Credit Derivatives Product Management

J.P. Morgan Securities Inc.

New York
2Q02
Andrew Palmer (212) 834-7083

Credit Derivatives Product Management www.morgancredit.com

Credit Derivatives: A Primer

PRODUCT REPORT
Contents
The Case for Credit Derivatives
................................................... 2
Basic Credit Derivative
Structures ................................ 7
Common Pricing Factors ........ 9
ISDA and Credit Derivative
Contracts ............................... 10
Conclusion .............................11
IFR Credit Derivatives
House of the Year
This article introduces the basic structures for and applications of credit derivatives that
have emerged in recent years. The applications discussed provide strategies for risk
managers addressing portfolio concentration risk, for issuers seeking to minimize the costs
of liquidity in the debt capital markets, and for investors pursuing assets that offer
attractive relative value. Credit derivatives create enormous opportunities to profit from
discrepancies in the pricing of credit risk across distinct markets through the ability to
bypass barriers between different asset classes, maturities, rating categories, and
currencies.
Highlights
• A Credit Derivative is a bilateral financial contract that isolates the credit risk of a
reference credit and transfers that risk between two parties.
• JPMorgan estimates that the credit derivative market grew to $2 trillion by year-end
2001, more than doubling in size over year-end 2000 and increasing tenfold over the
last four years.
• Credit Default Swaps represent 95% of all credit derivatives.
• Credit derivatives do not create a new form of risk but provide a new way to transfer
existing credit risk.
• Credit Derivatives act as a conduit for information across markets for distinct asset
classes.
• Credit derivatives provide a liquid market for short sales of credit instruments
without the risk of a short squeeze.
• The credit derivative market provides liquidity when clients need it the most.

• A Credit Default Swap (the most common credit derivative) is a bilateral financial
Risk Credit Derivatives contract by which the protection Buyer pays a periodic fee in return for a contingent
House of the Year
payment by the protection Seller, if a credit event occurs with respect to the designated
Reference Entity.
• A Credit Linked Note is a security with principal and/or coupon payments linked to the
occurrence of a credit event with respect to a specific reference entity.
• Like most derivatives, credit derivatives have evolved a variety of structural variations,
Best Online Derivatives which can be executed in either an unfunded or a funded form.
Research and Analysis
• Investors extract Relative Value through a two-step decision process:
1. Do I like the credit?
2. How do I obtain the best value for taking credit risk?
• To determine relative value, we must isolate the credit portion of the cash instrument
and compare it to the credit derivative spread.
• Credit Default Swaps add depth to the secondary market for credit risk beyond
the secondary market for the underlying credit instruments.
• Credit derivatives free investors from maturity and availability constraints of the cash
market.
Please visit our website for live 2-way credit
default swap quotes:
http://www.morgancredit.com

Distribution of this report is restricted in certain countries. Important information concerning these and other restrictions is set forth at the end of this
report.
 New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 2

THE CASE What are credit derivatives?

FOR CREDIT
DERIVATIVES A Credit Derivative is a bilateral financial contract that isolates the credit risk of a reference credit and
transfers that risk from one party to another. In doing so, credit derivatives separate the ownership and
management of credit risk from other qualitative and quantitative aspects of ownership of financial
THE CASE assets. Thus, credit derivatives share a key feature of other successful derivative products, which is the
potential to achieve efficiency gains through a process of market completion. Credit derivatives can
achieve market completion by allowing credit risk to be transferred to the most efficient holder of that
risk, even if the underlying asset could not be transferred to that holder.

Until the advent of an efficient credit derivative market, credit remained a major component of business
risk for which no tailored risk-management products existed. To manage credit risk, loan portfolio
managers were limited to a strategy of portfolio diversification backed by line limits, with an occasional
sale of positions in the secondary market. Derivative users were limited to purchasing insurance, letters
of credit, guarantees, or negotiating collateral provisions to Master Agreements. Corporations either
carried open exposures to key customers’ accounts receivable or purchased insurance, where available.
Investors were constrained in their activities by the availability of publicly traded assets in
predetermined maturities and volumes. These strategies are inefficient because they do not separate
credit risk from the asset associated with that risk.

Consider a corporate bond which represents a bundle of risks including duration, convexity, callability,
and credit risk (constituting both the risk of default and the risk of volatility in credit spreads). If the
only way to adjust credit risk is to buy or sell that bond, which would consequently affect positioning
across the entire bundle of risks, there is a clear inefficiency. Fixed income derivatives introduced the
ability to manage duration, convexity, and callability independently of bond positions. Credit
derivatives complete the process by providing the ability to independentlymanage default and credit
spread risk.

