cd conference 2004 credit derivatives 101

Betsy MettlerVice President,J.P. Morgan Securities Inc.

INTRODUCTION TOCREDIT DERIVATIVES

JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE

The Explosive Growth of Credit Derivatives

180 350 586 893 1,1891,952

2,690

4,799

10,000

1997 1998 1999 2000 2001 2002 2003 2004E 2007ESource: British Banker�s Association, ISDA, McKinsey & Co.

Credit Derivatives Market Growth: Volumes Traded ($ billions)

1

Evolution of Market Participants

� Predominantly buyers of protection

� Hedge over concentrations in loan portfolios

� Sell protection to subsidize their hedging programs and diversifytheir portfolio

� Predominantly sellers of protection

� No funding requirement

� Attractive leverage

� Alternate liability class to be underwritten providing exposureto corporate credit risk

� Predominantly sellers of protection

� Relative value

� Ability to customize credit risk

� Ability to short credits

� Active as both buyers and sellers of protection

� Convertible arbitrage

� Ability to short credits

� Basis trades: bonds vs. protection

� Equity vs. Credit

Bank Portfolio Managers Insurance Cos/Asset Managers

Reinsurers/Monolines Hedge Funds

Evolution of the Credit Derivatives Market

1994 20041999

Total growth

Banks Re-insurers Hedge Funds Real MoneyIns. Co.

Asset Managers

2

Future Participants: Corporates

Improve returns onbalance sheet cash or

pension assets

Create creditcapacity for new orlong-term business

arrangements

Hedge financialassets received from

the acquirer in anasset sale

Manage variability offuture interest

expense

Improve efficiency ofhedges of cash flowsfrom/to third parties

Hedge sellerindemnities in an

acquisition structure

Credit Derivatives

3 3

Diversity of Market Participants

Insurance14%

Hedge funds13%

Banks synthetic securitization

10%

Reinsurance10%

Third-party asset managers

7%

Corporates3%

Banks38%

Source: Risk February 2003

Special Purpose Vehicles5%

4

Conduit of Information

� In sourcing and selling generic credit risk,the credit derivatives desk serves as a linkbetween many different markets

� Example activities of convertible bondfunds create positive basis andrelative value opportunities forinvestors� A corporation issues a convertible

bond� Convertible bond funds look to

purchase cheap call options on theunderlying equity

� These funds buy the bond and buyprotection stripping out the creditrisk

� Spreads in the credit derivativesmarket will widen as a result of thisincreased demand

JPMorgan CDSTrading Desk

Corporatereceivables

Equity market

Bond market

Credit DefaultSwap market

Convertiblemarket

Loan market

5

Credit Derivatives Allow Investors to Customizetheir Source of Credit Risk

� Range of tenors available

� Most liquid tenor is five-year maturity

� Quarterly end dates

� Notional size ranges

� Investment Grade: USD 5 to 20 million

� High Yield: USD 2 to 5 million

� Trade approximately 800 credits globally across:

� Countries

� Ratings categories

� Asset classes

� Synthetic Market

� Customized baskets of credit exposure6

Single Name Credit Default Swaps

Contingent payment upon a Credit Event

Reference Entity

ProtectionBuyer

Fee/premiumProtection

Seller

Risk

95% of all creditderivatives arecredit defaultswaps

� A Credit Default Swap is a contract whereby the Protection Buyer transfers the risk that a CreditEvent will occur on the Reference Entity

� In return for protection, the Buyer pays a fee to the Protection Seller

� Upon a Credit Event, the protection Seller pays par for bonds or loans of the defaulted entity.Protection Seller effectively pays 100%�Recovery Rate

� The Protection Buyer takes on the same risk profile as if they shorted a bond, also referred to asselling risk

� The Protection Seller takes on the same risk profile as if they bought a bond also referred to asbuying risk

7

Interest rate

Funding

Credit

Bond/Loan

Credit

T + 120bp

Asset Swap

Credit

Funding

Libor + 80bp 80bp

Credit Default Swap

Prices for Credit Default Swaps are InitiallyDerived from Bond/Loan Prices

� A bond or loan contains interest rate risk, funding risk, and credit risk

� Credit default swaps isolate and transfer credit risk

� To determine the theoretical price of credit risk

� Swap the bond/loan into a floating rate investment (asset swap)

� Remove the funding cost (assume a funding of LIBOR)

� Credit risk remains, which gives you the theoretical price for credit protection

8

Compare Buying a Bond with Selling Protection:5-year Par Bond Yielding 4.2%, (T + 120bp)

