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11 September 2002

IntroductionThe credit derivatives market has grown significantly in recent years, revolutionising

the trading of credit risk. Close to zero in the mid-nineties, the British Bankers

Association estimated the outstanding notional at just under US$1 trillion in 2000 and

expects it to top the US$1.5 trillion mark by the end of 2002. The (modified) 1999 ISDA

documentation now provides a legal framework and many of the problems of the early

days (such as the definition of credit events) have largely been ironed out. Recent

developments in the US indicate that the market is trending towards a two-credit-

event market there (thus more closely resembling the corporate bond market). This

should attract more participants and increase liquidity, helping the market to mature.

Credit derivatives facilitate the transfer and repackaging of credit risk. They have de-

linked credit risk from funding and separated the ownership of an asset from the

ownership of the risk. As such, they allow market participants to buy credit risk for names

not available in the cash market, and the number of actively traded names has increased

significantly. Why is this a very important development?

The risk attached to a credit includes the deterioration of spread and/or rating (not

necessarily going hand in hand, as witnessed over recent years), as well as default

and recovery (defining the ultimate loss). Within a portfolio, credits show varyingdegrees of correlation. Credit derivatives allow protection buyers to hedge these risks,

increase diversity and bring down concentrations in an efficient and flexible way. At the

same time, they offer protection sellers the opportunity to add credit exposure

according to their risk appetite. There may also be more liquidity than the cash market.

Risks include credit event definitions, spread volatility and counterparty risk.

Who would be interested in trading credit risk? Historically, banks have extended loans

to corporates, other banks and sovereigns, thus building their credit portfolios. In

addition, the bond markets have grown significantly over the past few years. The 1988

Basle Capital Accord requires banks to allocate a certain amount of capital for credit

exposure to different obligors, not taking into account credit ratings or correlation. As aresult, banks started to take advantage of the arbitrage possibilities regulatory capital

requirements created. The market has come a long way since. Banks now increasingly

manage their economic capital and the revised Accord (Basle 2), which is due to be

implemented by the end of 2006, will adopt a refined approach towards credit risk. In

addition, new protection sellers like insurers, reinsurers, fund managers and, as of late,

hedge funds are entering the credit markets.

Credit default swaps have dominated the market as the building blocks for most credit

derivative structures. A single-name credit default swap allows an investor to replicate a

cash position without using any funding. However, the scope of credit derivatives goes

far beyond this. There is a wide range of innovative applications, three of which the

credit-linked note, the synthetic CDO and the first-to-default basket we shall discuss.

Credit derivatives facilitate the

trading of credit risk

They have de-linked credit risk

from funding and separated the

ownership of an asset from its

risk

Credit risk encompasses

deterioration, default and

ultimate loss

Banks dominate the market

with increasing interest from

(re-)insurers, fund managers

and hedge funds

Credit default swaps dominate

as the building blocks for most

structures

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The mechanics

What is a credit default swap?A credit default swap (CDS) is a bilateral contract in which one party (the protection

buyer or the seller of the credit risk) pays a periodic, fixed premium to another (the

protection seller or buyer of the credit risk) for protection related to credit events on

an underlying reference entity or obligation. Usually the premium is paid quarterly

and expressed in basis points per annum of the swaps notional. If a credit event

occurs, the protection seller is obliged to make a payment to the protection buyer in

order to compensate him for any losses that he might otherwise incur. Thus the credit

risk of the reference entity or obligation is transferred from the protection buyer to the

protection seller. A CDS is therefore similar to an insurance contract or a financial

guarantee i.e. of unfunded nature. Alternatively it can be thought of as an unfunded

FRN (which also largely excludes the interest rate risk), with the premium similar to the

credit spread over Libor.

A credit default swap

Source: DrKW

Determining the premium and the compensation payment both require a valuation of

credit risk. Credit risk is defined as the product of the likelihood of default (P d) and the

actual loss (L), which in turn depends on the recovery (R).

C = Pd* (1-R)*100 where L = 1-R

The credit spread is a function of P, R and maturity assuming a risk-free interest rate

(e.g. Libor). In addition, liquidity, regulatory capital requirements as well as the market

sentiment and perceived volatility and shape of curve are usually priced in. As a result,

in order to price a CDS, we need to know the credit, its default probability and recovery

rates, which depend on the level of seniority of the debt, plus market information. The

rating agencies, and in particular Moodys, provide a long history of statistical

information on one-year and cumulative default probabilities, as well as recovery rates

for different products.

Therefore, the counterparties in a CDS first need to agree on three broad issues; (i)

what the reference entity or obligation(s) is, (ii) what the credit events will be and (iii)

how and when the payment will be settled. Most CDS contracts1 are based on 1999

International Swaps and Derivatives Association (ISDA) standard documentation.