When comparing investing in Credit Default Swaps versus investing in bonds, the protection Seller is
analogous to the buyer of bonds, because both are accumulating credit risk. Accordingly, the protection
Buyer is analogous to the seller of bonds because both are shorting credit risk.

The importance of credit derivatives

Until recently, the credit derivative market was perceived as a tool used by banks to achieve regulatory
capital relief. Banks have expanded their use of credit derivatives to include economic risk reduction as
well. Furthermore, since 1997, the credit derivative market has seen dramatic increases in usage by
other active participants (re-insurance and insurance companies, asset managers, mutual funds, hedge
funds, corporations, and CDOs) creating substantial growth and liquidity in the marketplace. Let’s
explore two applications used by recent entrants to the credit derivative market to extract value:

Application: Credit Default Swaps create liquidity

Credit Default Swaps add depth to the secondary market for credit risk beyond that of the secondary
market of the underlying credit instruments which, may not be liquid for a variety of reasons. Loan
sales or the assignment or unwinding of other derivative contracts typically require the notification
and/or consent of the customer. Credit derivatives allow users to reduce credit exposure in a
confidential transaction, where the reference entity need neither be party to the transaction nor even
aware of it. The transaction occurs without physically transferring the assets.
New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 3

A structured tax or accounting position can create significant disincentives to sell an otherwise liquid
position. Credit derivatives can hedge the credit exposure without triggering a sale for either tax or
accounting purposes.

In many cases, Credit Default Swaps can create exposure comparable to the underlying credit
instrument or likewise can hedge exposure contained in an asset that an individual cannot or does not
want to sell. For example, companies often face business concentration risk to key customers through
accounts receivable. An insurance contract may provide compensation for provable losses. However,
Credit Default Swaps do not require an actual loss to be incurred and they can be traded in the
secondary market, providing an effective hedge for credit deterioration as well as default.

Application: Exploiting a funding advantage or avoiding a disadvantage

The return for assuming credit risk of an asset is the net spread earned after deducting the investor’s
cost of funding the asset. For example, it makes little sense for an A-rated bank funding at LIBOR flat
to lend money to a AAA-rated entity that borrows at LIBID: After funding costs, the A-rated bank takes
a loss but still owns the risk.

In the cash market, entities with a high cost of funds buy higher risk assets to generate spread income.
However, since there is no funding requirement for most credit derivatives, investors can take exposure
to more highly rated, but uncorrelated credits and realize a profit at a lower overall risk. On the other
hand, institutions with low funding costs may capitalize on their funding advantage by purchasing
credit-risky assets while buying protection on the same credit risk. As long as the premium for buying
protection is less than the net spread earned on an asset containing the credit risk (referred to as
negative basis), the investor retains a net positive income stream, but remains credit neutral with respect
to the Reference Entity.

The exponential growth of the credit derivative market has been a watershed development in credit risk
management for both investors and hedgers across a broad spectrum of market participants and asset
classes. Credit derivatives are fundamentally changing the way risk managers price, hedge, transact,
originate, distribute, and account for credit risk. While the above definition of credit derivatives
captures traditional credit instruments (guarantees, letters of credit, and loan participations), newer
credit derivative structures provide greater precision in isolating, managing, and transferring generic
credit risk.

Increased use of Credit Derivatives

JPMorgan estimates that the global credit derivative market grew to $2 trillion by year-end 2001,
more than doubling in size over year-end 2000 and increasing tenfold over the last four years. The
graph below illustrates the increase in use of credit derivatives over time by different sectors of the
credit derivative market, which in turn has driven growth in the overall credit derivative market.
New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 4

Chart 1: Market Growth

Evolution of the Credit Derivative Market

Total Growth

Banks Re-insurers Hedge Funds Real

RealMoney
Money

1994 1998 2002

Several distinct arguments combine to account for the increased use of credit derivatives by all
institutions that routinely carry credit risk as part of their day-to-day business.

1. The credit derivative market provides liquidity to the cash market in times of market stress.
Since the advent of the credit derivative market, and particularly throughout 2001, we have seen that
during times of overall market stress the credit derivative market has been the first source of liquidity.

A good case study of how the credit derivative market reacts during times of general market stress can
be seen by examining trading flows before and after the week of September 11. Based on the average
of the four trading weeks preceding September 11, the weekly trading volume of credit derivatives
almost tripled when financial markets resumed full activity on September 17. During this time period
the credit derivative desk intermediated consistent two-way flows (see chart 2 below). The percentage
of protection bought as compared to protection sold did not change to a large degree.