Bond cash flows Equal credit derivative cash flows

Principalon Bond

Interest Rate = 300bp

5yr Libor Spread = 40bp

Credit = 80bp

Credit Default Swap Spreads

Scenario #1: No default

9

Compare Buying a Bond with Selling Protection:5-year Par Bond Yielding 4.2% (T + 120bp)

Bond cash flows Equal credit derivative cash flows

Interest Rate = 300bp

5yr Libor Spread = 40bp

Credit = 80bp

Credit Default Swap Spreads

Seller of protection pays $100,receives default bond worth$40, net is loss of $60

-$100 costof bond After default,

sell bond for$40

Scenario #2: Default in year 4, 40% recovery rate

10

Negative Basis Trade: Example

� Example: 5-year IBM Corp. par bond yielding T + 120bp

� The credit risk component of this bond is 80bp

� If credit protection is offered at /60bp, then 20bp of negative basis exists

� An investor should buy the bond and buy protection and receive 20bp running for thelife of the trade

� Negative basis players (including trading desks) will typically take this position whenthe negative basis exceeds 15bp

� These arbitrage opportunities evaporate relatively quickly and rarely exceed 30bp

Interest rate

Funding

Credit

Bond/Loan

Credit

T + 120bp

Asset Swap

Credit

Funding

Libor + 80bp 80bp

Credit Default Swap

11

Positive Basis Trade: Example

� Example: 5-year IBM Corp. par bond yielding T + 120bp

� The credit risk component of this bond is 80bp

� If credit protection is bid at 100bp/, then 20bp of positive basis exists

� Investors exploit positive basis as an alternative to the cash investment preferring tosell protection over buying the bond to pick-up an extra 20bp in relative value fortaking the same credit exposure

� Positive basis opportunities can persist for a longer period of time and the spreaddifferential is not limited by technical reasons

� Selling bonds and selling protection is difficult because a term repo trade is difficultto maintain

Interest rate

Funding

Credit

Bond/Loan

Credit

T + 120bp

Asset Swap

Credit

Funding

Libor + 80bp 80bp

Credit Default Swap

12

Standardization of Credit Default Swap Confirmation

� Standardized documentation has led to the dramatic growthof the credit derivatives market

� Investment Grade and High Yield North Americanconfirmation based on the 2003 ISDA credit derivativesdefinitions

� Standard 2003 contracts began trading June 20, 2003

� Contracts proved effective by Enron, Worldcom and otherdefaults

� Worldcom: close to 600 contracts outstanding� Estimated over 7 billion in notional� No disputes or litigation� No mechanical settlement problems

13

How the Triggering Mechanism of a Credit DefaultSwap Works: Watch, Check, Deliver

Watch Deliver

ProtectionBuyer

Deliverable ObligationsProtection

Seller

100% of notional

� Watch a predefined group of Obligations of the Reference Entity

� Check that a Credit Event has occurred, in which case

� Deliver another predefined group of Deliverable Obligations in return for par

Check

Obligations Credit EventsDeliverable Obligations

14

�Obligations� Limit which Instruments canTrigger Protection on a Credit Default Swap

� Borrowed Money: bond, note, loan, commercial paper, and letters of credit

DerivativeContracts

GeneralCreditors

�Payment�

�Borrowed Money�Bonds Loans

Watch Deliver/SettleCheck


15

�Obligations� Limit which Instruments canTrigger Protection on a Credit Default Swap

� The standard Credit Events under ISDA definition:

� Failure to Pay

� Bankruptcy

� Restructuring

� High Yield Credit Default Swaps trade without Restructuringas a Credit Event



16

�Deliverable Obligations� Limit which Obligationscan be Delivered upon a Credit Event

� Deliverable Obligations means any Bond or Loan ranked senior or better inthe capital structure (i.e. senior unsecured)



ProtectionBuyer

Deliverable ObligationsProtection

Seller

100% of Notional

17

Physical Settlement Timeline

CreditEventoccurs

Buyer deliversNoPS to Seller

PhysicalSettlementDate

Physical Settlement Period(as per Section 8.6 capped

at 30 Business Days)Maximum of 30 calendar days

CEN & PAI deliveredby Buyer or Seller(must be before the14th day afterScheduledTermination Date)

Notes: CEN = Credit Event NoticePAI = Publicly Available InformationNoPS = Notice of Physical SettlementSection 8.6 of the 2003 Credit Derivative Definitions provides the Physical Settlement Period should be �the longestnumber of Business Days for settlement in accordance with then current market practice� of the obligations beingdelivered

18

Valuing a Credit Default Swap Position Using CDSW

� Enables user to perform mark-to-market valuation on vanilla Credit Default Swap

� Model type set to J for JPMorgan

� Three sections make up CDSW

� Deal Information: original trade details� Spreads: current market spreads� Calculator: valuation of position

19

This material is not a product of J.P. Morgan Securities Inc.�s (�JPMSI�) Research Departments, and you should not regard it asresearch or a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those ofthe individual author and may differ from the views or opinions expressed by JPMSI�s Research Departments or otherdepartments or divisions of JPMorgan and its affiliates. Research reports and notes produced by the Firm�s ResearchDepartments are available from your salesperson.

