07 3&4

07-3&4 Financial Engineering and Its Role in Credit-Risk Management
1. Economics of Financial Engineering 2. Derivatives: Structured vs. Indexed Products 3. Special Role of Securitization and Credit Derivatives in Managing Credit Risk
a. b. c. Index Derivatives Default Swaps Basis Risk
4. Ethical Issues in Market Making

Edward J. Kane, BC 07-3&4
NEED FOR DUE DILIGENCE

Every Lender Employs Multiple Technologies of Lending: Deal Formats Must Adapt to the Informational and Regulatory Environments in Which Lender and the Borrower Operate
Three Mutually Reinforcing Components Define the DueDiligence Technology Used in a Particular Lending Chain: 1. Screening Mechanisms 2. Contract Structure (e.g., covenants, collateral rights, enhancements, amortization schedule, reporting requirements) 3. Monitoring Strategy
The Modern Credit-Risk Management Uses More Outside Information and More Trading than Buy-and-Hold Dealmaking
Deal-Maker Client
Compensation & Advancement Opportunities
Credit Risk Mgt. Group

Counterparty evaluation Credit limits Concentration risk mgt.
Credit Pricing
Credit Portfolio
Risk Transfer
The Credit Market
Theme: Capital Needed to Support Credit Risk can be reduced by active portfolio management
Customer Base Gives banks concentrated exposures to customer default Active management can diversify credit risk across many industries & countries.
Source: ERisk and Enron
Tactics of Modern Credit-Risk Management

Straightforward Methods: Sell Parts of Loans Extend Business Beyond Geographic Locations of Offices Securitize Assets Synthetic Methods Covered in this Course Segment: Structured Finance Activity: -- Credit Derivatives -- Credit Enhancements
Economic Basis of Financial Engineering is Communicated by the concepts Etymological and Metaphorical Roots
Engineering is the art or science of making practical application of knowledge uncovered in a pure science: as (e.g.) in improving engines. With the aid of lawyers, Financial Engineers apply the pure theory of state-contingent claims to devise new contracts or processes to extend the work of long-established forms of financial dealmaking: rely predominantly on techniques for synthetically replicating (cloning) patterns of contractual cash flows. Why do lawyers play a big role? Contracts have to be enforceable in the jurisdictions in which they trade.
Definition of Financial Engineering:

Financial engineering is an emerging body of related risktransfer techniques: methods by which to hedge or speculate more efficiently (Coopers & Lybrand).
Using derivative instruments as a contracting technology, these techniques break down and replicate standard deals synthetically and generate new ways to understand, measure, and manage risks. Structured derivative products (segment the distribution and funding of risks in an observable underlying asset) vs. indexed derivative products (create a betting market for movements in an observable economic or financial index).
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Derivatives: Can you find an Imbedded French and Boston Word?
DERIVATIVES
A structured "financial derivative product" is an obligation to service a well-defined part of another financial claim. It is created by unbundling and repackaging pieces (or "strips") of so-called fundamental instruments: Using a river metaphor, structured derivative may be said to divert substreams of cash-flow streams on standard instruments. A second Metaphor for re-engineering value-creation is manuscript preparation. This metaphor better fits indexed products, in that authors use either scissors and tape or word-processing software to cut out undesired material and to move good sentences and paragraphs around.
Derivatives are Risk-Management Tools

decompose standard financial instruments such as loans [=underlyings] into imbedded subcontracts [=derivatives]. FSFs construct a subsequent synthesization of these imbedded elements into innovative (and sometimes complex) cross-market structures that can lessen information asymmetries and adaptively serve counterparties. each of the terms placed in quotes deserves study: standard, subcontracts, synthesization, counterparties.
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Etymology of the word Derivative is also Mathematical:

In math, every derivative of a continuous function f(x) is imbedded in the function itself. Students familiar with the Taylor Series representation for a continuous f(x) should recognize that it clarifies precisely this point: It expands f(x) around x0 as a function of f(x), f(x), , f()(x).
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Mechanisms for Credit Transfer

Definition: A Credit Derivative is any contract that shifts around the risks embedded in a loan or bond contract.
Structured Credit Derivatives are by no means new (deposit insurance and other guarantees). What is new is the creation of instruments that let counterparties trade finely divided categories of risk separately in a (usually) highly liquid market. Credit transfers create new ways for financial institutions to lose as well as to generate net worth. [Irony: Dispersing other risks simultaneously funnels and concentrates liquidity risks on to a handful of core dealer institutions.]
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Considered as a Technology of Risk Transfer and Risk Assumption, Derivatives Have Opened Up At Least Three New Specialties in Finance
1. The Derivatives Industry: Jobs for dealers and traders. 2. The Hedge-Fund Industry 3. The Risk-Management Industry: New
work for alleged experts, specialized accountants, and regulators.
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Derivative contracts complete the links between what had previously been unconnected dealmaking markets.
In structured products, cash-flow re-engineering creates explicit derivative contracts that are merely implicit in the elements of holistic dealmaking: cash flows, amortization schedules, and covenant obligations. Derivatives allow a bank to: construct and trade synthetic substitutes for (say) a longterm deposit instrument without actually issuing or redeeming deposits per se: make something artificially that nature made long before. Efficiently transfer to (or acquire from) other parties designated risk exposures for itself or for bank customers. Improve a customer corporations balance sheet in whatever ways the corporations managers desire.
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Three Paths of Risk Transfer: insure, trade away, or hedge.

Untransferred risk is self-insured to the extent it is supported by enterprisecontributed capital. That self-insurance is a default option for supporting risk links integrated risk management to the allocation of firm capital across different activities or profit centers.
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Let Me Tell You a Story about Derivatives and Underlyings
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Parable of Consuming a Sunday Dinner of Chicken as a Child

1) at Cafeteria vs. shopping at supermarket in early 1940s 2) where did garbage parts go at home? In the garbage. Where did they go at 1940s cafeteria? Soups; chicken loaf; chicken salad. Where do they go now? Soup makers, pet food manufacturers, fertilizer manufacturers, hot dogs, institutional food service.
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Financial Engineers use Derivatives to disaggregate and transfer business risks.

chicken stripping and repackaging provides a metaphor by which to explain private and loophole sources of efficiency gains from synthetics. The metaphor emphasizes how pent-up private value can be released or unleashed by contractually unbundling conceptually separate risks.
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How does this "unbundling" and repackaging unleash value? -- It reduces Wastage associated with forcing "byproducts" on holders of standard instruments as in whole-chicken "tied sales."
Different people's "garbage parts" (e.g., backs, necks, and gizzards) go to individuals who value them at all (e.g., food-service managers in college dorms) and lets valuable parts (e.g., breast, legs) go to those who value them most. Underlying idea is that everything truly "edible" ought to trade at a positive price to someone. Stripping increases the equilibrium price of garbage pieces and supports opportunities for innovations such as buffalo wings.
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First Four Generations of Derivatives Instruments

