Contents

Market prepares for bankruptcy test

Protocol in place as investors brace themselves for next credit event

The next credit event to hit the credit derivatives market, which could only be a matter of days away, will see the introduction of a new protocol for handling the settlement of affected instruments. The new protocol will cover more types of credit derivative than previous initiatives of this kind.

US-based structured credit investors say that there is a widespread belief that Dura Automotive Systems could file for bankruptcy in the US this week, which could trigger a credit event highly significant for the derivatives market. CDS on Dura's bonds are included in the CDX HY index, but its impact extends beyond that.

"The Dura spread is currently among the widest in the index, but its spread has whipsawed all over the place this summer. It's safe to say that the single name CDS have also been getting a lot of people's attention," one hedge fund manager says.

If Dura does file for bankruptcy, which some suggest is imminent, or when another credit event hits the market, it is understood that ISDA will unveil a new settlement protocol. That protocol will be more comprehensive than previous ones in that it will incorporate more than the index trades affected, according to ISDA.

"The new protocol will be regarded by those in the market as being tested over the next couple of credit events because it will apply not only to index trades, but also to the other main types of credit derivatives, such as single name CDS and bespoke tranches. It has further significance because it is not going to be just a one-off," reports one dealer.

ISDA confirms that it is prepared to deal with the next credit event impacting the derivatives market, whichever credit it involves, and will test the new protocol on a couple of credit events before determining whether the format will be adopted on a prospective basis and folded into its credit derivatives definitions. CDS index protocols have been utilised since last year and have previously been introduced on a case-by-case basis.

The most recent was aimed at facilitating the settlement of credit derivative trades involving Dana Corporation, a US company that filed for bankruptcy on March 3, 2006. The Protocol enabled institutions to amend their documentation for such index trades from physical to cash settlement with prices established by a Dutch auction.

Previous and future protocols are open to ISDA members and non-members alike. ISDA estimates that previous protocols have attracted around 95% of both dealers and buy-side firms engaged in index trades on each of the respective credits.

Given that participating in such auctions can be a costly exercise – an input error during the Dana auction cost HSBC just under US$3m – many buy-side firms are not overly keen to be involved. Nevertheless some of the larger fund managers and more active hedge funds are known to take issue with the auctions' lack of dealer independence.

One possible addition to the new protocol is an arbitration panel to resolve deliverability disputes, which could remove some independence concerns. However, this is still believed to be in the early planning stages and unlikely to be in place in time for the next few credit events the market looks set to face.

MP

Investors move into longer maturities

Tranche and CDO trading heads out along the curve

Spreads have continued to narrow in both the index and CDO markets. Investors and consequently structurers are now moving into longer-dated products in an effort to pick-up yield.

Standardised index tranches have continued to narrow significantly over the past week with the 5y iTraxx index equity tranche trading at a record low of 14.3% on Tuesday. In the US the equivalent tranche on the CDX index was trading a 26.1%, only 2% wider than its record low.

Consequently, investors are having to look elsewhere to obtain returns, while keeping an eye on the impending index roll on 20 September. "The market is totally focused on the roll - we are recommending clients to buy 7y S3 equity risk as it appears cheap on the curve. We also like buying protection on the 5y 3-6% tranche on a delta adjusted basis," say Arun Singhal, structured credit strategist at Lehman brothers.

In on-the-run tranches, investors have also looked to move out of shorter dated structured credit and many have moved into the 7y and 10y in search of wider spreads. As a result, some of these contracts have also come in to tighter levels than have been seen in recent months.

Tightening spreads and concern over credit deterioration has also resulted in increased interest in more senior tranches including 10y super senior CDX and iTraxx. Such interest is an indication of investors adopting a more defensive strategy, because super senior is much less credit sensitive than more junior tranches.

A similar trend has been seen in the CDO market. "We have recently seen a definite trend away from 5y maturity CDOs to 7y and even 10y transactions," says Rob Pomphrett, head of structured product syndicate at RBC Capital Markets.

"This is in part due to the improved liquidity in 7y and 10y contracts. But the real driver is the overall reduction in credit spreads, making it necessary to increase the maturity of CDOs in order to reach investors' spread targets - particularly for managed transactions. The extension in maturities of CDOs is one of the reasons that credit curves have generally flattened between the 5, 7 and 10y," Pomphrett explains.