This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment byJPMorgan to enter into any transaction. No reliance should be placed on the information herein, which is preliminary and doesnot constitute all the information necessary to evaluate investing in any financial instrument or participating in any transaction.This material may also include information obtained from sources believed to be reliable, but JPMorgan does not warrant itscompleteness or accuracy. Any decision to invest in any financial instrument, or participate in any transaction, describedherein should be based solely on the final documentation related thereto. Nothing herein is a recommendation to invest in anyfinancial instrument or participate in any transaction or legal, tax, regulatory or accounting advice, and each prospectiveinvestor or transaction participant must make an independent assessment of such matters in consultation with its ownprofessional advisors. Additional information is available upon request. JPMorgan is the marketing name for J.P. MorganSecurities Inc. (member, NYSE/NASD) and its investment banking affiliates.

Eric Beinstein*Vice President,J.P. Morgan Securities Inc.

CREDIT DERIVATIVES PRICINGAND RESEARCH


Measures of Spread for Bonds

21

Basis Report

22

Yield to Maturity: Premium Bond

Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (105) 10 10 110

YTM 105 = 10 + 10 + 110(1 + YTM) (1 + YTM)^2 (1 + YTM)^3

YTM = 8.06%

23

Z-Spread: Premium Bond

Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%

Bond flows (105) 10 10 110

Z-Spread 105 = 10 + 10 + 110(1 + 0.005 + Z) (1 + 0.010 + Z)^2 (1 + 0.020 + Z)^3

Z-Spread = 6.17%

24

I-Spread: Premium Bond

Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (105) 10 10 110

I-Spread = YTM - Swap Rate at Bond Maturity

I-Spread = 8.06% - 2.00% = 6.06%

25

Asset Swap Spread: Premium Bond


Bond flows (105) 10 10 110

Fair Value 123.41 = 10 + 10 + 110(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Duration 2.92 = 1 + 1 + 1(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Asset Swap Spread = (123.41 - 105) / 2.92 = 6.31%

Asset Swap Spread = (Fair Value Bond Price � Actual Bond Price) / DurationFair Value bond price assumes bond had no credit risk, i.e., discounted at swap rate

26

In Summary�

PremiumBond

YTM 8.06%

Z - Spread 6.17 Best measure of comparable bond value asadjusts for shape of Swap curve

I - Spread 6.06 Not as good as Z spread as ignores Swapcurve shape, but usually a reasonableapproximation for high grade bonds

Par ASWSpread

6.31 A tradable value, not a good value measure forbonds far from par

27

Yield to Maturity: Discount Bond

Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (92.13) 5 5 105

YTM (92.13) = 5 + 5 + 105(1 + YTM) (1 + YTM)^2 (1 + YTM)^3

YTM = 8.06%

28

Z-Spread: Discount Bond


Bond flows (92.13) 5 5 105

Z-Spread (92.13) = 5 + 5 + 105(1 + 0.005 + Z) (1 + 0.010 + Z)^2 (1 + 0.020 + Z)^3

Z-Spread = 6.12%

29

I-Spread: Discount Bond

Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (92.13) 5 5 105

I-Spread = YTM - Swap Rate at Bond Maturity

I-Spread = 8.06% - 2.00% = 6.06%

30

Asset Swap Spread: Discount Bond


Bond flows (92.13) 5 5 105

Fair value 108.82 = 5 + 5 + 105(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Duration 2.92 = 1 + 1 + 1(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Asset Swap Spread = (108.82 - 92.13) / 2.92 = 5.72%

Asset Swap Spread = (Fair Value Bond Price � Actual Bond Price) / DurationFair Value bond price assumes bond had no credit risk, i.e., discounted at swap rate

31

In Summary�

PremiumBond

DiscountBond

YTM 8.06% 8.06%

Z - Spread 6.17 6.12 Best measure of comparable bondvalue as adjusts for shape of Swapcurve