1. 2. Corporate Stocks and Bonds (written against earnings produced by the physical assets of the issuer.) Passthrough securitization (uses paste but no scissors)
Subsequent Two Generations are Examined Next: 3. Structured Finance (uses scissorsequivalent to control-x keysbefore pasting) 4. Indexed products
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Generation 3. Structured finance goes beyond clipping and simple pooling to undertake imaginative Repackagings of pieces of Securities in the pool. The instructive metaphors for derivative instruments are deconstruction or clipping: think of Igors robbing graves for usable body parts for Dr. Frankenstein to incorporate into his synthetic monster.
Less horrifically, derivatives technology works like high-tech scissors and paste. Process clips claims to familiar cash flows, for the purpose of delicately sorting them into reorganized piles or tranches of logically related claims. Tranche is the French word for slice. Inventive principles for reorganizing pieces can lead to customization of standardized instruments.
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Word Origins: The word structured emphasizes the use of imbedded derivatives while Finance stresses that such dealmaking creates debt-equity hybrid securities. One goal of S.F. is to execute a risk-controlled arbitrage: creatively arbitraging differences in the price paid for riskbearing in different markets, instruments, or regulatory environments. The term structuredcomes from dealmaking elements in which contingent financial commitments are triggered by verifiable events whose realization is uncertain. Structured finance may be likened to balance-sheet surgery: It lets FSF managers support assets with minimal amounts of their own capital. Analogy: Deals set a Windows-like menu of events to which events act as a mouse that clicks on payoffs.
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STRUCTURED FINANCE CAN MAKE THINGS THAT DONT EXIST IN NATURE
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DISASSEMBLING A STRUCTURED PRODUCT
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Generation 4: Indexed Derivatives

We Can Illustrate by Looking at an Index Contract written as a swap of pay-fixed (PF) and payvariable (PV) coupons. The PV part promises I the total return generated ex post by a specified Government Bond Index over the contract period.
Notation
B: Initial Notional Amount (N.B. Notional Amounts are Never Paid) B*: Final Notional Amount Determined by PF Index (1+I)B R: The PV index (usually LIBOR) Note: N.B. means Nota Bene (Note Well)
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Notional value of a derivative contract is a benchmark value that states a quasi-principal amount used to stipulate a deliverable obligation at settlement dates.
Aggregate Market Value averages in the range of 3% to 3.5% of Notional Value (N).
Enormous growth in the notional value of derivative contracts = $88 Trillion at yearend 1999. $111T in 2001; $220T in 6-04 (BIS), $298T in 605, and $370T in 6-06.
Always remember that market value of contracts at each date is much less: Ranges between 1.5% and 3.5% of (N) for individual contracts.
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CASH FLOW Receive: Total Return on Fixed-Rate Bonds B* - B Pay: LIBOR = R -RB Net Inpayment to the RFPV side B* - B - RB [=(I-R)B]
The final figure is the amount to be exchanged on the next settlement date. The PV faces the net outflow if R>I.
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Instructive Contrast: What would one earn by taking a Parallel Leveraged Position in the Actual Bonds that make up that Index?
p Buy Bonds: B paying a holding-period yield h = i+ p
Borrow at LIBOR: -B Net Inpayment
CASH FLOW B + hB -RB - B (h-R)B
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The fundamental difference between holding a physical and a synthetic instrument is whether one owns tangible bonds that pay a given return h or one holds a claim on a counterparty that pays the virtual yield h given by the PF index I. The swap position adds counterparty risk to the extent the swap is not perfectly enhanced.
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In the FSF industry, value can be released by unbundling activities in two ways: by allocating risk more efficiently or by creating loophole value in lowering tax or regulatory burdens.
Transcending Charter Limitations: Failure of 67-year effort to keep banks out of other major financial businesses-- (1) mutual funds and other securities businesses & (2) insurance sales & underwriting-- resembles how banks might get into chicken sales if they had been forbidden to sell whole chickens. Banks could transcend charter limitations by selling chicken parts if chicken sales promised to be profitable. This exemplifies regulatory arbitrage. In fact, banking organizations performed more and more parts of the forbidden business in-house -- i.e., within a holding-company structure of jointly owned nonbank corporations -- without ever violating blanket restrictions. Over time, financial engineering broke down traditional charterimposed sectoral and intrafirm boundaries of the FSF industry and the Gramm-Leach-Bliley Act of 1999 formally recognizes this.
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Financial engineering teaches us the value of viewing standard instruments as if they were syntheticizations. In each standard mortgage a bank holds, it takes a collection of long and short positions in six imbedded derivatives:
1. Long: Interest only strip 2. Long: Principal only strip 3. Short: Interest rate cap 4. Long: Interest rate floor
5. Long: Credit risk

6. Short: Prepayment option (or put) on the collection of other pieces
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SYNTHETIC REPLICATION
#1-#4: The first four positions could be synthesized from zerocoupon bondlets that engineers might construct and price from existing Treasury securities. Particularly easy for a fixed-rate mortgage because #3 & #4 cancel out. #5: Credit risk concerns the realizability over time of the contractual spread over the synthetic positions in Treasuries. #6: Value of lenders short position in the put falls and becomes more negative as interest rates fall (because prepaid funds must be reinvested at a yield lower than the cancelled mortgage). Query: What happens to borrowers and lenders put values when interest rates rise?
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Topic 3: Securitization-Driven and Synthetic Approaches to Credit-Risk Management

Traditional Loan Contracts are ILLIQUID instruments. -Underwriting analysis (=basis for setting yield and deal structure) is hard to convincingly communicate to others -Hence, until late in the 20th century, Concentrations in bank loans to Relationship Customers were held to maturity and managed through careful origination, diversification, and capital support.
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Historically, lending was holistic. Modern Lending Deconstructs the Steps Traversed in Making a Loan and Shifts Much of the Responsibility for Measuring and Pricing Risk to Inside or Outside Quants.
Allows FSFs either to specialize in-house or to outsource the subset of risks and skills needed at each particular stage.
1. Applications Generation Origination 2. Processing 3. Underwriting 4. Closing 5. Servicing/Collection [6. Insuring risk of shortfalls in payments due] 7. Funding (temporary vs. permanent risk support) 8. Postloan monitoring and risk support or transfer
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Division of Labor is Determined by the Extent of the

