1. CREDIT DERIVATIVES PRIMER Jasper Kim, JD/Esquire

2. 2 Seminar Outline: 5 Parts Ⅰ. Int’l Finance 101 - Nature/overview of basic/plain vanilla financial products (incl. debt, equity) Ⅱ. Derivatives Products – Rationale & Background Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations, including (but not limited to): - Options - Futures - Swaps (including fx, cds, interest rate, baskets) - Credit Linked Notes (CLNs) - Asset Backed Securities (ABS) - Special purpose vehicles (SPVs) with embedded derivatives Ⅳ. Derivatives Documentation: ISDA & Beyond Ⅴ. Q&A

3. Ⅰ. Int’l Finance 101

4. 4 Ⅰ. INT’L FINANCE 101 Q: What is the purpose of the international financial markets? In other words, why are we here?

5. 5 Ⅰ. INT’L FINANCE 101 Int’l Financial Markets Serve 2 Purposes: –Transfer funds from parties with surplus funds to parties who need funds –Transfer funds to redistribute the unavoidable risk associated with cashflow generated by tangible asset among those seeking and providing funds

6. 6 Ⅰ. INT’L FINANCE 101 WHAT TRIGGERED THE GLOBALIZATION OF THE MARKETS?

7. 7 Ⅰ. INT’L FINANCE 101 4 REASONS: Deregulation/ Liberalization of markets and IFC’s Tech advances for analyzing/ selling/ executing order –Ex: PC’s, Bloomberg Increased fin market institutionalization –Shift from retail to institutional investor demand –Institutional investors more willing to transfer funds overseas Emerging market participation (Markets relating to developing to developing countries)

8. 8 Ⅰ. INT’L FINANCE 101 WHAT’S THE DIFFERENCE BETWEEN ‘EQUITY’ AND ‘FIXED INCOME’ PRODUCTS?

9. 9 Ⅰ. INT’L FINANCE 101 DEBT ≒ ‘Fixed Income’ products/markets ≒ Instruments requiring fixed payments (of principal plus interest) to the investor in exchange for the issuer to borrow funds (principal)

10. 10 Ⅰ. INT’L FINANCE 101 EFFECTIVELY, WHAT DOES THIS MIRROR?

11. 11 Ⅰ. INT’L FINANCE 101 DIAGRAMS FOR DEBT CASHFLOWS Issue Rate Interest Payment Dates Maturity Date ISSUERINVESTOR Bond Note Principal (P) ISSUER INVESTOR R ISSUERINVESTOR Note P

12. 12 Ⅰ. INT’L FINANCE 101 ‘EQUITY’ MARKETS/PRODUCTS: Gives the ‘equity holder’ a certain percentage (%) of ‘equity’ (ownership) interest of the issuer

13. 13 Ⅰ. INT’L FINANCE 101 ISSUERINVESTOR Equity Paper Face Value ISSUER INVESTOR Dividends (if applicable)

14. 14 Ⅰ. INT’L FINANCE 101 BOTH ‘DEBT’ AND ‘EQUITY’ PRODUCTS ARE = ________ ?

15. 15 Ⅰ. INT’L FINANCE 101 THERE ARE 2 TYPES OF ‘MARKET PLAYERS’: WHAT ARE THEY?

16. 16 Ⅰ. INT’L FINANCE 101 BUYERS (=INVESTORS) = ? SELLERS = ?

17. 17 Ⅰ. INT’L FINANCE 101 WHAT ARE THE MOTIVATIONS OF BUYERS ? WHAT ARE THE MOTIVATIONS OF SELLERS ?

18. 18 Ⅰ. INT’L FINANCE 101 WHAT ARE THE 2 EMOTIONS THAT RULE WALL STREET?

19. 19 Ⅰ. INT’L FINANCE 101 GREED = BUYERS OR SELLERS? FEAR = BUYERS OR SELLERS?

20. 20 Ⅰ. INT’L FINANCE 101 WHAT HAPPENS IF THE CENTRAL BANK RAISES INTEREST RATES?

21. 21 Ⅰ. INT’L FINANCE 101 EQUITY MARKETS?

22. 22 Ⅰ. INT’L FINANCE 101 DEBT MARKETS, GENERALLY? BOND PRICES? BOND YIELDS?

23. 23 Ⅰ. INT’L FINANCE 101 The markets compensate players for ‘risk-taking’ Higher Risk, Higher Return/Premium/Yield, and vice versa You have products like high risk, high yield bonds THEREFORE

24. 24 Ⅰ. INT’L FINANCE 101 In the credit derivatives markets: 1. Risk is transferred from P1 to P2 (effectively, taking a ‘view’ or ’position’) 2. The new risk-taker (P2) is compensated for taking such risk * Note: generally, only the ‘risk’ (not legal ownership) is transferred

25. Ⅱ. Derivatives Products – Background & Rationale

26. 26 Ⅱ. Derivatives Products – Background & Rationale The SURGE in credit derivatives: South Korea: – Currently (2007): 30 trillion won in credit derivatives products – In 3 short years (2010): over 100 trillion won The World: – Currently (2007): over $948 trillion (total gross outstanding) – (2003): $2,306 billion

