CDS, Recovery Locks, Digital default Andrew Granger (44-20) 7777-1025 swaps, credit-linked notes, constant maturity CDS, and first to default [email protected] baskets. Yasemin Saltuk (44-20) 7777-1261 [email protected] JPMorgan publishes daily reports that analyze the credit derivative Peter S Allen markets. To receive electronic copies of these reports, please contact a (44-20) 7325-4114 Credit Derivatives research professional or your salesperson. These [email protected] reports are also available on www.morganmarkets.com. The certifying analyst(s) is indicated by a superscript AC. See last page of the www.morganmarkets.com report for analyst certification and important legal and regulatory disclosures. Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research [email protected] Credit Derivatives Handbook December, 2006 Andrew Scott, CFA (1-212) 834-3843 [email protected] Part I: Credit default swap fundamentals ........................................................................................................5 1. Introduction..........................................................................................................................................................................6 2. The credit default swap .......................................................................................................................................................8 Credit events........................................................................................................................................................................9 Settlement following credit events ....................................................................................................................................10 Monetizing CDS contracts.................................................................................................................................................11 Counterparty considerations ..............................................................................................................................................12 Accounting for CDS ..........................................................................................................................................................12 3. Marking CDS to market: CDSW .....................................................................................................................................13 4. Valuation theory and credit curves ..................................................................................................................................15 Default probabilities and CDS pricing...............................................................................................................................15 The Shape of Credit Curves...............................................................................................................................................18 Forwards in credit..............................................................................................................................................................20 Summary............................................................................................................................................................................22 Risky Annuities and Risky Durations (DV01) ..................................................................................................................23 5. The ISDA Agreement ........................................................................................................................................................24 Standardized documentation..............................................................................................................................................24 The new CDS settlement protocol.....................................................................................................................................24 CDX Note settlement procedures ......................................................................................................................................32 “Old-fashioned” CDS settlement procedures ....................................................................................................................33 Succession events ..............................................................................................................................................................34 6. The importance of credit derivatives................................................................................................................................38 7. Market participants...........................................................................................................................................................40 Part II: Valuation and trading strategies........................................................................................................43 Decomposing risk in a bond ..............................................................................................................................................44 Par-equivalent credit default swap spread .........................................................................................................................46 Methodology for isolating credit risk in bonds with embedded options............................................................................52 9. Basis Trading......................................................................................................................................................................55 Understanding the difference between bonds and credit default swap spreads .................................................................55 Trading the basis................................................................................................................................................................57 10. Trading Credit Curves ....................................................................................................................................................62 Drivers of P+L in curve trades...........................................................................................................................................62 Curve trading strategies.....................................................................................................................................................70 1. Equal-Notional Strategies: Forwards.............................................................................................................................70 2. Duration-weighted strategies.........................................................................................................................................76 3. Carry-neutral strategies..................................................................................................................................................80 Different ways of calculating slide ....................................................................................................................................82 Calculating breakevens......................................................................................................................................................84 The Horizon Effect ............................................................................................................................................................86
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