Market: Unbundled Parts of Lending Technology are Automating, Digitizing, and Globalizing
Many Social Benefits Re Information Generation, but Two Negatives: Outsourcing relocates important decisions and intensifies the difficulties in shaping ones ability to assess Ethical Risk: the problem of assuring that due diligence is performed in all individual functions with holistic loan-officer model, a continuous double-checking role is played by high-level committees who are subject to legal penalties for negligence and malfeasance. [Good judgment comes from experience. Experience comes from exercising poor judgment = error-learning about the extent of ones susceptibility to disaster myopia.] with outsourcing model, loan committee must rely on reputations, bonding agreements, and fraud & negligence laws, but internal controls that support this reliance at the outsourcer break down when the outsourcer becomes insolvent. I call the threat of such a breakdown the risk of exogenous transfer reversal.
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Computer or Credit-Agency Scoring of Borrowers Obscures the Character of Due-Diligence and Pricing Activity
Point scores classify customers in line with the probability of engaging in a targeted form of behavior. Model Risk: Usefulness of scores depends on size of underlying sample and representativeness of its relevant subsample cells. Also, on reliability of input data and sincerity with which the outsourcers acquit their tasks. Scoring is driving automation of all links in the lending chain: shapes the collection & verification of databases Credit scores and ratings can be fed directly through an implicit and explicit loan pricing matrix. But when loan officers doctor data, GIGO holds.
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Theme: Expanding Use of Derivatives in Securitizations

Putting aside the counterparty risks it introduces, Securitization synthetically replicates standard assets. We can use intermediation as a foil*:
In intermediation, a loan originator uses its own debt to fund the assets. Securitization creates a new tradable instrument a securityby pooling the promised cash flows from a number of similar assets, such as mortgages or receivables from credit-card accounts. Responsibility for forwarding the cash flows stripped from the underlying assets falls on a separate entity and the obligation carries external or internal credit enhancements: third-party guarantees or excess collateral. Pooling diversifies risk and the credit enhancement reduces the need for bondholders to monitor underlying borrowers. Finally, assets that would be awkward or costly to sell off individually are transformed by market-making into liquid instruments.
*What is a foil? e.g., in the story of Cinderella?
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Securitizations and derivatives may be instructively thought of as treating standard financial instruments as a series of forward contracts to be split apart and creatively reassembled for customer convenience and FSF fun and profit.
Unlike a spot contract, a forward contract has two different dates: (1) a dealmaking date, and (2) an execution date.
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Securitization of loans typically transfers monitoring and loss-control responsibilities for the underlyings to an explicit credit enhancer who may well lie outside the investor group. Historically, variations evolved in character of traditional interlender participation agreements. These variations prefigured the use of derivatives but lacked a liquid market:
a) b) c) d) Pro rata participations LIFO participations: establish seniority Strip participations (to early vs. late cash flows) Recourse participations
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Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs) are Customized asset pools created by slicing or clipping early and late cash flows assigning them to separate security "tranches*."
-- Financial engineers treat each underlying mortgage as a collection of post-dated coupons and sort early and late pieces into separate piles. -- E.g., ignoring the credit and prepayment risk, we might group payments due on a 15-year mortgage into receipts due in 1-2; 3-7; 8-12; 13-15 years.
*Reminder: "Tranche" (noun) is a French word for slice
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Illustration of Possibilities for Stripping and Repackaging a 15-year Annual-Payment Fixed-Rate Mortgage
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Key: Above the dotted line = repayment of principal Below the dotted line = interest payment
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As a way to collateralize its exercise of the due diligence in originating loans, a fifth residual tranche in any securitized asset pool is held by the originator.
Residuals are retained interests that an institution keeps after selling and securitizing a loan pool. They are called the Z tranche. They pay no positive principal or interest until all other tranches are retired. Zs are credit enhancements in that they put the originator (or subsequent holder) in a first-loss position if cash flows cannot service the securities. Losses may require outpayments to meet shortfalls in cash flows available to pay other tranches. Residuals are highly volatile and, if recourse is entailed, their value may turn negative. Residuals have generated deep losses for the FDIC in several recent failures: e.g., First National Bank of Keystone, WV.
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Illustration of Another Approach to Stripping and Repackaging a 15-year Annual-Payment Fixed-Rate Mortgage
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Key: Above the dotted line = repayment of principal (PO strip) Below the dotted line = interest payment (IO strip)
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Z tranches are important in indexed products and in Interest-Only Strips and PrincipalOnly Strips: Especially for POs on risky debt
-- Such strips treat each coupon as separable into principal and interest. -- IO strips have a falling cash-flow pattern. -- PO strips show an opposite rising cash-flow pattern: have substantial exposure to prepayment and default risks.
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Residuals Are Edible, But Not Very Tasty
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Why is This a Better Example of a Residual?
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Exercise: Stripping and Repackaging a $100 mil. Pool of 6.5% 15-year Mortgages into Two Tranches to Concentrate Prepayment & Credit Risk
Tranche A has a face value of $50 million and pays 6% annually. Tranche B has a face value of $50 million and pays 7% annually. (This tranche bears more risk from default and has less early payment volatility than the more-liquid tranche A). Mortgagor prepayments and amortization reduce the principal of Tranche A until this Tranche is retired. Example: With no prepayments or amortization, annual payments would be: Tranche A: $3 mil. Tranche B: $3.5 mil.
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Suppose interest, amortization and prepayments on the pool produce cash flows in the first year of $8.5 million. The following annual payments would be made to the holders of each Tranche: Tranche A: $5.0 mil. Tranche B: $3.5 mil. What would be the principal and interest payments due on Tranche A in year two? Not $50 mil. And $3 mil. Principal: $50 mil. - $2 mil. = $48 mil. Interest: .06($48 mil.) = $2.88 mil.
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Issue to Think About Can Trading derivatives be better than trading the underlying assets: Why?
May be the only practicable way to trade underlyings May enable customization of payoffs May take advantage of particular types of information May permit greater implicit leverage for short horizons May lower transactions cost for short holding periods May entail more favorable implicit borrowing and lending rates May generate special tax and regulatory advantages.
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What Advantages Explain this Minicase?

1999 News Item in Lecture Notes describes a Hong Kong bank as selling $129 million in its own mortgage loans to a securitizer and buying back securities backed by the same loans.
Compared to funding by deposits, pent-up economic value released to the originating bank were:
Bonds customize timing of payouts by stripping & reassembling standard flows Could resell the bonds flexibly over time and in flexible pieces Banking Book item converted to a Trading Book item
Loophole value:
Capital requirements applied against position shrunk from a 50% to a 20% risk weighting.
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Index Derivatives provide another way to hedge concentrated exposures to collectability risk (i.e., default risk) in relationship-based loans or swaps are provided by a booming market in so-called credit-default derivatives.
Instruments whose payoffs are linked in some way to a change in the credit quality of a specified asset or collection of assets. Grown in notional value from only about $2 billion in Summer of 1995 to an estimated $20 trillion in mid2006. It is the cutting-edge instrument of integrated risk management today.
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Credit risk becomes insurable by a third party when it can be defined as the exposure to changes in mark-to-market value brought about by the occurrence of a designated credit event. A contractable credit event means an observable change in a counterpartys ability to service its debt. Special dangers from global, nationwide, or industrywide events: e.g., effects of 9-11-01 terror on cash flows of credit-card banks; effects of telecom meltdown on largest banks.
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A credit default swap resembles a casualty insurance policy written against the occurrence of a default event during the life of a swap. A counterparty buys protection against default on a type of loan or receivable from a dealer by paying a per-period fee.
Payout is triggered by specified and observable default events on publicly traded securities of a particular issuer (or one of a basket of issuers) stipulated in the contract. Harder vs. softer events: covenant violations vs. repudiation Promised payments are indexed to returns observed on a stipulated reference security or an index of corporate loans, corporate bonds, or emerging market sovereign bonds. Initial competition in index design and usage is giving way to standardization.
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Legally Differentiating a CDS from a Casualty Insurance Policy