27. 27 Ⅱ. Derivatives Products – Background & Rationale

28. 28 Ⅱ. Derivatives Products – Background & Rationale

29. 29 –Responsibilities of the Legal Risk Manager  Understanding the Markets  Fixed Income  Equity  Commodities  Foreign Exchange  Emerging Markets –Understanding the Businesses as a Lawyer  Market-driven Trades  Proprietary Trading  M&A  Underwriting / Syndication  Loan Lending & Trading  Asset Management Ⅱ. Derivatives Products – Background & Rationale

30. 30 –Legal Risk Management Common Sense  Transparency of Risk  Professional Judgment  Experience –Conventional Market Risk Measures  Relevant Benchmarks  Historical Volatility  Sector Exposure  Regional Exposure (by region)  Currency Exposure  Market Exposure (by country) Ⅱ. Derivatives Products – Background & Rationale

31. 31 Credit Risk Management  Fundamental and traditional risk measurements  Underwriting standards  Rating Categories  Due Diligence and Monitoring  Portfolio Risk Limits  Average Rating  Minimum Rating  Maturity  Diversification  Risk mitigation (workout)  Expected Default Frequency Ⅱ. Derivatives Products – Background & Rationale Introduction to Risk Management and Value-at-Risk (VaR)

32. 32 Most Active Transactions: Asset Swap Total Return and Index Swap Default Swap Structured Instruments: Credit Linked Notes (CLNs) Credit Spread Option CBOs, CLOs, Synthetic CLOs Synthetic Leveraged Loan Synthetic Revolving Credit Agreements Ⅱ. Derivatives Products – Background & Rationale Credit Derivatives Overview

33. 33  Flexible Credit/Sector Exposure Tailoring  Access: Sourcing names and maturities not available through cash instrument market  Flexibility: Uncoupling of interest and credit exposure  Diversification  Yield Enhancement  Exposure to short maturities  Relative Value and Replication  Hedging  Market plays Ⅱ. Derivatives Products – Background & Rationale Credit Derivative Strategies

34. 34 Ⅱ. Derivatives Products – Background & Rationale The BIS Risk Weights Type of Reference Entity BIS Risk Weight Charge as % of Notional OECD Government0%0.0% OECD Bank20%1.6% Other100%8.0%

35. 35  Internal and External Education  Infrastructure: Compliance, Trading, and Accounting Systems  Signing ISDA Agreements  Several hundred plan sponsors and separate accounts  Multiple dealers and banks  A dozen custodians  Legal resources  Shortcomings of the Standard Representations in ISDA  Not developed for investment managers acting as agent  Often impossible for managers to make  Requires involvement of plan sponsors and custodians Ⅱ. Derivatives Products – Background & Rationale Client Challenges

36. 36 Documentation Trading Counterparty Risk Management Compliance Accounting and Custodial Ⅱ. Derivatives Products – Background & Rationale Infrastructure Issues

37. 37  Limited Recourse Sub-account managed by manager or bankruptcy remote trust  Size Matters No trigger with account size change May require lower collateral threshold and minimum transfer  Collateralization Eligibility Threshold and minimum transfer amount  Manager Termination Avoid early termination through assignment  Assignment Both parties consent Ⅱ. Derivatives Products – Background & Rationale Documentation

38. 38 Changes in Credit Condition Credit Spreads in Cash Market Cost of Alternatives Regulatory Capital Requirements General Market Liquidity Pricing Models –Traditional Credit Judgment –Quality of Historical Default Rates and Recoveries –Availability and Quality of Historical Spread –Availability of Volatility and Correlation data –Credit Default Swap Curves –Basis Between Credit Swap and Other Benchmarks –Modeling Tranched Credit and Basket Products Ⅱ. Derivatives Products – Background & Rationale Understanding Factors Impacting Prices

39. 39 Credit Risk Liquidity Risk Operational Risk Market Risk Systemic Risk Legal Risk Regulatory Risk Ⅱ. Derivatives Products – Background & Rationale What Risks?

40. 40 Foreseen economic turndown with a resultant decrease in credit quality Volatile exchange risk Anticipated increase/decrease in inflation rate with knock-on effect on interest rates Hunches on the movements of particular stock markets and companies traded on those markets Ⅱ. Derivatives Products – Background & Rationale Why Hedge?

41. 41 Objectives: 1.Introduce you to the notion of risk and the role of derivatives in managing risk Discuss some of the general terms – such as short/long positions, bid-ask spread – from finance that we need 2.Introduce you to three major classes of derivative securities Forwards Futures Options 3.Introduce you to the basic viewpoint needed to analyze these securities 4.Introduce you to the major traders of these instruments Ⅱ. Derivatives Products – Background & Rationale

42. 42 Finance is the study of risk –How to measure it –How to reduce it –How to allocate it All finance problems ultimately boil down to three main questions: –What are the cash flows, and when do they occur? –Who gets the cash flows? –What is the appropriate discount rate for those cash flows? The difficulty, of course, is that normally none of those questions have an easy answer Ⅱ. Derivatives Products – Background & Rationale

