ML Credit Derivative Handbook

Derivatives

The Key Piece In The Puzzle

FirstTo

Default

Risk

Management

Corporate

Bonds

Volatility

Capital

Structure

Arbitrage

Convertible

Bonds

Credit

Linked

Notes

Credit Derivatives

CREDIT

Europe

16 April 2003

Chris Francis

(44) 20 7995-4445

chris_francis@ml.com

Atish Kakodkar

(44) 20 7995-8542

atish_kakodkar@ml.com

Barnaby Martin

(44) 20 7995-0458

barnaby_martin@ml.com

Credit Derivative

Handbook 2003

A Guide to Products, Valuation, Strategies and Risks

Merrill Lynch Global Securities Research & Economics Group

Global Fundamental Equity Research Department

RC#60910601

Investors should assume that Merrill Lynch is
seeking or will seek investment banking or other
business relationships with the companies in
this report.

Refer to important disclosures at the end of this report.

Credit Derivative Handbook 2003 – 16 April 2003

2

Refer to important disclosures at the end of this report.

CONTENTS

nSection

Page

Market Evolution: Going

Mainstream?

1.Market growth, importance and prospects

3

Credit Default Swap Basics 2.The basic concepts

10

Valuation of Credit Default

Swaps

3.Arbitrage relationship and an introduction to survival probabilities

13

Unwinding Default Swaps 4.Mechanics for terminating contracts

19

Valuing the CDS Basis 5.Comparing CDS with the cash market

29

What Drives the Basis? 6.Why do cash and default market yields diverge?

35

CDS Investor Strategies 7.Using CDS to enhance returns

44

CDS Structural Roadmap 8.Key structural considerations

60

What Price Restructuring? 9.How to value the Restructuring Credit Event

73

First-to-Default Baskets 10.A guide to usage and valuation

84

Synthetic CDO Valuation 11.Mechanics and investment rationale

95

Counterparty Risk 12.Credit risks associated with CDS trades

109

Bank Capital Treatment 13.How the BIS views CDS

114

ADDITIONAL CONTRIBUTORS

Mary Rooney

US Credit & Derivatives Strategy

mary_rooney@ml.com

(1) 212 449-1306

Jón G. Jónsson

European Credit Strategy

jon_jonsson@ml.com

(44) 20 7995-3948

Arik Reiss

Equity Derivatives Research

arik_reiss@ml.com

(44) 20 7996-2278

Jeremy Wyett

Convertibles Research

jeremy_wyett@ml.com

(44) 20 7995-4670

David (Yong) Yan

Structured Finance Research

y_yan@ml.com

(1) 212 449-3219

Wenbo Zhu

Structured Finance Research

wenbo_zhu@ml.com

(1) 212 449-6891

Daniel Castro

Structured Finance Research

dan_castro@ml.com

(1) 212 449-1663

Leslie Johnson

US Credit Research

Leslie_johnson@ml.com

(1) 212 449-7884

Credit Derivative Handbook 2003– 16 April 2003

Refer to important disclosures at the end of this report.

3

1. Market Evolution: Going Mainstream?

Credit derivative markets have grown rapidly since the mid-1990s. We think
that the outlook for growth remains strong as the product is increasingly
adopted by traditional mainstream credit investors as a tool for maximising
returns.

The Role of Credit Derivatives

We view credit derivatives as the most important new mechanism for transferring

credit risk.

In simple terms, credit derivatives are a means of transferring credit risk between
two parties by way of bilateral agreements. Contracts can refer to single credits or
diverse pools of credits (such as in synthetic Collateralized Debt Obligations,
CDOs, which transfer risk on entire credit portfolios). Credit derivative contracts
are over-the-counter (OTC) and can therefore be tailored to individual
requirements. However, in practice the vast majority of transactions in the market
are quite standardised.

Within an economy a broad variety of entities have a natural need to assume,
reduce or manage credit exposures. These include banks, insurance companies,
fund managers, hedge funds, securities companies, pension funds, government
agencies and corporates. Each type of player will have different economic or
regulatory motives for wishing to take positive or negative credit positions at
particular times. Credit derivatives enable users to:

•hedge and/or mitigate credit exposure;
•transfer credit risk;
•generate leverage or yield enhancement;
•decompose and separate risks embedded in securities (such as in convertible

bond arbitrage);

•synthetically create loan or bond substitutes for entities that have not issued in

those markets at chosen maturities;

•proactively manage credit risk on a portfolio basis;

•use as an alternative vehicle to equity derivatives (such as out-of-the-money

equity put options) for expressing a directional or volatility view on a

company; and

•manage regulatory capital ratios.

Conventional credit instruments (such as bonds or loans) do not offer the same

degree of structural flexibility or range of applications as credit derivatives.

A fundamental structural characteristic of credit derivatives is that they de-couple
credit risk from funding. Thus players can radically alter their credit risk
exposures without actually buying or selling bonds or loans in the primary or
secondary markets.

Credit default swaps (CDS) are developing into an increasingly standardised
means of transferring credit risk– not just between entities but between different
markets for risk. We believe that the development of a deep and relatively liquid
credit derivative market has the potential to play an important role in efficiently
allocating credit risk within economies.

Arguably, the differing capital adequacy requirements of different types of credit
investor can distort this efficient credit allocation. If this is the case then an
effective and standardised market for credit risk may tend to promote“capital
efficient” in addition to“efficient” allocation of credit.

Credit derivatives are relatively
pure credit instruments, which
de-couple credit from

funding. . .

. . .and can drive efficiency in

risk allocation. . .

. . .and/or capital efficiency