JD

The protection sellers

This week, Tom Jasper, ceo of Primus Guaranty, answers SCI's questions

Tom Jasper

He realised that the banks that were traditionally lenders to the corporate world were trying to move away from being the investors in the loans and bonds that this activity generated, to being distributors of the lending risk. The trend most obviously manifested itself in the big balance sheet CDOs that were launched around that time.

By the time I was approached, the idea of Primus had been discussed with the ratings agencies and a number of different structures were mooted, before a decision was made to focus on a credit DPC (CDPC). The idea being to do the same for credit derivatives that DPCs had done for interest rate derivatives - create a stand-alone entity able to offer the benefits of its triple-A rating to a firm's customers even though the firm itself was lower-rated.

Primus took the DPC idea one step further – most DPCs back to back risk to a parent but we wanted to back to back the risk to a level of capital, which was part of a real operating company. So, Primus is not a structured transaction vehicle as would be the case with a CDO, but the ratings agencies said they would be willing to rate it.

With that agreement in principle in place and Primus' capital model already developed, I joined the company. From there, we needed to build out the operating guidelines, hire key people, obtain triple-A ratings and go out and raise the capital the CDPC would need, and run the business on an ongoing basis.

All those seemingly straightforward tasks are highly complex and time intensive so it was not until March 2002 that we received our ratings and the company's funding was in place. We did our first transaction that June and Primus was finally genuinely involved in the structured credit business and we have been so ever since.

We now use our triple-A rating to secure counterparty lines and sell credit protection to currently 44 customers around the world. We were originally only allowed to sell single name protection, but for about a year and a half have had approval from the ratings agencies to sell protection on pools of credit risk in the form of bespoke tranches as well.

As of June 30th, 2006, our portfolio of credit swaps sold stood at US$15.36bn, which includes $350m on tranches. It is a highly diversified portfolio of primarily investment grade risk covering 550 reference entities primarily based in North America and Europe.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The standardisation of credit default swap documentation, because that has allowed people to buy and sell protection using a common document which is really essential to a marketplace.

Q: How has this affected your business?
A: It is fundamental to it – without standardisation our business would not be possible. Ratings agencies get very uncomfortable unless they are confident that the document under which you are transacting is both the market standard and does what it is supposed to do. The ratings agencies are very concerned that there is only one call on our capital and that call on our capital is a credit event and that event is clearly defined.

Q: What are your key areas of focus today?
A: In terms of Primus Financial Products (PFP), it's to continue to grow our portfolio of sold credit protection and at the same time to continue to expand the areas in which we can do business. Right now, the number one item on our agenda that we are working on with the ratings agencies is gaining approval to sell protection on ABS through CDS of ABS.

Q: What is your strategy going forward?
A: Our corporate strategy is to utilise the high levels of expertise in assessing credit risk that we have gained through the creation and development of our credit platform. This means further growing the PFP portfolio and also building out our asset management business

For example, Primus currently manages manages three synthetic CDOs; plans are underway for a CLO; and we are looking to move into the CDO of ABS space. In addition, we have launched PRS Trading Strategies, a credit strategies fund, to establish a track record in order to attract third-party assets under management.

Q: What major developments do you need/expect from the market in the future?
A: We are certainly intrigued by all the market developments there have been that relate to ABS and, again, the standardisation of documentation across the sector. There are also plenty of discussions around loan CDS that are of interest too. Here, we have a hired a high yield team, initially to work on our CLO, but clearly we have the capacity to assess the credit risk associated with loans and as that sector develops we think it will be an attractive market for us.

About Primus
Headquartered in Bermuda, Primus Guaranty is involved in key segments of the global credit risk transfer market through its principal operating subsidiaries Primus Financial Products and Primus Asset Management.

Primus was capitalised and commenced operations in 2002. The company completed its IPO in 2004 and is listed on the New York Stock Exchange.

AAA/Aaa-rated Primus Financial Products offers protection against the risk of default on corporate and sovereign obligations through the sale of credit default swaps. As such, it is deemed a credit derivatives product company or CPDC.

Primus Asset Management manages Primus Financial's credit swap business and provides credit portfolio management services to third parties.

Primus Guaranty is led by its ceo, Thomas W. Jasper, who has been in the derivatives business for over 20 years. During that time, Jasper created Salomon Brothers' interest rate swaps business, co-founded ISDA and chaired Salomon Swapco, the market's largest derivatives products company.