I - Spread 6.06 6.06 Not as good as Z spread as ignoresSwap curve shape, but usually areasonable approximation for highgrade bonds

Par ASWSpread

6.31 5.72 A tradable value, not a good valuemeasure for bonds far from par

32

Dollar Price Effect and Expected Value

33

Bond Pricing and Probability: The Framework

100

108

40

Cash atmaturity

AssumedValue ifdefault

Pricetoday

Discount factor = 2%

A simplified example:

34

Bond Pricing and Probability: The Framework (cont�d)

100

108

40

Cash atmaturity

AssumedValue ifdefault

Pricetoday

Discount factor = 2%

91.24%

8.76%

Probability of no default

108 X 0.98 X 0.9124 + 40 X 0.98 X 0.0876 = 100

No Default path Default path

35


100108

40

91.24%

8.76%

?

105

40

Asset A Asset B

We know the �fair value� of another asset with a different coupon,based on the probability of default determined with the first asset

36


100

108

40

91.24%

8.76%

97.32

105

40

91.24%

8.76%

Asset A Asset B

We know the �fair value� of another asset with a different coupon,based on the probability of default determined with the first asset

105 X 0.98 X 0.9124 + 40 X 0.98 X 0.0876 = 97.32

No Default path Default path

37


100

108

40

91.24%

8.76%

97.32

105

40

91.24%

8.76%

100 = 108/(1+YTM)

YTM = 8.00%

97.32 = 105/(1+YTM)

YTM = 7.89%

Asset A Asset B

38


Asset A Asset BPrice $100 $97.32Number purchased 5 5.138Maturity payment 108 105Recovery per asset 40 40

If no defaultDollars after 1 year 540 539.46 0.54

If defaultDollars remaining 200 205.51 (5.51)

Basis of zero does NOT mean owning A or B will give the same return

So� If have $500 to invest

39

Asset A Asset B

If no defaultDollars after 1 year 540 X 0.9124 539.46 X 0.9124

+ +If defaultDollars remaining 200 X 0.0876 205.51 X 0.0876

Expected value = 510.21 = 510.21


The expected value is the same

Note: figures above exclude discount factor for simplicity. If multiply each term above by 0.98 expected values = 500.00

Probability of no default

40


The goal: A metric which tells us these two assets are of equal value

100

108

40

91.24%

8.76%

97.32

105

40

91.24%

8.76%

Asset A Asset B

Asset A Asset BYield 800bp 789bp

Spread over LIBOR (Z-Spread) 600bp 589bp

Asset Swap Spread 600bp 573bp

Par Equivalent CDS Spread 600bp 600bp

41

Structuring a Bond Versus CDS Trade

42

Basis Report

43

Basis Report (cont�d)

� Trade strategies: positive basis (CDS is cheaper than bond)

� Switch from bond position to default swap position (sellprotection)

� Short bond and sell protection

� Investigate why markets pricing same risk differently

� Trade strategies: negative basis (Bond is cheaper than CDS)

� Buy bond, buy protection for credit-risk-free position withpositive carry

� As such positions are credit risk neutral, the credit doesn�tmatter�it�s a quantitative exercise

� Investigate why markets pricing same risk differently

44

� Determine amount of protection to sell to have equivalentrisk profile as owning the bond:

� In GMAC 6.750% 2006 example: Bond price: $107.01,Assumed Recovery 50%

� How much protection do I sell to have same default risk asI had when holding the bond?

Amount at risk = Bond Price + ¼ of coupon - Recovery

= (107.01 + 6.750/4 - 50) = $58.70

= Amount at risk / (1- Recovery Rate)

$58.70 / (1 � 0.5) = $117.40

Positive Basis: Switch from Bond into Protection

45

Positive Basis: Switch from Bond into Protection(cont�d)

Creditexposure

Rateexposure

Creditexposure

Rateexposure

$58.70$50.00

Not at risk (recovery value)

Bond dirty price $108.70

$108.70

CDS equivalent $117.40

$58.70$58.70

$108.70

Amount at risk

� In GMAC 6.750% 2006 example:

46

Positive Basis: Bond Return on $100 Notional Position

Creditexposure $58.70$50.00

$108.70Rateexposure

� Credit earnings = Spread over swaps (Z-Spread) X Cash invested

� Rate earnings = Swap spread X Cash invested

Credit earnings = 104bp X 108.70 = $1.13

Rate earnings = 353bp X 108.70 = $3.84

Bond return on $100 notional position $4.97

47

Positive Basis: CDS and Swap Return withEqual Risk to Bond

� Credit earnings = Spread over Swaps (Z-Spread) X Cash invested

� Rate earnings = Swap spread X Cash invested

$58.70$58.70

$108.70

Creditexposure

Rateexposure

Credit earnings = 124bp X 117.40 = $1.46

Rate earnings = 353bp X 108.70 = $3.84

Clean swap -7bp X 104.24 = $(0.07)