1. Casualty Insurance requires the protectionbuying party to have an insurable interest (i.e., a long position in the underlying asset). A CDS may simply place a bet. Risk seller in a CDS may not own any of the risk it is buying protection against. 2. CDS payoffs are based on formulas. Payoffs on Casualty Insurance are based on proof of loss, employing subjective (and often weaselly) estimates prepared by professional appraisers and loss adjusters.
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The protection-buying or risk-selling counterparty A pays a per-period fee (often called the default swap spread) of f basis points on the notional amount to the risk-buying counterparty B. As in an insurance contract, B makes a payment only in the specified contingency: a default by one or more of the contracts reference credits.
With cash settlement, the payment is calculated as the fall below par in the market price of the specified reference security OR indexed product at a stipulated time interval after the reference default event. The idea is to mimic the loss incurred by actual creditors of the reference credit: called event risk to contrast it to market risk. Triggering events must be defined in ways that are legally enforceable in a governing jurisdiction.
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Cash-Settlement Illustration
Premium (upfront or periodically) Default Swap Buyer
(Buys Protection: i.e., shorts the exposure in the underlying)
Payment in case of default of reference obligation
Default Swap Seller

(Assumes or goes long in the Risk)
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Protective Credit Default Swap

Default Risk of Company X
Premium in bps of the notional value
Risk Seller protection buyer option buyer
Risk Buyer protection seller option writer
Example of credit event: failure to pay, bankruptcy, cross-default, restructuring, repudiation, downgrading, etc.
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Hard to Assess the Net Benefits of a CDS: Affected by Nine Contractable Elements
1. 2. 3. 4. 5. 6. 7. 8.
9.
Premium (e.g., spread over LIBOR) Reference obligation (usually several bonds or an index) Notional amount Notional Price (need not be par) Tenor of swap Definition of default events Type of settlement (physical or cash) Verifiability of Signatory Counterpartys Authority to Obligate its Organization Adequacy of Collateral Support
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Predictive Power of CDS Spreads from 3-mo LIBOR (May 22, 2003)
Corporation Bid Offer Bid chg. U.S (weekly) American Exp. 37 43 10 AOL T.W. 152 168 30 Citigroup 26 32 9 Disney 90 100 11 Federated Dept. Stores 62 78 12 Ford 443 457 45 Ford Credit 362 378 45 General Electric 39 45 2 Cap Corp. GMAC 272 288 45 Goldman Sachs 43 49 6 Hertz 350 370 35 Hewlett Packard 36 44 0 IBM 27 33 0 Lehman Brothers 43 51 5 Merrill Lynch 44 50 5 Morgan Stanley 45 51 6 Philip Morris 254 266 -60 Wal-Mart 13.2 20.7 -1 Edward J. Kane, BC 07-3&4 Corporation Europe ABN AMRO Aventis Credit Lyonnais CSFB DaimlerChrysler Bid Offer Bid Chg. (Weekly) 22 27 22 49.5 115 132 128 40 40 17 51 0 0 0 6 15 10 8 0 0 0 5 Source: JPMorgan Name ASIA Fujtsu Japan Korea Malaysia Mizuho Bank Bid Offer Bid Chg (Weekly) 147 18 105 107.5 185 110 36.5 35 60 12 0.5 0 0 0 9 0 4 3
14 19 16 42.5 105
127 15 95 92.5 185
Deutsche Telekom 122 France Telecom Marks & Spencer Siemens UBS Vodafone 118 30 30 11 41
Qantas Airways 110 Sony Telstra Toshiba 21.5 35 40
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EXAMPLE OF JUMP RISK IN A MARKIT BBB INDEX DERIVATIVE
Index Spread
Index Price
Source: http://www.markit.com/cache/curves/02c06a3e71aae49c2087589805d.png
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Payment Triggers in Default Swaps

Credit Events triggering the exercise of a Default swap on a corporate obligation are: Bankruptcy Failure to Pay Restructuring If applicable (suppressed except in customized instruments) Under standard documentation, exercise requires 3 kinds of notice: Credit Event Notice Notice of Publicly Available Information Notice of Intended Physical Settlement (if relevant)
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Hypothetical Example Of Cash Settlement

Suppose the notional value N of a credit default swap is $100 mil. and that the reference obligation is priced at par (i.e , 100%) at the commencement date. Suppose a default occurs and that the average bid price of the reference obligation at active dealers falls to 35%. Assuming that the accumulating coupon is defaulted as well, the protection seller would owe : $100 mil (1.00.35) = $65 mil.
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Credit Default Swaps address both counterparty risk in swaps and the concentration-risk in FSF portfolios. Credit swaps unbundle default risk for all or part of a loan. Like an external credit enhancement, a credit swap separates the management of credit risk from the asset in which that risk naturally imbeds itself. A credit swap allows an institution to go long or short in a designated reference credit, usually a basket of bonds issued by credit-sensitive major names. With a credit-default basket, protection is usually limited to the date that the first basket issuer suffers a default event, shortly after which the contract is settled for cash at comparable market value. Such contracts are called first-to-default swaps.
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A Credit Swap provides a nontransparent way for a borrowers lead bank to share a customers risk without openly syndicating or securitizing the loan paper. Open rebalancing might disrupt the customer relationship. Credit swaps can trade a prioritized X percent of unpaid obligations on particular loans --or pools of loans-- to another party for cash or for a deposit paying a fixed or variable interest rate.
A way to Replace an FSFs local or regional Exposure to Concentrated Names with that of a highly Rated Counterparty to which there may not be any prior credit Exposure or local presence.
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Derivatives-based information can improve credit-risk management in 3 ways: Measurement: Credit has a synthetic price
KEY LESSONS
Monitoring: Loss exposures can be tracked in real-time