As of June 30, 2006, Primus Guaranty had consolidated assets of approximately US$717m and consolidated shareholders' equity of approximately US$407m.

MP

"We want to be the Gorilla"

In this week's Provider Profile we talk to Andy White, global head of trade and risk management at Reuters, about the potential of its recent acquisition - Application Networks

Reuters has an enviable position among the world's financial companies - it has more reach than most, thanks to its news service, and ubiquitous trading system Kondor+. Few vendors can boast such an 'in' with traders, and therefore it is something of a surprise that providing a risk management and trading system to satisfy the requirements of the most demanding of tier one banks has been out of the company's reach thus far.

Andy White

"Reuters had a dispersed expertise in risk" explains Andy White, global head of trade and risk management, "there was certainly the right talent, but the company lacked the necessary focus to put this talent to work effectively. Reuters should have been providing risk management systems for tier one banks, they have certainly been asking for one from us. Banks also want their clients - hedge funds, and institutional investors using hedge fund strategies - to own a system to enable them to participate effectively in the structured products markets."

These tier one banks, such as Goldman Sachs and SocGen are "bedding the balance sheet" says White, to make more money today and in the future, in exotic products, particularly structured credit. He explains: "These banks have two unique aspects to their business, quant-generated proprietary pricing models, which of course they guard very jealously, and a trading system, enabling them to get products out to market. It is the latter aspect where they require a robust, state of the art system to develop. If they don't go to the effort of building one in-house, which is less of a trend these days, they buy from the market."

However, the ultra modern system needed for today's e-commerce enabled trading environment is not readily available. There are of course plenty of risk management system suppliers, but Reuters claims that most vendors have old client/server architecture that isn't able to stand up to the rigours of today's modern trading environment. A scalable, internet ready system with a flexible design is needed to enable banks to add new products and asset classes seamlessly, and to communicate real-time positions with colleagues, clients and exchanges around the world's markets.

Consequently only a handful of vendors has been opening up new opportunities amongst tier one banks, claims White. "Calypso and Application Networks were the only names consistently mentioned by banks, and by sales people in the market close to these sell-side accounts" he says.

"Reuters has a mandate to be successful in this market, and so we searched for an acquisition to get us there. Calypso wasn't for sale, and Application Networks hadn't really gone to market yet. The company was new, and they had been developing the product for two years. Nevertheless, word was getting out that this was a system that would provide the trading technology banks are looking for," White says. "So we bought it, for $41million. Someone from SocGen called me that day and said that Reuters had just made the best acquisition in its history."

Reuters was seduced by the fact that J-Risk, Application Networks' product, was "designed for purpose". According to White, J-Risk wasn't built for any specific asset class and could therefore be adapted exactly how a bank wanted it to work. Headed by derivatives expert Evrard van Hertsen, who had previously developed and sold Renaissance Software to SunGard in the 1990s, J-Risk also offers traders a real-time, global view of their positions, coupled with sophisticated pre-trade analytics, claims White.

In addition, White notes that pricing libraries, which are the very core of a bank's intellectual property, can be integrated at source, whereas other systems - for example, Murex - require that the vendor be given access to these libraries to perform the integration process. "Clearly a bank is not going to be comfortable giving a third party such access and will avoid the scenario whenever possible," he says.

White espouses J-Risk's advantages further: "Once the framework is built it is ready for any asset class. The libraries are created, and new structured products can be built in about 60 minutes - a real advance on old systems' capabilities."

This capability is seen by Reuters as giving it for the first time the tools to tackle effectively its three strategic customer segments. First, to serve the risk-taking needs of its top accounts in Europe; second, to sustain a concerted effort at taking on the American market where it has lacked coverage to date; and third, allow it to access the buy-side's needs; in particular hedge funds, and tier two and three banks.

Hedge funds will be able to access the new Kondor Version 4, which encompasses a newly combined J-risk, together with Reuters' cash trading system Kondor+, via their fund administrator or prime broker, on a 'pay per use' basis, so reducing the costs traditionally associated with buying a new system, explains White. "Banks can also white label the product for their client base," he adds.

Reuters is excited about its prospects in structured products, especially the potential in the credit derivatives markets. White sums up its goal in dead-pan fashion: "We want to be the gorilla in this industry. We want to squash the monkeys and chimpanzees."