The credit derivative market is better able to provide liquidity during periods of market stress than the
cash market because of the way the respective trading desks are traditionally positioned. Cash desks
are typically long risk because they hold an inventory of bonds. Credit derivative desks are typically
short risk because they hold an inventory of credit protection. During periods of market stress, clients
can reduce long risk positions by either selling bonds or buying protection. At such times, cash desks
are reluctant to increase their inventory and assume more risk by purchasing bonds from clients. In
contrast, credit derivative desks are happy to go from short to flat by selling their inventory of
protection (the equivalent of going long a cash bond). Credit derivative desks can also source
additional protection from clients who had previously used the product to short credits and now wish to
monetize that position. These characteristics support two-way flows in the credit derivative market and
provide liquidity and accurate credit pricing when other markets are less active.
New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 5

Chart 2: Market Stress

Total notional of credit derivative

volume
270%
100%
56%

Prior 4-week Sept. 10–14 Sept. 17–21

avg.

Prior four-week average September 17–21

Protection
Protection bought
sold Protection
40%
44% bought
Protection
56%
sold
60%

Source: JPMorgan internal data

2. The credit derivative market also provides liquidity to individual credits under stress.
The same factors which allow credit derivatives to add liquidity to a stressed market also allow it to
provide liquidity to individual names – an inventory of protection held by dealers and a desire among
other clients to monetize naked short positions.

An excellent example of how the credit derivative market provides liquidity to deteriorating credits is
the decline of Enron. As disclosure of Enron’s off balance sheet liabilities caused spreads to widen,
Credit Default Swaps in Enron became more active and continued to trade in standard size (USD
5,000,000 to 10,000,000) across the curve. Eventually, S&P downgraded Enron’s debt to junk, which
caused Dynegy to pull out of a planned merger. When the downgrade occurred, liquidity in Enron
bonds was limited to those maturing in August 2009 trading in lots which rarely reached USD
5,000,000. At the same time, dealer desks continued to sell their inventory of protection and helped
clients monetize protection they had previously purchased. In fact, trading continued right up until
Enron filed for bankruptcy protection in early December 2001.

In addition to demonstrating how the credit derivative market adds liquidity, the Enron bankruptcy also
shows how effective credit derivatives function as a product. Enron was the largest and most liquid
entity in the credit derivative market to have a Credit Event. Once the bankruptcy occurred, Credit
Default Swaps were triggered and settled in an orderly and timely fashion without dispute – the product
worked as expected.
New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 6

3. Credit Derivatives act as a conduit for information across markets for distinct asset classes.

Chart 3: Central Location

Loan market

Bond market
Cred. Der.
Ctpy. Risk
JPMorgan CDS
Trading Desk

Equity market Convertible

market

Corporate
Receivables

In sourcing and selling generic credit risk, the credit derivative desk serves as a link between many
different markets. As a result of its central position the credit derivative market will often account for
price movements in the cash market. If a corporation is obtaining a new loan, institutions exposed to
the credit risk of that loan will often seek a hedge against concentrations of risk by using credit
derivatives. As lenders purchase protection on an entity to which they are exposed, spreads in the credit
derivative market will widen. This change will occur before the effects of the new loan have rippled
through to be reflected in bond market spreads. Thus, the credit derivative market will serve as a link
between institutionally separate markets.

4. Credit derivatives isolate credit from other aspects of ownership of credit instruments.
The Reference Entity, whose credit risk is being transferred, need neither be a party to a credit
derivative transaction, nor even aware of it. This confidentiality enables risk managers to isolate and
transfer credit risks discreetly, without interfering with important business relationships. In contrast, a
loan assignment through the secondary loan market requires borrower notification, and a silent
participation requires the participating bank to assume as much credit risk to the selling bank as to the
borrower itself.

Since the Reference Entity has no seat at the negotiating table , the terms (tenor, seniority,
compensation structure) of the credit derivative transaction can be customized to meet the needs of the
buyer and seller of risk, rather than the particular liquidity or term needs of a borrower. The availability
and discipline of accurate market pricing enable institutions to make pricing and relationship decisions
more objectively.

