ISDA PRESS REPORT - OCTOBER 29, 2001

CREDIT DERIVATIVES
	*	Pricing Synthetic CDO's - Derivatives Week

REGULATORY
	*	CFTC makes amendments to CFMA 2000 - Risk News

TRADING PRACTICE
	*	Banks tout economic derivatives - IFR

Pricing Synthetic CDO's
Derivatives Week - October 29, 2001

Traditionally collateralized debt obligations (CDOs) involve a transfer of
collateral assets. The CDO liabilities then reference the cash flows
(principal and interest) of the collateral assets. But CDOs are increasingly
issued in synthetic form, where there is no physical transfer of collateral.
In these structures the CDO references default losses, rather than the cash
flows of the referenced collateral. 

Credit Default Swaps 

In their simplest form synthetic CDOs are akin to single name credit default
swaps. A credit default swap is a contract where one party ,the protection
buyer, makes periodic payments in exchange for payments contingent on a
credit event. In a single name credit default swap, the credit event is the
default of a single issuer. Thus, the price of the credit default swaps
reflects the market's view of the default likelihood of the reference name. 

In unfunded form a synthetic CDO is essentially a basket default swap. In
this case, in return for a premium, the protection seller makes contingent
payments based on the default losses incurred by a portfolio or basket of
assets. The protection may be for first loss or equity, in which case the
seller pays for the initial default losses, up to some threshold; second
loss or mezzanine, where the seller pays losses beyond the first loss
threshold up to some higher limit; or senior, where the seller pays all
losses beyond a threshold. 

Synthetic CDOs may also be structured in funded form. The simplest form of
this structure is a combination of a risk free bond and a basket default
swap. The initial investment is used to purchase the risk free bond and at
the outset the investor receives the risk free rate of interest from the
bond as well as premium payments from the basket default swap. As losses
occur on the reference portfolio the principal of the bond is reduced to pay
the required contingent payments. At the maturity of the structure the
investor receives the remaining principal of the risk free position. In both
funded and unfunded forms the pricing of synthetic CDOs is primarily a
matter of pricing the basket default swaps themselves. 

Correlation Products 

It is often said that synthetic CDOs are correlation products because their
value depends not only on the probability of default for each individual
name in the reference portfolio, but also on the correlation between those
names. Consider a simple case where the reference portfolio consists of two
names, each with a 5% probability of default. Assume two levels of
protection, one paying on the first default, and one paying on the second.
If the names are independent, then the probability that the first loss
protection is triggered is 1 - (0.95)2 = 9.75%, that is, 100% less the
chance that there are zero defaults. The probability that the second loss
protection is triggered is (0.05)2 = 0.25%, that is, only if there are two
defaults. On the other hand, if the defaults are perfectly correlated, then
there are only two possibilities: either both or neither of the names
default. Thus, the probability that either protection is triggered is the
probability that both names default, or 5%. Note that for the first loss
protection the increased correlation has reduced the likelihood that the
protection is invoked, and therefore reduced the fair price of this
protection. For the second loss piece, the increased correlation has
increased the trigger likelihood and fair price. 

The relationship between correlation and pricing holds generally for the
first loss and most senior levels of protection in basket default swaps. For
the first loss piece, since losses are capped, the pricing is driven
primarily by the likelihood that no losses occur, which increases with
correlation. For the senior piece, the pricing is driven by the likelihood
that an extreme loss occurs, which is greater in cases of higher
correlation. 

Pricing 

Based on the discussion above most pricing models require individual default
probabilities and a correlation across the names in the pool. Since
individual default probabilities can often be obtained from single name
credit-default swaps correlation is the main pricing parameter for synthetic
CDOs. 

Consider an example structure with USD36 million of collateral, where first
loss protects against the first USD5 million of losses, second loss protects
against the next USD10 million of losses, and the remaining losses are
protected by the senior tranche. We can model spreads on each of these
tranches at different correlation levels. For example, using a correlation
of 45%, we obtain model spreads of two basis points, 250bps and 1,642bps for
the senior, second loss, and first loss protection respectively. We can
repeat this exercise at different correlation levels to obtain the
sensitivity of spreads to changes in correlation. Figure 1 shows the
normalized cost of protection for each tranche at different correlation
levels. We can see that the cost of protection for the senior tranche
increases with increasing correlation, that is the cost increases as senior
debt gets riskier, while the first loss protection cost decreases with
increasing correlation, that is the cost decreases as equity gets less
risky. Note that, in this particular example the cost of second loss
protection behaves like senior as an increasing function of correlation. 

