Introduction to Credit DerivativesPresented by: Teaching Session 92 SOA Annual Meeting Orlando, Florida October 28, 2003 Kevin Reimer, FSA, CFA ING Institutional Markets Greg Henke, FSA, CFA Citigroup Michael J. Hambro, FSA, MAAA AON Consulting What is a Credit Derivative? • An agreement that transfers credit risk between parties - Privately held - Negotiated and customized - Large and liquid markets • Synthetically creates or eliminates credit exposures - Quickly becoming the purest way to take or hedge credit risk • Similar to an insurance contract…but different - Actively traded and liquid - No direct loss has to occur in order for protection buyer to be paid • Uses ISDA documentation and ISDA Master Agreements with counterparties - Similar to Interest Rate Swaps 1 Types of Credit Derivatives • Single Name Credit Default Swap (CDS) • Collateralized Debt/Loan Obligation (CDO/CLO) - Split into tranches with different risk/return characteristics - Equity, Mezzanine, Senior, Super Senior, Single Tranche CDOs • Credit Linked Note (CLN) - Funded transaction where credit derivative is embedded in a note • Total Rate of Return Swap (TRoR Swap) • Asset swaps • Basket CDS - Pool of names (First to default, nth to default, last to default, etc.) • Credit Spread Products - Credit spread lock swaps, options, etc. Markets in Credit Derivatives Types of Credit Derivatives Asset Swaps 5% Total Rate of Return Swaps 6% Credit Linked Notes 10% Credit Default Swaps 43% Collateralized Debt/Loan Obligations 26% Basket CDS 5% Credit Spread Products 5% Percentages are estimates of 2004 market share (Source: British Bankers’ Association) 2 Credit Default Swap xx bps per annum Protection Buyer (Firm A) Contingent Payment Protection Seller (Firm B) Contingent Payment is made in case of a credit event on the reference credit, which is defined as one of the following: 1. 2. 3. 4. 5. 6. Failure to pay Bankruptcy Obligation Default Obligation Acceleration (no longer common) Repudiation/Moratorium (followed by restructure/failure to pay) Material adverse restructuring of debt (4 options – can be removed, or replaced by a narrower definition, in exchange for a lower premium) Credit Default Swap – Example 67 bps per annum Protection Buyer (Firm A) Contingent Payment Protection Seller (Firm B) • Firm A buys USD 10mm 5-year protection on Walt Disney Company (BBB+/Baa1) from Firm B - September 16th, 2003 quote: 66/67 - Bid/Ask quote usually for USD 5-10mm for 5-year - Firm A pays a premium of 67 bps per annum until maturity (or a credit event) - Premium can be paid semi-annually, quarterly, upfront, etc. based on market convention 3 Credit Default Swap – Example (Cont.Manage exposures on loan portfolio .2001 supplements clarified restructuring and convertibles .Now vast majority on corporate names In 1999 ISDA promulgated credit derivative definitions to make contracts more standard and transparent .Net buyers to get regulatory capital relief . two methods for settlement Cash Settlement Protection Buyer (Firm A) - (Par less Recovery Value) Protection Seller (Firm B) Recovery Value determined from averaging several dealer bids Physical Settlement Defaulted Security Protection Buyer (Firm A) Par Protection Seller (Firm B) - Defaulted Security will be cheapest-to-deliver obligation How Did Credit Derivatives Evolve? First transactions by banks in early to mid 1990s .Maintain client relationships Initial transactions primarily based on sovereign credits .) If a credit event occurs.2003 re-write incorporated supplements and new restructuring definitions Subsequent improvements to definitions of default events furthered the convergence trend between the cash and synthetic markets 4 . 000 $500 $0 1997 1998 1999 2000 2001 2002 2003 (est.) Standardized Documentation with 99 ISDA Definitions Volume ($bln) Year Market Players Protection Buyers Banks Brokers Hedge Funds Other 52% 21% 12% 15% Protection Sellers Banks Insurers Brokers Other 39% 33% 15% 13% 2002 Market Participation 5 .500 $2.500 $1.) 2004 (est.500 $3.500 $4.000 $3.Growth of Credit Derivatives Growth of Credit Derivatives $5.000 $1.000 $4.000 $2. . early buyer of credit protection to hedge their loan portfolios .Large. 6 .How do Market Participants Use Credit Derivatives? 