5. Credit derivatives are the most efficient way to short a credit without the risk of a short
squeeze. While it is nearly impossible to achieve long term repo funding for corporate bonds or short-
sell a bank loan, a short position can be synthetically achieved by purchasing credit protection.
Consequently, risk managers can short specific credits or a broad index of credits, either as a hedge of
existing exposures or simply to profit from a negative credit view. The possibility of short sales then
opens up a wealth of arbitrage opportunities. Global credit markets display discrepancies in the pricing
of the credit risk across different asset classes, maturities, rating categories, and currencies. These
discrepancies persist because arbitrageurs have traditionally been unable to purchase cheap obligations
against shorting expensive ones to extract profit. As these opportunities are exploited, credit-pricing
discrepancies will gradually disappear.
 New York J.P. Morgan Credit Derivatives: A Primer
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6. Credit derivatives (except when embedded in structured notes) are off-balance-sheet

instruments offering considerable flexibility in terms of leverage. The appeal of off- as opposed to
on-balance-sheet exposure increases with increasing funding and asset administration costs.. Bank
loans have not traditionally appealed to hedge funds and other non-bank institutional investors because
of the administrative burden of assigning and servicing loans and the absence of a repo market.
Without the ability to source secured financing for bank loans via a repo market, the return on capital
offered by bank loans has been unattractive to institutions that do not enjoy access to unsecured
financing. However, by taking bank loan exposure using a credit derivative, a hedge fund can both
synthetically finance the position and avoid the administrative costs of direct asset ownership. The
degree of leverage will depend on the amount of up-front collateralization, if any, required by the swap
counterparty. Credit derivatives have opened up new ways to distribute the credit risk embedded in
bank loans and other instruments into the institutional capital markets.

BASIC Credit Default Swaps

CREDIT
DERIVATIVE A Credit Default Swap (the most common credit derivative) is a bilateral financial contract by which the
protection Buyer pays a periodic fee in return for a contingent payment by the protection Seller, if a credit
STRUCTURES event occurs with respect to the designated Reference Entity.

Chart 4: Credit Default Swap

Reference Risk
entity

Fee/premium
Protection buyer
Protection seller
Contingent payment on default

Credit Linked Notes

A Credit Linked Note is a security with principal and/or coupon payments linked to the occurrence of
a credit event with respect to a specific reference entity. In effect, a Credit Linked Note embeds a
Credit Default Swap into a funded asset to create a synthetic investment that replicates the credit risk
associated with a bond or loan of the reference entity. Credit Linked Notes are typically issued on an
unsecured basis directly by a financial institution, but may also be issued from a collateralized special
purpose vehicle (typically a trust). Credit Linked Notes provide access to the credit derivative market
for investors who cannot trade derivatives or do not have an ISDA Master Agreement with JPMorgan.

Credit Linked Notes may be issued directly by JPMorgan Chase Bank or through a special purpose
vehicle (SPV) program. CORSAIR is the brand name for JPMorgan's proprietary SPV program for
issuing Credit Linked Notes. In the U.S. each CORSAIR credit linked note is issued by a discrete
bankruptcy remote trust established solely for the purpose of that specific transaction. Other CORSAIR
vehicles exist in various jurisdictions throughout the world to address investor needs as well as tax and
structural considerations. Each CORSAIR vehicle has standardized documentation and minimal
execution costs, creating a platform for efficient and timely CLN issuance.
New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 8

Chart 5: Corsair Credit-linked note Trust program

(1) L+10 (2) 80bps

AAA Asset- JPMC
Trust Credit default
Backs
swap

L+90
(3) Trust setup cost

Certificates

Other Credit Derivatives

Like most derivatives, credit derivatives have already evolved a variety of structural variations which
can be executed in an unfunded or funded form. Examples include:
• “First to Default Basket”: A credit derivative, which transfers credit risk with respect to multiple
reference entities. The protection Seller agrees to make a contingent payment to the Buyer with
respect to the first reference entity in the basket for which a credit event occurs, and does not have
exposure to subsequent credit events.
• “First-Loss Basket”: A credit derivative in which the Seller of protection agrees to make
contingent payments to the Buyer of protection upon the occurrence of a credit event with respect
to one or more reference entities. The contingent payment amount for each credit event equals par
less the liquidation value of an obligation of the impaired reference entity, with the aggregate
amount of contingent payments due by the Seller of protection capped at an agreed portion of the
total reference portfolio. The structure allows the Seller of protection to obtain levered exposure to
a portfolio of credits.
• HYDI-100 (High Yield Debt Index) is designed to provide investors with the ability to trade on a
liquid diversified index that is highly correlated with the JPMorgan Domestic High-Yield Index.
The HYDI-100 consists of a basket of 100 Credit Default Swaps referencing a diversified pool of
high-yield credits. The pool of credits within the contract remains static for the five-year life of
the trade, but a new five-year contract referencing an updated pool of names is offered every six
months. The index offers investors exposure to a hundred different credits in over twenty sectors
in the high yield market.
• “Synthetic Securitization”- A first-loss basket structure that references a portfolio of bonds, loans
or other financial instruments held on a firm’s balance sheet. The technique replicates the credit
risk transfer benefits of a traditional cash securitization while retaining the hedged assets on the
balance sheet of the bank. Advantages over cash securitization include reduced cost, ease of
execution and retention of on-balance sheet funding advantage.
• BISTRO (Broad Index Secured Trust Offering), the synthetic securitization program
developed by JPMorgan, is a structure that transfers tranches of credit exposure to large
diversified portfolios of commercial or consumer loans from the securitizing bank to
investors.
New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 9

