CREDIT DEFAULT SWAPS

17 October 2003 Version: 1.00

2003 Bloomberg L.P. All rights reserved.

BLOOMBERG
Credit Where its Due
The growth of the derivatives market continues apace. The Bank for International Settlements, the central banks bank, reckoned that the global derivatives market was valued at about $142 trillion at the end of last year, based on underlying assets. The International Swaps and Derivatives Association (ISDA) 2002 Year-end Market Survey noted that credit derivatives were the fastest growing part of this market. Both ISDA and Fitch Ratings estimate that the volume of credit default swaps stands at about $2 trillion Fitch says that this is almost 40 percent more than it estimated in March. According to the British Bankers' Association (BBA), the volume of credit derivatives almost doubled between the end of 2001 and the end of last year and is set to more than double again to $4.8 trillion by the end of 2004. A BBA Credit Derivatives Report published on September 18, 2002, showed that more than half of all credit derivatives transactions are booked in London, with the US accounting for less than onethird. Banks are both the biggest buyers (52%) and the biggest sellers (39%) of protection. Securities houses are the next largest buyers of protection (21%) followed by hedge funds (12%). Insurance companies come a close second to banks as sellers of protection (33%), with securities houses third (16%). Most transactions provide protection for between one and five years. About twothirds of the reference entities are A/BBB credits; nearly two-thirds are nonfinancial corporates, and about one-fifth are banks closely followed by sovereigns. Most credit derivatives activity is concentrated in the hands of relatively few banks JP Morgan Chase, Citibank and Bank of America. Federal Reserve Chairman Alan Greenspan commented on May 8 that a single dealer seems to account for about one-third of the global market, and a handful of dealers together seem to account for more than two-thirds. However, whilst Greenspan has said credit derivatives make financial markets more flexible by spreading risk, billionaire investor Warren Buffett, the world's second-richest man, calls them financial weapons of mass destruction. The Fitch survey showed that the companies that feature most often in credit derivatives contracts are France Telecom SA, Ford Motor Co., General Motors Corp., DaimlerChrysler AG and General Electricity Co. According to Bloomberg News on July 9, Matthew Cottrell, an associate director at Fitch, said that a few years ago, we would have seen WorldCom Inc. and Enron Corp. at the top of this list. Thats something to think about. Whatever your thoughts on credit derivatives, they constitute an important market experiencing explosive growth that you cannot afford to ignore. Keep on top of all the news, views, prices and analysis with the comprehensive credit derivatives functionality on the BLOOMBERG PROFESSIONAL service. Versatile. Accurate. Reliable. Give credit where its due THERE HAS NEVER BEEN A BETTER TIME TO SWAP TO BLOOMBERG.

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Live Custom Monitors Live CDS contributor prices, news, technical studies, and more at one glance

ALL THE KEY CDS PRICES AND DATA IN ONE PLACE WHERE YOU NEED IT, WHEN YOU NEED IT, HOW YOU NEED IT Customize BLOOMBERG Launchpad views of co-mingled contributor pages of live CDS quotes; real-time market monitors; technical analysis studies; customized calendars of economic releases, government and central bank announcements; key news on the credit derivatives markets; live TV broadcasts, and much more. Each BLOOMBERG Launchpad view is a fully flexible, customized set of up to 25 extra Bloomberg applications that you can distribute on your workstation in addition to the four main windows of your BLOOMBERG PROFESSIONAL. And you can build and store up to 20 different Launchpad views. BLOOMBERG Launchpad frees up your main screens from the task of monitoring so you can maximize the resources you dedicate to sophisticated analytical functions.

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Credit Derivatives News All the news you can use in the credit markets

GET AHEAD WITH NEWS THAT MAKES AND BREAKS THE MARKET MOVEMENTS Keep on top of all the latest news, views, and opinions that impact the credit derivatives markets. Access live TV broadcasts and breaking news stories, or catch up on archived multi-media reports that put the current news in perspective. BLOOMBERG NEWS stories include real-time illustrations using BLOOMBERG PROFESSIONAL functions, so you have at your fingertips all the information you need to make your decisions. Each story includes not only the journalists by-line, but also their phone number and e-mail address so you can contact them directly with your comments, opinions, and questions. Access news, monitors, quotes and messages from your phone, Palm, or Win CE/Pocket PC device so you can keep in touch with whats important for you job any time, any place, any how.

