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The Structured Credit Handbook
“The Structured Credit Handbook is an outstanding achievement. It provides and excellent and well-written tutorial on all aspects of structured credit markets and includes many interesting examples and applications. The book brings a wealth of institutional knowledge together with first-class economic analysis by some of the leading practitioners in the field. Rejan, McDermott, and Roy have written the definitive reference that students, researchers, investors, and market professionals have been waiting for.”—Francis Longstaff, Allstate Professor of Insurance and Finance, UCLA Anderson School of Management “The Structured Credit Handbook is a unique blend of products and trading strategies. This is an authoritative and colorful treatment designed for investors and sales-and-trading professionals covering structured credit products. All of the key products are covered.”—Darrell Duffie, Dean Witter Distinguished Professor of Finance, Stanford University “Finally, a clearly written and comprehensive road map of the world of structured credit! The Structured Credit Handbook incisively analyzes the entire spectrum of structured credit products, from single name CDS to CDOs. Well-suited for students and practitioners alike, this book provides a unique, practical framework for understanding this complex and rapidly changing field. This book is destined to become a fixture in trading rooms, investment departments, and classrooms around the world.”—Ian Lui, Chief Investment Officer and Christopher Ni, Deputy Chief Investment Officer, Shin Kong Life Insurance Co. Ltd.
Arvind Rajan (Author), Glen McDermott (Author), Ratul Roy (Author)
9780471747499, Wiley
Hardback, published 2 March 2007
496 pages, Drawings: 199 B&W, 0 Color; Screen captures: 2 B&W, 0 Color; Tables: 105 B&W, 0 Color
23.6 x 16 x 3.8 cm, 0.73 kg
The Structured Credit Handbook is a comprehensive introduction to all types of credit-linked financial instruments. This book provides state-of-the-art primers on single tranche collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), credit derivatives (such as credit default swaps and swaptions), and iBoxx indexes. Filled with in-depth insight and expert advice, The Structured Credit Handbook covers all aspects of the synthetic arbitrage CDO market, including new instruments such as CDO2. Readers will also gain a firm understanding of the investment rationale, risks, and rewards associated with CDO investments through this valuable resource. The exploding use of credit derivatives and collateralized debt obligations (CDOs) has transformed the world of credit, creating an $18 trillion market almost overnight and resulting in innumerable investment and career opportunities globally. The Structured Credit Handbook provides the reader with a comprehensive and clear roadmap to today's new credit landscape. The full spectrum of structured credit products, from single-name CDS to CDOs, is explained in a simple, clear fashion that is free from the financial jargon and mathematical complexity which characterize many other derivative texts. The handbook begins with an in-depth explanation of the building blocks of the structured credit markets, single-name default swaps and indexes, and it culminates with complex products such as credit options, synthetic tranches, CDOs based on bank loans and asset-backed securities, and CDO-squareds. Written by experienced practitioners who have participated in this market since its infancy, each of the thirteen chapters introduces and analyzes a new product and explains its practical applications. A rich set of real-life case studies illustrate the application of each product in a concrete market setting. The book may be used in a semester-long course on structured credit as part of a business or finance curriculum. Whether you are a market professional, a university student or faculty member, or simply a financially savvy layperson, look no further for an up-to-date and thorough introduction to this rapidly growing and exciting field. Dr. Arvind Rajan, Managing Director, Citigroup Global Markets, is engaged in proprietary trading of Structured Credit products, and until recently, was global head of Structured Credit Research and Strategy at Citigroup. Glen McDermott (New York, NY) is Director of Fixed Income Sales and the former head of CDO Research at Citigroup Global Markets Inc. Ratul Roy is head of CDO Strategy for Citigroup Global Markets and has spent the prior nine years in structuring or analyzing CDOs and other structured credit products.
