eurex yearbook 2007

The Wo rld of Cre d i tA chronology from 1999 to 2008

5Contacts

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iTraxx® is a registered trademark of International Index Company Limited (IIC) and has been licensed for use by

Eurex. IIC does not approve, endorse or recommend Eurex or iTraxx® Europe 5-year Index Futures, iTraxx®

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Derivatives Association, Inc.

Editor Natasha de Terán

Eurex editorial adviser Byron Baldwin

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The world of credit:a chronology from 1999 to 2008

Pictures: Alamy, photolibrary, Corbis,

Reuters, Getty

Repro: ITM Publishing Services

Printed by Buxton Press

ISBN: 1-905435-58-4

4 Contents

ContentsThe World of Credit A chronology from1999 to 2008

34

70 94

63

Forewords

8 The world of credit

By Michael Peters, global head of sales,

member of the Eurex Executive Board

12 Indexing for growth

By David Mark, chief executive,

International Index Company

15 Cataloging changes in the

credit markets

By Natasha De Terán, editor,

The World of Credit

A chronology from 1999 to 2008

The landscape

18 The growth of the

credit markets

By Hardeep Dhillon

24 Credit derivatives:

the basic instruments, the users

and the uses

By Hardeep Dhillon

28 Evolution of the credit

derivatives market

By Hardeep Dhillon

34 iTraxx® Indexes – the global

benchmark for the credit markets

By Tobias Spröhnle,

International Index Company

38 The upsides

By Natasha de Terán

42 The darker side of credit derivatives

By John Ferry

49 Regulatory intervention

By John Ferry

54 Automation, transparency

and the aftermath of regulatory

intervention

By John Ferry

58 The Bloomberg Pricing Model

By Mirko Filippi, Bloomberg LP

63 Eurex iTraxx® Credit Futures

By Michael Hampden-Turner and

Michael Sandigursky, Citigroup

Case studies

70 Portfolio overlay strategy using

Eurex iTraxx® Credit Futures

By Byron Baldwin, Eurex

5Contents

131 78

3

74 Generating alpha – trading credit

versus equity and equity volatility

on exchange

By Byron Baldwin, Eurex

78 Credit futures: application

and strategies

By Jochen Felsenheimer,

HypoVereinsbank

82 Making the case for

credit derivatives

By Sarah Smart,

Standard Life Investments

85 A look back at May 2005: Did the

models cause the correlation crisis?

By Ammar Kherraz, Morgan Stanley

Investment Management

90 Credit indexes: an efficient route

to asset allocation

By Gareth Quantrill, Scottish Widows

Investment Partnership

94 Playing the spread dispersion

using index arbitrage

By Fabrice Jaudi and Alexandre

Stoessel, ADI Alternative Investments

97 Using iTraxx® across the

fund spectrum

Natasha de Terán interviews

Raphael Robelin from BlueBay

Asset Management Plc

99 Evaluating opportunities in the

credit markets

By Chetlur Ragavan, BlackRock

104 Making the most of new

credit opportunities

John Ferry interviews Graham Neilson

from Credaris

107 Using iTraxx® in exotic structures


Ryan Suleimann from

Fortis Investments

110 The use of iTraxx® in

structured credit


Igor Yalovenko from WestLB

114 CDS and iTraxx®: adding to the

fixed income manager’s armory

By Maria Ryan, Barclays

Global Investors

118 No free lunch, but a

good opportunity to

make money

By Riccardo Pedrazzo,

Banca IMI

122 The use of iTraxx®

Options in corporate

bond portfolios

By Stefan Sauerschell,

Union Investment

126 Opportunity funds:

the thinking investor’s CDO

By Dipankar Shewaram,

BlueBay Asset Management

131 The use of iTraxx®

Indexes in traditional euro

corporate portfolios

By Martine Wehlen-Bodé,

UBS Global Asset Management

Conclusion

134 Credit derivatives:

outlook, challenges and

perspectives

By Natasha de Terán

122

7Contents

nnovation and growth in the

credit markets have been

rampant since credit deriva-

tives first emerged. Many

investors have migrated to, or

been drawn to, credit and, as a

result, the market is now as

sophisticated as any of the longer-standing,

larger asset classes. Funds have poured into

the sector as investors that previously

shunned or ignored the market have waded

in. Even those that have remained on the

sidelines no longer can ignore it – they look

closely at movements in the credit area toI

The world of credit

By Michael PetersGlobal Head of SalesMember of the Eurex Executive Board

8 Foreword

Innovation and growth inthe credit markets have been

rampant since creditderivatives first emerged

identify possible trends and imminent shifts

that will affect their own markets.

As a result, credit derivatives have experi-

enced explosive growth. The notional volumes

of traded credit default swaps (CDS) had

risen from less than USD 1 trillion in 1996 to

more than USD 49 trillion by the end of

2006, according to rating agency Fitch. And

there is no evidence that it is slowing down.

The credit index market has enjoyed no less

spectacular a trajectory: having represented

just 9 percent of transaction turnover in

2004, they account today for nearly 50

percent of total volumes. Eurex is privileged

to be playing a part in the development of

this market and honored to be working with

the International Index Company (IIC), the

firm behind the benchmark iTraxx® Indexes.

In bringing the first-ever listed credit futures

contracts to the market, Europe’s largest

derivatives exchange will be working

together with the benchmark index provider.

The combination is undeniably compelling.

The IIC’s iTraxx® rules-based Indexes are

the most widely followed, the most

objective and the most transparent CDS

indexes in the European market. Eurex,

meanwhile, offers a broad range of interna-

tional benchmark products and operates the

most liquid fixed income markets in the

world, with open, equal, and low-cost elec-

tronic access. With market participants con-

nected from 700 locations worldwide,

trading volume at Eurex exceeds 1.5 billion

contracts a year. The exchange already lists

the flagship European fixed income and

equity index futures contracts. The Euro-

Bund Futures are the world’s most heavily

traded bond futures and the benchmark for

the European yield curve. They are often

used as the standard reference by those

comparing and evaluating interest rates in

Europe and managing interest rate risk.

On behalf of everyone at Eurex, I hope

you will find this publication stimulating

and interesting – and the new Eurex iTraxx®

Credit Futures a useful addition to your

trading toolbox.

9Foreword

Credit derivatives haveexperienced explosive

growth.The notionalvolumes of traded creditdefault swaps had risen

from less than USD 1 trillionin 1996 to more than USD

49 trillion by the end of 2006

ooking back over the

emergence of credit as

an asset class, it is clear

that the pace of devel-

opment has been

meteoric. This holds as true

for the sell-side’s ingenuity

in devising new products

and structures as it does for investors’ fast-

grown appetite and for the establishment of

standardized, widely followed market indexes.

The emergence of credit indexes dates

back just a few years. It was early 2004; a

number of investment banks had packaged

some credits and called the result a credit

derivatives index. Some had even devised a

few basic rules to support their indexes, but

the indexes served mainly to provide easy

references for baskets of credits.

This was convenient for the sell-side, but

for obvious reasons it proved difficult for

buy-side institutions: the lack of standardi-

zation made it difficult to trade the products

with anyone other than the issuing bank. The

result was the same as it would be for any

market lacking standardized index products –

higher bid/offer spreads and lower volumes.

It became increasingly apparent that end

customers would be better served by a single,

transparent, objective set of market stan-

dards. Hosting this at an institution far

removed from a single bank’s trading floor

was another imperative. This did not mean

limiting the number or type of products, but

rather having only a single reference point,

such as an industry-wide accepted index.

The next steps involved convincing

investment banks that, despite having to

give up proprietary indexes, they would

both be able to retain control through index

governance and, ultimately, benefit from

that. Fortunately, the banks soon recognized

L

Indexing forgrowth

By David MarkChief ExecutiveInternational Index Company (IIC)

12 Foreword

this, realizing that they were likely to see

greater trading volumes from increased

standardization.

And so the iTraxx® Index idea was born.

In the absence of credit derivatives being

publicly traded and there being no readily

available volume data, it was agreed that the

iTraxx® Indexes would be investable, reflecting

the most liquid traded credits, as measured by

data provided by the sell-side. Diversification

would be ensured through relevant rules,

designed to prevent concentration.

Even making allowance for the benign

credit environment of recent years, the

resulting volumes of index trades (and their

share of all credit derivatives trading) have

surpassed the most optimistic projections.

Such volumes prove that common, trans-

parent, objective standards and readily

available data build confidence and can be a

huge help in driving the development of

‘newer’ asset classes.

In addition to direct index trades, there has

been a proliferation of second and third gen-

eration products based on, or referring to,

the iTraxx® Indexes. These have been

developed by investment banks in response

to buy-side needs.

As an index company we serve the needs

of all market participants and thus continue

to see our role as multi-faceted. Naturally, we

will continue to update the current iTraxx®

Indexes and, from time to time – when

market conditions warrant – we will make

small changes to the index rules. At all times,

such changes will follow close consultation

with participants, ensuring that the indexes

reflect the market’s needs.

We will also continue to expand our index

family to include other, closely related asset

classes – for instance, we recently launched

the iTraxx® LevX® Indexes, extending our

coverage to leveraged loans. And in the

future we will doubtless broaden our geo-

graphical reach – entering newer or

emerging markets, such as the Eastern

European or CIS countries.

The principles governing iTraxx® will,

however, remain unchanged: to develop and

publish indexes that are independent,

objective, transparent and accessible. As for

any new index, the primary goal will always

be to ensure that it is driven by the needs of

market participants, and becomes the

market-leading index in its field.

It is only by strictly adhering to these gov-

erning rules that iTraxx® has succeeded so far

– and, in particular, achieved its most notable

success: broadening credit’s appeal. While the

initial development of credit as an asset class

was largely focused on trading between the

‘street’ and hedge funds, more classical buy-

side institutions only increased their

involvement in the market once the indexes

had become more established.

The introduction of a wider range of index-

based products, such as the Eurex iTraxx®

Credit Futures, takes another step in this

direction. These futures will doubtless further

broaden participation in this asset class by

attracting those who do not wish, or do not

have the ability, to trade OTC derivatives. IIC is

delighted to have worked with Eurex to

produce the contracts and wishes the

exchange every success with the products.

13Foreword

It became increasinglyapparent that end

customers would bebetter served by a single,

transparent, objective setof market standards

riting about such

a fluid and fast-

moving subject as

the derivatives

business is rarely – if

ever – unexciting. But

trying to pin down such an

elusive quarry can be unusually challenging–

and putting together this book has proved to

be no exception.

Between inception and publication, sen-

timent in the credit markets has shifted dra-

matically. At the time of writing, it is impos-

sible to determine exactly how matters will

play out, but one thing is certain: the events

of recent months have underscored not only

the central position that the credit industry

now holds in the wider financial markets,

but also the pivotal role that the iTraxx®

Indexes now play in the credit markets.

The iTraxx® Indexes have become such

critical market indicators that they are no

longer followed just by dedicated credit pro-

fessionals. Movements in the indexes have

been widely tracked throughout the last few

months, and their progress has been scruti-

nised and reported on by all sectors of the

media. The iTraxx® Crossover, HiVol and

Main Indexes were referenced no less than

32 times during July 2007 in The Financial

Times alone.

Market events have also demonstrated

just how important a liquid, transparent

and tradable benchmark credit instrument

is set to become. Credit is now firmly

established as an asset class, and credit

derivatives and credit index products are

the most widely used instruments within

the market. An exchange-traded credit

futures product, that can be used quickly,

efficiently and cheaply, could dramatically

improve the market. It could attract new

market users and generate even greater

trading volumes.

Thanks to central counterparty clearing,

there is no double credit risk in trading

credit futures, enabling users to discount

their worries about counterparty credit risk

deterioration, as well as their concerns over

increased correlations between counterparty

credit risk and underlying credits. Such a

facility will always be a bonus, but in times

of stress, like those we have recently been

witnessing, these considerations come to

the fore.

Listed credit products, such as the Eurex

iTraxx® Credit Futures contracts, should also

serve to demystify the credit world, increase

transparency and allay fears about risk con-

centrations, over-the-counter trade backlogs

and legal documentation issues.

Those asset managers, analysts and traders

that have kindly contributed to this book

have been unambiguous in their regard for

these instruments. They welcome the emer-

gence of the first exchange-listed futures

products and look forward to using them

more extensively – and not just in times of

stress, but in the daily run of business.

W

Catalogingchanges in thecredit marketsBy Natasha de TeránEditor The World of CreditA chronology from 1999 to 2008

15Foreword

The growth of thecredit markets The development of the credit markets has transformed the European investment landscape. HHaarrddeeeepp DDhhiilllloonn looks back at the early evolution of the market

18 The landscape

The arrival of the singleEuropean currency

lowered the costs ofissuing and investing in

bonds by eliminatingcurrency risk and reducing

transaction costs. It drovesupply and demand

he European credit

markets have

undergone a par-

adigm shift since the

introduction of the

euro in 1999. Market

participants have now

grown accustomed to

viewing Europe’s credit market as being

much on a par with the U.S. – busy, buoyant,

liquid and integrated – and many may,

therefore, fail to recall the state of affairs

that existed before the European Economic

and Monetary Union (EMU).

When the London-based investment bank

S.G. Warburg & Co. pioneered the first

eurobond back in July 1963, a USD 15 million

deal launched by the Italian toll road

operator Autostrade, the stage was set for

the growth of the European credit markets;

but the markets failed to respond. For

decades after – indeed until EMU – they

remained fragmented, heterogeneous and,

because of the numerous currencies involved,

they also lacked the depth and breadth of

the dollar credit market.

The evolution of a pan-European fixed

income market was further hindered by cor-

porates borrowing in their local currency, and

by national laws that required insurance

companies and pension funds to invest large

portions of their assets in their local currency.

The euro

The euro was introduced to world financial

markets as an accounting currency on

January 1, 1999, and launched as physical

coins and banknotes in 2002. It replaced the

transitional European Currency Unit (ECU).

The arrival of the single European currency

lowered the costs of issuing and investing in

bonds by eliminating currency risk and

reducing transaction costs. It drove supply

and demand.

The European bond market, initially domi-

nated by a handful of top-tier banks and

financial issuers, has since undergone a

remarkable transformation. Today, it encom-

passes a broader quality range of issuers, and

a more eclectic representation of sectors, and

has effectively changed Europe’s ‘currency

culture’ into a ‘credit culture’.

How has this happened? Well, in part

because the trend of decreasing government

bond issuance and low interest rates on

these transactions forced many more

investors to look to corporate bonds for

enhanced yield. This provided the impetus for

an increased supply of investment-grade

bonds – with high credit quality and rela-

tively low risk of default – and high yield, or

so-called ‘junk’ bonds, which are rated below

investment grade at the time of purchase

and have a higher risk of default.

A shift in behavior away from unprofitable

bank financing was a major driver of bond

issuance. A similar trend had earlier shaped

the U.S. market, where reduced lending

margins and a deterioration in the credit

quality in bank lending books further

encouraged the growth of corporate bonds.

An increasing number of U.S. and interna-

tional issuers that entered the Eurobond

market in an attempt to diversify their

funding sources engendered further devel-

opment and variety. Meanwhile, the bursting

of the Dotcom bubble in 2000 and the

resultant underperformance of stock markets,

and the contraction of most European

economies, precipitated an auxiliary move by

local market participants away from equity-

financing towards bonds. Finally, the raft of

high-profile corporate bankruptcies that hit

the market around this point – not least

Enron, Global Crossing and WorldCom –

T19Case studiesThe landscape

led banks to tighten their lending policies

still further.

The European corporate sector facilitated

this process of bank disintermediation by

loosening its ties with the commercial

banking sector and turning to the debt

capital markets for direct funding. As a result,

the bond market soon came to be regarded

as a more efficient and cheaper means of

financing than traditional bank lending.

Companies quickly recognized that it was

much more flexible and did not include

many of the restrictive financial covenants

of bank loans.

This, in turn, led to an increase in the

number of one-off borrowers, lesser known

and lower-rated companies, that had previ-

ously either been restricted to their local cur-

rency markets or had been dependent on

bank loans. By accessing the bond markets,

companies were not only able to diversify

their funding sources, but also their creditor

base, because bonds were syndicated over

many more investors in Europe and abroad.

The early years

In the aftermath of the euro’s introduction,

there was an initial period of major leveraging

by companies. Dominating corporate bond

supply were the telecom companies, which

piled more debt onto their balance sheets to

finance the cost of 3G licences, followed by

the auto industry and utility companies. A

low interest rate environment enabled the

refinancing of transactions at a lower cost,

while the pressure on firms to improve

returns and shareholder value, and the need

to address pension fund shortfalls, were also

factors in supporting issuance.

The pace of mergers and acquisition

(M&A) activity in Europe – which was pri-

marily driven by large scale M&A deals in the

telecom, bank, industrial and energy sectors,

and by leveraged buyouts by private equity

firms – contributed substantially to keeping

the bond market buoyant.

Foreign companies also targeted the

European market as an alternative source of

financing. Those with European businesses

were able to capture potentially lower yields

in the euro market through transactions that

did not have to be swapped back into U.S.

dollars. Indeed, ever since Xerox and Gillette

launched debut EUR-denominated deals in

January 1999, there has been a steady flow

of transactions from other North American

and international corporates.

The increase in market liquidity, and the

development of a large and liquid pool of

assets, nurtured a growing number of

investors at a time when government bond

issuance was falling sharply. Investors began

to acquire corporate bonds in ever-larger

numbers, due to the declining returns on

government bonds and a perceived yield pick-

up over traditional instruments.

Another development was the increase in

the number of institutional investors that had

become comfortable investing in bonds

further down the credit quality curve than

would have been imaginable even five years

ago. Institutional investors still have an over-

whelming demand for equities, but the

growth in demand from this sector strongly

supported the bond markets. To a large

extent, this is because some institutional

investors, mainly pension funds and insurance

companies, have long-term obligations and

need to match the tenors of their assets and

liabilities – a factor that committed them to

investing in the corporate bond market.

21The landscape

Dominating corporate bond supply were the

telecom companies, whichpiled more debt onto their

balance sheets to finance thecost of 3G licences, followed

by the auto industry andutility companies

22 The landscape

The primary and secondary markets

Bonds are sold first in the primary market,

also known as the new issue market. Here,

borrowers, banks and investors come

together to launch a transaction through a

book building process, which determines the

price and level of demand for the bonds.

The investment bank, also known as the

underwriter or book runner, assists the

issuer to structure the bond and prepares

the documentation.

Depending on the size and structure of the

transaction, either a sole underwriter or a

syndicate of underwriters can be involved.

The underwriter acts as an intermediary,

buying the bonds from the issuer and then

reselling them to investors. Most of the

money received from the sale of the primary

issue goes to the issuer. The investment

banks earn fees and can make a profit by

selling the bonds for more than they paid.

It is on the secondary market that bonds

are bought and sold following their original

sale. This trading is predominantly con-

ducted over-the-counter (OTC), either by

telephone or on electronic trading plat-

forms. The secondary market offers

investors some flexibility in the pricing and

timing of their bond trades, and investors

who sell bonds receive the profits, minus

any fees or commissions. The issuer of the

bonds plays no role in trading on the sec-

ondary market, nor receives any proceeds

from these transactions.

Teething problems

In the early years, poor liquidity in the sec-

ondary market for corporate bonds was a

major constraint on investors’ involvement,

because the trading in many issues was

small. Another hindrance was the tendency

of institutional investors to buy and hold

bond assets, thereby further dampening both

trading activity and liquidity.

Certain segments, such as the gov-

ernment bond market, were more liquid

and relatively transparent, but the corpo-

rate bond segment continued to lack trans-

parency because of the absence of any

established central source of independent

data and pricing information. Banks were

the primary source of information for

industrial and lower-rated companies and

little attention was paid to the role of credit

analysis. Instead, investors simply focused

on higher-quality debt. Investment man-

dates also restricted many from investing

in lower-quality, high yield bonds.

At this time, obtaining data was often

cumbersome and even then it was expensive

to access and analyze. The lack of European-

wide regulation or legislation, combined with

the relative immaturity of the market,

created a number of poor market practices,

including the lack of disclosure, timely docu-

mentation and adequate covenant protec-

tions in bond prospectuses.

To add insult to injury, investors could be

subject to declines in bond prices and had no

way to safeguard against this. Many investors

held bonds until maturity, so they would only

profit if the assets rose in value. Benefiting

from a decline in the price of a bond, or

shorting, was difficult because the associated

lending fees and transaction costs could

render it uneconomic. Finding matching

counterparties was also difficult, because the

bond market was far less concentrated than

the equity markets and, typically, each issuer

had several bonds outstanding with different

maturities and structures.

The underwriter acts asan intermediary, buying

the bonds from theissuer and then reselling

them to investors

24 The landscape

Credit derivatives: thebasic instruments, theusers and the uses

HHaarrddeeeepp DDhhiilllloonn explores the early days of the credit derivativesmarket – the basic instruments, their users and applications

he arrival on the

scene of credit deriva-

tives was to transform

the European credit

markets radically. The

instruments alleviated

many of the problems

discussed in the previous

chapter and fostered a dramatic surge in

investor interest.

Credit derivatives emerged from the secu-

ritization of mortgaged-backed securities in

the 1980s, when credit risk was hedged by

transferring the actual assets from the books

of bank lenders. The derivatives instruments

were first traded sporadically at the end of

the 1980s, but it was the 1990s that proved

to be decisive for the fledgling market.

The pioneers of credit derivatives were

those banks – prominent among them

JPMorgan, Merrill Lynch, Credit Suisse and

Bankers Trust – that had attempted to devise

financing solutions that would provide

insurance against the risk that a bond or loan

would default. They subsequently began

marketing nascent forms of credit derivatives

to the wider markets, but it took a number of

years before a real market for the products

began to emerge.

The first deals

The U.S. investment bank Merrill Lynch is

credited with launching the first credit deriv-

ative, a USD 368 million contract, in 1991.

And the following year the International

Swaps & Derivatives Association (ISDA®)

first used the term ‘credit derivatives’ to

describe this new, exotic over-the-counter

(OTC) contract.

Although a number of European banks

had been analyzing how to structure con-

tracts, it was another U.S. investment bank,

JPMorgan, which first set the European

market in motion. Combining derivatives

with credit was still a novel and unproven

idea, but in 1994 JPMorgan’s London deriva-

tives desk structured a ‘first to default’ swap.

It was designed to insure against the default

risk of three European government bonds

and safeguard the bank against risks in its

growing government bond trading business.

A further defining moment came in 1997,

when JPMorgan launched its Broad Index

Secured Trust Offering (Bistro), a transaction

that transferred a significant amount of

diverse credit risk to an external company or

special purpose vehicle (SPV). By employing

credit derivatives to offload the risk on a

USD 9.7 billion corporate loan portfolio,

Bistro helped JPMorgan both to clean up its

balance sheet and manage its risk. The bank

quickly grasped its wider application and

began touting the solution to other firms

with ever-increasing success.

Credit derivatives steadily gained traction

thereafter, as banks’ derivatives and swaps

desks grew ever more involved. By 1995,

the market for contracts written on indi-

vidual companies, or single-name credit

default swaps (CDS), was flourishing. It

swelled further when more sophisticated

fixed income managers started to come

into the market in 1997.

By this time, there were estimated to be

up to 15 dealers that were willing to quote

prices in basic instruments in the U.S. market.

The old guard of banks – JPMorgan, Bankers

Trust, Merrill Lynch, Credit Suisse First Boston,

Chase Manhattan, Bear Stearns and CIBC

Wood Gundy – was now being supplemented

by newer entrants like Lehman Brothers,

Citibank and Bank of Montreal.

Despite the heavy involvement of North

American banks, by 2000, it was London

that emerged as the dominant center in the


Although a number ofEuropean banks had been

analyzing how to structurecontracts, it was another U.S.investment bank, JPMorgan,which first set the European

market in motion

26 The landscape

global credit derivatives market. It boasted

about ten active Market Markers and a

much larger number of banks involved in

niche areas, together with the necessary

core of non-bank underwriters and inter-

dealer brokers.

Pivotal to the growth of the European

market was the imminent arrival of the New

Basel Accord and its capital adequacy rules.

These require banks to apply minimum

capital standards and hold a certain level of

reserves against assets, and played a funda-

mental role in forcing banks to improve the

risk profile of their balance sheets. Against

the backdrop of the incoming regulation,

banks saw credit derivatives as powerful

tools that could be used to isolate and lay

off unwanted credit risks. They realized they

could manage their loan and credit port-

folios better, if they protected themselves

against potential losses by transferring the

credit risk to another party, while keeping

the loans on their books.

The classic role of CDS in the early days

was, therefore, to hedge concentrations of

risk, improve the diversity of exposure and

reduce the amount of capital that banks

needed to allocate to their portfolios. Banks

also used CDS to reduce credit risk exposure

to counterparties, enabling them to continue

to offer loans without exceeding internal risk

concentration limits.

The emergence of credit as an asset class

had already highlighted the concomitant

hazards: investors appreciated that bonds

were far from risk free and were, therefore,

attracted to a form of credit protection

against so-called ‘event risks’. This base of

users, meanwhile, grew to include insurance

companies, hedge funds, corporates and

asset managers.

The CDS product

Whereas bonds and loans are financial con-

tracts between a borrower and a lender,

credit derivatives – and specifically CDS con-

tracts – are contracts between two counter-

parties that reference a specific borrower.

In essence, the CDS is an OTC insurance

policy that transfers the credit risk of a par-

ticular corporation or government from one

party to another. A standard CDS contract is

a privately negotiated bilateral agreement

where one party, the protection buyer, pays a

periodic fee or premium to another, the pro-

tection seller. The contract is designed to

cover potential losses that could damage a

loan or bond as a result of unforeseen devel-

opments, or a credit event (see chart, above).

A credit event includes instances where

the reference entity on which the contract is

written is unable to pay its debts, such as a

bankruptcy or restructuring. If a credit event

is triggered, then the seller of protection will

make a payment to the buyer of the contract.

Buying credit protection is equivalent to

shorting the credit risk, while selling is

termed as ‘going long’ a reference entity.

The early issues

Although the credit derivatives market

expanded at a record pace, the instruments

faced resistance from many quarters and

experienced a number of teething problems.

Initial concerns related to banks’ increasing

counterparty exposure through their use of

credit derivatives, because these contracts

were only as robust as the counterparty to

the trade. Many potential users and outside

observers were wary about the product,

noting how it still had to be tested in a

serious downturn.

Some commentators were particularly

scathing. Among other things, credit deriva-

tives were labeled ‘fool’s gold’, and likened to

‘games of Russian roulette’: one influential

critic, no less than Berkshire Hathaway’s

investment magus, Warren Buffett, went so

far as to term them “financial weapons of

mass destruction”. Even the rating agency

Source: Brian Eales Study, The Case for Exchange-based Credit Futures Contracts, 2007

Standard & Poor's is reported to have had its

reservations, initially refusing to rate credit

derivatives products.

One critical element in limiting the

expansion of CDS in the early stages was the

absence of any broadly accepted and stan-

dardized documentation that could clarify the

precise terms and conditions of contracts.

Liquidity was hampered because the Inter-

national Swaps and Derivatives Association

(ISDA®) had yet to finalize documentation for

basic credit derivatives structures or for

standard definitions of credit events.

ISDA® had published a standardized letter

confirmation – allowing dealers to transact

under the umbrella of an ISDA® Master

Agreement – in 1991, but it was not until

1999 that formalized guidelines for sovereign

and non-sovereign CDS contracts appeared.

Prior to this, contracts tended to be nego-

tiated on an ad hoc basis between buyers

and sellers of protection. Not only did this

routinely delay transactions, but it also

opened up the possibility of disputes when

credit events occurred.

As the Bank of International Settlements

(BIS) commented: “Risk shedders appear,

sometimes, to have been able to exploit the

terms of credit derivatives agreements at the

expense of risk takers, insofar as payments

under CDS contracts are not conditional on

actual losses.”

Another problem concerned the settlement

of CDS contracts and the issue of deliverable

bonds. In some circumstances, the physical

settlement option was not always available

since CDS were being used to hedge exposures

to assets that were not readily transferable, or

to create short positions for users who did not

own deliverable obligations.

In addition, the absence of insurance-spe-

cific regulations addressing credit derivatives

prevented some insurance companies from

entering the market. There was also a lack of

clarity from regulators as to the impact of

credit derivatives on European banks’ credit-

related capital charges and the levels of

capital allocation required on a financial insti-

tution’s balance sheet against outstanding

credit derivatives contracts.

One more stumbling block to liquidity

was the absence of a balanced two-way

market – quite simply, there were more

hedgers looking to lay off credit risk than

there were buying it. As a result, initial deal

sizes remained limited to trades in the

region of EUR 25 to 50 million.

Pricing transactions was also a challenge

because there was no industry-standard

pricing model for credit. This meant that

traders were often obliged to analyze the

price of the underlying asset to provide an

indication of the levels at which a CDS

might be priced or traded. This was some-

what easier to gauge for more liquid bond

issues and for frequent borrowers, but the

test for many was to price credit derivatives

based on debt instruments for which there

was little available public information or no

credit rating.

Finally, risk management tools and quan-

titative models were still in development,

and many firms were in the early stages of

implementing credit value-at-risk or other

quantitative credit risk management

methodologies.

The combination of all these factors meant

that even though the issues did not actually

stall the CDS market, they served to unnerve

many of its participants and, in doing so,

hampered the develop-ment of next-gener-

ation credit products based on CDS.

27The landscape

Evolution of the creditderivatives marketThe credit derivatives market opened up a plethora of opportunities for investors.HHaarrddeeeepp DDhhiilllloonn assesses the impact they had on different corners of the credit world

28 The landscape

A dispute betweenNomura and Credit

Suisse First Boston ondeliverable bonds, in

the wake of theRailtrack default in

October 2001,prompted a

further dispute

hen the British

Bankers’

Association (BBA)

first began collating

statistics on the credit

derivatives market in

1996, volumes totalled

some USD 180 billion. Five

years later, they had grown to USD 1

trillion, and the BBA’s most recent forecasts

suggest they will accelerate to USD 33

trillion by 2008, up from 2006’s figures of

USD 20 trillion.

The market’s rapid growth over the first

years of this century – as well as its sub-

sequent evolution – owes much to two

principal factors: the introduction of

standardized International Swaps &

Derivatives Association (ISDA®) documen-

tation and the arrival of the iTraxx®

Index family.

The legal documentation

The publication of the ISDA® Standard

Agreement in March 1999 was critical in

assisting the expansion of the market to a

wider investor base. The new Master

Agreement was developed in response to dis-

agreements between buyers and sellers in the

wake of the 1998 Russian default and, in

particular, whether the delay in payments on

the City of Moscow’s debt constituted a

credit event. The English courts ruled in favor

of the buyers, but doubts remained.

In response to ongoing market events,

ISDA® issued three supplements to the 1999

guidelines within the next two years. These

new definitions were soon put to test when,

in October 2000, the U.S. life insurer Conseco

extended the maturity profile on USD 2.8

billion worth of bonds and loans. Some par-

ticipants questioned whether such a restruc-

turing should constitute a credit event

because it did not inevitably lead to losses.

Others viewed it as being indisputably a neg-

ative credit development.

ISDA® responded in May 2001, with the

publication of a Restructuring Supplement

that provided counterparties with a selection

of four ‘modified restructuring clauses’.

The issue of successor events came to the

fore only a month later, when U.K. utility,

National Power, demerged into two com-

panies, thereby creating two successor

entities. This resulted in uncertainty over

which would be the new reference entity for

existing credit default swap (CDS) contracts

– at the time the ISDA® documents only

stipulated a successor assuming ‘all or sub-

stantially all of the obligations’. ISDA® subse-

quently published the Successors and Credit

Events Supplement in November, stating

that the new reference entity would hold 75

percent or more of the bonds or loans.

A dispute between Nomura and Credit

Suisse First Boston on deliverable bonds, in

the wake of the Railtrack default in October

2001, prompted a further dispute. The U.K.

courts eventually ruled in February 2003, that

Nomura, the protection buyer, was entitled to

deliver Railtrack convertible bonds as physical

settlement. ISDA® responded by issuing the

Convertible, Exchangeable & Accreting

Obligations Supplement.