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Company Credit Analysis Check a companys financial health and the extent of its obligations

ASSESS THE DANGER OF A COMPANY GOING INTO DEFAULT View the distribution of a companys debt and loan structure, so you can anticipate any future refinancing problems and decide if and when it is in danger of default. Use sophisticated models to assess the financial health and outlook of a company, and estimate the one-year probability of default, so you can more accurately gauge the relevant credit quality of a reference entity.

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Cash Market Spreads Bond Spreads Investigate how the bond market values an issue relative to its peers

USE PROPRIETARY CREDIT CURVES TO ASSESS CDS SPREADS Use the comprehensive database of par yield curves and indexes grouped by currency, industry sector, and rating so you can establish the fair value of a credit. Check the details of the underlying credit model the bonds used to construct the curve, the goodness of fit and the dispersion of the bonds prices about their modelled values. Use the theoretical credit spread of a reference entity to estimate indicative CDS levels. Plot theoretical credit spreads or graph the evolution of the CDS basis.

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Cash Market Spreads Swap Spreads Calculate how the swap market values an issue

USE THE SWAP MARKET TO GAUGE THE CDS LEVELS Use the Asset Swap Calculator to determine a bonds par-asset swap spread and its zspread. The z-spread is a better measure for comparing the credit quality of different bonds and relative value with CDS than either the par-asset swap spread or the interpolated spread over the swap curve. The credit default swap spread minus the asset swap spread is known as the CDS basis. Generally, the worse the credit of the reference entity, the greater the basis. Plot the history of bond spreads over swaps so you can assess if a CDS on the reference entity may widen or tighten.

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CDS Contributor Prices Compare CDS quotes from all the main providers including Bloomberg Generic values

CHECK OUT DIFFERENT CDS CONTRIBUTORS BID AND ASK QUOTES Trawl through the selection of different CDS contributors and call up their home pages. If you find you dont have permission to see a particular providers quotes, just use the contact details they give you on their page so you can ask them for access privileges. Select a specific CDS for a reference entity and compare all the CDS quotes you have permission to see on one screen so you can determine which is the best value.
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CDS Spread Curves Set up your CDS default settings

SET UP YOUR PREFERRED SETTINGS FOR PAR CDS SPREADS CURVES, USER DEFAULTS, USER DEFINED CURVES AND CDS CONTRIBUTORS Choose your default price sources for different currencies, market sectors, debt types, and reference entities. Search for the CDS tickers for a particular reference entity, or look up the spread curve for a given CDS ticker. Set up your spreads curves interpolation method, CDS ticker pricing method for missing points, FMC curve construction method, and CDS calculation default model.

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CDS Price Selection Choose your price defaults for different currencies, market sectors and reference entities

CHOOSE THE CDS SPREADS YOU WANT TO DRIVE YOUR ANALYSIS Select up to four different price providers for a sector, group of names, or specific reference entity. If your favorite contributor does not provide a quote for a particular CDS, your next choices will be selected in the order you specified. You can adjust the contributor quotes by user-defined spreads so you can modify the shape of the curve. The default source is the Bloomberg Generic Average Price.
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Comparative CDS Price Analysis Check the agreement between contributors quotes and see which provides the best rate

USE YOUR CHOSEN CDS CONTRIBUTOR WITHIN THE BLOOMBERG OR MICROSOFT EXCEL Use the CDS quotes from different contributors simultaneously in the same function and plot the price spread history. Track historical prices from up to four providers on one graph so you can see how they compare to each other, the market average prices, or your own custom index. Import the CDS prices from various sources for a group of reference entities into Excel so that you can build your own proprietary spreadsheets.
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CDS Calculator Create, store and value your CDS deals

