CDO training program

CONFIDENTIAL

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

CDO Technology Overview

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

CDOs

Concept is derived from securitisation Pool, tranches Pool with a very minimum of 10 to 20 assets Below 10 / 20 assets => Exotic Credit Derivatives area Usually the minimum is 50 (optimal number = 100 to 120 assets) Tranches = debt securities format Senior (super-senior = AAA tranche) Mezzanine (upper, lower) Equity (most junior debt) Also called « first loss » tranche

Less risk SENIOR MEZZ. EQTY.

More risk

CDO training program

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- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

CDOs (cont’d)
Senior: 80 Mezz : 15 Eqty : 5

Mecanism Let’s assume the following tranching…

Pool 100

… and 3 different senarios: If over the CDO life, the cumulative losses of the pool = 3
Senior tranche is not hit Mezz tranche is not hit

Increasing number of defaults

Equity tranche is hit by 3

Eqty tranche investors partially lose their investment

If over the CDO life, the cumulative losses of the pool = 10
Senior tranche is not hit Mezz tranche is hit by 5 Mezz tranche investors partially lose their investment EQTY tranche investors lose all their investment

Equity tranche is totally hit (by 5)

If over the CDO life, the cumulative losses of the pool = 25
Senior tranche is hit by 5 Senior tranche investors partially lose their investment Mezz tranche investors lose all their investment EQTY tranche investors lose all their investment
4

Mezz tranche is totally hit (by 15) Equity tranche is totally hit (by 5)

CDO training program

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Different Asset Classes

.30/03/2007 17:07:02 Different Asset Classes Corporate risks High Grade High Yield Mix of both Asset Backed Securities (‘ABS’) 2 main caracteristics: Default rate < to those of corporate assets class Relatively higher stability of ratings (more resilient to economic downturns) SME Loans (small & medium companies) CDO tranches ( CDO-squared) CDO training program 6 .C:\USERS\Stephane DELAINE\STR .CDO CWA & investissement\presenations\post asian seminar slides .

30/03/2007 17:07:02 Different Structures .CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR ..

30/03/2007 17:07:02 Different types of structures: 4 criteria Objective Balance Sheet vs Arbitrage CDO Balance sheet = credit portfolio management.C:\USERS\Stephane DELAINE\STR . capital optimization. reglementary issues.CDO CWA & investissement\presenations\post asian seminar slides .… Arbitrage = taking advantage of the difference between the average return on the reference portfolio and the payments made to the tranches investors (= excess spread) Transfer mode Cash vs Synthetic Cash = True sale of the underlying credit assets portfolio Synthetic = risk transfert via CDS Cash Flow CDO vs Market value CDO Cash flow = CDO revenues driven by those of the underlying credit assets portfolio + revenues allocation to investors according to note seniority (= cash flow waterfall) Market value (CDS based technology) = CDO performance linked to the variation of the underlying credit assets market value Static vs Managed CDO Static = Credit assets reference pool is defined at implementation and remain unchanged during all the life of the transaction Managed = Credit assets reference pool can fluctuate over time according to CDO manager trading decisions CDO training program 8 ..

30/03/2007 17:07:02 Flurry of innovations won’t be discussed CDO^2 CPPI (Constant Proportion Portfolio Insurance) CPDO CDO with equity buckets Mix between debt and Eqty in order to enhance the CDO return profile L/S (Long / Short structure) Hedging vs market spreads variations Etc… CDO training program 9 .C:\USERS\Stephane DELAINE\STR .CDO CWA & investissement\presenations\post asian seminar slides ..

CDO CWA & investissement\presenations\post asian seminar slides ..C:\USERS\Stephane DELAINE\STR .30/03/2007 17:07:02 Let’s focus on 3 cases Funded Loan Securitisation Partially Funded Synthetic CDO Single-tranche synthetic CDO CDO training program 10 .

C:\USERS\Stephane DELAINE\STR .5% Notes First loss exposure The bank selects a pool of loans to be securitized Notes proceeds CDO training program 11 .CDO CWA & investissement\presenations\post asian seminar slides .5% EURIBOR + 45bp Notes Investors = protection providers Senior exposure Reference pool Assets face value = 100% True sale Pool of credit assets Assets face value = 100% Mezzanine BB Face value = 20% EURIBOR + 90bp Notes Intermediary exposure Cash Borrower 4 Loan agreement (=Notes proceeds) Equity Face value = 13..30/03/2007 17:07:02 Cash CDO / Funded Loan Securitisation Bank = Transaction Sponsor / Manager Borrower 1 Borrower 2 Borrower 3 Loan agreement Loan agreement Loan agreement Management Agreement SPV Assets Liabilities Senior Debt AAA Face value = 66.