Implied Correlation 

We can back out an implied correlation for each tranche from CDO prices in
the same way we would obtain implied volatility from option prices and the
Black-Scholes pricing model. An implied correlation extracted in this
fashion depends on the specific CDO pricing model, but the observations
above hold generally. Suppose the market spreads for our example structure
are 2bps, 150bps and 2,000bps for the senior, second loss, and first loss
protection respectively. We can compare these observed spreads with our
model spreads to calibrate a correlation parameter for each tranche. For
example the model spread is equal to the observed spread for the senior
tranche, 2bps, when we price it using a 45% correlation. In other words, the
implied correlation for the senior tranche is 45%. The implied correlation
for each tranche can be inferred from Figure 1 as the correlation level with
which our pricing model recovers the observed market spread. We can see that
for the first and second loss tranches, the implied correlation is roughly
20%, while for the senior tranche the implied correlation is 45%. 

A first application of the implied correlation is to mark to market a
synthetic tranche on an ongoing basis. As we observe changes in the spreads
for the individual names in the pool, we can reprice the tranches above by
assuming the correlation level is constant, but updating the spreads.
Additionally, implied correlations can be used for relative value analysis.
For example, senior and second loss tranche protection increase in value as
correlation increases. Since both tranches depend on the same basket of
names, we would expect them to have a similar implied correlation. As
mentioned above, the implied correlation of the senior tranche (45%) is
significantly higher than that of the second loss tranche (20%). This means
that senior protection is expensive relative to second loss protection. We
can also perform relative value analysis across deals if we believe that the
pools in two different CDOs have similar characteristics, in terms of credit
quality, industry, and geographical distribution. For example, if two CDOs
have similar pools and structure we would expect to observe comparable
implied correlations for their senior tranches. All else being equal, a
discrepancy in implied correlation can serve as an indicator of a
discrepancy in price between the two structures. 


CFTC makes amendments to CFMA 2000
Risk News - October 29, 2001
By Naomi Humphries

The Commodity Futures Trading Commission (CFTC) has released the final rules
relating to the trading of equity futures products in the United States.
These rules implement provisions of the Commodity Futures Modernisation Act
of 2000 (CFMA) that lift the 19-year ban on the trading of single-stock and
narrow-based stock index futures in the US. 

The final rules are in line with the new CFMA statutory provisions regarding
the specification of listing standards and conditions for trading security
futures products. The rules also establish requirements related to the
self-certification of rules and rule amendments, reporting of data,
speculative position limits, and special provisions regarding the contract
design for the cash settlement and physical delivery of security futures
products. 

The CFTC received comment from the Chicago Mercantile Exchange (CME), the
Chicago Board Options Exchange (CBOE), the American Stock Exchange (Amex)
and the Intermarket Surveillance Group (ISG). The CFTC adopted several
revisions consistent with comments, but stated: "Generally, the commentators
supported the proposed rules." 

The CFTC also streamlined the trading process in its revisions of rules
governing commodity futures and options intermediaries on October 19,
following the enactment of the CFMA and the resulting revisions to the
Commodity Exchange Act (CEA). Key rules governing intermediaries, including
futures commission merchants, introducing brokers, commodity pool operators
and commodity trading advisers, have been revised to provide greater
flexibility consistent with the mandate of the CFMA to streamline and
eliminate unnecessary regulation for entities registered under the act. 

They include a provision for retail customers to have broad access to
registered derivatives transaction execution facilities, by permitting them
to trade through a commodity trading adviser with $25 million or more in
assets under management, and a proposal to replace the current prescriptive
rule over ethics with a statement of acceptable practices. 

The CFTC claimed that comments from Fimat, a registered futures commission
merchant, and securities broker-dealer, Exchange Analytics, an ethics
training provider, the CBOT, the National Futures Association and the
Managed Funds Association, all generally supported the adoption of the
proposed amendments for commodity futures and options intermediaries. It
added that the issue that generated the most discussion was ethics training.


Acting chairman at the CFTC, James Newsome, said: "These rules are just the
first step in the Commission's review of appropriate regulatory relief for
intermediaries. We have begun the intermediary study that Congress directed
us to perform, and we may well be implementing additional regulatory reforms
prior to the study's conclusion." 