Reuters cannot expect the opposition to meekly allow them into their clients and take their accounts though, can they? White is certainly confident: "There are others offering an alternative solution, and although for example likes of MUST, owned by Misys (see SCI, issue one) is a great product, there is uncertainty hanging over Misys' future (it may be up for sale, with several private equity groups said to be interested) which may put them at a disadvantage with clients: banks like to know who they're buying from. We have had a lot of enquiries, we are ready - in Version 4 we will have a combination of the best cash trading system and the best derivatives system on the market."

JW

Credaris appoints Buhr

The latest people and company moves

Credaris appoints Buhr
Credaris, the credit-specialist asset manager, has appointed Bob Buhr as its head of credit research. This new position has its focus on fundamental research and relative value decisions in the corporate and structured credit space. Bob's know-how and experience will complement the company's funds and products, and the research function is planned to be built out further under his direction, Credaris says.

Buhr joins from Citigroup where he was an md for European Credit Research. Previously, he ran the Corporate Research Department at Citicorp Securities. Buhr also worked on the buy-side at Loomis, Sayles & Co in Boston, after starting his career in the Corporate Department at Moody's Investors Service.

Andrew Donaldson, ceo at Credaris, observes: "Credit research, correctly applied, is not a purely scientific process but key to our business. We feel Bob's skill and experience add wonderfully to our team, and it is difficult to find anyone to match, let alone better, on this front."

Ashurst strengthens structured finance
The derivatives team of international law firm Ashurst has been expanded with the appointment of two partners, Chris Whiteley and James Coiley, to its securities and structured finance practice in London.

Whiteley joins from the London office of White & Case, where he specialised in OTC derivatives transactions. Prior to joining White & Case, he worked in JP Morgan's credit portfolio group and rates marketing team. Coily arrives from BNP Paribas where he was Head of Structured Derivative Products in the Legal and Transaction Management department. Formerly an associate at Ashurst, he specialises in structured credit derivatives and credit CPPI.

CDO ratings head quits
Richard Gambel, head of the synthetic collateralised debt obligation group at Fitch Ratings in London, has left the agency. No details are known of his destination, but a Fitch spokesperson confirmed that Gambel would be replaced in due course.

Alexaline leaves buy-side
Henri Alexaline arrived at BNP Paribas' investment grade credit research team this week. He is based in London and reports directly to Marc Watton, head of investment grade credit research. Alexaline joins the bank BNP Paribas from the buy-side, where he has worked within credit research for a number of large firms, most recently at Henderson Global Investors.

Chang joins Morgan
Charles Chang, formerly director of structured credit at Fitch Ratings in Hong Kong, has joined JP Morgan as a credit structurer. The bank says that Chang will focus on the Greater China market and now reports to Lawrence Seah, head of credit structuring and marketing for Asia ex-Japan, based in Hong Kong.

Meanwhile, Stephen Fitzpatrick has joined the firm in London from Société Générale as a vp in flow credit trading responsible for the industrial sector. He reports to James Kenny, head of European corporate credit trading.

Markit acquires MarketXS
Markit Group has bought MarketXS a provider of software and technology for data distribution and trading solutions to the financial services industry. Market says the combination of the two firms will provide clients with an enhanced ability to monitor the global financial markets in real-time; to publish and distribute proprietary and public prices and trade information across all asset classes. It will also address the evolving requirements posed by the European Markets in Financial Instruments Directive (MiFID).

Lance Uggla, CEO of Markit, says: "The acquisition of MarketXS creates a powerful combination that will allow Markit to create exciting new products." While, Charles Longden, Global Head of Credit Trading at ABN AMRO, notes: "Not only will the acquisition enhance Markit's ability to serve the dealer community as our requirements develop, but it will also give institutional investors a new channel through which to access data, accelerating the evolution of the financial markets."

The combined company will be known as Markit Group Limited and will have over 300 employees with offices in London, Amsterdam, Brussels, Chicago, Luxembourg, New York, Singapore, Tokyo, Toronto and White Plains.

Send all your people moves to John Donnelly

US SME CLOs lead the way

A round up of this week's structured credit news

US SME CLOs lead the way
A Moody's Investors Service report on US CLOs backed by small- to medium-sized business loans (SME CLOs) shows that the once-small sector is now one of the fastest growing and best-performing in the US CDO market. Because spreads are wider than those on typical syndicated loan assets, new issuance is motivated by arbitrage opportunity as well as by the financing needs of specialty finance companies, Moody's says. The agency expects continued extensive growth in the sector, which has a substantial amount of assets that can be securitised.