One party provides credit

protection to another according

to pre-defined credit events

Determining the premium and

protection payment require a

valuation of credit risk

CDS counterparties need to

specify three broad issues in

the documentation

Protection buyer

Premium (bp)

Reference entityor obligation

Protection seller

Contingent payment

Protection buyer

Premium (bp)

Reference entityor obligation

Protection seller

Contingent payment

1 It is estimated over 90%.

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Reference entity or obligation

As no particular asset is sold, a reference entity upon which protection is being writtenneeds to be identified. It may be a corporate, financial institution or a sovereign. A CDS

may reference a specific obligation of this entity a reference obligation and if this is

the case credit events would be linked to this obligation only. But more commonly

protection will be written on the reference entity without specifying a particular

obligation. Therefore the seniority and type of obligation that will trigger a credit event

will be identified in the documentation. Typically a CDS will reference an issuers

senior unsecured debt, and credit events could be linked to bonds or loans or to the

broader category of borrowed money.

Definitions of obligations

Category Characteristics

- Payment - Pari passu ranking

- Borrowed money - Specified currency

- Bonds - Not sovereign lender

- Loans - Not domestic currency

- Bonds or loans - Not domestic law

- Reference obligation only - Listed

- Not contingent

- Not domestic issuanceSource: International Swaps and Derivatives Association

SettlementThere are two methods of settlement for a CDS physical or cash.

In a physically settled CDS, upon the occurrence of a credit event the protectionbuyer would deliver an obligation to the protection seller and receive par in return.

If credit events are linked to a reference obligation, the scope of deliverable

obligations usually extends to include all obligations that rank pari-passu with the

reference obligation. The protection seller will be delivered the obligation that is

cheapest to deliver.

In a cash settled transaction, the protection seller would pay the difference

between market value and par (instead of having an obligation delivered) after a

specified period of time (e.g. 30 or 60 days). The protection buyer would obtain the

market price either from a calculation agent or via dealer poll. Again, if the market

value of a reference obligation cannot be obtained for whatever reason, then a

pari-passu ranking obligation with a similar maturity would be valued instead.

Settlement of a credit default swap

Source: DrKW

Which obligation(s) credit eventswill be linked to need to be defined

Two methods of settlement

Cash settlement

Protection buyerObligation

Protection seller

Par

Protection buyer Protection sellerPar Market value

Physical settlement

Cash settlement

Protection buyerObligation

Protection seller

Par

Protection buyer Protection sellerPar Market value

Physical settlement

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While the recovery value is usually the unknown variable, there are transactions in

which a fixed, pre-defined cash settlement amount (fixed recovery) is agreed.

The result is that the protection seller bears the loss on the obligation, but this loss

may differ according to the method of settlement. The protection seller may prefer

physical delivery if he thinks that by waiting and allowing the price of the obligation to

stabilise, he may realise a higher recovery. Intuitively one might think physical

settlement, or indeed a longer cash settlement period (i.e. 60 days rather than 30),

would result in a higher recovery as it gives the price of the credit more time to settle

down. However, recent history paints a cloudier picture, as this was not the case with

Enron and WorldCom, for example.

Credit events

The 1999 ISDA Credit Derivatives Definitions lists six credit events2.

Bankruptcy

Failure to pay

Restructuring

Obligation acceleration

Obligation default

Repudiation/moratorium

The first five relate to corporate obligations, whereas repudiation/moratorium is more

applicable to sovereigns. A CDS contract must define at least one credit event, but

usually it will include more. In recent months, obligation acceleration and default have

been dropped from standard CDS documentation, and most contracts are now based

on bankruptcy, failure to pay and restructuring. However, as we discuss recent

developments indicate that the market is moving towards even narrower credit event

definitions, with moves afoot, primarily in the US, to drop restructuring as a credit event

altogether. There are some obstacles to this, but at some point in the future it is

conceivable that protection may be written on bankruptcy and failure to pay only.

Bankruptcy

Generally this refers to a reference entity becoming insolvent or being unable to pay its

debts. The definition also includes a provision whereby any action taken by a reference

entity in furtherance3 of a bankruptcy would also constitute a credit event e.g. if a

company was known to be planning, or even just considering, filing for bankruptcy,

even if it had not yet done so.

Failure to pay

After the expiration of any applicable grace period, a reference entity fails to make

payments when due under one or more of its obligations. A minimum threshold (the

Payment Amount) needs to be specified and may vary depending on what obligations

the CDS is referencing.

The loss may differ according

to the method of settlement

Six credit events listed by ISDA

Bankruptcy, failure to pay andrestructuring have become the

standard credit events

but for how long?

2 The procedure for notifying the protection seller of a credit event is detailed in the documentation. Its occurrenceneeds to be confirmed by public sources e.g. the news wires.3 See 1999 ISDA Credit Derivatives Definitions, ISDA, for more details.

