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ISDA PRESS REPORT - OCTOBER 29, 2001
CREDIT DERIVATIVES * Pricing Synthetic CDO's - Derivatives Week REGULATORY * CFTC makes amendments to CFMA 2000 - Risk News TRADING PRACTICE * Banks tout economic derivatives - IFR Pricing Synthetic CDO's Derivatives Week - October 29, 2001 Traditionally collateralized debt obligations (CDOs) involve a transfer of collateral assets. The CDO liabilities then reference the cash flows (principal and interest) of the collateral assets. But CDOs are increasingly issued in synthetic form, where there is no physical transfer of collateral. In these structures the CDO references default losses, rather than the cash flows of the referenced collateral. Credit Default Swaps In their simplest form synthetic CDOs are akin to single name credit default swaps. A credit default swap is a contract where one party ,the protection buyer, makes periodic payments in exchange for payments contingent on a credit event. In a single name credit default swap, the credit event is the default of a single issuer. Thus, the price of the credit default swaps reflects the market's view of the default likelihood of the reference name. In unfunded form a synthetic CDO is essentially a basket default swap. In this case, in return for a premium, the protection seller makes contingent payments based on the default losses incurred by a portfolio or basket of assets. The protection may be for first loss or equity, in which case the seller pays for the initial default losses, up to some threshold; second loss or mezzanine, where the seller pays losses beyond the first loss threshold up to some higher limit; or senior, where the seller pays all losses beyond a threshold. Synthetic CDOs may also be structured in funded form. The simplest form of this structure is a combination of a risk free bond and a basket default swap. The initial investment is used to purchase the risk free bond and at the outset the investor receives the risk free rate of interest from the bond as well as premium payments from the basket default swap. As losses occur on the reference portfolio the principal of the bond is reduced to pay the required contingent payments. At the maturity of the structure the investor receives the remaining principal of the risk free position. In both funded and unfunded forms the pricing of synthetic CDOs is primarily a matter of pricing the basket default swaps themselves. Correlation Products It is often said that synthetic CDOs are correlation products because their value depends not only on the probability of default for each individual name in the reference portfolio, but also on the correlation between those names. Consider a simple case where the reference portfolio consists of two names, each with a 5% probability of default. Assume two levels of protection, one paying on the first default, and one paying on the second. If the names are independent, then the probability that the first loss protection is triggered is 1 - (0.95)2 = 9.75%, that is, 100% less the chance that there are zero defaults. The probability that the second loss protection is triggered is (0.05)2 = 0.25%, that is, only if there are two defaults. On the other hand, if the defaults are perfectly correlated, then there are only two possibilities: either both or neither of the names default. Thus, the probability that either protection is triggered is the probability that both names default, or 5%. Note that for the first loss protection the increased correlation has reduced the likelihood that the protection is invoked, and therefore reduced the fair price of this protection. For the second loss piece, the increased correlation has increased the trigger likelihood and fair price. The relationship between correlation and pricing holds generally for the first loss and most senior levels of protection in basket default swaps. For the first loss piece, since losses are capped, the pricing is driven primarily by the likelihood that no losses occur, which increases with correlation. For the senior piece, the pricing is driven by the likelihood that an extreme loss occurs, which is greater in cases of higher correlation. Pricing Based on the discussion above most pricing models require individual default probabilities and a correlation across the names in the pool. Since individual default probabilities can often be obtained from single name credit-default swaps correlation is the main pricing parameter for synthetic CDOs. Consider an example structure with USD36 million of collateral, where first loss protects against the first USD5 million of losses, second loss protects against the next USD10 million of losses, and the remaining losses are protected by the senior tranche. We can model spreads on each of these tranches at different correlation levels. For example, using a correlation of 45%, we obtain model spreads of two basis points, 250bps and 1,642bps for the senior, second loss, and first loss protection respectively. We can repeat this exercise at different correlation levels to obtain the sensitivity of spreads to changes in correlation. Figure 1 shows the normalized cost of protection for each tranche at different correlation levels. We can see that the cost of protection for the senior tranche increases with increasing correlation, that is the cost increases as senior debt gets riskier, while the first loss protection cost decreases with increasing correlation, that is the cost decreases as equity gets less risky. Note that, in this particular example the cost of second loss