CDS and swap return with equal risk to bond $5.23

48

Positive Basis: Unwinding the Position� With an upward sloping yield curve, unwinding the swap before maturity

will probably incur a loss to the client

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

1-yr 2-yr 3-yr 4-yr

Expected 3-month rate client is paying JPMorgan

Actual fixed rate JPMorgan is paying client

49

Positive Basis: Pick-Up in Return fromEqual-Risk Switch

Pick-up in return from equal-risk switch $0.26

Summary numbers No default DefaultBond + $4.97 $(58.70)CDS + Swap + 5.23 (58.70)

$0.26 $0.00

50

Positive Basis: Summary

Risky creditRisk freecredit

Rate exposure

Long a bond

=

Short protection (onequal default risk

position)

+Receiving fixed on a

credit contingentswap

51

Par CDS Calculator

52

The analyst(s) denoted by an asterisk ("AC") hereby certifies that: 1) all of the views expressed in this research accurately reflect his or her personal views about any and all ofthe subject securities or issuers; and 2) no part of any of the analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or viewsexpressed by the analyst(s) in this research.

Copyright 2004 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co., and its subsidiaries and affiliates worldwide. J.P.Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc., is a member of the NFA. J.P. MorganSecurities Ltd. (JPMSL), J.P. Morgan Europe Limited and J.P. Morgan plc are authorized by the FSA and JPMSL is a member of the LSE. J.P. Morgan Equities Limited is amember of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the HongKong Monetary Authority. J.P. Morgan Securities Singapore Private Limited is a member of Singapore Exchange Securities Trading Limited and is regulated by the MonetaryAuthority of Singapore ("MAS"). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Services Agency in Japan. J.P.Morgan AustraliaLimited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMSAL) is a licensed securities dealer.

Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions andestimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed heremay not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes inrates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financialinstrument. JPMorgan and/or its affiliates and employees may hold a position, may undertake or have already undertaken an own account transaction or act as market maker inthe financial instruments of any issuer discussed herein or any related financial instruments, or act as underwriter, placement agent, advisor or lender to such issuer. Clientsshould contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permits otherwise. This report may have beenedited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. This report should not be distributed to others or replicated in anyform without prior consent of JP Morgan. This report has been issued, in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Servicesand Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by personswho are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only withrelevant persons. In other European Economic Area countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL does not issue or distribute this material to "retail clients." Therecipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms"wholesale client" and "retail client" have the meanings given to them in section 761G of the Corporations Act 2001.

"Dow Jones" and the Dow Jones TRAC-X Indices are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain purposes byJPMorganChase Bank. The DJ TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representation regarding theadvisability of investing in such product(s).

JPMSI or an affiliate has managed or co-managed an offering of securities within the past twelve months for Altria Group, Inc., Amerada Hess Corporation, American ElectricPower Company, Inc., American Express Company, Arrow Electronics, Inc., Baxter International Inc., Bristol-Myers Squibb Company, Cargill, Inc., Caterpillar FinancialServices Corp, Cendant corp, Centex Corp, CIT Group Inc., Clear Channel Communications, Inc., Comcast Corp., Computer Sciences Corp., Cox Communications, Inc., DukeEnergy Corp., Eastman Chemical Company, Electronic Data Systems Corp., FirstEnergy Corp., General Electric Capital Corp, General Motors, Hallibutron Co., InternationalBusiness Machine, Liberty Medai Corp., MBNA Corp., Monsanto Co., News America, Inc., Ryder System, Inc., Sempra Energy, SLM Corp., Target Corp., Textron FinancialCorp., Boeing Capital, Kroger Co., The Walt Disney Co., Toys "R" US Corp., Valero Energy Corp., Wells Fargo & Co., Wyeth

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53


DOW JONES TRAC-X


Overview

55

Dow Jones TRAC-XSM

No. of credits Launch date Next roll date

Dow Jones TRAC-XSM Europe 100 June 2003 March 2004

Dow Jones TRAC-XSM North America 100 July 2003 March 2004

Dow Jones TRAC-XSM Japan 50 July 2003 March 2004

Dow Jones TRAC-XSM North America High Yield 100 July 2003 May 2004

Dow Jones TRAC-XSM Emerging Markets 19 August 2003 March 2004

Dow Jones TRAC-XSM Australia 25 September 2003 March 2004

Dow Jones TRAC-XSM Asia 25 October 2003 March 2004 (exp)

