The StructuredCredit

Handbook

ARVIND RAJANGLEN MCDERMOTT

RATUL ROY

John Wiley & Sons, Inc.

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The StructuredCredit

Handbook

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The StructuredCredit

Handbook

ARVIND RAJANGLEN MCDERMOTT

RATUL ROY

John Wiley & Sons, Inc.

Copyright c 2007 by Arvind Rajan, Glen McDermott, and Ratul Roy. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Rajan, Arvind.The structured credit handbook / Arvind Rajan, Glen McDermott, Ratul Roy.

p. cm.(Wiley finance series)Includes bibliographical references and indexes.ISBN 978-0-471-74749-9 (cloth)1. Credit derivatives. 2. CreditManagement. 3. Default (Finance).

I. McDermott, Glen, 1968 II. Roy, Ratul, 1964 III. Title.HG6024.A3R35 2007332.7dc22

2006019227

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

www.wiley.com

To the memory of my dad, V. Varadarajan (19212002),whose faith in my potential

still inspires me.A.R.

This book is dedicated to Gail B. McDermottand to the memory of

Maurice and Claire McDermottand John F. Brennan.

G.M.

To my parents, Tapan and Uma, for theirlove and faith in me.

R.R.

Contents

Acknowledgments xix

About the Authors xxi

About the Contributors xxiii

Introduction: A Roadmap of the New World of Structured Credit 1How Structured Credit Completes Markets 2Enabling Technology 3Improved Liquidity, Transparency, and Customizability 3Growth of Structured Credit Markets 4

Asset Classes 4Products 4Participants 7

Core Uses of Structured Credit 8Nonrecourse Leverage 8Diversification 8Customization of Risk Profiles 9Separating Legal from Beneficial Ownership 9Separating Funding from Risk Transfer 9Isolating and Hedging Risk 10Representative Examples of Structured Credit Solutions 10

Who Should Read This Book? 11How This Book Is Organized 11

PART ONEIndex and Single-Name Products

CHAPTER 1A Primer on Credit Default Swaps 17

Arvind Rajan

The Market for Credit Default Swaps 17Transaction Terminology and Mechanics 22

vii

viii CONTENTS

Prerequisites for Credit Derivatives Transactions 22What Happens in Case of a Credit Event? 23Unwinding Default Swap Transactions 25The DV01 of a Credit Default Swap 25The Default-Cash Basis 26

Some Uses of Default Swaps 26Buying a Note versus Selling Default Protection 26Freeing Up or Using Bank Credit Lines 27Filling a Maturity Gap 28Expressing Curve or Forward-Rate Views 28Barbell-Bullet Trade 29Taking Advantage of Tight Repo Levels

without Financing 29Case Study: Relative ValueCashing In on the Curve

Steepness in Telecoms 30How to Blend CDs and Cash in Long-Maturity-Curve

Trades 30Implementing Credit Curve FlattenersTwo Basic

Approaches 33Appendix: Equivalence of a Bond Spread and Default Swap

Premium 35Specialness of the Underlying 36Effect of Accrued Default Swap Premium 36Accrued Interest on the Underlying Risky Security 37Accrued Interest on the Underlying Risk-Free

Security 37

CHAPTER 2Credit Default Swaptions 39

Arvind Rajan and Terry Benzschawel

Payer Options 40ExampleWhen to Buy a Payer 41ExampleWhen to Sell a Payer 42

Receiver Options 42ExampleWhen to Buy a Receiver 43Effect of DV01 on Credit Swaption Payoffs 43ExampleWhen to Sell a Receiver 44

Credit Swaption Payoffs in Default 46Credit Swaption Implied Volatility 47

Conclusion 47

Contents ix

Case Study: Are Tight Spreads Giving You Butterflies? 49Introduction 49Float Like a Butterfly, Sting Like a Bee 50Butterfly versus Payer 50Variations 54Details of Butterfly Construction 54Conclusion 54

CHAPTER 3Constant Maturity Credit Default Swaps 57

Olivier Renault and Ratul Roy

Basics of CMCDSs 57Participation Rate 58Behavior of CMCDSs 59

Impact of Spread Level 60Impact of Spread Volatility 64

Capped CMCDS 66Hedging CMCDSs 68Trading Strategies with CMCDSs 69

Selling CMCDS Protection 69Buying CMCDS Protection 70Combination Trades and Index CMCDSs 70

Conclusion 72Case Study: Taking Curve Views with CMCDSs 72

Features of CMCDSs 73Trade Ideas 73

Appendix: Computing the Participation Rate 76

CHAPTER 4Credit Derivatives Indexes 79

Jure Skarabot and Gaurav Bansal

Introduction 79Family of Credit Derivatives Indexes 80Structure of the CDX/iTraxx Index Family 81Administration of Indexes 83Basket of Credit Default Swaps 83

Trading ExampleThe Index 84Up-Front and Running Payments 84

Trading ExamplePremium Payments 85What Happens in Case of a Credit Event? 86

Trading ExampleCredit Event 87

x CONTENTS

Settlement Process after Credit Event 87Physical Settlement (Indexes and Tranche Products) 88Cash Settlement (Tranche Product Only) 88

Recent Defaults in CDX Indexes 88Index versus Intrinsics 90Investment Strategies with Credit Derivatives Indexes 91

Investors 92Index-Related Structured Credit Products 92Issues and Concerns 93

Conclusion 93Case Study: DJ CDX HY and DJ CDX EMConversion of

Price Level into a Spread Level 94Case Study: Using iTraxx to Replicate Bond Portfolios 94