US SME CLO issuance rose from three transactions with volume just under US$1.5bn in 2001 to 24 transactions with volume of over US$14.5bn for 2006 YTD. Of these, 12 are transactions that have either closed or are expected to close in the third quarter of this year.
 
"With the deals static and loan prepayments also relatively high, earlier transactions were very short lived. Most paid off liability tranches in three years or less. With demand rising, a growing number of deals are now managed and able to replenish prepayment proceeds. This allows specialty finance companies to extend the weighted average lives for this source of financing. Barring a sudden deterioration in the collateral, these transactions should be longer lived, promising a longer stream of returns to equity holders," says Moody's analyst David Burger.
 
Meanwhile, Moody's is seeking comments on proposed changes to its US cash-flow CLO rating methodology. The changes incorporate Moody's new probability-of-default ratings (PDRs) and loss-given-default assessments (LGDs) for speculative-grade corporate issuers.
 
"We believe these new measures will bring additional precision to our CLO ratings analysis," says Moody's team md William May. Historically, Moody's derived default probability and recovery assumptions for CLOs from its expected loss ratings. Going forward, Moody's plans to use its new direct assessments of these measures, the PDRs and LGDs, in rating CLOs.
 
Moody's says it does not expect that these proposed changes will result in materially different ratings when applied either to existing CLOs or to new CLOs, as compared with its current methodology. However, preliminary testing, which was based on typical CLO structures, indicates that while the expected losses of some lower-rated tranches may increase, the expected losses of higher-rated tranches decrease under the new methodology. The closing date for comments is 20 October.
 
New Japan index
International Index Company and QUICK Corp., one of Japan's leading financial information vendors, have signed an agreement governing the publication of IIC's iTraxx Japan index. Under the terms of the agreement, IIC appoints QUICK as publication agent for the iTraxx Japan index.
 
As the publication agent, QUICK will calculate and publish the 'iTraxx Japan Index –Theoretical' and, in addition, publish the 'iTraxx Japan Index - Official'. The 'iTraxx Japan Index –Theoretical' is calculated by QUICK based on the simple average of the constituents' closing spreads, whereas the 'iTraxx Japan Index - Official' is based on the indicative or traded CDS index levels. As for the other iTraxx CDS indices, Markit Group acts as the calculation agent for the iTraxx Japan Index – Official.
 
SciComp adds credit derivatives
SciComp, a provider of derivatives pricing technology, has released version 4.0 of SciFinance. SciFinance aims to help quantitative analysts and financial engineers build derivatives pricing and risk models (delivered as source code or Excel add-ins) from concise, high-level descriptions of derivatives. The SciFinance product suite now includes calibration functionality, automatic C++ source code generation and expanded coverage of credit derivatives, in addition to coverage of interest rate derivatives, convertible bonds, cross currency, energy derivatives, emerging market products, FX derivatives and hybrid instruments.
 
The SciFinance 4.0 credit module, SciFinance for Credit, includes support for CDOs, single tranche CDOs, CLNs, CDO-squareds, cash CDOs, CLOs, synthetic CDOs, credit default swaps, defaultable bonds and single-name instruments. Users can structure credit instruments in limitless ways using a wide variety of numerical methods, customise models of default and interest rate and apply calibration routines, the company says.
 
Cairn and HSBC's next generation long/short CPPI
Cairn Financial Products and HSBC have launched MINTs, a principal-protected managed long/short credit CPPI transaction. Notes have been issued in US$ and € with maturities of 7 and 8 years. The notes pay a contingent coupon of Libor +150 and Euribor +150, respectively, with a higher overall target return.
 
The core strategy of MINTs consists of long and short positions in different tranches of the iTraxx Europe and Dow Jones CDX.NA.IG investment grade credit indices. The aggregate of long and short positions is broadly credit market neutral, while having the benefit of substantial positive carry in current market conditions. In addition to the core index tranche strategy, Cairn utilises its experience to provide on-going surveillance and risk management of individual names in the credit indices using its technology platform for fundamental credit analysis.
 
The initial closings have totalled in excess of USD 150 million with additional taps expected over the coming weeks. Vanaja Indra of Cairn Capital comments: "Working together with HSBC on the MINTs transaction has allowed Cairn Financial Products to significantly widen its investor base through HSBC's global distribution network. The success was especially notable in Asia, where HSBC's strong distribution and Cairn's management expertise allowed us to deliver the next generation of this attractive long/short strategy."
 