An ISDA® working group studied the new

definitions and the latest version, the 2003

ISDA® Credit Derivatives Definitions, came

into effect in June that year, incorporating all

three supplements.

The iTraxx® Indexes

Secondly, came the indexes. The first tradable

credit derivatives index emerged in 2000

when U.S. investment bank JPMorgan

29Case studiesThe landscape

W

30 The landscape

launched the European Credit Swap Index,

quickly followed in 2001 by the High Yield

Debt Index, or HYDI, for the high yield

market. Morgan Stanley’s Synthetic Tracers

on U.S. bonds and JPMorgan’s European

Credit Derivatives Index (JECI) and Emerging

Markets Derivative Index (EMDI), were

launched the following year.

Further competition appeared in April

2003, when Morgan Stanley and JPMorgan

merged their proprietary indexes to form

Trac-x, prompting Deutsche Bank and ABN

Amro to launch the iBoxx® 100, as a rival

competitor for the European market. An

American version of iBoxx® was launched

later in the year, again going head-to-head

with Trac-x North America.

The indexes gained some traction, but by

2004 participants had become convinced

that the establishment of a single, stan-

dardized index would better serve the market.

That same year, iTraxx® was formed out of

the merger of iBoxx® and Trac-x and consti-

tuted the 125 most frequently traded credit

default swaps.

The market’s development

It is hard to overplay the effect of these two

events on the development of the credit

derivatives market. Following the intro-

duction of the standardized documents and

indexes, the market raced ahead: not only

did volumes in single-name CDS explode,

but index trades soared, new users poured

into the market and a plethora of new uses

was found for the products.

Investors already appreciated that credit

derivatives could be used for a multitude of

different applications – the products offered

an extremely flexible method of expressing a

variety of investment strategies with tailored

sizes, currency denomination and maturities.

And because credit derivatives enabled credit

risk to be separated from interest rate risk,

investors found the instruments could be

applied as a substitute for cash bond trades:

they did not necessarily need to buy or sell a

bond or loan to gain exposure to a desired

issuer, nor did there have to be a physical

bond outstanding.

Early uses of the instruments included

hedging individual or single-name credit

exposure, or managing the credit risk of a

total portfolio. Investors also employed them

to increase yield – leveraging the value of

credit derivatives and undertaking basis

strategies to exploit the difference between

cash bond and CDS prices. Credit derivatives

were further used to separate risks embedded

in certain instruments, such as convertible

bonds, and to help firms manage their regu-

latory or economic capital requirements.

The expanding product range

It was only after the iTraxx® and ISDA® ini-

tiatives that the credit derivatives product

range really began to expand and diversify.

And although single-name CDS were for a

long time the most common instrument,

their dominance has increasingly been chal-

lenged by a growing demand for index

trades. Indeed, the latest industry survey

from rating agency Fitch estimated that the

volume of index trades outpaced single-

name trades for the first time in 2006.

But combining the indexes did not simply

enhance liquidity in index-based trades

themselves, it enabled a raft of ever more

sophisticated products to be developed.

Some dealers, for instance, had previously

traded tranches based on the indexes

between themselves, but it was not until the

iTraxx® family had been formalized that a

standardized market of index tranches

Although single-name CDSwere for a long time the

most common instrument,their dominance has

increasingly beenchallenged by a growingdemand for index trades

emerged. Dealers began tranching the new

iTraxx® Indexes almost immediately after

their launch. More importantly, they agreed

to quote standard tranches on these port-

folios, ranging from equity or first loss

tranches (0–3 percent) to the most senior

9–12 percent tranches.

These new tranches not only shared the

same underlying portfolios, and the same

subordination and thickness, but the docu-

mentation supporting the trades was also

standardized, as all the Market Makers had

agreed to confirm with the same documents.

This meant that investors who had traded in

a tranche with one dealer could easily mark

their positions to market, or unwind their

trades with different Market Makers without

any transactional risk.

Standardized tranching also spawned a

host of new products. First-to-default stan-

dardized baskets and other tranched index

products began to appear in 2004, substan-

tially boosting the transparency and effi-

ciency of trading correlation.

Prior to the introduction of standardized

iTraxx® tranches, correlation desks had, to a

large extent, hedged their correlation posi-

tions by generating more client business.

Banks could hedge their market risk by

using the index, but not the entire corre-

lation risk unless they managed to place the

other parts of the capital structure. The

iTraxx® tranches completely changed this.

They permitted banks to create, market and

sell single-tranche structures in record time.

And at far lower cost than had previously

been possible.

Credit-linked notes, basket products and

credit spread options were the first more

structured tools to be used widely, but par-

tially-funded synthetic collateralized debt

obligations (CDOs) also rapidly grew in

importance. One of the most groundbreaking

of the new instruments, synthetic CDOs are

collateralized debt obligations that are

backed by pools of credit derivatives. The

synthetic CDO market soon eclipsed the cash

CDO market because of its greater opera-

tional simplicity. While tight spreads in the

cash market makes it difficult to source

underlying assets for traditional CDOs, syn-

thetic CDO transactions avoid this issue and

have the flexibility to reference credits from

different countries, as well as a range of

credit assets including loans, mortgage- and

asset-backed securities, high-yield and

emerging market debt.

Volumes also quickly grew in equity-linked

credit products and swaptions, as well as

total return swaps that were developed to

sell customized exposures to investors

requiring a pick-up in yields on their port-

folios. An index option market meanwhile

developed alongside, enabling investors to

buy or sell a current standard iTraxx® CDS at

a future date and given price.

More recent developments have included

the expansion of the iTraxx® family. Since it

first debuted in 2004, dealers started writing

credit derivatives on other debt assets, such as

leveraged loans. iTraxx® expanded its family in

tandem with these developments, launching

its LevX® Leveraged Loan Index in 2006.

CDS have also formed the foundations

for two recent structured credit innovations:

constant proportion portfolio insurance

(CPPI) transactions and constant proportion

debt obligations (CPDO). Credit CPPI is a

leveraged capital-guaranteed deal that ref-

erences CDS portfolios and the iTraxx®

Indexes. There has been a flurry of deals

31The landscape

32 The landscape

since ABN Amro launched Rente Booster,

the first credit CPPI deal in 2004. The Dutch

investment bank also pioneered CPDOs,

which combine CPPI and CDO technology to

generate returns of 200 basis points over

Libor by dynamically leveraging exposure to

a portfolio of CDS.

The users

As credit derivatives became increasingly

standardized, and these new trading and

investment tools arrived on the market, they

developed into indispensable tools for

investing in credit and managing credit risk.

Consequently, a larger number of traditional

asset managers entered the market. In fact,

by 2004–2005, the range of participants

had expanded to include mutual funds,

pension funds, corporate treasurers and

other investors, all of whom were looking to

transfer credit risk, or for extra yield on

their investments to compensate for the

narrowing returns on conventional cor-

porate and sovereign issues.

Banks, hedge funds and securities houses

nonetheless remained the biggest buyers of

CDS protection, while insurance companies

and monolines tended to be protection

sellers, absorbing much of the market’s

credit risk. Within this broad segregation

there were further divisions: larger com-

mercial banks tended to be protection

buyers, while smaller or regional entities,

such as German Landesbanks, were pro-

tection sellers. Corporates, government and

export credit agencies were net buyers,

while pension funds and mutual funds were

net sellers. Corporates, meanwhile, began to

use CDS to insure themselves against credit

exposures with risky commercial counter-

parties, such as customers or suppliers.

The infrastructure

The development of the market infra-

structure gathered momentum as the

market took off. The interdealer trading firm

Creditex, for instance, launched the first

electronic platform for trading index-based

credit derivatives in 2004. The emergence of

this, and other subsequent dealer-to-dealer

electronic platforms, facilitated greater

transparency and turnover in the interdealer

market, speeding up price dissemination and

market efficiency, thereby enhancing trans-

parency and liquidity, and making trading

easier for dealers.

This evolution highlighted the need for

independent pricing and valuation services

and less reliance on pricing based on dealers’

proprietary models. As a result, and in a

matter of just a few years, a dealer-owned

firm, Markit, emerged as the benchmark

provider of independent data and portfolio

Banks, hedge funds andsecurities houses

nonetheless remained thebiggest buyers of CDS

protection, while insurancecompanies and monolines

tended to be protectionsellers, absorbing much of

the market’s credit risk

valuations of credit derivatives. A raft of

other providers also entered the market, pro-

viding additional data sources, such as

Interactive Data, SuperDerivatives, Numerix,

Barra Credit and Credit Market Analysis.

The client or dealer-to-customer side of

the market did not, however, evolve so

rapidly. While a growing proportion of

dealer-to-dealer trades were conducted elec-

tronically, the few initiatives launched to

serve the client side of the market failed to

gain traction. Thus, the transparency, liquidity

and operational benefits of the electronic

markets were largely the preserve of the

giant dealer firms.

Nonetheless, the consensus at this time

was that the growing importance of CDS, the

exponential increase in volumes and

improving liquidity would continue apace,

while an ever-expanding pool of investors

would further enhance liquidity.

iTraxx® Indexes – theglobal benchmark forthe credit markets

n recent years, the credit

default swap market has experi-

enced exponential growth. A

major driver behind this has been

the development of a transparent

index market.

Standardized credit default

swap (CDS) indexes revolutionized

corporate credit trading, opening

the door to greater liquidity and trans-

parency, attracting new investors and cre-

ating important standardized vehicles for

the structured credit markets.

Credit indexes are easy and efficient to

trade. Investors can use them to trade

credit risk separately from interest rate

and/or currency risk, to express bullish or

bearish views on credit as an asset class

and to actively manage investment port-

folios – all the while benefiting from the

low transaction costs associated with

static portfolios.

The present

Credit has become a recognized asset class

and a source of risk. Most market partici-

pants have some form of credit exposure

that needs to be managed, measured and

priced, and first generation credit derivative

instruments enabled investors to do this, as

well as to trade this risk separately from

interest rate and/or currency risk.

The first-generation products were

quickly embraced by the market and, as a

result, the credit derivatives market grew

rapidly in its early years – but it was only

with the creation of the first standardized

indexes, the iTraxx® family, that the market

really began to take off.

The International Index Company (IIC)

manages and administers the iTraxx® Indexes

and sets the market standards for investing,

trading and hedging the iTraxx® Index family.

With the iTraxx® families, IIC not only covers

the European and Asia/Pacific CDS markets,

where it has rapidly become the benchmark,

but it also recently debuted in the European

leveraged loan CDS market with its iTraxx®

LevX® Indexes.

As an independent index supplier, IIC is

committed to open and transparent markets.

Setting the market standard to facilitate

investment, trading, hedging in the indexes

and helping to improve market liquidity in

tradable iTraxx® CDS Indexes, is an important

part of IIC’s business rationale. Its indexes are

objective, rules-based and dependable, and

adhere to the highest quality standards.

As a result of the growing standardi-

zation brought to the market by IIC, index

volumes have grown rapidly in recent years.

The British Bankers Association (BBA) esti-

mated that index trading had become the

second largest segment of the credit deriva-

tives market by the end of 2005. The

London-based association estimated that it

accounted for some 30 percent of total

Standardized credit indexes are the backbone of the credit markets.TToobbiiaass SSpprrööhhnnllee, from International Index Company (IIC), details howthe indexes are constructed and explains how they are used

I

34 The landscape

35The landscape

volumes, only marginally less than the 33

percent share of single-name credit default

swaps. A more recent survey by the rating

agency Fitch has revealed that index trades

have since outpaced single-name trades.

Fitch estimates that index trades accounted

for some 44 percent of volumes at the end

of 2006, compared to the 40 percent of

total volumes driven by single-name CDS.

The purpose

Investors can use iTraxx® CDS Indexes to

trade large positions in credit names without

having to take on direct exposure to the

underlying securities, and managers can use

the indexes to manage the three separate

components of their portfolios: credit risk,

interest rate duration and relative value.

But the instruments also provide trading

opportunities for other participants, such as

speculators and arbitrageurs. For instance,

taking a short credit position in the iTraxx®

Europe (the main index of 125 equally-

weighted investment grade names) without

exposure to a cash bond position, offers

upside potential in the case of underlying

credit deterioration. Arbitrageurs can also

use the indexes to exploit spread differen-

tials between the CDS, equity and cash

markets. The additional liquidity provided by

trading desks, hedge funds and arbitrageurs

undertaking these strategies has greatly

influenced the index market, making it more

liquid and thus an easier and more efficient

means of gaining risk diversification and

market exposure.

Since the iTraxx® Indexes were introduced,

the basis between EUR-denominated cash

bonds and CDS has been greatly reduced.

This is because trading desks have increased

their trading activity substantially, and hedge

funds seeking to profit from price ineffi-

ciencies between the CDS and cash bond

markets have helped to tighten the

cash/synthetic gap.

As the index market has developed and

expanded, and liquidity in credit has

improved, it has become possible to trade

Comprehensive European platformBenchmark indexes Sector indexes Standard maturities

iTraxx® Europe

Top 125 names in terms of CDS volume traded in the six months

prior to the roll

Non-Financials

100 entities

Financials Senior

25 entities

Financials Sub

25 entities

iTraxx® Europe, HiVol

35710

iTraxx® Crossover

5 and 10

iTraxx® Sector Indexes

5 and 10

First to Default baskests:Autos, Consumer, Energy, Financial (sen/sub), Industrials, TMT, HiVol, Crossover, Diversified

iTraxx® Europe HiVol

Top 30 highest spread namesfrom iTraxx® Europe

iTraxx® Europe Crossover

Exposure to 50 European sub-investment grade

reference entities

Source: IIC

36 The landscape

tighter ranges and higher volumes, and to

enter and exit relative value and curve trades

at lower cost. The liquidity and transparency

provided by the indexes has paved the way

for new products, such as standardized first-

to-default baskets, sector indexes and

iTraxx® tranches.

Short-biased managers and momentum

traders are now able to put on volatility

trades in sub-sector indexes, exploiting their

fundamental views on specific sectors. Index

baskets offer investors timing flexibility and

low-cost trading structures, allowing active

managers to implement credit duration

strategies largely independent from the

primary and secondary cash markets. The

iTraxx® tranches were initially created for

mark-to-market purposes and to help book

runners manage their P&L accounts, but

index tranches are now actively traded and

are also being used to trade and/or hedge

correlation risk. Because the underlying

portfolios and maturity dates are fixed,

iTraxx® Index Market Makers are also able to

quote a range of standard tranches from

equity or first-loss tranches, up to the most

senior tranches.

A particularly exciting by-product of the

increased liquidity and transparency in the

index market has been the very recent emer-

gence of exchange-traded futures contracts

based on the iTraxx® Indexes. It is early days

yet, but these contracts can provide a new

dimension for buy-side organizations to

manage credit risk.

The outlook

When the markets needed a benchmark for

managing credit risk, iTraxx® provided the

tool. It has also stimulated trading activity

and provided an efficient means of port-

folio hedging and established itself as a

market standard.

By adding liquidity and transparency to

the markets, the iTraxx® family also helped

establish credit risk as an asset class in its

own right – an asset class that is now every

bit as complex as other more established

markets such as equity.

This success could not have been achieved

without the goodwill and cooperation of

investment banks, but especially not without

the input of investment managers. Having

identified the need for indexes and hedging

instruments and pushed for their devel-

opment, this community played a pivotal

role in iTraxx®’s development.

Investment managers will likely continue

to press for products and opportunities to

serve their changing needs. At the same

time, credit derivative products will likely

become more widely accepted. This will

mean that those players still prevented from

using the instruments by mandates or regu-

lations will soon enter the market. Those

using credit derivatives for the first time will

likely use the standardized indexes or

instruments based on them, such as the

new futures contracts.

All these factors will continue to drive the

credit derivatives market – and in particular,

the index market, fuelling volume and liq-

uidity. The International Index Company will

remain at the forefront of activity, spear-

heading the market’s development with the

principles of independence, transparency

and objectivity at its core.

International Index Company Ltd. (IIC) is the market leader for fixed income and credit

derivatives data and indexes. Established in 2001, IIC calculates and publishes the inde-

pendent iBoxx® bond prices using multiple price contributors and rigorous quality controls.

The iBoxx® bond indexes set new standards in the investment community for transparency

and accessibility and have been adopted by the market for use as benchmarks, in research

and as the basis for financial products. The index families include the iBoxx® euro, British

pound, U.S. dollar, global inflation-linked, ABS and euro high yield bond indexes.

IIC also manages and administers the iTraxx® European and Asian Credit Derivatives

Indexes, and calculates and distributes the iBoxx® FX trade-weighted foreign exchange

indexes for ten major currencies. IIC is owned by ABN AMRO, Barclays Capital, BNP Paribas,

Deutsche Bank, Deutsche Börse, Dresdner Kleinwort, Goldman Sachs, HSBC, JPMorgan,

Morgan Stanley and UBS.

Tobias Spröhnle joined IIC in 2006, where he is head of derivatives. In this role he is respon-

sible for the global iTraxx® Credit Derivatives Index families. He holds a diploma in economics

and information management and is a chartered financial analyst (‘CFA’).

After starting his career in the German private banking industry, Tobias joined Eurex/

Deutsche Börse Group in 2000, where he occupied different roles in market supervision and

product design for fixed income derivatives. In his role as a product designer, he was project

manager for the iTraxx® Credit Futures products, the first exchange-traded credit derivatives in

the world.

38 The landscape

Credit derivatives rose from obscurity to become mainstream derivatives instruments in record time.NNaattaasshhaa ddee TTeerráánn finds out how they have benefited the wider financial markets

The upsides

he creation of credit

derivatives had

indeed transformed

the world of finance,

strengthening the

banking system and rein-

venting credit as a

streamlined asset class.

Historically, debt had financed much of

the world’s corporate activity, but credit

had been overshadowed by its headline-

grabbing cousin, equity, which was per-

ceived as a more exciting asset-class that

was easier to access and, in most cases,

offered higher returns.

The low-key perception of debt masked its

potential importance in global capital

markets. Few people outside Wall Street

could have predicted the impact that credit

would have on financial markets once the

smartest brains in finance had developed an

effective risk-transfer tool that was the

equivalent of turning tin into silver.

“Perhaps the most significant development

in financial markets in decades has been the

rapid development of credit derivatives,” the

former Federal Reserve Chairman Alan

Greenspan told a gathering at the Bond

Market Association in New York last year.

Among other things, he said, “it has made

the banking sector more resilient”.

Greenspan’s best illustration of his thesis

was that between 1998 and 2000, the peak

of the Dotcom boom, the equivalent of USD

1 trillion of debt had been taken out by the

telecommunications industry, of which a sig-

nificant part went into default. Yet not a

single major U.S. financial institution ran into

difficulty because, when the Dotcom bubble

burst in 2000, the credit derivatives market

had played an effective role in defusing the

very major credit problems. The new market

had passed its first test.

The enhanced resilience of the banking

sector is the common thread that runs

through many of the comments made by

regulators and central bankers over the past

five years. Although, it must be noted that

they, as circumspect guardians of the

financial system, have also warned the world

of its darker side – but more of that in the

next chapter.

Mitigating risks

As the credit derivatives market grew

unabated after 2000, it continued to face

more challenges because low interest rates

were stoking an ever-increasing appetite for

debt, while rising energy and commodity

prices were testing the market’s tolerance

for risk.

The Reserve Bank of Australia’s deputy

governor, Glenn Stevens, noted in 2006: “A

striking feature over the past several years

has also been the way in which a succession

of events that might previously have trig-

gered a significant disturbance in financial

markets have been absorbed relatively easily.”

Two of the events to which Stevens may

have been referring were the twin credit

ratings downgrades to junk of the world's

two biggest car manufacturers and corporate

debtors, General Motors and Ford, and the

biggest hedge fund liquidation in history, that

of Connecticut-based, Amaranth Advisors.

Market practitioners were equally quick to

point out that the parallel existence of the

seemingly unflappable financial marketplace

and the growth of credit derivatives has not

been mere coincidence.

“We have been through several market

corrections in the past few years and in each

case, markets have recovered,” said Anshu

Jain, Deutsche Bank's head of global markets

and the chief architect of the German bank’s

reinvention as a global derivatives power-

house. “In retrospect, people think the market

has been characterized by calm, continuous

and even benign conditions. Derivatives are

a big part of explaining that phenomenon,”

he added.

The development of the interest rate swaps

market in the 1980s left bankers grappling to

find a tool to manage their other major risk –


As the credit derivativesmarket grew unabated after

2000, it continued to facemore challenges because

low interest rates werestoking an ever-increasing

appetite for debt

40 The landscape

credit. Historically, banks’ lending practices

had been constrained by their inability to

dispose of loan risks that they no longer

wanted to hold. In practice it was possible,

but it was a convoluted process. The market

for loan trading was illiquid and the borrower

had to be notified of the transfer, which

risked jeopardizing the entire banking rela-

tionship with the customer.

Moreover, in the case of an economic

downturn, banks were forced to cut the

amount of loans they issued, creating a

‘credit crunch’ effect. This typically led to

higher borrowing costs, and ultimately

defaults, which affected the wider economy.

Loans sat stagnating on banks’ balance

sheets, exposing them to potentially huge

losses in the event of a major default or

series of defaults.

Perversely, in some cases, banks would

actually increase the amount of loans to

healthier corporate sectors as a way of diver-

sifying their risk. Credit derivatives made the

process fluid, while keeping their core

business intact.

“Credit default swaps are transforming the

way banks operate in the market, and due to

credit portfolio management practices have

indeed profound implications for the banking

business model,” Jean-Claude Trichet, pres-

ident of the European Central Bank, told del-

egates at the International Swaps and

Derivatives conference in April 2007. “Banks

increasingly find credit default swaps a

highly attractive mechanism for reducing

exposure concentrations in their loan books,

while simultaneously allowing them to meet

the needs of their corporate customers.”

Minimizing costs

As this decade has progressed, the needs of

the customer have been met not only by the

availability of credit, but also in cheaper

funding costs. Credit derivatives cannot take

all of the plaudits, of course, because strong

economic growth, low interest rates and a

consumer boom since 2002 have kept default

rates near an all-time low.

Nevertheless, the banks’ growing use of

credit derivatives has freed up more capital

to make more loans and generate more fees,

without them having to set more capital

aside for regulatory purposes. Indeed, as

Trichet said in the same speech: “Some evi-

dence from the United States, based on indi-

vidual loan data, supports the idea that

banks are increasing the supply of credit as

they obtain additional credit protection

through credit derivatives.”

The increased agility of the banking system

has also led to a reassessment of what is

suitable credit risk, and this has reinforced

the already low default rates, which has

brought wider implications for the economy

as a whole.

The changing shape of business banking

and risk management was further stream-

lined by the rapid growth of so-called syn-

thetic collateralized debt obligations (CDO).

These ingenious examples of financial engi-

neering enable banks to bundle together

groups of credit default swaps (CDS), dividing

them into parcels of varying risk, before

selling them on to investors.

Synthetic CDO volumes surged from 2004

after banks created credit derivatives indexes,

which became the building blocks for CDOs

and other products, enabling banks to further

slice-and-dice risk according to their view of

the financial health of companies. Investors

benefited from gaining exposure to a group

of companies of their choice, without having

to source the individual underlying bonds.

The first CDOs had been composed of

corporate bonds, which took many months

to bring together. The market accelerated

with the onset of credit derivatives, and CDS

indexes in particular, because banks could

package them together much more swiftly –

in some cases, in one day.

The proliferation of synthetic CDOs led

directly to a compression of credit risk pre-

miums. The CDO market now stands at

USD 1.5 trillion, having grown by more

than USD 500 billion last year, according to

Morgan Stanley. Although just a fraction of

the overall size of the credit derivatives

Historically, banks’lending practices had

been constrained by their inability to dispose

of loan risks that they nolonger wanted to hold

market of USD 34.5 trillion, the

market’s impact on credit spreads has

been significant.

As banks built the CDOs, typically they

would hedge their positions by selling CDS

in the market. At a time when investors and

banks were less concerned about company

defaults, there was less demand to buy CDS

and credit risk premiums fell to near record

lows as a result. According to Standard &

Poor’s Leveraged Commentary & Data unit,

for instance, U.S. junk-rated companies now

pay an average spread of 2.38 percentage

points more than LIBOR, a record low, com-

pared with more than 4 percentage points

in 2003.

To illustrate the benefits of this large-scale

dispersion of credit risk, consider the example

of Eastman Kodak, the world’s largest pho-

tography company. By mid-2005, the once

blue chip company had reported losses

totalling USD 1.6 billion over six consecutive

quarters and its credit rating had been cut

three times by Moody’s. In a world without

credit derivatives, banks might have balked at

the prospect of lending further to the

company. Yet Kodak was still able to borrow

USD 2.7 billion at 0.75 basis points less than

it had three years earlier. That may have been

due to its CDS being contained in more than

150 CDOs, according to data from bond

research firm, CreditSights. Eastman Kodak

duly secured the funding it needed to fight

another day.

In this case, the CDS market had helped

avoid the possibility of a default and the

prospect of thousands of job losses.

Attracting new investors

As with all asset classes, the premise of

CDS rests on its effectiveness as a risk

management tool, or in common trader

parlance, the ability to ‘go short’. For gener-

ations, corporate debt investors had been

hamstrung by their inability to hedge bond

portfolios; when credit conditions worsened,

risk premiums rose and companies started

defaulting on their bonds. For many fund

managers it represented a critical barrier

to entry.

And for those involved in the debt markets,

the choices were few: they either bought

more bonds to diversify or became forced

sellers. In practice this was time consuming,

inefficient and expensive. Restocking the

portfolio made things even more expensive.

The introduction of the iTraxx® Indexes in

2004 made life a whole lot easier. Soon,

much credit derivatives trading activity was

based on the indexes, making the difference

between the buy and sell rates (or the bid/

offer spread) small and the cost of hedging a

bond portfolio significantly cheaper, in turn,

making the process much faster.

It is also arguable that the increased use of

credit derivatives by fund managers after

2004 contributed to a reduction in corporate

risk premiums. In the past, investors had

demanded what was known as a ‘liquidity

premium’. They wanted to be rewarded suffi-

ciently to compensate for transactional risks,

and, as a result, borrowing rates were artifi-

cially higher than they should have been.

Borrowers were attracted to the longer-term

funding that the bond market provided, not

to the lending margins they were offered.

The adoption of credit derivatives as a

more effective way of hedging their bond

portfolios gave investors more flexibility, or,

as one private equity manager recently put it,

meant that there had “never been a cheaper

time to go to the bond market”.

41The landscape

42 The landscape

The rapid expansion of the credit derivatives market came at a price.JJoohhnn FFeerrrryy exposes the flaws and teething problems

The darker side of credit derivatives

he emergence of the

credit derivatives

market clearly pro-

duced some well-docu-

mented benefits for

both the individual

buyers and sellers of

credit risk, and for the

financial system as a whole. But as the

market for credit default swaps (CDS) and

other forms of credit risk transfer continued

to expand exponentially and become more

established – and as the structured credit

products that referenced these instruments

continued to grow – so negatives, as well as

positives, emerged.

The regulators were not unaware of the

issues. Financial regulators often talk pub-

licly about the development of the over-

the-counter (OTC) derivatives market and

their associated concerns. But during the

early years of this century they increasingly

turned their attention to credit derivatives.

Their worries centered on how banks were

processing credit derivatives contracts in

their back offices, as well as how legal,

counterparty, liquidity, concentration and

other risks might be casting a shadow over

the growing market.

Nearly all the risks were highlighted in

an October 2004 report produced by the

Financial Stability Forum (FSF). The FSF had

requested its Joint Forum’s Working Group

on Risk Assessment and Capital undertake a

review of credit risk transfer (CRT) activity.

The report was based on a number of inter-

views and discussions with market partici-

pants and noted the importance of consid-

ering the financial stability issues that

could be associated with CRT activity. It

highlighted several key risk management

risks associated with CRT: operational risk,

counterparty credit risk, legal risk and liq-

uidity risk.

Processing issues and operational risk

Ironically, in view of the sophistication of

the market’s tools and techniques, the infra-

structure that supported credit derivatives

operations was based on old-fashioned

systems and outdated technology.

All OTC derivatives are cumbersome to

confirm, but operational advances over the

years had eased the processes for many

product types. Credit derivatives, by com-

parison, did not enjoy the same levels of

operational streamlining.

Credit derivatives have some peculiar fea-

tures that mean the back-office paperwork

is hugely important. Unlike more established

and standardized interest rate and equity

derivatives, credit derivatives trades have to

be supported by lengthy documentation

outlining the terms of the deal. The com-

plexity of the instruments and the rapid

growth in volumes only exacerbated the

associated paperwork burden and the oper-

ational shortfall.

Back-office controls are particularly

important for the credit derivatives market

because when two parties agree a sale they

are effectively transferring the risk of default

on a bond, or group of bonds. But the con-

tract does not become valid until all the

parties sign the documents, or confirm it

electronically. The hypercharged expansion of

the market meant that the dealers' ability to

process such trades was severely tested and

it is probable that all participants fell behind

in confirming the often-complex terms

involved in transactions. The Joint Forum

Report said: “CRT activity also gives rise to

operational risks. Most significantly, the OTC

derivatives market generally has struggled to

develop transactions processing and set-

tlement mechanisms that reduce operational

and settlement risks. The relevant issues

include backlogs of unsigned master agree-


Credit derivativestrades have to

be supported by lengthy

documentationoutlining the

terms of the deal

44 The landscape

ments and unsigned confirmations, as well as

the prevalence of manual systems and the

risk that they break down with increased

volume. In the CDS market, especially, market

participants recognize that the problem of

unsigned confirmations had reached

excessive proportions, with some transac-

tions going unconfirmed for months.”

Legal risk

In terms of legal risks, the Joint Forum sum-

marized the issue as follows: “Market partici-

pants agreed on the paramount importance

of legal certainty in these types of transac-

tions, but emphasized that this requires sig-

nificant work to ensure it is achieved.”

Legal or contract risk had, indeed, been a

perennial issue in the credit derivatives

market since its inception. As bilateral OTC

deals, CDS require close legal scrutiny by

those signing the contracts, which is why

many credit derivatives desks often have

lawyers sitting nearby.

Jean-Claude Trichet, president of the

European Central Bank, returned to the theme

of legal risk in an address to the International

Swaps and Derivatives Association’s (ISDA®)

annual general meeting in April 2007: “It is

important that market participants clearly

understand the precise rights and obligations

which they assume when entering into credit

derivatives transactions, as standardized con-

tracts do not always work out in the way that

contracting parties anticipate,” he said. “Also,

in some cases, case law has demonstrated

that the courts can take divergent views

regarding the meaning of ISDA®’s definitions

of credit derivatives.”

In the most basic of instances there has

been confusion between the buyer and seller

of CDS regarding the specific legal entity on

which the CDS was written. In other cases,

market participants entered into contracts on

the wrong legal entity. But over the years

other issues emerged, such as CDS dealers

arguing over the wording of contracts, or

whether a default had actually occurred.

Further difficulties arose out of restruc-

turing events. The 1999 ISDA® definitions

included debt restructuring – such as low-

ering a coupon or extending maturity – as a

designated credit event that would trigger

repayment on a CDS. Controversy arose in

2000 with the restructuring of loans to

Conseco, when banks agreed to extend the

maturity of the company’s senior secured

loans in return for higher coupon and col-

lateral payments. This triggered protection on

about USD 2 billion of CDS.

David Mengle, ISDA®’s head of research,

noted in his paper, Credit Derivatives: An

Overview, that: “Protection buyers then took

advantage of an embedded ‘cheapest to

deliver’ option in CDS by delivering longer-

dated senior unsecured bonds, which were

deeply discounted – worth about 40 cents on

the dollar – relative to the restructured loans,

which were worth over 90 cents on the dollar.

Protection sellers ended up absorbing losses

that were greater than those incurred by pro-

tection buyers, which led many sellers to

question the workability of including restruc-

turing.” The result was a modification to the

definition of restructuring that placed some

limits on deliverable bond maturity and,

therefore, on the cheapest–to–deliver option.

