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					Credit Index Products
FpML 4.1




June 2004




Version 1.1
Credit Index Products Functional Specification



                            Table of Contents

1.      REVISION HISTORY............................................................................................................................................ 3

2.      INTRODUCTION ................................................................................................................................................... 4
     2.1.      SUMMARY.........................................................................................................................................................4
3.      DJ ITRAXX PRODUCT DESCRIPTIONS ........................................................................................................ 5
     3.1.      DJ ITRAXX EUROPE ........................................................................................................................................5
     3.2.      THE EUROPE INDEX ........................................................................................................................................5
     3.3.      EUROPE SECT OR INDICES ..............................................................................................................................5
     3.4.      THE HIVOL INDEX...........................................................................................................................................6
     3.5.      THE CORPORAT E INDEX ................................................................................................................................6
     3.6.      THE CROSSOVER INDEX ..................................................................................................................................6
4.      DJ IBOXX PRODUCT DESCRIPTIONS .......................................................................................................... 7

5.      TRADING MECHANICS....................................................................................................................................... 8
     5.1.      W ORKED EXAMPLES ......................................................................................................................................8
6.      DERIVATIVE PRODUCTS................................................................................................................................. 10
     6.1.      TRANCHED I TRAXX ......................................................................................................................................10
     6.2.      DJ ITRAXX FUT URES ....................................................................................................................................10
     6.3.      DJ ITRAXX OPT IONS....................................................................................................................................10
7.      IMPLEMENTATION ............................................................................................................................................ 11
     7.1.      INDEX TRADES...............................................................................................................................................12
     7.2.      TRANCHED INDEX PRODUCT S.....................................................................................................................13
     7.3.      INDEX DEFINIT ION .......................................................................................................................................13
     7.4.      BASKET TRADES............................................................................................................................................14
     7.5.      CDO DEFINIT ION ..........................................................................................................................................15




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Credit Index Products Functional Specification



        1.             Revision History

Version      Reason                                  Name             Date

1.0          Initial                                 Bernard Mullen   June 2004

1.1          External Release                        Bernard Mullen   June 2004




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Credit Index Products Functional Specification



        2.      Introduction

                This document describes the mechanics of credit index products. The two
                types of index products are those that are defined from the resulting merger of
                iBoxx Ltd and TRAC-X LLC, with Dow Jones Indexes.

                        Dow Jones iTraxx for the CDS products

                        Dow Jones iBoxx for the bond index products

                In Europe and Asia, a new body, the International Index Company, has been
                created to administer both the DJ iTraxx and the DJ iBoxx .

                In the US merger, all of the banks will join the CDS IndexCo. to administer the
                index products.

                The European indices have been merged as of June 2004. The US indices will
                be merged at the next US roll date in September.

                The major functional difference between the iTraxx and iBoxx product lines
                appears to be that the iTraxx products are re-issued at each roll date (i.e. a
                new basket is created) whereas the iBoxx products are re-balanced (in a
                similar way to the re balancing of the FTSE equity index).

                The schema definitions and extensions are based upon the First Working Draft
                of FpML Version 4.1 issued 20th February 2004.

                2.1.     Summary

                This document is split into five parts.

                        The first part gives some background on the new DJ iTraxx and DJ
                         iBoxx index products.

                        The second part further illustrates the products by way of worked
                         examples of how a credit event materially affects trades executed on
                         the index.

                        The third part considers some of the derivative products that are being
                         proposed, based on the various credit indices.

                        Although the focus of this document is the index products, they are
                         very similar in structure to CDO type products. The fourth part
                         considers extensions to the FpML schema for not only tranched index
                         products, but also basket CDS and CDO and also the definition of the
                         index.




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Credit Index Products Functional Specification



          3.      DJ iTraxx Product Descriptions1

                  The Dow Jones iTraxx product is the merger of the iBoxx and DJ TRAC-X index
                  products.

                  All of the iTraxx notes and CDS products are based on standardized
                  documentation.