Acknowledgments xix About the Authors xxi About the Contributors xxiii Introduction: A Roadmap of the New World of Structured Credit 1 How Structured Credit Completes Markets 2 Enabling Technology 3 Improved Liquidity, Transparency, and Customizability 3 Growth of Structured Credit Markets 4 Asset Classes 4 Products 4 Participants 7 Core Uses of Structured Credit 8 Nonrecourse Leverage 8 Diversification 8 Customization of Risk Profiles 9 Separating Legal from Beneficial Ownership 9 Separating Funding from Risk Transfer 9 Isolating and Hedging Risk 10 Representative Examples of Structured Credit Solutions 10 Who Should Read This Book? 11 How This Book Is Organized 11 PART ONE Index and Single-Name Products CHAPTER 1 A Primer on Credit Default Swaps 17 The Market for Credit Default Swaps 17 Transaction Terminology and Mechanics 22 Prerequisites for Credit Derivatives Transactions 22 What Happens in Case of a Credit Event? 23 Unwinding Default Swap Transactions 25 The DV01 of a Credit Default Swap 25 The Default-Cash Basis 26 Some Uses of Default Swaps 26 Buying a Note versus Selling Default Protection 26 Freeing Up or Using Bank Credit Lines 27 Filling a Maturity Gap 28 Expressing Curve or Forward-Rate Views 28 Barbell-Bullet Trade 29 Taking Advantage of Tight Repo Levels without Financing 29 Case Study: Relative Value—Cashing In on the Curve Steepness in Telecoms 30 How to Blend CDs and Cash in Long-Maturity-Curve Trades 30 Implementing Credit Curve Flatteners—Two Basic Approaches 33 Appendix: Equivalence of a Bond Spread and Default Swap Premium 35 Specialness of the Underlying 36 Effect of Accrued Default Swap Premium 36 Accrued Interest on the Underlying Risky Security 37 Accrued Interest on the Underlying Risk-Free Security 37 CHAPTER 2 Credit Default Swaptions 39 Payer Options 40 Example—When to Buy a Payer 41 Example—When to Sell a Payer 42 Receiver Options 42 Example—When to Buy a Receiver 43 Effect of DV01 on Credit Swaption Payoffs 43 Example—When to Sell a Receiver 44 Credit Swaption Payoffs in Default 46 Credit Swaption Implied Volatility 47 Conclusion 47 Case Study: Are Tight Spreads Giving You Butterflies? 49 Introduction 49 Float Like a Butterfly, Sting Like a Bee 50 Butterfly versus Payer 50 Variations 54 Details of Butterfly Construction 54 Conclusion 54 CHAPTER 3 Constant Maturity Credit Default Swaps 57 Basics of CMCDSs 57 Participation Rate 58 Behavior of CMCDSs 59 Impact of Spread Level 60 Impact of Spread Volatility 64 Capped CMCDS 66 Hedging CMCDSs 68 Trading Strategies with CMCDSs 69 Selling CMCDS Protection 69 Buying CMCDS Protection 70 Combination Trades and Index CMCDSs 70 Conclusion 72 Case Study: Taking Curve Views with CMCDSs 72 Features of CMCDSs 73 Trade Ideas 73 Appendix: Computing the Participation Rate 76 CHAPTER 4 Credit Derivatives Indexes 79 Introduction 79 Family of Credit Derivatives Indexes 80 Structure of the CDX/iTraxx Index Family 81 Administration of Indexes 83 Basket of Credit Default Swaps 83 Trading Example—The Index 84 Up-Front and Running Payments 84 Trading Example—Premium Payments 85 What Happens in Case of a Credit Event? 86 Trading Example—Credit Event 87 Settlement Process after Credit Event 87 Physical Settlement (Indexes and Tranche Products) 88 Cash Settlement (Tranche Product Only) 88 Recent Defaults in CDX Indexes 88 Index versus Intrinsics 90 Investment Strategies with Credit Derivatives Indexes 91 Investors 92 Index-Related Structured Credit Products 92 Issues and Concerns 93 Conclusion 93 Case Study: DJ CDX HY and DJ CDX EM—Conversion of Price Level into a Spread Level 94 Case Study: Using iTraxx to Replicate Bond Portfolios 94 Motivation 94 Typical Portfolio Risks 95 Replicating Interest Rate Risks 96 Using iTraxx to Replicate Broad Credit Market Risk 96 Adjusting for Single-Name Risk through Default Swaps 99 Performance 100 Conclusion 104 Appendix: Description of the Roll Process 106 Risky PV01 of a CDS Contract 106 Calculation of Intrinsic Spread of the Index 107 Risky PV01 of an Index 108 Mark-to-Market Estimation of an Index Position 108 CHAPTER 5 The Added Dimensions of Credit—A Guide to Relative Value Trading 111 Overview of Curve Trades 111 Learning Curves 112 Drivers of Curve Steepness 113 Putting on a Curve Trade 115 Cross-Currency Trades 116 Cross-Currency Opportunities in Bonds 117 Cross-Currency Trades in CDSs 117 Basis Trades 118 Back to Basis 118 Drivers of Basis 122 Why CDSs and Bonds Are Two Sides of the Same Coin 122 Trading the Basis 126 A New Spread Measure: C-Spread 129 Debt-Equity Trades 129 Meet the Models 129 The Debt-Equity Cycle 130 A Practical Hurdle or Two 131 Debt-Equity Trading in Practice—Arbitrage or Mirage? 