ISDA® had published standardized credit

derivatives definitions in 1999, as a basic

framework for documentation. These

underwent various modifications and were

then updated in 2003 in response to the

many problems that had emerged, high-

lighting legal risks to market participants.

But even so, legal doubts remained.

In 2006, for example, Aon Financial

Products and Société Générale engaged in a

court battle over a CDS on the Republic of

Controversy arose in 2000with the restructuring ofloans to Conseco, when

banks agreed to extend thematurity of the company’s

senior secured loans in return for higher coupon and collateral payments

the Philippines. Aon had sold protection to

Bear Stearns on a Philippine corporate

backed by a government agency. It then

bought sovereign protection on the

Philippines from the French bank. Market

observers assumed this was done to hedge

the contract Aon had sold. The Philippine

agency subsequently withdrew backing for

the Philippine corporate triggering default

on the contract Aon had sold. This event

did not, however, trigger a payout on the

Aon-Société Générale contract, and so a

dispute emerged. A U.S. court ultimately

upheld the content of both buy-and-sell

contracts, with the result that Aon was

obliged to honor its payout to Bear Stearns

but did not receive compensation from

Société Générale.

Counterparty credit risk

As bilateral OTC derivatives trades, CDS nec-

essarily entail credit risk exposures, namely

the credit risk of the counterparty to the

trade. For instance, a bank that buys pro-

tection against a reference entity through a

CDS will rid itself of that particular credit risk,

but at the same time it will take on the risk

that the counterparty selling the protection

might not be able to pay out. Likewise, a pro-

tection seller takes on counterparty risk

because the seller will lose expected premium

income if the buyer defaults.

Although banks and other institutions

generally have strict procedures for checking

and evaluating counterparties, counterparty

risk will always remain. Lars Nyberg, deputy

governor of the Swedish Central Bank, drew

attention to this risk in a speech earlier this

year, saying: “Counterparty risks exist in

most financial agreements, but as the credit

derivatives market is so young and growth is

so rapid, there is particular reason to be

aware of them.”

The Joint Forum noted how market par-

ticipants manage this counterparty credit

risk in various ways. One of the most

common methods is by way of a collateral

support agreement (CSA) that accompanies

the ISDA® trade documentation and that

requires lesser counterparties to post addi-

tional collateral against their trades. CSAs

are, however, operationally burdensome. To

work effectively, they require constant over-

sight and administration with periodic

marking-to-market and margin and col-

lateral adjustments as pre-agreed thresholds

are breached.

An additional complication that can arise

– both in regard to the evaluation of coun-

terparty credit risk and the value of credit

protection provided by CRT instruments and

CSA agreements – concerns the potential

correlation that can exist between an

underlying reference entity and the pro-

tection seller. For example, if the CDS pro-

tection seller’s credit risk is highly correlated

with the credit risk referenced in the CDS

itself, the extent of credit risk reduction for

the protection buyer is much less than if the

protection seller were largely uncorrelated

to the reference entity.

Some OTC market participants set up

Special Purpose Vehicles (SPV) and ran their

derivatives trades through them. The SPVs

stood in the middle of the deals becoming

the trade counterparty to both sides. While

this removed the counterparty risk element,

it added extra layers of complexity, expense

and organizational difficulty.

45The landscape

Although banks andother institutions

generally have strictprocedures for checking

and evaluatingcounterparties,

counterparty risk will always remain

46 The landscape

Liquidity risk

Related to the issue of counterparty risk is

liquidity risk. The CDS market is heavily con-

centrated among a limited number of dealing

banks, while the real ‘liquidity’ is centered on

a relatively small amount of reference

entities: less well-known ‘names’ are traded

only infrequently, and many structured deals

have no real liquidity at all. Given the lack of

transparency in the market, it is impossible to

predict how the market will cope under

extreme circumstances.

This issue was raised by the Joint Forum,

has repeatedly been revisited by regulators,

and was aired again in May this year when

Donald Kohn, vice chairman of the board of

governors of the U.S. Federal Reserve, spoke

at a conference in Atlanta. There he warned

that the credit risk transfer markets are

dependent on a small set of key intermedi-

aries, and that, in the extreme, “price varia-

tions and other adverse developments could

call into question the viability of these inter-

mediaries, threatening a larger cumulative

real effect”.

Concentration risk

Related to the above two risks are concen-

tration risks. These were highlighted in

several Fitch reports – most particularly the

rating agency’s 2002 study: Liquidity in the

Credit Default Swap Market: Too Little Too

Late? and a 2003 report, Global Credit

Derivatives: Risk Management or Risk? The

2002 study found on the one hand that liq-

uidity (even in commonly traded names)

tended to dry up in times of stress, after

rating agency downgrades and in high

volatility periods. The 2003 study, mean-

while, highlighted the dominance of just a

few dealers – as measured by the gross

amount of protection sold, the top 30 global

banks and broker dealers held approximately

98 percent of positions. Worse, counterparty

risk was concentrated among just the top-

ten global banks and broker dealers.

Opacity risk

The general opacity of the market is another

issue that cannot be ignored. In the OTC

markets, buyers and sellers of risk are not

obliged to disclose details of particular CDS

deals. As recently as 2006, Frank Partnoy and

David Skeel of the University of Pennsylvania

Law School noted in their paper, The Promise

and Perils of Credit Derivatives: “The market

for Credit Default Swaps is quite opaque.

Because swaps are structured as OTC deriva-

tives, they are largely unregulated.”

Increasing liquidity in the CDS market

helped improve pricing transparency for the

most liquid credit derivatives, but this has

not stopped some market observers from

calling for formal moves to be made on OTC

deal and pricing information. “Although there

is some price transparency in certain seg-

ments of the credit default swaps market, we

believe there should be a centralized pricing

service for credit derivatives generally,” stated

Partnoy and Skeel in their paper.

To a limited extent, centralized pricing

services do currently exist (though these are

non-obligatory), but highly esoteric credit

derivatives and CDS written on less liquid

names are another matter. For complex, or

bespoke products – ‘nth-to-default’ deriva-

tives on a basket of credit exposures, for

example – pricing can be highly subjective.

Such derivatives are generally marked to

model rather than marked to market, which

means the pricing is only as good as the

veracity of the underlying quantitative model

used, as well as the inputs to that model.

Advances

The Joint Forum report then remains as

important today as it was when it was first

published. Although considerable advances

have since been made – many of them in

direct response to the report’s findings –

the significance of the issues raised has

not diminished.

“The market for creditdefault swaps is quite

opaque. Becauseswaps are structured

as OTC derivatives,they are largely

unregulated”

The backlogs in confirmationsof derivatives contracts andunauthorized assignments

undermined the effectivenessof the market as a whole

Regulatoryintervention

n February 2005, the U.K.

Financial Services Authority (FSA)

was prompted (perhaps by the

Joint Forum’s report) to write to the

largest players in the market. The

FSA warned them that it was con-

cerned about the levels of unsigned

confirmations in existence and the

risks these posed to market efficiency

and confidence. The regulator said it felt

that the backlogs in confirmations of deriv-

atives contracts and unauthorized assign-

ments undermined the effectiveness of the

market as a whole.

Unauthorized assignments, it said, posed

the risk that participants might not be sure

who their counterparties were and raised the

question as to what extent they could rely

on the credit derivatives they had written or

bought. If a credit event occurred, then the

buyer of protection would not necessarily be

able to find the entity responsible in order to

settle the contract.

The ‘Dear CEO’ letter from the FSA was

followed by a report, published in July that

year, by the Counterparty Risk Management

Policy Group (CRMPG), an influential industry

organization. The CRMPG had concluded that

there was a need for “urgent industry-wide

efforts” to cope with serious back-office and

potential settlement problems in the credit

default swaps (CDS) market. It also called on

the industry to put a stop to the practice

whereby some market participants were

assigning their side of a trade to another

institution without the consent of the

original trade counterpart.

“Among other things, this practice has the

potential to distort the ability of individual

institutions to effectively monitor and

control their counterparty credit exposures,”

noted Gerald Corrigan, managing director at

Goldman Sachs and chairman of the CRMPG,

at the time.

In August 2005, the Federal Reserve Bank

of New York took up the baton. President

Though regulators largely welcomed the advent of credit derivatives, they soon realizedthat there were abundant flaws in the systems that supported the products. JJoohhnn FFeerrrryyexplores the lead-up to regulatory intervention

I

49The landscape

50 The landscape

Timothy Geithner summoned 14 major

credit derivatives dealers to attend a meet-

ing. The topic under discussion was going to

be an ugly one: operational issues in the

CDS market.

The Fed meeting took place in September

that year and the outcome was a concerted

effort by the world’s major derivatives dealers

to improve credit derivatives processing, red-

uce backlogs and a commitment to report on

progress regularly. To a large extent, these

efforts have been successful, but what had

led to the difficulties in the first place?

The simple explanation is that credit deriv-

atives volumes had increased at such a rapid

pace, with intermediation on credit deriva-

tives deals being handled by a relatively small

number of key dealers, that middle and back

office teams simply could not keep up with

what their front offices were doing. But to

leave it at that would be too simplistic. The

difficulties experienced by the market did

not, in fact, stem purely from exploding

volumes. To gain a thorough understanding

of the issue requires us to delve a little

deeper and to go back to fundamentals.

Novations

Over-the-counter (OTC) derivatives, which by

definition trade synthetically, do not involve

a transfer of ownership, as cash securities

trading does, but rather a transfer or pay-

ment of mark-to-market value, which can be

offset or cancelled in three different ways.

The two parties to an OTC trade can agree

a termination, or a so-called tear-up,

whereby they agree to cancel the original

obligation following a payment. Alternatively,

one side of a deal can choose to enter an

offsetting transaction. In this scenario, the

original deal is left in place but its economic

effects become mute. In the third option, one

of the parties can enter into a novation –

also referred to as an assignment – whereby

the rights and obligations of the derivatives

are transferred to a third party in exchange

for a payment.

In the latter case, the OTC market’s stan-

dard template for conducting derivatives

deals, the International Swaps and Derivatives

Association (ISDA®) Master Agreement,

requires a transferor to obtain prior written

consent from the remaining party before a

novation takes place.

Such novations were used relatively infre-

quently until the CDS market began to take

off. The usual method of exiting a deal was

through an offsetting transaction. But as

hedge funds became more active in CDS, so

novations became increasingly common.

Hedge funds generally prefer to unwind

through novations rather than offsets,

because they are reluctant to incur additional

credit exposure in the form of offsetting

swaps. They also, generally, prefer novations

to terminations because terminations can

limit unwind possibilities and have the

potential to reveal the trading strategies

being used.

In the wake of mounting hedge fund

involvement in the CDS market and the

emergence of index trading, the use of

novations increased considerably. Indeed,

the CRMPG in its 2005 report estimated

that novations constituted 40 percent of

trade volume.

“Novations became a problem because of

participants’ failure to follow established pro-

cedure,” explained David Mengle, ISDA®’s

head of research, speaking at a financial

markets conference held in Atlanta this May.

This was because some investors who wished

to step out of transactions via novations

were not obtaining prior consent from the

remaining party. Sometimes the transferee

was not verifying that the transferor had

obtained clearance, while in other cases the

remaining party, which might not have

known of the novation until the first pay-

ment date, would simply back-date its books

to the novation date and change the coun-

terparty name.

The finger pointing went further, according

to Mengle: “When dealers complained that

investors failed to obtain consent, investors

countered that remaining parties might have

given consent but failed to transmit the

Hedge funds generally preferto unwind through novations

rather than offsets, becausethey are reluctant to incur

additional credit exposure inthe form of offsetting swaps

necessary information to the back office in a

timely manner.” Either way, the situation pre-

sented significant operational problems in

the form of confirmation backlogs.

Settlements

There was another issue surrounding the

treatment of credit events. When a company

files for bankruptcy protection, any CDS con-

tracts on its name need to be fully or par-

tially settled. The original CDS contracts re-

quired that the buyer of default protection

hand over the company's bonds to the seller

of protection. However, by 2005, it was clear

that the volume of outstanding credit deriva-

tives contracts could far exceed that of the

bonds available for delivery.


By 2005, it was clear thatthe volume of outstandingcredit derivatives contractscould far exceed that of thebonds available for delivery

52 The landscape

This was certainly the case when U.S.

car parts manufacturer, Delphi, filed for

bankruptcy in October 2005. The volume of

CDS contracts outstanding was larger than

the volume of bonds by a factor of ten. The

International Monetary Fund noted in its

2005 Financial Stability Report, that contract

settlement following a default could thus

become a source of ‘market vulnerability’.

To address the shortage of bonds and to

simplify the settlement of contracts, dealers,

together with the ISDA®, developed a cash-

only settlement mechanism that market par-

ticipants can choose to adopt on an ad hoc

basis. In the adopted process, dealer auctions

set a notional cash price for the bonds of a

bankrupt company. The offsetting trades are

then cancelled, leaving only the net positions

to be settled. The market can adhere to this

as an alternative to physical delivery, thereby

eliminating any problems arising from a

shortage of deliverables. ISDA® intends to

include this methodology as the primary

means of settlement in its next set of credit

definitions, and has already included a

variant of it in its recently issued loan CDS

documentation. ISDA®’s revised definitions

are due out later in 2007 or in early 2008.

Confirmations

Like any other OTC instrument, credit deriva-

tives are traded on the basis of two parties

transacting directly or via some form of

intermediary. Each party will typically capture

the trade in its internal systems for post-

trade processing and risk management.

Sometimes counterparties will add an addi-

tional step in the process, known as the

affirmation stage, a process whereby the

two parties verify the key economic details

of the trade. The final stage of transacting

involves the two parties reviewing and

putting together the full terms of the trade

in a confirmation.

Ideally, these confirmations should be

processed very shortly after a trade is done.

In the case of the credit derivatives market,

however, this was far from the case. In fact,

by 2004 the average confirmation backlog

for large dealers represented more than 23

trading days. By mid-2005 it was taking

major banks an average of 44 days to

confirm a standard plain vanilla credit deriv-

ative, and double that for more complex,

exotic trades. In September of that year there

were over 150,000 unconfirmed credit deriv-

atives transactions, 98,000 of which were

more than 30-days old. The difficulties and

uncertainties surrounding novations, which

often meant that those buying and selling

credit derivatives could not be sure of the

identity of their counterparty, only exacer-

bated the backlog of unconfirmed trades.

Even though in many jurisdictions verbal

contracts are enforceable by law, the absence

of written deal confirmations was clearly a

major problem. The lack of documented

transactions not only disrupted the flow of

information within firms, and increased the

chances of errors going undetected, but

there were also doubts as to whether parties

would be able to prove the details of any dis-

puted trades. Ultimately, this could have led

to inaccurate measurement and manage-

ment of credit and market risks. Meanwhile,

backlogs could – and doubtless did – lead to

margin and payments breaks, disrupting the

trade cycle.

The confirmations issue, as it came to be

known, was a problem – but it was the

sheer number of unconfirmed trades in cir-

culation that really worried regulators. As

the FSA’s director of wholesale firms

In the adopted process,dealer auctions set a

notional cash price for thebonds of a bankrupt

company.The offsettingtrades are then cancelled,

leaving only the netpositions to be settled

division, Thomas Huertas, noted in a speech

that he gave in April 2006 in London. He

said: “Backlogs in confirmations of credit

derivatives trades pose similar risks as those

posed by unauthorized assignments. With-

out a valid confirmation in place, there is no

way of being certain that the two counter-

parties to the deal agree that there is in fact

a deal, or that they agree on the terms of

the deal.”

Without valid confirmations in place,

Huertas expressed that it was doubtful

whether firms, or the marketplace in

general, could truly gain the benefits

promised by the credit derivatives market.

He said: “It is questionable, at least from

this regulator's perspective, as to whether

firms can include unconfirmed transactions

in their calculations of exposures under

netting agreements, and whether firms can

give effect to unconfirmed transactions in

calculating counterparty exposures under

netting agreements, or in calculating large

exposures and capital requirements for

credits ‘protected’ by unconfirmed deriva-

tives transactions”.

Huertas was far from alone in his con-

cerns. The then Federal Reserve chairman,

Alan Greenspan, for instance, berated dealers

for “using 19th-century methods of dealing

with 21st-century financial instruments”.

At the end of the day the regulators felt

they had to bring the world’s major deriva-

tives dealers to account and serve them an

ultimatum: clean up the market in which

you are the major participants, or we will

step in and sort it out for you. Dealers, of

course, disliked the thought of having to

endure even more regulatory intervention

than they were already subject to. They

therefore wasted no time in putting in

place a plan of action to attempt to sort

out the operational problems in the credit

derivatives market.

53The landscape

“Without a valid confirmationin place, there is no way ofbeing certain that the twocounterparties to the deal

agree that there is in fact a deal, or that they agree on the terms of the deal”

54 The landscape

JJoohhnn FFeerrrryy recalls how the market responded to the regulators’scrutiny, by launching the OTC derivatives market’s largest clean-up

Automation, transparency and the aftermath of regulatory intervention

he moves instigated

by the regulators to

sort out the opera-

tional deficiencies in the

credit derivatives market

were unavoidable. If the

dealing houses did not

clean up the market, then

the regulators were tacitly threatening to

intervene. The moves were also decisive, in

that they were put in place rapidly. As a

result, the fears of regulators and those oper-

ating in the market were much alleviated.

Here, we consider how the industry came

together to take practical steps to solve

the problem.

When the 141 key credit derivatives dealers

got together at the behest of the New York

Federal Reserve in September 2005, they

agreed a crucial plan to sort out the opera-

tional mess.

Working with the International Swaps and

Derivatives Association (ISDA®), these firms

agreed to implement the trade organization’s

Novations Protocol. They also promised that

by the end of January the following year, the

number of confirmations outstanding by

more than 30 days would be reduced by 30

percent, compared to the levels that existed

at the end of September 2005, with further

cuts to be made by the end of the following

March. The dealers also pledged to provide

regulators with monthly figures for trade

volumes, confirmations, settlements and fails.

In February 2006, the Fed formally said

that the industry group had fulfilled the

commitments outlined the previous year.

Specifically, it was happy that the 14 dealers

had implemented ISDA®’s Novations

Protocol; that there was increased use of

electronic processing of confirmations; a

reduction in the backlog of trades that were

unconfirmed; and that the industry had

worked well towards improving the credit

default swap (CDS) settlement process.

“All 14 major dealers have met the January

31, 2006 commitment to reduce by 30

percent the number of confirmations out-

standing by more than 30 days. As a group, a

54 percent reduction was achieved by the

end of January,” said the Fed. “Separately, vir-

tually all active clients have been added to an

industry-accepted electronic confirmation

platform. This has facilitated an increase of

total trade volume that is electronically con-

firmed from 46 percent in September, to 62

percent in January.”

The protocol

A key element in the improvement was

ISDA®’s Novation Protocol, which stan-

dardized the process by which participants

to a novation agree or provide consent to a

transfer. The protocol specifies a set of

explicit duties to which the parties to a

novation have to adhere.

Under the protocol, a party wishing to act

as a transferee has to obtain prior consent

but can do so electronically. If the remaining

party provides consent before 18:00 New

York time, then the novation is complete and

the remaining party can respond by e-mail. If

the remaining party does not provide

consent by this time, then the transferor and

transferee enter an offsetting deal that gives

a similar economic result to the novation.

The idea is that a participant in the credit

derivatives market that wishes to assign its

obligations to a third party should quickly get

a response from the other counterparty to

the original deal. Market participants were

given a deadline to sign up to the new pro-

tocol, and dealers agreed to stop trading with

parties that did not comply with it. The result

was that the dealers were largely successful

in seeing the protocol adopted throughout

the market.

“By the end of 2005, over 2,000 firms,

including practically all frequent participants


In February 2006 the Fedformally said that the

industry group had fulfilledthe commitments outlined

the previous year

1Bank of America, N.A., Barclays Capital, Bear, Stearns & Co., Citigroup, Credit Suisse,

Deutsche Bank AG, Goldman Sachs & Co., HSBC Group, JPMorgan Chase, Lehman Brothers,

Merrill Lynch & Co., Morgan Stanley, UBS AG, Wachovia Bank, N.A.

56 The landscape

in the credit derivatives market, had signed

the Novation Protocol, and the major banks

had implemented the necessary procedures

to assure that they could give prompt

responses to assignment requests,” reported

Thomas Huertas, the Financial Services

Authority’s (FSA) director of wholesale firms

division at the end of April 2006.

Eradicating the backlogs

Banks, meanwhile, committed additional

resources to working through the vast

numbers of confirmation backlogs. Firms

put in place so-called SWAT teams – either

external consultants, or staff that had been

redeployed from other back office opera-

tions – to attack the problem. Banks also

conducted ‘lock-ins’ with each other: the

ops teams of the two institutions staying in

a room with each other until they had

cleared away all the trades between them

that awaited confirmation.

As a result of these efforts, the total

number of unconfirmed trades had declined

to 74,000 at end of March 2006, a reduction

of over 50 percent from the figure in

September 2005. Trades unconfirmed after

30 days fell to 29,000, a decline of over

70 percent.

Getting rid of existing backlogs solved only

part of the problem, however. The aforemen-

tioned responses were no more than fire

fighting. What the industry really had to do

was to put in place long-term solutions –

processes that would ensure that such high

levels of backlogs never appeared again.

To move towards achieving this goal, the

major players worked to bring almost all the

most frequent traders onto electronic confir-

mation platforms. This entailed a com-

mitment to make full use of the Depository

Trust & Clearing Corporation’s (DTCC)

Deriv/SERV – an automated matching and

confirmation platform that the DTCC had

debuted in late 2003.

Again, the efforts seemed to work. By

September 2006, the Fed reported that the

14 largest dealers had reduced the number

of all confirmations outstanding by 70

percent, and of confirmations outstanding

past 30 days by 85 percent. Meanwhile, the

dealers had doubled the share of trades con-

firmed electronically to 80 percent of total

trade volume and the DTCC began working

on a trade information warehouse. The

warehouse is essentially an over-the-counter

(OTC) derivatives trade database and a

central support infrastructure designed to

facilitate automation and centralized pro-

cessing of post-trade events, such as cash

flows, novations and terminations.

The clean-up in credit derivatives pro-

cessing showed that light pressure from reg-

ulators is often enough to make the dealing

industry sort out collective problems. But why

did it take regulatory intervention, and why

was the problem allowed to escalate to such

a large extent in the first place?

Speaking in May 2007, ISDA®’s head of

research, David Mengle, related the situation

to game theory and the classic prisoner’s

dilemma – each participant in the market

would have benefited from adhering to

proper procedures but there was no way of

knowing if the other parties would do

likewise. The result was no change and

increases in confirmation backlogs.

“On the one hand, dealers were aware of

the problem and would benefit if all parties

to novations followed established procedures.

But on the other hand, refusing to agree to

novations if procedures were not followed

would lead to losing potentially profitable

business to those dealers that did not insist

on proper procedures,” Mengle said.

Competitive considerations also made

dealers reluctant to exert pressure on their

most active clients. “It was not until regu-

latory intervention that there was sufficient

The clean-up in creditderivatives processing

showed that lightpressure from regulatorsis often enough to makethe dealing industry sort

out collective problems

cover for dealers to insist on adherence by

their clients. In this case, a relatively light

touch by a regulator was sufficient to bring

about a solution,” added Mengle.

No end in sight

Looking ahead, it seems clear that the

industry will not be able sit back and enjoy

the fruits of its 2005/2006 efforts, but rather

it will need to invest in further improvements.

Indeed, though regulators have been quick to

applaud the efforts completed to date, they

have been equally swift to point out that

further action is needed.

Automation, for instance, is not yet as

ingrained as it should be and so far only

incorporates plain vanilla transactions.

Moreover, only 31 percent of CDS trades are

confirmed on the same day, and error and

re-booking rates in CDS transactions are still

among the highest of all OTC transactions.

The challenge is now to improve on and

extend the automation processes, to stan-

dardize the complex products and, where

possible, to move these to electronic confir-

mation systems.

Over the past year, regulators have

stressed repeatedly the importance of con-

tinuing progress in these areas. Indeed, as

John Tiner, then chief executive officer of

the U.K.’s FSA, noted in his address at

ISDA®’s annual general meeting in Boston:

“There is still a need for continued vigilance

on everyone’s part and the submission of

credit derivative confirmation metrics to

regulators still plays an important part in

this respect.”

In a May 2007 paper from Harvard Law

School (Credit Derivatives, Settlement and

Other Operational Issues), the author,

Alexandre Richa, pointed out that with the

backlog in confirmations largely solved, the

emergence of the issue revealed a problem of

information processing, not only between

those trading in the market but also between

the market and regulators.

“Before 2005, the authorities did not seem

to have a clear view of what the financial

institutions were doing in the credit deriva-

tives market. It is unclear to what extent the

situation has improved,” noted Richa. “We

should pursue the efforts to improve the

information flow between the major market

participants and the supervisory authorities.

The existing meetings to assess the progress

made in the reduction of the backlog are a

first step in the right direction.”

As the OTC credit derivatives market con-

tinues to expand exponentially, there will

always be the risk that operational problems

could return to haunt it. Moreover, the rise

of CDS trading and credit risk transfer has

largely taken place in the context of a

benign credit environment. Strong global

growth with low inflation and reasonably

predictable monetary policies, as well as

solid corporate performance in terms of

profits, have been the order of the day. If

and when the environment changes for the

worse, which many believe is now inevitable,

the fear is that operational difficulties will

again return to the OTC credit derivatives

market. As Tiner concluded in his ISDA®

speech: “Now that the immediate risk of

operational backlogs and unauthorized

assignments in credit derivatives is largely

mitigated, it is right that the industry’s

attention is now on potential operational

risks that would arise in a more volatile

credit market. You could say we have had a

long dry summer in which to get the

groundwork done, but now it is time to get

the roof on before winter comes around.”

57The landscape

As the OTC creditderivatives market

continues to expandexponentially, there will

always be the risk thatoperational problems

could return to haunt it

58 The landscape

Bloomberg’s MMiirrkkoo FFiilliippppii explains the Bloomberg Pricing Model forCDSW/FCDS screens and Bloomberg defaults in CDSD/SWDF

The Bloomberg Pricing Model

loomberg models

have benchmark

status in the credit

default swaps (CDS)

space; Market Makers

and institutional

investors communicate

price, trade and mark-

to-market information on CDS transactions

using the popular Bloomberg CDSW function.

CDSW is also popularly used to evaluate

contracts based on CDS indexes, such as the

iTraxx® Indexes and tranches, and the facility

has been recently expanded to price the

Eurex iTraxx® Credit Futures contracts.

The first part of this chapter will describe

the analytics behind the CDS Bloomberg

Model, while the second part will focus on

how to set up the different variables (interest

rates, CDS curves, etc.) in order to replicate

the futures contract’s final settlement prices

or its intraday levels.

1 Bloomberg Model for CDS pricing

The Bloomberg Model is available on the

CDSW screen along with other models, such

as JPM and Hull-White. It prices a credit

default swap as a function of its maturity,

the deal spread, the CDS and yield curves and

the notional amount in question. The model

consists of two main components: a default

probability ‘stripper’ and a CDS pricer. The

conventions, assumptions and auxiliary

market data used in both components

are identical.

The key assumptions employed in the

Bloomberg Model are:

� constant recovery as a fraction of par

� piecewise constant risk-neutral

hazard rates

� default events being statistically inde-

pendent of changes in the default free

yield curve.

The last assumption allows us to perform any

discounting with the current default-free

discount factors, without assuming that

interest rates are deterministic.

The CDS pricer takes as inputs the

schedule, a default probability function and a

discount function. As an output it produces

the present value of the default leg (also

known as the protection leg) for a unit loss-

given default as well as the present value of

a flow of a unit premium until the earlier of

default and maturity.

The model value of the CDS is determined

by multiplying the default leg by the notional

amount of currency times one, minus the

assumed recovery rate, and subtracting from

this the contractual deal spread (premium

rate) times the notional amount of currency.

The required payment schedule is then

generated by CDSW from the user inputs for

the maturity dates and other conventions.

The discount function, which takes the date

as input and returns a discount factor, uses

standard interest rate market conventions, and

can be configured to different underlying

instruments through the SWDF function (as

explained in section two).

The default probability function is gen-

erated from an input CDS curve (also fully

configurable, as described in section three) by

the default probability curve stripper.

Symbolically, we can express the present

value of the premium leg as shown in the

equation below. Where:

c is the annualized deal spread

N is the notional amount

P(t) is the discount function

Q(t) is the default probability function, giving

the cumulative default probability to time t;

And t measures time with time 0 being the

B59Case studiesThe landscape

Equation expressing the present value of the premium leg

60 The landscape

default leg. Therefore, the principal of the

transaction will be zero.

The pricer screen also produces two risk

measures: the spread and interest rate

(DV01), which represent the number of cur-

rency units that the value of the transaction

will change by as a result of a parallel shift of

one basis point in the CDS curve or interest

rate forward curve.

On implementation the integrals above are

evaluated piecewise, each piece being no

longer than three months and small enough

to justify locally flat hazard rates and

forward interest rates.

The curve stripper takes a set of standard

maturity CDS as inputs, along with their

associated schedules, a yield curve and a

recovery rate. A set of risk-neutral default

probabilities for future dates is produced by a

bootstrapping algorithm, which starts from

the shortest maturity and progresses recur-

sively over the input maturities.

The specific assumption on default proba-

bility function is that it has the shape:

for . Then, is determined so

that the CDS pricer will match the par spread

of the first input CDS. Given , is

found, the CDS pricer will correctly price the

second input CDS, and so on. The value of

Q to each input CDS maturity is presented in

the CSDW screen under the heading

‘Default Prob’.

2 Interest rate curve settings

Interest rate curve settings affect CDS

pricing, as they determine the discounting

rates that are applied to the instruments’

cashflows. They can be changed through the

SWDF <go> function.

The three indispensable settings are:

1) The curve type (which determines

how the interest rate curve is built).

We advise it should be built on

‘Standard Rates’, under selection

number one.

2) The pricing source (the rate source for

each curve). For a list of choices, move

your cursor to any of the highlighted

fields. The sources are used in order of

preference; if the first choice is not

available, the second choice is selected,

and so on. NOTE: If you do not select a

contributor, SWDF defaults to Bloom-

berg composite pricing. For consistent

intraday and historical CDS futures

pricing, use the Bloomberg Composite

present and T = the time to maturity of

the deal. denotes the fractional

year between successive premium payment

dates, and the function measures

the length of time over which premium has

accrued since the last premium payment

date, both measured in the relevant day-

count convention.

The present value of the default leg can

similarly be expressed as:

Where R is the assumed fractional

recovery of par in case of default.

As shown in the CDSW screen, the par

spread for a CDS is determined as the

spread that equates the present value of the

premium leg with the present value of the

(‘CMPL’) and London trading hours (‘L’).

3) The interpolation method (the method

used to interpolate values between

maturity points on the swap curve). The

interpolation method can be changed in

SWDF, under ‘User Defaults’ and should

be set to ‘Smooth Forward/Piecewise

quadratic’.

3 CDS curve settings

The standard Bloomberg CDS Curve Spread

Defaults settings that Eurex uses for the

Bloomberg CDS Pricing Models to calculate

the credit futures settlement prices should

be changed via the Bloomberg function

CDSD <go>

These are as follows:

1) Set the ‘IMM Override’ field (reference

dates for the Par-CDS-Curve). The

setting should be number 2 ‘IMM

Maturities’.

2) Set the ‘CDSW default Date Generation

Method’ (choosing number 2 ‘IMM’, the

CDS cashflow dates are generated with

IMM defaults).

4 Set the pricing model

Set the ‘Bloomberg’ Model as the default

pricing model (‘CDS Default Model’).

5 Set the pricing source for the under-

lying iTraxx® Indexes to ‘CBIL’

Change your settings from the CDSD

function (number 12: Indexes) for the

indexes underlying the futures contract.

6 CDS futures contracts in Bloomberg:

how to find them?

