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Buyside'&  Buyside Challenges \4Portfolio Level Considerations of Credit Derivatives54 Infrastructure   Documentation  Z&Understanding Factors Impacting Prices'&  ")Buyside Use of Various Credit Derivatives*)  k Asset Swap    lIndex Total Return Swap  q +Single Reference-Entity Credit Default Swap,,Transfer the credit risk of an issuer (reference entity) from one entity (buyer) to another (seller) Seller of protection agrees to buy  obligations of the reference entity at par in the event of a public notice Default event is defined a  publicly available notice to: A payment failure larger or equal than  Payment Requirement on an obligation equal or larger than  Default Requirement Settlement can be  Physical or  Cash Deliverable obligations can be Reference obligation Any of Deliverable obligations According to ISDA it could be any borrowed money: loans,cp, bond, and bond and loan Must be specified in long confirm |G5v|G5vA>w0Advantages of Default Swap over Short Corporates11\In general they tend to be cheaper than similar cash bond because: buyers inability to hedge their risk in any other market (shorting public debt can be quite risky and subject to adverse technicals) expensive risk capital charges required against credit risk Increases yield with minimal increase in spread duration Very attractive break-even cushion against spread widening Ability to do default swap opens up unique opportunities to tailor credit exposure of the portfolio - i.e. take advantage of credit curve steepness (buy longer dated cash bonds and roll over short dated credit protection) More flexibility - Default swap does not tie up cash to earn spread Allows creating higher information ratio strategies that may be leveraged for higher returns than similar risk strategies Access to names and maturities that otherwise may not be availablezC9P=9;C9;#Pricing Methodology * r"Pricing Single-entity Default Swap##Compare Libor spread of cash bond of the issuer of similar maturity with the default swap rate Compare all-in yield of a synthetic bond of  Default Swap+AAA ABS with the cash bond Compare a given spread with valuation based on long-term default probability and recovery rates based on transition probability matrix and recovery value QQs3Transition Probability (S&P CreditWeek 15 April 96)*4   t3Recovery rates (CreditMetrix using several studies)43  u#Simple Example of Breakeven Spreads$$ /.[]{|} !"#$%&'P  ` ffMMM̙̙` ` MMMMMM` f3` ff` 3f3f` ff3ff3` 33>?" dU@*?" dd<@% ( 5" _#5 K\ n?" dd@   @@``@n?" dd@  @@``PP     `0p>>  G( dP   s * z @ z T Click to edit Master Title Style! !0  B z  p)p?@ z TClick to edit Master text styles Second level Third level Fourth level Fifth level $!     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S   <D ?? ! z G*(    B ??vP  z E*     B ??v  z G*( B  s *޽h/. ? ̙33 @{(    < ??P!  z @ Ron D'Vari     < ?? ! z E*(   BĦ ??vP  z ETitle goes here    B$ ??v  z E*( B  s *޽h/. ? ̙33  $ B:`(    3 rgֳgֳ ?@`    3 rDgֳgֳ ?`   N  6ffd޽h ? 0 >, *State Street Research pl0(  l~ l s *D0@` z  l <0??0pR >lMorning Session A: Introduction to Risk Management and Value-at-Risk (VaR) Morning Session B: Portfolio VaR and Different Approaches to Measuring VaR Afternoon Session A: Risk Management for Derivatives and Using Derivatives Afternoon Session B: Risk Management Applications Afternoon Session C: Credit Risk Management and Integration of Market and Credit Risk TK 2 2j>F'TT l # l11??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B l s *޽h ? ffMMM̙̙ >, *State Street Research `( Adx `~ ` s *$2@`   ` <2??0pV  F 2 TT ` # l21??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1   ` <D3??0 Risks Facing Financial Intermediaries Lending Funding and Warehousing Hedging Servicing Securitization Trading Operation Deposit Gathering Treasury Capital Market Activities & 2% ,TTB ` s *޽h ? ffMMM̙̙o >, *State Street Research  ho(  h~ h s *@`   h <d??0pV  F 2 TT h # lģ1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1  h <$??pw vrObjectives of Enterprise-Wide Risk Management Balance Sheet Management Performance Measurement Motivation and Compensation Strategic Decision Support Role of Information Flow and Visibility in Risk Management Implementation Issues For Transitioning to An Enterprise-wide Risk Management Culture System Information flow and visibility Training Management Commitment /hN 2- hNB h s *޽h ? ffMMM̙̙ >, *State Street Research  p(  p~ p s *1@`   p <3??0pV  F 2 TT p # l41??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1  p <d4??p  Risk-Adjusted Capital Framework Operational Risk Credit Risk Market Risk Risk-Adjusted Return on Capital (RAROC) Computation Benefits Limitations  )(! 