C:\USERS\Stephane DELAINE\STR . Moody’s. Fitch. …) Rating based on Default statistics (historical data) Sponsor’s commitment = Equity retention Bank commits itself to keep the first losses unhedged in order to prove its good faith to investors vs any arbitrage temptation Many drawbacks (= heavy structure) but some advantages in terms of funding stability (vs synthetic CDO that are non-funded structures) Good for banks with weakening rating interest level (swap rate + spread) defined the day the structure is implemented and remains unchanged through the life of the deal (=usually 5 years) In terms of rating CDO training program 12 .. it is created for the sole purpose of the CDO SPV issues rated securities (with various tranches from AAA/Aaa to BB/Ba3 in general) that are all placed to Investors Securities rated by rating agencies (S&P.CDO CWA & investissement\presenations\post asian seminar slides . but in most cases.30/03/2007 17:07:02 Funded Loan Securitisation (cont’d) Named Cash CLO (Collateralised Loan Obligation) True sale to an SPV for the full amount of the CLO The SPV can already exist.

30/03/2007 17:07:02 Partially Funded Synthetic CDO Bank A AAA: 90% Reference potfolio of credit assets Super senior CDS Premium (20bppa) Bank B (20% BIS weighted) Non funded part 2.. Pledge collateral to Bank A: Neutralizes bank A exposure towards SPV Enables bank A to benefit from a 0% BIS weighted treatment 2.CDO CWA & investissement\presenations\post asian seminar slides . Pledge Collateral Portfolio tranching AAA: 3% A: 3% BBB: 3% EQTY : 1% SPV Subordinated CDS Premium Treasuries (0% BIS weighted) CLN : 9% EQTY: 1% Cash Intermediary exposure Funded part First loss exposure 1. Pledge Collateral Collateral (Treasuries) Notes proceeds Cash Market Eqty tranche can be kept by the bank in order to enhance the risk profile of the structure 1. Pledge collateral to investors: Neutralizes investors exposure towards Bank A credit risk Enables Bank A to issue AAA rated notes though itself rated AA (or below) CDO training program 13 .C:\USERS\Stephane DELAINE\STR .

30/03/2007 17:07:02 Partially Funded Synthetic CDO (cont’d) Focus on reg.44MEUR Mezz tranche RWA = 9MEUR * 0% = 0MEUR Reg Cap = 0MEUR * 8% = 0MEUR Eqty tranche Reg Cap = 1MEUR (1:1 ratio) New total RWA = 18MEUR Such synthetic CDO deal : Enables the bank to reduce its RWA from 100MEUR to 18MEUR Leaves Tier 1 component of Reg cap unchanged (pre and post securitization) Enables a huge benefit on the [Core Reg Cap / RWA] ratio that is dramatically increased Eqty tranche nominal deducted from Tier3 component on a 1:1 basis CDO training program 14 . Optimization (Basle I) RWA & Capital before securitization of the pool (H): Pool = fully drawn corp.. credit assets for a total amount of 100MEUR RWA = 100MEUR Reg cap ≥ RWA * 8% = 8MEUR RWA & Capital after securitization of the pool Super senior tranche RWA = 90MEUR * 20% = 18MEUR Reg Cap = 18MEUR * 8% = 1.C:\USERS\Stephane DELAINE\STR . Cap.CDO CWA & investissement\presenations\post asian seminar slides .

30/03/2007 17:07:02 Single tranche Synthetic CDO Bank A AAA: 90% Reference potfolio of credit assets Portfolio tranching AAA: 3% A: 3% A: 3% BBB: 3% EQTY : 1% Subordinated CDS Premium (45bppa) Protection provider Correlation desk Delta hedging Position dynamically managed vs « long & hold » strategy type CDS Market CDO training program 15 .CDO CWA & investissement\presenations\post asian seminar slides ..C:\USERS\Stephane DELAINE\STR .

30/03/2007 17:07:02 Single-tranche Synthetic CDO (cont’d) Only one tranche is created and sold to an investor. …) Structure that can be self managed or externally managed Bilateral instrument (= no distribution) Non publicly rated structure Correlation desks are the natural counterparties Correlation desk traders Delta-hedge their position in the CDS markets Tranche underlying names need to be liquid Pricing & rating of single tranches will now be examined in part 2 CDO training program 16 ..CDO CWA & investissement\presenations\post asian seminar slides . The capital structure is not entirely distributed Single-tranche synthetic CDOs are also called « Bespoke tranches » Indeed.C:\USERS\Stephane DELAINE\STR . term.tranche size. subordination. the investor can customize various caracteristics (= portfolio composition. rating.

C:\USERS\Stephane DELAINE\STR .30/03/2007 17:07:02 Base Case Loss distribution characteristics .CDO CWA & investissement\presenations\post asian seminar slides ..

71%. 0..5% each With the same 3-year bullet tenor for all the names With the same 1.PD for all names (typically they are all Baa3) With the same 30% recovery rate for all names The key parameter discussed is correlation In our base case.30/03/2007 17:07:02 Base Case – CDORom use Let our base case be an homogeneous portfolio with 200 names with a nominal of 100M each Equally weighted.C:\USERS\Stephane DELAINE\STR . we assume a level of correlation at 10% Correlation is supposed to be the same across the portfolio Pool total nominal = 20.CDO CWA & investissement\presenations\post asian seminar slides .000M CDO training program 18 .