The CDS futures contracts are retrievable

under the following tickers:

� FEAU7 Index

iTraxx® Europe 5-year Index Futures

(active contract)

� FEBU7 Index


(defaulted contract)1

� FHAU7 Index

iTraxx® Europe HiVol 5-year Index Futures

(active contract)1

� FHBU7 Index


(defaulted contract)

� FXAU7 Index

iTraxx® Europe Crossover 5-year Index

Futures (active contract)

� FXBU7 Index

iTraxx® Europe Crossover 5-year Index

Futures (defaulted contract)1

In the ticker symbols:

� ‘F’ stands for ‘Future’;

� ‘E’, ‘H’ and ‘X’ relate respectively to ‘iTraxx®

Europe’, ‘iTraxx® HiVol’ and ‘iTraxx®

Crossover’;

� ‘A’ means ‘Active’ (which will be the con-

tract with the lowest factor, the contract

containing no defaults);

� ‘B’, ‘C’, etc: these sequential letters of the

alphabet describe indexes that contain ‘1’,

‘2’ and increasing number of defaults; (i.e.

B=1 default, C=2 defaults and so on)

� ‘U7’ indicates the September 2007 expiry.

The futures can also be accessed via:

� CEM EUX <go>; which is the contract

exchange menu for Eurex Deutschland;

� CTM CDS <go>; which is the contract

table menu for all futures contracts on CDS-

single-name and CDS indexes.

61The landscape

A set of risk-neutral defaultprobabilities for futuredates is produced by a

bootstrapping algorithm,which starts from the

shortest maturity andprogresses recursively over

the input maturities

1 If and when a default situation occurs.

62 The landscape

7 CDS futures contracts on Bloomberg:

how to calculate the fair price?

Once the settings are properly organized,

users can calculate the future fair price

(intraday, at settlement, also for historical

dates) through a new analytical Bloomberg

function: FCDS <go>.

FCDS can be launched in two ways:

� either from the Description Page (DES) of

the future;

� or by typing, for instance, FEAU7 Index

FCDS <go>.

Bloomberg LP’s founding vision in 1981 was to create an information-services, news and media company that provides business and

financial professionals with the tools and data they need on a single, all-inclusive platform. The success of Bloomberg is due to the con-

stant innovation of its products, unrivaled dedication to customer service and the unique way in which it constantly adapts to an ever-

changing marketplace. The New York-based company employs more than 9,000 people in more than 125 offices around the world.

Bloomberg is about information: accessing it, reporting it, analyzing it and distributing it, faster and more accurately than any other

organization. The BLOOMBERG PROFESSIONAL service, the company's core product, is the fastest-growing real-time financial infor-

mation network in the world.

Mirko Filippi is a business manager in charge of fixed income and inflation derivatives, structured notes and property derivatives. Mirko

joined the business side of Bloomberg two years ago, having covered those asset classes as sales specialist for three years. Mirko previ-

ously worked as a quantitative analyst at the capital modeling department of BoE and CNB focusing in particular on STIRS and exotic

options. Mirko terminated his post-graduate studies with a masters degree in financial engineering in the U.K. An Italian native, Mirko

now manages the business from London and less frequently from New York.

Another advantage oftrading on exchange is the

degree of confidence that themarket has in a product that

is completely standardized

Eurex iTraxx® Credit Futures

he new 5-year iTraxx®

Investment Grade, HiVol and

Crossover Index Futures were

launched on March 27, 2007.

For credit default swap (CDS)

indexes this marks the final

stage of a remarkable three-year

evolution from exotic over-the-

counter (OTC) credit derivative to

exchange-traded security. The British Bankers

Association estimates that index credit deriv-

atives such as CDX and iTraxx® make up at

least 30 percent of the USD 26 trillion credit

derivatives market.

Futures on these indexes will build on this

success by making index credit derivatives

accessible to a much broader audience than

could have used the OTC contract. The future

has an identical risk profile to the index

credit default swap but the fact that it is

margined has a significant impact.

� No credit lines are required for futures,

which is a significant advantage for

investors who have high demands on

their capital or limited access to credit.

� No ISDA®s have to be in place between

counterparties, which removes a signif-

icant administrative burden.

� Margined products have no counterparty

risk. The cost of trading futures is,

therefore, considerably lower as counter-

party risk costs money in terms of capital

usage and administration costs.

� Index credit default swaps require a

sophisticated booking and risk man-

agement system. CDS are typically closed

out with an offsetting CDS with another

party, which means that over time a CDS

book can grow to be quite large.

� Futures are completely fungible; with the

result that managing them can be done on

a net basis.

Another advantage of trading on exchange

is the degree of confidence that the market

has in a product that is completely stan-

dardized. The underlying OTC index CDS is

All about Eurex iTraxx® Credit Futures – reprinted from a March 7, 2007research report by MMiicchhaaeell HHaammppddeenn--TTuurrnneerr and MMiicchhaaeell SSaannddiigguurrsskkyy. Withgrateful thanks to Citigroup Corporate and Investment Banking

T

63The landscape

64 The landscape

also standardized but for many investors

the simplicity of a futures contract will

prove popular.

� iTraxx® Futures trade on a price basis

(which means convexity does not play a

part) and daily P&L can potentially be cal-

culated without a calculator. Ticks move x

contracts x tick value. This suits ‘futures

orientated’ investors, while investors who

prefer a spread-based product can

convert the price to spread and view the

contract in this way.

� Exchange-traded contracts have complete

order book and trade transparency which

helps to give investors confidence.

Futures trade on a contract size of EUR

100,000 notional which is a much smaller

granularity than is available for the OTC con-

tract, again opening up trading to a whole

new potential category of small investors.

Contract mechanics

So how has Eurex managed to commoditize

an OTC credit derivative?

Eurex has chosen to reference the most

liquid index CDSs, the front or on-the-run

contracts. There are three active six-month

futures trading on the Investment Grade,

HiVol and Crossover Indexes. At the rolls

there is a brief period (five exchange days)

of futures overlap when both the vintage

and new indexes trade together to enable

market participants to roll into the new

future before the old one expires.

The CDS contract has been transformed

into a bond, the future trades on that bond

price, i.e. essentially on the PV of the CDS.

To clarify this it is helpful to think of it in

four components:

� Par is 100 at inception for all the indexes

and will reduce proportionally as defaults

occur in the underlying index. It will

reduce by 1/n for each default, where ‘n’ is

a number of equally weighted constituents

in the reference index. For example, if a

default were to occur in the iTraxx®

Investment Grade Index, the par value

would drop to: 100 - 1/125 = 99.2. This

mirrors the change of notional in the OTC

index CDS.

� PV of the underlying spread change

reflects the change in the market’s view on

credit quality of the reference basket since

the inception of the index. Each new series

of iTraxx® Indexes have a standard coupon.

This coupon is roughly equal to an average

spread of the index basket at a time of

issuance. In order to standardize trading,

this coupon is fixed and does not change

with credit quality of the underlying

basket. The current series (S6) of iTraxx®

Europe was issued with 30 bps coupon,

while a current market quote is around

24 bps. Therefore the protection buyer

needs to be compensated by the seller for

this 6 bps in the PV of the contract. More

formally for a protection buyer:

01DV bp PV • Δ= ,

where bpΔ contractual coupon –

current spread and DV01 is the present

value of a single basis point (DV01 is a

non-linear function, a model is required

for accurate pricing, by convention the

market uses the model on the CDSW, but

Eurex will have their own model for this

calculation.)

� Accrued coupon represents a portion of

the iTraxx® Index coupon due to the pro-

tection seller, similar to the ‘dirty price’ of

a bond. The accrual is based on fixed

coupon paid by the underlying index CDS.

It is calculated as a daily ‘straight-line’

accrual on an ACT/360 basis. Unlike OTC

indexes, which pay coupon quarterly,

future coupon will only be settled at

maturity. For example, the accrued coupon

on a future with a contractual coupon of

30 bps on the October 10, 2007 would be

20 days/360 x 30 bps x Par = 0.0167

� There is a default component: if a credit in

the index defaults then the future may

contain a component that is equal to the

recovery value of the defaulted name(s) in

the index. In the case of a default, a new

index will spawn and there will be two

indexes – one with a default component

and a clean one.

Exchange-traded contractshave complete order book

and trade transparencywhich helps to give

investors confidence

≈

Once each future starts trading, iTraxx®

spreads will change from the inception

level and the future will trade away from

par to reflect the value of the upfront

payment now embedded into the price. If

spreads tighten, the future will trade above

par, while the opposite is true when spreads

widen. This closely resembles price behavior

of a fixed coupon bond. In fact, thinking of

the future as a bond is useful to under-

standing it in terms of risk, dirty/clean

prices and its relationship to the OTC

index CDS.

Since futures prices are observable and

the P&L of a future is a simple function of

the number of ticks made and the number

of contracts held, no model is required.


If spreads tighten, thefuture will trade above

par, while the opposite istrue when spreads widen

66 The landscape

However, it is inevitable that market

participants will want to break the futures

price into its constituent parts and to know

what iTraxx® spread is implied by a given

futures price. Also, at expiry Eurex will cash

settle futures using a ‘closing’ iTraxx® spread.

For both of these purposes a model is

required to be able to move between futures

price and index spreads.

Treatment of defaults

When it comes to treatment of defaults,

iTraxx® Futures mimics the OTC index con-

tract. In case of an anticipated credit event,

International Index Company (IIC), which

oversees the administration of iTraxx®

Indexes, may publish a separate version of

the index that excludes a name that is on the

edge of bankruptcy. In case of iTraxx®

Investment Grade, this means a 124-name

basket. If this occurs, Eurex will also list a

124-name future, which will trade without

the defaulted credit and whose par com-

ponent will be 99.2. Both 125- and 124-

name futures will trade until future expiry or

until another credit event occurs.

The announcement of a CDS protocol

will be used as a sole trigger of an actual

trigger event. The following day, the par of

the contract will be reduced by 1/n. At this

stage, calculations for both the accrued

premium and PV of spread change are

based on the reduced par. Additionally, the

price of the future will contain ‘expected

recovery’ of the defaulted name. For

instance, 40 percent expected recovery

would contribute 0.32 (40 percent times 0.8

units of par).

Actual recoveries are determined by an

ISDA® recovery auction and until that day

the recovery component remains variable.

This allows investors to create a synthetic

recovery swap by trading the 125-name

future versus the 124-name future. A single

complication arises when recovery auction is

scheduled after the expiry of the future.

When recovery is still not fixed at expiry of

the future, the 125-name future will be split.

The non-defaulted part will be settled based

on 124-name contract, while a recovery

component will continue trading as a single

name future until the auction date.

Next steps

The success of the iTraxx® Futures will

largely depend on it gaining enough liq-

uidity to become a mainstream method of

taking a credit view. Market Makers have

few incentives to entice investors to stick

with OTC markets, as bid/offer spreads are

already quite tight and the operational

costs of maintaining a large CDS book rela-

tively high.

We see futures extending into longer

maturities. A one-year future referencing

static 5-year index will help investors to

express their views on credit transition more

efficiently. The next logical step will be to

trade exchange-traded options on futures.

Liquid OTM options will satisfy a current

demand for cheap ‘crisis’ hedge attracting

more investors’ interest than the moribund

OTC swaption market.

The success of theiTraxx® Futures will

largely depend on itgaining enough

liquidity to become amainstream method of

taking a credit view

Contract value

EUR 100,000

Settlement

Cash settlement, payable on the first

exchange day following the Final

Settlement Day.

Price quotation

In percentage, with three decimal places for

the iTraxx® Europe 5-year Index Futures and

with two decimal places for the iTraxx®

Europe HiVol and iTraxx® Europe Crossover

5-year Index Futures as the sum of

� the basis, determined as the ni, whereby

ni represents the weight of the i’th ref-

erence entity in the underlying index

series, which has not experienced an actual

credit event (basis = 100, as long as no

credit event has occured);

� the present value change calculated on

the basis;

� the accrued premium since the effective

date of the underlying index series based

on the coupon fixed for the underlying

index series;

� and, if applicable, the proportional

recovery rate of the i’th reference entity in

the underlying index series which experi-

enced an actual credit event.

Minimum price change


The Minimum Price Change is 0.005 percent,

equivalent to a value of EUR 5.


and iTraxx® Europe Crossover 5-year Index

Futures

The Minimum Price Change is 0.01 percent,

equivalent to a value of EUR 10.

Contract months

The nearest semi-annual month of the March

and September cycle will be available for

trading; trading in the back month contract

starts on the 20th calendar day if this is an

exchange trading day; otherwise on the next

exchange trading day.

Last Trading Day

The fifth exchange day following the 20th

of the respective contract month.

Daily Settlement Price

The Daily Settlement Price for the current

maturity month is determined during

the closing auction of the respective

futures contract.

67The landscape

Contract Specifications

Contract Standards

Contract Product ID Underlying Currency Bloomberg Code

iTraxx® Europe 5-year Index Futures F5E0 The current iTraxx® Europe EUR FEAA

5-year Index Series

iTraxx® Europe HiVol 5-year Index Futures F5H0 The current iTraxx® Europe EUR FHAA

HiVol 5-year Index Series

iTraxx® Europe Crossover 5-year Index Futures F5C0 The current iTraxx® EUR FXAA

Europe Crossover 5-year

Index Series

The Daily Settlement Pricefor the current maturity

month is determined duringthe closing auction of the

respective futures contract

68 The landscape

For the remaining maturity month the

Daily Settlement Price for a contract is deter-

mined based on the average bid/ask spread

of the combination order book. Further

details are available in the clearing conditions

on www.eurexchange.com.

Final Settlement Price

The Final Settlement Price is established at

17:00 CET on the Last Trading Day in percent,

as the sum of:

� the basis determined as the ni, whereby

ni represents the weight of the i’th ref-

erence entity in the underlying index

series, which has not experienced an actual

credit event (basis = 100, as long as no

credit event has occured);

� the present value change of the underlying

index series resulting from the change of

the credit spread in relation to the basis.

The present value calculation on the final

settlement day is based on the official

iTraxx® Index levels as published by IIC at

17:00 CET and the deal spread (coupon) of

the underlying index. The mid-spread

reflecting the mid-point between the bid

and ask spreads of the official iTraxx®

Index levels are considered for the present

value calculation.

� the accrued premium calculated from the

effective date of the underlying index

series based on the coupon fixed for the

underlying index series;

� and, if applicable, the proportional

recovery rate of the reference entity in the

underlying index series, which experienced

an actual credit event; The calculated Final

Settlement Price will be determined with

four decimal places and rounded to the

next possible price interval (0.0005; 0.001

or a multiple thereof).

Trading hours

08:30 – 17:30 CET. On the Last Trading Day

trading ceases at 17:00 CET.

Occurrence of a Credit Event

Upon occurrence of a credit event, the credit

futures contract will continue to trade in its

original form, including the reference entity

subject to the credit event. In addition, Eurex

Upon occurrence of a creditevent, the credit futures

contract will continue totrade in its original form

Citi's Credit Product Strategy Group, headed by Matt King, provides advice and research

on credit portfolio management, from the latest views on CDOs and exotic structured credit

to the euro and British pound cash markets. The team was ranked number one in 2004, 2005

and 2006 for credit strategy and number one for credit derivatives by Euromoney in 2006. Citi

is the largest financial institution in the world and a global force in corporate and structured

credit markets.

Michael Hampden-Turner is a director in Citi's Credit Products Strategy Group in London.

Within this global research and strategy group he focusses on European cash CDOs, CLOs and

synthetic structured products. He has worked in similar research roles in structured credit at

the Royal Bank of Scotland, interest rate derivatives at WestLB and equities Smith New Court

Merrill Lynch. Michael studied economics and history at Trinity College Cambridge and

Harvard University.

Michael Sandigursky, CFA is a vice president in the credit derivatives structuring team of

Citigroup, based in London. Before moving to structuring, he specialized in quantitative ele-

ments of credit derivatives and structured credit in his role within credit strategy. Previously,

Michael worked for several years in Citigroup Corporate Bank in London and Russia. Michael

holds an MBA from London Business School, and degrees from the University of Economics

and Finance and the University of Electronics in St. Petersburg, Russia.

will list a futures contract based on the new

version of the underlying index (for example,

124 reference entities).

For all details regarding the handling of a

credit event as well as the determination of

Final Settlement Prices, please refer to the

full contract specifications published on

www.eurexchange.com.

69Case studies

Case studies

Portfolio overlaystrategy using EurexiTraxx® Credit Futures Eurex’s BByyrroonn BBaallddwwiinn explains how the new iTraxx® CreditFutures introduce more options in European fund management

70 Case studies

ith the introduction

of the Eurex iTraxx®

Europe, HiVol and

Crossover Credit Futures

contracts on March 27,

2007, the world’s first

exchange-traded credit

derivatives1 began trading.

Combined with Eurex’s existing benchmark

fixed income futures contracts of Euro-

Schatz, Euro-Bobl, Euro-Bund and Euro-

Buxl®, the iTraxx® Credit Futures contracts

introduce greater opportunities in European

fixed income fund management.

The benefit of introducing credit as an

asset class within fixed income fund man-

agement is underlined in a recent paper by

Brian Eales2. Using data from the September

to December 2006 period, Eales looked at the

benefits of incorporating credit into a

European government bond portfolio. In his

study, credit exposure was introduced

through the iTraxx® Europe Index, while

Bloomberg/EFFAS Euro Market 3-5 Year Bond

Index was considered as the proxy for a

short-term maturity European government

bond holding, (see diagram 1, left).

The analysis demonstrated that the

inclusion of credit into a bond portfolio

reduced risk and increased return. The results

showed that a 10 percent inclusion of iTraxx®

reduced risk by 0.19 percent and increased

return by 1.63 percent, while a 20 percent

holding increased risk by only 0.10 percent

but increased return by 3.27 percent. The

attraction of augmenting credit within fixed

income portfolio management is underlined

in diagram 2 (above), which looks at the

history of a synthetic iTraxx® Credit Future

and the Eurex Euro-Bobl Future. There has

W71Case studies

Diagram 2: Synthetic iTraxx® Credit Future and Eurex Euro-Bobl Future

Diagram 1: Efficient Frontier: Euro Market Tracker 3-5 Year Bloomberg/EFFAS Bond Index

Sources: B. Eales The Case for Exchange-based Credit Futures Contracts,

Bloomberg LP and data from IIC Ltd.

Source: Eurex and IIC Ltd. CFE1 Future is the synthetic iTraxx® Credit Future,

OE1 is the front month Eurex Euro-Bobl Future

The analysis demonstratedthat the inclusion of credit

into a bond portfolio reducedrisk and increased return

72 Case studies

also been a study carried out by Hans

Byström, Lund University, on the relationship

between iTraxx® CDS Index and equity prices3.

Consider the situation of a European fixed

income fund manager, who manages a EUR

500 million short maturity European gov-

ernment bond portfolio that has a (modified)

duration of 4.5 years. The fund manager

decides to switch 20 percent of the European

bond exposure to a European credit exposure

using the Eurex Euro-Bobl and iTraxx®

Europe Credit Futures contracts.

Steps

1. Calculate Portfolio Basis Point Value (BPV is

the price value of an 0.01 change in yield):

Portfolio BPV = Portfolio Modified

Duration x Portfolio Value x 0.0001 =

4.5 x EUR 500 million x 0.0001 =

EUR 225,000

2. Calculate the BPV of the Eurex Euro-Bobl

Futures contract using the Bloomberg

DLV and DUR function. (See diagram 3,

above.) BPV of the Eurex Euro-Bobl Future

= BPVCTD/CFCTD

Where BPVCTD is the BPV of the cheapest-

to-deliver bond and CFCTD is the con-

version factor of the cheapest-to-deliver

bond. Alternatively, the BPV of a futures

contract can be generated very quickly

using the Bloomberg FRSK function (i.e.

for the September 2007 Euro-Bobl

Futures contract it is

OEU7<cmdty>FRSK<go>, which gives

0.04807 in price terms, 9.614 futures ticks

or EUR 48.07 in monetary terms).

3. Calculate the appropriate number of

Eurex Euro-Bobl Futures to sell to

synthetically reduce the fund managers’

European government bond exposure by

20 percent: Number of Euro-Bobl

Futures to sell = (EUR 225,000/EUR 48.07)

x 0.20 = 936

4. Calculate the Eurex Euro-Bobl

Futures/Eurex iTraxx® Europe Credit

Futures ratio. The BPV of the Euro-Bobl

Future is EUR 48.07 (see step 2). The

price value of a basis point change in

the CDS curve in terms of the iTraxx®

Europe Credit Future is EUR 45.25,

which can be generated using the

Bloomberg FCDS4 screen. Type

FEAA<index>FCDS<go> and go to

SprdDV01 (there is a small interest rate

exposure being long credit futures, but

the exposure is minimal, see IR DV01).

(See diagram 4, below.) Therefore, the

ratio is: 1 Eurex Euro-Bobl Futures con-

tract/1.06 Eurex iTraxx® Credit Futures.

The fund manager sells 936 Eurex Euro-

Bobl Futures and buys 992 Eurex iTraxx®

Europe Credit Futures to synthetically

switch 20 percent of his European bond

exposure to a European credit exposure.

By way of this portfolio overlay strategy,

the fund manager can quickly switch

part of his European bond exposure to a

European credit exposure, while leaving

his existing portfolio intact5.

Diagram 4: Bloomberg FCDS Screen

Diagram 3: Bloomberg DLV Screen

Used with permission of Bloomberg LP

Use

d w

ith p

erm

issio

n fr

om B

loom

berg

LP

73Case studies

5. When the fund manager feels the out-

performance of credit has run its course,

he can unwind the short Euro-Bobl/long

iTraxx® Europe Credit Futures spread

position. Diagram 5 (above, top) outlines

portfolio overlay using Eurex Euro-Bobl

and iTraxx® Credit Futures contracts.

The Eurex OTC Block Trade Facility (BTF) is

extended to iTraxx® Credit Futures and pro-

motes maximum liquidity and trading flexi-

bility for a fund manager initiating portfolio

overlay strategies across European credit and

bonds. The BTF6 allows market participants,

trading either for their own account or on

behalf of customers, to enter off-exchange

transactions in Eurex futures and options

contracts and yet still have the transactions

cleared by Eurex Clearing AG, the Eurex

Clearing House, (see diagram 6, above).

Conclusion

Using derivatives in portfolio overlay

increases the efficiency of fund management

by allowing fund managers to move quickly

from one asset class to another, without dis-

rupting the underlying portfolio. The recent

launch of the Eurex iTraxx® Credit Futures

contracts introduces a new asset class for

this strategy. The iTraxx® Credit Futures

contracts offer fund managers a highly

leveraged (0.29 percent of underlying

margin required for iTraxx® Europe Index

Futures; 0.55 percent for iTraxx® HiVol

Index Futures and 2.0 percent for iTraxx®

Crossover Index Futures) and cheap (exchange

fees of EUR 0.40 per EUR 100,000) access to

credit market ‘beta’7,8.

Further reading1 Eurex, Credit Derivatives – Always…

Making Fresh iTraxx®. See the Eurex web site:

http://www.eurexchange.com/documents/

publications/crd_en.html

Eurex, Eurex iTraxx® Credit Futures: Building

on the Market Benchmark, Eurex Xpand,

April 2007 edition.2 B. Eales, London Metropolitan University,

The Case for Exchange-based Credit Futures

Contracts.3 H. Byström, Lund University, Credit Default

Swaps and Equity Prices: The iTraxx® CDS

Index Market.4 M. Filippi, Bloomberg, Eurex CDS

Futures in Bloomberg.5 B. Baldwin, Derivatives: a tool for efficient

fund management, Pensions Week,

December 2004.6 Eurex OTC Block Trade Facility. Eurex website

link: http://www.eurexchange.com/trading/

market_model/wholesale/block_trades_en.

html7 B. Baldwin, Successful Portable Alpha

Investing with exchange traded derivatives,

Pensions Week, December 2005.8 Eurex, Complete Your Picture in Fixed

Income Fund Management.

Diagram 5: Using iTraxx® Credit Futures in portfolio overlay

Diagram 6: Eurex OTC Block Trade Facility

Initial Portfolio

Portfolio Overlay

LongEuropean

GovernmentBond

Exposure

LongEuropean

GovernmentBond

Exposure

Long EuropeanCredit Exposure

Buy EurexiTraxx®CreditFutures

New SyntheticPortfolio

Sell EurexEuro-BoblFutures

Contract

iTraxx® Europe Index Futures

iTraxx® HiVol Index Futures

iTraxx® Crossover Index Futures

Euro-Schatz Futures

Euro-Bobl Futures

Euro-Bund Futures

Euro-Buxl® Futures

OTC Block Trade – minimum amount of contracts

2,500

1,500

1,000

4,000

3,000

2,000

500

Generating alpha –trading credit versusequity and equityvolatility on exchangeBByyrroonn BBaallddwwiinn describes how the Eurex iTraxx® Credit Futures have introduced new alpha generation opportunities in Europe

74 Case studies

urex’s recent

launcha of the

world’s first

exchange-traded

credit derivatives con-

tracts has opened up a

wealth of new opportu-

nities to generate alpha

across European asset classes.

Eurex, Europe’s largest derivatives exchange,

already lists benchmark derivatives for the

European equity, fixed income and volatility

markets. The introduction of iTraxx® Europe,

Crossover and HiVol CDS Index Futures has

expanded the exchange’s range of products to

the credit markets, opening up opportunities

to generate alpha across the range of Euro-

pean financial asset classes. Crucially, the

exchange-traded credit derivatives products

offer advantages over and above their over-

the-counter (OTC) counterparts – particularly

as regards transparency, the introduction of a

central clearing house, reduced counterparty

risk and independent daily valuations.

The causality between credit spreads, the

equity market and equity volatility (including

the option volatility skew) can be attributed

to ‘the leverage effect’ – a fall in equity

prices increases a company’s leverage,

thereby increasing the risk to equity holders,

and increasing equity volatility. John C. Hull

in Options, Futures & Other Derivatives, out-

lined the causality as follows: “As a com-

pany’s equity declines in value, the com-

pany’s leverage increases. This means that

the equity becomes more risky and its

volatility increases. As a company’s equity

increases in value, leverage decreases. The

equity then becomes less risky and its

volatility decreases. This argument shows

that we can expect the volatility of equity to

be a decreasing function of price”. Therefore,

one would expect an inverse relationship

between equity prices and credit spreads – or

a positive relationship between the iTraxx®

CDS Index/Eurex iTraxx® CDS Index Future

and equity (see diagram 1), and a positive

relationship between credit spreads and

equity volatility. However, there could be sit-

uations (i.e. LBO and M&A activity), which

would result in a breakdown of the inverse

relationship and actually result in increasing

equity prices with increasing credit spreads.

An increase in the option volatility put skew

is known to reflect the markets’ expectations

of an increasing downside risk in equity

pricesb: therefore, one would also expect a

positive relationship between the option

volatility, put skew and credit spreads1.

Hans Byström in Credit Default Swaps and

Equity Prices: The iTraxx® CDS Index Marketc

looked at the empirical relationship between

the iTraxx® CDS Index market and the

equity market and made the following

empirical findings2:

� There is a clear empirical link between

the iTraxx® CDS Index market and the

equity market.

� There is a tendency for European sectoral

iTraxx® CDS Indexes to narrow when stock

prices rise and vice versa.

� Firm specific information is imbedded into

equity stock prices before it becomes

imbedded into CDS spreads – the equity

market leads the CDS market.

� Stock price volatility is significantly corre-

lated with CDS spreads – spreads are

found to increase when stock price

volatility increases and vice versa.

� And finally, there is significant autocorre-

lation in the iTraxx® market.

In diagram 1 (above) the statistical historical

relationship between iTraxx® Crossover Series

6 Index synthetic future and the Eurex DAX®

Future is illustrated.

Such a close correlation between iTraxx®

Crossover and the Eurex DAX® Future – a R2

of 0.97 would suggest that, should there be a

divergence between the two variables, a con-

vergence trade, taking a view on the re-estab-

lishment of the historical relationship between

two markets, can be established. With the

recent launch of the Eurex iTraxx® CDS

Futures contracts, such a relative value/cross

asset class position can now be established on

exchange, with the added benefits of trans-

parency, independent mark-to-market valu-

ation and a central clearing house.

E75Case studies

Diagram 1: iTraxx® Crossover Series 6 synthetic future & Eurex DAX® Future

How can such relative value/cross asset

class positions be structured? One method

would be to structure such strategies in

terms of the ratio of the monetary value of

each of the respective contracts’ risk posi-

tions based on historical price volatility.

For example, structuring a Eurex iTraxx®

Crossover Index/DAX® position, typing

GXU7<index>HVT<go> on Bloomberg will

generate historical price volatility data for

the Eurex DAX® Future, and typing

FXAU7<index>HVT<go> will generate his-

torical price volatility data for the Eurex

iTraxx® CDS Crossover Index Future.

Taking the 30-day historical price volatility

measures for both contracts:

Eurex DAX® Future

8,105.50 (DAX® Future price) x 18.553

percent (30-day historical price volatility) =

1,503.81 index points = EUR 37,595.

Eurex iTraxx® CDS Crossover Index Future

99.15 (iTraxx® CDS Crossover Future price) x

6.698 percent (30-day historical price

volatility) = 6.641 index points = EUR 6,641.

The monetary value of each of the

respective contracts’ risk positions (based on

the 30-day historical price volatility) would

suggest we should structure a Eurex DAX®

Future: Eurex iTraxx® CDS Crossover Index

Future relative value strategy in a 1: 5.66

ratio. (Though obviously, as the relative price

volatilities change, then the ratio of DAX®

Futures to iTraxx® CDS Crossover Futures

would need to be adjusted.)

The attraction of generating alpha across

European asset classes are further under-

lined in diagram 2 (top, right), which looks

at the index price history of the Eurex Dow

Jones EURO STOXX 50® Index Future price

and a synthetic iTraxx® CDS Europe Index

Future price.

Again, one approach to structuring a Eurex

Dow Jones EURO STOXX 50® Index Future/

Eurex iTraxx® CDS Europe Index Future rel-

ative value strategy, would be to ratio the

respective contracts’ monetary value of the

risk position based on historical price volatility:

Eurex Dow Jones EURO STOXX 50®

Index Future

4,538 (Dow Jones EURO STOXX 50® Index

Future price) x 14.079 percent (30-day his-

torical price volatility) = 638.90 index points

= EUR 6,389.

Eurex iTraxx® CDS Europe Index Future

100.07 (iTraxx® CDS Europe Index Future

price) x 0.742 percent (30-day historical price

volatility) = 0.7425 = EUR 742.50.

Therefore, based on the 30-day historical

price volatilities for the two contracts, the

ratio to structure a Eurex Dow Jones EURO

STOXX 50® Index Future/Eurex iTraxx® CDS

Europe Index Future relative value strategy

would need to be initiated in a 1 Dow Jones

EURO STOXX 50® Index: 8.6047 iTraxx® CDS

Europe Index Future ratio (1:8.6047).

Such cross asset/relative value strategies

can be extended to initiate Eurex iTraxx®

Credit Index Futures versus European Equity

volatility plays, using the Eurex VSTOXX®,

Diagram 2: Eurex Dow Jones EURO STOXX 50® Index Future and synthetic iTraxx® CDS Europe Future

76 Case studies

Contract OTC Block Trade – minimum amount of contracts

iTraxx® Europe Index Futures 2,500

iTraxx® HiVol Index Futures 1,500

iTraxx® Crossover Index Futures 1,000

Euro-Bobl Futures 3,000

Dow Jones EURO STOXX 50® Index Futures 1,000

Dow Jones EURO STOXX 50® Index Options 1,000

DAX® Futures 250

VSTOXX® Volatility Index Futures 100

VDAX-NEW® Volatility Index Futures 100

VSMI® Volatility Index Futures 100

Diagram 3: Eurex OTC Block Trade Facility

VDAX-NEW® and VSMI® equity volatility

index contracts, and to European Credit

versus European equity volatility skew posi-

tions, using the Eurex Dow Jones EURO

STOXX 50® Index Option contracts3.

The Eurex OTC Block Trade Facilityd (BTF)

enables the initiation of such relative value/

cross asset class strategies in Eurex futures

and options products off-exchange, while

maintaining the benefits of having a position

in exchange-traded derivatives products,

cleared by the Eurex clearing house.