2 *( B p s *޽h ? ffMMM̙̙" ">, *State Street Research "(  ~  s *d~@`    <~??0pV  F 2 TT  # l$1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1   <??p )Responsibilities of the Risk Manager Understanding the Markets Fixed Income Equity Commodities Foreign Exchange Emerging Markets Understanding the Businesses Market Making Proprietary Trading Brokerage Underwriting / Syndication Lending Asset Management %]` 2$]`*$B  s *޽h ? ffMMM̙̙ #>, *State Street Research w0(  ~  s *d1@` f   <nf??0pV  F 2 TT  # l$of1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1   <of??p^ Risk Management Function Limit Management Capital Allocation Performance Evaluation Regulatory Capital Requirements Economic Capital Requirements The Risk Management Cycle Identify Measure Manage Evaluate Improve i) 2)FB  s *޽h ? ffMMM̙̙ $>, *State Street Research jbP(  ~  s *$rf@`    <dqf??0pV  F 2 TT  # lrf1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 s  <pf??p^ Risk Management Common Sense Transparency of Risk Professional Judgement Experience Conventional Market Risk Measures Option Adjusted Duration and Key Rate Durations Beta Historical Volatility Sector Exposure Currency Exposure Market Exposure (by country) Greeks for Derivatives 8" 28"TB  s *޽h ? ffMMM̙̙ %>, *State Street Research p(  ~  s *tf@` f   <qf??0pV  F 2 TT  # ldtf1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1   <qf??p  Evolution from Asset Liability Management and Elaborate Guidelines to Value-At-Risk Single Measure Allows for Integration of Multiple Risks (credit, market, operation, etc.) Allows for Full Incorporation of Time Variance in Risk Assessment hT 2SB  s *޽h ? ffMMM̙̙D >, *State Street Research xD( D@ x~ x s *$5@`   x <5??0pV  F 2 TT x # l51??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1  x <D6??pF K+Comprehensive Methodology for Measuring Market Risk(s) Multi-factor Models for Measuring Investment Portfolio Risk Performance Measurement and Attribution Value at Risk Definition and Computation Treatment of Derivatives Different Approaches to Measuring VAR Forecasting Risks and Correlations 7=(~ 26 =(} B x s *޽h ? ffMMM̙̙ !>, *State Street Research ( D. ~  s *6@`    <7??0pV  F 2 TT  # l$81??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 &  <8??@G TCredit Risk Management Fundamental and traditional risk measurements Underwriting standards Rating Categories Due Diligence and Monitoring Portfolio Risk Limits Average Rating Minimum Rating Maturity Diversification Risk mitigation (workout) Option-based Credit Risk Management Expected Default Frequency Single Name Rating Portfolio VaR .\'*$! 2 .\'*$!NB  s *޽h ? ffMMM̙̙ '>, *State Street Research _W( G   Bxf???@n  IMorning Session B Portfolio VaR and Different Approaches to Measuring VaRJJ0  # lyf1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B  s *޽h ? ffMMM̙̙ >, *State Street Research f^X( 9 X X <d7??@n  VAfternoon Session C: Credit Risk Management and Integration of Market and Credit RiskWW0 X # l41??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B X s *޽h ? ffMMM̙̙ &>, *State Street Research KC(  x  c $$uf@`  a  <vf??0pJ Most Active Transactions: Asset Swap Total Return and Index Swap Default Swap Structured Instruments: Credit Linked Notes (CLNs) Credit Spread Option CBOs, CLOs, Synthetic CLOs Synthetic Leveraged Loan Synthetic Revolving Credit Agreements 27 2 2 27P C  # lwf1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B  s *޽h ? ffMMM̙̙ >, *State Street Research P(    # l1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1   N ??@`    <d??0p t Flexible Credit/Sector Exposure Tailoring Access: Sourcing names and maturities not available through cash instrument market Flexibility: Uncoupling of interest and credit exposure Diversification Yield Enhancement Exposure to short maturities with low price sensitivity Relative Value and Replication Cheaper synthetic cash positions Hedging Leverage or Financing + 2  % 28    2!    2 2+%8 !!jB  s *޽h ? ffMMM̙̙k >, *State Street Research p k(   ~   s *0  3   <??`  Internal and External Education Accurate Portfolio Analytics and Risk Models Consistent Framework for Use In Portfolio Context Infrastructure: Compliance, Trading, and Accounting Systems Signing ISDA Agreements Several hundred plan sponsors and separate accounts Multiple dealers and banks A dozen custodians Legal resources Shortcomings of the Standard Representations in ISDA Not developed for investment managers acting as agent Often impossible for managers to make Requires involvement of plan sponsors and custodians% 2s  25% 2  2s59i?r   # lD1??  State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @B   s *޽h ? ffMMM̙̙:  >, *State Street Research   T: (  T~ T s *@`   T <d??