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Restructuring

This has been the most controversial credit event, and it is most relevant in the contextof hedging loans rather than bonds. According to the 1999 ISDA Definitions,

restructuring is a change in the terms of an obligation due to a deterioration in credit

quality of a reference entity that leaves creditors materially worse-off. The five

restructuring events listed are a reduction in the rate or amount of principal payable, a

reduction in the amount of principal or premium payable at maturity or at scheduled

redemption dates, a postponement or deferral of interest or principal payments, a

change in the ranking of an obligation causing it to be subordinated, or a change in the

currency or composition of any interest or principal payments.

In August 2000, Conseco restructured its maturing bank loans in order to forestall an

impending liquidity crisis. The maturity of a portion of the loans was extended, and

even though creditors were compensated through an increased coupon, a new

corporate guarantee and additional covenants, this restructuring triggered a credit

event under the ISDA Definitions. This caused uproar and sparked considerable

discussion about the merits of restructuring as a credit event, and the market went

through an uncertain period during which liquidity declined.

There were two key points that were up for debate in the aftermath of Conseco-gate

and at which protection sellers felt particularly aggrieved. Firstly, protection sellers

argued that banks (protection buyers) were not materially worse off as a result of the

restructuring and were compensated for the maturity of Consecos debt being

extended. Secondly, as protection buyers were able to deliver any obligation ranking

pari-passu to or higher than the reference obligation, they delivered the cheapest-to-

deliver bond. Some of Consecos bonds were trading at distressed levels, therefore

protection sellers incurred losses that they arguably would not have done if they were

long the reference obligation (i.e. the bank loan) itself.

As a response to the discussion and in order to address the concerns of market

participants, ISDA produced some supplemental definitions in May 20014 that have

been termed modified restructuring. The new definitions include a Restructuring

Maturity Limitation, which limits the maturity of deliverable obligations to 30 months

and thereby prevents protection buyers from delivering long-dated obligations that

might be trading at a significant discount. To meet the Pari-Passu Ranking criterion,

an obligation must have the ranking in the priority of payment that the reference

obligation had as of the later of the trade date or its issue date. This is to ensure that if

a reference obligation is subordinated in a restructuring, protection sellers cannot

deliver a subordinated obligation.

These new definitions have largely addressed the uncertainty that arose from

Conseco, and market participants in the US and Asia have incorporated modified

restructuring into most CDS contracts. In Europe, the transition has not yet been made

and old (i.e. unmodified) restructuring persists for now. However, a European version

of modified restructuring is currently being negotiated and is expected to be ready by

the end of the year.

The most controversial andfrequently discussed credit

event

The Conseco restructuring in

August 2000 had a significant

impact on the market

It sparked considerable debate

about the ISDA 1999 definition

of restructuring

As a response, ISDA produced

some supplemental definitions

modified restructuring

Modified restructuring has

been incorporated in the US

and Asia, but not yet in Europe

4 See Restructuring Supplement to the 1999 ISDA Credit Derivatives Definitions, ISDA, 11 May 2001.

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Despite the new definitions, controversy and uncertainty still surround restructuring as

a credit event. A credit event was called on Xerox in June this year when the companyextended the maturity of its bank loans, much to the dismay of protection sellers. There

is little doubt that Marconis restructuring, announced last month, in which it will swap

over 4bn of debt for equity, cash and some new debt should justifiably trigger a credit

event, however credit events have not yet been called. There is a debate over whether

CDS contracts have been legally triggered as the process has not yet reached court,

and there is also confusion over whether the relevant credit event is restructuring or

the companys effective bankruptcy. Even though the restructuring has not reached

court, the mere announcement of it should be sufficient to trigger payment. Credit

events could be called imminently, and the market is waiting for somebody to set a

precedent.

Reflecting the problems and uncertainty that still exist, J.P. Morgan, one of the leading

players in the credit derivatives market, has recently stated that it will drop

restructuring from the CDS contracts that it uses to hedge its own portfolio. The reason

cited is the growing concern amongst insurance companies and other protection

sellers over banks benefiting unduly from restructuring. We understand that other US

banks are moving in a similar direction, and the anti-restructuring movement is

gathering momentum5. Because the bond markets are more developed in the US, the

CDS market is based primarily on bonds and therefore dropping restructuring as a

credit event is a logical step in the US.

Outside the US, regulation is major obstacle. In Europe for instance, banks argue that

regulators would not grant them capital relief if contracts excluded restructuring,

although the Bank of International Settlements is currently being lobbied to accept

two-credit-event capital relief. The CDS market in Europe remains very much bank-

loan driven, therefore retaining restructuring makes more sense than in the US. But as

the bond markets continue to develop, moving towards two credit events would be a

natural progression. A two-credit-event CDS market i.e. where contracts would be

based on bankruptcy and failure to pay would certainly bode well for liquidity, as it should

attract more participants. That said, we may see two separate markets develop one for

bonds (without restructuring) and one for loans (with restructuring).