Diagram 3 (bottom, left) outlines the

minimum amount of contracts that can be

traded under the BTF.

Conclusion

The recent launch of the Eurex iTraxx®

CDS Futures has greatly extended the

possibilities of generating alpha through

various relative value strategies across

European asset classes with the benefits of

substantially reduced counterparty risk, a

central clearing house and independent

mark-to-market valuation.

Eurex is a leading derivatives exchange. One of Eurex’s key strengths is the open, low-cost electronic access to the global exchange network.

Eurex provides access to a broad range of global benchmark products, including the most liquid fixed income markets worldwide. Every day, par-

ticipants trade more than seven million contracts, from around 700 different locations. Alongside the fully-computerized trading platform, Eurex

also operates an automated and integrated clearing house. Acting as a central counterparty, Eurex Clearing AG guarantees the performance of

all trades entered into at the Eurex exchanges. The same guarantee is extended to cover Eurex Bonds, Eurex Repo, and all cash securities listed at

the Frankfurt Stock Exchange (Xetra® and floor) or at the Irish Stock Exchange (ISE).

Byron Baldwin is a member of the institutional investor sales team at Eurex. Byron has over 25 years of experience in derivatives working with

hedge funds, central banks, fund management companies and corporations. He has written a number of articles on the use of derivatives in

fund management – he recently wrote an article for Pensions Week, Is Portable Alpha Investing the answer for Pension Funds?, as well as two

articles, Derivatives: a tool for efficient fund management and Complete Your Picture in Fixed Income Investment Management for Eurex, and

has lectured on derivatives at the London Metropolitan University. Byron read monetary economics at the London School of Economics for his

BSc economics degree and finance for his MSc degree at the University of Leicester Management Centre.

Further readingaEurex, Credit Derivatives – Always…Making Fresh iTraxx® See the Eurex website:

http://www.eurexchange.com/documents/publications/crd_en.html aEurex, Eurex iTraxx® Credit Futures: Building on the Market Benchmark, Eurex Xpand,

April 2007 edition.bA number of articles have been written on the predictive power of the option volatility skew, namely,

B. Mizrach, Did option prices predict the ERM Crisis?, R. Cont, Beyond implied volatility: Extracting

information from option prices, G. Murphy, When option prices meet the volatility smile and

M. Rubenstein, Implied Binomial Trees, to name just a few. cH. Byström, Lund University, Credit Default Swaps and Equity Prices: The iTraxx CDS Index Market.dEurex OTC Block Trade Facility. Eurex web site link:

http://www.eurexchange.com/trading/market_model/wholesale/block_trades_en.html1 Merton in On the Pricing of Corporate Debt: The Risk Structure of Interest Rates produced an

equity based credit model taking asset values and volatilities from equity prices producing

a firm credit default probability. Riskmetrics adapted the Merton model and produced CreditGrade

which produces a company’s default calculations based on a firm’s equity volatility and

leverage ratio.2 Norden and Weber in The co movement of credit default swap, bond and stock markets; an empirical

analysis made similar findings.3 Such relative value positions are not only limited to European equity. Using the Eurex Euro-Bobl

Futures contract with the Eurex iTraxx® Credit Futures contracts, European credit/European fixed

income cross asset positions can be initiated. See B. Baldwin, Portfolio Overlay using Europe iTraxx®

Credit Futures – Introducing more options in European Fund Management for a discussion of the

Euro-Bobl Future: iTraxx® Credit Future ratio.

77Case studies

Credit futures:application andstrategiesHypoVereinsbank’s JJoocchheenn FFeellsseennhheeiimmeerr describes some of the different ways in whichthe Eurex iTraxx® Credit Futures can be put to work

78 Case studies

79

Futures should facilitate thecredit portfolio managementprocess and the development

of standardized cross-assettrading strategies

he innovative power

of credit market prac-

titioners remains as

strong as ever. During

the last few years, a

wide range of new

instruments have been

developed – new collater-

alized dedt obligation (CDO) structures,

credit default swaptions, and standardized

tranches being some of the most popular

examples. The growing standardization of

the instruments and the legal documen-

tation supporting them have facilitated this

trend, fuelling liquidity and transparency in

the credit derivatives market and triggering

enormous growth rates. According to the

British Bankers Association, the outstanding

amount of credit derivatives exceeded USD

34 trillion at the end of 2006 – around six

times the outstanding balance of over-the-

counter (OTC) equity derivatives. During the

last five years, credit derivatives have been

the fastest growing segment of all estab-

lished asset classes.

The iTraxx® Index products are among

the most liquidly traded instruments in the

credit market – the iTraxx® Europe, HiVol,

and Crossover Indexes being the flagship

products with the highest turnover and

greatest levels of popularity. Once these

indexes had been established, and taken off,

the obvious next step towards the market’s

completion was, of course, the listing of

credit futures contracts. Futures should

facilitate the credit portfolio management

process and the development of stan-

dardized cross-asset trading strategies.

The Eurex iTraxx® Credit Futures contracts

were the first exchange-traded credit deriva-

tives contracts, though similar contracts have

since launched in the U.S. The first and most

important fact about the iTraxx® Futures

contract is that, in contrast to its name, it is

not a futures contract in a strict sense, as it

does not have a forward payoff profile.

Instead, it can be viewed as a standardized

exchange-traded total return index on an

unfunded underlying. In contrast to a

forward CDS contract, the Eurex iTraxx®

Credit Futures contract involves premium

payments (not as real cash-flows, but as

accruals), and default risk (forward CDS are

usually knock-out-on-default contracts)

during the holding period. Moreover, in con-

trast to the underlying OTC iTraxx® swap

contracts (which are quoted in basis point

spreads), the Eurex iTraxx® Credit Futures

contracts are quoted in price terms.

Furthermore, the quoted prices are dirty

prices, reflecting the accrued premium

(referring to the deal spread of the under-

lying swap contract), changes in value in the

underlying iTraxx® swap contract (due to

spread changes), and losses arising from

credit events (including the recovery rates).

From a credit portfolio management per-

spective, futures contracts can be used to

implement cost-efficient hedging and overlay

management strategies. Liquid exchange-

traded futures contracts also provide a par-

ticularly cost-efficient alternative to OTC

swap contracts for immunizing European

credit portfolios against systematic risks.

And they can be used to implement core-

satellite strategies. In such cases credit

futures will be the core investment, while

the alpha-generation, curve positioning

trades and so forth will be managed via

satellite CDS or cash trades. Finally, many

market participants may choose to use the

Eurex iTraxx® Credit Futures contract as an

attractive alternative to the underlying swap

contract, or to actively manage cross-asset

portfolios. In all cases the users will benefit

from the contract size and regulatory

advantages, as well as from using stan-

dardized instruments from a single toolbox.

Strategic cross-asset management strate-

gies will likely gain traction, as cost-efficient

overlay strategies can now be implemented

by combining liquid instruments – for instan-

ce, by using the Eurex iTraxx® Credit Futures

contract in conjunction with well-established

instruments, such as the DAX® Futures. The

consistent construction principles behind the

Eurex futures contracts make these ideal

instruments to use in cross-asset strategies,

as the complexity of delta-adjustments is

negligible (via the tick value of the contracts),

while beta remains the major challenge.

TCase studies

Three trading strategies:

credit versus equity, versus volatility,

and versus rates

Credit versus equity

Debt-equity trades on indexes are not ‘real’

capital structure arbitrage trades, but index

futures can be used to express general views

on the relative attractiveness of debt versus

equity. An increasing number of accounts are

already implementing such trading positions,

for instance, by playing the MDAX® Future

versus the iTraxx® Crossover Index in swap

format. This trade can now be easily imple-

mented using the futures, as the DV01 of the

index swap is transferred into a ‘tick value’

(as is the case with the MDAX® Futures) and

correlation can be easily calculated using

Eurex iTraxx® Crossover Futures quotes,

instead of spread levels. Moreover, the pos-

sible introduction of listed credit options will

allow investors to trade implied volatilities in

the credit market versus implied volatilities in

the equity market.

Inter-market vega-trades can be seen as

a further step in the cross-asset trading uni-

verse. From a strategic perspective, we

would prefer equity versus debt (owing to

LBO and M&A risks, as well as the renais-

sance of shareholder-friendly measures),

which translates, for example, into a long

position in the Dow Jones EURO STOXX 50®

Future and a short position in credit futures

(HiVol or Europe).

Credit versus rates

Interest rates and spreads are linked.

However, there are two basic theories that

suggest exactly the opposite. Fundamental

investors will argue that rising rates reflect

an improving economic environment, which

translates into lower default rates and conse-

quently, lower spreads. In this case, the credit

return is negatively correlated to the curve

return. The opposite is true according to so-

called spread-yield aficionados, who will

argue that declining yields force yield

hunters into spread products (triggering

tighter spreads), hence spread and curve

returns are positively correlated. Regardless

of one’s viewpoint, such ideas can easily be

implemented using credit futures and, for

example, the Bund Future (which is still the

most liquid derivative instrument worldwide).

Trading credit versus volatility

From the well-known Merton-model we

know that there is a fundamental rela-

tionship between the implied volatility of a

company’s stock price and its credit risk. This

relationship stems from the fact that a

company’s stock can be viewed as a call

option on the company's assets (with the

strike being related to the leverage, i.e. the

equity/debt ratio), and its credit risk as a cor-

responding put option. However, in this

approach one would need to know the

asset’s volatility, which is usually implied

from equity volatility. There is also another,

more technical relationship, as credit risk has

a similar payoff profile to a far-out-of-the-

money put option. In the case of a credit

event, not only will credit investors suffer,

but the stock will also drop dramatically, trig-

gering a payoff in the put options. In this

respect, equity portfolio managers use out-

of-the-money put options to hedge against

large drops in their investment. Hence, the

implied volatility of such options usually has

a high correlation to credit spreads. However,

as liquid instruments for trading credit

From the well-known Merton-model we know

that there is a fundamentalrelationship between the

implied volatility of acompany’s stock price

and its credit risk

80 Case studies

The futures contract will likelybe used as an underlying

reference for performancecertificates and notes

(iTraxx® Future) and volatility (VDAX-NEW®

Future) are now available, such strategies can

be generalized to index levels. As an example,

a long credit risk position in the iTraxx®

Future, can be hedged via a long volatility

position in the VDAX®.

Product outlook

Following the successful launch of the

first credit futures, we expect that further

exchange-based credit products will be

listed on exchanges, including option-

related payoffs.

The most obvious enhancement is the

introduction of futures contracts on other

maturities within the liquid iTraxx® universe.

In addition to the existing 5-year futures

contracts, the iTraxx® Europe Index can also

be liquidly traded in 3-year, 7-year, and 10-

year formats in the OTC market, while a

liquid 10-year index swap market also exists

for the HiVol and the Crossover Indexes. The

introduction of a wide range of maturities to

the futures offering will allow investors to

put on curve positions on the indexes, imple-

menting so-called ‘calendar spread’ trades. In

addition, futures based on other index swaps

within the iTraxx® universe – for instance,

the iTraxx® financials senior and subordi-

nated sub-indexes, might also be introduced.

Another very interesting innovation

might be the introduction of options refer-

encing the Eurex iTraxx® Credit Futures

contracts. Although the credit default

swaption market has become quite liquid,

the lack of transparency and ongoing con-

cerns over the underlying modelling

framework have been deterring real money

accounts from using credit default swap-

tions for hedging purposes, or to build up

exposure to spread volatility. The intro-

duction of Eurex-listed standardized

credit options should thus be of

particular interest and benefit to market

participants.

The futures contract will likely be used as

an underlying reference for performance

certificates and notes. Total return certifi-

cates that reference the iTraxx® Future

could also be attractive products, even for

retail clients. In addition, exchange-traded

funds could potentially be based on the

future, with the added advantage of daily

price settlement.

Other likely developments include:

� Index-linked structures, such as constant

proportion debt obligations (CPDOs), will

switch from the swap to the futures con-

tract, once liquidity in the futures market

surpasses that in the OTC market.

� Hybrid and cross-asset products will likely

be linked to the futures, rather than to

swap contracts, owing to the benefits and

the high standardization of Eurex-traded

futures contracts.

Bayerische Hypo- und Vereinsbank AG

(HypoVereinsbank) is one of the three

largest banks in Germany. Its roots

reach back to the 18th century. As an

internationally operating institution,

domiciled in Munich, it offers customers

the entire range of products of services

of a modern financial services provider.

HypoVereinsbank has a network of

nearly 700 branch offices in Germany,

and sees itself as a bank for private cus-

tomers and small and midsized busi-

nesses. Its competitive advantage lies in

its in-depth knowledge of regional

markets and in close, intensive cus-

tomer relationships. In addition,

HypoVereinsbank offers all the advan-

tages of an ‘integrated universal bank.’

Since 2005 it has been of member of

UniCredit Group, a banking group with

over 140,000 employees serving cus-

tomers in 19 countries in Europe.

Jochen Felsenheimer heads the credit

strategy and structured credit team of

UniCredit MIB's global research

department and is responsible for

quantitative and qualitative credit

strategy, including credit derivatives,

structured credits, relative value

analysis, and credit portfolio opti-

mization. He is a co-author of Active

Credit Portfolio Management (Wiley

2005) and he holds a PhD in eco-

nomics from Ludwig Maximilians

University in Munich.

81Case studies

Making the case forcredit derivatives Standard Life Investments’ SSaarraahh SSmmaarrtt makes the case for using credit derivatives andexplains how the instruments can usefully complement traditional case-basedinvestment strategies

82 Case studies

ver the last few years,

investors have

realized that

whatever they

measure is what

will get managed.

For instance, if they

assess a manager’s per-

formance against a market

benchmark on a quarterly basis, their

manager will keep close to the benchmark.

The manager will also avoid putting on posi-

tions – however potentially profitable these

might be – if the return expectations cannot

be guaranteed within the quarterly meas-

urement period.

As a result of this realization, there has

been an increasing willingness on the part of

investors to give managers the ability to take

longer-term views. Combined with a growing

appetite for absolute returns, this is good

news for fund managers. And, it is particu-

larly good news for managers looking to

generate absolute returns from dynamic

exposure to areas of market risk. Why?

Because even if managers have a strong view

that a particular area of the market is over-

valued, it is difficult for them to identify

exactly when that overvaluation will be cor-

rected. Longer measurement timescales

enable the absolute return manager to invest

in views that he believes will be rewarded at

some unidentified point over the next 18–24

months, for example.

But it is not all good news. Putting on a

trade and waiting for it to deliver can be a

painful process if you have to pay for the

carry while waiting for your view of the

market to be realized. This lesson was very

clearly demonstrated by Long Term Capital

Management: the fund’s view did come good

in the end, but unfortunately it ran out of

money waiting for this to occur. What is

useful, in such a scenario, is to execute a

trade that covers the cost of the carry and

also has a low exposure to market direction.

In the following example, we consider such a

scenario when seeking to gain exposure to

the credit market.

Making positions pay for themselves

In this scenario, our fund manager holds the

view that there is a correction due in the

credit market. He believes there will be spread

widening at some point in the near future,

but he is not sure when. He is running an

absolute return fund with a cash benchmark,

so any position he takes needs to deliver

returns relative to cash. Were he managing a

long-only fund and unable to use derivatives,

he would be restricted from shorting the

credit market and would not be able to get

any benefit in his portfolio from any potential

spread widening.

Fortunately, the fund rules allow the fund

manager to use derivatives. He is, therefore,

able to implement this view by buying credit

default swaps (CDS). By holding these instru-

ments, the fund is short credit risk and will

benefit from spreads widening. Using the

recently launched iTraxx® Credit Futures

provides further advantages as the manager

is able to quickly trade in these transparent

instruments with a central counterparty,

without having to go through administration

and legal processes such as the ISDA® set up.

However, the fund has to pay carry to

execute this trade. As the fund manager does

not know when the widening will happen,

the fund will lose money while he waits for

his view to play out. The manager, therefore,

looks for a ‘payer position’ to help neutralize

the cost. Ideally the payer position will have

the following characteristics:

� Be market neutral, (i.e. it will not make or

lose significant value as the market rises

and falls).

� Have a positive carry.

� Be exposed to risks that are diversified

with the core position, (i.e. a situation in

which this trade loses money will be less

of a concern, as the core position will be

making money in the same scenario.)

O83Case studies

Sour

ce: B

loom

berg

Position construction

To implement his view that credit spreads will

widen, the manager executes the following:

Instrument iTraxx® Crossover 5-year

Trade direction Long

Size of trade EUR 10,000,000

Cost of carry EUR 204,000 pa

DV01 4,300

Breakeven 47.44 bps

If spreads widen to 280 bps, this position

will deliver EUR 326,800. However, if this

widening occurs twelve months after the

trade is executed, the return is reduced by

62 percent to EUR 122,800, due to the cost

of carry.

To cover this cost, the manager also exe-

cutes the following payer position:

It can be seen that, assuming the curve

remains unchanged, the payoff from this

trade will cover the carry requirements of

the core position. In reality, if the trade

were left on for a period of time we would

expect a higher return as the position

slipped down the curve.

The payer position is not, however, risk-

free. The position will lose money if the

curve flattens between the 5- and 10-year

points. We consider that the risk of a capital

loss due to curve flattening is mitigated by

the following:

� The trade will steepen naturally as it slips

down the curve.

� The curve is currently quite flat at this

point and there appears to be little room

left for further flattening.

� The trade is executed in the Crossover

rather than the Investment Grade market.

We consider that the higher level of CDO

activity in the Investment Grade market

makes it more susceptible to being com-

pressed by the hedging of structural

credit risk.

By holding this position, the fund is also net

long default risk and will lose money if a

bond in the index defaults. We believe the

market is overcompensating for the default

risk being assumed within this trade. In the

environment of an overall increase in default

rates, we expect the core position to deliver

strong returns to the fund and outweigh any

loss in value in the payer position.

This example demonstrates how, over a

longer period, fund managers are able to

implement strategies in cases where they

are confident about the investment, but

less sure about timing.

The use of derivatives enables the

fund manager to express views he might oth-

erwise not be able to express in a long only

fund, and enables him to put in place ‘payer

positions’ that help to cover the cost of carry

while he waits for his strategy to deliver.

Standard Life Investments was

launched in 1998 and is a wholly-owned

subsidiary of Standard Life Investments

(Holdings) Limited, which in turn is a

wholly-owned subsidiary of Standard

Life plc. It is a leading asset man-

agement company, with GBP 135 billion

of assets under management (as at

March 31, 2007). This includes over GBP

49 billion in bonds. Standard Life

Investments has an international

presence in Hong Kong, the U.S., Canada,

India and China to ensure that it forms

a truly global investment outlook.

Sarah Smart trained as a chartered

accountant with Coopers & Lybrand,

and joined Standard Life Investments

in 1999, where she worked on a variety

of new product developments in mul-

tiple asset classes, including equities,

real estate and absolute return funds.

Sarah joined the strategic solutions

unit of Standard Life in September

2004, where she is responsible for the

development and management of tai-

lored liability driven solutions for insti-

tutional investors.

84 Case studies

Instrument iTraxx® Crossover 5-year iTraxx® Crossover 10-year

Trade direction Short Long

Relative duration 6.62/4.3 = 1.54 A

Relative spread 303/204 = 1.49 B

A>B, therefore trade will pay per EUR 1 million of trade: 1,107 pa

Size of trade required (EUR million) 283.83 184.36

Expected payment EUR 204,000 pa

May 2005 was a testingmonth for correlation

trading and, to date, themost volatile period in the

young life of this market

he credit derivatives

market has seen

phenomenal growth

in liquidity, volumes,

and sophistication. By

mid 2005, the time of

the events under

scrutiny in this note, the

traded volume of the credit derivatives

market had reached USD 12.43 trillion,

dwarfing the USD 4.83 trillion of the once

derivatives markets leader, equity deriva-

tives. The market size is now estimated to

have grown to around USD 30 trillion,

making credit the fastest expanding class of

financial derivatives. While credit default

swaps (CDS) are the basic building block of

the credit derivatives space, a lot of the

growth has been driven by activity in the

so-called correlation market, essentially the

market for tranches on CDS portfolios.

May 2005 was a testing month for corre-

lation trading and, to date, the most volatile

period in the young life of this market.

Following a ruthless and surprisingly timed

downgrading of the car makers GM and Ford

by the rating agency S&P on May 5, 2005,

the financial equivalent of a hurricane hit

credit spreads. A sharp rise in idiosyncratic

risk took place, with CDS spreads widening

to record levels and reaching their peak on

May 17. The correlation market saw a

violent move in the relative pricing of CDS

index tranches. Crucially, those relative

price moves were at odds, not only in mag-

nitude but also in the arithmetic sign, with

what traders understood the mathematical

models had suggested. Although, even-

tually, CDS spreads generally returned to

their pre-May levels (see figure 1, following

page), the correlation market sustained

some lasting damage.

Morgan Stanley Investment Management’s AAmmmmaarr KKhheerrrraazz examines the limits of deltahedging and correlation models

T

A look back at May 2005:Did the models cause thecorrelation crisis?

85Case studies

The relative valuation of tranches never

went back to its pre-crisis levels. The financial

press called the events a ‘correlation crisis’,

and it was.

Press reports talking of banks’ correlation

desks and hedge funds suffering multi-

million-dollar trading losses attracted neg-

ative publicity for the market. Crucially, ques-

tions were raised over the reliability of the

mathematical modelling machinery that had

become the industry standard for modeling

credit correlation.

The mathematical modelling

The mathematical model in question is the

one-factor Gaussian copula. This was first

introduced to credit by Li (2000), for the case

of two entities in a portfolio, and then gene-

ralized to the case of n entities by Gregory

and Laurent (2003). Other authors later put

forward several modifications and implemen-

tation methods for the model and its varia-

tions. The one-factor Gaussian copula rapidly

climbed up in popularity, becoming the

‘Black-Scholes’ of the correlation market.

Here, we will give a very brief description of

the modelling process.

Consider a CDS portfolio, referencing the n

credit entities C1,…, Cn . Let the default, up

to some fixed time horizon T, of each credit

Ci be modelled by the random variable Xi.

More specifically, we determine a ‘barrier’

level bi, such that Ci defaults (by time T) if

and only if Xi < bi. In the Gaussian copula

framework, the Xi s are standard normal, and

bi is given by:

where is the standard normal distri-

bution function, and Pi is the probability of

Ci defaulting (by time T).1 Furthermore, the

one-factor Gaussian copula models each Xiby:

where M and the i s are mutually inde-

pendent standard normal random variables

and

The one-factor Gaussiancopula rapidly climbed up

in popularity, becomingthe ‘Black-Scholes’ of the

correlation market

Figure 1: iTraxx® Europe 5-year CDS Indexes (Main and Crossover) in mid 2005. Index levels are par spreads in basis points

86 Case studies

M is called the market (or common) factor

(and since there is only one market factor

here, the setup is called a one-factor model),

while i is called the idiosyncratic factor.

The i s are (naturally enough) called the

betas; they are the sensitivities of each

credit to the market factor. Notice how this

determines the correlation structure of the

credits involved;

cor .

A common further assumption is to let all

betas be equal – denote that then by . The

correlation structure then boils down to a

single number .

Observe how the n default processes are

‘conditionally independent’; fix a value for

the market factor and the Xi s become inde-

pendent. This is a valuable feature in terms

of computationally estimating the joint dis-

tribution of the n loss distribution and even-

tually pricing tranches on the portfolio.

Numerical integration methods (such as

Gaussian quadrature) allow the easy imple-

mentation of the model.

The crisis

By May 2005, GM and Ford had already been

keeping the credit market nervous for

months. The financial troubles of the two car

makers were a threat to their credit ratings

and, potentially, their ability to honor their

debt obligations. On May 4, 2005, billionaire

Kirk Kerkorian injected GM shares with their

biggest one-day gain in more than 40 years

by offering an USD 870 million investment in

the company. Suddenly, there was hope for

the embattled car maker. The following day

that hope was dashed. On May 5, 2005, the

rating agency S&P downgraded GM and

Ford, sending their respective USD 292 billion

and USD 163 billion debts to junk. The timing

of that decision, coming only one day after

Kerkorian's announcement, took the market

off guard.

A correlation trade that was very popular

in the run-up to May 2005 was the ‘equity vs

mezz’ trade. This involves going long (i.e.

selling protection on) an equity tranche (such

as the 0–3 percent) and ‘hedging’2 that by

going short (i.e. buying protection on) a mez-

zanine tranche (e.g. the 3–6 percent).

Let us explore the appeal of this trade at

the time. Table 1 (below) gives the prices for

the 0–3 percent and 3–6 percent pieces of

the iTraxx® Europe Index on May 4, 2005, the

day before the crisis.

The delta of a tranche (on an index) is

the sensitivity of its PV to the PV of the

underlying index3. It is also the hedge ratio:

showing how much protection you need to

buy on the index to hedge a long position

(of a notional 1) on the tranche. Traders

took these deltas one step further. The

1pi is directly deducible from the

CDS market.2

So traders thought at the time.3

It is the first derivative of the tranche PV

with respect to the index PV.

A correlation trade thatwas very popular in the

run-up to May 2005 wasthe ‘equity vs mezz’ trade

Table 1: Traded upfront (as percent of notional), spread (in basis points), and delta for the two

tranches in the ‘equity vs mezz’ trade on the iTraxx® Main 5-year basket, as of May 4, 2005

Upfront Spread Delta

iTraxx® 0–3% 29% 500 17

iTraxx® 3–6% 0% 168 6

87Case studies

ratios of two tranche deltas are frequently

used as the ratio of the needed notionals

of those two tranches so that they ‘hedge’

each other. Let us apply this to the example

in Table 1 (page 87): The trader:

1. Sells protection on EUR 10 million of the

0-3 percent tranche, therefore receiving

EUR 2.9 million (= 29 percent of 10

million) upfront, plus an annual EUR 0.5

million (= 500 bps of 10 million) in carry

(i.e. in coupon spread).

2. Buys protection on approx. EUR 28

million of the 3-6 percent tranche (so

the mezzanine tranche’s notional multi-

plied by its delta equals the equity

tranche’s notional multiplied by its delta).

This leads to paying about EUR 0.47

million (= 168 bps of 28 million) in carry.

The net position, considered by the trader

‘delta-neutral’, receives the sizeable upfront of

EUR 2.9 million, in addition to an annual EUR

0.03 million (= 0.5 million – 0.47 million) of

positive carry – a seemingly irresistible trade.

The trouble with this trade is that, as the

eventful May 2005 unravelled, both legs of

the position moved in an unfavorable direc-

tion; the equity tranche widened and the

mezzanine piece tightened (see table 2,

above). The ‘hedge’ was a double-disaster. To

this day, the relative pricing of equity and

mezzanine tranches have never returned to

the levels everybody took for granted before

May 2005. The financial press termed this the

‘correlation breakdown’. Many traders felt

they had been misled by the models and, in

particular, that the model's deltas had turned

out to be worthless.

May 2005 left market participants

polarized over whether the models were

to blame. Some argued that the crisis had

exposed the one-factor Gaussian copula as

totally inadequate, while others came to the

Table 2: Levels, during May 2005, of the 5-year iTraxx® equity and junior mezzanine tranches,

quoted as traded upfront (as percent of the notional) for the equity tranche and par spread in

basis points for the mezzanine tranche. In addition to the traded upfront, the equity tranche

pays an annualized spread equal to 500 bps

Many traders felt they hadbeen misled by the modelsand, in particular, that themodel's deltas had turned

out to be worthless

4 May 5 May 6 May 17 May 26 May

iTraxx® 0–3% 29% 30% 31% 49% 34%

iTraxx® 3–6% 168 158 165 170 120

88 Case studies

defence of the industry-standard model,

saying that it was the traders, not the mod-

ellers, who had got it wrong. So was it the

mathematical models or the trading strategy

that inflicted all those losses of May 2005?

Put bluntly, who was to blame: the traders

or the modellers?

The verdict

There is no doubt that the industry-standard

modelling framework suffers from several

shortcomings. For example:

1. The normal distribution is known to

underestimate, compared to the ‘real

world’, the probability of (joint) extreme

events (the so-called lack of tail

dependence).

2. Reducing the correlation matrix to a

single number (simply referred to as the

correlation) is an oversimplification that

is bound to backfire.

3. There are several other (potentially dan-

gerous) simplifying assumptions: recov-

eries upon default are assumed to be

known in advance, betas are assumed to

be deterministic, and there is no

imposed consistency between portfolio

loss distributions corresponding to dif-

ferent time horizons.

However, the direct reason for the breakdown

of the ‘equity vs mezz’ trade is that the

traders had taken deltas too far. A delta is

mathematically a first derivative, that will

work as a hedge ratio as long as the under-

lying remains close to the value on which the

delta was originally calculated. A simple

Taylor expansion will show that the first order

derivative does not account for all the risk.

What happened to the tranche space in May

2005 was a redistribution of the risk across

the capital structure, that would almost cer-

tainly have occurred regardless of which

model was established as industry standard.

The May 2005 events, however painful for

some, proved a valuable educational oppor-

tunity. Traders learnt, albeit the hard way, the

limitation of a delta hedge – among other

things. Modellers have also had to reflect

upon the limitations of the model, such as

the ones highlighted above.

The search for better correlation models

will continue. While the tractability of the

Gaussian copula is difficult to beat, a trade-

off between computational convenience and

practicality continues to be the center of a

huge amount of research and reflection.

References:

Gregory J., Laurent J-P. (2003): I will survive,

Risk magazine, June.

Li D.X. (2000): On default correlation: a

copula function approach, Journal of fixed

income, 9:43-54.

Was it the mathematicalmodels or the trading

strategy that inflicted allthose losses of May 2005?

Morgan Stanley Investment Management (MSIM) is the asset management division of Morgan Stanley & Co., the global financial services

firm. MSIM specializes in managing assets for a range of institutional clients. MSIM manages USD 483 billion of assets, and services a wide

client spectrum with over 50 globally-diversified investment products.

Ammar Kherraz is a structured products strategist at Morgan Stanley Investment Management. He joined Morgan Stanley in 2007, with five

years’ investment industry experience. He holds a PhD in mathematical finance, in addition to an MSc with distinction in mathematics and

finance and is a visiting mathematical and computational finance lecturer at Imperial College London. He is also a member of Chatham House

(Royal Institute of International Affairs).

89Case studies

Credit indexes: anefficient route to asset allocationScottish Widows Investment Partnership’s GGaarreetthh QQuuaannttrriillll demonstrates how iTraxx® Indexesand Futures contracts offer fund managers an efficient means of reshaping their portfolios

90 Case studies

91Case studies

The introduction of single-name and

index-based creditderivatives has delivered

a significant degree ofextra flexibility to

asset managers

sset allocation imple-

ments our views about

the expected returns

from a variety of asset

classes. For instance,

if we believe invest-

ment grade cor-

porate bonds will

provide superior returns to high-yielding

bonds, we will allocate a higher proportion of

our portfolios to investment grade assets.

Sector and stock selection may be reliant

on a positive or negative move in the under-

lying market, but we find that it is more

often market neutral. For example, we are

currently overweight in the telecom sector

because it is undervalued due to an overhang

of bonds. And we recently sold all of our

exposure to Wm Morrison, after speculation

about an impending corporate restructuring

and the possibility of a bond buy-back

resulted in spreads tightening to unsus-

tainable levels. In both cases the strategy

will be successful if we get the sector and

stock decision right, not because of a

general move.

Historically, all of these activities have

been implemented through cash bonds.

However, the introduction of single-name

and index-based credit derivatives has

delivered a significant degree of extra flexi-

bility to asset managers.

The indexes

The three most frequently traded European

credit index products are listed below:

� iTraxx® Europe (Main)

This index comprises the 125 investment

grade rated European entities with the

highest credit default swap (CDS) trading

volume over the previous six months. It is

constructed by selecting the highest-

ranking entities in each of the following

sectors: automobiles (10 entities); con-

sumers (30); energy (20); industrials (20);

TMT (20); financials (25).