COMBINE THE CDS MODEL YOU PREFER WITH THE PRICE CONTRIBUTORS YOU FIND MOST RELIABLE Import CDS quotes from your chosen contributors or your own customized par CDS curve; input calculated credit spreads; enter cumulative default probabilities. Whichever one you highlight, the CDS pricing model will calculate the other two. Choose from the versatile, state-of-the-art Modified Hull-White CDS pricing model or the widely-used JP Morgan CDS methodology (see Appendices I and II for details) to evaluate the deal. Mark-to-market your CDS contract, or check the market value for a given deal spread. Find out how sensitive a CDS it is to changes in credit spreads.
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FAQ Sheet Find answers to frequently asked questions What is a Fair Market Curve and how can I use it? A Fair Market Curve is a fixed maturity, par yield curve derived from the prices of all bonds in a given sector. Sectors are defined by currency, industry classification, and credit rating. You can access the extensive database of credit curves using the function FMC. Curves are color-coded so you can see which have been recently added or amended. The function CURV shows the bonds used to construct the curves and the tickers for the par yield curve indexes. Use the Fair Market Curves and the FMC indexes to calculate bond spreads over swaps for generic credits so you have a guide to CDS levels. FMC<GO> CURV<GO> What are the differences between the asset swap spread and the z-spread? The Asset Swap Calculator, ASW, shows a bonds asset swap spread and its z-spread. These spreads compare the gross price of a bond to its net present value (NPV) in the swaps market. The asset swap spread is an annuity expressed in basis points; the NPV of this plus the gross price of the bond equals the NPV of the bonds cash-flows. The zspread is a constant number of basis points added to each implied zero swap rate; the NPV of the bonds cash-flows discounted using this adjusted credit curve equals the bonds total price. When spreads are small, the asset swap spread and the z-spread are close. The spreads diverge for bonds from weaker credits, with the zspread tending to be the higher. The z-spread is the better measure for estimating CDS relative values. HELP ASW<GO>2<GO>7<GO> What is the CDS basis? Calculated bond spreads are different from the reference entitys quoted CDS spreads. The CDS basis is the CDS spread minus the asset swap spread. If the CDS spread is wider than the asset swap spread, the basis is positive; if it is tighter than the asset swap spread, the basis is negative. You can calculate the basis using the Custom Index Expression, CIX. CIX<GO> Where can I see contributed CDS prices? Use the function MRKT to access all current market contributors quoted CDS spreads. Some providers may give you permission to see their quotes, others will not. If you want to be enabled to see a particular contributors prices, contact the provider directly using the information they display on their screen. MRKT<GO>

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FAQ Sheet continued Find answers to frequently asked questions How can I find the CDS tickers for a reference entity? Call up the CDS tickers for the names on any CDS contributor page by pressing the <TAB> key (this also gives you the information you need to add the contributor page to a Launchpad view). Access the CDS tickers for a given reference entity from the Description Page, DES, for any of its bonds this takes you to the CDS Default screen, CDSD (see below). Search for CDS tickers or reference entities using CDSD. TELEFO4.5 09<CORP>DES<GO> How can I see the price quotes for a particular CDS? For a particular CDS ticker, the All Quotes function, ALLQ, shows the price quotes from all the contributors that have given you access to their data. CTLFOE3<CURNCY>ALLQ<GO> What is the CDS Bloomberg Generic Average Price? The Bloomberg Generic Average Price (mnemonic CBGN) is the mean of all contributor prices that have updated during the day, excluding the highest and lowest prices when there are 5 or more contributed prices that day for that ticker; (a generic is posted only if at least 2 prices are contributed). The CBGN is the same for all customers, irrespective of which contributors they can access. Can I choose what CDS prices to use? Yes. Use CDSD to select your favorite CDS spread contributors for a particular currency, market sector, debt type or individual issuer; combine contributed quotes with user-defined spreads; choose which method to use for spread curve interpolation, and what values to use for missing points. You can also append a specific CDS pricing contributors mnemonic to the CDS ticker if you want to use their spreads either within the environment of the BLOOMBERG PROFESSIONAL service or within a spreadsheet. This lets you compare and graph the prices from different sources including the Bloomberg Generic Average Price using the mnemonic CBGN. CDSD<GO> CTLFOE5 CBGN<CURNCY><GO> Can I store and mark-to-market my CDS trades? Yes. Use the CDS pricing calculator, CDSW, to create and store your CDS deals. Select which pricing model you want to use the JP Morgan model or the Modified Hull-White model (See Appendices I and II) and choose the price source you prefer (see above). CTLFOE3<CURNCY>CDSW<GO>
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Appendix I The JP Morgan Credit Default Swap Model

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Appendix II The Modified Hull-White Credit Default Swap Model

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Appendix II continued
The Modified Hull-White Credit Default Swap Model

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