Obligation acceleration or default

The two are very similar, but they are no longer common in most contracts. Obligation

acceleration means that one or more obligations have become due and payable earlier

than they would otherwise have been due to the default (or similar condition) of a

reference entity. As with failure to pay, this is subject to a minimum threshold amount

(the Default Requirement) that needs to be specified in the documentation. The only

difference with obligation default is that one or more obligations have become capable

of being declared due and payable, even though they may have not yet been.

Repudiation/moratorium

A reference or government entity challenges or rejects the validity of one or more of its

obligations, or imposes a standstill or deferral on payment. Again this has to be for an

amount exceeding the Default Requirement.

Controversy surrounding

restructuring still exists

Could we see CDS contracts

exclude restructuring in the

future?

Outside the US, regulation is a

major obstacle

These are very similar, but have

recently been omitted from

most CDS transactions

Typically relates to sovereign

obligations

5 A tale of two restructurings, Creditflux, 5 September 2002

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The credit derivatives market

Volume and compositionThe growth of the credit derivatives market has been exceptional, and in its 1999/2000

Credit Derivatives Survey the British Bankers Association (BBA) estimated that

outstanding volume would increase almost tenfold from 1997 to 2002. As this is an

over-the-counter market, it is difficult to gauge its exact size. ISDA puts the outstanding

volume of CDS transactions at US$918.9bn at end-20016. Their data includes single

name CDS, basket and portfolio trades, but assuming that the composition of the

market has not changed significantly, then the total outstanding volume of credit

derivatives should currently be well in excess of US$1 trillion. As the graph below

shows, the size of the credit derivatives market is also increasing vis--vis the

corporate bond market. In 1997, credit derivatives represented less than 10% of

outstanding US corporate bond issuance, but by the end of 2002 we expect this figure

to be somewhere around 40%.

The credit derivatives vs. the corporate bond market: outstanding volume (US$ bn)

* Excluding asset swaps

** The credit derivatives figure is a BBA estimate, while the corporate bonds figure is an estimate as of Q1 2002

Source: BBA 1999/2000 Credit Derivatives Survey, Bond Market Association

Single name CDS are the largest component of the market, but their share has fallen

from 52% in 1997 (2002 estimate: 37%) as the market has developed and become more

diverse. Increasingly, however, single name CDS are becoming the building blocks of

more complex structured products, particularly CDOs as banks and asset managers

seek to exploit arbitrage opportunities synthetically rather than via the cash market.

Portfolio/CDO products account for the second largest portion, and we have seen a

considerable number of deals referencing portfolios, both static and managed, of single

name CDS. This has been facilitated by the improved liquidity and deepening of the CDS

market, which itself is the result of the standardisation of documentation and greater use

of the market as understanding and technical expertise have increased.

In terms of underlying, the focus has shifted from sovereigns to corporates, which now

account for the largest share of the market as the graph on the following page shows.

The credit derivatives market

has shown exceptional growth

over the past five years

Single name CDS are the

largest component of the

market

Corporates dominate in terms

of underlying

6 See 2001 Year End Survey, www.isda.org

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1997 1998 1999 2000 2002E**

Credit derivatives*

US corporate bonds

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The global credit derivatives market

Source: BBA 1999/2000 Credit Derivatives Survey

Market participantsThe credit derivatives market remains bank-dominated. Banks are natural lenders and

should always have a demand to hedge credit risk. As protection buyers, they have

been able to hedge certain risk positions in their portfolios and thus reduce their

regulatory (or economic) capital requirements. This has also enabled them to reduce

concentration risk to particular industries or countries and fill unutilised credit lines. In

Europe in particular, banks have transferred the risk of large portfolios through

synthetic CDOs. This has become increasingly interesting in light of the need to

enhance shareholder value and return on equity. However, as the table below shows,

banks share of the market is estimated to have fallen since 1999 as insurance

companies and corporates in particular have become more active.

Given the similarity of a CDS to a financial guarantee, it is natural that insurance

companies (especially monolines) have been far more active sellers than buyers of

protection. They have played an important part in the CDO market by taking the high

quality super senior CDS positions in (largely unfunded) synthetic deals (see page 16),

as well as equity pieces which has allowed them to gain leveraged exposure to a

portfolio of credits. Similar to banks, they have also used credit derivatives to reduce

risk concentrations e.g. to hedge country risks. Securities firms maintain an important

role as market makers, reflected in an almost equal proportion of protection buying and

selling. Although their overall market share is still small, fund managers, particularly

hedge funds, are becoming increasingly important players.