00% % of portfolio loss 12.5% 15..00% 14.00% 18.00% 0.Portfolio Loss distribution graph Loss Distribution 20.00% 16.0% 16.0% 13.5% 39.00% 6.0% 37.00% 4.0% 10.5% 30.0% 1.0% Probabilities CDO training program 19 .5% 12.5% 36.5% 6.5% 18.5% 27.0% 31.CDO CWA & investissement\presenations\post asian seminar slides .0% 4.5% 24.5% 3.00% 2.00% 0.30/03/2007 17:07:02 Base Case .5% 9.0% 22.0% 7.0% 19.0% 34.C:\USERS\Stephane DELAINE\STR .0% 25.00% 10.0% 28.00% 8.5% 33.5% 21.

6% 0.76% 0.84% 8.7% 0.89% 9.22% Cum Prob 0.0% 0.00% 99.4% 0.13% 2.0% 0.12% 1.907799833 0.5% 0.93% 9.16% 2.8% 0.17% 2.40% 1.855773167 0.00% 99.01% 99.9% 1.2% 0.90% 9.82% 8.773310167 0.23% 1.329017667 0.23% 0.328024 0.96% 10.7% 0.7% 0.96% 10.9% 0.00% 99.86% 8.00% 99.4% 0.07% 2.00% 99.1% 0.839991667 0.97% 11.610565333 0.0% 0.1% 0.14% 1.3% 0.86% 9.31% 1.3% 0.0% 0.00% 99.4% 0.77% 8.05% 0.6% 0.487974667 0.02% 99.5% 0.5% 0.00% 99.88% 9.8% 0.7128165 0.5% 0.82% 8.617369167 0.01% 99.28% 2.1% 12.0% 0.94% 1.837185167 0.01% 99.93% 9.06% 0.148552667 0.00% 99.787376333 0.49% 2.713940667 0.10% 0.66% 0.6% 0.3% 0.10% 2.94% 10.91% 9.86% 8.01% 99.00% 99.3% 0.12% 1.909956167 [8%-11%] Tranche Loss Rate Probabilities Cum Prob 8.95% 10.6% 0.331104167 0.96% 10.15% 1.02% 99.485512167 0.C:\USERS\Stephane DELAINE\STR .614605167 0.0% 0.11% 1.00% 99.0% 14.7% 0.96% 10.21% 0.6% 0.01% 99.0% 0.489143333 0.149101167 0.8% 0.2% 0.01% 99.93% 10.44% 0.1% 0.97% ∑ Prob = 1 CDO training program 20 .1% 0.01% 99.4% 0.8% 15.786371333 0.00% 99.33% 2.01% 99.87903 0.616134833 0.147986833 0.9% 0.147581667 0.5% 9.00% 99.881380667 0.91% 9.30/03/2007 17:07:02 Base Case – Zoom on [0%-3%] and [8%-11%] tranches [0%-3%] Tranche Loss Rate Probabilities 0.09% 2.9% 0.81% 8.78% 8.9% 2.3% 0.95% 10.2% 4.4% 17.04% 0.3% 0.94% 10.91% 9.95% 10.00% 99.8% 5.98% 2.00% 99.709715833 0.00% 99.89% 9..7% 0.784625667 0.1% 0.00% 99.325696 0.5% 1.6% 2.8% 0.CDO CWA & investissement\presenations\post asian seminar slides .9% 0.03% 99.880650667 0.01% 99.00% 99.2% 0.7% 0.01% 99.4% 0.25% 1.77% 8.2% 0.840908167 0.64% 3.2% 0.00% 99.

202 99. Cap.00% 574 95. inferred from Distribution Capital Economique Cum.00% 265 90. Loss 50.00% 1.000M) An 1. Prob.8% equals 12% of the pool nominal (= 2.98% 2.CDO CWA & investissement\presenations\post asian seminar slides .359 EL 256 Expected Loss equals 256 million which represents 1..C:\USERS\Stephane DELAINE\STR .00% 781 99.30/03/2007 17:07:02 Base Case .861 99.29M / 20. which is consistent with a Baa3 pool Ec Cap 99.000M) Ec Cap = 9 times EL The capital buffer amount is very important CDO training program 21 .El & Ec.28% EL over a 3-year period roughly corresponds to a 42 bppa spread. Cum.359M / 20.28% of the pool nominal (= 256. Port.90% 1.

.30/03/2007 17:07:02 Main drivers of Cum Loss Distribution .CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR .

. the more important the cumulative losses Other parameters of lesser impact Diversification (# of names) LGD Default Prob Tenor EL Increase Increase Impacts on Cum Loss Distribution Ec Cap Fat Tail Increase Increase Increase Increase Rating Deteriorate Deteriorate Increase on Senior tranche Decrease on Eqty tranche Neutral on Mezz.CDO CWA & investissement\presenations\post asian seminar slides . Tranche Correlation Neutral Increase Increase CDO training program 23 .30/03/2007 17:07:02 Portfolio Loss distribution What are the main drivers of the loss distribution? Key 1 factor = Default rate of each entity The higher the PD rate of the portfolio.C:\USERS\Stephane DELAINE\STR . Tranche Spread Increase Increase Increase on Senior tranche Decrease on Eqty tranche Neutral on Mezz. the more fat tailed the cumloss distribution Key 3 factor = Tenor The higher the CDO maturity. the more important the cumulative losses Impact level on the cumloss curve Key 2 factor = Correlation The higher the correlation.