ICAP launches new credit platform
ICAP has launched a new version of its electronic credit trading platform, ICAP-Credit. The platform provides electronic pricing and trading capability for credit default swaps (CDS) bonds, and repos on one screen.
 
Traders using the ICAP platform will also benefit from improved post-trade verification as a result of ICAP's link with the DTCC's new single-screen affirmation platform AffirmXpress. Furthermore, ICAP-Credit has joined forces with Markit Portal, the partnership marks the first time the CDS community has had an integrated trading and information platform.
 
"The ICAP-Credit link with Markit presents a unique window onto the financial markets that for the first time fuses asset pricing, news and independent credit research into a single trading screen. This will improve the flow of information and price discovery for the CDS trading community," Gary Smith md at ICAP comments.

MP

Markets for trading credit correlation - part one

The first of two articles by Satyajit Das

Trading in credit correlation is driven by a number of inter-related factors:

• The development of the single tranche CDO market forced dealers to assume correlation risk. In traditional CDOs, the fact that the entire capital structure was sold to investors meant that the default correlation risk was largely transferred. In a single tranche CDO, the dealer retains the risk on all unsold tranches. The risk is hedged in the single name credit default swap market using credit deltas. The hedge requires the dealer to assume default correlation risk. The performance of the hedge is driven by the realised correlation against the assumed correlation at the time of pricing.

• Interest by investors and traders (both in banks and hedge funds) in explicitly trading credit correlation with a view to monetising expectations on correlation movements.

The development of a standardised credit index CDO market facilitated the growth of a traded market in default correlation.

Tranched CDOs – Impact of Default Correlation

The pricing of individual tranches in a CDO is a function of the default correlation between individual obligors in the underlying portfolio. The pricing of individual credits is a function of the size of the exposure, the probability of default and the loss given default (driven by the recovery rate). The probability of default and the recovery rate is reflected in the market credit spread for the obligor. For a portfolio of credits, the pricing is driven by the default correlation between individual obligors and the structure of the tranches (the attachment and detachment points). The default correlation drives the total losses on the portfolio. The tranche structure determines the share of losses on the portfolio that is borne by a tranche.

In CDO structures, in general, the equity tranche investors are long default correlation between the obligors in the underlying portfolio. In contrast, senior investors are short default correlation. This reflects the fact that at low correlation levels the credit losses are borne primarily by the subordinated tranches. Higher correlation levels imply higher level of losses for senior tranches. This means that an equity tranche will generally increase in value if default correlation within the portfolio increases. In contrast, the senior tranches will decrease in value if default correlation increases. It is important to understand that the above analysis refers to the "mark-to-market" value of the tranches only. Actual realised losses on the CDO tranches are purely a function of defaults and loss given default.

Implied Default Correlation

Development of trading in standardised CDOs has resulted in prices of individual tranches increasingly being quoted in terms of "implied correlation". The implied correlation approach is similar to the implied volatility approach used in option trading. Given a market premium established by option trading, an implied volatility is generally derived using the market standard Black-Scholes option pricing model.

The approach relies on observable market prices of individual tranches established by trading. Trading in CDO tranches on standardised credit indexes has increased. Transaction cost have decreased due to the low-bid offer spreads guaranteed by accredited market makers and increased liquidity. This has meant increasingly observable tranche prices that have allowed market implied credit correlation data to be extracted. This contrasts with more traditional methodologies for deriving credit correlation data. This relied on historical information.

The available tranche prices are used to back out the implied correlation. The implied correlation is derived using the standard Gaussian copula approach that is the currently favoured approach to pricing CDOs. It is feasible to calculate two separate types of implied correlation from market prices - compound correlation and base correlation. In practice, the market favours the use of base correlation¹.

The major benefit of implied correlation is that it provides a simple framework within which standardised CDO tranche prices can be interpreted. It also isolates the impact of changes in default correlation from the effect of changes in other variables such as changes in credit spread. It is also relatively easy to understand. The availability of implied correlation has lead to the emergence of a traded credit correlation market. However, as discussed in greater detail below, whilst not without value, the concept of implied correlation provides an overly simplistic and naïve view of the economics of credit portfolios and the value dynamics of CDO tranches.