                  The iTraxx indices will be defined in three areas

                         DJ iTraxx Europe

                         DJ iTraxx North America

                         DJ iTraxx Asia/Pacific

                  3.1.    DJ iTraxx Europe

                  All indices and sectors trade in an unfunded format with both 5 and 10-year
                  maturities, with the exception of the corporate index that will trade in a 5-year
                  maturity only. Funded Notes are available in due course for 5-year maturities for
                  the DJ iTraxx Europe, Corporate and Crossover

                  In summary the DJ iTraxx Europe index products are:

                  3.2.    The Europe Index

                  The Europe index is comprised of 125 equally weighted European names
                  selected by a dealer poll based on volume rankings and includes sector
                  indices.

                  Can be traded in CDS format or as a note issued by iBond Securities plc.
                  Standard maturities are 5 years for the notes and 5 and 10 years for the CDS.

                  A new series of the Europe Index is issued every six months.

                  3.3.    Europe Sector Indices

                  The Europe index is split into the following sector indices:

                         Financials (Senior and Subordinated)

                         Non-Financials

                         Autos

                         Consumer cyclicals

                         Consumer non-cyclicals

                         Energy

                         Industrials


1
    From ‘DowJonesiTraxx CDS indices Europe 2004’

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Credit Index Products Functional Specification



                        TMT

                A new series of each Europe Sector Index is issued every six months.

                3.4.     The HiVol Index

                The HiVol index is comprised of 30 names in the Europe index with the widest
                credit default swap spreads.

                Tradable in CDS format only with 5 and 10 year maturities.

                A new series of the HiVol Index is issued every six months.

                3.5.     The Corporate index

                The Corporate index is comprised of the largest, most liquid non-financial
                names from the iBoxx € Corporate bond index, including non-European names.
                Each entity is weighted in accordance with its Aggregate Duration Value.

                Can be traded in CDS format or as a note issued by iBond Securities plc.
                Standard maturity is 5 years.

                A new series of the Corporate Index is issued every six months.

                3.6.     The Crossover Index

                The Crossover index is comprised of the 25 most liquid non-Financial European
                names rated BBB/Baa3 or lower and on “Negative Outlook”

                Can be traded in CDS format or as a note issued by iBond Securities plc.
                Standard maturities are 5 years for the notes and 5 and 10 years for the CDS.

                The next roll date is September 2004.




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Credit Index Products Functional Specification



        4.      DJ iBoxx Product Descriptions

                TBC Since these will not be created until September




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Credit Index Products Functional Specification



        5.      Trading Mechanics

                5.1.     Worked Examples

                The first set of examples detail the trading mechanics of the index products.

                5.1.1. Funded Investment With Credit Event – Cash Settlement

                Investor buys €10m DJiTraxx Europe Note on Issue Date

                The note is issued and pays € +45bp per annum quarterly for 5 years.

                The investor pays the issuer EUR 10M and receives € + 45bp. Per annum on a
                quarterly basis.

                A credit event occurs on a reference entity in year 3.

                So the issuer cash settles the recovery amount to the investor on the credit
                event. The 125 names have an equal weighting in the index. If we assume a
                recovery rate of 40% then the issuer pays

                10,000,000 / 125 * 40% = EUR 32,000

                The notional amount is then reduced to

                10,000,000 – (10,000,000/125) = EUR 9,920,000

                This is the redemption value on maturity of the note.


    Issue Date
    EUR 10,000,000




                                                                          Redemption value
                                                                          EUR 9,920,00




                Based on 10M                                     Based on 9.92M
                Notional                                         Notional


                               Default on one entity. Issuer pays to
                               investor EUR 32,000


                                        Figure 5-1 Funded Cash settlement



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Credit Index Products Functional Specification



                5.1.2. Unfunded Investment with Credit event – Physical
                       Settlement

                Investor buys €10m DJ iTraxxEurope CDS

                The market maker pays 45bp. Per annum on a quarterly basis.

                A credit event occurs on a reference entity in year 3.

                The 125 names have an equal weighting in the index, so the counterparty pays
                to the market maker €80,000 (i.e. €10,000,000/125) and the market maker
                delivers to the counterparty €80,000 nominal face value of deliverable
                obligations of the reference entity.

                The notional amount is then reduced to

                10,000,000 – (10,000,000/125) = EUR 9,920,000



                               Default on one entity. Counterparty pays
                               to market maker €80,000


     Issue Date
     EUR 10,000,000




                 Premium based on                               Premium based on
                 10M Notional                                   9.92M Notional


                               Default on one entityMarket maker
                               delivers €80,000 face value of deliverable
                               obligation of reference entity



                                    Figure 5-2 Unfunded Physical Settlement




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Credit Index Products Functional Specification



           6.      Derivative Products

                    Apart from trading in the index products themselves there are a number of
                    derivatives products that are either currently traded or tabled to be introduced in
                    the near future.