` ^Besides fundamental analysis of reference credit and counterparty overall portfolio suitability has to be established. Optimal allotment of risk budget to credit derivatives Portfolio s total risk is budgeted to key active exposures Level and shape of term structure of interest rates Volatility Sector/Credit exposures (by sector by credit by maturity) Risk Analysis and Its Transparency Accurate accounting of credit derivatives in daily and intraday portfolios multi-factor absolute and relative risk reports Measure credit, spread change, and structural risks Quantitative Relative Value Framework W.r.t. cash instruments or other forms of risk Liquidity and Pricing Infrastructure 2; y4$ 2 & 2/ % 2;x$&/%9i?r T # lČ1??  State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @B T s *޽h ? ffMMM̙̙Q >, *State Street Research Q(  ~  s *@`    <??` YDocumentation Trading Counterparty Risk Management Compliance Accounting and Custodial  Z% 2Z9i?r  # lD1??  State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @B  s *޽h ? ffMMM̙̙ >, *State Street Research XP0( `G10 0~ 0 s *@`   0 <d??`v JDLimited Recourse Sub-account managed by manager Size Matters No trigger with account size change May require lower collateral threshold and minimum transfer Collateralization Eligibility Threshold and minimum transfer amount Manager Termination Avoid early termination through assignment Assignment Both parties consent % 2  2 % 2b  2% 22  2% 2+  2 % 2  2  2  2 S2 C9i?r 0 # lď1??  State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @B 0 s *޽h ? ffMMM̙̙9 >, *State Street Research L9(  L~ L s *@`   L <?? GChanges in Credit Condition Credit Spreads in Cash Market Cost of Alternatives Regulatory Capital Requirements General Market Liquidity Pricing Models Traditional Credit Judgment Quality of Historical Default Rates and Recoveries Availability and Quality of Historical Spread Availability of Volatility and Correlation data Credit Default Swap Curves Basis Between Credit Swap and Other Credit Pools Modeling Tranched Credit and Basket@ 2  2 8? L # lD1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B L s *޽h ? ffMMM̙̙ >, *State Street Research @(  @~ @ s *d@`  / @ <Ē??0p[ GPresentation Focus: Asset Swap Total Return and Index Swap Default SwapJ 24 2 )8? @ # l$1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B @ s *޽h ? ffMMM̙̙    0tH (  XE tx t c $D@`  \ t <??  t Motivation Swap floating assets to fixed or vice versa Trade away imbedded options in a bond or layer in options R 2h 2 i t # ltU1 ?? JSSRM*( t # l4V1 ??`0p S Counter Party*( B t 3 rDԔ??  B t@ S ~?DԔ?? t 3 rV1??4  HCoupon from Bond A   t 3 rTW1??@` x2Some Index (Libor, CMT, fixed level etc.) + Spread*3(2  t # lW1 ??  LBond A*(B  t S ~?DԔ??00B  t S ~?DԔ??  t  ftX1??0` XCoupon and Principle(  t  f4Y1??0v C Market Price  t # lY1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B t s *޽h ? ffMMM̙̙  H@P| (  |x | c $TZ@`   | <Z?? P  K Motivation Adjust exposure without buying or selling individual securities Hedging, Relative Value, Market access, Flexibility Avoid paying bid-ask spread for a short dated trade Get financing (leverage) R 2 2  | # l[1 ?? JSSRM*( | # l[1 ??`0p S Counter Party*( B | 3 rDԔ??  B |@ S ~?DԔ?? | 3 r\1??0`  OIndex Sector Total Return   | 3 r\1??@B v0Libor + Spread or Total Return of Another Sector*1(0  | # l]1 ??  _SSRM Holdings in a Sector*(B  | S ~?DԔ??p00B  | S ~?DԔ??  |  ft^1??`, YHoldings Total Return(  |  f4_1?? e Market Price  | # l_1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B | s *޽h ? ffMMM̙̙   bZp(  x  c $T`@   x  c $`?@@    # la1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B  s *޽h ? ffMMM̙̙   \T( Q C x  c $   r  S ``     # lD1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1 B  s *޽h ? ffMMM̙̙   H (  Hx H c $`@   x H c $d?@@   H # lķ1??  $State Street Research & Management, Ron D Vari, Ph.D., CFA * (D C @F1  H B$  p)p? 0 : ? H B  p)p?p mMethod 1: Basis - Asset Swap vs. Default Swap (works only for single name) Method 2: Model Loss Distribution "mnO% 8 @ H   H  fD1 ?? P o%Market Implied Default Probabilities.&(%B H 3 rD8c??    @ PpP H@ H  f1 ??@  XCredit Spreads.(  H  fĺ1 ??p XRecovery Rates.(  H  f1 ??P  \Asset Correlations.(  H  fD1 ??P P  ^Default Correlations.(B  H S ~?D8c??P P B HB S ~?D8c??P `B H S ~?D8c??P B HB 3 rD8c??P` 2 H # l1 ?? @ E Simulator (  H  fĽ1 ?? P [Loss Distribution.(B H 3 rD8c?? p B HB S ~?D8c?? P B H S ~?D8c??B H s *޽h ? ffMMM̙̙>      ~ (  r  S @   r  S @  L  N N #   61111? 4 M O ACCOUNT*    ZB  s *?J g9   Bdu1111?$4  Z$Default Option on $10mm TCI 7 6/99%%   6$v1111?d90 N d COUNTER-PARTY:   ZB  B s *?Jg9   Bv1111?$3 A 40BP/Annum       6Dw1111?t9M N ;AAA Asset Back Maturing 6/15/99 (+20 to 25bp over Treasury)*<;  ZB   s *?t9ZB   s *?t9  Bw1111? '\- :Bond   Bx1111? 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