Banks tout economic derivatives
IFR - October 29, 2001

Deutsche Bank and JP Morgan will be using an auction mechanism to deliver
the new derivatives products, which they say will be self-clearing and
self-hedging. The solution licensed to the two banks to create derivatives
on economic statistics will also be applicable to corporate earnings and
revenues, mortgage prepayments, equity prices, central bank target rates,
index-related products, electric power, weather degree days, credit or any
event-driven market where the development of risk management tools has been
constrained by illiquidity, according to the developer of the solution, New
York-based Longitude.

"Once the mechanisms are up and running and validated, we could envision
structured notes on swaps linked to the auction process itself," said JP
Morgan Chase's Chris Harvey, managing director of foreign exchange and
interest rate derivatives sales for the Americas.

Deutsche Bank has picked Germany's lfo and Japan's Tankan as the debut
products for its economic derivatives franchises in Europe and Japan. JP
Morgan Chase is still in the process of selecting its inaugural US economic
statistics product.

JP Morgan and Deutsche Bank declined to disclose the cost of their franchise
on the economic derivatives. To retain their exclusive agreements with
Longitude for the Parimutuel Digital Call Auction (PDCA)-enabled
derivatives, the banks must meet performance benchmarks. Longitude charges a
fee based on the notional volume cleared through its system.

Using Longitude's PDCA bookrunner product, Deutsche Bank, for example, would
engage in pre-marketing or preselling activity that is similar to that in a
bond or equity syndicate offering, followed by a short auction period.
During the auction period, the bank would submit orders to buy or sell
digital options on the economic data covered to Longitude's web-based
system.

Upon receipt of the orders, Longitude's system produces bid/offer prices for
the derivatives being offered, and other relevant market equilibrium
statistics, such as limit order books. Longitude routes this information
back to the bank, which publishes the statistics for its customers. In this
example, Deutsche Bank would be counterparty to transactions that are
filled.

An order that is filled would result in an International Swaps and
Derivatives Association-documented transaction. The filled orders should
hedge themselves because in a pari-mutuel system all claims that end
in-the-money are funded by those out-of-the-money. "Longitude's clients can
offer derivatives without assuming additional risks on their own balance
sheets," said Andrew Lawrence, chief executive of Longitude. As the systern
accepts orders with limit prices, capital markets participants can have a
high level of price certainty.

In a pari-mutuel system, prices are market-driven and determined by customer
participation, rather than a model or subjective assessment of the price of
risk.

Doubfers
"A pari-mutuel model is a demand and supply based market, so the question
becomes: Will there be enough participants?" said Richard Sandor, chief
executive of Environmental Financial Products and one of the architects of
the interest rate futures markets.

"Is it view taking or [traditional] hedging? I'm not sure," said one bulge
bracket firm's head of market risk management.

Numbers of participants are difficult to predict because they will depend
upon the design of the specific auction, said Longitude's Lawrence. "Perhaps
as few as 10-15 total orders can form a very rich auction equilibrium," he
said.

The cost of operating the call auction is another consideration. A high
transaction charge will mean less money for the winners. "It varies from
market to market. But because banks are not taking market risk, the price
for the service will be modest," said Lawrence. "In general, it has always
been considered extremely desirable to disaggregate risk factors to the
fullest extent possible because they can always be easily recombined."

"Let's assume a health maintenance organisation (HMO) wishes to hedge out
its exposure to annual medical cost inflation in the US, and that the health
industry accounts for slightly less than 20% of US gross domestic product.
What can this HMO do now in the traditional markets to mitigate this risk?
Not much. But JP Morgan could offer derivatives based directly upon this
very important measure in order to offer a risk management product for this
HMO," he said.

Both JP Morgan and Deutsche Bank are expecting early interest from financial
institutions, and fixed-income participants in particular, because no
mechanism for isolating and hedging or speculating on the growth rate of a
country's economy currently exists.

Deutsche Bank's strategy for introducing the new products will initially
hinge on drumming up internal interest, said Kevin Rodgers, global head of
currency options at Deutsche Bank in London. In January, the bank's trading
desks will start using it internally to hedge their own positions. This
activity will be useful in providing the bank with probability
distributions, he added.

Deutsche Bank will then try to get other banks' proprietary and swap desks
to use the system. The new products will probably be available for use by
hedge funds, commodity trading advisers and fund managers by the third
quarter of next year. JP Morgan Chase expects to start its franchise market
on US economic statistic derivatives next month.

**End of ISDA Press Report for October 29, 2001**

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Scott Marra 
Administrator for Policy and Media Relations
International Swaps and Derivatives Association 
600 Fifth Avenue 
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Phone: (212) 332-2578 
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