COMMON Relative Value analysis of Credit Swaps

PRICING
Determining the Relative Value of a credit derivative is important when an investor must decide
FACTORS whether to use derivatives or cash instruments to go long or short credit risk. From many investors’
perspectives, credit derivatives add value simply by providing access to credit exposure from sources
that would not otherwise be available (i.e. market completion). However, where credit derivatives exist
in parallel with alternative investments offering similar risks, the investor needs to ascertain the relative
value of a credit derivative position in comparison to more traditional assets (like bonds or loans). In
order to make this comparison we need to price the credit risk embedded in the cash instrument. For the
traditional fixed-income investor, it is possible to envision a bond containing three types of risk:
• Credit Risk
• Funding Risk
• Interest Rate Risk

Since a Credit Default Swap isolates credit risk, its theoretical price should be the price of a bond
stripped of interest rate and funding risk. Typically, bonds are offered as fixed-rate investments whose
prices are expressed as a spread over treasuries. These bonds can be asset-swapped into a floating rate
investment with a return expressed as a spread over LIBOR. When purchasing a bond, an investor has
to borrow to fund the asset, therefore the cost of funds must be subtracted from the return on the asset to
find the net return. Since Credit Default Swaps are unfunded investments, the LIBOR portion of this
equation can be removed leaving the theoretical price of the credit risk. This calculation assumes that
the investor funds at LIBOR flat. If credit protection is offered in the marketplace at a level higher than
the theoretical price of credit risk, then more relative value is achieved through selling protection over
buying the bond.

Chart 6: Comparing Bonds with Credit Default Swaps

Bond/loan Asset swap CDS

Credit Credit Credit
Funding Funding
Int. Rate Risk

T + Y bps Libor + X* bps X* bps

*Where X = (T+Y) minus Swap Rate

Consider a five year corporate bond trading at a spread of 120bps over Treasuries. Assuming an asset
swap spread of 80bps, the bond can be swapped to pay a floating rate of LIBOR plus 40bps. An
investor with a cost of funds of Libor flat will have a return of 40bps. Also assume credit protection is
offered at 50bps per annum. Since the Credit Default Swap pays the investor a spread that is 10bps
wider than the asset swapped spread, it can be argued that selling protection (long risk) offers better
value (positive basis) relative to purchasing an asset swapped bond. Of course, if an investor has a
higher cost of funding than LIBOR flat, the economics of selling protection versus buying the bond
become even more compelling.

Positive basis can exist for many reasons. A protection buyer may be willing to pay a higher price for
credit protection than the LIBOR stripped, asset swapped equivalent of a bond, because its risk is
located in a different market (loan, convertible, or receivables) where the cost of holding the same
credit risk is more expensive. Since credit derivatives allow the isolation and transfer of credit risk
 New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 10

across asset classes, credit risk should naturally move to the most efficient (i.e. cheapest) holder of that
risk.

Counterparty considerations
In a Credit Default Swap, the protection Buyer has credit exposure to the protection Seller contingent
on the performance of the Reference Entity. If both the Reference Entity defaults and the Seller defaults
then the Buyer is left exposed, although the final recovery rate on the position will benefit from any
positive recovery rate on obligations of both the Reference Entity and the Seller. Counterparty risk
consequently affects the pricing of credit derivative transactions. Protection bought from higher-rated-
counterparties will command a higher premium. Similarly, protection purchased from a counterparty
whose default probability is highly correlated with that of the Reference Entity will lead to a lower
premium. When trading with JPMorgan, counterparty credit risk for lower rated counterparties is
mitigated through the posting of collateral, rather than through the adjustment of the price for
protection. Therefore, counterparties who have executed with a CSA (Collateral Support Annex) with
JPMorgan will receive substantially better execution.