Management: Exposures can be quickly (albeit imperfectly) hedged
Benefits of diversification: Proactive credit-risk management may let an FSF increase revenues without proportionally increasing risk or capital.
Availability of Pricing Software: Credit Derivatives Calculator 3-20-03 - New York-based inter-dealer broker GFI has launched its credit derivatives pricing tool, Fenics Credit. GFI partnered with risk management and derivatives academics John Hull and Alan White to develop the tool.
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Summary Slide Beyond Hedging, Credit Derivatives Can:

Develop Exposures to Credits or Sectors where no prior origination capacity exists. Fashion Complex Synthetic Positions:
Can Take a short or long position in any sector quickly Can go short and long different names in the same industry sector Can lower effective burdens from capital requirements due to high ratings of the counterparty
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DERIVATIVES CAN EVEN CREATE A SYNTHETIC BANK
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Basis Risk Exists in Credit Derivatives

Basis Risk refers to the chance that returns on the reference security or index and the hedgeable item will not move in lockstep. Why? Reputation Risk and Correlation issues
1. Default events for the security and hedgeable item are imperfectly correlated as are their post-default returns. 2. The danger in relying primarily on counterparty guarantees is that counterparty default and issuer default can easily be positively correlated as well.
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Why take Basis Risk?: For FSFs that can build a partly internally diversified portfolio, credit derivatives whose payoffs are triggered by macro country or related-industry events are easier to find and cheaper to buy than protection against counterparty-specific events.
[Kumar, Risk, 6-01]
Russian, Turkish, Argentine Economic Weakness Vendor Financing of Telecom or Dot.com Companies
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To Manage or Supervise the Risk of Transfer Reversals, One Must Recognize How Risk of DueDiligence Breakdowns at Outsourcers Intensifies Perennial Threats to an Institutions Brand/Reputation
1. Lapses in Controls Against Abusive Dealmaking

2. Lapses in Controls Against Fraud 2. Lapses in Access & Data-Protection Controls
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Changing Financial Environment Expands the Range of Hedging Vehicles, But Encourages Disaster Myopia Regarding Their Outsourcer Effectiveness.
1.
Traditional Sources of Bank Losses a. Sour or Corrupt Loans b. Adverse Movements in Interest Rates or Currency c. Endgame Gambles for Resurrection: Funding Riskier Loans; Expanding Duration and Currency Imbalances
Values
2. Nontraditional Sources of Bank Losses a. Finiteness of Residual Obligations Imbedded in Securitized Loan Pools. b. Basis Risk in Derivatives Hedges c. Counterparty Risk Concentrations and Embedded Leverage From Multiple Hypothecation of Collateral, Margining, and Loss-Exposure in Speculative nonhedging) derivatives positions d. Legal Risk: Lawsuits Alleging Violations of Legal Responsibilities. Courts and ISDA end up redefining disputed credit events.
Cross(i.e.,
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Authorities Dont Know How to Supervise Basis Risk in Credit Derivatives?

Basis Risk refers to the chance that returns on the reference security or index and the hedgeable item will not move in lockstep. Credit derivatives improve market completeness, but gaps remain. Why? Easy-to-Overlook Imperfections in Hedges for Reputation Risk and Various Correlation issues
1. Default events for the security and hedgeable item are imperfectly correlated as are their postdefault returns. 2. Dangers of Double Default: When credit transfers rely primarily on counterparty guarantees, counterparty insolvency and issuer default can easily prove positively correlated.
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Topic 4: Ethical Issues in Making Markets

Contemporary financial-services deal-making blends three distinct ways of helping customers to price, diversify, or transfer risk:
Intermediation (Issue indirect debt; use proceeds to buy direct debt) Market-Making Fee-for-Service
-- next 11 slides offer an overview of the last two activities and explain how together these activities support growth in structured finance.
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Fee-for-service business focuses on broad financial-engineering services: credit enhancement and creative, flexible, and wideranging deal-making:
Comprises advisory and servicing activities that draw on the FSFs reputation, expertise, and diversified network of connections.
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Market-making per se
To make a market an FSF must stand ready to deal in contracts at the initiative of parties with whom they have no prior relationship. (autodealers, e.g.) Service lies in providing liquidity (i.e., immediacy) by acting as counterparty to both sides of other counterparties speculative or hedging contracts.
Think of a used-car dealer who stands ready to buy latemodel cars with no particular would-be buyer in mind.
76
Contracts that are liquid allow balance-sheet positions to be created or unwound quickly at fair value at low transactions costs. In a dealer market, liquidity is higher, the lower is the bid-asked spread and the larger is the size of the maximum trade that can be executed at the quoted spreads. Illustrations: By these measures, the market for:
1. Options on a stock is less liquid than the market for the stock itself; 2. Trading in most municipal or corporate bonds dries up about 6 months after its issue date.
77
Ethics of Financial Engineering: Must Respect Rules Against Abusing Disadvantaged Customers
Financial Market-Making has ethical requirements, codes, guidelines, and standards that resemble lemon-law adjustments to caveat emptor. When the seller has more or better information than the buyer, Caveat Emptor generates poor incentives. Standards and their burdens vary across different regulators. Suitability Doctrine: Acting as a dealer obliges an FSF to respect the suitability doctrine, which imposes a quasi-fiduciary duty to propose or carry out investments-- most especially in new or exotic instruments-- that are at least putatively suitable for the particular customer.
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Tiered Structure of Ethics Regulation

SEC-registered broker-dealers are subject to duediligence, know-your-customer rules set by selfregulatory organizations (NASD, trade associations, and the stock exchanges).Why? To cooperatively protect both customers and counterparties. Federal regulators oversee SRO ethical standards In 1996, the SEC approved an NASD-generated twopart test for suitability for institutional customers:
(1) a customers ability to evaluate the investment risk independently; (2) the customers capacity for independent judgment. [ Futures commission merchants (FCMs) are subject to
similar rules set by the federal CFTC and private National Futures Association. ]
79
TMI: Standards for securities dealers that are national banks or direct subs of natl. banks are negotiated between SEC and the OCC. Standards for BHC affiliates are negotiated with the FRB. Networking Rules limit compensation paid for referrals; Trust Operations need not register as broker-dealers with SEC Derivatives standards for banks are looser but similar to the NASD rules and interpretations of suitability.
80
Minicase: Suitability Standard is Not Just for Widows & Orphans

In Feb. 2001, a $6 billion Hawaiian thrift institution (American Savings Bank) filed suit against UBS PaineWebber Inc. The suit alleges that PaineWebber should have known that $84 million in Collateralized Debt Obligations it recommended, offered, and sold to American would ultimately be ruled not eligible for purchase by a federally insured thrift institution by the Office of Thrift Supervision. Classroom Issue: Should seller have the responsibility to learn the rules under which a regulated buyer operates? But what if seller does know these rules?
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Should the Suitability Doctrine be extended to cover Subprime Lenders?