Credit derivatives market participants

End-1999 actual End-2002 estimate

Protection Buyers Protection Sellers Protection Buyers Protection Sellers

Banks 63% 47% 51% 38%

Securities firms 18% 15% 15% 16%

Corporates 6% 3% 10% 5%

Insurance companies 5% 24% 11% 26%

Governments 2% 1% 3% 1%

Mutual funds 1% 2% 3% 4%

Pension funds 2% 3% 3% 5%

Hedge funds 3% 5% 4% 5%Source: BBA 1999/2000 Credit Derivatives Survey

The market remains bank-

dominated

but other players are

becoming more active

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1997 1999 2002E

Corporates Banks Sovereigns

Total return swaps

10%

Portfolio/CDOs

18%

Credit spread

products

6%

Basket trades

7%

Asset swaps

11%Credit default

swaps

37%

Credit-linked

notes

11%

Underlying Composition (end-2002 estimate)

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Market characteristics

Why use credit derivatives?There are multiple reasons why banks, insurers, corporates and fund managers use

credit derivatives. Credit derivatives facilitate risk management by increasing diversity

or lowering concentrations, thereby potentially reducing regulatory (or economic)

capital requirements and increasing income. Theoretically, this could be achieved

through the cash market, but the credit derivatives market provides greater flexibility,

efficiency and liquidity. That said, there are some challenges including greater spread

volatility, counterparty risk as well as different default probabilities and, depending on

settlement, recovery values. The table below illustrates the motivation of protection

buyers and sellers.

The motivation of protection buyers and sellers

Protection sellers Protection buyers

Portfolio/credit risk management

Free regulatory capital

Manage economic capital

Exploit arbitrage

Increase return via fee income

Fill credit lines

Source: DrKW

The CDS vs. the cash marketFlexibilityCDS offer a more flexible way to both assume and short credit risk, as the restrictions

of the cash market can be overcome. In the cash market investors are limited to an

entitys outstanding bonds (and/or loans), whereas CDS contracts can be tailored in

terms of maturity, size and the type of obligation. By referencing borrowed money,

CDS also facilitate credit exposure to entities without public bond issues, creating a

more diverse credit universe and avoiding exposure to frequent issuers. For those

wishing to short credit, buying protection can circumvent the potential difficulties of

borrowing the cash instruments and the risks of the repo market (e.g. funding or short

squeezes on the bond). As credit derivatives are an over-the-counter product, more

complex structures can be tailor-made according to the investors risk appetite.

The cash market imposes a number of restrictions in terms of the volume and pattern

of issuance volume and number of issuers. If one takes the European corporate bond

market as an example, issuance rose tenfold between 1995 and 2000. Europes single

currency in 1999 set a milestone and corporate issuance reached 193bn7 in 2001.

Our credit strategists expect new issuance to fall to around 125bn7 in 2002, and for

outstanding volume to be around 600bn7 at the end of the year. The market in Europe

is still dwarfed by the US$ corporate bond market, where outstanding volume is

expected to reach US$4 trillion (including financials) by the end of 2002.

There are multiple reasons to

use credit derivatives

Restrictions of the cash market

can be overcome

These restrictions include the

volume and pattern of issuance

and number of issuers

7 Excluding financials

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-denominated corporate bond supply excluding financials (bn)

Source: DrKW

In the past few years, corporate bond supply in Europe has been particularly strong

from industries in which companies were increasing leverage and/or expanding rapidly

via M&A e.g. telecoms, and more recently from companies with significant refinancing

needs. Still, issuance has been fairly irregular over time, making it difficult to plan credit

investments. A look at iBoxx, a credit index that includes issues exceeding 500m and

denominated in , shows that it currently includes 440 bonds from 210 different issuer

groups. By industry, banks and financial services dominate with over a 30% share,

followed by telecoms and autos as the chart below illustrates.

The CDS market in comparison does not rely on new bond issuance and therefore

offers better opportunities to select a more diversified portfolio. According to our credit

derivatives desk, there are around 400-500 credits that are traded (mostly investment

grade), which are represented in the chart below. We can see that the industry

distribution is far more even compared to iBoxx, as the market is not skewed in favour

of particular sectors. Industrials, energy and metals and consumer products account

for a larger proportion of the market, while the share of banks and financials, telecoms

and autos is much smaller.