C:\USERS\Stephane DELAINE\STR ..CDO CWA & investissement\presenations\post asian seminar slides .30/03/2007 17:07:02 Tenor impact on portfolio loss distribution .

282 Ec.98% 7000 Tenor (in year) 1 3 6 9 x2. the bigger the EL and the Ec.035 6000 5000 Million 4000 3000 2000 1000 0 0 5 10 15 Tenor (year) EL EC99.762 6. Cap.98 The longer the tenor.2 12 EL (MEUR) 63 256 554 845 x1.30/03/2007 17:07:02 Tenor impact on EL & Ec Capital Expected Loss & Capital @ 99. 99.738 4.2 1.98 (en MEUR) 991 2. Cap.. the lower its rating CDO training program 25 .CDO CWA & investissement\presenations\post asian seminar slides .359 3. the longer the tranche maturity. In other words.C:\USERS\Stephane DELAINE\STR .

CDO CWA & investissement\presenations\post asian seminar slides .30/03/2007 17:07:02 DP Impact on portfolio loss distribution ..C:\USERS\Stephane DELAINE\STR .

In other words..1% loss rate curve . Cap.CDO CWA & investissement\presenations\post asian seminar slides . you have higher probabilities to have big losses with low rated pool.1.30/03/2007 17:07:02 Loss Rate (Default Probability) impact on EL & EC. Cap. Probability .5% Portfolio losses in % of pool nominal The higher the DP. the bigger the EL and the Ec.5% loss Rate curve 1% 1.C:\USERS\Stephane DELAINE\STR . CDO training program 27 .

C:\USERS\Stephane DELAINE\STR ..CDO CWA & investissement\presenations\post asian seminar slides .30/03/2007 17:07:02 Correlation impact on portfolio loss distribution .

1. probability of default (p) each. the sum of the probabilities for k= 0.C:\USERS\Stephane DELAINE\STR .30/03/2007 17:07:02 In theory two correlation extreme cases No correlation No link between the various default Binomial case 25% Probability of each situation 20% 15% Binomial 10% 5% 0% 0 8 16 24 32 40 48 56 64 72 80 88 Number of defaults amongst 100 96 Binomial calculation Sample with (n) elements.n ] BINOMDIST(3.CDO CWA & investissement\presenations\post asian seminar slides ..k) * p^k * (1-p) ^(n-k) With X being the number of defaults. Proba of having (k) defaults is P(X=k) = C(n. and K Є [0. FALSE) And of course. 1. 2 etc is 100% Maximum correlation Bimodal distribution Either no loan default or all the loans of the pool default Probability of each situation 70% 60% 50% 40% 30% 20% 10% 0% 0 8 16 100% Correlation case Full Correl 24 32 40 48 56 64 72 80 88 Number of defaults amongst 100 96 CDO training program 29 . 200.71%.

. the more fat tailed the distribution looks like.00% 0.00% 10.00% 5.CDO CWA & investissement\presenations\post asian seminar slides .00% 25.00% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 Correl = 10% Correl = 20% Correl = 30% The intermediate cases with correl 10% or correl 20% etc are a kind of blend between correl = 0% and correl 100% The higher the correlation.C:\USERS\Stephane DELAINE\STR .00% 15.00% Probabilities 30. The higher the correlation.00% 20.00% 35.30/03/2007 17:07:02 In real life Intermediate cases 40. the more important the impact of the 100% correlation bimodal distribution ( situations) Greater probability to have no loss at all the curve moves to the left the curve moves to the right Higher probabilities for extreme Greater probability to have all the underlyings defaulting at the same time CDO training program 30 .

CDO CWA & investissement\presenations\post asian seminar slides .78% CumProb = 8.30/03/2007 17:07:02 Correlation @ 10% vs Correlation @ 20% CumProb = 88.C:\USERS\Stephane DELAINE\STR .8% 3% Same mean 6% Portfolio losses in % of pool nominal The pricing of the tranche is proportional to the sub area Below the curve CDO training program 31 .05% Probability -10% correlation -20% correlation 2.59% CumProb = 8.29% CumProb = 90.12% CumProb = 1.19% CumProb = 3..

30/03/2007 17:07:02 Correlation @ 10% vs Correlation @ 20% (Cont’d) The two distributions have the same mean ( = 2.C:\USERS\Stephane DELAINE\STR . the higher the spread Correlation increases Senior tranche price Correlation decreases Eqty tranche price Correlation has a relatively neutral impact on Mezz tranche Note: such statement is no longer true for very high correlation levels (impact of the 100% correlation bimodal distribution) CDO training program 32 .8%) Correlation impacts the standard deviation of the cumloss distribution Correlation increases the sub area of senior tranches ( Loss distribution attracted to the right) For the correlation @10%..12% probability that cumulative losses over 3 year will fall in the [6% .CDO CWA & investissement\presenations\post asian seminar slides . there is a 3.100%] interval of pool size For the correlation @20%.100%] interval of pool size Naturally those expected losses will drive the tranche pricings The larger the area of the tranche below the curve.05% probability that cumulative losses over 3 year will fall in the [6% . there is a 1.

