Vasant,

Can you, please, review this Newsletter article.
I had to put something together rather quickly last night.

Vince

---------------------- Forwarded by Vince J Kaminski/HOU/ECT on 04/02/2001 
07:37 AM ---------------------------


VKaminski@aol.com on 04/01/2001 11:22:50 PM
To: vkamins@enron.com
cc: VKaminski@aol.com 
Subject: Newsletter


Complexity of modern financial markets never ceases toamaze me. Te links  
between different financial instruments are sometimes verysubtle and it 
takes  
understanding of many different types of transactions toexplain the  
interdependencies. Recently, I have been receiving E-mails fromdifferent  
academics and practitioners asking for explanation of anomalydetected in  
pricing of credit default swaps. One E-mail asked the followingquestion:  
According to a Bank of America publication, your (Enron) default swapspreads  
are consistently trading about 80 basis points wider than your assetswaps.  
Any idea of what is going on here? 

Icame up with an answer with the help of Bryan Seyfried from Enron  
Credit.com,our unit in London trading credit protection tools. The answer  
requiresexplaining first what are credit default swaps. In a plain-vanilla  
credit default swapstructure, the buyer pays a premium for protection he or  
she receives in case acredit event (default) takes place in the case of a  
reference entity. In theevent of default by the reference entity, the seller  
of the protection isrequired to pay an amount equal to the difference 
between  
the initial price ofthe credit exposure and its recovery value. For example,  
the protection may bepurchased for a bond issued by the reference entity. In  
the case of a default,the seller of protection pays the difference between  
the face value of the bondand its current(post-default) market price.  
Mispricing of credit default swaps often takes placefollowing an issuance by  
the reference entity of convertible bonds. Aconvertible bond can be looked 
at  
as a combination of a regular coupon bond anda long-term equity option.  
Sometimes the equity option may be mispriced and beavailable at a lower 
price  
than the comparable equity options that can beobtained at the derivatives  
markets. The hedge funds buy convertible bonds toacquire the option 
component  
but are not interested in taking the issuer,scredit. They seek to lay off  
credit risk by selling the asset swaps or bybuying protection through 
default  
swaps. This arbitrage leads in many cases,after a large convertible bonds  
issue, to imbalance in the asset swaps marketsvs. default swaps markets. The  
cost of credit protection goes up but this hasnothing to do with  
deterioration of the issuer,s credit.  
One may expect that this imbalance will be eliminated overtime and the 
prices  
of default and asset swaps will converge. Frictions andrigidities in the  
capital markets may slow down this process. 
Enron issues recently a$1.9 billion convertible bond that became a target of  
arbitrage activitiescarried out by the hedge funds. What is very interesting  
is that analysts wholook at one segment of the financial markets in 
isolation  
from other segmentsmay be unable to explain the dynamics of prices.  
Globalization has arrived andit has more than one dimension.
 - credit.doc