11 CDS: How Are They Used? Banks . often motivated by regulatory arbitrage . this year negative impact .Initially. industry or geographic region.Often MTM through earnings.Desire to hedge could be due to size of exposure to a single credit.Now common to buy and sell protection to diversify. last year saw positive impact on earnings. but maintain aggregate credit exposure amounts. CDS: How Are They Used? Reinsurance Companies .Significant early seller of credit protection for income .Some protection buyers as a hedge.g. e.Managing reinsurance recoverables 7 .Also use CDS for convertible bond arbitrage Corporates .Exposures to WC clients due to deductibles ..Active protection sellers as risk takers .CDS improved their ability to write Financial Guarantees and take “unfunded” credit risk .Protect non-qualified benefits Non-Life Insurance Uses . vendor financing .No longer a growth business for most Reinsurers CDS: How Are They Used? Other Users Hedge Funds .Reinsurers were looking for “new” risks to diversify their exposures that can be analyzed using an actuarial approach .Reinsurers are used to taking risks on the liability side of their balance sheet . 6 MM Net Asset Yield: 110 bps Liability Cost: 20 bps After-tax ROE: 12% GAAP: MTM (133) 8 . Net Duration: 0 yrs. DV01 Rate: $0. AA/AAA names .Will OTTI drive companies to separate duration and credit exposures? Mortgage Securitization Transformed Banks Will Credit Securitization Transform Insurers? Synthetic Life Company XYZ Life Company • • • • • • • • • • 1st Loss Synthetic CDO • • • • • • • • • • Assets: $1Bn Surplus: $60 MM Asset Duration: 6 yrs.Change profile without triggering deemed sale .Avoid Fx or duration limitations . e.6 MM Net Asset Yield: L+110 Liability Cost: L+30 After-tax ROE: 11% GAAP: BV Notional: $1Bn Equity Investment: $60 MM Asset Duration: 0 yrs Net Duration: 0 yrs.. DV01 Rate: $0 DV01 Spread: $0.Access higher quality credits.Synthetic GIC block (next slide) .0 DV01 Spread: $0.g.CDS: How Are They Used? Life Insurance Companies . Private and silent transaction • Capital management .No need to sell asset (and therefore maintain relationships) .Advantages of Using Credit Derivatives 17 Advantages of Using Credit Derivatives – Buy Side • Hedge existing risk exposure to a particular credit .Create ‘optimal’ credit risk exposures in portfolio .Potential to increase RoE’s • Potential negative basis • Allows increased capacity to names in cash market • Can be negotiated and tailored for specific needs • Facilitates taking an outright negative view on a credit 9 . Advantages of Using Credit Derivatives – Sell Side • Synthetic (unfunded) way of taking credit risk while bundling asset and liability sides of a transaction .Similar to buying a corporate bond and issuing a GIC .Single tranche CDOs .May allow for higher quality names not available in the funded market due to RoE constraints Advantages of Using Credit Derivatives – Sell Side (Cont’d) • More flexibility in creating exposures based on view .Implied LIBOR flat funding versus issuers actual cost-of-funds • Liquidity • Diversifies exposure to names .Pick attachment point and subordination .First/last to default • Potential positive basis • Can be negotiated and tailored for specific needs • Allows increased capacity to names in cash market 10 . income fluctuations • Regulatory issues . linking with funded assets • Capital and tax issues • Need for liquidity (cash) in case of credit event • Systems constraints • Headline Risk Regulatory Issues for Insurance Companies Using Credit Derivatives 22 11 . mark-to-market. IAS 39.Restructuring. doubles counterparty exposure • Accounting issues . allowed deliverables • Counterparty Risk .Replication. definitions.Issues to Consider when Using Credit Derivatives • Documentation Risk . reference entity.Unless unwind with same counterparty.FAS 133. Provides Central Banks with a range of financial services and promotes cooperation among Banks .Helps in the implementation of international financial agreements 12 .Permitted activities .Based in Switzerland is majority owned by Central Banks around the world . regulation for credit derivatives .Describe the regulatory environment for U.Remedial actions • Bank for International Settlements (BIS) .S.Identify the global regulatory participants and their roles .Risk management policies and controls .Discuss key developments .Regulatory Overview and Challenges for Credit Derivatives • Credit derivative market is global • Banks and financial guarantors (often subsidiaries of banks) are the major participants • During this topic we will .Describe U.Minimum