C:\USERS\Stephane DELAINE\STR ..CDO CWA & investissement\presenations\post asian seminar slides .30/03/2007 17:07:02 Pricing in theory: only one correlation .

78% (see p.25 Global Pool [0% .100%] 36.30/03/2007 17:07:02 Conversion of CumLoss into bppa of pool nominal (Approximate calculations*) Mezz Senior Eqty [0% .78%) CDO training program 34 .28 3. the corresponding tranche pricing is 36.32 3.31bppa of pool nominal (= 40bpba * 90.6%] [6% .4).100%] 40 Correlation @ 10% Correlation @ 20% x3 40 * Duration concept not taken into account Most sensitive tranche in terms of correlation In the base case.31 35. we assume an average CDS spread for the pool @40 bppa of pool nominal For a 10% correlation The [0%-3%] loss tranche having a cumulative probability of 90..3%] [3% .C:\USERS\Stephane DELAINE\STR .41 1.43 0.CDO CWA & investissement\presenations\post asian seminar slides .

19% * 40 bppa) 109bppa of tranche nominal (=3.210 1.44bppa of tranche nominal (=0.28bppa /3%) * Duration concept not taken into account Return carried by the Eqty tranche = 12% of the pool nominal Senior tranche 0.C:\USERS\Stephane DELAINE\STR .CDO CWA & investissement\presenations\post asian seminar slides .44 1.28bppa of pool nominal (= 8.33 For 10% correlation.30/03/2007 17:07:02 Translation into tranche pricings (Approximate calculations*) Eqty Mezz Senior [0% .42bppa /94%) Key point : pricing of upper tranches are quiete close to 0 bppa CDO training program 35 .6%] [6% .. the corresponding tranche pricing is 1210 bppa of tranche nominal (= 36.05% * 40 bppa) 0.100%] 1. equity tranche The [0%-3%] cumloss tranche size being 3% of pool nominal.31bppa / 3%) Correlation @ 10% Correlation @ 20% Same type of calculations apply to mezzanine and senior tranches Mezzanine 3.42bppa of pool nominal (= 1.177 109 115 0.3%] [3% .

.CDO CWA & investissement\presenations\post asian seminar slides .30/03/2007 17:07:02 Pricing in real life: not only one correlation! .C:\USERS\Stephane DELAINE\STR .

.12%] [12% .30/03/2007 17:07:02 Compound correlation model limits Theory single correlation model Real life various correlation levels Step 1 : tranche pricing calculated from a unique correl Correl Pricing bppa Tranche [0% .9%] [9% .6%] [6% .3%] [3% .6 0.C:\USERS\Stephane DELAINE\STR .CDO CWA & investissement\presenations\post asian seminar slides .02 Step 2: Correls calculated by the market Market Spread Correl Deducted 1 046 86 33 12 6 20% 6% 30% 40% 50% Pricing not so close to 0 Step 1: Determination of the spread of each tranch of a portfolio using the historical unique correlation @ 6% (used by rating agencies) via the « Normal Copula Model » Step 2: Calculation of correlations using market spread Market spread are not deducted from one level of correlation but various levels of correlation according to tranche attachment and detachment points CDO training program 37 .22%] 6% 6% 6% 6% 6% 1 610 140 10 0.

the higher the level of correlation induced by the market CDO training program 38 .and hence higher correlation levels Such a market practice explains the correlation smile (same as for the options markets) The more senior the tranche.30/03/2007 17:07:02 Real market pricings are not so close to zero! Determining tranche pricings through a CumLoss approach with a unique correlation figure is indeed possible around the equity zone But when applying the same approach to upper mezz and senior tranches.CDO CWA & investissement\presenations\post asian seminar slides .1 bppa? The law of supply and demand leads to higher market spreads. you find spread levels extremely low (near to zero bp) Whereas the market quotes hardly fall below 1 or more bppa Who would sell protection at 0.C:\USERS\Stephane DELAINE\STR ..

8% 24. only one correlation will apply to the whole portfolio … market quotations cannot be derived from a model with only 1 correlation Correlation varies according to the tranch seniority Market needs to ensure liquidity for upper tranches The smile reflects the fact that market does not believe in a single correlation model Europe [0% .30/03/2007 17:07:02 Correlation Smile: Theory vs market prices Though only one correlation figure should prevail for the entire portfolio & tranche pattern… Indeed.C:\USERS\Stephane DELAINE\STR .3% 18..CDO CWA & investissement\presenations\post asian seminar slides .9%] [9% .12%] [12% .9% 7.8% 30.5/17.9% Smile de corrélation CDO training program 39 . when a default occurs.3%] [3% .25/33.4% 20.22%] [3% .5 Mid-market implied correlation 19.100%] Bid/Ask 28.6%] [6% .25 + 500 235/275 95/115 50/65 18/26 13.