Credit derivatives market vs. iBoxx - by industry sector

Source: iBoxx and DrKW

Corporate bond supply in

recent years has been skewed

towards particular industries

CDS market: a more diverse

universe to choose from

0

50

100

150

200

250

1998 1999 2000 2001 2002 (end-

Aug)

0

5

10

15

20

25

30

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

1999 2000 2001 2002

Banks

6%

Energy and metals

10%

Industrials

20%

Autos

4%

Financial services

9%

Healthcare

4%

Telecoms

5%

Consumer

products

11%

Media

6%

Retail

6%

Utilities

6%Transportation

4%

Technology

6%

Hotel and

leisure

1%Banks

20%

Energy and metals

2%

Industrials

8%Autos

14%

Hotel and

leisure

1%

Technology

2%

Transportation

1%

Utilities

10%

Retail

1%

Media

1%

Consumer

products

7%

Telecoms

20%

Healthcare

1%

Financial services

12%

CDS market iBoxx

Annual Monthly

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Efficiency

As CDS are unfunded instruments, credit and funding decisions can be separated fromone another. Protection sellers can take pure credit risk, tailored to their own

specifications. They do not need to fund the position, and credit expertise can

therefore be leveraged more cost-effectively. In addition, banks can hedge credit

portfolios much more efficiently than if they had to physically transfer all the assets

(and fund such a transaction). These portfolios can be tranched into products with

different risk/return profiles and investors can chose risk positions according to their

risk appetite/return requirements. This increases the efficiency of the market.

Liquidity and market dynamicsCompared to the cash market, the credit derivatives market tends to be more volatile.

Liquidity, or the lack of it, is driven by news on a particular name or industry sector,

new issuance in the cash market, etc. Generally bid-offer spreads are greater in the

CDS market. In the more liquid names, the spread will be 10-20bp depending on

market conditions, but significantly greater in others. However, the CDS market has

tended to be more liquid than the cash market in off-the run names or in times of

distress e.g. Russia in 1998, Railtrack, as well as with large volumes.

As with most derivatives, CDS exaggerate movements in the underlying market,

meaning that protection sellers are subject to greater volatility than if they held an

equivalent cash position. Generally, in periods of deteriorating credit sentiment the

CDS widens more than the cash bond as market participants clamber to buy protection

in order to hedge their positions or go short. As we have already mentioned, actually

selling the bond or shorting it may be difficult when there is negative news surrounding

an issuer, but in the CDS market there is usually an offer for protection that can be hit.

Dealers mark out their offers as the demand for protection increases, and this creates

a more exaggerated widening compared to the cash market, although arguably it

represents a more accurate pricing of that issuers credit risk. Likewise a tightening in

the cash may be magnified in the CDS, as the premium for protection falls quickly as

credit concerns subside. These trends are more evident with weaker credits, but they

still exist in more stable names.

As CDS are unfundedinstruments, credit and funding

decisions can be separated

Greater liquidity in times of

stress, in off-the-run names

and large transactions

Spread volatility is typically

greater

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Spread comparison of the CDS and cash market 1

1 All spreads are mid levels, and corporate bond spreads are asset swap spreads

Source: iBoxx and DrKW

Counterparty riskAs well as the credit risk of the reference entity, in a CDS there is also the default risk

of the counterparty to consider. For benchmark issuers, this typically results in theCDS market trading slightly wider than the cash (positive basis), as the graphs above

show. In off-the-run names where the cash is less liquid than the CDS, negative basis

may exist on occasions (i.e. the CDS is trading inside the cash). This creates a

possible arbitrage between the two markets by taking a cash position and

simultaneously buying protection. However, this trade can be difficult to identify in

practice, and because the cash position needs to be funded it does not represent the

most efficient use of capital.

Counterparty risk adds a few

basis points, so CDS usuallytrade outside the cash market

0

100

200

300

400

500

600

700

Jan-02 Mar-02 May-02 Jul-02 Sep-02

5yr CDS 6.75% '08

0

100

200

300

400

500

Jan-02 Mar-02 May-02 Jul-02 Sep-02

5yr CDS 5.875% '06

0

50

100

150

200

250

Jan-02 Mar-02 May-02 Jul-02 Sep-02

5yr CDS 6.125% '06

0

200

400

600

800

1000

1200

Jan-02 Mar-02 May-02 Jul-02 Sep-02

5yr CDS 5.75% '06

0

20

40

60

80

100

Jan-02 Mar-02 May-02 Jul-02 Sep-02

5yr CDS 5.375% '08

0

40

80

120

160

200

Jan-02 Mar-02 May-02 Jul-02 Sep-02

5yr CDS 5.25% '06

France Telecom Deutsche Telekom

DaimlerChrysler Fiat

RWE Endesa

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Defaults and recoveries may differ from historical data

Default probability and recovery values for a given credit may differ from historical datafor the cash market, depending on the definitions of credit events as well as the terms

and conditions of settlement. In 2001, Moodys published a report7 in which they

discussed at length the notion that a CDS may, if certain (soft) credit events are

included in the contract, expose investors to a higher frequency and severity of losses

than if they held an equivalent cash position.

Moodys definition of a default encompasses any missed or delayed payment of

interest and/or principal, bankruptcy and receivership, and a distressed exchange.