capital requirements .S life insurers Global Regulation • Central Banks .Each country’s Central Bank controls the activities of its market participants . EU has committed to adopt IAS standards by 2005 13 .Developing Basel Capital Accord II .IAS 39 addresses derivatives .Has established International Accounting Standards .Developed ISDA Master Agreement for derivative contracts .International Accounting Standards Board (IASB) .Developed Basel Capital Accord I in 1988 .Striving to achieve uniform accounting standards internationally .Implementation targeted for year-end 2006 • International Swaps and Derivatives Association (ISDA) .Global trade organization for privately negotiated derivatives .Each market participant operates under the accounting standards of its country’s .Expected to be completed by year-end 2003 .Global Regulation (Cont’d) • Basel Committee on Banking Supervision . and documentation Global Regulation (Cont’d) Accounting . contract terms.Standardized definitions of credit events.Committee under BIS .Developing new standards based on asset and liability approach . Office of Thrift Supervision . including FAS 133 Accounting for Derivative Instruments and Hedging Activities Key Regulatory Issues and Developments Disputes over terms of contract and definitions .Federal Deposit Insurance Corporation (FDIC) .Interagency Capital Requirements Accounting .Buyer of credit protection wants the most liberal definition of default and the most liberal definition of securities deliverable to protection seller upon default .S Regulation Regulation of U.S Banking Organizations .U.ISDA continually working to update standardize definitions and documentation .FASB.Office of Comptroller of Currency (OCC) .Board of Governors of Federal Reserve System (FED) .Seller of credit protection wants restrictive definitions of default and deliverable securities 14 . banks. 15 .Key Regulatory Developments Example: Railtrack.While dispute in progress ISDA clarified (prospectively) when convertible debt can be delivered to satisfy contract Basel II Capital Accord Capital requirements critical in pricing and availability of credit derivatives Basel I Capital Accord . forcing Nomura to purchase and deliver plain debt . a UK provider of railroad services . or corporate Cont’d….Requires at least 8% ratio of capital to risk-weighted surplus .Nomura sued and prevailed in court .Nomura had bought Railtrack convertible bonds and tried to deliver to CSFB in consideration for payment of face amount .Risk weights depend on whether borrowers are sovereign.CSFB refused to accept convertibles.In late 2001 Railtrack went into receivership .Published in 1988 .Nomura Securities purchased Credit Default Swap (CDS) on Railtrack from Credit Suisse First Boston (CSFB) in 2000 . More granular risk differentiation . the goal is too require the same amount of aggregate capital .In order to optimize capital utilization.Bank A can buy credit protection from Bank B . Bank A can purchase CDS on its better corporate credits and retain exposure to riskier (and presumably higher yielding) credits.6% to 12%.S intends to adopt Basel II for large banks ($250 billion) and for internationally active banks 16 .Counterparty exposure to Bank B will have a weighting of 20% . depending on borrower credit evaluation .Maintains minimum 8% capital to risk-weighted assets .Basel II Capital Accord (Cont’d) Risks defined too broadly and can lead to capital arbitrage .Implementation targeted for 2006 U.All corporate debt has a 100% weighting .Uses both standardized approach and internal rating based approach to risk evaluation .Includes supervisory review process and market discipline .Initially. Basel II Capital Accord (Cont’d) Basel II makes several improvements .Flat 8% capital ratio in Basel I can effectively vary from 1. despite previous EU indication of adopting IAS in 2005.EU banks feel that this will create undue earning volatility and are indicating reluctance to adopt this standard. GAAP .S.FAS 133 can and has caused earnings volatility International Accounting Developments .Fair value or cash flow hedge . are not derivatives.Carried on balance sheet at fair value with changes in fair value going through income statement . However. Accounting for Derivative Instruments and Hedging Activities .S GAAP credit derivatives fall under the scope of FAS 133. credit derivatives 17 .Hedge accounting permitted in certain circumstances . Financial guarantees vs.Credit derivatives would generally satisfy the definition of derivative under FAS 133 .FAS 133 interpretation of Mod-Co contracts as containing credit derivatives .Some assets.IAS 39 (many similarities to FAS 133) would require derivatives to be treated as assets and liabilities and carried at fair value (with hedge treatment exceptions) .Accounting Developments For U.Currently banks in many European countries account for derivatives off balance sheet . in this case FAS 133 requires the credit derivative that is part of the credit linked be split out from the host contract and treated separately as a derivative Accounting Developments (Cont’d) U. such as credit linked notes.Must demonstrate hedge effectiveness . Income generation . caps. but generally allow derivatives for the following purposes . say 3% of admitted assets 18 .S Life Insurers (Cont’d) Specific limitations for derivative activities .One of the problems that have faced life insurers for many years is the lack of uniform state insurance laws. caps. and floors may not exceed.Aggregate statement value of options.Aggregate statement value of options. including investments laws.Hedging . .S.5% of admitted assets . but important differences exist. 7.Credit Derivative Challenges for U.Hedging . say. and floors written may not exceed.Asset replication Credit Derivative Challenges for U.Investment laws are becoming more standardized.S Life Insurers Each U. State derivative investment laws differ. life insurer is subject to the life insurance investment laws of its domicile state . Risk measurement and management policies and procedures .Credit Derivative Challenges for U.Purpose of each derivative transaction .S Life Insurers (Cont’d) Note that the limitation on income generation transactions precludes life insurers from writing naked CDS.Governance .Limitations apply to statement value of fixed income assets subject to call or put.A key limitation is that income generation only applies to covered calls or puts Asset replication .S Life Insurers (Cont’d) Income generation .Infrastructure and systems controls 19 . such as the “super senior” trances of synthetic CDS.Documentation .Based on limitations for authorized asset type being replicated Credit Derivative Challenges for U. Limitation commonly 10% of admitted assets . Life insurers engaging in derivative activities must have a derivative use plan . SSAP 86 allows fair value hedges and cash flow hedges .Derivative premium treated as deferred liability .Can only be used in covered situations in which an asset owned by the insurer hedges the derivative risk .S Life Insurers (Cont’d) Statutory Accounting .Statement of Statutory Accounting Principles No.Hedge effectiveness must be regularly demonstrated .Credit Derivative Challenges for U. Income Generation. 86. such as credit risk Credit Derivative Challenges for U. Accounting for Derivative Instruments and Hedging.Insurer can hedge specific components of risk. and Replication (Synthetic Asset) Transactions Hedging .S Life Insurers (Cont’d) Income generation .Carrying valued depends on accounting for covering asset 20 .Strict limitations apply . Ideally.Unlike FAS 133.Accounting Statutory Accounting .S Life Insurers – Risk-Based Capital NAIC RBC Formula does not explicitly address modern uses of credit derivatives For example.S Life Insurers . the insurer would substitute the credit quality of Bank B for the credit quality of Company A in determining its RBC. the embedded derivative (CDS) would not be bifurcated from the host contract Credit Derivative Challenges for U. . This assumes that the terms of the CDS afford appropriately afford protection on the bond However.An example would be a credit linked note or a synthetic CDO that is constructed of default-free bonds and Credit Default Swaps to replicate exposure to a basket of corporate credits . Need for convergence of economic capital and RBC 21 . based on the rating of the security.In this case statutory accounting would treat the note or CDO as a regular fixed income asset. assume an insurer purchases a CDS on Company A (on which the insurer holds a bond) from Bank B.Credit Derivative Challenges for U.Asset Replication (Synthetic Assets) .Asset replication means using a set of derivatives and cash instruments to replicate the investment characteristics of permissible assets . the NAIC formula does not appear to provide this