43. 43 As you know from other classes, we can generally classify risk as being diversifiable or non-diversifiable: –Diversifiable – risk that is specific to a specific investment – i.e. the risk that a single company’s stock may go down (i.e. Enron). This is frequently called idiosyncratic risk –Non-diversifiable – risk that is common to all investing in general and that cannot be reduced – i.e. the risk that the entire stock market (or bond market, or real estate market) will crash. This is frequently called systematic risk The market “pays” you for bearing non-diversifiable risk only – not for bearing diversifiable risk –In general the more non-diversifiable risk that you bear, the greater the expected return to your investment(s) –Many investors fail to properly diversify, and as a result bear more risk than they have to in order to earn a given level of expected return Ⅱ. Derivatives Products – Background & Rationale

44. 44 In this sense, we can view the field of finance as being about two issues: –The elimination of diversifiable risk in portfolios –The allocation of systematic (non-diversifiable) risk to those members of society that are most willing to bear it Indeed, it is really this second function – the allocation of systematic risk – that drives rates of return –The expected rate of return is the “price” that the market pays investors for bearing systematic risk Ⅱ. Derivatives Products – Background & Rationale

45. 45 A derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables Some common examples include things such as stock options, futures, and forwards It can also extend to something like a reimbursement program for college credit. Consider that if your firm reimburses 100% of costs for an “A”, 75% of costs for a “B”, 50% for a “C” and 0% for anything less Ⅱ. Derivatives Products – Background & Rationale

46. 46 Your “right” to claim this reimbursement, then is tied to the grade you earn. The value of that reimbursement plan, therefore, is derived from the grade you earn We also say that the value is contingent upon the grade you earn. Thus, your claim for reimbursement is a “contingent” claim The terms contingent claims and derivatives are used interchangeably Ⅱ. Derivatives Products – Background & Rationale

47. 47 So why do we have derivatives and derivatives markets? –They somehow allow investors to better control the level of risk that they bear –They can help eliminate idiosyncratic risk –They can decrease or increase the level of systematic risk Ⅱ. Derivatives Products – Background & Rationale

48. 48 A First Example There is a neat example from the bond-world of a derivative that is used to move non-diversifiable risk from one set of investors to another set that are, presumably, more willing to bear that risk Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park –They financed the park through the issuance of earthquake bonds –If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park Ⅱ. Derivatives Products – Background & Rationale

49. 49 Normally this could have been handled in the insurance (and re- insurance) markets, but there would have been transaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs. –Presumably the bondholders of the Disney bonds are basically the same investors that would have been holding the stock or bonds of the insurance/reinsurance companies –Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all This was not “free” insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not there, they would have paid a lower rate A First Example Ⅱ. Derivatives Products – Background & Rationale

50. 50 This example illustrates an interesting notion – that insurance contracts (for property insurance) are really derivatives! They allow the owner of the asset to “sell” the insured asset to the insurer in the event of a disaster They are like put options (more on this later.) A First Example Ⅱ. Derivatives Products – Background & Rationale

51. 51 Positions – In general if you are buying an asset – be it a physical stock or bond, or the right to determine whether or not you will acquire the asset in the future (such as through an option or futures contract) you are said to be “LONG” the instrument. If you are giving up the asset, or giving up the right to determine whether or not you will own the asset in the future, you are said to be “SHORT” the instrument. –In the stock and bond markets, if you “short” an asset, it means that you borrow it, sell the asset, and then later buy it back. –In derivatives markets you generally do not have to borrow the instrument – you can simply take a position (such as writing an option) that will require you to give up the asset or determination of ownership of the asset. –Usually in derivatives markets the “short” is just the negative of the “long” position Ⅱ. Derivatives Products – Background & Rationale

52. 52 So now we are going to begin examining the basic instruments of derivatives. In particular we will look at (tonight): –Forwards –Futures –Options The purpose of our discussion today is to simply provide a basic understanding of the structure of the instruments and the basic reasons they might exist. –We will have a more in-detail examination of their properties, and their pricing, in the weeks to come. Ⅱ. Derivatives Products – Background & Rationale

53. 53 A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain future price –Forward contracts are normally not exchange traded –The party that agrees to buy the asset in the future is said to have the long position –The party that agrees to sell the asset in the future is said to have the short position –The specified future date for the exchange is known as the delivery (maturity) date Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

54. 54 The specified price for the sale is known as the delivery price, we will denote this as K –Note that K is set such that at initiation of the contract the value of the forward contract is 0. Thus, by design, no cash changes hands at time 0. The mechanics of how to do this we cover in later lectures As time progresses the delivery price doesn’t change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time –Consider the situation at the maturity date of the contract. If the spot price is higher than the delivery price, the long party can buy at K and immediately sell at the spot price S T, making a profit of (S T -K), whereas the short position could have sold the asset for S T, but is obligated to sell for K, earning a profit (negative) of (K-S T ) Ⅱ. Derivatives Products – Background & Rationale Forward Contracts

55. 55 Example: –Let’s say that you entered into a forward contract to buy wheat at $4.00/bushel, with delivery in December. –Let’s say that the delivery date was December 14 and that on December 14 th the market price of wheat is unlikely to be exactly $4.00/bushel, but that is the price at which you have agreed (via the forward contract) to buy your wheat –If the market price is greater than $4.00/bushel, you are pleased, because you are able to buy an asset for less than its market price –If, however, the market price is less than $4.00/bushel, you are not pleased because you are paying more than the market price for the wheat –Indeed, we can determine your net payoff to the trade by applying the formula: payoff = S T – K, since you gain an asset worth S T, but you have to pay $K for it –We can graph the payoff function: Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