Motivation 94Typical Portfolio Risks 95Replicating Interest Rate Risks 96Using iTraxx to Replicate Broad Credit Market Risk 96Adjusting for Single-Name Risk through Default Swaps 99Performance 100Conclusion 104

Appendix: Description of the Roll Process 106Risky PV01 of a CDS Contract 106Calculation of Intrinsic Spread of the Index 107Risky PV01 of an Index 108Mark-to-Market Estimation of an Index Position 108

CHAPTER 5The Added Dimensions of CreditA Guide to Relative Value Trading 111

Matt King and Michael Sandigursky

Overview of Curve Trades 111Learning Curves 112Drivers of Curve Steepness 113

Putting on a Curve Trade 115Cross-Currency Trades 116

Cross-Currency Opportunities in Bonds 117Cross-Currency Trades in CDSs 117

Basis Trades 118Back to Basis 118Drivers of Basis 122Why CDSs and Bonds Are Two Sides of the Same Coin 122Trading the Basis 126

Contents xi

A New Spread Measure: C-Spread 129Debt-Equity Trades 129

Meet the Models 129The Debt-Equity Cycle 130A Practical Hurdle or Two 131Debt-Equity Trading in PracticeArbitrage or Mirage? 132Deciding What to Trade 133A Recovery Trade 134

iTraxx Credit Indexes 134Truly Global 135Youve Got to Roll with It 136iTraxx Intrinsics 137What Happens When a Name Defaults? 139Equiweighted or Not 139Second-Generation Products: iTraxx Tranches 139

Credit Options 140Its a Knockout 140Effect of Convexity on Credit Option Payoffs 141Delta-Exchange 143Why Sell an Option (Riskier Strategy) Rather

Than Buy One? 143Option Strategies 144

PART TWOPortfolio Credit Derivatives

CHAPTER 6Single-Tranche CDOs 149

Jure Skarabot, Ratul Roy, and Ji-Hoon Ryu

Overview of Single-Tranche CDOs 149Advantages of Single-Tranche CDOs 150Key Features of Single-Tranche CDO Transaction 150Description of the Product and Basic Structure 151Main Decision Steps for Investors 153Key Issues in Modeling and Valuation 155Single-Tranche CDO Risk Measures and Hedging 158Substitution of Credits 164Single-Tranche CDO Market 166Investment Strategies 167

xii CONTENTS

Case Study: Dispersion Trades and Tranches 180Traditional Bull-Bear Trade 180Not Just Another Bull-Bear Tranche Trade 181Whos Afraid of Blowups? 181Buy Protection on 10-Year 3 to 7 Percent CDX IG

Tranche, Sell Protection on 5-Year 10 to 15 PercentCDX IG Tranche 183

Effect of Blowups in CDX IG on the Dispersion Trade 184Trade Sensitivity Analysis 184How to Choose the Most Efficient Tranches 187Conclusions 190

Case Study: Attractions of Hedged Mezzanines 190Motivation 191The Trade 191Comparing Delta-Hedged Equity and Mezzanines 192Time-Decay Profile 194Conclusion 195

CHAPTER 7Trading Credit Tranches: Taking Default Correlationout of the Black Box 197

Ratul Roy

The Credit Tranche Market 197Importance of Default Correlation in Tranches 199Problems with Traditional Correlation Measure 199

Skew in Default Correlation 201Further Flaws in Tranche Correlation 201Correlation Skew Is Like a Volatility Surface 201Skew Is Markets Risk Preference 204Investor Risk Appetite May Scale Across Markets 207Greeks: Managing Correlation and Delta Risk 209In Summary: Why Skew Is a Better Model 213

Trading Opportunities for Investors 214Tranche Correlation Can Still Provide Insight 214Pricing Off-Market Tranches 217

Conclusion and Future Agenda 219Case Study: Curve Trades in Tranche Markets 220

Curve Trades, Tranche Markets, and Technicals 220Trade Recommendation 221Market Drivers for the Tranche Curve Trades 221Base Correlation Analysis and Market Technicals 223

Contents xiii

Technicals Driving the Flattening of Tranche Curves 224Analysis of Investment Strategy 225

CHAPTER 8Understanding CDO-Squareds 229

Ratul Roy and Matt King

CDOs versus CDO2 230Value of CDO2s Derives Broadly from Inner CDOs 232CDO2 versus Inner CDO 234Like Mezzanine, but with Tails 235CDO2 versus Master CDO 236Economic Value versus Rating Quality 238Uses of CDO2: Long, Short, and Correlation! 239Structures: Good, Bad, and Ugly 239

Inner CDO Tranche Seniority and Thinness 240Overlap of Credits 242Nonuniformity of Portfolios 243Fungible and Tradable Subordination 244

How Managers Can Add Value 246Not Just Credit Selection 246Manage to the Structure 248

Conclusion 249Case Study: Term Sheet 249

CHAPTER 9CPPI: Leveraging and Deleveraging Credit 253

Olivier Renault

Product Mechanics 253Managed CPPIs 256

When Is CPPI Suitable? 257Choice of Trading Strategies 257

Case Study: Performance Comparison of Strategies 258Baseline: Unlevered Strategies 258Simulations 258Results 259Performance Comparison in CPPI Setup 263Other Strategies 264

Appendix: Our Methodology 265Our Estimations and Simulations 265