Spread [0% .6%] tranche spread known from mkt Given that [3% .6%] BaseCorrrel (6%) then calculated f-1(Spread [0% .30/03/2007 17:07:02 Bootstrapping method Base correlation related to x% is the correlation of the [0. Bootstrapping is a calculation method that derives the BaseCorrel of a senior tranche from a more junior tranche CDO training program 40 .C:\USERS\Stephane DELAINE\STR .6%]) 6%.3%]) = compound Correlation [3% .6%] = Spread [0% .CDO CWA & investissement\presenations\post asian seminar slides .9% tranche spread known from mkt BaseCorrrel (9%) then calculated etc. x%] equity tranche on a standardised portfolio Recursive calculation of the base correlation curve [0%-3%] tranche spread known from mkt BaseCorrrel (3%) then calculated f-1(Spread [0% ..6%] tranche pricing depends on BaseCorrel (3%) and BaseCorrel (6%).3%] + Spread [3% .

. the skew is the slope of the BaseCorrel curve with a proportionality factor in the definition) A steepening of the skew conveys a spread increase of the upper tranches Smile Effect The skew level is ruled by the law of supply and demand Smile effect CDO training program 41 .CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR .30/03/2007 17:07:02 Base Correlation curve after bootstrapping calc Skew measures the steepness of the BaseCorrel curve In other words.

26%] 231bppa Base Correlation Skew 90% 80% 70% Correlation 60% 50% 40% 30% 20% 10% 0% … whereas skew changes Mezz tranche spread level 0% 5% 10% 15% 20% 25% Detachem ent Level Initial Correlation Skew Mouvement CDO training program 42 .C:\USERS\Stephane DELAINE\STR .25%] 248bppa [16% .30/03/2007 17:07:02 Mezzanine tranche pricing is sensitive to skew Base Correlation Skew 90% Parallel shift in the correlation Correlation 80% 70% 60% 50% 40% 30% 20% 10% 0% 0% 5% 10% 15% 20% 25% level does not impact Mezz tranche spread level… (H): Portfolio spread = 54bppa [15% .26%] 211bppa Detachem ent Level Initial Correlation Parallel Shift [16% .25%] 228bppa [15% .CDO CWA & investissement\presenations\post asian seminar slides ..

the higher the correlation at detachment point.30/03/2007 17:07:02 Mezzanine tranche pricing is sensitive to skew (Cont’d) Impact of changing correlation @ attachment point All things being equal. the bigger the tranche spread The slope of the base correlation curve decreases Impact of changing correlation @ detachment point All things being equal ..C:\USERS\Stephane DELAINE\STR . the higher the correlation at attachment point. tranche CDO training program 43 .CDO CWA & investissement\presenations\post asian seminar slides . the lesser the tranche spread The slope of the base correlation curve increases It’s the slope of the base correlation curve that affects tranche pricing Note: A parallel shift of the base correlation curve only impacts the spread levels of Eqty and Senior tranches Neutral impact on Mezz.

.CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR .30/03/2007 17:07:02 Mark-to-Market .

000.919 % of Invested Notional -1.87% 3.720.000.000 -1.71 CDO Tranche (Unfunded transaction) Amount Tranche Value Market Spread Bp Value -35.02% 0.615.6%] Nominal Tranche 3 billion Nominal pool 100 billion CDO Tranche (Unfunded transaction) Amount Tranche Value Market Spread Bp Value 641.CDO CWA & investissement\presenations\post asian seminar slides .56% 4.17% 0.263.30/03/2007 17:07:02 Base case Closing Pool @ 25 bppa Tenor 5 year 14 days Correlation_Attach 15% Correlation_Detach 23.837.6%] Nominal Tranche 3 billion Nominal pool 100 billion After 1 year Pool @ 40 bppa Tenor 4 year 14 days Corelation _Attach 12% Correlation_Detach 22% Tranche [3% .26% CDS Portfolio Amount Number of Names Outstanding Portfolio Notional Portfolio Expected Loss % of Outstanding Portfolio 125 100.753 % of Invested Notional 0.62% -1.83 CDS Portfolio Amount Number of Names Outstanding Portfolio Notional Portfolio Expected Loss % of Outstanding Portfolio 125 100.000 -1.000.376 CDO training program 45 .256 -1.000.C:\USERS\Stephane DELAINE\STR .225..8% Tranche [3% .

.7% * [0.68bppa This cost related to the global cost of carry of the pool = 1.7 billion MtM (for the investor) = .7 year] * 100 billion Tranche converted into pool Duration Variation in Underlying’s spread Pool nominal MtM (for the investor) = .37 million Calculation looks like the MtM of a Bond CDO training program 46 .25%] * [3.CDO CWA & investissement\presenations\post asian seminar slides . my tranche represents 6.7%. the higher its relative cost of carry. It means that the tranche behaves like 6.68bppa / 25 bppa = 6.7% of the portfolio global cost of carry Cost of carry of the tranche related to pool nominal = 56 bppa * 3% = 1. the delta of the tranche is 6.7% It can be noted that the lower the tranche seniority.6. and thus the more important its Delta In other words.C:\USERS\Stephane DELAINE\STR .7% * 100 billion = 6.7% of the portfolio in terms of MtM Delta-hedging (by a correlation desk) will thus be done on a nominal of 6.30/03/2007 17:07:02 Explanation of MtM in order of magnitude At Closing.40% .0. Portfolio spread = 25 bppa ( Tranche spread = 56 bppa ( CDS cost of the whole pool) CDS cost for the tranche) Thus.

CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR ..30/03/2007 17:07:02 Greeks or portfolio sensitivity to risk factor shifts .

.30/03/2007 17:07:02 Greeks or portfolio sensitivity to risk factor shifts Delta .CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR .

9%]: 30MEUR [3% -.C:\USERS\Stephane DELAINE\STR .7 * 30MEUR = 171MEUR or 17.3%]: 30MEUR Subordinated CDS Premium Protection provider Correlation desk Delta hedging (H): Delta = 5.30/03/2007 17:07:02 Delta: Volumetry Bank A Reference potfolio of credit Assets 1 GEUR Portfolio tranching [9% .1% of the pool nominal CDO training program 49 .CDO CWA & investissement\presenations\post asian seminar slides .6%] :: 30MEUR [3% 6%] 30MEUR [0% .100%] 910MEUR [6% .7 * tranche notional CDS Market In this example. the correlation desk must realise its delta hedge on a nominal equal to almost 6 times the tranche notional 5..

C:\USERS\Stephane DELAINE\STR . Delta main features Tranche delta range from 0% to 100% of pool nominal Tranche delta are usually quoted in terms of notional amount needed to hedge the tranche against spread movements of the particular underlyings. Delta = (Tranche spread var.) * Tranche notional Tranche Delta depends on: Attachment point (= subordination) Tranche thickness Pool spread Time to maturity Default correlation CDO training program 50 .. / CDS on the specific underlying spread var.30/03/2007 17:07:02 Delta: generals Tranche Delta is used: By investors (correl desk) to hedge their exposure to movements in the CDS spread of the underlying credits Delta = definition of the CDS underlying nominal that needs to be sold / bought to hedge a short/long synthetic CDO tranche position By CDO sponsors to manage the transactions Delta = indication of the cost of substituting underlying credits.CDO CWA & investissement\presenations\post asian seminar slides .

C:\USERS\Stephane DELAINE\STR .00% Tranche size Tranche [0% .00% 10.46 15% / 23. spread @ 25 bppa 648.12% ] Tr anche Delta in % of pool The more junior the tranche.00% 0.33 23.58% 60.30/03/2007 17:07:02 Delta: Tranche attachment point impact 70. the higher its delta Tranches that are lower in the capital structure are more risky as there is less protection against default risk CDO training program 51 .18 Tranche spread with portf.00% 7..7% 3.80 15% / 15% 62.33 6.54% 17.19% 55.00% 20.3%] 3% [3% -6%] 3% [6% .00% [0% .00% 50.8% 12.8% / 30.CDO CWA & investissement\presenations\post asian seminar slides .3%] [3% -6% ] [6% .00% 30.28 16.7% / 36.07 51.9% ] [9% .04 30.00% Delta 40.9%] 3% 3% [9% . spread Delta in % Base Correl @ 26 bppa of pool AP / DP 668.12%] Tranche spread with portf.9% 2.

4% 4.. spread with portf. spread Delta in % @ 26 bppa of pool @ 25 bppa size 51.1% 6.00% 15% / 28.8%] [3% .9%] Tranche spread Tranche spread Tranche with portf.6% ] [3% .8 36.55% 33. a wider tranche is exposed to a larger band of losses.46 3% 12.00% 0.00% 15% / 26.8% 8.00% AP / DP 10.8%] [3% .7% 2.60% 18.00% 14.00% Delta [3% .4 6% 15.00% 15% / 23.7%] [3% .6%] [3% .00% 16.92% 38.C:\USERS\Stephane DELAINE\STR .28 55.00% Base Correl 12.73 5% 15.00% 15% / 30.54% 43.CDO CWA & investissement\presenations\post asian seminar slides .9% ] Tr anche Delta in % of pool The larger the tranche.30/03/2007 17:07:02 Delta: Tranche detachment impact Tranche [3% .62 41.98 47.46 4% 13.7%] [3% . and is therefore more risky Note that the increase in tranche delta flattens out once the limit of possible losses is reached CDO training program 52 . the higher delta For a fixed level of subordination (here = 3%).

the delta of the Eqty tranche converges to 100% of the pool nominal. The riskier the pool..CDO CWA & investissement\presenations\post asian seminar slides .30/03/2007 17:07:02 Delta: other factors impacts Pool spread: Tranche deltas are linked to the risk profile of the pool. the delta of the Eqty tranche decreases and the delta of the senior tranche increases CDO training program 53 . the greater the delta of the Eqty tranche the lower the delta of the senior tranche Time to maturity: As the time to maturity tends to 0. and the deltas of all other tranches converge to 0% : Default correlation As correlation level increases.the risk is shifted to the senior tranche (= higher probability of joint default). defaults becomes less likely to occur.C:\USERS\Stephane DELAINE\STR .