56. 56 Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

57. 57 Example: –In this example you were the long party, but what about the short party? –They have agreed to sell wheat to you for $4.00/bushel on December 14. –Their payoff is positive if the market price of wheat is less than $4.00/bushel – they force you to pay more for the wheat than they could sell it for on the open market. Indeed, you could assume that what they do is buy it on the open market and then immediately deliver it to you in the forward contract. –Their payoff is negative, however, if the market price of wheat is greater than $4.00/bushel. They could have sold the wheat for more than $4.00/bushel had they not agreed to sell it to you. –So their payoff function is the mirror image of your payoff function: Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

58. 58 Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

59. 59 Clearly the short position is just the mirror image of the long position, and, taken together the two positions cancel each other out: Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

60. 60 Long Position Net Position Short Position Forward Contracts Ⅱ. Derivatives Products – Background & Rationale

61. 61 A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset at a certain time for a certain price. Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts. This results in more institutional detail than is the case with forwards The long and short party usually do not deal with each other directly or even know each other for that matter. The exchange acts as a clearinghouse. As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails Futures Contracts Ⅱ. Derivatives Products – Background & Rationale

62. 62 The largest futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) Futures are traded on a wide range of commodities and financial assets Usually an exact delivery date is not specified, but rather a delivery range is specified. The short position has the option to choose when delivery is made. This is done to accommodate physical delivery issues –Harvest dates vary from year to year, transportation schedules change, etc Futures Contracts Ⅱ. Derivatives Products – Background & Rationale

63. 63 Options on stocks were first traded in 1973. That was the year the famous Black-Scholes formula was published, along with Merton’s paper - a set of academic papers that literally started an industry Options exist on virtually anything. Tonight we are going to focus on general options terminology for stocks. We will get into other types of options later in the class There are two basic types of options: –A Call option is the right, but not the obligation, to buy the underlying asset by a certain date for a certain price –A Put option is the right, but not the obligation, to sell the underlying asset by a certain date for a certain price Note that unlike a forward or futures contract, the holder of the options contract does not have to do anything - they have the option to do it or not Options Contracts Ⅱ. Derivatives Products – Background & Rationale

64. 64 The date when the option expires is known as the exercise date, the expiration date, or the maturity date The price at which the asset can be purchased or sold is known as the strike price If an option is said to be European, it means that the holder of the option can buy or sell (depending on if it is a call or a put) only on the maturity date. If the option is said to be an American style option, the holder can exercise on any date up to and including the exercise date An options contract is always costly to enter as the long party. The short party is always paid to enter into the contract –Looking at the payoff diagrams you can see why… Options Contracts Ⅱ. Derivatives Products – Background & Rationale

65. 65 Let’s say that you entered into a call option on IBM stock: –Today IBM is selling for roughly $78.80/share, so let’s say you entered into a call option that would let you buy IBM stock in December at a price of $80/share. –If in December the market price of IBM were greater than $80, you would exercise your option, and purchase the IBM share for $80. –If, in December IBM stock were selling for less than $80/share, you could buy the stock for less by buying it in the open market, so you would not exercise your option. –Thus your payoff to the option is $0 if the IBM stock is less than $80 –It is (S T -K) if IBM stock is worth more than $80 –Thus, your payoff diagram is: Options Contracts Ⅱ. Derivatives Products – Background & Rationale

66. 66 T Options Contracts Ⅱ. Derivatives Products – Background & Rationale

67. 67 –What if you had the short position? –Well, after you enter into the contract, you have granted the option to the long-party. –If they want to exercise the option, you have to do so. –Of course, they will only exercise the option when it is in there best interest to do so – that is, when the strike price is lower than the market price of the stock. So if the stock price is less than the strike price (S T <K), then the long party will just buy the stock in the market, and so the option will expire, and you will receive $0 at maturity. If the stock price is more than the strike price (S T >K), however, then the long party will exercise their option and you will have to sell them an asset that is worth S T for $K. –We can thus write your payoff as: payoff = min(0,S T -K), which has a graph that looks like: Options Contracts Ⅱ. Derivatives Products – Background & Rationale

68. 68 Options Contracts Ⅱ. Derivatives Products – Background & Rationale

69. 69 This is obviously the mirror image of the long position. Notice, however, that at maturity, the short option position can NEVER have a positive payout – the best that can happen is that they get $0. –This is why the short option party always demands an up-front payment – it’s the only payment they are going to receive. This payment is called the option premium or price. Once again, the two positions “net out” to zero: Options Contracts Ⅱ. Derivatives Products – Background & Rationale

70. 70 Long Call Short Call Net Position Options Contracts Ⅱ. Derivatives Products – Background & Rationale

71. 71 Recall that a put option grants the long party the right to sell the underlying at price K. Returning to our IBM example, if K=80, the long party will only elect to exercise the option if the price of the stock in the market is less than $80. The payoff to the holder of the long put position, therefore is simply payoff = max(0, K-S T ) Options Contracts Ⅱ. Derivatives Products – Background & Rationale