ISDA International Swaps and Derivatives Association

AND
Increased standardization in credit derivative documentation has been an important factor in the
CREDIT market’s growth and liquidity The International Swap and Derivatives Association (ISDA) has
DERIVATIVE produced a standardized short form letter confirmation for Credit Default Swaps which incorporates the
CONTRACTS 1999 ISDA Credit Derivatives Definitions and various supplements thereto, and which is transacted
under the umbrella of its ISDA Master Agreement. Standardized confirmation and market conventions
mean the parties need only specify the terms of the transaction (see below), which inherently differ
from trade to trade.

Credit Derivative Contracts

When entering into a Credit Default Swap, several key aspects of the contract need to be agreed
between the parties:
• Reference Entity
• Credit Events (usually standard market convention)
• Settlement Method (usually standard market convention)
• The party who is the Buyer and the party who is the Seller
• Scheduled Termination Date (the date on which protection ends)
• Notional of the Trade (Fixed Rate Payer Calculation Amount)
• Price (Fixed Rate) – expressed in basis points per annum

Defining the Reference Entity is perhaps the most important aspect of the credit derivative contract
because it ensures that the counterparties are hedging or taking exposure to the proper risk. If the
operating subsidiary of a holding company files for bankruptcy, but the holding company does not, only
the swaps which reference the bankrupt company will trigger.

A Credit Event is the occurrence of a significant event that triggers the contingent payment on a Credit
Default Swap. The Credit Events are defined in the 1999 ISDA credit derivatives definitions. They
include the following events:
• Bankruptcy
 New York J.P. Morgan Credit Derivatives: A Primer
Andrew Palmer (212) 834-7083 Page 11

• Failure to Pay
• Restructuring

The Settlement Method for a standard Credit Default Swap is Physical Settlement. Upon occurrence
of a Credit Event, the protection Buyer will physically deliver obligations from a predefined set of
Deliverable Obligations in return for a payment of par. Following physical delivery, the protection
Seller is in the same position as if they had purchased the cash instrument prior to default. This means
a protection Seller will face a similar loss experience after a Credit Event regardless of whether they
purchased bonds or sold protection.

Credit Default Swap Maturities usually run up to ten years, with five years being the most liquid
maturity.

The average Notional of the typical trade is about $5 to $25 million for investment grade reference
entities, $2 to $5 million for high yield credits and $5 to $20 million for emerging market credits.
However, substantially larger transactions can be and have been executed with relative ease. Credit
Default Swaps, and indeed all credit derivatives, are almost exclusively inter-professional (meaning
non-retail) transactions. While publicly rated credits enjoy greater liquidity, ratings are not necessarily a
requirement. The only true limitation to the parameters of a Credit Default Swap is the willingness of
the counterparties to act on a credit view.

CONCLUSION The use of credit derivatives has grown exponentially since the beginning of the decade. Transaction
volumes have picked up from the occasional tens of millions of dollars to regular weekly volumes
measured in hundreds of millions of dollars. While it is true that banks have been the foremost users of
credit derivatives to date, it would be wrong to suggest that banks will be the only institutions to benefit
from them. The end-user base is broadening rapidly to include a wide range of broker-dealers,
institutional investors, money managers, hedge funds, insurers, reinsurers, and corporates. Growth in
participation and market volume is likely to continue at its current rapid pace, based on the unequivocal
contribution credit derivatives are making to efficient risk management, rational credit pricing, and
ultimately, systemic liquidity. By enhancing liquidity, credit derivatives achieve the financial
equivalent of a “free lunch” whereby both Buyers and Sellers of risk benefit from the associated
efficiency gains. Credit derivatives can offer both the Buyer and Seller of risk considerable advantages
over traditional alternatives. Both as an asset class and a risk management tool, credit derivatives
represent an important innovation for global financial markets with the potential to revolutionize the
way that credit risk is originated, distributed, measured, and managed.

Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to
change without notice. Past performance is not indicative of future results. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor.
The investments discussed may fluctuate in price or value. Changes in rates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of
any financial instrument. JPMorgan and/or its affiliates and employees may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or
lender to such issuer. J.P. Morgan Chase & Co. and/or its subsidiaries and affiliates has likely managed or co-managed an offering of securities within the past three years for the credits mentioned within this presentation.
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