                    6.1.    Tranched iTraxx

                    According to the US Financial Accounting Standards Board (FASB), banks
                    filing earnings statements under US Generally Accepted Accounting Principles
                    rules will have to use accrual accounting for parts of their trading portfolio not
                    valued using „observable market data‟.

                    For a book of synthetic CDO tranches and basket default swaps priced using
                    default correlation estimates, that could prevent trading revenues being
                    recognized for periods of up to 10 years. 2

                    The fact that there are now market makers quoting prices in the various index
                    tranches means that the „observable market data‟ requirement is met. This is
                    one major benefit of the Tranched iTraxx contracts over bespoke synthetic CDO
                    tranches.

                                                                                             3
                    The TriBoxx products trade on 0-3%, 3-6%, 6-9%, 9-12% and 12-22%

                    6.2.    DJ iTraxx Futures

                    Exposure traded as futures contracts is being planned.

                    6.3.    DJ iTraxx Options

                    Options on the spread movements of the DJ iTraxx. Again these are being
                    planned.




2
    http://db.riskwaters.com/public/showPage.html?page=12385

3
    http://www.creditflux.com/public/samples/2003_11/article2.htm

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Credit Index Products Functional Specification



        7.      Implementation

                Following the FpML specification (Version 4.1) the index products are
                represented as a derivation of the simple single name CDS. This gives two
                immediate problems for index products:

                        There is no definition of the constituents of an index

                        Where an index trade is funded there appears to be no representation
                         for the notional exchange.

                The implementation can be thought of as two types of trade:

                Basket Trades – Here if 50M protection is bought on a first to default basket
                then the whole 50M (less the recovery amount) is due on the first default and
                the basket ceases to exist.

                Index and CDO Trades – Here each of the reference entities in the structure
                has a weighting. In the case of the index products the default payoff is
                weighted accordingly and the index trade continues with a lower amount of
                notional.

                The credit default swap element is used by FpML to define both the single
                name CDS and Credit Index trades. These are differentiated on the
                GeneralTerms element using a choice. It is proposed to extend this choice to
                cover baskets, CDO (both full structure and tranched) and tranched index
                products.




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Credit Index Products Functional Specification



                A suggested extension to the FpML schema is shown in Figure 7-1 Extension
                to FpML 4.1.




                                        Figure 7-1 Extension to FpML 4.1

                7.1.     Index Trades

                The index definition should not form part of the trade message since it is
                unnecessary (in the same way that futures series and contracts would not be
                sent with each trade). The FpML definition is:




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Credit Index Products Functional Specification




                                Figure 7-2 Index Trade - Section from FpML 4.1

                7.2.     Tranched Index Products

                As for the index products the index definition is not part of the trade message.
                A suggested schema is:




                               Figure 7-3 Tranched Index - Extension to FpML 4.1

                Note: The logical thing to do here is to combine the tranched index products
                with the „full structure‟ index products. This may be the way the FpML schema
                develops.

                7.3.     Index Definition

                A new element will need to be created, that does not form part of the trade
                message, but is used to define the index constituents. A suggested schema
                is:




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Credit Index Products Functional Specification




                               Figure 7-4 Index Definition - Extension to FpML 4.1
                With ReferencePooldDefinition expanded as:




                         Figure 7-5 Reference Pool Definition - Extension to FpML 4.1
                The ReferencePoolDefinition defines each of the reference entities and also any
                tranches that are tradable.

                7.4.     Basket Trades

                At this point it is probably useful to look at the structure for basket trades and
                CDO. A suggested schema for a basket trade is:




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Credit Index Products Functional Specification




                         Figure 7-6 Bask et Trade - Extension to FpML 4.1
                Here the currentDefaults element will need to be maintained during the life of
                the trade as it indicates how many credit events there have been on the basket.

                7.5.     CDO Definition

                CDO definitions are very much like the index products. A suggested schema
                definition is:




                         Figure 7-7CDO Trade - Extension to FpML 4.1




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