protection behaves like senior as an increasing function of correlation. Implied Correlation We can back out an implied correlation for each tranche from CDO prices in the same way we would obtain implied volatility from option prices and the Black-Scholes pricing model. An implied correlation extracted in this fashion depends on the specific CDO pricing model, but the observations above hold generally. Suppose the market spreads for our example structure are 2bps, 150bps and 2,000bps for the senior, second loss, and first loss protection respectively. We can compare these observed spreads with our model spreads to calibrate a correlation parameter for each tranche. For example the model spread is equal to the observed spread for the senior tranche, 2bps, when we price it using a 45% correlation. In other words, the implied correlation for the senior tranche is 45%. The implied correlation for each tranche can be inferred from Figure 1 as the correlation level with which our pricing model recovers the observed market spread. We can see that for the first and second loss tranches, the implied correlation is roughly 20%, while for the senior tranche the implied correlation is 45%. A first application of the implied correlation is to mark to market a synthetic tranche on an ongoing basis. As we observe changes in the spreads for the individual names in the pool, we can reprice the tranches above by assuming the correlation level is constant, but updating the spreads. Additionally, implied correlations can be used for relative value analysis. For example, senior and second loss tranche protection increase in value as correlation increases. Since both tranches depend on the same basket of names, we would expect them to have a similar implied correlation. As mentioned above, the implied correlation of the senior tranche (45%) is significantly higher than that of the second loss tranche (20%). This means that senior protection is expensive relative to second loss protection. We can also perform relative value analysis across deals if we believe that the pools in two different CDOs have similar characteristics, in terms of credit quality, industry, and geographical distribution. For example, if two CDOs have similar pools and structure we would expect to observe comparable implied correlations for their senior tranches. All else being equal, a discrepancy in implied correlation can serve as an indicator of a discrepancy in price between the two structures. CFTC makes amendments to CFMA 2000 Risk News - October 29, 2001 By Naomi Humphries The Commodity Futures Trading Commission (CFTC) has released the final rules relating to the trading of equity futures products in the United States. These rules implement provisions of the Commodity Futures Modernisation Act of 2000 (CFMA) that lift the 19-year ban on the trading of single-stock and narrow-based stock index futures in the US. The final rules are in line with the new CFMA statutory provisions regarding the specification of listing standards and conditions for trading security futures products. The rules also establish requirements related to the self-certification of rules and rule amendments, reporting of data, speculative position limits, and special provisions regarding the contract design for the cash settlement and physical delivery of security futures products. The CFTC received comment from the Chicago Mercantile Exchange (CME), the Chicago Board Options Exchange (CBOE), the American Stock Exchange (Amex) and the Intermarket Surveillance Group (ISG). The CFTC adopted several revisions consistent with comments, but stated: "Generally, the commentators supported the proposed rules." The CFTC also streamlined the trading process in its revisions of rules governing commodity futures and options intermediaries on October 19, following the enactment of the CFMA and the resulting revisions to the Commodity Exchange Act (CEA). Key rules governing intermediaries, including futures commission merchants, introducing brokers, commodity pool operators and commodity trading advisers, have been revised to provide greater flexibility consistent with the mandate of the CFMA to streamline and eliminate unnecessary regulation for entities registered under the act. They include a provision for retail customers to have broad access to registered derivatives transaction execution facilities, by permitting them to trade through a commodity trading adviser with $25 million or more in assets under management, and a proposal to replace the current prescriptive rule over ethics with a statement of acceptable practices. The CFTC claimed that comments from Fimat, a registered futures commission merchant, and securities broker-dealer, Exchange Analytics, an ethics training provider, the CBOT, the National Futures Association and the Managed Funds Association, all generally supported the adoption of the proposed amendments for commodity futures and options intermediaries. It added that the issue that generated the most discussion was ethics training. Acting chairman at the CFTC, James Newsome, said: "These rules are just the first step in the Commission's review of appropriate regulatory relief for intermediaries. We have begun the intermediary study that Congress directed us to perform, and we may well be implementing additional regulatory reforms prior to the study's conclusion." Banks tout economic derivatives IFR - October 29, 2001 Deutsche Bank and JP Morgan will be using an auction mechanism to deliver the new derivatives products, which they say will be self-clearing and self-hedging. The