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JPM CDS Handbook 2006

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JPMorgan Corporate Quantitative Research department guide to Credit Derivatives, specifically Credit Default Swaps. Includes valuation, trading strategies, indices, etc.
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    The certifying analyst(s) is indicated by a superscript AC. See last page of the report for analyst certification and important legal and regulatory disclosures. www.morganmarkets.com  About this handbook This handbook reviews both the basic concepts and more advanced trading strategies made possible by the credit derivatives market. Readers seeking an overview should consider Sections 1.1 - 1.3, and 8.1. There are four parts to this handbook: Part I: Credit default swap fundamentals 5 Part I introduces the CDS market, its participants, and the mechanics of the credit default swap. This section provides intuition about the CDS valuation theory and reviews how CDS is valued in practice. Nuances of the standard ISDA documentation are discussed, as are developments in documentation to facilitate settlement following credit events. Part II: Valuation and trading strategies 43 Part II provides a comparison of bonds and credit default swaps and discusses why CDS to bond basis exists. The theory behind CDS curve trading is analyzed, and equal-notional, duration-weighted, and carry-neutral trading strategies are reviewed. Credit versus equity trading strategies, including stock and CDS, and equity derivatives and CDS, are analyzed. Part III: Index products 111 The CDX and iTraxx products are introduced, valued and analyzed. Options on these products are explained, as well as trading strategies. Tranche products, including CDOs, CDX and iTraxx tranches, Tranchlets, options on Tranches, and Zero Coupon equity are reviewed. Part IV: Other CDS products 149 Part IV covers loan CDS, preferred CDS, Recovery Locks, Digital default swaps, credit-linked notes, constant maturity CDS, and first to default  baskets.  JPMorgan publishes daily reports that analyze the credit derivative markets. To receive electronic copies of these reports, please contact a Credit Derivatives research professional or your salesperson. These reports are also available on www.morganmarkets.com. Corporate Quantitative Research New York, London December, 2006 Credit Derivatives Handbook Detailing credit default swap products, markets and trading strategies Corporate Quantitative Research Eric Beinstein AC   (1-212) 834-4211 eric.beinstein@jpmorgan.com Andrew Scott, CFA   (1-212) 834-3843 andrew.j.scott@jpmorgan.com Katy Le   (1-212) 834-4276 trang.t.le@jpmorgan.com Ben Graves, CFA   (1-212) 622-4195 benjamin.j.graves@jpmorgan.com European Credit Derivatives Research Jonny Goulden   (44-20) 7325-9582  jonathan.m.goulden@jpmorgan.com Saul Doctor    (44-20) 7325-3699 saul.doctor@jpmorgan.com  Yasemin Saltuk   (44-20) 7777-1261 yasemin.x.saltuk@jpmorgan.com Peter S Allen   (44-20) 7325-4114 peter.allen@jpmorgan.com    Eric Beinstein (1-212) 834-4211 eric.beinstein@jpmorgan.com  Andrew Scott, CFA (1-212) 834-3843 andrew.j.scott@jpmorgan.com Corporate Quantitative Research Credit Derivatives Handbook December, 2006   2 Part I: Credit default swap fundamentals 5 1. Introduction.......................................................................................................................................................................6 2. The credit default swap....................................................................................................................................................8 Credit events.....................................................................................................................................................................9 Settlement following credit events .................................................................................................................................10 Monetizing CDS contracts..............................................................................................................................................11 Counterparty considerations...........................................................................................................................................12 Accounting for CDS.......................................................................................................................................................12 3. Marking CDS to market: CDSW ..................................................................................................................................13 4. Valuation theory and credit curves...............................................................................................................................15 Default probabilities and CDS pricing............................................................................................................................15 The Shape of Credit Curves............................................................................................................................................18 Forwards in credit...........................................................................................................................................................20 Summary.........................................................................................................................................................................22 Risky Annuities and Risky Durations (DV01)...............................................................................................................23 5. The ISDA Agreement .....................................................................................................................................................24 Standardized documentation...........................................................................................................................................24 The new CDS settlement protocol..................................................................................................................................24 CDX Note settlement procedures...................................................................................................................................32 “Old-fashioned” CDS settlement procedures.................................................................................................................33 Succession events...........................................................................................................................................................34 6. The importance of credit derivatives.............................................................................................................................38 7. Market participants........................................................................................................................................................40 Part II: Valuation and trading strategies 43 8. Comparing bonds to credit default swaps ....................................................................................................................44 Decomposing risk in a bond...........................................................................................................................................44 Par-equivalent credit default swap spread......................................................................................................................46 Methodology for isolating credit risk in bonds with embedded options.........................................................................52 9. Basis Trading...................................................................................................................................................................55 Understanding the difference between bonds and credit default swap spreads..............................................................55 Trading the basis.............................................................................................................................................................57 10. Trading Credit Curves.................................................................................................................................................62 Drivers of P+L in curve trades........................................................................................................................................62 Curve trading strategies..................................................................................................................................................70 1. Equal-Notional Strategies: Forwards..........................................................................................................................70 2. Duration-weighted strategies......................................................................................................................................76 3. Carry-neutral strategies...............................................................................................................................................80 Different ways of calculating slide.................................................................................................................................82 Calculating breakevens...................................................................................................................................................84 The Horizon Effect.........................................................................................................................................................86    Eric Beinstein (1-212) 834-4211 eric.beinstein@jpmorgan.com  Andrew Scott, CFA (1-212) 834-3843 andrew.j.scott@jpmorgan.com Corporate Quantitative Research Credit Derivatives Handbook December, 2006   3   Changing Risky Annuities over the Trade Horizon........................................................................................................86 A worked example..........................................................................................................................................................86 Horizon Effect Conclusion.............................................................................................................................................89 11. Recovery rate and curve shape impact on CDS valuation ........................................................................................90 