Defining Fair and Efficient Rules and Remedies would be a Daunting Task.
82
In Brief: N.Y. Suit Could Test Loans' 'Suitability' From: American Banker Friday, March 23, 2007 By Kate Berry A lawsuit brought by a New York plaintiff's attorney could produce a limited test of the application of suitability standards to home lending. Jacob Zamansky, a principal at Zamansky & Associates, asked a state court in Nassau County, New York, on Tuesday to bar the defendant lenders from collecting on mortgages or foreclosing on the homes of 24 elderly borrowers, on grounds that the loans were made without regard to their ability to repay. Congress has discussed imposing a suitability standard that would make lenders responsible for choosing the appropriate loan product for a customer. A comparable duty exists in securities law. In an interview Thursday, Mr. Zamansky said, "Industry standards require mortgage lenders to 'know their customer' and consider the suitability of the borrower. The loans are legally void and unenforceable because they were unsuitable for the borrowers." And in a court filing he argued that "banking regulations" oblige lenders "to engage in, and adopt, 'safe and sound' lending policies which prevent abusive or predatory loans to borrowers who lack the ability or means to repay." None of the six lenders named in the suit - Countrywide Home Loans Inc., IndyMac Bank, Homecomings Financial LLC (a unit of GMAC LLC), PHH Mortgage Corp., Washington Mutual Inc., and First National Bank of Long Island - returned calls by press time. Five financial advisers, eight securities firms, two mortgage brokerages, and two insurance companies are also named as defendants. Mr. Zamansky negotiated a $400,000 settlement in 2001 from Merrill Lynch & Co. in a suit claiming a Queens pediatrician lost half a million dollars in following the recommendations of the stock analyst Henry Blodget. Edward J. Kane, BC 07-3&4
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SUMMARY OF THIS CLASS

Principal course goal is to school you in activities in which FSF jobs are expanding. Four themes sounded today:
a) Financial dealmaking creates many opportunities for synthetically replicating natural or standard assets. Structured Products resemble laboratory scientists isolating and reassembling pieces of DNA to clone an existing organism or to synthesize new creatures. b) Financial intermediaries create value by interposing themselves between the interest rates paid by nonfinancial borrowers and lenders on debt instruments. They create additional value by arbitraging the price paid for packaging a given risk in different ways; c) Ways to control concentration risk in an FSFs natural customer base are expanding: modern vs. traditional tools of pricing, diversifying, and transferring risk. d) Regulators and Reputational concerns impose ethical duties on market-makers: FSF ethics officers
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Self-Study: In what sense is an exchange-traded mutual fund (ETF) an extension of the securitization concept? How is it a form of securitization? Resembles Passthrough Pooling in that an ETF combines or tapes together tradeable claims to the fruits of many distinct enterprises so as to avoid concentrated exposure to particularized sources of risk. How is it a conceptual extension? The pool is not fixed. Managers offer both a diversifying and losscontrol wrinkle over directly holding stock: a secondgeneration derivative Instrument.
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Self-Study: Reputation Risk is Part of Basis Risk

JP Morgan says downgrade will impact derivatives business Risk News Sept. 18, 2002. JP Morgan Chases credit rating agency downgrades yesterday will affect its derivatives business, the ban told RiskNews at the end of the London trading day today. We see a small impact on our derivatives flows from this, said a spokeswoman for the bank, which has largely downplayed the rating agencies actions. The spokeswoman added that JP Morgan Chase is still rated at the top-end of our peer group. But she was unable to comment specifically on which areas of its derivatives business would be most affected. Rating agencies Standard & Poors (S&P) and Fitch have lowered JP Morgan Chases long-term credit rating from AA to AA-. The rating agencies acted after JP Morgan Chase warned that it expects third-quarter earnings to be well below the second quarter. The bank cited a weak trading performance and losses on loans to telecom and cable companies.
86
Self-Study: A class assignment analyzes a Total Return (TROR) Swap

Counterparties promise to exchange cashflows based on (1)TROR [=coupon and capital appreciation] on a reference asset or index and (2) LIBOR plus a negotiated spread. We will study interest-rate swaps in a few weeks.
87
Illustration
Libor +/- Spread TROR Payer Total rate of return (coupon + price change) TROR Receiver
Either or both might be speculating or hedging price risk elsewhere in their portfolios.
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Protective Total Return Swap

(trades credit & market risk)
Reference asset (bond or credit to company X)
Positive Price Changes
Total Return Payer

Risk Seller Protection Buyer
Interest Rate Payments LIBOR +/- Spread
Total Return Receiver

Risk Buyer Protection Seller
Negative Price Changes
89
Interest-rate changes on lesser-quality credits may be driven by changes in market interest rates or changes in market perceptions of an issuers default risk. When an index Bond B carries default risk, a total-return swap transfers two kinds of risk: = default event risk and not just market-wide resale risk.
90
Provides An Important Example of MarketCompletion Services A Total Return Credit Default Swap Synthetically Links what two Tangible Instruments?
Bond with Credit Risk
Protected Side of a TR Credit Default Swap
Riskless Bond*
* Why is riskless in quotes??
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Risk Magazine- March 2006/Volume19/No3
DTCC to develop credit default swap warehouse- by Hann Ho