solution licensed to the two banks to create derivatives on economic statistics will also be applicable to corporate earnings and revenues, mortgage prepayments, equity prices, central bank target rates, index-related products, electric power, weather degree days, credit or any event-driven market where the development of risk management tools has been constrained by illiquidity, according to the developer of the solution, New York-based Longitude. "Once the mechanisms are up and running and validated, we could envision structured notes on swaps linked to the auction process itself," said JP Morgan Chase's Chris Harvey, managing director of foreign exchange and interest rate derivatives sales for the Americas. Deutsche Bank has picked Germany's lfo and Japan's Tankan as the debut products for its economic derivatives franchises in Europe and Japan. JP Morgan Chase is still in the process of selecting its inaugural US economic statistics product. JP Morgan and Deutsche Bank declined to disclose the cost of their franchise on the economic derivatives. To retain their exclusive agreements with Longitude for the Parimutuel Digital Call Auction (PDCA)-enabled derivatives, the banks must meet performance benchmarks. Longitude charges a fee based on the notional volume cleared through its system. Using Longitude's PDCA bookrunner product, Deutsche Bank, for example, would engage in pre-marketing or preselling activity that is similar to that in a bond or equity syndicate offering, followed by a short auction period. During the auction period, the bank would submit orders to buy or sell digital options on the economic data covered to Longitude's web-based system. Upon receipt of the orders, Longitude's system produces bid/offer prices for the derivatives being offered, and other relevant market equilibrium statistics, such as limit order books. Longitude routes this information back to the bank, which publishes the statistics for its customers. In this example, Deutsche Bank would be counterparty to transactions that are filled. An order that is filled would result in an International Swaps and Derivatives Association-documented transaction. The filled orders should hedge themselves because in a pari-mutuel system all claims that end in-the-money are funded by those out-of-the-money. "Longitude's clients can offer derivatives without assuming additional risks on their own balance sheets," said Andrew Lawrence, chief executive of Longitude. As the systern accepts orders with limit prices, capital markets participants can have a high level of price certainty. In a pari-mutuel system, prices are market-driven and determined by customer participation, rather than a model or subjective assessment of the price of risk. Doubfers "A pari-mutuel model is a demand and supply based market, so the question becomes: Will there be enough participants?" said Richard Sandor, chief executive of Environmental Financial Products and one of the architects of the interest rate futures markets. "Is it view taking or [traditional] hedging? I'm not sure," said one bulge bracket firm's head of market risk management. Numbers of participants are difficult to predict because they will depend upon the design of the specific auction, said Longitude's Lawrence. "Perhaps as few as 10-15 total orders can form a very rich auction equilibrium," he said. The cost of operating the call auction is another consideration. A high transaction charge will mean less money for the winners. "It varies from market to market. But because banks are not taking market risk, the price for the service will be modest," said Lawrence. "In general, it has always been considered extremely desirable to disaggregate risk factors to the fullest extent possible because they can always be easily recombined." "Let's assume a health maintenance organisation (HMO) wishes to hedge out its exposure to annual medical cost inflation in the US, and that the health industry accounts for slightly less than 20% of US gross domestic product. What can this HMO do now in the traditional markets to mitigate this risk? Not much. But JP Morgan could offer derivatives based directly upon this very important measure in order to offer a risk management product for this HMO," he said. Both JP Morgan and Deutsche Bank are expecting early interest from financial institutions, and fixed-income participants in particular, because no mechanism for isolating and hedging or speculating on the growth rate of a country's economy currently exists. Deutsche Bank's strategy for introducing the new products will initially hinge on drumming up internal interest, said Kevin Rodgers, global head of currency options at Deutsche Bank in London. In January, the bank's trading desks will start using it internally to hedge their own positions. This activity will be useful in providing the bank with probability distributions, he added. Deutsche Bank will then try to get other banks' proprietary and swap desks to use the system. The new products will probably be available for use by hedge funds, commodity trading advisers and fund managers by the third quarter of next year. JP Morgan Chase expects to start its franchise market on US economic statistic derivatives next month. **End of ISDA Press Report for October 29, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT. Scott Marra Administrator for Policy and Media Relations International Swaps and Derivatives Association 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Fax: (212) 332-1212 Email: smarra@isda.org
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