treatment. purchase a credit default swap. and earn a spread of about 175 bp. which is probably a much smaller risk.Credit Derivative Challenges for U. credit default swap pricing is much different than our above assumption indicates. If the credit default swap cost is around 25 basis points. an investor can buy the bond. 22 .S Life Insurers Summary of Needed State Regulatory Improvement Uniform investment laws . The default risk of the bond issuer is replaced by the counter party risk of the protection seller (investment bank). Moody’s annual corporate bond default study indicates that the average annual default cost (annualized cumulative default probability times 1 minus recovery rate) is 25 basis points. Actually.Numerical limits Address growing uses of credit derivatives RBC Pricing Credit Default Swaps (CDS) Assume that a 5-year corporate bond rated BBB2 trades at 200 basis points over the 5-year Treasury.Permitted activities . not historical default probabilities. . (A) the present value of the expected payoff from the credit default is calculated. .Inductively. we can calculate the default density at each time interval. we can estimate the probability of the issuer defaulting at different future times.Note that default probabilities are risk-neutral.If the reference issuer has a sufficient range of bond maturities that are actively traded.First.In order to determine default probabilities.Then. Also. .Value of Treasury Bond –Value of Corporate Bond= Present Value of Cost of Defaults . temporarily assume no counter party risk. . 23 . 1 Valuing Credit Default Swaps I (2000) Pricing Credit Default Swaps (Cont’d) . assuming no counter party risk: . .Assuming a given difference between the value of a corporate bond and its corresponding maturity Treasury bond. . we need to make an assumption about recovery amounts upon default. higher recovery amounts imply higher risk-neutral default probabilities.Pricing Credit Default Swaps Hull and White1 describe a process for valuing credit default swaps. it is assumed that the value of a Treasury Bond (risk-free) exceeds the value of the reference corporate bond solely due to the possibility of defaults.If this is not the case we can use bonds from other issuers that have the same default risk as the reference entity. Also. . Example of CDS Pricing.The credit swap premium is the spread that equates (A) and (B).Pricing Credit Default Swaps (Cont’d) . 2000 Maturity Actual Bond Yield Spread to Treasuries in bp CDS Spread (Premium) from Hull and White Model 1 5 10 20 199 213 240 269 189 209 227 253 24 . Ashland Inc – July 13. (B) the present value of $1per year credit default swap periodic fees (premium) is calculated. Liquidity 25 . buy the credit default swap. If the credit default swap premium is materially higher than the yield spread. and buy the Treasury bond.Pricing Credit Default Swaps Note that the credit default swap premium is close to the actual bond yield spread. Conversely. and short the Treasury bond. sell the credit default swap. the investor would short the corporate bond.The bond is trading at a deep discount or premium . Pricing Credit Default Swaps There are situations in which the CDS spread calculated in the model differs somewhat from the bond yield spread .Recovery rates are assumed to be well above 50% . if the credit default swap spread is materially lower than the bond yield spread.The Treasury curve is very steep . the investor would buy the bond. The model we previously discussed can be extended to price a CDS based on a the distribution of default losses for N reference bonds. say N. by constructing correlations of “credit indices” between each pair of reference bonds. Also.4 0.8 5-Year Swap: Recovery Rate: 30% *Source: Hull and White Valuing Credit Default Swaps II (2001) 26 . CDS Pricing Example Multiple Reference Entities Payoff on First Default Spread in bp* Number of Reference Entities (all BBB rated) 1 2 5 10 194 386 946 1842 194 351 707 1122 194 289 444 580 Cred index Corr 0 0.Pricing Credit Default Swaps Extension to Multiple Reference Entities For many CDS applications more than one reference entity will be used. the value of the payoff from the CDS may depend on the distribution of defaults on a pool of. reference bonds. 4 187.6 134.1 Current Developments within the Credit Derivative Industry 54 27 .3 0.4 185.1 170.3 0.8 177.Pricing Credit Default Swaps Counter party Risk CDS Spread in bp* Counterparty Rating AA A AAA Cred index Corr 0 194.3 194.5 156.3 194.1 174.8 5-Year Swap: Recovery Rate: 30% Reference Entity is BBB *Source: Hull and White (2001) BBB 194.2 181. 