72. 72 Options Contracts Ⅱ. Derivatives Products – Background & Rationale

73. 73 The short position again has granted the option to the long position. Of course the long party will only do this when the stock price is less than the strike price. Thus, the payoff function for the short put position is: payoff = min(0, S T -K) And the payoff diagram looks like: Options Contracts Ⅱ. Derivatives Products – Background & Rationale

74. 74 Options Contracts Ⅱ. Derivatives Products – Background & Rationale

75. 75 Since the short put party can never receive a positive payout at maturity, they demand a payment up-front from the long party – that is, they demand that the long party pay a premium to induce them to enter into the contract. Once again, the short and long positions net out to zero: when one party wins, the other loses. Options Contracts Ⅱ. Derivatives Products – Background & Rationale

76. 76 Long Position Short Position Net Position Options Contracts Ⅱ. Derivatives Products – Background & Rationale

77. 77 Traders frequently refer to an option as being “in the money”, “out of the money” or “at the money”. –An “in the money” option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would receive a payout. For a call option this means that S t >K For a put option this means that S t <K –An “at the money” option means one where the strike and exercise prices are the same. –An “out of the money” option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would NOT receive a payout. For a call option this means that S t <K For a put option this means that S t >K. Options Contracts Ⅱ. Derivatives Products – Background & Rationale

78. 78 T Out of the money In the money At the money Options Contracts Ⅱ. Derivatives Products – Background & Rationale

79. 79 We will come back to put-call parity in a few weeks, but it is well worth keeping this diagram in mind. So who trades options contracts? Generally there are three types of options traders: –Hedgers - these are firms that face a business risk. They wish to get rid of this uncertainty using a derivative. For example, an airline might use a derivatives contract to hedge the risk that jet fuel prices might change. –Speculators - They want to take a bet (position) in the market and simply want to be in place to capture expected up or down movements. –Arbitrageurs - They are looking for imperfections in the capital market. Options Contracts Ⅱ. Derivatives Products – Background & Rationale

80. 80 One of the fundamental ideas that we will use is the “law of one price”. Basically this says that if two portfolios offer the same cash flows in all potential states of the world, then the two portfolios must sell for the same price in the market – regardless of the instruments contained in the portfolios. –This is only true to “within transactions costs”, i.e. the bid-ask spread on each individual instrument. –Sometimes one portfolio will have such lower transactions costs that the law will only approximately hold. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

81. 81 Financial engineering is the notion that you can use a combination of assets and financial derivatives to construct cash flow streams that would otherwise be difficult or impossible to obtain. Financial engineering can be used to “break apart” a set of cash flows into component pieces that each have different risks and that can be sold to different investors. Collateralized Bond Obligations do this for “junk” bonds. Collateralized Mortgage Obligations do this for residential mortgages. Financial engineering can also be used to create cash flows streams that would otherwise be difficult to obtain. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

82. 82 The Schwab/First Union equity-linked CD is a good example of financial engineering. When it was issued (in 1999), the stock market was (and had been) incredibly “hot” for several years. –Many investors wanted to be in the market, but did not want to risk the market going down in value. The equity-linked CD was designed to meet this need. –As we will demonstrate, an investor could “roll their own” version of this, but in doing so would have incurred significant transaction costs. Plus, many small investors (to whom this was targeted) probably could not get approval to trade options. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

83. 83 The Contract: –An investor buys the CD (Certificate of Deposit) today, and then earns 70% of the simple rate of return on S&P 500 index over the next 5.5 years. –If the S&P index ended up below the initial index level (so that the appreciation was negative), then the investor received their full initial investment back, but nothing else. –Thus, the payoff to the CD was simply: –So let’s say that you invested $10,000, and that in June of 1999 the index was 1300 (so that you were, in essence, buying $10,000/1,300 or 7.69 units of the index). Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

84. 84 In 5.5 years your payoff will be based upon the index level. Potential index levels and payoffs include: IndexSimple Rate of ReturnCash Received 1000- 23.07%$10,000 1200- 7.69%$10,000 1300 0.00%$10,000 1400 7.69%$10,538 1500 15.38%$11,076 2000 53.85%$13,769 (Note that on 12/30/2004 the S&P 500 was at 1211.92!) The following chart demonstrates the payouts. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

85. 85 Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

86. 86 Now, the first thing about that chart that you should notice is that it looks an awful lot like the shape of a call option, although the slope of the upward-sloping part is not as steep. This is our first indication that we may be able to decompose this into two simpler securities. Indeed, one way of decomposing this security would be to assume that we bought a bond that paid $10,000 at time 5.5, and that we bought 5.38 call options with a strike of 1300 (70% of 10,000/1300.) The next graph demonstrates this position’s payoff. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

87. 87 Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

88. 88 This position is ALSO identical to a position consisting of: –$10,000/1300 = 7.692 units of the index. –$10,000/1300 = 7.692 put options on the index (K=1300) –(-(1-.7)*$10,000/1300 = -2.30769) CALL options on the index. The reason for the short call options is because the CD only gives us 70% of the return on the index, so we have to sell back some of that return via the call option (note that we will earn a premium for this.) The following chart shows this: Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