� iTraxx® HiVol

This index comprises the 30 entities with

the widest 5-year CDS spreads from the

iTraxx® Europe Non-Financials Index.

� iTraxx® Crossover (X-over)

This comprises the 50 European non-

financial entities with the highest CDS

trading volume over the previous six

months. To qualify for inclusion, entities:

� must have more than EUR 100

million of publicly traded debt;

� rated BBB-/Baa3/BBB- or higher,

(Fitch/Moody’s/S&P) are excluded;

� must have a spread of at least

twice the average spread of

the constituents of the iTraxx®

Non-Financial Index, with a

maximum of 1,250 bps or upfront

of 35 percent;

� must be equally weighted in

all indexes.

Asset allocation

The iTraxx® suite of indexes is very liquid.

Average trade sizes for Main, HiVol and

Crossover are EUR 100 million, EUR 50

million and EUR 25 million respectively.

Outstanding contracts on the current series,

across the three, amount to approximately

EUR 5 trillion. These trading volumes are sig-

nificantly higher than turnover in the cash

bonds of the reference companies.

Consequently, the spread between the price

of buying or selling the indexes (i.e. trading

costs) is much lower than in funded index

products or in cash bonds.

The liquidity and low transaction costs of

A

index derivatives have a number of important

implications for asset managers like our-

selves, and our clients.

Firstly, they allow strategic asset alloca-

tions to or from the credit markets to be

implemented quickly – and with minimal

market disturbance. The manager then has

the option of unwinding the derivative

position over time as he or she buys or sells

cash bonds. This can be particularly helpful

in the high-yield market where investing a

significant allocation in the cash market

can take several days, or even weeks – in

contrast, the equivalent market exposure

can be gained through the iTraxx® Cross-

over Index in significant size in a matter

of minutes.

Secondly, and because of the lower trans-

action costs involved, the indexes present a

greater number of asset allocation opportu-

nities, in which the manager’s expected

return after transaction costs is sufficient to

implement the trade.

Thirdly, the ability to use a derivative (or an

unfunded) product significantly increases our

ability to manage fund inflows and outflows

efficiently. For example, if we know that we

have money coming into a fund and we

believe the current level of credit spreads to

be attractive, then we can sell protection on

the index in advance of the cash arriving, and

‘lock in’ the current attractive level.

Preserving the alpha opportunity

Perhaps most pertinent today, given the

recent rise in credit market volatility, iTraxx®

Index products allow us to hedge market

exposure (beta), while preserving the sector

and stock selection (alpha) opportunities.

Historically, when we chose to allocate

away from credit, we sold a portion of our

cash bonds. This had the effect of incurring

significant trading costs, tying up portfolio

managers’ time and reducing the impact of

the sector and stock selection in our port-

folios. By using index derivatives, we can

swiftly make asset allocation decisions

without touching our underlying portfolio

positions, at a lower cost, and without signif-

icant portfolio management intervention.

For example, if we wanted to reduce our

allocation to high yield by 10 percent we

could do this in either of two ways:

1) By selling 10 percent of all holdings in

the portfolio.

Action: sell EUR 50 million of high-yield

bonds with a 20 bps bid/offer spread (for size).

Transaction costs = EUR 315,000.

2) By selling EUR 50 million iTraxx® Crossover.

Action: sell EUR 50 million of iTraxx® Cross-

over with a 1.5 bps bid/offer spread (for size).

Transaction costs = EUR 31,124.

If we use the Crossover Index in option

two, not only does this reduce our trans-

action costs, but we also preserve the

underlying sector and stock positions on the

total portfolio. Furthermore, if we assume

that the asset allocation sale occurred at

the start of the year and was held for a

twelve-month period – during which the

portfolio manager achieved his 100 bps

outperformance target – then we would

preserve the EUR 500,000 benefit of

the outperformance.

In this example the benefit of using option

two over option one is:

Option two also has another significant

benefit: namely, that the reduction in market

risk can be implemented in a matter of

minutes, whereas option one could poten-

tially occupy the portfolio managers for

several days. With the arrival of exchange-

traded credit futures, option two is now

available to a large number of clients who

are unable or unwilling to use over-the-

counter derivatives.

Expanding the alpha opportunity

The introduction of credit index derivatives

allows us to express views beyond the limita-

tions of the benchmark, and to target more

accurately those elements of the market on

which we have a view.

For example, at the moment we see the

main risks to credit spreads coming from

the high levels of leverage in the financial

system, the impact of private equity, M&A

92 Case studies

Table 1

Index Normal Bid/offer Equivalent Normal Bid/offermarket size spread bond market size spread EUR million (basis points) EUR million (basis points)

Main 100 0.25 A-rated Bank 10 4

HiVol 50 0.5 BBB-rated 5 4Telecom

Crossover 25 1 B-rated HY 3 10bond

Table 2

� Lower transaction costs

E315,000 – E31,124 = E283,876

� Preserved alpha

100 bps alpha x E50 million = E500,000

= E783,876

and corporate re-leveraging. Traditionally,

we would have expressed such a view by

being underweight relative to the

benchmark in those particular companies

that we felt were especially vulnerable to

such risks. However, this approach would

have limited our ability to be underweight

to only those companies that appear in the

index, and we could only have gone under-

weight to them, to the extent of their

weight in the index.

The HiVol Index has a concentrated

exposure to a number of companies that we

perceive as being vulnerable to M&A, private

equity or re-leveraging. By buying protection

on this index, we can create a larger

underweight position than could be achieved

by traditional methods. For example,

Cadbury Schweppes, Compass, Kingfisher,

Marks & Spencer and Tate & Lyle are all

underweighted in our cash bond funds.

However, while their collective index weight

is only 0.55 percent, they constitute 17

percent of the Series 7 HiVol Index. This index

also contains several other names about

which we have concerns.

Conclusion

The introduction of index-based derivatives

provides a useful degree of flexibility,

allowing bond fund managers to reshape

their portfolios more quickly for strategic or

tactical purposes. Access to these instru-

ments can only increase with the advent of

exchange-traded credit index futures.

Furthermore, the greater liquidity and lower

trading costs of these instruments should

produce better outcomes for clients.

Scottish Widows Investment Partnership (SWIP) is one of the U.K.'s largest asset management companies, with GBP 98 billion*

invested across all major asset classes - including U.K. and international equities, property, bonds and cash. SWIP manages a diverse range

of specialist funds for U.K. and international clients, including pension schemes, charities and local government authorities as well as life

assurance, pension and investment funds for the parent company Lloyds TSB . The company manages over GBP 41 billion* (in fixed interest

and cash assets and offers a range of strategies with different risk/return profiles to suit a variety of client needs.

Gareth Quantrill is head of bond product at SWIP, where he is responsible for aggregate bond mandates and the development of the

firm’s structured credit business. He has over 15 years of investment experience, having started his career at Norwich Union in 1991. In

2000, he joined SWIP as credit portfolio manager and was made head of credit in 2004. Gareth moved to Henderson Global Investors as

head of credit in 2005, before rejoining SWIP in 2007.

*Source: SWIP, as at June 30, 2007

93Case studies

Access to these instrumentscan only increase with the

advent of exchange-tradedcredit index futures

ith the

launch of

credit futures

on March 27,

2007 – the first

exchange-traded

credit derivatives

worldwide – Eurex

not only extended the range of tradable

credit instruments, but also paved the way

to the introduction of new and innovative

trading strategies.

This article describes how credit futures

can be used to replicate credit spreads. As

spread dispersion is often also a good proxy

for investors’ risk aversion, these strategies can

be used as efficient and low-cost tools for

portfolio diversification, hedging or arbitrage.

There is no universal mathematical defi-

nition of credit spread dispersion. For a

sample of issuers, the standard deviation

normalized by the average spread is an

acceptable measure, able to reflect the real

market spread dispersion. While such a

measure is quite hard to replicate in a port-

folio, it allows us to observe the link between

dispersion and the credit market.

In chart 1, we can see that an increase in

dispersion occurred during the main spread-

widening periods of the last three years.

Indeed, it appears logical for a wider market

to be more dispersed and a tighter market

less dispersed. However, that rule is not sys-

tematic because various other factors affect

dispersion, such as activity in the structured

credit market or rumors about leveraged

buyouts (LBOs). Such factors can affect the

dispersion independently of market direction.

Analyzing dispersion

Spread dispersion is a useful indicator of

market participants’ risk aversion. When risk

aversion is high, investors shift their invest-

ments to the higher part of the ratings curve

and reduce their exposure to lower rated

94 Case studies

ADI Alternative Investments’FFaabbrriiccee JJaauuddii and AAlleexxaannddrreeSSttooeesssseell describe how creditfutures can be used in spread dispersion trades

W

Playing the spreaddispersion usingindex arbitrage

95Case studies

Chart 1: Cumulative iTraxx® Europe & Crossover Indexes universe: historical dispersion and average spread

whereas the iTraxx® Europe 5-year Index

includes issuers with average ratings of

BBB+. Chart 3 (next page) illustrates there is

a relatively good correlation between the

iTraxx® Europe Crossover/iTraxx® Europe and

our dispersion indicator. Replicating an index

ratio means selling one index and buying

another, ending up with a neutral position,

not in nominal terms, but on a spread-

adjusted basis. The strategy is carry neutral,

avoids negative time decay and allows

investors to be more patient.

Example of strategy using the iTraxx®

Credit Futures

Let us suppose that on January 2, 2007, the

Eurex iTraxx® Europe 5-year Index Futures

and the iTraxx® Europe Crossover 5-year

issuers. In such a scenario, spread dispersion

naturally increases.

On the other hand, when investors are

risk takers, they seek to increase their carry

by reducing their portfolio’s credit quality,

causing a decrease in dispersion.

Of note is the violent spread compression

over the last quarter of 2006. That com-

pression demonstrated the effects of inves-

tors’ quest for higher yields in a tighter

market. Eventually, following the spread

widening in March 2007, the market made

an equally violent turnaround and dispersion

drastically increased.

Replicating dispersion through indexes

If spread dispersion reflects an investor’s

positioning on the ratings curve, then it is

possible to approximate it with a simple ratio

between two qualifying indexes. For instance,

the iTraxx® Europe Crossover 5-year Index

contains names with a BB average rating

Chart 2: Average spread

Large dispersion

Low dispersion

AAA

AAA AA

20 bps

10 bps 400 bps

800 bps

A BB B CCC

AA A BB B CCCBBB

BBB

Index Futures are respectively quoted at

100.33 and 102.71, implying credit spreads of

22.75 bps and 215 bps and a spread ratio of

9.45. Let us suppose we buy a notional EUR

10 million of the Crossover contract at 102.71

and sell EUR 94 million notional of the

Europe contract at 100.33.

On February 21, 2007, the contracts

respectively trade at 100.34 and 104.34,

implying credit spreads of 22.25 bps and 175

bps – or a spread ratio of 7.86.

The result of the strategy is the following:

P/L = 10,000,000 x (104.34% – 102.71%) –

94,000,000 x (100.34% – 100.33%)

= EUR 153,600.

Conclusion

Spread dispersion is a variable on its own

and does not necessarily replicate market

performance. Indeed as shown in chart 1,

in the past there have been some bullish

markets with high dispersion as well as

bearish markets with low dispersion. This is

due to the numerous factors affecting dis-

persion: the level of default rates, significant

structured products activity, idiosyncratic risk

(LBO’s, re-leveraging, and so on). Regardless,

the replication of dispersion as a diversifi-

cation tool in a credit portfolio is attractive.

Furthermore, in some market contexts, it can

also be a low cost directional macro-hedge

(with neutral carry).

The launch of the Eurex iTraxx® Credit

Futures on the three main indexes introduces

arbitrage opportunities to the credit markets

that have long been successfully deployed in

the equity market.

96 Case studies

ADI Alternative Investments is an alternative investment manager specializing in convertible arbitrage, credit arbitrage, high yield, merger

arbitrage and fixed income. The credit arbitrage desk at ADI was set up in 2003. The team consists of eight staff, whose mission is to develop

quantitative and qualitative strategies using credit derivatives instruments.

Fabrice Jaudi is a senior portfolio manager within the credit arbitrage team. He joined ADI in early 2003 to develop the credit arbitrage funds,

having begun his career at Dexia Asset Management as a fund manager. At Dexia he participated actively in the development of the con-

vertible bond arbitrage and credit arbitrage funds from 1996 to 2003 and, from 2001 onwards, he developed and was in charge of credit deriv-

atives activity. Fabrice graduated as a financial analyst from the European Federation of Financial Analysts, and holds a masters degree in

economics and a postgraduate specialization in finance from Université Paris II – Panthéon Assas.

Alexandre Stoessel is a senior portfolio manager in the credit arbitrage team. He joined ADI in March 2002 to take responsibility of cash man-

agement within the portfolio management team. After the successful launch of ADI EONIA, he was appointed senior portfolio manager within

the credit and volatility team in 2004. He started his career in 1996 at Société Générale Capital Markets, working as a programmer analyst. In

1998 he joined Cardif Asset Management where he held a post as portfolio manager on cash enhanced money market funds. From 2001 to

2002, he worked at Commerzbank as a proprietary trader. Alexandre is a graduate of ENSIMAG (Ecole Nationale Supérieure d’Informatique et

Mathématiques Appliquées de Grenoble).

Chart 3: iTraxx® Europe & Crossover Indexes: dispersion and spread ratio

aphael, can you

explain how your

investment teams

are set up at

BlueBay?

Investment teams at

BlueBay are structured

in such a way that each

group is headed by a long-only and a long-

short specialist. This allows for a good mix of

disciplines – one specialist tries to outperform

an index, while the other aims to generate

absolute returns. We have structured the teams

in this way, as we believe that the two skill-

sets are complementary and the investment

process seeks to get the best of both.

What do you use the iTraxx® Indexes for

and why?

We use the iTraxx® credit default swaps (CDS)

Indexes across all of our funds, primarily to

adjust credit beta at the overall portfolio level.

This highly liquid instrument gives us good

diversification (the underlying exposure is

split equally between up to 125 issuers) and is

highly correlated to the overall credit market.

Therefore, it offers, in our opinion, the best

way to implement our top-down view on

credit spreads in our funds.

What did you use before the arrival of

the iTraxx® product?

When I started at BlueBay in 2003, the CDX

product was already established in the U.S.,

but the iTraxx® group had not yet been

formed in Europe – instead, two rival CDS

index families were competing. At this point,

we did not believe that the indexes were

transparent enough. They were also much

more technically driven – which made them

quite risky to use – and liquidity was scant.

As a result, we were somewhat restricted.

For instance, if there was a conflict

between our top-down and bottom-up

views, we had to examine which was the

stronger and compromise accordingly. We

implemented this by either doing nothing, or

by selling a part of the portfolio. The launch

of the iTraxx® Index family has meant that

we can move efficiently. When we need to

adjust risk, we can do it at much lower cost

through the iTraxx®, so its establishment has

been an enormous benefit.

What are the key advantages of the

iTraxx® Indexes over and above single-

name CDS?

The problem with trading single-name bonds

or CDS is that the bid/offer spreads are still

very wide, therefore, trading in and out of

positions can be very costly. In contrast, the

indexes are now so liquid and widely traded

that bid/offer spreads are much narrower

and we can use them to quickly re-adjust our

risk with very limited transaction costs. So,

for us, it is the instrument of choice as a

97Case studies

Using iTraxx® acrossthe fund spectrumRRaapphhaaeell RRoobbeelliinn talks to editor NNaattaasshhaa ddee TTeerráánn about how BlueBay funds utilize the iTraxx® Indexes

R

inflows in index format in a first stage,

before transferring the risk into the less

liquid single-names that we believe are

attractive. Using the index as a first step

allows us to wait for more attractive

pricing, new issues and so forth.

What are you views on the Eurex iTraxx®

Credit Futures?

The futures should, in theory, have a

number of advantages for us – the main

ones being the reduced amount of docu-

mentation and back-office work they

involve, along with the lower bid/offer

spreads usually available in the exchange-

traded markets. If the contracts were liquid

we could do a very large amount of business

through them, as the back-office con-

straints would be much lighter. At the

moment we have two people dedicated to

managing our novations (the exchange of

new debts or obligations for older existing

ones). These staff could be redeployed if

we were able to use the futures instead of

the OTC instruments to open and close out

our positions.

98 Case studies

credit beta overlay – we do not have to get

rid of single-name exposures, but can use the

indexes to adjust our overall risk.

For instance, let us say we have a port-

folio of 100 names that we really like and

think will outperform the index. While

holding this position, there will be times

when we may feel the market is due for a

modest widening in spreads or that credit

could underperform in the short-term. In

other words, we think we have too much

beta-adjusted risk. Without iTraxx®, we

would have to sell out of the selected

single-names. This is not ideal for two

reasons. Firstly, we research the credits in

great depth before putting on these single-

name trades and want to retain our long

term exposure to them and, secondly, the

bid/offer spread, even in the more liquid

single-name CDS that make up the main

index, is around 5 bps. If we use the index

instead, we can keep the exposure to the

names we are happy with, still generating

alpha through those bottom-up bets, even

while adjusting the credit risk at the beta

level. An additional benefit comes from the

considerably lower transaction costs – the

bid/offer spread on the main iTraxx® Index

is usually 0.25-0.5 bp – well below the 5

bps for the single-name CDS.

Which iTraxx® instruments do you use

and how frequently do you trade them?

For the long-only funds, we use the main

iTraxx® Index, but we also use the HiVol and

Crossover Indexes, depending on what we

are hedging and the portfolio holdings.

We trade the indexes quite regularly –

not just when our top-down view changes

as already described, but also when we

change our views on a particular credit, and

when we receive new inflows to the fund.

For instance, if we decide that an indi-

vidual bond has reached its top, we will sell

our position and substitute the iTraxx®

Index to keep our risk exposure the same

until we are ready to reinvest on a single-

name basis. In this way, we are able to keep

the overall amount of credit risk in line

with our top-down view on spreads at all

times – whatever our view on particular

credits. Similarly, we usually invest fund

BlueBay Asset Management Plc was founded in 2001, and is one of the largest independent managers of fixed income credit funds

and products in Europe, with assets under management of approximately USD 13.1 billion (as at June 30, 2007). Based in London, with

offices in Tokyo and New York, it provides investment management services to institutions and high-net-worth individuals globally.

BlueBay provides long-only, long/short and structured products across emerging market, high yield and investment grade credit. The

company, which was admitted to the official list of the U.K. Listing Authority and to trading on the main market of the London Stock

Exchange in November 2006, also manages segregated mandates on behalf of large institutional investors.

Raphael Robelin is the senior portfolio manager for the investment grade bond fund at BlueBay. He joined the company in August 2003

from Invesco where he was a portfolio manager for investment grade funds. Prior to that, Raphael was a portfolio manager with BNP

Group and Saudi International Bank. He holds a degree in engineering (IT) and applied mathematics from EFREI as well as a masters

degree in management and international finance from the Sorbonne.

99Case studies

BlackRock’s CChheettlluurr RRaaggaavvaann details how credit derivatives and credit indexes are helpingorganizations manage their exposures and generate excess returns

Evaluating opportunitiesin the credit markets

he dramatic growth

of the credit deriva-

tives market over the

past few years has

ushered in a new era of

credit investing and

attracted a fresh gener-

ation of investors.

No longer constrained by the illiquidity in

cash bonds, investors are not forced to play

the market only from the long side. Prior to

the ascendancy of credit derivatives, they

would simply not own a credit they did not

like, as most were unable to short bonds in

their portfolios; now, they can easily buy

credit protection as a means of taking a neg-

ative stance on a credit.

The expanded toolbox afforded by credit

derivatives is clearly enabling investors to

look for relative value opportunities wherever

they exist, from both the long and the short

sides of the market. This, in turn, has resulted

Tin greater transparency and price discovery

within the credit markets.

At the portfolio level, the recent advances

in technology and analytics are enabling

investors to easily tailor their exposure to

specific risk slices of the market, at appro-

priate levels of risk premium. It is much

easier now for credit investors to enter into

and exit from relative value trades, and

to do these in size, than it was just a few

years ago.

This enhanced ability to look for relative

value opportunities is even more crucial in a

benign market environment. Chart 1 (below)

illustrates the extent to which credit risk pre-

miums narrowed over the past few years.

Chart 1: Option-adjusted spreads to treasuries of global aggregate and euro aggregate corporate indexes

Source: Lehman Brothers

On the surface, the tightening of credit

spreads has been supported by robust cor-

porate earnings, generous free cash flows and

healthy corporate balance sheets. Corporate

default rates are at an historically low level,

even for the high yield sector. The trailing

twelve-month global corporate speculative-

grade default rate fell to a mere 1.2 percent in

May, 2007, well below its long-term average

of 4.48 percent, according to Standard &

Poor’s. The rating agency also noted how the

twelve-month rolling downgrade ratio (ratings

downgrades to total rating actions) was at 62

percent, close to the lowest level observed in

recent years. These compelling dynamics, com-

bined with the global quest for higher yields

and surplus liquidity, kept credit spreads tight

over the past few years.

Beneath the surface, however, credit con-

ditions appear to be deteriorating. Corporate

leverage has been rising (albeit from its low

level) with ever increasing levels of leveraged

buyout (LBO) activity. Moreover, there has

been a general easing of bond and loan

covenants that are meant to protect lenders,

increasing instances of pay-in-kind (PIK)

coupon features, and debt financings pri-

marily to fund share buybacks and/or deliver

larger dividends to shareholders. Most

importantly, there has been a discernible

deterioration in the credit quality of the bor-

rowers tapping the market. Almost one-third

of all new high yield issuance in the first five

months of 2007 was rated CCC+ or lower. In

some ways, these conditions are not dis-

similar to the conditions that prevailed in

the subprime mortgage market in the U.S.

only recently. Weak borrowers, unsustainable

levels of debt and poor underwriting stan-

dards all set the stage for the precipitous fall

in subprime valuations.

While the outcome for credit markets

remains uncertain, it is tempting for inves-

tors to seek relative value opportunities

without taking any outright exposure to the

credit market. An array of credit derivatives

products, such as single-name credit default

swaps (CDS), CDS index baskets and tranches

and bespoke collateralized debt obligation

(CDO) structures, allow investors to alter their

exposures and tailor their portfolios in spe-

cific ways to establish optimal positions

within the credit markets.

In this article, we will highlight a market

neutral relative value strategy - an index

arbitrage strategy. Index arbitrage involves

exploiting valuation differences between a

credit derivative basket (such as the iTraxx®

Crossover Index) versus its components.

Theoretically, a credit derivatives basket

should track closely the valuation of its com-

ponents. In practice, however, demand and

supply factors will determine the valuation of

the basket. This is somewhat analogous to

the pricing of a closed-end mutual fund,

where the traded price is based on the

demand and supply dynamics of the fund

and not the underlying securities.

Arbitrage opportunities in the index

markets generally arise as a result of large

flows in the underlying credit derivatives

market. For instance, when the demand for

protection on specific single-name CDS rises

or falls because of CDO demand, the index

may not keep pace with all of its con-

stituents. Conversely, when several macro

hedge funds trade large volumes of credit

derivatives baskets, the potential for indi-

vidual CDS to fall out of line with the value

of the basket becomes pronounced.

To exploit this anomaly, investors need

quick and efficient methods for evaluating

credit derivatives baskets and their con-

stituents. In the following example (chart 2),

we will show how BlackRock uses AnSer®,

BlackRock Solutions’ analytic calculator, to

discern and exploit relative value opportu-

nities between the iTraxx® Index and its con-

stituent members.

The index highlighted is the iTraxx®

Crossover 5-year Index (ITRAXX XO.7). It is

one of several standard credit derivatives

indexes that provide default protection on a

basket of issuers – in this case 50 European

Crossover names1. Using AnSer®, we compute

the breakeven spread for the iTraxx® Index.

The breakeven spread (displayed as BE CDS

Spread) is equivalent to the spread that one

would pay for protection today, given a CDS

contract of the same maturity and terms (i.e.

the spread at which an at-the-money XO.7

100 Case studies

Corporate default ratesare at an historically

low level, even for thehigh yield sector

101Case studies

5-year would trade today). In this case, it is

approximately 239 bps, as of March 28, 2007.

Within AnSer®, we can also look at the

individual CDS that make up the iTraxx®

Crossover Index. The screen in chart 3 (fol-

lowing page) displays each name, current

face amount, default date/recovery rate (for

defaulted names) and other relevant

indicative data and valuation assumptions.

(Note: XO.7 has had no defaults).

AnSer®’s portfolio analyzer tool allows us

to analyze the basket as an intrinsic portfolio,

wherein each constituent is valued separately

as a single-name CDS, using the index prop-

erties (including maturity, document clause,

tier and coupon – 230 bps for XO.7). The

report can also display the CDS spread and

recovery rate assumptions used to value each

constituent member of the iTraxx® Crossover

Index. The breakeven spread for the portfolio

computed as a collection of individual CDS, is

approximately 206 bps.

In the example illustrated in chart 4,

the ‘basis’2, which reflects the difference

between the breakeven CDS spread of the

index versus its components, is 33 bps (239

bps less 206 bps), illustrating the fact that

the index was trading cheap relative to the

intrinsic portfolio as of March 28, 2007.

Portfolio managers can capture this basis by

‘buying’3 the cheaper asset (selling index

protection) and ‘selling’ the richer asset

(buying protection on all of the underlying

constituent members). Conversely, if the

‘basis’ is negative, the trade can be reversed

to lock in the excess spread.

An important caveat for the portfolio

manager is that he must be cognizant that

indexes can be more liquid than the under-

lying names, particularly in the high yield

sector. This could result in the ‘basis’ remaining

positive (or negative) over an extended period.

It is important to track the basis over a period

of time, using simple statistical measures

such as ‘z-scores’ (the number of standard

Chart 2: Breakeven CDS spread computed in AnSer®

Note: BlackRock’s main source for market CDS spreads is Mark-it Partners, and represents a composite of daily quotes from several dealers.

deviations of the current basis from its his-

torical average) to ascertain the relative

richness or cheapness of the different assets.

Another risk to this strategy is cash-flow

related, owing to the potential differences

between par swaps in the single-name CDS

market and off-market swaps within the

indexes. (All single-names in the iTraxx®

Crossover Index are struck at the same level

as the index, which is 230 bps, while indi-

vidual CDS contracts are struck at the pre-

vailing market premium). Furthermore, trans-

action costs incurred by trading a basket of

single-name CDS against the index also need

to be considered before deploying this

strategy. Index arbitrage is by no means a

‘risk-free’ arbitrage. Nevertheless, index arbi-

trage can be profitable, enabling portfolio

managers to generate alpha without taking

an outright exposure to the credit market.

The above strategy is just one example of

how credit derivatives and credit indexes are

helping organizations manage their expo-

sures and generate excess returns in these

challenging times. The use of credit deriva-

tives has grown exponentially and the end-

user base has broadened rapidly. Transaction

volumes are large, providing the necessary

liquidity and transparency to investors. These

conditions enable credit investors to manage

their exposures efficiently and exploit relative

value trading opportunities.

102 Case studies

Chart 3: Analysis of basket constituents in AnSer®

1Crossover bonds are corporate bonds

that have less credit risk than most

junk bonds and higher yields than most

investment grade bonds. They are typi-

cally rated at the lowest level of

investment grade or at the highest level

of non-investment grade.2This basis is different from the cash

bond versus CDS basis.3Buying in this context is analogous

to going long credit risk (i.e. selling

protection).

103Case studies

Chart 4: Breakeven CDS spread computed in AnSer®

BlackRock® is a premier provider of global investment management, risk management and advisory services. With 36 offices located in 18

countries around the globe, BlackRock serves clients in over 50 countries. Its client base includes public and private pension funds, insurance

companies, third-party distributors, corporations, banks, official institutions, charities and individuals. In Europe, BlackRock has been a trusted

investment partner of its clients for many decades.

Chetlur Ragavan, CFA, CLU, is a managing director and member of the Portfolio Analytics Group within BlackRock Solutions. Chetlur's service

to the firm dates back to 1980, including his years with Merrill Lynch Investment Managers, which merged with BlackRock in 2006. At MLIM,

Chetlur was most recently the global head of fixed income research. Prior to that, he served as senior risk manager for fixed income. Chetlur

earned a BA degree in operations research from the University of Madurai, an MBA in finance from Madras University, and an MS degree in

computer sciences from New Jersey Institute of Technology.

Note: The BE CDS spread of the portfolio is the average of constituent BE CDS spreads weighted by their standalone CDS Sprd DV01. This adjusts for spread dispersion within

the index; higher spread names have a lower duration and would contribute less to the average. Another way of thinking about this, is that higher spread names are expected

to default sooner, leaving tighter names that would reduce the average spread. This expectation is priced into today’s index spread.

Making the most of newcredit opportunitiesCredaris’ chief investment strategist and portfolio manager, GGrraahhaamm NNeeiillssoonn, describes to JJoohhnn FFeerrrryyhow credit derivatives technologies have transformed the credit investment landscape

104 Case studies

Credit markets and productshave witnessed some

phenomenal periods ofvolatility in recent years

Credaris was established in 2003, just as

the structured credit market, or at least

the synthetic structured credit market,

was really starting to take off. How did

the market’s evolution tie in with the

establishment and development of

Credaris’ business?

The financial market events that occurred

between 1999 and 2003, in the equity and

bond markets, gave pension fund, asset and

liability managers, as well as the predomi-

nantly long-biased investment community at

large, a very big wake-up call. Not only had

equities undergone one of the biggest bear

markets in 70-odd years, but bonds and

equities hadn’t always behaved in the way

most textbooks suggested they would do.

That meant that the old model of having a

diversified portfolio of equities and bonds

was definitely challenged. Credit was usually

included in there somewhere, but it was gen-

erally just part of the bond portfolio.

Suddenly people had more of an incentive to

look for alternatives to the traditional mix.

What I think credit derivatives demon-

strated – and this is one reason why we’re in

the business – is that they can be used to

create products that have a low correlation to

traditional asset classes, and offer different

methods of providing the ultimate nirvana of

an improved risk-adjusted return profile.

Also, if we look at the evolution of credit

over the last five or six years, two important

things have occurred. Firstly, the broader

credit market has changed radically. The

spread available on credit products has

imploded. Secondly, instruments have

evolved very rapidly. The standardization of

credit derivatives language has played a large

part in this growth, and that standardization

has brought about an increase in tradable

instruments. These factors have combined to

push credit closer to the forefront of the

asset class mix. Credit markets and products

have witnessed some phenomenal periods of

volatility in recent years but, I think, emerged

stronger as a result.

What types of products are you

offering today?

We manage funds and products based

around two types of credit assets: asset

backed securities (ABS) and corporate

credit. Each fund is a long/short fund with

a target of attractive risk-adjusted total

returns. For example, we manage a

long/short structured ABS fund called the

secured finance fund. This fund has con-

tinued to create positive returns, thanks to

its ability to take both long and short

exposure to structured ABS products. This

makes it stand out hugely compared with

other long-biased funds in the structured

ABS arena, which have not been so for-

tunate. One of our main corporate credit

offerings is a long/short structured credit

fund, which generates attractive double-digit

returns through active management of deriv-

ative-based structured credit assets, such as

collateralized debt obligations (CDOs) and

constant proportion portfolio insurance

(CPPI) products. Again, these are defined by

the underlying assets, whether these be

structured ABS products or corporate credits.

The corporate credit-based products include

a principle protected version of our

long/short structured credit fund, and a prin-

ciple protected single-name credit default

swap (CDS) product, which is uniquely credit

spread market neutral.

Tell us about your investment and

structuring approach.

Our corporate credit business approach is

centered on singling out three key risk com-

ponents – single-name risk, market spread

risk and default correlation risk. A lot of

credit funds out there today have tended to

drift into becoming multi-strategy credit

funds, with the manager trading anything

available – tranches, options, single-name

CDS, indexes, debt-equity trades, convertibles,

and so on. Now this is certainly an approach

that can work, but given the growing com-

plexity of instruments, our bias is to keep

things simple by isolating key building blocks.