� Dow Jones has signed agreements to be responsible for the operation, development, marketing andlicensing of all the DJ TRAC-X indices

� As one now views the Global Stock Markets via indices like S&P 500, FTSE and NIKKEI, so will credit beviewed in the future via DJ TRAC-X North America, DJ TRAC-X Europe and DJ TRAC-X Japan

� The Future for credit will allow

� Options on credit

� Tranched risk

� Exchange tradingNote: �Dow Jones� and �Dow Jones TRAC-XSM� are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain

purposes by JPMorgan Chase. The Dow Jones TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makesno representation regarding the advisability of investing in such product(s)

56

Benefits of Dow Jones TRAC-X Indexes

Use credit default swaps to maximizeliquidity�the portfolios are composed of themost liquid Credit Default Swap names fromJPMorgan and Morgan Stanley trading volumes(Dow Jones will set up advisory committees todetermine index compositions)

Cost efficient and timely access to the CreditMarkets via index swaps and credit-linkedsecurities

Daily reports on actual versus theoretical pricing

Liquidity

Diversification

Transparency

57

DJ TRAC-X Participant Uses to Date Have Included:

� DJ TRAC-X is designed to be attractive to all credit market participants

� Banks� Express trading views on the overall credit market� Hedge credit exposure within loan and bond portfolios

� Fund Managers and Insurance Companies� Provides quick, cost-efficient credit diversification� Hedge credit exposure within portfolios� Hedge ramp-up risk for CSOs and large cash inflows

� Hedge Funds and Trading Accounts� Express trading views on overall credit market� Hedge credit shorts within convertible portfolio

� Corporates� Hedge credit spreads ahead of new issuance� Cost-efficient diversification for excess treasury liquidity

58

Features of Dow Jones TRAC-X Global Indices

59

Dow Jones TRAC-X NA participants: 2003

20%

1%

46%

33%

Pension Funds

Dow Jones TRAC-X NA Participants

54%14%

1%2% 1%

4%4%

20%

Dow Jones TRAC-X NA HY Participants

Banks

Hedge Funds

Asset Managers

High Yield Fundsand Core Plus

Hedge Funds

Banks

Bank ProprietaryDesks

Insurance

CorporatesForeign Funds

Pension Funds

60

5-year 10-year OptionsDJ TRAC-X Index Swap Funded maturity maturity Available

DJ TRAC-X North AmericaDJ TRAC-X NA x x x x xDJ TRAC-X NA High Beta x x x xDJ TRAC-X NA TMT x x xDJ TRAC-X NA FIN x x x

DJ TRAC-X North America High YieldDJ TRAC-X NA High Yield 100 x x xDJ TRAC-X NA High Yield BB x x xDJ TRAC-X NA High Yield B x x xDJ TRAC-X NA High Yield High Beta x x x

DJ TRAC-X EuropeDJ TRAC-X Europe x x x x xDJ TRAC-X Europe Corp x x x xDJ TRAC-X Europe Financial Senior x x x xDJ TRAC-X Europe Financial Sub x x x xDJ TRAC-X Europe TMT x x xDJ TRAC-X Europe Industrial x x xDJ TRAC-X Europe Consumer x x x

DJ TRAC-X Europe High Yield x x xDJ TRAC-X Asia x xDJ TRAC-X Japan x xDJ TRAC-X Australia x xDJ TRAC-X Emerging Markets x x x

Overview of Global Dow Jones TRAC-X Products

61

Dow Jones TRAC-X North America Series 2

� For Dow Jones TRAC-X North America, there is usually a 1bp bid-to-offer in $50 million a side

62

Dow Jones TRAC-X NA High Yield Series 2

� For Dow Jones TRAC-X NA High Yield, there is usually a 1/4 to1/2pt bid-to-offer in $10 million a side

63

Dow Jones TRAC-X Structure and Mechanics

64

Unfunded DJ TRAC-X NA Series 2 Mechanics:An Example

� DJ TRAC-X NA March 2009 contract with 100bp p.a. spreadQuoted spread: [65-66]bp

� Investor goes long $100 million notional

(1) Client pays 35bp running and pays accrued to enter the trade

(2) Client receives 100bp p.a. to take risk on 100 credits

Entering a long risk DJ TRAC-X NA unfunded trade

100 reference

credits

100bp p.a. = $1,000,000

[$1,861,531 + Accrued (230,556)] = 2,092,086

JPMorgan Investor

65

Unfunded DJ TRAC-X NA Series 2 Mechanics:An Example (cont�d)