132 Deciding What to Trade 133 A Recovery Trade 134 iTraxx Credit Indexes 134 Truly Global 135 You’ve Got to Roll with It 136 iTraxx Intrinsics 137 What Happens When a Name Defaults? 139 Equiweighted or Not 139 Second-Generation Products: iTraxx Tranches 139 Credit Options 140 It’s a Knockout 140 Effect of Convexity on Credit Option Payoffs 141 Delta-Exchange 143 Why Sell an Option (Riskier Strategy) Rather Than Buy One? 143 Option Strategies 144 PART TWO Portfolio Credit Derivatives CHAPTER 6 Single-Tranche CDOs 149 Overview of Single-Tranche CDOs 149 Advantages of Single-Tranche CDOs 150 Key Features of Single-Tranche CDO Transaction 150 Description of the Product and Basic Structure 151 Main Decision Steps for Investors 153 Key Issues in Modeling and Valuation 155 Single-Tranche CDO Risk Measures and Hedging 158 Substitution of Credits 164 Single-Tranche CDO Market 166 Investment Strategies 167 Case Study: Dispersion Trades and Tranches 180 Traditional Bull-Bear Trade 180 Not Just Another Bull-Bear Tranche Trade 181 Who’s Afraid of Blowups? 181 Buy Protection on 10-Year 3 to 7 Percent CDX IG Tranche, Sell Protection on 5-Year 10 to 15 Percent CDX IG Tranche 183 Effect of Blowups in CDX IG on the Dispersion Trade 184 Trade Sensitivity Analysis 184 How to Choose the Most Efficient Tranches 187 Conclusions 190 Case Study: Attractions of Hedged Mezzanines 190 Motivation 191 The Trade 191 Comparing Delta-Hedged Equity and Mezzanines 192 Time-Decay Profile 194 Conclusion 195 CHAPTER 7 Trading Credit Tranches: Taking Default Correlation out of the Black Box 197 The Credit Tranche Market 197 Importance of Default Correlation in Tranches 199 Problems with Traditional Correlation Measure 199 Skew in Default Correlation 201 Further Flaws in Tranche Correlation 201 Correlation Skew Is Like a Volatility Surface 201 Skew Is Market’s Risk Preference 204 Investor Risk Appetite May Scale Across Markets 207 Greeks: Managing Correlation and Delta Risk 209 In Summary: Why Skew Is a Better Model 213 Trading Opportunities for Investors 214 Tranche Correlation Can Still Provide Insight 214 Pricing Off-Market Tranches 217 Conclusion and Future Agenda 219 Case Study: Curve Trades in Tranche Markets 220 Curve Trades, Tranche Markets, and Technicals 220 Trade Recommendation 221 Market Drivers for the Tranche Curve Trades 221 Base Correlation Analysis and Market Technicals 223 Technicals Driving the Flattening of Tranche Curves 224 Analysis of Investment Strategy 225 CHAPTER 8 Understanding CDO-Squareds 229 CDOs versus CDO2 230 Value of CDO2s Derives Broadly from Inner CDOs 232 CDO2 versus Inner CDO 234 Like Mezzanine, but with Tails 235 CDO2 versus Master CDO 236 Economic Value versus Rating Quality 238 Uses of CDO2: Long, Short, and Correlation! 239 Structures: Good, Bad, and Ugly 239 Inner CDO Tranche Seniority and Thinness 240 Overlap of Credits 242 Nonuniformity of Portfolios 243 Fungible and Tradable Subordination 244 How Managers Can Add Value 246 Not Just Credit Selection 246 Manage to the Structure 248 Conclusion 249 Case Study: Term Sheet 249 CHAPTER 9 CPPI: Leveraging and Deleveraging Credit 253 Product Mechanics 253 Managed CPPIs 256 When Is CPPI Suitable? 257 Choice of Trading Strategies 257 Case Study: Performance Comparison of Strategies 258 Baseline: Unlevered Strategies 258 Simulations 258 Results 259 Performance Comparison in CPPI Setup 263 Other Strategies 264 Appendix: Our Methodology 265 Our Estimations and Simulations 265 PART THREE Collateralized Debt Obligations CHAPTER 10 Collateralized Loan Obligations 269 Leveraged Loan Market Overview 270 Strong Primary Market Growth 270 Broadening Investor Base 272 Increasing Secondary Market Liquidity 273 Continuing Challenges to Loan Market Liquidity 275 Key Loan Characteristics 276 Loan Structures 281 Revolving Credit Facilities 281 Amortizing Term Loans 281 Institutional Term Loans 282 Pro Rata Loans 282 Overview 282 Key Characteristics 283 Investment Opportunities 284 Middle-Market Loans 285 Overview 285 Key Characteristics 285 Investment Opportunities 