Take single-name risk in a portfolio

105Case studies

106 Case studies

context first. If you have selected a portfolio

of 100 names, then the fundamental

analysis behind these names clearly needs

to be thorough. Through the use of credit

derivatives you can manage that single-

name risk appropriately, either via hedging

or through substitution activity. Certainly, the

advantages of having the correct approach

to managing single-name exposures became

very evident in the second-quarter of 2005,

during the so-called correlation meltdown.

You mean when Ford and General Motors

(GM) were downgraded?

That’s right. But it should also be remem-

bered that, as well as these two names

blowing out in April that year, the vast

majority of investors arrived at the second-

quarter 2005 party very long credit. This

highlighted the single-name risk in a struc-

tured portfolio context – if you had a port-

folio of 100 names, including GM and Ford

at that point, then this obviously had strong

implications for risk management. Another

major risk component, highlighted during

that episode, is that of general market

spread risk. Funds and products have dif-

fering degrees of exposure and flexibility to

manage market spread risk exposure. Credit

spreads can widen or tighten for credit-

based reasons or for external reasons

related to macro market volatility. We

believe that a broader view of the credit

market, and credit spread movements, taken

from a macro perspective, is a critical

element to successful credit fund and

product management.

The third factor is correlation risk. If you

have a portfolio of 100 names, then some of

the names will be more closely correlated

than others in terms of their default proba-

bility. Default probability is determined by

issues such as spread level, sector and geo-

graphic concentration. Once again, Ford and

GM were a classic case in point during the

second-quarter of 2005. That period high-

lighted how single-name risk can have a

knock-on effect on the general level of

overall credit market spread risk and

direction, as well as how the correlation

market prices risk across tranches.

What was the fallout from that episode

for structured credit players?

From our point of view it did two things. It

told us that our approach to managing the

risk was right, and it created a huge amount

of value in the market. The irony was that the

most profitable trade you could put in place

after the dislocation happened, was the trade

that got everyone in trouble. We took the

opportunity to begin our long/short

structured credit fund, which has provided

extremely attractive returns ever since.

How do you use the credit derivatives

market to manage your three key

risk factors?

We will use single-name CDS up and down

all the maturity curves. For managing market

spread risk we can use standard index

products, and for correlation risks we can

utilize the standardized tranche markets.

How do you view the emergence of credit

futures, and how do you see the credit

derivatives market progressing from here?

It will take time, but I think listed futures,

such as the Eurex iTraxx® Credit Futures,

could become part of the risk architecture

of the credit market. They could potentially

bring more players to the market. Not

having to go through the ISDA® documen-

tation routine is an advantage and may

speed up some approval processes, and we

could potentially see retail players enter the

market, as well as more direct investment

through pension vehicles.

More generally, I think credit derivatives

techniques are moving into other underlying

assets. We’re seeing the extension of credit

derivatives technologies to the asset backed

and the loan worlds, including the devel-

opment and growth of tranches on related

indexes. The underlying instruments, and the

underlying fundamentals driving those instru-

ments, will encounter their own problems

going forward, but they will provide lots of

opportunity for people like us, whether we’re

buying, selling or creating products, to extract

value from the markets.

Credaris is a credit-specialist asset

manager based in London and operating

in the global secured, unsecured and

structured credit markets. With EUR 1.4

billion of capital, the firm offers tailored

solutions in the form of funds, structured

products and separate mandates.

Graham Neilson is a portfolio manager

and leads Credaris' investment strategy.

He has wide experience in trading and

strategy across a diverse range of asset

classes from Asian equity and foreign

exchange markets to global credit and

bond markets. Prior to joining Credaris,

Graham was global head of credit

strategy at ABN Amro. He holds a

master’s degree in economics from

St. Andrew’s University, Scotland.

“The idea behind the deal isto take advantage of the

increased variety andliquidity in index-based

credit instruments”

Using iTraxx® inexotic structures

How and where do you use iTraxx®?

Within our collateralized debt obligation

(CDO) and CDO squared products we only

use single-name credit default swaps (CDS),

but we have been actively using the indexes

since December 2005, when we launched our

first constant proportion portfolio insurance

(CPPI) product, Matisse, together with Credit

Suisse as arranger.

Tell us about your CPPI products?

The first CPPI is an absolute return fund that

takes positions on correlation in the stan-

dardized synthetic CDO market by going

long equity tranches, and short mezzanine

tranches of the iTraxx® and DJ CDX Indexes.

We enter into long equity/short mezzanine

tranche trades in the iTraxx® and CDX

Indexes, and use single-name swaps to

cancel out names we consider to be at risk.

The idea is to take advantage of the

increased variety and liquidity in index-based

credit instruments and to benefit from both

spread widening and tightening scenarios. In

other words it is a convex strategy, (i.e. a

strategy that is relatively market neutral and

benefits from spread decompression, as well

as spread compression).

We also use iTraxx® extensively in our

two other credit CPPI products: Cézanne

and Delacroix.

Cézanne was launched in May 2006 and

arranged by UBS. It is essentially a market

spread compression or decompression

strategy, that goes long the Main iTraxx® and

CDX and short the iTraxx® and CDX HiVol

Indexes. The deal is structured to offer

investors exposure to a senior layer of risk in

the high triple-B/single-A area, by going long

the iTraxx® and CDX Main Indexes and short

the HiVol Index on both the iTraxx® and CDX.

Fortis Investments’ RRyyaann SSuulleeiimmaannnn describes to editor NNaattaasshhaa ddee TTeerráánnhow his firm uses iTraxx® Indexes within its exotic credit products

107Case studies

If we are really bearish on spreads, we

employ a hedge ratio of 1:1, while if we are

very bullish on spreads we would go long

four times on the Main iTraxx® and one time

short on the HiVol.

This strategy benefits from spread

widening on more volatile names, while

leaving investors exposed to idiosyncratic risk

on higher rated names. A key part of our role

is to manage that idiosyncratic risk by

hedging with single-name CDS.

Our third CPPI deal, Delacroix, was

arranged by JPMorgan in November 2006. In

this deal, the portfolio references flexible

long/short positions on the credit indexes,

tranches of the indexes and single-name CDS

risks. Typically, 50 percent of the portfolio is

dedicated to long/short trades on any two of

the tranches, and 50 percent to long/short

positions on the indexes – the Main and

HiVol Indexes, for example. The rationale here

is that the tranches are more representative

of idiosyncratic risk and the indexes rep-

resent the systemic risk, so we can at times

be short one and long the other, long both or

short both. By dynamically managing and

adjusting these positions with different

hedges, the product should be able to benefit

investors during each part of the credit cycle.

How often do you trade the indexes?

Our style of management on these products

is not hedge fund-like – we do not engage in

frequent or daily trading or look for short

term gains. Instead we put on strategic

trades, generally adjusting our position just

three to four times a year. Where we obvi-

ously intervene more often is on the hedging

side, adjusting our hedges once or twice a

month, either using the iTraxx® and CDX

Indexes or single-name CDS, depending on

the strategy. That said, index liquidity is enor-

mously important to us and is a key consid-

eration in using the indexes, for, once the

credit cycle changes, we will obviously need

to trade far more often.

How important are the iTraxx® and other

standard indexes to your strategies?

Very – if we did not have the iTraxx® and DJ

CDX Indexes, we would have to do multiple

single-name trades to hedge our positions.

This would entail a lot of back-office work

and, because the names would need to be

very liquid and tradable in size, it would also

require considerable back-end credit

analysis to identify suitable credits, espe-

cially for those illiquid credits that trade

rarely. The indexes have proved to be enor-

mously useful for going long and short

credit risk, though it is almost impossible to

quantify the savings.

How important has the introduction of

standardized tranching technologies been?

Enormously important. It would have been

next to impossible to put these deals

together before the arrival of the stan-

dardized iTraxx® tranches. Instead, we

would have had to use tranches from

bespoke CDOs, which would have been

completely illiquid and difficult to trade.

Furthermore, they would have been very

costly to trade as you are typically limited

to transacting with the bank behind the

CDO, and the bid/offer spreads on such

tranches tend to be very wide.

In short, it would have been nigh on

impossible – or as good as impossible – to

put these CPPI deals together without the

standardized tranches.

“Our style of managementon these products is nothedge fund-like – we do

not engage in frequent ordaily trading”

108 Case studies

“A liquid futures contractwill definitely help

by increasing liquidity andtransparency in the market”

How could you envisage using the new

Eurex iTraxx® Credit Futures?

The futures could be very interesting new

instruments. In a leveraged buy-out (LBO)

context, for instance, we could use them to

bet or hedge against a name being taken out

by an LBO, using the iTraxx® Futures in con-

junction with a single-name CDS – going

long one and short the other, depending on

the bet. Alternatively, we could use them for

basis strategies: going long the index using

futures and short the actual index, in order

to benefit from negative or positive basis

moves between the names and the actual

traded level of the future.

Neither of these strategies would be eligible

within our existing CPPIs, so we would have to

create another product or would need to

amend the documentation of one or more of

our existing products to allow us to use them

– but these are obvious strategies to consider

as the futures contracts gain in liquidity.

What effects will the futures contracts

have on the market?

Counterparty credit risk, back office, clearing,

confirmations and transparency risks are

important considerations for us – and the

futures will likely introduce considerable ben-

efits on all sides. They should help remove

the ‘black box’ worries that surround credit

derivatives and should help the market and

the regulatory authorities to be more com-

fortable with the instruments. Furthermore,

they should help introduce a better and more

robust legal framework, encouraging more

funds into the market and helping CDS to

really become the flagship instruments of the

credit markets. Already CDS are nearly there

– spreads in the cash bond market are fol-

lowing the CDS market’s lead, but there is

still more to be done and a liquid futures

contract will definitely help by increasing

liquidity and transparency in the market.

The idea is extremely appealing.

Fortis Investments is the global asset management arm of the Fortis group. With some EUR 125 billion assets under management, it

manages investments on behalf of institutional, retail and private clients. Fortis has EUR 26 billion invested in structured finance products,

ranging from plain vanilla CDOs to CDO squared and CPPI products.

Ryan Suleimann is a senior fund manager at Fortis Investments in Paris. He is responsible for managing exotic structures – particularly

long/short strategies within CDOs, CDO squared and CPPI products.

109Case studies

The use of iTraxx® instructured creditEditor NNaattaasshhaa ddee TTeerráánn discusses the role that the iTraxx® Indexes have played inthe development of structured credit products with WestLB’s IIggoorr YYaalloovveennkkoo

110 Case studies

111Case studies

Structured credit canbe instrumental in

capturing the differentdrivers of credit

portfolio performance

Firstly, could you outline the benefits of

structured credit, and explain why

investors might be motivated to invest in

the market?

The short answer is that structured credit is

worthy of exploration, because it expands the

investment universe and gives investors

much more tailored exposure to credit than

they would otherwise get. But this deserves

some more explanation.

Prior to the development of securitization

and structuring techniques, most institu-

tional and private investors would have

gone into the credit asset class by buying

cash loans or bonds. The drawback with

such a strategy is that the pay-off on these

cash investments is very asymmetrical:

investors get some upside return if things

go well, but they stand to lose the majority

of their investment if things go badly. Broad

diversification is, therefore, the key for

smoothing these asymmetric returns.

Private and smaller investors face a par-

ticular problem, in that it is as good as

impossible for them to build up a well-

diversified credit portfolio: they would need

to buy literally hundreds of bonds from dif-

ferent regions and market segments to

achieve the proper diversification, but would

not readily find sellers of such small lots.

Investing in a typical bond fund, meanwhile,

offers only limited flexibility, as far as the

debt classes and interest rate exposures are

concerned, plus it can involve significant

transaction costs.

In contrast, structured products and credit

indexes can offer investors simple, clean

paths around these issues. Through synthetic

index trades, all sorts of investors – both

large and small – can quickly and economi-

cally build up diversified credit exposures.

Meanwhile, collateralized debt obligation

(CDO) tranching techniques can be used to

create very particular risk/return profiles. We

can tranche portfolios of high yield loans to

create safe investments with AAA ratings, or

tranche portfolios of low-yielding

investment grade bonds to create high-

yielding equity investments. In this way,

structured credit broadens the investment

universe: expanding available debt classes

for investors who are either restricted from

investing below a certain rating level or

looking for additional sources of return.

Thus, tranching is used both for risk

reduction and yield enhancement purposes.

In addition, structured credit can be

instrumental in capturing the different

drivers of credit portfolio performance. Cash

credit portfolios give investors exposure to

both alpha and beta factors – the credit per-

formance of a particular debt class repre-

senting the beta factor, and the manager’s

bond or loan selection representing the alpha

component. These two will jointly dictate

how the portfolio performs – and in a cash

credit investment there is no way of sepa-

rating the two. In contrast, CDO tranching

techniques allow us to separate those two

components: we can create alpha-orientated

investments by putting together equity or

junior tranches, with all the upsides of good

portfolio management; or we can create

beta-orientated investments with mezzanine

and more senior tranches, which, being less

dependent on portfolio selection, give broader

exposure to the debt class in question.

How has the structured credit market

evolved since the establishment of the

iTraxx® Indexes? What were the previous

alternatives?

The first CDOs were securitizations of cash

bond and loan portfolios. These products had

very useful applications, but were unwieldy

and costly to construct. When a bank puts

together a cashflow CDO comprised of bonds

or loans, it typically has to go out and source

all that collateral, warehouse it and carry the

risk if the transaction fails to materialize or is

delayed. Building up such a portfolio can

take months, depending on the issuance level

of the desired assets and their liquidity.

As soon as a liquid credit default swaps

(CDS) market emerged, CDO structurers were

able to put together so-called ‘Synthetic

CDOs’ – CDOs based on portfolios of CDS.

Banks arranging synthetic CDOs can go out

and transact 100 (or more) CDS trades with

homogeneous features in a single day,

gaining exposure to the same portfolio of

credits that they could take months to build

up in the cash markets. By the end of 2003,

some USD 50 billion of synthetic CDOs had

been issued, but the real jump in synthetic

issuance took place with the introduction of

the iTraxx® Indexes.

The reason for this is that the indexes

make synthetic CDO structuring hedging and

trading much easier. Using an index contract

further simplifies portfolio size adjustments,

because there is less need to trade individual

CDS. The products can also be structured and

sold on a single-tranche basis, as standard

index tranches are quoted by dealers daily.

This allows banks to issue, say, A-rated single

mezzanine tranches with a Euribor spread of

some 100 bps, without having to sell the

senior and junior parts of the capital

structure. In such cases, the issued tranches

are hedged out with delta and correlation

hedging techniques using the indexes and

standard index tranches. This is a major

advantage, because marketing full capital

structure CDOs requires arranging banks to

find investors for each tranche – a process

that can be convoluted and lengthy.

Because synthetic CDOs are often privately

placed transactions, they are difficult to track,

but the estimates for 2006 issuance range

from USD 100 to 300 billion, depending on

the source and methodology. We know for

certain, however, that virtually all of the cor-

porate credit CDOs being issued now are syn-

thetic structures, while other debt classes,

such as ABS and leveraged loans, dominate

the issuance of cashflow CDOs.

Various investors, including CDO managers,

have directly benefited from the iTraxx®

Indexes as well. This is because the indexes

have lower transaction costs, and give

investors far greater flexibility and trans-

parency in determining CDO features, such as

tranche subordination, maturity, thickness,

and ratings. Investors can also be sure that

desired portfolios are constructed quickly as

the ramp-up periods are much shorter for

synthetic deals, and there is far less uncer-

tainty over portfolio composition than there

is with normal cash-based CDOs. Professional

investors can calibrate portfolio default prob-

abilities to the market spreads of the portfolio

names, and the correlations between them to

the implied correlation from the quoted

iTraxx® tranches (base correlation skew),

making it much easier to do model-based

pricing. Finally, investors that buy single-

tranche deals avoid the conflicts of interest

that sometimes arise in full capital structure

CDOs with the holders of other tranches.

How have the iTraxx® Indexes facilitated

structured credit investment?

Enormously – but differently for distinct user

types. iTraxx® gives more sophisticated

investors the opportunity to put on delta

neutral trades – taking views on changes in

the correlation of underlying portfolios. They

can do this by going long or short standard

iTraxx® tranches, and delta-hedging these with

the indexes: if the correlation changes in the

desired direction they will profit accordingly –

independently of how the portfolio credit

spread moves. Also, because standard iTraxx®

tranches are actively quoted on a daily basis,

investors can easily benefit from the trends by

trading the relative value of different tranches

– doing so-called ‘relative value trading’

between different parts of the capital

structure. For instance, towards the end of

2005 many investors switched out of mez-

zanine tranches into super senior risk, because

The products can also bestructured and sold on a

single-tranche basis, asstandard index tranches are

quoted by dealers daily

112 Case studies

More recently, historically low default expectations

encouraged a trend towardthe equity tranches

they saw more value there. More recently, his-

torically low default expectations encouraged

a trend toward the equity tranches.

Finally, because the iTraxx® Indexes are

quoted and traded across several maturities,

investors can use the indexes to do relative

value trades on the credit curve: trading

5-year exposures against 7- or 10-year expo-

sures. They can go long and short different

maturities and benefit from the change in

the shape of the credit curve, much as they

would do from interest rate flattener or

steepener trades.

What about the more traditional buy-

and-hold investors and banks?

These investors have been able to use the

iTraxx® Indexes to get diversified exposure

to the corporate credit universe and to

leverage or de-leverage that exposure to

particular rating or risk profiles. The sudden

rise and importance of innovative struc-

tured products, such as constant proportion

debt obligations (CPDO), which can pay

Euribor spreads of over 100 bps for a AAA-

rated note, would be impossible without

liquid credit indexes. For banks, this is par-

ticularly important because the introduction

of the Basel II regime will allow for much

more refined regulatory treatment of

investment grade structured credit invest-

ments, reducing risk weightings from 100

percent to 20 percent or below for AAA-

rated tranches.

Banks are now also able to use iTraxx® to

hedge their corporate loan portfolios far

more simply and economically than they

were able to previously. Instead of doing

multiple CDS trades to hedge out individual

risks, they can hedge out their overall port-

folio exposure by doing so-called macro

hedges through the index or sub-indexes.

For instance, if they think that credit risk

will worsen or spreads widen, they can buy

protection via an iTraxx® swap – a very

effective and low-cost way of ‘macro-

hedging’ their portfolios.

How do the Eurex iTraxx® Credit Futures

complement the iTraxx® family?

Credit futures are particularly well-suited for

investors that are not advanced enough to

get involved in the over-the-counter (OTC)

market directly, whose business is not large

enough to justify the necessary infrastruc-

tural investment to do so, or who wish to

deal in small-sized trades that the major OTC

dealers do not cater for. Larger and more

sophisticated investors are already used to

trading in the OTC markets. However, if liq-

uidity in the Eurex iTraxx® Credit Futures

increases, they may well start using them as

alternatives to the OTC products, as there will

potentially be some overlap, and even some

arbitrage opportunities between the two.

113Case studies

WestLB is a leading German bank with a strong international presence. It is involved in credit origination, securitization, structuring and

trading and acts regularly as an arranger of structured transactions tailored for German saving banks, as well as for private, institutional

and international investors.

Igor Yalovenko is an executive director in the fixed income analysis group within WestLB’s research unit. He provides research coverage

for the whole range of structured credit products and his particular focus is on portfolio optimization.

CDS and iTraxx®: addingto the fixed incomemanager’s armory Barclays Global Investors’ MMaarriiaa RRyyaann describes how credit default swaps and theiTraxx® Indexes can be gainfully deployed in fixed income portfolios

114 Case studies

115Case studies

The CDS and bondmarkets have tended to

have different investorbases, with varying

constraints

n June 2007, the iTraxx® Index

responded to the increased nerv-

ousness in the market caused

by the sub-prime mortgage

market turmoil in the U.S. Over

the month, spreads on the iTraxx®

credit default swap (CDS) Index in

Europe expanded by 4 bps, from 20

to 24. What may be a little surprising

is that over the same period, corporate bond

market spreads ended the month unchanged

at 22 bps.

Chart 1 (below) shows spreads on the

iTraxx® Index versus the single A-rated com-

ponent of the European corporate bond

index (iBoxx®). There are some very valid

reasons why these markets can dislocate,

demonstrating that some structural differ-

ences between them can make arbitrage

very difficult.

IChart 1

Different markets, different investors,

different values

The CDS and bond markets have tended to

have different investor bases, with varying

constraints. Asset management mandates

often preclude investors from using the CDS

markets, or stop them from taking short

positions, but hedge funds have been active

in the CDS market for some time. The distinct

investor profiles can result in different

behavior affecting the markets, with one

market reacting to events over a longer

investment horizon than the other.

Even fund managers who use these instru-

ments tend to have different investment

styles and use them in different ways to

hedge funds. Asset managers are often

measured against corporate bond bench-

marks, so they have a natural bias towards

holding a substantial number of physical cor-

porate bonds. If they have a fundamental

view on the credit of an individual company,

they may take an overweight or an under-

weight position in that issuer versus its

weight in the benchmark. This can be done

either through physical corporate bonds or

by trading individual CDS contracts. However,

asset managers have increasingly chosen to

maintain their physical corporate bond posi-

tions, using CDS indexes to reduce or

increase their overall credit risk as their views

dictate. The main reasons for this are that

CDS indexes tend to be far more liquid and

much cheaper to trade than corporate bonds.

Difficulties with arbitrage

Hedging a CDS index with a portfolio of

bonds is particularly difficult due to the

diverse nature of the bond market. The

iTraxx® Europe Index is made up of 125 of

the most liquid names in the CDS market,

with 5- and 10-year tenures. In order to

execute a perfect arbitrage strategy, indi-

vidual physical securities, matching each

constituent of the index, would need to be

readily available in the bond market. This is

not always the case, as some issuers in the

index do not even have bonds outstanding

that can be used for a perfect match. Some

of the other difficulties that investors

encounter in finding perfectly matched secu-

rities are listed below:

� Liquidity – The bond market may not be

liquid enough to provide access to the

required securities at a reasonable size and

price. Some index components will have

no bonds that can be used, so access to

the loan market may be required. In table

1 (below) you can see that there are only

47 issuers or 72 bonds that are over

EUR 1 billion in size, highlighting the liq-

uidity difficulties that could arise when

accessing some of the smaller securities.

� Maturity – Matching maturity profiles of

all components of the index is also dif-

ficult. The iTraxx® Indexes are 5- and 10-

year instruments, but the maturity of cor-

porate bonds varies across the curve.

Thomson is an example, where matching

issuer and maturity is problematic. It is a

component of the iTraxx® Europe Index,

but the only corporate bond that could be

a match is a perpetual bond, which is

callable in 2015. Therefore, to match this

component of the iTraxx® investors would

need to choose between matching the

issuer risk or the maturity/curve risk, but

they could not match both.

� Covenants and seniority level – Some

bonds have covenants and seniority prop-

erties that can materially affect their value

and, hence, performance. Valeo is an auto-

mobile components company and a com-

ponent of the iTraxx® Index. It has two

bonds within the vicinity of the 5-year

tenor of the iTraxx® Index, maturing in

2013 and 2011. The 2011 bond, however, is

a convertible, so it is not really a suitable

match. The better selection would be the

2013 bond, but it has a change of control

covenant, meaning that the bond would

be bought back at 100 in the event of a

leveraged buyout or mergers and acquisi-

tions activity. As this bond currently trades

at a price of 92.7, it would outperform sig-

nificantly in such an event, while its corre-

sponding CDS within the iTraxx® Index

might be expected to perform badly. Thus,

if investors want to hedge the exposure to

Valeo within the iTraxx® Index, they would

need to accept this risk.

� Event risk (default) – In the case of a

default, the buyer of protection in the CDS

116 Case studies

Table 1

iBoxx® Europe Corporate Universe

Total

With duration between 3 and 7

Notional over EUR 750 million

Notional over EUR 1 billion

Number of issuers

304

254

137

47

Number of bonds

906

523

271

72

The iTraxx® Indexes are 5- and 10-year

instruments, but thematurity of corporate

bonds varies across the curve

market can choose between a set of bonds

that could be delivered, typically selecting

the bond that would be the cheapest to

deliver. On default, an arbitrageur that has

sold a bond, and sold protection on the

issuer’s corresponding CDS single-name

component of the index, may find the

bond delivered to them differs from the

bond they sold. As the buyer of protection

is always likely to choose the cheapest-to-

deliver security, this discrepancy is unlikely

to be in the arbitrageur’s favor. The value

of this option can go some way toward

explaining the dislocation between bond

and CDS markets.

Dislocation between the two markets can

persist as long as the cost of implemen-

tation is greater than the arbitrage oppor-

tunity. In current market conditions we

estimate that the dislocation would need to

be at least 10 bps for it to make a rea-

sonable investment proposition when taking

account of current transaction and repo

costs (i.e. the cost of borrowing securities to

take short positions). With the current

spread at just over 2 bps, it is hard to

imagine a dislocation this wide.

Conclusion

CDS are an important addition to the fixed

income manager’s armory. The rapid growth

of CDS volumes in recent years, and the

development of new instruments based on

CDS-type technologies, attests to the

instrument’s usefulness. However, in order to

use them efficiently, it is crucial to under-

stand the differences that can exist between

CDS and the underlying physical securities.

In particular, differences in risk character-

istics between physical bonds and CDS that

cannot be hedged, can result in valuation

differences between both single-name and

index CDS, and their associated physical

securities. Efficient use of CDS in a portfolio

requires a precise understanding of the dif-

fering sources of risk, and of their potential

impact on risk in a portfolio.

Barclays Global Investors (BGI) was

established over 30 years ago, and is

is the world's largest fund manager.

A subsidiary of Barclays Plc, the

company has a 3,369-strong workforce

worldwide and manages EUR 1,399

billion of assets for 2,903 clients globally.

BGI offers funds focusing on active,

index and asset allocation strategies, as

well as services including liability

driven investment, currency strategies,

cash management, securities lending,

hedging strategies, transitions and

commodities trading. BGI is the global

leader in the ETF business by assets

under management, via the

iShares range. BGI pioneered the first

index strategy in the 1970s and

continues to research and analyze

innovative ways to deliver risk-con-

trolled, cost-effective investment returns

for its clients.

Maria Ryan is a strategist in the

fixed income team, responsible for

relationships with fixed income clients

and investment consultants. She

joined BGI in September 2006, having

previously worked at Henderson

Global Investors as an investment

director responsible for U.K. pension

funds and at JPMorgan Investment

Management as a global fixed income

portfolio manager and client advisor.

Maria graduated from the University

of Limerick in 1990 with a Bachelors

degree in business studies, majoring

in economics and accounting.

117Case studies

No free lunch, but agood opportunity tomake money Banca IMI’s RRiiccccaarrddoo PPeeddrraazzzzoo explains the ‘skew’ in iTraxx® Indexes and showcasessome simple strategies that can be used to exploit it

118 Case studies

119Case studies

The fair value of the indexis approximately the

weighted average of theconstituents’ spread, with

the weights being the riskyDV01 of the constituents

The skew trade: the basics

A skew trade is simply an index-versus-con-

stituents arbitrage trade. To lock in the dif-

ference between the fair spread of an index

and the spread of its constituents, one would

buy or sell protection on the index while

buying or selling protection on its con-

stituents. The origin of the term ‘skew trade’

comes from the market practice of calling

the difference between the fair value and the

market price of the index the ‘skew’.

Skew trade opportunities arise across

the whole iTraxx® spectrum. For example,

the iTraxx® Main has 125 constituents,

each with a weighting of 0.8 percent. You

would expect that the price of the index

would equal the average of the constituent

spreads – but as we will see it is somewhat

different. Liquidity in the iTraxx® Main is

now very strong, and the bid/offer spread

is usually as low as 0.25 bp. Let us presume

that the constituents’ bid/offer spreads are

approximately 2 bps, so that the average

bid of constituents is 22 bps and the

average offer is 24 bps. You would expect

to find iTraxx®’s value somewhere around

23 bps, otherwise an arbitrage opportunity

would arise.

When you see an arbitrage opportunity

you have to ask yourself: how is this pos-

sible? The answer is typically down to liq-

uidity, market segmentation and trade exe-

cution issues. Liquidity in the iTraxx® Index is

very strong, so moves in the constituent

credit default swap (CDS) names usually lag

index movements, especially in fast-moving

or high-volume market conditions.

There are many different investors in the

iTraxx® Indexes. For example, there are flows

from macro traders, flows from structured

products desks, flows from the tranche

market, and flows that come from single-

name traders. All these traders and investors

are looking for different opportunities and

focus on different factors, thereby creating

the arbitrage opportunities.

As a result, if you look at the skew in the

most liquid iTraxx® Indexes (Main, Crossover

and HiVol), you will find that there is a pos-

itive correlation between the skew in dif-

ferent indexes: when flows arrive they hit all

the iTraxx® Indexes.

Defining the ‘fair spread’

There are three points in the calculation of

the fair spread. If you compare the simple

average of the constituents with the index

(as we did earlier), you are not using the fair

spread of the index because of cashflow mis-

matches at the point of default. In fact, you

are trading an index at a flat value of, say, 23

bps for each name, with 125 names at dif-

ferent values. To better understand this

effect, think of an index with only two

names, one trading at 50 bps and the other

at 150 bps. Is the correct value of the index

with only these two names the simple

average 100 bps? No. In fact, if one name

defaults, let us say the 150 bps name, you

will receive 50 bps from the ‘good’ name,

whereas you will pay 100 bps on the index. It

follows, therefore, that the fair spread must

have something to do with the level of

spreads and the probability of default of

each constituent. Indeed, the fair value of

the index is approximately the weighted

average of the constituents’ spread, with

the weights being the risky DV01 of the

constituents. You are, therefore, going to

weight names with high spreads (high prob-

ability of default) less, meaning that in a

replication strategy you are going to sell a

lower amount of names with higher

spreads, to compensate for the loss from

the cashflow mismatch at default.

The second point is the maturity mismatch

that appears in the three months when

single-name CDS roll and the index does not.

You usually have only 3-, 5-, 7- and 10-year

CDS prices, so you have to estimate the value

of constituents with the same index maturity.

The third point is the ‘quotation bias’ that

arises from the market practice of having

indexes with fixed initial spread levels

120 Case studies

(though this point is negligible in market

conditions, where the coupons and traded

levels are roughly equivalent).

From theory to practice

Execution plays a large role in skew trades.

It is difficult to lock-in the theoretical skew

for two reasons: the first is the operational

risk at the point of execution; the second

is that you need good firm prices from

several counterparties.

When you are confident with the level of

skew that you are going to lock-in, you have

to call a number of counterparties and try to

organize the trade. As the single-name is the

less liquid leg of the trade you have to start

with this, sending a list of bid/offer wanted

in competition (B/OWIC), to your counter-

parties. This quotation process can be quite

time-consuming for traders, so you can

expect to wait at least 15–20 minutes to

receive your quotes back.

Let us say, for example, that you called

your counterparties at 11:00 and asked them

to give you prices, from 11:30 for two

minutes. At 11:30 the first lists may arrive,

but you may not receive the remainder until

after 11:32, by which time the other offers

will have expired.

You now have to make your decision. You

have to compare the lists, pick the best

prices, check them against the index price to

ensure the level of skew is still good, and

then decide if you are prepared to omit

some of the names for which you did not

get good prices. The bad news is that you

have to do this very quickly – you have to

ask your counterparties to quote you prices

for a finite period and, of course, the longer

that period, the worse the prices. Depending

on the number of counterparties, as well as

the level of ‘last looks’ that you are com-

fortable with, the whole process can take

anything from two to ten minutes. While

sending your ‘done files’ on the single-name

trades, you have to try to get best execution

on the indexes.

‘Pure arbitrage’ versus ‘directional

cheap option’

The skew trade can be done for two main

purposes: either for ‘pure arbitrage’, or for

what is known as a ‘directional cheap option’.

Of course, you can also trade only a subset of

single-names versus the whole index, but

this is more of a ‘statistical arbitrage’ trade,

which we are not exploring in this instance.

The ‘pure arbitrage’ approach

In a ‘pure arbitrage’ trade you lock-in the dif-

ference between the fair value of the index

and constituents, receiving a positive carry.