The Depository Trust and Clearing Corporation (DTCC) is developing a central trade information warehouse and support infrastructure to standardise how credit derivatives trades are processed across the industry. The New York-based clearing and settlement company hopes the first phase of the new technology will be ready by mid-2006, and expects to eventually extend it to other over-the-counter derivatives products. The warehouse will comprise a comprehensive database containing the 'golden copy' of each trade - the accepted details of a credit default swap contract - and hopes to position itself as an independent third party for reference and processing. "It's a way of ensuring dealers' and other participants' books and records are aligned without having to go through, for example, repeated reconciliations or cashflow breaks," says Bill Hodgson, head of business development at the DTCC in London. The database will be constantly updated to take account of any actions, such as full and partial assignments and terminations, as well as the calculation and bilateral netting of cashflows in each contract. The initiative follows increased regulatory concern in the US and Europe over the adequacy of credit derivatives confirmation processes. The DTCC says the infrastructure will help firms ensure accurate balance-sheet information, promote correct and complete payments, and manage credit events more smoothly. "Our long-term shared vision with the industry is to focus on how to manage post-trade processing in the OTC derivatives market," says Robert McGrail, DTCC executive managing director for domestic and international core services. "Beginning with credit derivatives, our goal is to create at DTCC a global, extendable and open platform to reduce the risk and cost associated with OTC derivatives." The DTCC has been working with all the major dealers to develop the trade warehouse and support infrastructure, which will be overseen by its senior operations group, a unit established by the OTC derivatives operations and planning committee of the company's board. With further industry consultation, the company plans to add more downstream processes to the support infrastructure at a later stage, possibly including credit event processing, says Hodgson. This would allow market participants to more quickly pinpoint the number of trades affected by a given credit event than is currently possible. Other OTC derivatives, including rates, equities, forex and commodities, may be added to the technology at 92 a later stage. Edward J. Kane, BC 07-3&4
Risk Magazine: March 2006/Volume19/No3 - Progress made in CDS backlog- by Rachel Wolcott
The Federal Reserve Bank of New York has announced that progress has been made by credit derivatives dealers in reducing the number of confirmations outstanding by more than 30 days, beating a target set by the Fed in September. "It's important to keep in mind the background against which these reductions have been achieved, which is increasing volumes and credit events," says Karel Engelen, policy director at the International Swaps and Derivatives Association in New York. "It's been hard won." The group of 14 credit derivatives dealers met the New York Fed on February 16 to report a 54% reduction in the number of confirmations outstanding by more than 30 days. That exceeds the group's stated objective of a 30% reduction, set after the dealers were summoned to a meeting with the Fed last September to discuss the confirmation backlog problem. In addition, total trade volumes confirmed electronically increased from 46% in September last year to 62% in January. "The Fed's involvement with this issue has put it much higher on dealers' agendas," says Guy America, London-based head of credit trading for JP Morgan. He points to the market's adoption of electronic confirmation solutions as a key factor contributing to the swift decrease in unsigned trades. Automation "Our greatest ally is automation," agrees Julian Day, policy director at Isda in London. "One of the reasons for the increase in the rate of automation of the trade confirmation process was the rapid on-boarding of smaller players to automated systems such as the Depository Trust and Clearing Corporation (DTCC)." Along with the New York-based DTCC's automated processing and settlement service, Isda's 2005 novation protocol, which facilitates the transfer of existing trades to third parties, is also a driver behind the improvement. A total of 1,953 trading entities had signed up to the novation protocol by the time the adherence period closed on November 30. Dealers also say the credit derivatives tear-up service offered by Sweden-based technology firm TriOptima has been instrumental in eliminating obsolete trades. But not everyone is convinced the 54% reduction in the number of confirmations outstanding is quite the achievement dealers and the Fed suggest. Critics say the unresolved trades represent a significant amount of risk still in the system. In addition, some sceptics believe the easiest trades to work out have been tackled first, leaving the more complicated trades still remaining. Credit derivatives practitioners will continue to focus on technology by encouraging investors and dealers to sign up to automated trade confirm platforms. The industry will also work to get more products types on to electronic systems, say dealers.
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CDS Markets Get Bigger Than Big The fast growth of credit derivatives is too significant to ignore. The annualized growth rate of credit default swap (CDS) trading has been more than 100 percent for the past three years running, something that has never happened in the financial markets before. Trading in single-name CDS and CDS indices alone more than doubled in 2006, surging to more than $20 trillion by the middle of the year, says the Bank for International Settlements (BIS). And the British Bankers Association (BBA) predicts the global market in credit derivatives to rise to at least $33 trillion by the end of 2008. More opportunities come up in this market each year, not only in our structured credit business but also in our regular bond funds, remarks Rob Mead, head of credit for Europe at Pimco, one of the largest fixedincome portfolio managers in the world with $641.6 billion in assets under management as of September 30, 2006. He says it is often cheaper to trade CDS contracts rather than bonds when taking views on corporate credit risk. More hedge funds, proprietary trading desks, loan portfolio managers, insurance companies, emerging market investors, as well as pensions and high-net worth individuals (which include a growing number of celebrities, a source in London says) are participating in the credit derivatives market now. This has not only provided the market with a significant amount of liquidity but also a greater variety of products and trades. Increased liquidity in the CDS markets has meant you can do more tailored strategies and this has attracted hedge funds of all styles, not just credit ones. Pensions and other traditional investors who might not have had a mandate to trade credit derivatives this time last year are using them to diversify and enhance yield, says Kevin Gould, the head of data products and analytics at Markit.
94
Cont.- Constant proportion portfolio insurance (CPPIs) and rated equity of collateralized synthetic obligation (CSO) are some of the strategies still attracting interest in the current tight-spread environment. Ally Chow, global head of structured credit product management and syndicate at Calyon, says: A potential widening could benefit CPPIs partly because of the capital guaranteed or newly rated features so that is one reason why these structures continue to be attractive. Nonetheless, most structured credit players have never seen spreads so tight. And some people are worried that tighter spreads caused investors to jump into more complex, highly leveraged products in 2006, for example constant proportion debt obligations (CPDOs). This has fueled concern at regulatory bodies on both sides of the Atlantic. But CPDOs are not the only form of leverage that could force tighter spreads. Credit derivative product companies (CDPCs) have also received a fair amount of scrutiny for potentially adding leverage to the system. CDPCs could slow down a widening in CDS spreads. You could have credit spreads stay tighter for longer, but then when a certain threshold passes you could have a more severe widening as credit fundamentals change, explains Paul Horvath, head of synthetics at Merrill Lynch in London. Some sources say that CDPCs could impact the market more than CPDOs do on CDS indices. The super-senior market, which is where a lot of CDPCs target, is a thinner, more technical market. U.S. index traders quote two-way prices on the U.S. CDX market in amounts of $5 billion. If the estimated amount of CPDOs done today is about $3 billion, with an average starting leverage of around 10, then $30 billion of index risk has been created by CPDOs: $15 billion in iTraxx and $15 billion in CDX. It is new risk, so it will have an exaggerated effect. But this is not a crazy amount of risk considering the size of the CDS market now, adds Paul Levy, head of structuring at Merrill Lynch in London. Bear Stearns is expected to launch its Blue Ribbon CPDO this year, though all eyes were on Deutsche Bank at press time. In December 2006, it said it would launch NewLands Financial with AXA. AXA-IM will manage the assets, while Deutsche Bank provides risk management, infrastructure and other operational services. Sources also say that while as many as 24 CDPCs are in the pipeline (not all are backed by investment banks), not even half of them will ever launch. Still, it would be premature to say that these vehicles are failing. Like SIVs, they 95 Edward J. a long BC 07-3&4 up resources and get going, one dealer in London explains. Kane, time to build just take
CONT.- Rating agencies are taking time, but theyre also saying this segment of the market is not just about plugging a trade into a model. I know one CDPC that got delayed because the rating agency didnt think the guy who was hired to be CEO was suitable. In that sense, rating agencies are doing a good job at monitoring this market and not letting it turn into a gold rush, he adds. Most sources expect default rates to remain low and leverage high. Crowded markets are always going to be difficult to extract value from, explains Mead. But we think that the negative basis between the spread on CDS versus the spread on the cash bond, e.g., around 15 basis points, is a sensible bid that has both strong positive carry as well as good potential for capital gains. We expect to see opportunities like this in 2007 as the market for single-name CDS and CDS index tranches continue to grow, Mead adds. In some ways the tight-spread environment has put more focus on education too. The bottom line is that institutions are becoming more intuitive, and therefore are demanding better information, e.g., real-time data, says Gould. Most products are built around baskets of credit now, so you need more information in order to find the value. Tighter spreads mean players are looking for products that allow them to add yield. This requires independent valuations, he adds. Gould says dealers have become particularly concerned about the compliance and reputational risk issues associated with giving a poor valuation. Mead says it is important for banks and managers to make sure the appropriate product is marketed to appropriate investors. There has been an increasing focus on making sure new investors understand what credit derivatives are and how they can be used in all kinds of portfolios, not just credit ones or with collateralized debt obligations (CDOs). Single-name CDS and CDS index trades are efficient ways to take short positions. And the negative basis trade, which we see as a carry-driver of any portfolio, without taking a long or short position in credit, provides opportunities for a broader set of investors, he adds.
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CONT.- The investor base for structured credit continues to expand. Pensions, particularly those in Europe, made headlines for trading CDS contracts and buying more CDO tranches and CPPIs. Investment banks in London started beefing up pension advisory groups last year as a way to market more structured credit products to these kinds of funds. Retail investors also attracted some attention. Kathy Sutherland, JPMorgans global head of product management and syndicate, explains: High-net worth individuals typically want principal protection and more diversified returns than what they usually get from private equity assets. Even so, no other type of player has received as much attention for its use of credit derivatives as hedge funds. Some sources say hedge funds now make up at least half of the activity in credit derivatives trading. Despite recent scrutiny for potentially using inside information on CDS contracts based on the companies that they lend to, hedge funds participation in this market is only expected to increase. The inside information issue has also fueled regulators concern about hedge funds influence on the underlying debt markets. The hedge fund market is a trillion dollar market and only a small proportion of them, probably less than 10 percent, invest in credit. But this asset class is a growing allocation for many types of funds, considering that the most successful strategies for hedge funds over the past year have involved credit, Sutherland remarks. Investors have warmed up to CDS contracts on asset-backed securities (ABS), commercial mortgage-backed securities (CMBS) and leveraged loans. Strong volumes in leveraged loan CDS (LCDS) and increasing liquidity in ABCDS and CDS on CMBS have got firms interested in developing businesses, both bespoke and franchise, across the different asset classes, proclaims Ian Wilson, head of global synthetic structured credit marketing at JP Morgan. Technology around the correlation of the underlying assets is similar, so there are bound to be more correlation services. Banks would be leveraging on the credit correlation desks experience in investment grades, he adds. Tom Price, head of leveraged loan CDS (LCDS) at Markit, is quick to add that the development of synthetic indices last year has attracted more investors. With the recent launch of the LevX index in Europe and the forthcoming launch of the LCDX index in North America, investor interest in loan CDS is growing fast. He said that by the end of 2006 notional outstandings in LCDS contracts had grown to an estimated $40 billion. Edward J. Kane, BC 07-3&4
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CONT.- ABCDS contracts could also lead to a lot more structured credit trades, not least since they allow players to buy ABS assets in different currencies. Before these contracts were developed, if you wanted to sell U.S. home equity loan ABS in cash you had to find people who were willing to invest in U.S. dollars. Now you have all sorts of investors, from Norwegian krona to Japanese yen ones, explains Horvath. Nonetheless, a few wrinkles in the LCDS contracts still need to be ironed out, namely the fact that the U.S. and Europe treat loan refinancings differently. Kimberly Summe, general counsel for Isda, says: Hedge funds are probably the most active players but they arent always the ones with issues [e.g., regarding succession events, such as financial restructurings, wholesale debt redemptions or leveraged buyouts]. The players who have issues with some of the definitions are portfolio managers at banks. They do not like non-cancellable products because they potentially lose their hedge. Increased standardization has been an important driver of growth in all of the CDS markets. Its challenging because although we have an increasingly diverse membership we have to go with what the majority of players want in terms of standardisation. This doesnt mean we cannot accommodate minority views by providing optionality in the template, adds Summe. A research analyst from an American bank in London agrees with many other sources who say that structured credit investors are thinking more global than this time last year. When I meet clients for the first time, I immediately ask if they can do non-European exposure. Many of them do now because the advancements in the credit derivatives markets have made it so easy to hedge mismatches, he comments. But the question that few structured credit players seem to discuss is how much bigger the CDS markets could get. Considering that the corporate market is already said to be 10 times the size of the underlying bond one, this is bound to become a more critical point in 2007. 98

