08 February 2007 Fixed Income Research http://www.credit-suisse.com/researchandanalytics Credit Derivatives Handbook Credit Strategy Contributors Ira Jersey +1 212 325 4674 [email protected] Alex Makedon +1 212 538 8340 [email protected] David Lee +1 212 325 6693 [email protected] This is the second edition of our Credit Derivatives Handbook. With the continuous growth of the derivatives market and new participants entering daily, the Handbook has become one of our most requested publications. Our goal is to make this publication as useful and as user friendly as possible, with information to analyze instruments and unique situations arising from market action. Since we first published the Handbook, new innovations have been developed in the credit derivatives market that have gone hand in hand with its exponential growth. New information included in this edition includes CDS Orphaning, Cash Settlement of Single-Name CDS, Variance Swaps, and more. We have broken the information into several convenient sections entitled "Credit Default Swap Products and Evaluation”, “Credit Default Swaptions and Instruments with Optionality”, “Capital Structure Arbitrage”, and “Structure Products: Baskets and Index Tranches.” We hope this publication is useful for those with various levels of experience ranging from novices to long-time practitioners, and we welcome feedback on any topics of interest. FOR IMPORTANT DISCLOSURE INFORMATION relating to analyst certification, the Firm’s rating system, and potential conflicts of interest regarding issuers that are the subject of this report, please refer to the Disclosure Appendix. 08 February 2007 Credit Default Swap Products and Evaluation 3 Brief Overview 3 Definition of a Credit Default Swap 3 Levered Loan CDS 5 Unwinding a CDS Transaction 5 Unwinding an Off-Market CDS 6 Points Upfront 7 Restructuring Language Differences 7 Cash Settlement for Single-Name CDS 9 Succession Rules 10 Index Products 11 Index Arbitrage 13 Corporate Bond LIBOR Pricing Methodologies 15 Adjusting Spreads on Premium-Priced Bonds 17 Basis Evaluation 18 Repo “Special” 19 Credit Suisse’s Approach to Basis Trading 21 Valuation of Step-Up Bonds 22 Steep CDS Curves Effect on Rolls 23 Steepeners and Flatteners 24 CDS Orphaning and Confusing Name Changes 25 Credit Default Swaptions and Instruments with Optionality 29 Credit Default Swaption Review 29 Cancelable CDS and Other Exotics 31 Implied vs. Historical 32 Where’s the Skew? 32 Options Embedded in Bonds 33 Constant-Maturity Credit Default Swaps 34 Introducing CDS Variance Swap 35 Recovery Trades. Digital CDS 37 Capital Structure Arbitrage 39 Debt vs. Equity. Potential to Win in the “Wings” 39 The Trickiest Thing in Cap Arb: Hedging 40 Other Capital Arbitrage Flows to Watch 43 Trading Implied Equity vs. Implied CDS Volatility 46 Structured Products: Baskets and Index Tranches 47 Review of Nth to Default 47 Tranched DJ CDX Products 49 Path Dependency and Tranche Carry 50 Constant Proportional Debt Obligations (CPDOs) 52 Credit Derivatives Handbook 2 08 February 2007 Credit Default Swap Products and Evaluation Brief Overview Derivatives are financial instruments that are “derived” from other base financial instruments, such as stocks, bonds, loans, currencies and commodities, and provide investors with a multitude of ways to manage risk. Since the advent of the Credit Derivatives Market over a decade ago, it has grown exponentially as participants and investors have become more sophisticated, driven by both innovation and the need to manage risk and return. Credit Default Swaps (CDS), instruments designed for investors to take or hedge a firm’s credit worthiness and default risk for the bonds and loans of companies, are now one of the main elements driving the growth of the global derivatives market. The notional amount traded in CDS now exceeds the face value of many of their reference entities and the market is often more liquid than the debt markets themselves. Exhibit 1 tracks the growth of the CDS market since 2001. Exhibit 1: Notional Size of Credit Default Swap Market since 2001 30,000 25,000 20,000 15,000 10,000 Notional Amt (US$ billions) (US$ Amt Notional 5,000 0 1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 Source: ISDA Definition of a Credit Default Swap A Credit Default Swap (CDS) is essentially a contract struck between two parties that allows the isolation and transfer of credit risk for bonds and loans. In this agreement, the party that shorts credit risk is the protection buyer and pays fixed periodic payments to the party taking on the credit risk, the protection seller. This transaction provides the protection buyer with credit exposure similar to a short position and the protection seller with exposure similar to a levered long position in the bond. The periodic payments between the protection buyer and seller continue