You would like to minimize the P&L volatility,

by putting the trade on at a historically large

level of skew, thereby maximizing the chance

of being able to unwind the trade at a profit.

In a ‘pure arbitrage’ trade you have to wait

for a large skew, but growing competition for

these trades can make timing difficult.

Furthermore, large skews often arise in

periods of market volatility which of course

brings further execution issues.

In a ‘pure arbitrage’ trade you will

probably hold the trade for a while, in fact

your goal is to secure a positive carry

without any real risk (to do this, of course,

you have to hedge the mismatch of cash

flows at default with a ‘delta-hedge’). You

have to pay attention to the real level of

skew, as you cannot use the simple average

of constituents, but you have to look at the

fair value of the index. So you receive money

(the positive carry) for the mark-to-market

losses at inception and are exposed to P&L

volatility. But you have to bear in mind that

the P&L volatility can be very painful in

extreme market moves. In the second week

of July 2007, for example, the skew in the

Crossover Index rose to 20 bps compared to

Large skews often arisein periods of market

volatility, which ofcourse brings further

execution issues

a maximum of 10 bps just a week earlier. If

you locked the skew at 10 bps in the

Crossover (and this is a quite heroic

assumption), with EUR 5 million in each

name and EUR 200 million for the index, the

loss could be as high as EUR 1 million.

The ‘directional cheap option’ approach

Another way to exploit the skew is through

what we can call a ‘directional cheap option’.

There is a positive correlation between the

indexes and skew. In a spread-tightening envi-

ronment we would expect the skew to be

more negative: many flows arrive on the index

and single-name CDS lag this movement.

Otherwise, in a spread-widening environment

we would expect the skew to become more

positive: this is what we saw in the second-

week of July 2007 in the Crossover Index.

You can take advantage of the skew with

the ‘directional cheap option’ approach either

by executing a ‘plain vanilla’ trade, or by

buying or selling different amounts of the

indexes. For example, if the skew is negative,

you would expect to make money in a

widening environment because the skew

would become more positive. So you can buy

less of the index and, if the skew becomes

more positive, you will close the trade flat or

with a moderate gain. Or, if the skew remains

at the level that you locked in, you can earn

a more positive carry than you would have

done on the ‘plain vanilla’ trade.

121Case studies

Intesa Sanpaolo is among the top banking groups in the Eurozone, with a market capitalization of EUR 70 billion (as of August 31,

2007). It is the leader in Italy, with an average market share of more than 20 percent in all business areas (retail, corporate and wealth

management). With a network of more than 6,200 branches distributed throughout the country, and market shares above 15 percent

in most Italian regions, the group offers its services to about 10.5 million customers.

Riccardo Pedrazzo works on the credit derivatives desk at Banca IMI (Intesa Sanpaolo).

Some mathematics on the calculation of the index fair spread

Denoting with:

= the day-count fraction (ti - ti-1);

= the discount factor from time ti up to the evaluation date;

= the survival probability at the time ti as seen at the evaluation date.

The PV of the premium leg of a single CDS is:

The PV of an index of m single CDS is:

The PV of an index of m single CDS must be equal to

the sum of m PV of the very same m single CDS

We can find the spread S that solves the equation

As demonstrated, on coupon payment dates, all are almost the same, while on the

other dates the first is smaller. The equation can thus be seen as the weighted average of

the constituents’ spread with the weights being the risky DVO1 of the constituents.

The use of iTraxx®Options in corporatebond portfoliosUnion Investment’s SStteeffaann SSaauueerrsscchheellll explains how iTraxx® Options can be used inrelative value trades and hedging strategies

122 Case studies

123Case studies

It is vital to know theempirical facts of the credit options

market and, above all, the behavior of

implied volatility

nvestment companies through-

out Europe have increasingly

been using iTraxx® Index con-

tracts and iTraxx® Index Options to

actively manage systematic credit

risks in corporate bond portfolios.

As these investment companies

generally have a credit risk position in

their benchmark portfolios, it is natural for

them to use credit derivatives instruments

for hedging. However, the use of credit index

options also allows additional active and risk-

adjusted portfolio management strategies. In

addition to new option-based relative value

strategies as a further alpha source, spread

volatility can also be actively used as a new

asset class.

There are two types of credit index

options: payers and receivers. A payer is the

right to buy a specific spread level protection

for a credit index. In other words, an investor

who has bought a payer has a put position in

corporate bonds and expects the credit

spread to expand. A receiver is the right to

sell a specific spread level protection for a

credit index. An investor or a trader who has

bought a receiver has a call position in cor-

porate bonds, and expects the credit spread

to narrow.

The maturities of the liquid index options

are between one and six months and are

based on the current 5-year iTraxx® Index

contracts. The final maturity of the liquid

iTraxx® Options is, in each case, the 20th of

March, June, September or December.

iTraxx® Options are European options, (i.e.,

they can only be exercised upon maturity).

As a rule, prices are listed in cents or as a

percentage of the nominal value of the

option1. Option buyers must pay the writer

an upfront premium. If an in-the-money

index option is exercised, settlement is

made physically.

Index option buyers receive a short (in

the case of a receiver) or long (in the case

of a payer) protection position in the

respective index contract from the option

writer. In the event of a credit default, the

iTraxx® Option continues to be traded

without the defaulted name. If, for

example, payer buyers exercise this type of

option, they receive a long protection index

position from the payer writer. The payer

buyer also receives a long protection

position in the name subject to the credit

event from the payer writer.

The options with the tightest bid/offer

spreads are the at-the-money index options.

At present, iTraxx® Crossover Options have

the highest volume of liquidity. However,

with the further growth of the credit deriva-

tives market, it is expected that there will be

more liquidity in the iTraxx® Main and

iTraxx® HiVol Options.

To properly use credit index options, it is

vital to know the empirical facts of the credit

options market and, above all, the behavior

of implied volatility. A modified Black-Scholes

model is used to price credit index options:

the implied credit spread volatility, and the

forward spread levels, are the key factors that

impact on the option price.

The difference between implied and

realized credit spread volatility, the so-called

volatility risk premium, is comparatively large

I

1One cent is 0.01 percent of the notional.

in normal credit market situations. Chart 1

(above) shows the difference between the

implied and realized spread volatility of the

iTraxx® Main in the period from April 2005

to June 2007.

In periods of stress, such as that experi-

enced in the credit market in the April–May

2005 period, the implied volatility of iTraxx®

Main Options increases and the volatility

risk premium falls. The implied credit spread

volatility is, therefore, directional. If the

credit spread widens, both the implied and

historical spread volatility will increase. If

the spread narrows, they will fall. These

empirical correlations also apply for iTraxx®

HiVol and iTraxx® Crossover Options.

The volatility risk premium in the credit

market is high compared with other

financial markets, such as the equities

market. The large difference between the

implied and realized spread volatility can

largely be explained by the imbalance

between supply and demand: whereas

options traders at banks and brokers act as

net writers of volatility, most credit

investors are net buyers of volatility.

124 Case studies

In the credit market, the volatility skew, or

the curve of the implied volatilities of the

individual strike spreads, is comparatively flat.

However, when the strike spread increases,

there is a tendency for implied volatility to

rise. Chart 2 (below) illustrates the correlation

for the iTraxx® Main Index.

As a rule, implied volatility increases with

the remaining maturity of the index option.

Inversions may result in periods of stress in

the credit market. In this case, credit index

options with a shorter maturity will have

higher implied volatilities.

The use of index options affords managers

far greater flexibility in determining the

opportunity/risk profile of their top-down

credit strategies. For portfolio managers, the

use of iTraxx® Options is primarily of interest

to hedge against an imminent or possible

widening in credit spreads. Individual

strategies can also be tailored to the needs of

particular credit portfolios through a careful

combination of long and short positions in

payers and receivers.

For instance, a risk reversal or bearish

cylinder can be set up as an optional alter-

native strategy to buying credit protection. In

this trade, an out-of-the-money receiver is

written and an out-of-the-money payer is

bought. The trick is for the written option

position to mostly finance the payer, or the

credit put buy. This approach protects

investors from strong increases in the spread,

however, they must accept a loss in the

option position if the spread narrows further.

Chart 3 (top, right) shows the oppor-

tunity/risk structure at maturity for a

bearish cylinder position on the iTraxx®

Main S7.

The position entails writing a receiver

with a strike at 21 at 5 bps. A payer with a

Chart 1

Chart 2

Source: JPMorgan, Union Investment

Sour

ce: U

nion

Inve

stm

ent

strike at 25 at 6 bps is bought with on the

same notional. The spot spread of the

iTraxx® Main was almost 22.5 when the

position was opened, and the volatility

skew between the two strike spreads was

comparatively steep at 4 volatility points.

The cost of this hedging strategy would

have been lower if the volatility spread had

been less steep.

If the iTraxx® Main Index remains between

the two strike spreads of 21 and 25 at

maturity, the position costs 1 bp. Breakeven

for the entire position is the iTraxx® Main S7

at 25.25. That means that hedging would

start at this index level. If the spread widens

to 30 in the iTraxx® Main S7 by September

20, 2007, the position would enjoy a profit

of 20.5 bps based on the notional of the

payer position. Conversely, the position

would suffer a loss below spread levels of 21

for the iTraxx® Main, and at an index of 17

on maturity, the entire position would have

made a loss of 18 bps based on the notional

of the receiver.

Compared to the outright sale of pro-

tection on the iTraxx® Main Index, less carry

has to be paid. If the index is between the

two strikes upon the options’ maturity, the

investor suffers a loss of 1 bp from the

option position. However, the investor can

collect the carry premium from the cor-

porate bond portfolio.

This cylinder strategy shows just one way

in which index options can be used to make

hedging strategies more flexible. In addition

to traditional hedging strategies, investors in

the credit options market can benefit from

higher volatility premia by writing volatility

using straddles or strangles. A multitude of

relative value strategies can also be deployed

with options – for example, volatility skew

steepening or flattening positions are

examples of relative value strategies. In stress

situations with rapid spread increases, the

volatility skew may flatten off in the credit

option market, with increasing implied

volatilities. This is due to institutional

investors’ high demand for at-the-money

payer options. In this situation, a portfolio

manager can benefit from a volatility flat-

tening position by buying a payer option

with a higher strike spread and selling

another with a lower strike spread.

As liquidity continues to increase in the

credit derivatives market, there will doubtless

be a reduction in the volatility risk premium

for iTraxx® Options. This will lead to a

reduction in the profitability of volatility

option strategies and some relative value

option strategies, however, the increased liq-

uidity and standardization will also allow a

much wider group of investors to efficiently

hedge their corporate bond portfolios.

125Case studies

Union Investment was founded in 1956 and ranks among the three leading German fund managers by market share. Its principal share-

holders include German co-operative banks and highly respected international private financial institutions. Assets under management

totalled over EUR 130 billion as of May 2006.

Stefan Sauerschell studied economics at Johann Wolfgang Goethe-University in Frankfurt, where he focused on finance and statistics. In

July 1999 he joined Union Investment as an FX portfolio manager. In 2001 he became fixed income portfolio manager and since October

2002 he has also been responsible for producing credit research on brokerages and U.S. banks.

Chart 3

Opportunity funds:the thinkinginvestor’s CDO BlueBay Asset Management’s DDiippaannkkaarr SShheewwaarraamm presentsthe case for opportunity funds

126 Case studies

CDO issuance hasbecome less about

doing the right deal atthe right time and moreabout doing all deals in

all market conditions

ate last year the col-

lateralized debt obli-

gation (CDO) market

breached the USD 1

trillion mark; a major

milestone for a market

that was worth under

USD 100 billion just six

years ago. In the wake of the record down-

grades and defaults of 2001/2002 the CDO

market was about as popular as a mosquito

at a barbeque. Thanks to the 2003 credit rally

and significant improvements in the credit

environment, as well as innovation by deal

structurers, the CDO market has been gaining

acceptance across an ever-widening range of

investors. Today, the CDO space is one of the

most rapidly growing segments of global

derivatives markets. And investors’ appetite

for CDO-type structures shows no sign of

abating. CDOs might be flavor of the day but

they are not without limitations. With few

viable alternatives available, investors have

been willing to overlook some of their struc-

tural flaws. But a new breed of structures is

emerging – in particular, there is a growing

interest in opportunity funds, or ‘hybrid

CDOs’ as they are sometimes known.

The CDO challenge

The CDO market, as we know it today, has its

origins in the collateralized bond obligation

(CBO) market that began to develop in the

mid-to-late 1990s. Investors sought to take

advantage of some kind of arbitrage in the

market (hence typical CDOs are also known

as arbitrage CDOs), essentially by buying a

cheap asset and locking in the relative value

over a period of time. The logic is that as the

asset quality improves, the overall value of

the investment improves. This is attractive to

investors because both the financing cost

and leverage are fixed. Of course, this does

require a certain element of market timing –

CDOs are all about doing the right deal at the

right time. The ideal period for issuing CDOs

being at the bottom of the credit cycle when

investors are able to lock–in cheap assets.

Today, arbitrage deals are the main driver

of growth in the European CDO market. But

CDO issuance has become less about doing

the right deal at the right time and more

about doing all deals in all market conditions.

This was precisely why some investors got

their fingers burnt during the 1999–2001

period – asset managers then were issuing

CDOs as a product for all seasons. What we

are seeing now is not dissimilar. The chal-

lenge to CDO managers is that, as specialists,

they need to continue to issue and replenish

these vehicles. They have limited options or

incentives to return capital and if their only

business is to manage CDOs, they are likely to

be motivated to keep issuing them. What

they are essentially saying is that they are

going to leverage high-yielding assets on a

term basis, regardless of market conditions

and necessarily over the course of a credit

cycle – as most transactions have a term of

twelve or more years.

Provided you can take advantage of market

conditions you believe in, and you have

enough time to buy the assets without being

forced to buy the market, opportunistic CDO

issuance is a good thing. But programmed

issuance is not – it necessarily implies that

some of the CDOs may underperform.

CDOs – know their limits

While under certain market conditions CDOs

clearly have their advantages, they do have a

number of structural shortcomings. They are

very much an asset class play. A typical CDO

structure is backed by a single asset class –

usually leveraged loans or asset backed secu-

rities (ABS) – and has little flexibility to invest

in different parts of the capital structure.

Traditional cash CDOs are also highly

leveraged – often ten to twelve times at a

L127Case studies

fixed level for a 12- to 15-year term. This

time period is necessarily going to include a

credit cycle; but with little flexibility on the

asset composition front and no control over

leverage, CDOs are consequently challenging

to manage through the cycle.

Another major drawback is that they

offer investors limited liquidity – CDO

tranches are typically traded as instruments

and redemption options are very limited.

A typical CDO leads a somewhat schizo-

phrenic existence – it is regulated, in a sense,

by the rating agencies; they look at the sta-

tistical default probabilities of the underlying

collateral and impose constraints that limit

the managers’ flexibility to manage the port-

folio. The ultimate aim being to protect the

debt which provides the leverage to the port-

folio. CDO equity investors, meanwhile, are

looking for attractive total returns from the

manager. Yet that manager is being con-

strained – and regulated on a day-to-day

basis – by parties that have no interest in

high returns for the equity tranche.

So, in a credit downturn it becomes much

more difficult for the manager to actively

manage risk. It also means that managers may

face a conflict of interest in managing the

portfolio for both debt and equity investors.

One other thing for investors to consider is

that they run the risk of buying into a

bubble. Lured by the instant gratification of

accumulating significant assets under man-

agement (AUM) very quickly, everybody and

his brother are launching a CDO/CLO.

Yet some managers are entering the

market without experience in the asset class,

the instruments or even the structural

framework. In addition, the overlap between

collateral pools in CDOs of a given asset

class may be very high between transactions

of similar vintage, leaving very little flexi-

bility to react to a downturn. When things

do go wrong, CDOs/CLOs will be subject to

some of the limitations we mentioned. And

within each asset class they will likely be

very correlated.

Opportunity funds: lots of advantages,

less limitations

Luckily, the structured products area is con-

stantly evolving to suit more types of assets

and different market conditions. Opportunity

funds combine some of the main benefits of

traditional CDOs and hedge funds, while

minimizing many of their limitations.

So, what are opportunity funds?

Essentially, these are low leverage structures

in which the manager has considerable flexi-

bility in portfolio construction, the ability to

go short (generally) and controls financial

leverage (typically without the involvement

of rating agencies).

Opportunity funds are actively managed,

and have the flexibility to invest in different

parts of the capital structure. Like a conven-

tional CDO, opportunity funds use financial

leverage to enhance total returns. But

leverage is modest and it is not the whole

story – these structures use a combination of

financial leverage and active management to

generate returns. What is more, it tends to be

the more stable, less risky assets in the

capital structure that are leveraged.

Opportunity funds have a number of

structural advantages. CDOs are relatively

inflexible trading vehicles – they tend to be

individual deals that have a single closing

and, therefore, their performance is highly

tied to the market conditions in which they

are closed or traded.

Opportunity funds, by contrast, are open-

ended and scalable. And that is very attractive

to investors – while CDOs are all about

finding the right manager with the right deal

at the right time, investors in an opportunity

fund can invest on their own timescale. What

is more, CDOs do not tend to have a self-

repair mechanism for leveraged investors.

So, once a certain level of losses occurs in

a CDO, cash flows are triggered away from

the equity holders to pay down the debt

holders. In a time of crisis, excess income in

Lured by the instantgratification of accumulating

significant assets undermanagement very quickly,everybody and his brother are launching a CDO/CLO

128 Case studies

the structure is taken away and used to pay

down the investors that, in a sense, need it

the least – i.e. the debt holders at the top

who already have the subordination pro-

tecting them.

There are typically no such triggers in

opportunity funds – even if there is a default

in the portfolio, investors in the equity por-

tion continue to receive the income stream

coming from the portfolio and, therefore, still

have the opportunity, over time, to recover

the total return of their investment.

It is all about the manager

Given the importance of alpha in an oppor-

tunity fund structure, the choice of asset

manager is absolutely crucial. A CDO/CLO will

generate returns in the presence of a manag-

er that does not trade – they could just pick

and hold assets to maturity as it is primarily

financial leverage of high income that gen-

erates the return. In an opportunity fund

structure, a significant part of the total return

will come from alpha generation and will

depend on the credit selection, trading capa-

bilities and sector skill of the asset manager.

Investors should, therefore, be looking for

a manager who has been managing the asset

class through the credit cycle and has been

managing the various components of the

portfolio for an extensive period of time.

Fundamentally, the manager needs to have a

short capability to manage the beta risk;

however, going short in any market can be

expensive if you cannot extract value

because it reduces returns to investors.

Stable returns throughout the credit cycle

An opportunity fund is a unique structure

designed to deliver capital preservation and

alpha generation throughout the credit cycle.

A varied and flexible toolbox enables the

portfolio manager to take what is essentially

a ‘best of asset class’ view on the portfolio

construction, irrespective of market condi-

tions. The manager can proactively and

dynamically manage the asset mix across the

capital structure from stable assets to stres-

sed and distressed assets. The assets can be

either fixed or floating, cash or synthetic.

Once the manager has constructed the

optimal portfolio for the prevailing market on

the long side, he also has the opportunity to

use a large short bucket to stabilize the port-

folio as required.

An opportunity fund is also a lightly

leveraged vehicle with the flexibility to adjust

overall leverage on the fund, as well as on

individual assets, depending on prevailing

market conditions. In summary, portfolio

construction is in the hands of the manager.

A hedge fund/long-only hybrid

While this is a new product in the market,

the asset classes and techniques it employs

are not. An opportunity fund strikes a

balance between hedge fund and long–only

investment types. It employs many of the

tools and techniques used in both invest-

ment strategies – leveraging these skills and

tools and applying them in a different ratio.

Opportunity funds embody many of the key

elements of a long-only fund – for instance,

they are often EU-domiciled, may be listed

and typically publish weekly NAVs and offer

significant transparency in terms of the asset

holdings. There are typically sector and issuer

constraints, albeit broad-based ones, and asset

bucket constraints in terms of minimum and

maximum allocations (unlike a hedge fund in

which there are no limitations). But by the

same token they do have some hedge fund-

129Case studies

130 Case studies

like characteristics – most opportunity funds

have a very sizable short bucket as well as the

ability to invest across asset classes, unlike a

traditional long–only fund.

Opportunity knocks

It is still early days for opportunity funds and

they remain the contrarian trade, primarily

because the market is awash with CDOs and

this is what institutional investors are buying.

There is nothing wrong with CDO technology

per se, but it is subject to some of the limita-

tions we have outlined above.

Given the numerous attractive features of

the opportunity fund-type structure, it seems

inevitable that these will evolve at the

expense of CDOs/CLOs.

Opportunity funds are also evolving as an

alternative to traditional hedge funds –

investors who cannot invest in hedge funds

because of their domicile or lack of trans-

parency or their fee structures can incor-

porate opportunity funds into their asset

bucket; this is a ‘long plus’ or a ‘regulated

hedge fund’-type strategy for those investors.

The long-only world is evolving in this way

because there is a distinct need to become

more flexible and open-minded in terms of

types of assets and the allocation to alterna-

tives investors are considering.

Up until now, opportunity fund struc-

tures have been primarily used in the high

yield and leveraged loan domain. But the

same concept can work equally well with

other asset classes – emerging market debt

lends itself particularly well to this type

of structure .

CDOs clearly have their benefits at the

right time and the right place; they are par-

ticularly suited to market conditions that do

not require active management. With the

credit environment beginning to look

decidedly less friendly, the advantages of

opportunity funds are clearly beginning to

outweigh those of traditional CDOs.

BlueBay Asset Management Plc was founded in 2001. It is one of the largest independent managers of fixed income credit funds and

products in Europe, with assets under management of approximately USD 13.1 billion (as at June 30, 2007). Based in London, with offices in

Tokyo and New York, it provides investment management services to institutions and high net worth individuals globally. BlueBay provides

long-only, long/short and structured products across emerging market, high yield and investment grade credit. The company, which was

admitted to the official list of the U.K. Listing Authority and to trading on the main market of the London Stock Exchange in November 2006,

also manages segregated mandates on behalf of large institutional investors.

Dipankar Shewaram is a senior portfolio manager at BlueBay. He joined the firm in March 2002 from ING Barings, where he worked as a

proprietary trader responsible for emerging market exposure. He previously spent two years at BNP Paribas as a senior emerging market

strategist focusing on the European and Middle Eastern markets, and two-and-a-half years at Deutsche Asset Management as a portfolio

manager. Dipankar holds a BSc in economics from University College London and an MSc in finance and economics from the London

School of Economics.

CDOs clearly have theirbenefits at the right time

and the right place

Input to our process comesfrom our fundamental

buy-side credit research and from our quantitative

modelling techniques

he birth of the credit

derivatives market has

transformed the cor-

porate bond market, as

well as the investment

approach of traditional

portfolio managers. This

case study analyzes the

use of iTraxx® Indexes in euro corporate

mandates at UBS Global Asset Management,

putting particular focus on the required

adjustments to our investment philosophy

and process when shifting from traditional

cash bond portfolio management to a

combination of cash bonds and credit

index derivatives.

Firstly, we will look at the investment phi-

losophy and process for traditional cash

bond mandates. Then, we will examine how

integrating iTraxx® Indexes into the invest-

ment universe impacts on the manager’s phi-

losophy and investment process.

Investment philosophy for traditional cash

bond mandates

UBS Global Asset Management’s investment

philosophy is based on three layers of

decision and sources of out-performance:

‘market alpha’, which reflects the overall

mandate beta exposure relative to the index,

‘sector alpha’, which represents industry,

rating and subordination strategies relative

to the index, and ‘issuer alpha’, which corre-

sponds to the selection of issuer and matu-

rities within a sector.

As shown in the graph, on the following

page, the three levels interact in a building-

block fashion.

UBS Global Asset Management.’s MMaarrttiinnee WWeehhlleenn--BBooddéémakes the case for using iTraxx® Indexes within traditional euro corporate bond portfolios

T

131Case studies

The use of iTraxx® Indexes in traditional eurocorporate portfolios

bonds. Additionally, the indexes allow market

views to be implemented in a timely manner.

Because of these advantages, we use the

iTraxx® Indexes for our daily portfolio man-

agement activities.

Impact on investment philosophy

As cash bond investors, we can adjust our

beta exposure with cash bonds, meaning

that we can use cash bonds to go long and

short beta versus a corporate bond bench-

mark. However, costs and speed issues can

be significant with cash bonds. Using the

iTraxx® Indexes instead, we can significantly

reduce our transaction costs and speed up

our reaction times, making short-term tac-

tical moves more interesting. So, while we

are not really creating new sources of alpha

through the index transactions, we are gen-

erating important efficiency gains and

shorter-term opportunities.

From an investment philosophy point of

view, however, there are two considerations:

1. Does the absolute out-performance

target require adjustment?

2. Does the split in performance contri-

bution from the ‘market alpha’, ‘sector

alpha’ and ‘issuer alpha’ change?

Given the efficiency gains that can be made

from using iTraxx® Indexes, the level of

expected out-performance should be raised.

To evaluate the impact, we looked at the

track record of a euro corporate investment

grade portfolio with a maximum derivatives

allocation of 15 percent. Without leverage,

the potential out-performance increased

by 15 bps.

As far as the performance contribution

from the various different sources of alpha

goes, our performance attribution model

demonstrates that about 60 percent of out-

Indexes allow market viewsto be implemented in a

timely manner

Sour

ce: U

BS G

loba

l Ass

et M

anag

emen

t

Investment process for traditional cash

bond mandates

Input to our process comes from our funda-

mental buy-side credit research and from

our quantitative modelling techniques.

These are the central starting points for our

investment decisions. Our team-based

approach combines the input of the quanti-

tative research and credit analyst groups

with portfolio management views, while

qualitative considerations help us to imple-

ment our strategy at the most advanta-

geous price.

Use of iTraxx® Indexes and the impact on

our investment process and philosophy

By using the iTraxx® Indexes, the market beta

and, to a certain extent, the sector beta can

be easily altered. This allows an efficient

implementation of long or short beta posi-

tions versus a corporate bond benchmark.

Index transactions can be realized in large

volume without great market impact and at

significantly lower transaction cost than cash

MARKET ALPHARelative Market Beta

SECTOR ALPHAIndustry Rating Subordination

ISSUER ALPHA

Issuer Maturity

132 Case studies

The market is no longersolely influenced by cashbond buyers, but also by

derivatives buyers

performance is generated by the ‘issuer

alpha’ and 40 percent is generated by the

‘market alpha’ and ‘sector alpha’. Using the

iTraxx® Indexes, speed and size are no longer

issues. Moreover, the indexes even allow us

to profit from smaller market movements, as

our breakeven costs are much lower. Thus,

the ‘market alpha’ and ‘sector alpha’ should

gain in importance using iTraxx®, and we

should expect their performance contri-

bution to increase accordingly. In short, we

should expect 50 percent of the alpha to be

generated by the ‘issuer alpha’ part and 50

percent by the ‘market alpha’ and ‘sector

alpha’ strategies.

Impact on the investment process

Trading in the EUR-denominated corporate

bond market has increasingly concentrated

on the derivatives side. This has meant that

the market is no longer solely influenced by

cash bond buyers, but also by derivatives

buyers such as financial companies or hedge

funds. The increasing concentration of

volumes on the synthetic side of the market

has also meant that sentiment is much more

visible here than in the cash market.

The impact of derivatives activity is cap-

tured in the qualitative part of our investment

process, where we study two technical

factors on a daily basis. Firstly, we look at the

skew – this being the difference between the

index spread and the underlying CDS. A pos-

itive skew (in which the spread of the index

is higher than the intrinsic spread of the

underlying CDS) is a good indication of a

high level of protection buyers, and vice

versa. Secondly, we look at the implied

volatility of the credit default swaptions,

which give a good indication of market nerv-

ousness. These two factors complement our

qualitative data.

On the credit research side, we have to

decide whether we want to research all the

index components before entering an

iTraxx® transaction. Because the index is

well-diversified and represents systematic

risk, issuer-specific risk does not warrant

individual coverage. This is especially true

for the iTraxx® Main Index, which consists

of 125 equally-weighted components.

Anyway, the iTraxx® universe has a high

level of research coverage at UBS Global

Asset Management.

Conclusion

We can say that the use of credit deriva-

tives indexes does not change the broad

investment concept, however, it does

introduce additional considerations into the

investment philosophy and process.

Furthermore, this case study demonstrates

that the investment philosophy and processes

cannot be static, but have to be reviewed and

adjusted to changes in market structure and

available instruments. The incorporation of

single issuer CDS into the investment universe

warrants the same considerations.

UBS Global Asset Management is

one of the world's leading

investment managers, providing

traditional, alternative and real estate

investment solutions to private, insti-

tutional and corporate clients, both

directly and through financial inter-

mediaries. The group offers a wide

range of innovative investment

products and services through a

global structure. Its approach com-

bines the expertise of investment pro-

fessionals with sophisticated risk

management processes and systems.

The investment areas comprise

equities, fixed income, alternative and

quantitative investments, global real

estate, global investment solutions

and infrastructure.

Martine Wehlen-Bodé heads the

euro corporate strategy team within

UBS Global Asset Management. The

team sets the strategy and manages

various investment funds and client

mandates in the EUR-denominated

corporate investment grade area.

133Case studies

he year 2007 was indelibly

marked by the subprime

mortgage collapse that shook

the credit markets. It is too

early to predict the exact

outcome of this so-called

‘credit crunch’, but we can safely

say that much will change in the wider credit

markets as a result.

The credit derivatives markets have by no

means been immune from the market

turmoil but, in some significant areas, they

have more than proved their worth – most

notably by their resilience. When liquidity

dried up in the cash credit markets and

trading came to a standstill, the credit deriv-

atives markets – in particular, the benchmark

iTraxx® Indexes – remained liquid. In fact,

iTraxx® volumes exceeded all expectations.

This not only provided hedgers and investors

with a vital route for trading in and out of

the credit market, but also supplied them

with the all-important pricing data with

which to value their positions.

The fact that liquidity largely remained

buoyant in the credit derivatives markets,

while the cash markets faltered, only served

to further underscore the pivotal position of

derivatives instruments within the credit

spectrum. But the dramatic volume surge

took its toll on back and middle offices. The

operational teams that support the all-

important trade affirmation, confirmation and

booking process struggled to keep pace with

the rise in ticket numbers. The delays in doc-

umentation and settlement led to an increase

in trade backlogs, valuation difficulties and

additional risk. At the same time counterparty

credit risk deteriorated quite dramatically.

Combined, these factors resulted in dealers

and buyside firms being left with uncon-

firmed trades, unquantified exposures and no

precise means of gauging the amount of

counterparty credit risk that they faced. All at

a critical juncture.

According to data published by infor-

mation provider, Markit, the amount of out-

standing confirmations rose sharply during

the summer period. Even worse, the amount

of outstanding credit derivatives confirma-

tions aged over 30 days rose to their highest

level since 2006. As a result dealers’ risk

management groups, buyside firms and

regulators will now all be seeking reas-

surance that operational improvements

are underway.

Among others the likely outcome of the

current turmoil is increased regulation –

though again it would be premature to try

and predict what shape this may take.

Another is an increased focus on the need

for accurate, independent valuation data

based on reliable, realtime transparent

market information. Those involved in the

credit derivatives market – and those still

poised on the fringes – will meanwhile

place a greater importance on liquidity and

on mitigating counterparty credit risk.

All of these issues play to the strengths

of exchange-listed, centrally cleared

products. Listed instruments offer definite

benefits to market participants in the form

of transparent mark-to-market valuation

and substantially reduced counterparty risk.

Thus, once the dust settles and investors

start to return to the credit markets, they

should go some way to help ensure greater

market stability.

T

Credit derivatives:outlook, challengesand perspectives By Natasha de Terán

134 Conclusion

"The market turbulence has provided the exchanges with a golden opportunity to challenge the much larger market in over-the-counter, or private

bilateral deals, as investors reassess counterparty risk and seek the advantages of centralised clearing … The exchanges also provide the certainty of

valuations from assets marked-to-market one or more times a day, unlike the more opaque OTC markets."

Doug Cameron, Financial Times, August 28, 2007

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