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This report has been published in conjunction with "Credit DerivativesHandbook, Volume 2: A Guide to the Exotics Credit Derivatives Market"
CREDIT DERIVATIVES
Global
Contributors
North AmericaAtish Kakodkar
 Strategist, MLPF&S(1) 212 449-0104atish_kakodkar@ml.com
Stefano Galiani
 Strategist, MLPF&S(1) 212 449-7416stefano_galiani@ml.com
EuropeJón G. Jónsson
Strategist, MLPF&S (UK)(44) 20 7995-3948on_jonsson@ml.com
 Alberto Gallo
Strategist, MLPF&S (UK)(44) 20 7995-8542alberto_gallo@ml.com
14 February 2006
Credit Derivatives Strategy
 New York: (1) 212 449-0104London: (44) 20 7995-3948
Credit DerivativesHandbook 2006 – Vol. 1
 A Guide to Single-Name and Index CDS Products
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be awarethat the firm may have a conflict of interest that could affect the objectivity of this report.Investors should consider this report as only a single factor in making their investment decision.Refer to important disclosures on page 118.
Global Securities Research & Economics Group Credit DerivativesStrategy
RC#60904501
 
Credit Derivatives Handbook 2006 – Vol. 1 – 14 February 2006
2
Refer to important disclosures on page 118.
CONTENTS
Section PageCredit Derivatives – A Market Overview 1.
 Market evolution, importance, participants and challenges
3CDS Basics & Valuation 2.
 Basic concepts, arbitrage relationship, survival probabilities
11Unwinding CDS 3.
 Mechanics for terminating contracts
21Upfront Pricing of CDS 4.
Compare upfront vs. running CDS spread 
29Valuing the CDS Basis 5.
Comparing CDS with the cash market 
37What Drives the Basis? 6.
Why do cash and default market spreads diverge?
47CDS Structural Roadmap 7.
 Key structural considerations
54CDS Indices 8.
The ABCs of CDX and iTraxx indices
73CDS Investment Strategies 9.
Using CDS to enhance returns
88Counterparty Risk 10.
Credit risks associated with CDS trades, Novation Protocol 
112
 
ADDITIONAL CONTRIBUTORS
Chris Francis
International Credit & Rates,Merrill Lynch (Singapore)chris_francis@ml.com
 (65) 6330-7210
Barnaby Martin
Credit Strategist, MLPF&S (UK)barnaby_martin@ml.com
 (44) 20 7995-0458
Mary Rooney
Credit Strategist, MLPF&Smary_rooney@ml.com
 (1) 212 449-1306
Heiko Ebens
Equity-Linked Analyst, MLPF&Sheiko_ebens@ml.com
 (1) 212 449-1049
Michelle Charles Olson
Credit Strategist, MLPF&Smichelle_charles@ml.com
 (1) 212 449-5106
Jeremy Wyett
Equity-Linked Analyst, MLPF&S (UK) jeremy_wyett@ml.com
 (44) 20 7995-4670
 
We would like to acknowledge
 Maksim Shchetkovskiy's
contribution while employed with Merrill Lynch research.
 
Credit Derivatives Handbook 2006 – Vol. 1 – 14 February 2006
Refer to important disclosures on page 118.
3
1. Credit Derivatives – A Market Overview
The credit derivatives market has grown significantly over the last few yearsand now exceeds both equity derivatives and corporate bond markets. Webelieve the outlook for growth remains strong as the product is increasinglyadopted by traditional mainstream credit investors and new instruments aredeveloped.In this first volume of our handbook, we discuss single-name CDS as well asthe CDS index market. The second volume takes an in-depth look at theexotic credit derivatives market including correlation and volatility products.
Moving Beyond Single-Name CDS
 
Evolution of the Credit Derivatives Market
Credit derivatives are over-the-counter (OTC) instruments designed to transfercredit risk between two parties by way of bilateral agreements. The most poularinstrument is the credit default swap (CDS) contract. Over the last few years thecredit derivatives market has evolved from a primarily single-name CDS marketinto a more complex market consisting of not only the more mainstream single-name CDS (in both high grade and high yield credit) but also the liquid CDSindices (CDX, iTraxx) and the more esoteric correlation and volatility products.CDS contracts can refer to single credits or portfolios, such as indices or syntheticCollateralized Debt Obligations (CDOs); senior or subordinated obligations of thereference entity; asset-backed instruments or loans; and usually have a termanywhere between one and ten years. More recently we have even seen the CDSconcept applied to preferred stock.Since CDS are OTC instruments, they can be tailored to individual requirements.However, in practice the vast majority of transactions in the market are quitestandardized. Notably, the development of CDS indices (such as CDX and iTraxx)has also fueled the development of second-generation CDS instruments such astranches or options on the indices (discussed in Volume 2 of the handbook).
 
Well Tested
Since inception, the credit derivatives market has been regularly tested on variousdocumentation issues. Some notable cases
1
relate to Reference Entity specification(Armstrong), Successors (National Power), Restructuring (Conseco, Xerox,Argentina), Deliverability (Railtrack), Guarantees (Marconi). These have been lessfrequent following the publication of the 2003 credit derivatives definitions whichironed out a lot of these kinks inherent in the earlier 1999 definitions.The introduction of new products such as indices and tranches has, however,raised new challenges driven by both complexity as well as immense popularity.In 2005 the market was tested on two fronts:
•
 
The recent spate of defaults in North America tested the operational riskembedded in the settlement procedure for the index and standardized tranchemarket.
•
 
The credit correlation market was severely tested in May due to the creditdeterioration of the auto sector, primarily GM and Ford.In our opinion, both these tests have strengthened the market. The creditcorrelation market has seen an increase in activity post the shakeout in May andhas the looks of a more mature market. The relatively smooth settlement of multiple defaults in 2005 has increased investor confidence in what was expectedto be a fairly volatile issue.
1
All these cases are discussed in depth in Volume 1, Chapter 7.
 
Chart 1: Beyond Single-Name CDS
SingleNameIndexVolatilityCorrelation
 
Source: Merrill Lynch
The market has been put to thetest several times2005 was a particularly challenging year 
of 00

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