until either the contract expires or the “reference entity,” a third party issuer, experiences a credit event. A credit event is an occurrence where the issuer fails to fulfill its debt obligations, which includes failing to pay its coupon, defaulting, or filing for bankruptcy and, if applicable, restructuring its debt. Upon a reference entity credit event, the protection buyer gives the seller an eligible obligation of the reference entity with a par amount equal to the value of the CDS contract (most times, the buyer pays accrued interest to the date of the credit event). The seller pays the buyer par for these obligations, after which the contract terminates. So, on a credit event there is a transfer from seller to buyer equal to the Credit Derivatives Handbook 3 08 February 2007 difference between par and the market value of the delivered obligation of the reference entity. Note that it is also possible to have a cash-settled CDS contract, where the seller pays the buyer par minus the market value of the reference obligation on a credit event.1 Due to the payout profile, CDS is commonly thought of as similar to buying insurance on a specific debt issuer. Since the nature of the contract creates residual counterparty credit risk (if the protection seller defaults before the reference entity, the buyer might be unprotected on a reference entity default), margin requirements are commonly used to minimize the counterparty exposure. If we compare the payments on a CDS contract to the payments on a leveraged position on a corporate bond, we see that the exposure is strikingly similar. As the charts below show, a long levered position in a corporate bond receives an annuity equal to the bond’s spread to LIBOR plus the LIBOR rate minus the repo rate. A seller of protection receives the fixed CDS premium (Exhibit 3). On a default, the long levered corporate bond position loses the price paid for the bond minus the recovery value of the defaulted bond. The seller of CDS loses par minus recovery. So, if the repo rate is close to LIBOR and the price paid for the bond is close to par, the payout profiles for a levered position in a bond and a CDS position are very similar. Exhibit 2: Cash Flows for a Levered Corporate Bond Position Interest rate Swap Coupon LIBOR + Spread Repo Coupon rate Corporate bond Investor Repo Price Price Netting the flows, the investor receives LIBOR plus Spread and pays the Repo rate. In case of a credit event, the investor can sell the defaulted bond, pay back the Repo lender and unwind the interest rate swap. Exhibit 3: Cash Flows for CDS Transactions Par Payment in Credit Event Investor Counterparty CDS Premium OR Par Payment in Credit Event Investor Counterparty CDS Premium The investor receives/gives the CDS premium. In case of a credit event, must pay/get par in exchange for a defaulted security, which can be sold in the market. Source: Credit Suisse 1 Although not a part of the master agreement yet, cash settlement protocols are currently being considered for inclusion in ISDA agreements. The default by Dura Automotive Systems (DRRA) was the first instance of a cash settlement for single-name CDS and was highlighted in our Trading Edge published on October 16, 2006. Credit Derivatives Handbook 4 08 February 2007 Levered Loan CDS The recent introduction of loan-only Credit Default Swaps, or LCDS, represents a new innovation in the derivatives market. LCDS are similar to vanilla CDS in most respects, but differ in several important aspects, including the deliverable obligations, the ability to cancel LCDS in certain circumstances, and the relevant obligations in the case of succession events. First, the deliverable obligations for the CDS are a certain class of levered loans, which differ from senior unsecured obligations where both loans and bonds are deliverable. For example, LCDS deliverable obligations include straight loans or revolvers, but not bonds. Seniority of liens are also specified in the contracts, so that a contract is on either First Lien or Second Lien, but typically not both. However, the contracts are typically triggered by a credit event on the loans or senior unsecured bonds. LCDS typically have HY credit event terms, or trade No R; therefore, restructuring is not usually considered a credit event. Second, unlike plain vanilla CDS, LCDS are canceled in the case that there are no longer any outstanding loans for a name. Relevant obligations can change based on which loans are outstanding; however, if there are no loans left to deliver into the contract, the contract ceases to exist after about a month and a half of being orphaned (vanilla CDS continue to exist even after being orphaned). LCDS should price based on this feature, especially on names that only have a limited number of loans outstanding, or have only short-term maturities that may not be renewed.