30/03/2007 17:07:02 Greeks or portfolio sensitivity to risk factor shifts Time to maturity ..C:\USERS\Stephane DELAINE\STR .CDO CWA & investissement\presenations\post asian seminar slides .

C:\USERS\Stephane DELAINE\STR . let’s simplify the MtM formula by ignoring the Delta impact (negligible since moving into a relatively narrow corridor) MtM (for the investor) = ..50% 0 1 2 3 4 5 Source: SG CDO Pricer tool -0.6%] mezzanine tranche Tranche spread decreases)… … up until a certain point of time when MtM increases again until reaching 0 at maturity (« time decay » impact on tranche MtM superior to « spread reduction » impact) CDO training program 55 .70% -0.80% All parameters being equal… We look at the [3% .02% MtM Point of time Issuance + 1Year + 2Years + 3Years + 4 Years + 5 Years (Residual maturity = 14 days) GCPM MtM in % of tranche nominal -0.30/03/2007 17:07:02 Variation of MtM with the time to maturity -0.6%] tranche We make strong assumptions: Portfolio spread (= 25bppa) remains unchanged all along the life of the CDO Correlation curve remains unchanged (Attachment point = 15% / Detachment point = 23.37% -0.02% -0.20% -0.CDO CWA & investissement\presenations\post asian seminar slides .54% Ye ar s 0.70% -0.70% -0.30% -0. the MtM deteriorates (there is less time for defaults to hit the [3% .10% -0.40% -0.[Tranche spread variation * Duration * tranche nominal] Tranche less risky As time to maturity decreases.60% -0.8%) To explain the curve shape.00% -0.

30/03/2007 17:07:02 Greeks or portfolio sensitivity to risk factor shifts Spread parallel move test ..C:\USERS\Stephane DELAINE\STR .CDO CWA & investissement\presenations\post asian seminar slides .

68 2.97 [3% .000 3.500 1.500 4.84 3.3%] tranche and the [3% .500 2.CDO CWA & investissement\presenations\post asian seminar slides .727 x2 2.58 4..4/1 is the leverage of that tranche Eqty tranche is the most sensitive to portfolio (and single-name) wide spread moves Note that « tranche spread vs pool spread » curve is sligthly convex Tranche spread (bppa) CDO training program 57 .6%] We move the portfolio spread from 25bppa to 50 bppa [0% .000 2.3%] Portfolio spread (bppa) 25 50 x2 75 100 125 Portfolio spread (bppa) 25 50 x2 75 100 125 Tranche spread (bppa) 872 1.000 500 0 25 45 65 85 105 125 145 Portfolio spread (bppa) [0% .6%] 4.2/1 is the leverage of that tranche The ratio 6.556 3.18 2.30/03/2007 17:07:02 Spread parallel move test [0%.6%] tranche Maturity = 5 years We make strong assumptions: Correlation curve remains unchanged: 15% /15% for the tranche [0%-3%] and 15% / 23.179 Tranche spread (bppa) 56 216 x4 436 686 942 Duration (year) 3.8% for the tranche [3% .C:\USERS\Stephane DELAINE\STR .3 2 Duration (year) 4.6%] spread (bppa) All parameters being equal… We look at the [0% .18 3.6%] tranche spread moves from 56 bppa (core) to 216 bppa The ratio 34.3%] tranche spread moves from 872 bppa (core) to 1727 bppa [3% .500 3.3%] spread (bppa) [3% .71 4.4 4.000 1.372 4.

CDO CWA & investissement\presenations\post asian seminar slides .C:\USERS\Stephane DELAINE\STR ..30/03/2007 17:07:02 Greeks or portfolio sensitivity to risk factor shifts Duration .

5 3 2.68 2.6%] tranche Maturity = 5 years We make strong assumptions: Correlation curve remains unchanged: 15% /15% for the tranche [0%-3%] and 15% / 23.727 2.3 2 Duration (year) 4.18 2.4 4..58 4.5 4 3.71 4.372 4.6%] All parameters being equal… We look at the [0% .30/03/2007 17:07:02 Duration [0%.6%] Duration can be defined as a kind of discounted average life time The riskier (= more junior) the tranche The higher the portfolio spread the higher the number of default the smaller the duration the higher the number of default the smaller the duration Note that American priced tranche will always have a smaller duration than European priced tranche CDO training program 59 .3%] tranche and the [3% .C:\USERS\Stephane DELAINE\STR .3%] Duration (years) Portfolio spread (bppa) 25 50 75 100 125 Portfolio spread (bppa) 25 50 75 100 125 Tranche spread (bppa) 872 1.556 3.5 0 50 100 150 Portfolio spread (bppa) [0% .18 3.179 Tranche spread (bppa) 56 216 436 686 942 Duration (year) 3.84 3.CDO CWA & investissement\presenations\post asian seminar slides .97 5 4.8% for the tranche [3% .6%] Duration [3% .3%] Duration [3% .5 2 1.

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