288 European Leveraged Loans 289 Overview 289 European Mezzanine Bank Loans 290 Key Characteristics 292 Investment Opportunities 292 Collateralized Loan Obligations 293 Efficient Access to Loan Market Investment Opportunities—Introducing CLOs 293 Basic CLO Structure 293 CLO Asset Manager 296 CLO Market Today 297 Key Drivers of CLO Outperformance 298 Conclusion 303 Middle-Market CLO Handbook 303 Middle-Market Size and Definition 304 Growing Investor Demand 305 Dominance of Institutional Term-Loan Debt 305 Second-Lien Loans Emerge 306 Investment Considerations for Middle-Market Investors 307 Legal Considerations 312 Middle-Market CLOs 312 CLO Investment Considerations 320 Conclusion 324 Appendix A: Middle-Market Loan Characteristics 325 Floating-Rate Coupon 325 Maturity 325 Callability 326 Covenants 326 Structure of a Middle-Market Loan 326 Appendix B: The Basic CLO Structure 327 Case Study: CDO Combination Securities—Tailoring Risk/Return Profiles 329 Introduction 329 Equally Rated CDO Combination Securities Are Not Equal 330 Value in Baa3-Rated CLO Combination Securities 332 Conclusion 334 CHAPTER 11 ABS CDOs 335 Overview of the Structured Finance Market 335 Basic Structure 335 Roles of Multiple Parties in a Securitization 336 ABS Market Fundamentals 336 Major Characteristics of Structured Finance Securities 344 Relative Value 344 Structural Protection 346 Collateral Stability 346 Challenges 348 CDOs of Structured Finance Securities 350 Investor Motivation 350 A Customized Investment 350 Relative Value 351 Major Considerations in CDO Investing 351 Leveraging Stability—Performance of SF CDOs 354 CDOs of SFSs Take Many Forms 354 Conclusion 358 Case Study: Relative Value in High-Grade Structured Finance CDOs 358 Transaction Overview 359 High-Grade SF Securities: A Strong Track Record 361 Cash Flow Analysis 363 Conclusion 364 Case Study: Untangling Mezzanine and High-Grade Structured Finance CDOs 364 Collateral Composition 365 Collateral Risk 366 Expected Loss 366 Correlation Views 368 Other Differences 368 Conclusion 369 Appendix: Rating Transition Matrices of Common Structured Finance Collateral 369 CHAPTER 12 CDO Equity 371 Cash Flow CDO Income Notes 373 Return Analysis 377 Defaults 378 Recoveries 380 Interest Rate Risk 382 Collateral Manager 384 Collateral Manager Review 384 Asset Selection 385 CDO Investment Guidelines 386 CDO Manager Types 388 Investment and Trading Philosophy 389 Asset Characteristics 391 Collateral Mix 391 Time Stamp or Cohort 392 Diversification 393 Structure 394 Trigger Levels 394 Senior Costs, Swaps, and Caps 395 Manager Fees and Equity Ownership 396 Credit-Improved Sales—Treatment of Premium 396 Conclusion 397 Case Study: Diversifying Credit Risk Using a CDO Equity Fund 397 Introduction 397 Modeling Assumptions and Analytical Techniques 398 Results 399 Conclusion 400 CHAPTER 13 Commercial Real Estate CDOs 403 CRE CDOs by the Numbers 403 Slow Start, but Growth Now Strong 403 Relative Value: Spread Pickup Often Gives CRE CDOs an Edge 405 CRE CDO Performance Has Been Strong 406 Collateral Mix: Diverse and Evolving 407 Building Blocks of a CRE CDO 409 B-Notes and Rake Bonds 411 Second Lien Loans 412 Mezzanine Loans 412 Preferred Equity 413 Whole Loans 413 CMBS First Loss Positions or B-Pieces 413 CRE CDO Managers and Sponsors 415 Who’s Who 415 What to Look for in a CRE CDO Manager 415 CRE CDO Investors: A Diverse Group 416 Key Events in the CRE CDO Market 417 A Market Is Born 417 The Rise of CRE CDOs as a Source of Financing 418 The Push for Flexibility 420 The Current State of the CRE CDO Market 421 Investor Analysis of CRE CDOs 422 CRE CDO Analysis for Traditional CDO Investors 423 CRE CDO Analysis for Traditional Real Estate Investors 423 Additional Suggested Collateral Analysis 428 Analysis of CMBS Certificates 428 Analysis of Uncertificated Securities 429 Appendix: List of CRE CDOs 432 Glossary 437 Term Sheet 439 Notes 443 Index 457
Arvind Rajan
Arvind Rajan and Terry Benzschawel
Olivier Renault and Ratul Roy
Jure Skarabot and Gaurav Bansal
Matt King and Michael Sandigursky
Jure Skarabot, Ratul Roy, and Ji-Hoon Ryu
Ratul Roy
Ratul Roy and Matt King
Olivier Renault
Glen McDermott, William E. Deitrick, Alexei Kroujiline, and Robert Mandery
Ratul Roy and Glen McDermott
Glen McDermott and Alexei Kroujiline
Darrell Wheeler and Ratul Roy
Subject Areas: Finance & accounting [KF]