Intuition..........................................................................................................................................................................90 CDS curve shape impact.................................................................................................................................................91 Recovery rate impact......................................................................................................................................................92 Assumptions at contract inception..................................................................................................................................93 Worked examples...........................................................................................................................................................94 12. Trading credit versus equity........................................................................................................................................97 Relationships in equity and credit markets.....................................................................................................................97 Finding trade ideas..........................................................................................................................................................98 A worked trade recommendation..................................................................................................................................100 13. Trading CDS against equity puts...............................................................................................................................106 Part III: Index products 111 14. Credit default swap index products...........................................................................................................................112 Introduction ..................................................................................................................................................................112 Mechanics of the CDX and iTraxx indices...................................................................................................................112 Basis to theoretical........................................................................................................................................................113 Comparing on-the-run and off-the-run basis................................................................................................................114 Credit events.................................................................................................................................................................115 CDX and iTraxx indices...............................................................................................................................................116 History of US CDS Indices...........................................................................................................................................120 15. CDX and iTraxx options.............................................................................................................................................121 Product description.......................................................................................................................................................121 Basic option strategy payoff diagrams..........................................................................................................................122 Using options to express a spread view........................................................................................................................122 Using options to express a volatility view....................................................................................................................122 Combining spread and volatility views ........................................................................................................................123 Option trading strategies...............................................................................................................................................124 The practical side to trading options.............................................................................................................................125 16. Trading credit volatility .............................................................................................................................................130 Defining volatility.........................................................................................................................................................130 Delta-hedging...............................................................................................................................................................131 The returns from delta-hedging in credit......................................................................................................................132 Historical analysis.........................................................................................................................................................133 Option glossary.............................................................................................................................................................134 17. Tranche products........................................................................................................................................................136 What is a tranche?.........................................................................................................................................................136 Why are synthetic tranches traded?..............................................................................................................................139 The mechanics of trading tranche protection................................................................................................................141 The role of correlation..................................................................................................................................................142 Pricing tranches............................................................................................................................................................143 Other products..............................................................................................................................................................146    Eric Beinstein (1-212) 834-4211 eric.beinstein@jpmorgan.com  Andrew Scott, CFA (1-212) 834-3843 andrew.j.scott@jpmorgan.com Corporate Quantitative Research Credit Derivatives Handbook December, 2006   4 Part IV: Other CDS products 149 18. Loan CDS.....................................................................................................................................................................150 Overview......................................................................................................................................................................150 Comparing CDS contracts across asset classes ............................................................................................................150 Similarities and differences between CDS and LCDS..................................................................................................151 Participants...................................................................................................................................................................154 Settlement following a credit event..............................................................................................................................154 Modifications to LSTA transfer documents .................................................................................................................156 Rating agency approach to LCDS in structured credit .................................................................................................156 Spread relationship between loans and LCDS..............................................................................................................157 19. Preferred CDS.............................................................................................................................................................158 Overview......................................................................................................................................................................158 Preferred stock CDS contracts differ from the standard CDS contract.........................................................................158 PCDS versus CDS........................................................................................................................................................160 Overview of preferred stock issuance and market........................................................................................................160 20. Profiting from views on recovery rates.....................................................................................................................162 Recovery Rate Lock .....................................................................................................................................................162 Digital Default Swaps...................................................................................................................................................167 21. Other credit default swap products...........................................................................................................................168 Credit linked notes........................................................................................................................................................168 Constant maturity credit default swaps (CMCDS) and credit spread swaps (CSS)......................................................169 First-to-default baskets.................................................................................................................................................170 Conclusion 171 Appendix I: JPMorgan CDSW Example Calculations Model......................................................................................172 Appendix II: How to get CDX and iTraxx data.............................................................................................................173
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