89. 89 Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

90. 90 Now, all three of these should sell for the same price – but there will be some differences because of transactions costs. –Really, this is why the Schwab equity-linked CD can work: investors (retail investors) are willing to turn to the “prepackaged” asset to avoid transaction costs (and to avoid timing difficulties with unwinding their position.) Let’s just think of this as a bond and.7 long call options for a moment. Clearly the call cannot be free, since the investor holds this option they must pay something for it. How much do they pay? –The interest that they could have earned on this money had they invested in a traditional CD. –At that time 5.5 year CDs were yielding 6%, so the investor “gives up” $3,777 dollars in year 5.5 dollars. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

91. 91 The equity-linked CD is just one example of financial engineering – the notion that investors are really just purchasing potential future cash flows and that any two sets of identical potential future cash flows must sell for the same price. This has led to a real revolution in finance, and we will discuss this idea throughout the semester. We will return to options pricing later in the semester. Next, we turn our attention to the futures/forwards markets and pricing. Financial Engineering Ⅱ. Derivatives Products – Background & Rationale

92. Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations

93. 93 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Presentation Focus: Asset Swap Total Return and Index Swap Default Swap Credit Linked Note (CLN) Asset Swap (using SPV) Call Option on an Asset Swap Total Return Swap (TRS) Index Swap Use of Various Credit Derivatives

94. 94 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Economic Motivation Swap floating assets to fixed or vice versa Trade away imbedded options in a bond or layer in options Bank Counter Party Coupon from Bond A Some Index (Libor, fixed level etc.) + Spread Bond A Coupon and Principal Index Level Asset Swap

95. 95 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Motivation Adjust exposure without buying or selling individual securities Hedging, Relative Value, Market access, Flexibility Index Total Return Swap Bank Counter Party Index Sector Total Return Libor + Spread or Total Return of Another Sector Holdings in a Sector Holdings Total Return Market Price

96. 96 Between trade initiation and default or maturity, protection buyer makes regular payments default swap spread to protection seller Protection Buyer Protection Seller Default Swap Spread Following the credit event one of the following will take place: Cash Settlement Protection Buyer Protection Seller 100- Recovery Rate Physical Settlement Protection Buyer Protection Seller Bond 100 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Mechanics of a Default Swap

97. 97 IssuersBankInvestors Credit Linked Coupons Issuer Funding Proceeds Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Structure of a Credit-Linked Note

98. 98 Fixed Rate Asset SPVISSUED NOTE Swap Counterparty Fixed Rate LIBOR + Spread LIBOR +Spread Fixed Rate Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Securitized Asset Swap Issued out of an SPV

99. 99 At Initiation At exercise Physical Settlement Call Option BuyerCall Option Seller Option Premium paid up front Call Option SellerCall Option Buyer Enter into asset swap package at the strike spread Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Mechanics of a Call Option on an Asset Swap

100. 100 During Swap At Maturity Total Return Payer Total Return Receiver(Investor) Coupons from reference asset Libor + Fixed Spread Total Return Receiver(Investor) Total Return Payer Any increase in the market value of the notional amount of the reference asset Any decrease in the market value of the notional amount of the reference asset Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Mechanics of a Total Return Swap

101. 101 During Swap Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Index Swap Mechanics Index PayerIndex Receiver Total Return from Index over interest rate period Libor + Fixed Spread

102. 102 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Single Reference-Entity Credit Default Swap Transfer the credit risk of an issuer (reference entity) from one entity (buyer) to another (seller) Seller of protection agrees to buy “obligations” of the reference entity at par in the event of a public notice Default event is defined a “publicly available notice” to: A payment failure larger or equal than “Payment Requirement” on an obligation equal or larger than “Default Requirement” Settlement can be “Physical” or “Cash” Deliverable obligations can be Reference obligation Any of Deliverable obligations –According to ISDA it could be any borrowed money: loans, cp, bond, and bond and loan –Must be specified in long-form trade confirmation

103. 103 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Advantages of Default Swap over Short Corporates In general they tend to be cheaper than similar cash bond because: buyers inability to hedge their risk in any other market expensive risk capital charges required against credit risk Ability to do default swap opens up unique opportunities to tailor credit exposure of the portfolio - i.e. take advantage of credit curve steepness (buy longer dated cash bonds and roll over short dated credit protection) More flexibility - Default swap does not tie up cash to earn spread Allows creating higher information ratio strategies that may be leveraged for higher returns than similar risk strategies Access to names and maturities that otherwise may not be available

104. 104 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Pricing Methodology Method 1: Basis - Asset Swap vs. Default Swap (works only for single name) Method 2: Model Loss Distribution Market Implied Default Probabilities Credit SpreadsRecovery Rates Asset Correlations Default Correlations Simulator Loss Distribution

105. 105 Ⅲ. Derivatives products – Diagrams, Cashflows, & Motivations Pricing Single-entity Default Swap Compare Libor spread of cash bond of the issuer of similar maturity with the default swap rate Compare all-in yield of a synthetic bond of “Default Swap+AAA ABS” with the cash bond Compare a given spread with valuation based on long-term default probability and recovery rates based on transition probability matrix and recovery value ACCOUNT Default Option on $10mm TCI 7 ¼ 6/06 COUNTER-PARTY 40BP/Annum AAA Asset Back Maturing 6/15/06 (+20 to 25bp over Treasury) Bond$10mm