� If none of the 100 credits default, investor earns 100bp p.a. until the maturity ofthe trade

� Profit or loss is recognized through coupon income and capitalappreciation/depreciation based on the price of the index

(1) Investor pays 1/100th of original notional to JPMorgan

(2) JPMorgan delivers principal amount of bonds or loans to investor

(3) Investor continues to earn 100bp p.a. on a reduced notional

No default

(3) 100bp on reduced notional ($99mm)

(2) $1mm notional of bonds/loans

(1) $1mm

One name defaults

JPMorgan Investor

66

Funded DJ TRAC-X NA Series 2 Mechanics: An Example

� DJ TRAC-X March 25, 2009 certificates with 4.25% coupon

� Quoted price: T + 101/99 [$102.36/102.45]

� Investor goes long $100 million notional

Entering a long risk DJ TRAC-X NA funded rate

(2) 4.25% * 1 * $100,000,000 = $4,250,000

100 reference

credits(1) ([$102.45] * 1 * $100mm) + Accrued=

$104,231,100Trust Investor

(1) Client pays ([$102.45] * 100 million * 1.00) + Accrued to enter the trade

(2) Client receives 4.25% coupon on $100 million

67

Funded DJ TRAC-X NA Series 2 Mechanics: An Example(cont�d)

� If none of the 100 credits default, investor earns 4.25% for five years and receives par at maturity

� Profit or loss is recognized through coupon income and capital appreciation/depreciation based onthe price of the DJ TRAC-XSM NA

No default

(1) Remaining principal amount is 99/100 of original notional

(2) JPMorgan delivers cash value of $1 million notional of defaulted bonds or loans (recovery rate)

(3) Investor continues to earn 4.25% on a reduced notional

(4) Each subsequent default will reduce the notional of the trade by 1/100th of the original notional

Investor

4.25% on reducednotional ($99mm)

Cash value of $1 millionnotional of defaulted bonds

Trust

One name defaults

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Options on Dow Jones TRAC-X

69

DJ TRAC-X North America Options: Product Details

�Put: Option to buy protection/payer optionCall: Option to sell protection/receiver option

�Exercise: European (only at the maturity of the option)

�Settlement: Physical, into DJ TRAC-X North America Series2 March 2009 upon exercise at the pre-set strike

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The analyst(s) denoted by an asterisk ("AC") hereby certifies that: 1) all of the views expressed in this research accurately reflect his or her personal views about any and all ofthe subject securities or issuers; and 2) no part of any of the analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or viewsexpressed by the analyst(s) in this research.

Copyright 2004 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co., and its subsidiaries and affiliates worldwide. J.P.Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc., is a member of the NFA. J.P. MorganSecurities Ltd. (JPMSL), J.P. Morgan Europe Limited and J.P. Morgan plc are authorized by the FSA and JPMSL is a member of the LSE. J.P. Morgan Equities Limited is amember of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the HongKong Monetary Authority. J.P. Morgan Securities Singapore Private Limited is a member of Singapore Exchange Securities Trading Limited and is regulated by the MonetaryAuthority of Singapore ("MAS"). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Services Agency in Japan. J.P.Morgan AustraliaLimited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMSAL) is a licensed securities dealer.

Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions andestimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed heremay not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes inrates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financialinstrument. JPMorgan and/or its affiliates and employees may hold a position, may undertake or have already undertaken an own account transaction or act as market maker inthe financial instruments of any issuer discussed herein or any related financial instruments, or act as underwriter, placement agent, advisor or lender to such issuer. Clientsshould contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permits otherwise. This report may have beenedited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. This report should not be distributed to others or replicated in anyform without prior consent of JP Morgan. This report has been issued, in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Servicesand Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by personswho are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only withrelevant persons. In other European Economic Area countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL does not issue or distribute this material to "retail clients." Therecipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms"wholesale client" and "retail client" have the meanings given to them in section 761G of the Corporations Act 2001.

"Dow Jones" and the Dow Jones TRAC-X Indices are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain purposes byJPMorganChase Bank. The DJ TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representation regarding theadvisability of investing in such product(s).