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07-3&4 Financial Engineering and Its Role in Credit-Risk Management

4. Ethical Issues in Market Making

NEED FOR DUE DILIGENCE

Edward J. Kane, BC 07-3&4

Credit Risk Mgt. Group

The Credit Market

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

Source: ERisk and Enron

Tactics of Modern Credit-Risk Management

Edward J. Kane, BC 07-3&4

Definition of Financial Engineering:

Edward J. Kane, BC 07-3&4

Derivatives: Can you find an Imbedded French and Boston Word?

Edward J. Kane, BC 07-3&4

Derivatives are Risk-Management Tools

Edward J. Kane, BC 07-3&4

Etymology of the word Derivative is also Mathematical:

Edward J. Kane, BC 07-3&4

Mechanisms for Credit Transfer

Three Paths of Risk Transfer: insure, trade away, or hedge.

Let Me Tell You a Story about Derivatives and Underlyings

Edward J. Kane, BC 07-3&4

Parable of Consuming a Sunday Dinner of Chicken as a Child

Financial Engineers use Derivatives to disaggregate and transfer business risks.

First Four Generations of Derivatives Instruments

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

STRUCTURED FINANCE CAN MAKE THINGS THAT DONT EXIST IN NATURE

Edward J. Kane, BC 07-3&4

DISASSEMBLING A STRUCTURED PRODUCT

Edward J. Kane, BC 07-3&4

Generation 4: Indexed Derivatives

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

Borrow at LIBOR: -B Net Inpayment

CASH FLOW B + hB -RB - B (h-R)B

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

5. Long: Credit risk

Edward J. Kane, BC 07-3&4

Topic 3: Securitization-Driven and Synthetic Approaches to Credit-Risk Management

Edward J. Kane, BC 07-3&4

Division of Labor is Determined by the Extent of the

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

Theme: Expanding Use of Derivatives in Securitizations

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

Edward J. Kane, BC 07-3&4

Residuals Are Edible, But Not Very Tasty

Edward J. Kane, BC 07-3&4

Why is This a Better Example of a Residual?

Edward J. Kane, BC 07-3&4

What Advantages Explain this Minicase?

Edward J. Kane, BC 07-3&4

Legally Differentiating a CDS from a Casualty Insurance Policy

Edward J. Kane, BC 07-3&4

Payment in case of default of reference obligation

Default Swap Seller

Edward J. Kane, BC 07-3&4

Protective Credit Default Swap