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With thanks to Sivan Mahadevan, Pinar Onur, Peter Polanskyji, Andrew Sheets who produced many of the slides herein
Table of Contents
Senior
Subordinate Debt
Preferred Stock
Equity (Common)
Losses from Reference Portfolio are borne by tranches in reverse seniority order
AAA Tranche (7.5%) AA Tranche (3%) A Tranche (2.5%) BBB Tranche (4%) BB Tranche (3%) Equity Tranche (10%)
Source: CreditFlux
Please see additional important disclosures at the end of this report.
Small Baskets
Credit Options
Indexation (TRAC-XSM Dow Jones CDX) Basis Trades Curve Trades Capital Structure Trades
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1 Year
5 Year
1980
1985
Cohort
1990
1995
2000
2005
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Zero Correlation
Series 5 Yr 3-7% 7-10% 10-15% 7 Yr 3-7% 7-10% 10-15% 10 Yr 7-10% 10-15% 37 0 53 0 138 0 0 176 0 0 CDX 4 CDX 5 6 0 0 13 0 0 CDX 6 CDX 4 42 8 4 155 32 14 93 46
Market
CDX 5 51 13 6 171 37 16 99 47 CDX 6
Difference
CDX 4 36 8 4 17 32 14 56 46 CDX 5 38 13 6 CDX 6 46 16 8
24 0 0 226 1 0 75 1
70 16 8 196 44 19 107 52
-5
37 16 46 47
-30
43 19 32 51
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Correlation Intuition
Subordinate tranches Spread decreases as correlation rises Senior tranches Spread increases as correlation rises
Senior Tranches
Subordinate Tranches
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Ticker DAL NWAC XIDE DPH CAL AKS AMR GT HAYZ DRRA VC F AEN GM ARM UIS NAV SSCC ABY TEN BOW POL DCN HPC TRW TRA TKR AL
Industry Group Airlines Airlines Auto Parts & Equipment Auto Parts & Equipment Airlines Iron/Steel Airlines Auto Parts & Equipment Auto Parts & Equipment Auto Parts & Equipment Auto Parts & Equipment Auto Manufacturers Oil & Gas Auto Manufacturers Auto Parts & Equipment Computers Auto Manufacturers Forest Products & Paper Forest Products & Paper Auto Parts & Equipment Forest Products & Paper Chemicals Auto Parts & Equipment Chemicals Auto Parts & Equipment Chemicals Metal Fabricate/Hardware Mining
Funding Gap/ Mkt Cap 1235% 875% 266% 256% 215% 147% 145% 112% 102% 81% 73% 68% 62% 43% 40% 36% 34% 33% 33% 32% 29% 27% 25% 22% 22% 22% 29% 24%
This list highlights companies where significant potential exists for a high realized default correlation
Cap based on the average of the 6 months prior to the bankruptcy filing Source: Morgan Stanley
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Section 3: Problems
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Real-World Correlation?
- World B the default propensity of three companies are highly correlated to each other but not to the rest
50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
100
50%
WORLD B Credit 1 2 3 4 100 90% 90% 90% 1 2 3 4 5 10% 10% 10% 50% 50% 100 Average 48%
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TRACERS spread scenario with five defaults in the first two years
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Please see additional important disclosures at the end of this report.
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Consistent across sub-portfolios Internally consistent and computable dynamics Tractable pricing and estimation Can be calibrated to CDS, index, options, tranches
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Problem 2: Estimation
c.f. Specification analysis of affine term structure models
Dai & Singleton Duffie & Singleton Gallant & Tauchen Hansen
Advantages
Elegant Can include arbitrarily complex products No likelihood function required
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Board Vision
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Important Disclosures
The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and/or one or more of its affiliates (collectively, Morgan Stanley) and the research analyst(s) named on page one of this report. Morgan Stanley policy prohibits research analysts from investing in securities/instruments in their MSCI sub industry. Analysts may nevertheless own such securities/instruments to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition. Morgan Stanley is involved in many businesses that may relate to companies or instruments mentioned in this report. These businesses include market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, investment services and investment banking. Morgan Stanley trades as principal in the securities/instruments (or related derivatives) that are the subject of this report. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report.
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9.19.06 po
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