JPMSI or an affiliate has managed or co-managed an offering of securities within the past twelve months for Altria Group, Inc., Amerada Hess Corporation, American ElectricPower Company, Inc., American Express Company, Arrow Electronics, Inc., Baxter International Inc., Bristol-Myers Squibb Company, Cargill, Inc., Caterpillar FinancialServices Corp, Cendant corp, Centex Corp, CIT Group Inc., Clear Channel Communications, Inc., Comcast Corp., Computer Sciences Corp., Cox Communications, Inc., DukeEnergy Corp., Eastman Chemical Company, Electronic Data Systems Corp., FirstEnergy Corp., General Electric Capital Corp, General Motors, Hallibutron Co., InternationalBusiness Machine, Liberty Medai Corp., MBNA Corp., Monsanto Co., News America, Inc., Ryder System, Inc., Sempra Energy, SLM Corp., Target Corp., Textron FinancialCorp., Boeing Capital, Kroger Co., The Walt Disney Co., Toys "R" US Corp., Valero Energy Corp., Wells Fargo & Co., Wyeth

A senior employee, executive officer, or director of JPMSI and/or its affiliates is a director of The Boeing Company, Bristol-Myers Squibb Company, Deere & Company,Electronic Data Systems Corporation, International Business Machines Corporation, The May Department Stores Company, McDonald's Enterprises, Motorola, Inc., ValeroEnergy Corporation, Verizon Communications, Inc.., Viacom Inc., Visteon Corporation, Wyeth (N/C FR American Home Product Corp)

71


INTRODUCTION TOCORRELATION PRODUCTS


Consider an FTD: Client Sells Protection

� Client receives periodic spread until Credit Event occurs

� Similar to single name CDS

� After Credit Event:

� Client is delivered defaulted bond

� Client pays par

� Transaction ends after the first Credit Event

CDS #1

CDS #2 1st Default?Buyer Seller(client) FTD

Contingentpayment

Premium

73

Basket Trade (FTD) Value Drivers

� Number of Basket Components

� As number of credits increases, likelihood of one defaulting also increases

� Greater number of names, greater premium paid

� Absolute Spread Levels

� Clustered spreads provide greatest value

� Outlying credit spreads skew basket premium

� Correlation

� Lower correlation� Higher risk (expected loss),

higher spread

Correlation

Sum of individual spreads

Widest individualspread

50% 100%0%

Spread

74

What Have People Actually Done?

� Example: Client sells FTD protection on five high-grade credits

� Yield enhancement

� Client chooses names to coincide with its own analysts�/in-house views

� Clustered spreads

� Credits have low correlation to maximize spread

Example

Credits 5-yr bid (bp) Summary statistics

EOP Operating Limited Partnership 48 FTD swap premium 176bp

Sears Roebuck Acceptance Corp. 46 Aggregate bid spread 220bp

SLM Corporation 42 Premium as a % of aggregatebid spread

80%

The Goldman Sachs Group Inc. 34 Premium as a % of highest bidspread

352%

Verizon Global Funding Corporation 50 Average spread 44bp

75

Tranched TRAC-X: The Benchmark for Correlation

� Extends Tranche Technology to an Index

� Leverages the Index Liquidity� Lower bid/offer� Largest number of market makers

� Greater Pricing Transparency� Two-way markets quoted daily by multiple dealers

� Follow-on Step in Market Standardization� Static and widely traded portfolio� Standardized documentation between dealers and

clients

� Range of TRAC-X indices can be referenced, including

� North America (five and ten years)

� North America high-yield

� Emerging markets

� Europe

30�100%

0�3%3�7%

10�15%

15�30%

7�10%

Note: Portfolio tranches shown are not drawn to scale

76

This material is not a product of J.P. Morgan Securities Inc.�s (�JPMSI�) Research Departments, and you should not regard it asresearch or a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of theindividual author and may differ from the views or opinions expressed by JPMSI�s Research Departments or other departments ordivisions of JPMorgan and its affiliates. Research reports and notes produced by the Firm�s Research Departments are availablefrom your salesperson.

This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment byJPMorgan to enter into any transaction. No reliance should be placed on the information herein, which is preliminary and doesnot constitute all the information necessary to evaluate investing in any financial instrument or participating in any transaction.This material may also include information obtained from sources believed to be reliable, but JPMorgan does not warrant itscompleteness or accuracy. Any decision to invest in any financial instrument, or participate in any transaction, described hereinshould be based solely on the final documentation related thereto. Nothing herein is a recommendation to invest in any financialinstrument or participate in any transaction or legal, tax, regulatory or accounting advice, and each prospective investor ortransaction participant must make an independent assessment of such matters in consultation with its own professional advisors.Additional information is available upon request. JPMorgan is the marketing name for J.P. Morgan Securities Inc. (member,NYSE/NASD) and its investment banking affiliates.

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cd conference 2004 credit derivatives 101

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