106. Ⅳ. Derivatives Documentation :ISDA & Beyond

107. 107 What Triggers the Default Swap? The default swap is triggered by a Credit Event. The ISDA definitions provide for six credit events that are usually defined in relation to a reference entity. Typically, only four or five will be used, depending on whether the reference credit is a corporate or sovereign. They are shown in Figure 40. Ⅳ. Derivatives Documentation: ISDA & Beyond

108. 108 The obligation used in the definition of a credit event needs itself to be defined. In order to get evidence of a credit event as it relates to an obligation, we need to specify the different categories of obligation. There are six possible categories: bond, bond or loan, borrowed money, loan, payment, and reference obligations only. Most trades will specify the obligations using bond, bond or loan, or borrowed money. A further eight obligation characteristics, listed in Figure 41, are used to refine the nature of the obligation. Ⅳ. Derivatives Documentation: ISDA & Beyond What is an Obligation?

109. 109 Following a credit event of a physically settled default swap, the protection buyer has to deliver the deliverable obligations to the protection seller. In order to specify what these are, we use many of the same types of categories and characteristics as were used for obligations. However, there are some additional characteristics that are specific to the deliverable obligations. These additional characteristics are listed in Figure 42. Ⅳ. Derivatives Documentation: ISDA & Beyond Deliverable Obligations

110. 110 Credit EventDescription Bankruptcy Corporate becomes insolvent or is unable to pay its debts. The bankruptcy event is, of course, not relevant for sovereign issuers. Failure to Pay Failure of the reference entity to make due payments greater than the specified payment requirement (typically $1 million), taking into account some grace period to prevent accidental triggering due to administrative error. A grace period may be specified, which may extend the maturity of the default swap if there is a potential failure to pay. Obligation Acceleration/ Obligation Default Obligations have become due and payable earlier than they would have been due to default or similar condition, or obligations have become capable of being defined due and payable earlier than they would have been due to default or similar condition. This latter alternative is the more encompassing definition and so is preferred by the protection buyer. The aggregate amount of obligations must be greater than the default requirement (typically $10 million) Requirement/ Moratorium A reference entity or government authority rejects or challenges the validity of the obligations. Restructuring Changes in the debt obligations of the reference creditor but excluding those that are not associated with credit deterioration, such as a renegotiation of more favorable terms. Ⅳ. Derivatives Documentation: ISDA & Beyond A List of the ISDA Specified Credit Events

111. 111 CharacteristicsMeaningComment Pari Passu Ranking Pari passu means senior unsecured if no reference obligation is specified. It means at least as senior as the reference obligation if it is defined. Expected to be used widely. Specified Currencies The credit event has to occur on obligations denominated in the specified currency. Also expected to be widely used. The default is G7 & Euro unless otherwise specified. Not sovereign Lender The obligation is not a loan from another sovereign.Applies to sovereign reference entities. Not Domestic Issuance The obligation is not issued In the domestic market.Used for emerging market credits. Not Domestic Law The legal framework used for the obligation is not that of the issuing country. Used for emerging market credits. Not Contingent There are no issuer options or other contingencies in the obligation. Used to exclude structured notes and zero coupon bonds. Convertible bonds are not considered to be contingent since the investor has the conversion option. Listed Refers to whether or not obligation must be listed on a recognised exchange. Likely to be used for European corporates and some sovereigns Not Domestic Currency Required that obligations are not denominated in the domestic currency. Used to cover Eurobond Issues. Ⅳ. Derivatives Documentation: ISDA & Beyond A List of the ISDA Obligation Characteristics

112. 112 Additional CharacteristicsComment Assignable Loans Consent Required Loan Direct Loan Participation Indirect Loan Participation There are used to specify the type of loan or interest in a loan that is delivered. Maximum Maturity Used to specify the maturity of the deliverable obligation Accelerated or Matured Transferable Specify whether the deliverable obligation is freely transferable Not bearer Can be used to eliminate illiquid bearer securities. Note that if a security settles through a major clearing systems then it will be considered not-bearer even if it is, e.g., Eurobonds Ⅳ. Derivatives Documentation: ISDA & Beyond Additional Characteristics for Deliverable Obligations

113. 113 Once a credit event has occurred, either one or other or both parties to the default swap must send a Credit Event Notice to the other. This can be sent up to 14 calendar days after the scheduled termination of the default swap, provided the credit event happened prior to the scheduled termination date. Ⅳ. Derivatives Documentation: ISDA & Beyond The Settlement Process

114. 114 The main task in the cash settlement process is to establish the final price of the reference obligation(s). Typically, a single valuation date is used A valuation time of 11.00 am is used, and the price used is the bid (though other choices are offer and mid-market) Ⅳ. Derivatives Documentation: ISDA & Beyond Cash Settlement

115. 115 Following the notification of the credit event, the protection buyer must determine what obligations will be delivered and send a Notice of Intended Physical Settlement to the protection seller. Typically, the obligations will then be delivered within the standard settlement period: e.g., if the Notice of Intended Physical Settlement is delivered on trade date, physical settlement occurs on T+3, i.e., three days after notification was given. Ⅳ. Derivatives Documentation: ISDA & Beyond Physical Settlement