Some types of restructuring, Conseco being an example (see page 6), would fall

outside Moodys definition of default and would not be captured by a Moodys rating or

by its historical default statistics. Neither would obligation acceleration and default,

while some components of ISDAs definition of bankruptcy are not consistent with

Moodys. For example, the placing of Railtrack under administration in December 2001

constituted a credit event under the ISDA definition of bankruptcy, however all of its

debt service obligations were being met in a timely manner. There was no payment

default and Moodys retained the companys investment grade rating.

While Moodys has some justification, its argument is now less relevant given the

advent of modified restructuring and the fact that obligation acceleration and default

are now omitted from CDS documentation. Moreover, if restructuring is dropped

altogether, then default probabilities should begin to more closely reflect those implied

by historical data. But at present the argument does still hold in certain circumstances

so it is a risk that needs to be considered, albeit a relatively small one.

Default probability and recoveryvalues may differ from

historical data

Some credit events are not

consistent with Moodys

defintion of default

Moodys argument has some

justification, but it is now less

relevant

8 Understanding the Risks in Credit Default Swaps, Moodys Investors Service, 16 March 2001

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CDS applicationsAs we have already mentioned, not only has the CDS market become very large in its

own right, but single name CDS are increasingly being used as the building blocks to

create more innovative structured products. Here we briefly explain three of the most

widely-used applications; the credit-linked note, the synthetic CDO and the first-to-

default basket.

Example 1: credit-linked noteA credit-linked note (CLN) can be thought of as a note with an embedded CDS, oralternatively as a collateralised CDS. The investor receives a pay-off that is dependent

on the performance of one or more reference credits. In its simplest form, a CLN pays

a coupon and redeems at par provided that no credit events have occurred on the

reference entity/obligation(s). If a credit event does occur, then the note is redeemed

for an amount equal to par minus the loss on the defaulted credit.

This is the basic design, but a CLN can be structured with additional features

according to investor requirements. It could be principal protected, meaning the

investor is repaid par at maturity regardless of whether a credit event has occurred or

not. A credit event would simply mean that the coupon stops being paid. Alternatively it

could be structured with coupon protection instead. Other variations include linking aCLN to credit spreads rather than credit events as such, or referencing it to an equity

or a commodity index.

There are two main types of CLN structure: an EMTN CLN and a SPV CLN. In the

former, the note is issued by a well-known entity (a bank or corporate), so the investor is

exposed to the credit risk of the issuer as well as the reference credit(s). In the latter, an

SPV issues the CLN and the note proceeds are invested in highly-rated collateral (e.g.

AAA ABS or government bonds), although this may also be done for an EMTN CLN.

EMTN vs. SPV CLN

Source: DrKW

CDS are increasingly be used

as the building blocks for more

innovative structured products

A CLN is effectively acollateralised CDS

It is a very flexible product and

can be tailored according to

investor requirements

There are two broad types: an

EMTN CLN and a SPV CLN

InvestorCDS

counterparty

CLN coupon

EMTN CLN

EMTN issuer

SPV CLN

InvestorCDS

counterpartySPV

Collateral

CLN coupon

Principal

Principal

Principal Bond coupon

CDS premium

CDS premium

Libor f unding

Bond coupon

InvestorCDS

counterparty

CLN coupon

EMTN CLN

EMTN issuer

SPV CLN

InvestorCDS

counterpartySPV

Collateral

CLN coupon

Principal

Principal

Principal Bond coupon

CDS premium

CDS premium

Libor f unding

Bond coupon

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CLNs are on-balance sheet investments and therefore are attractive to investors such

as insurance companies who cannot use credit derivatives directly (note that there aresome exceptions). Typically they provide a pick-up over a reference entitys senior

unsecured bonds, and a huge advantage is their flexibility. They can offer investors

exposure to one or more reference entities in any currency, with any maturity and with

any coupon structure. If required, a CLN can be rated by the rating agencies.

Example 2: synthetic CDOBefore the emergence of synthetics, bank CDOs were cash flow structures where the

originating bank sold a pool of assets (usually loans) off-balance sheet and obtained

funding. As the credit derivatives market developed, synthetic CDOs began to emerge

towards the end of the 1990s and have allowed banks to decouple risk transfer and

funding. In this type of transaction, the originating bank transfers the risk of a

designated reference portfolio by buying protection, achieving regulatory (or economic)

capital relief, while the assets themselves remain on-balance sheet. This risk is then

tranched up. As many banks can achieve a lower cost of funding in the senior

unsecured debt market, synthetic CDOs tend to be largely unfunded. The majority

(around 90%) of the underlying credit risk is transferred via a super senior CDS. For

the remaining 10%, the bank buys protection from an SPV, which then issues notes.