Default Correlation - Issues

The Gaussian copula and implied default correlation has emerged as the market standard for pricing CDO tranches and hedging credit risk within portfolios. The increased popularity of implied default correlation masks significant model risks². Specific concerns include:

• Constant correlation – the copula models uses a single correlation to summarise the default co-dependency relationship within the portfolio. This is convenient but misleading. In reality, default correlation will tend to a zero or 1 value reflecting the actual default or survival of any individual reference obligor upon the default of any firm within the portfolio. It is also unrealistic to assume that in a typical portfolio, the default correlation is similar across disparate industries and firms. Irrespective of the methodology used, the implied correlation approach does not provide pairwise correlation between the underlying reference entities. In practice, junior tranches in a CDO are sensitive to changes in the pairwise correlation. The modeling does not fully capture the risk or facilitate hedging.

• Correlation smiles and skews –fitting market prices of CDO tranches requires a correlation smile or skew (see Exhibit 1). In fitting observed market prices, compound correlation exhibits a "smile" effect; that is, implied compound correlation for equity and senior tranches is greater than that for the mezzanine tranches. Under base correlation approaches, fitting market tranche prices requires a correlation skew that is not a proper arbitrage-free model. There is no clear consensus about the causes of the correlation smile or skew. The most common view taken is that it reflects market inefficiency, specifically the segmentation of the investor market. This segmentation dictates that the supply and demand for different tranches varies. The correlation shifts reflect the pricing needed to clear the market for individual parts of the capital structure. This may reflect views about credit risk generally, differences between perceived systemic and idiosyncratic credit risk, risk aversion, attitudes to mark-to-market losses arising from spread volatility and liquidity effects. It may also reflect the fact that the Gaussian copula may not adequately capture the co-dependency between the constituents of a portfolio. From a theoretical perspective, in a correctly specified model all tranches would recover market prices based on the same correlation. This merely reflects that the default co-dependence structure is dependent upon the composition of the portfolio but independent of the capital structure of the CDO. The correlation smile or skew is consistent with the mis-specification of the underlying model.

• Simplifying assumption – differences in the reference assets underlying the CDO can significantly distort the pricing dynamics. The model assumes a homogenous reference portfolio. In practice, this assumption is frequently breached. For example, assume two portfolios with the same average characteristics and the same default correlation (say 25%). Assume that one portfolio has uniform pair-wise correlation. The second portfolio has an average pair wise correlation. Assume that the second portfolio exhibits higher correlation amongst higher credit spread (higher credit risk) constituents. This means that the second portfolio is likely to display higher volatility than the first portfolio. This reflects the fact that the second portfolio's performance is likely to be characterised by a higher probability of both higher numbers of default and a very low number of defaults³. This should affect the pricing of the tranches. In practice, the methodology used may not deal with the problem adequately.

• Omitted variable – the general methodology is inadequate for certain products. Where options on a credit portfolio (such as a credit index) are traded, the joint effects of default and credit spread changes must be modeled. This is because the value of the option depends upon the sequence of defaults and the credit spread changes of the surviving constituents of the portfolios. Existing models do not allow the correlated changes of default times and credit spreads.

In summary, the Gaussian copula and implied correlation used to model credit portfolios creates practical problems. It is useful only in the analysis of relatively simple credit portfolios.

Notes
1. For an excellent discussion of the different approaches to compound correlation see O'Kane, Dominic and Livesey, Matthew "Base Correlation Explained" (15 November 2004) "Base Correlation Explained" (15 November 2004) Lehman Brothers Quantitative Credit Research 3-20. For a discussion of base correlation, see Roy, Ratul and Shelton, David (16 September 2004) Trading Credit Tranches; Citigroup, Global Structured Credit Strategy, London.

2. See Duffie, Darrell "Time To Adapt Copula Methods For Modelling Credit Risk Correlation" (April 2004) Risk 77.

3. See Mashal, Roy, Naldi, Marco and Tejwani, Gaurav "The Implications Of Implied Correlation" (July 2004) Risk 66-68.

© 2006 Satyajit Das All rights reserved.
An earlier version of this paper appeared as "Trading Implied Default Correlation" (July 2006) FOW 47-52. This paper is based on Das, Satyajit (2005) Credit Derivatives, CDOs and Structured Credit Products – 3rd Edition; John Wiley, Singapore at Chapter 4. See the original text for detailed sources and references.

About Satyajit Das
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading ... explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.