116. 116 Bankruptcy Failure to pay Obligation Acceleration Obligation Default Repudiation/Moratorium Restructuring Ⅳ. Derivatives Documentation: ISDA & Beyond ISDA Credit Events

117. “becomes insolvent, or is unable to pay its debts or fails or admits in writing in a judicial, regulatory or administrative proceeding or filing its inability generally to pay its debts as they become due” Questions: 1. How is insolvency solved? - by reference to an income statement test? - by reference to a balance sheet test? 2. Impact on the timing of the credit event 3. There could be an “insolvency” not followed by bankruptcy or failure to pay 4. “Admits in writing” amendment of Nov. 28, 2001 - government/court filings: = trigger - newspaper interviews: = not trigger - Relation to “Publicly Available Information” at § 3.5 Knowledge of sponsor issue Note: more and more differences between the Bankruptcy Credit Events the Bankruptcy Event of Default of the Master 117 1. Bankruptcy – “Insolvency” Ⅳ. Derivatives Documentation: ISDA & Beyond

118. Takes any action in furtherance of, or indicating its consent to, approval of, or acquiescence in any of the foregoing acts 118 Deletions of the Bankruptcy “Catch all” provision Ⅳ. Derivatives Documentation: ISDA & Beyond

119. “Failure to Pay” means… the failure by a Reference Entity to make, when and were due, any payments in an aggregate amount not less than the Payment Requirement under one or more Obligation” –What about disputed trade obligations or non-payment for reasons other than credit problems? –Note: non-payment of trade obligations would not be a “default” for Moody’s –Drafting issue 119 2. Failure to Pay Ⅳ. Derivatives Documentation: ISDA & Beyond

120. Pre-May 2001 Restructuring Event Definition ( ⅰ ) a reduction in the rate or amount of interest payable or the amount of the scheduled interest accruals ( ⅱ ) a reduction in the amount of principal or premium payable at the maturity or at scheduled redemption dates ( ⅲ ) a postponement or other deferral of the date or dates for either (A) the payment or accrual of interest or (B) the payment of principal or premium ( ⅳ ) a change in ranking in priority of payment of any Obligations, causing the subordination of such Obligations ( ⅴ )any change in the currency or composition of any payment of interest or principal 120 3. Restructuring Ⅳ. Derivatives Documentation: ISDA & Beyond

121. Pre-May 2001 Restructuring Event Definition “ the occurrence of, agreement to or an announcement of any of the events described in Sec. 4.7 (a) ( ⅰ )-( ⅳ ) in circumstances where such event does not directly or indirectly result from the deterioration in the creditworthiness or financial condition of the Reference Entity ” New definitions adopted in May and November 2001 121 Restructuring (Cont’d) Ⅳ. Derivatives Documentation: ISDA & Beyond

122. A. The problems sought to be fixed –Conseco’s Aug. 2000 Restructuring Conseco paid for 3 month deferral of loan maturity, increased the coupon, new corporate guarantee. No diminished financial obligation in Moody’s view Maturity extension viewed as Credit Event under §4.7(a)( ⅲ ) –“cheapest to deliver” Option Buyer could deliver any senior debt obligation of Reference Entity Hence, in “soft” Credit Event, short-dated bank debt was restructured and collateral traded at significant premiums over longer-dated bonds 122 Restructuring (Cont’d ) Ⅳ. Derivatives Documentation: ISDA & Beyond

123. –Structural Subordination: subordination which is the result of other creditors receiving collateral or other benefits not received by the structurally subordinated creditor –Moral Hazard issue One lender could provoke a restructuring to get paid under credit protection instruments B. The Solutions Adopted –Concept of Multiple Holder Obligation Addresses Conseco issue Addresses Moral Hazard issue New: Multiple Holder Obligation in new §4.10 is an Obligation held by at least 3 unaffiliated holders with 2/3 vote needed on items ( ⅰ )-( ⅴ ) for it to be a Restructuring Creditor event 123 Ⅳ. Derivatives Documentation: ISDA & Beyond Restructuring (Cont’d )

124. Adoption of Restructuring Maturity Limitations –New §2.29 provides that a Deliverable Obligation can only be a Fully Transferable Obligation with a maturity date not later than the Restructuring Maturity Limitation Date, i.e., earlier of 30 months following the Restructuring Date and the latest final maturity date of any Restructured Bond or Loan –This language limits the value of the cheapest to deliver option Clarification of pari passu ranking: §2.30(b) only contractual subordination is a Credit Event 124 Ⅳ. Derivatives Documentation: ISDA & Beyond Restructuring (Cont’d )

125. C. Remaining Problems –Obligation Acceleration Multiple Holder Obligation not applicable Single holder can accelerate Possibility of “windfall” for accelerating bank that bought protection through CDs: example: borrower has some difficulties but there is no imminent danger of default. The bank has protections on the borrower including an Obligation Acceleration Credit Event. The bank accelerated the ban and gets bids on the remaining outstanding debt, say 85%. Bank gets 115% total –Bankruptcy Credit Event –Case of the Nov. 2001 Argentine bold swap HBK v. JPMorgan and Eternity Global Master Fund v. JPMorgan 125 Ⅳ. Derivatives Documentation: ISDA & Beyond Restructuring (Cont’d )

126. Ⅴ. Q&A