The note proceeds are usually invested in highly rated collateral, allowing a AAA rating

to be achieved on the senior notes. Deals have tended to issue AAA all the way down

to BB, with noteholders assuming any losses on the portfolio above the equity piece

(i.e. the first loss, which has usually been retained by the bank). Credit events aresettled by liquidating the collateral.

A synthetic CDO structure

Source: DrKW

By buying protection from an OECD bank, the originating bank reduces its regulatory

capital requirement on the super senior risk to 20% from 100%. Assuming that

government bonds are used as collateral, a 0% risk-weighting is achieved on the

portion of risk that is transferred via note issuance. If the equity is retained it attracts a

one-for-one capital charge.

CLNs offer investors a number

of benefits

Synthetic CDOs have been used

by banks to obtain regulatory

(and economic) capital relief

By freeing up capital, these

structures have allowed banks

to enhance shareholder value

Protection

xth loss 7% SPV

Originating bank

Noteholders

Collateral

Principal andinterest

CDS premium

Note proceeds

Note principaland interest

Referenceportfolio

Equity holder

Noteproceeds

Usually the

originating bank

First l oss 3%

Super senior 90%Super senior CDS

counterparty

Protection

CDS premium

Protection

xth loss 7% SPV

Originating bank

Noteholders

Collateral

Principal andinterest

CDS premium

Note proceeds

Note principaland interest

Referenceportfolio

Equity holder

Noteproceeds

Usually the

originating bank

First l oss 3%

Super senior 90%Super senior CDS

counterparty

Protection

CDS premium

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Basle 2 has been delayed until 2006 at the earliest, but when it is finally implemented

we expect the motivation for bank balance sheet CDOs to shift from regulatory toeconomic capital relief, as the current regulatory arbitrage will largely disappear. But as

regulatory and economic capital will be more closely aligned, banks, primarily those

adopting the internal ratings-based approach, should be able to retain the super senior

pieces of CDOs and significantly reduce their regulatory capital requirements.

Synthetic CDOs have evolved considerably over the years, both in terms of their

structure and motivation. Structural modifications that we have seen include the

omission of an SPV, fully unfunded deals and the combination of synthetic and cash

flow techniques. The traditional synthetic CDO was driven by banks seeking to gain

capital relief on cash assets already on their balance sheet. But economic capital

models discourage banks from cherry-picking their good assets and currently render

regulatory balance sheet deals defunct. As the CDS market has become more liquid,

banks, asset managers and hedge funds are increasingly ramping up portfolios by

selling protection into the market and using CDOs for arbitrage rather than balance

sheet purposes. As CDS trade wider than their cash equivalents, there are

considerable opportunities. The increased flexibility also means that portfolios with

greater diversity and granularity can be constructed, potentially reducing event risk and

ratings volatility for investors. Pools may be static or managed, but the dynamics of

managing CDS are different to managing a pool of bonds, particularly in terms of

spread volatility. This is something investors need to be cognisant of.

Example 3: first-to-default basketThis is a leveraged product that can either be issued as a CLN or structured in

unfunded form. The first credit to default in a basket of (two or more) reference entities

would trigger a payment to the protection buyer, and the structure would subsequently

unwind. Transactions may be cash settled, but more commonly they will involve

physical delivery of the defaulted asset. Should more than one default occur

simultaneously in the basket, then the asset of one defaulted reference credit only is

delivered i.e. the investor only loses once. Therefore a first-to-default basket allows

investors to leverage their credit exposure without increasing their downside risk. They

can obtain the yield of a low quality asset by taking exposure to high quality assets that

they are familiar with.

Pricing is driven by the credit spreads and the correlation of the names in the basket.

For a perfectly correlated basket, the first-to-default spread will be equal to the name

with the widest spread in the basket. For a perfectly uncorrelated basket, it would be

equal to the sum of all the spreads in the basket. In reality though, correlation lies

somewhere between these two extremes, and baskets are priced accordingly.

Determining the correlation is thus crucial, and on the next page we illustrate the

pricing of a basket consisting of six German investment grade corporates from different

industries.

Basle 2 is likely to effect a shift

from regulatory to economiccapital CDOs

Synthetic CDOs have evolved in

terms of their structure and

their motivation

It investors to leverage their

credit exposure without

increasing downside risk

Pricing is driven by the

underlying credit spreads and

correlation

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First-to-default pricing: an example (as of 01 September 2002)

Reference entity 5yr CDS Moody's S&P

Daimler Chrysler +145bp A3 BBB+

Metro + 70bp Baa1 BBB+

Deutsche Telekom +290bp Baa1 BBB+

Thyssenkrupp +150bp Baa1 BBB

Siemens + 60bp Aa3 AA-

Lufthansa +140bp Baa1 BBB+

First-to-default pricing Euribor +445bp

100% correlation Euribor +290bp

0% correlation Euribor +855bpSource: DrKW