00 0.93 0.71 1.50 0.88 -0.76 0.42 0.97 -0.96 0.83 0.37 -0.69 1.22 -0.43 0.76 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 1.30 0.35 0. WorldCom) have proven viability of settlement mechanisms and functionality of the market Soft defaults have forced tighter documentation.90 0.95 0.92 0.00 0.63 0.89 1.96 0.03 1.93 0.78 0.00 Correlation is defined as linear correlation between weekly changes of sector default swap spread indices over a 3-month trailing period Improvements: ISDA/Restructuring Hard defaults (Enron.14 26 0.59 20 0.53 0.92 0.82 0.56 0.40 1.75 0.26 0.48 -0.23 0.94 0.95 0.57 0.79 1.82 0.65 0.15 0.92 0.94 0.43 0.13 0.03 0.25 -0.46 0.64 0.87 15 0.13 0.81 1.97 0.72 0.91 1.39 0.84 0.44 0.50 1.57 0.75 0.93 -0.78 -0.77 0.21 -0.55 0.98 0.20 0.00 3 0.94 24 0.85 0.56 -0.94 0.83 19 0.77 0.63 0.57 0.87 0.89 0.87 1.81 0.83 0.34 -0.72 0.87 0.86 0.92 0.90 -0.89 0.71 0.60 0.00 0.80 0.91 0.92 0.57 -0.30 0.96 0.59 0.72 0.28 0.37 23 0.75 0.93 0.91 0.76 0.37 -0.23 0.78 0.65 0.00 0.69 0.43 0.25 0.82 0.91 10 0.77 -0.86 0.34 -0.93 0.76 0.94 0.94 0.73 1.18 0.00 0.86 0.00 0.22 0.04 -0.71 0.06 0.94 0.32 0.92 0.85 0.44 0.94 0.63 0.96 0.69 -0.94 0.93 0.52 0.71 0.69 0.96 1.18 0.58 0.83 0.95 0.00 2 0.89 0.52 0.93 0.04 0.79 0.52 0.00 0.00 0.37 0.24 0.93 0.72 0.46 0.97 0.95 0.79 0.31 0.24 -0.68 0.89 0.94 0.41 0.15 0.00 5 0.63 0.76 0.92 0.89 0.75 0.97 0.54 1.76 1.95 0.00 0.88 -0.87 0.88 0.35 0.18 0.64 0.68 0.97 0.96 0.94 -0.66 0.33 0.93 0.71 0.13 1.30 0.95 0.94 11 0. Technology Cable/Media & Publishing Telecommunications Retail Stores (Food & Drug) Retail Stores (Other) Tobacco Consumer Products Buildings/Construction REIT Health Care Pharmaceuticals 1 2 3 4 5 6 1 1.00 0.59 9 0.95 0.76 0.74 0.76 0.89 0.57 0.00 7 0.85 0.76 0.87 0.42 0.79 0.81 -0.65 0.94 21 -0.43 0.23 0.18 1.84 0.84 0.90 0.00 0. 2003 Automotive Manufacturers Vehicle Parts Transportation Aerospace/Defense Banks Securities Finance Insurance (Life) Insurance (P&C) General Industrials Chemicals Paper/Forest Products Electric/Other Utilities Oil & Gas Gaming/Lodging/Leisure Info/Data/Elec.87 0.77 0.57 0.00 -0.94 17 0.77 0.00 0.86 0.93 0.88 0.92 -0.00 0.50 0.84 0.57 0.23 0.84 0.90 0.76 0.97 8 0.90 0.97 1.86 1.61 0.00 0.91 13 0.60 0.92 0.53 0.91 -0.83 0.02 -0.94 0.55 0.65 0.98 -0.25 0.82 0.55 0.96 0. the definition of Restructuring has been retooled and acceleration has been dropped as a credit event Restrictions have been placed on the allowable maturity of bonds that can be delivered to protection sellers as the result of a credit event 28 .82 0.95 0.00 0.42 0.93 0.88 0.98 0.50 0.89 14 0.92 0.00 0.98 0.92 1.68 0.71 0.77 -0.95 0.77 0.83 0.64 -0.Other CDS Uses: Informational Clarity Credit Default Swaps (5 Year Offer Side) Sector Spread Correlations (3 Months) April 30.86 0.83 0.96 0.76 22 0.00 6 0.82 1.94 0.97 0.00 0.35 0.90 1.57 0.30 0.97 0.79 0.59 0.97 0.88 0.66 0.76 0.59 0.30 0.38 0.60 1.87 0.92 -0.85 0.37 0.70 0.37 0.41 0.86 25 -0.13 0.39 -0.83 12 0.00 0.93 0.97 1.91 0.96 0.95 18 0.82 0.37 0.93 1.34 0.96 0.89 16 0.84 0.94 0.78 -0.93 0.31 0.73 0.00 4 0.01 0.59 0.42 0.96 0. Improvements: Liquidity There are now over 500 investment grade names that trade in the CDS market Names are “always” available. 76/78 bps Improvements: STCDOs Many dealers now offer Single Tranche CDOs (STCDOs) STCDOs allow investors to select a custom portfolio of credits.. no need to find a willing seller that owns the bonds Higher quality names often trade in 5 basis point bid/ask markets Broad indices are often quoted in 2 basis point bid/ask markets. and to go long or short exposure to any tranche of the portfolio Investors do not have to wait until other tranches of the CDO are sold Investors can substitute underlying credits and even go long or short credits within the structure 29 .g. e. you could transact a customized.Closing Thoughts It took until 2001 for the first managed synthetic CDO to be executed Today. and there many extensions have a great deal of applicability for Insurance Companies that are able to analyze and manage credit risk. managed. Questions? 60 30 . single tranche CDO that would allow you to go long and short credits within the structure Most insurance company asset portfolios have been built based on the new issue calendar Credit Default Derivatives.