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This report has been published in conjunction with "Credit DerivativesHandbook, Volume 1: A Guide to Single-Name and Index CDS Products"
 
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. 2
 A Guide to the Exotics Credit Derivatives Market 
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 196. Analyst Certification on page 196.
Global Securities Research & Economics Group Credit DerivativesStrategy
RC#60904502
 
Credit Derivatives Handbook 2006 – Vol. 2 – 14 February 2006
2
Refer to important disclosures on page 196.
CONTENTS
Section PageExotics Credit Derivatives -Tried and Tested 1.
Overview of the exotics credit derivatives market 
3Single Tranche Synthetic CDO 2.
 A guide to bespoke single-tranches
8First-to-Default Baskets 3.
 A guide to usage and valuation
23Standardized Tranches 4.
 A guide to the index tranche market 
33Trading Correlation 5.
 Managing risks in tranche trading 
45Tranche Relative Value Tools 6.
 Identifying relative value in tranche markets
63Correlation Strategies 7.
 Interesting trade ideas in the tranche market 
80Modeling Correlation Products 8.
 Pricing models for CDOs & FTDs
101What Correlation? 9.
 Moving from compound to base correlation and beyond 
126Synthetic CDO^2 10.
CDO of CDOs
138Leveraged Super Senior 11.
 A guide to synthetic LSS 
148CDO Combination Notes 12.
Combining tranches to tailor investor needs
156CPPI for Debt Investors 13.
 Principal protection techniques
169CDS Options 14.
 Payers and Receivers, trading spread volatility
176CMCDS 15.
 Bulish on Credit, Bearish on Spreads
186
ADDITIONAL CONTRIBUTORS
Chris Francis
International Credit & Rates,Merrill Lynch (Singapore)chris_francis@ml.com
 (65) 6330-7210
Alexander Batchvarov
Research Analyst, MLPF&S (UK)alexander_batchvarov@ml.com
 (44) 20 7995-8649
Barnaby Martin
Credit Strategist, MLPF&S (UK)barnaby_martin@ml.com
 (44) 20 7995-0458
Altynay Davletova
Research Analyst, MLPF&S (UK)altynay_davletova@ml.com
 (44) 20 7995-3968
Lang Gibson
CDO Analyst, MLPF&Slang_gibson@ml.com
 (1) 212 449-3942
 
We would like to acknowledge
Maksim Shchetkovskiy's
 contribution while employed with Merrill Lynch research.
 
Credit Derivatives Handbook 2006 – Vol. 2 – 14 February 2006
Refer to important disclosures on page 196.
3
1. Exotic Credit Derivatives: Tried & Tested
Since late 2003, the credit derivatives market transformed itself from aprimarily single-name only market to a more complex market of single-name,index, correlation and options. This second volume of the handbook dealsprimarily with correlation and volatility based products. This includessingle-tranche synthetic CDOs (STCDO), first-to-default (FTD) baskets, CDSoptions and other related products.
Forces Driving the Market
The growth of the exotics credit derivatives market has been driven primarily bythree key forces:
•
 
Yield enhancement
: As spreads have tightened, investors have taken onmore leverage via the STCDO market either via the plain vanilla structure ormore leveraged synthetic CDO-squared (or CDO^2) structures. Investors withstrong credit views have also used FTD structures to enhance yield.
•
 
Index liquidity
: The wildly successful index (CDX & iTraxx) is theinstrument of choice to take on a macro credit view
1
. More importantly, theindices have also served as building blocks for the next generation of productssuch index tranches or index options.
•
 
Innovation
. The ever-changing needs of end investors have meant newstructures to express spread views with more sophisticated payoffs such asCDS options, cancelable CDS, or constant maturity CDS (CMCDS). Thisinnovation has extended into the tranche market to enable investors to capturevalue in different parts of the capital structure, e.g. leveraged super senior(LSS) notes.The STCDO market, in particular, has grown significantly over the last few years.However, the OTC nature of the market makes it difficult to measure the size of the market. Chart 1 represents an estimate of the STCDO volumes (both bespokeand standardized) over the last few years. According to this estimate, a majority of the recent volume relates to standardized index tranches (about 68% in FY05).However, these estimates are not adjusted for the tranche seniority and do notreflect the typically higher notionals for senior relative to junior tranches.
Chart 1: Single Tranche Synthetic CDO Volume Estimates
25941459411930077146243198665-100200300400500600700FY 031Q 042Q 043Q 044Q 04FY 041Q 052Q 053Q 054Q 05FY 05
    T   r   a   n   c    h   e    N   o    t    i   o   n   a    l    (    $    b   n    )
Source: Creditflux
1
Indices are described in more detail in Volume 1, Chapter 8.
Yield, liquidity and innovationhave driven growth
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