You are on page 1of 30

Introduction to Credit Derivatives

Presented by: Teaching Session 92 SOA Annual Meeting Orlando, Florida October 28, 2003
Kevin Reimer, FSA, CFA ING Institutional Markets Greg Henke, FSA, CFA Citigroup Michael J. Hambro, FSA, MAAA AON Consulting

What is a Credit Derivative?

An agreement that transfers credit risk between parties

- Privately held - Negotiated and customized - Large and liquid markets

Synthetically creates or eliminates credit exposures

- Quickly becoming the purest way to take or hedge credit risk

Similar to an insurance contractbut different

- Actively traded and liquid - No direct loss has to occur in order for protection buyer to be paid
Uses ISDA documentation and ISDA Master Agreements with counterparties

- Similar to Interest Rate Swaps

Types of Credit Derivatives

Single Name Credit Default Swap (CDS) Collateralized Debt/Loan Obligation (CDO/CLO) - Split into tranches with different risk/return characteristics - Equity, Mezzanine, Senior, Super Senior, Single Tranche CDOs Credit Linked Note (CLN) - Funded transaction where credit derivative is embedded in a note Total Rate of Return Swap (TRoR Swap) Asset swaps Basket CDS - Pool of names (First to default, nth to default, last to default, etc.) Credit Spread Products - Credit spread lock swaps, options, etc.

Markets in Credit Derivatives

Types of Credit Derivatives
Asset Swaps 5% Total Rate of Return Swaps 6% Credit Linked Notes 10% Credit Default Swaps 43% Collateralized Debt/Loan Obligations 26% Basket CDS 5% Credit Spread Products 5%

Percentages are estimates of 2004 market share (Source: British Bankers Association)

Credit Default Swap

xx bps per annum

Protection Buyer (Firm A)

Contingent Payment

Protection Seller (Firm B)

Contingent Payment is made in case of a credit event on the reference credit, which is defined as one of the following:
1. 2. 3. 4. 5. 6.

Failure to pay Bankruptcy Obligation Default Obligation Acceleration (no longer common) Repudiation/Moratorium (followed by restructure/failure to pay) Material adverse restructuring of debt (4 options can be removed, or replaced by a narrower definition, in exchange for a lower premium)

Credit Default Swap Example

67 bps per annum

Protection Buyer (Firm A)

Contingent Payment

Protection Seller (Firm B)

Firm A buys USD 10mm 5-year protection on Walt Disney Company

(BBB+/Baa1) from Firm B

- September 16th, 2003 quote: 66/67 - Bid/Ask quote usually for USD 5-10mm for 5-year - Firm A pays a premium of 67 bps per annum until maturity (or a credit event) - Premium can be paid semi-annually, quarterly, upfront, etc. based on market

Credit Default Swap Example (Cont.)

If a credit event occurs, two methods for settlement
Cash Settlement

Protection Buyer (Firm A)


(Par less Recovery Value)

Protection Seller (Firm B)

Recovery Value determined from averaging several dealer bids

Physical Settlement
Defaulted Security

Protection Buyer (Firm A)


Protection Seller (Firm B)

Defaulted Security will be cheapest-to-deliver obligation

How Did Credit Derivatives Evolve?

First transactions by banks in early to mid 1990s

- Net buyers to get regulatory capital relief - Manage exposures on loan portfolio - Maintain client relationships
Initial transactions primarily based on sovereign credits

- Now vast majority on corporate names

In 1999 ISDA promulgated credit derivative definitions to make contracts more standard and transparent

- 2001 supplements clarified restructuring and convertibles - 2003 re-write incorporated supplements and new restructuring definitions
Subsequent improvements to definitions of default events furthered the convergence trend between the cash and synthetic markets

Growth of Credit Derivatives

Growth of Credit Derivatives
$5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 1997 1998 1999 2000 2001 2002 2003 (est.) 2004 (est.) Standardized Documentation with 99 ISDA Definitions

Volume ($bln)


Market Players
Protection Buyers
Banks Brokers Hedge Funds Other 52% 21% 12% 15%

Protection Sellers
Banks Insurers Brokers Other 39% 33% 15% 13%

2002 Market Participation

How do Market Participants Use Credit Derivatives?


CDS: How Are They Used?


- Large, early buyer of credit protection to hedge their loan portfolios - Initially, often motivated by regulatory arbitrage - Desire to hedge could be due to size of exposure to a single credit, industry
or geographic region.

- Often MTM through earnings; last year saw positive impact on earnings,
this year negative impact

- Now common to buy and sell protection to diversify, but maintain aggregate
credit exposure amounts.

CDS: How Are They Used?

Reinsurance Companies

- Significant early seller of credit protection for income - Reinsurers were looking for new risks to diversify their exposures that can
be analyzed using an actuarial approach

- Reinsurers are used to taking risks on the liability side of their balance sheet - CDS improved their ability to write Financial Guarantees and take
unfunded credit risk

- No longer a growth business for most Reinsurers

CDS: How Are They Used?

Other Users Hedge Funds - Active protection sellers as risk takers - Also use CDS for convertible bond arbitrage Corporates - Some protection buyers as a hedge, e.g., vendor financing - Protect non-qualified benefits Non-Life Insurance Uses - Exposures to WC clients due to deductibles - Managing reinsurance recoverables

CDS: How Are They Used?

Life Insurance Companies

- Synthetic GIC block (next slide) - Change profile without triggering deemed sale - Access higher quality credits, e.g., AA/AAA names - Avoid Fx or duration limitations - Will OTTI drive companies to separate duration and credit exposures?

Mortgage Securitization Transformed Banks Will Credit Securitization Transform Insurers?

Synthetic Life Company
XYZ Life Company

1st Loss Synthetic CDO

Assets: $1Bn Surplus: $60 MM Asset Duration: 6 yrs. Net Duration: 0 yrs. DV01 Rate: $0 DV01 Spread: $0.6 MM Net Asset Yield: L+110 Liability Cost: L+30 After-tax ROE: 11% GAAP: BV

Notional: $1Bn Equity Investment: $60 MM Asset Duration: 0 yrs Net Duration: 0 yrs. DV01 Rate: $0.0 DV01 Spread: $0.6 MM Net Asset Yield: 110 bps Liability Cost: 20 bps After-tax ROE: 12% GAAP: MTM (133)

Advantages of Using Credit Derivatives


Advantages of Using Credit Derivatives Buy Side

Hedge existing risk exposure to a particular credit - No need to sell asset (and therefore maintain relationships) - Private and silent transaction Capital management - Create optimal credit risk exposures in portfolio - Potential to increase RoEs Potential negative basis Allows increased capacity to names in cash market Can be negotiated and tailored for specific needs Facilitates taking an outright negative view on a credit

Advantages of Using Credit Derivatives Sell Side

Synthetic (unfunded) way of taking credit risk while bundling asset
and liability sides of a transaction

- Similar to buying a corporate bond and issuing a GIC - Implied LIBOR flat funding versus issuers actual cost-of-funds Liquidity Diversifies exposure to names - May allow for higher quality names not available in the funded market due
to RoE constraints

Advantages of Using Credit Derivatives Sell Side (Contd)

More flexibility in creating exposures based on view - Pick attachment point and subordination - Single tranche CDOs - First/last to default Potential positive basis Can be negotiated and tailored for specific needs Allows increased capacity to names in cash market


Issues to Consider when Using Credit Derivatives

Documentation Risk
- Restructuring, definitions, reference entity, allowed deliverables

Counterparty Risk
- Unless unwind with same counterparty, doubles counterparty exposure

Accounting issues
- FAS 133, IAS 39, mark-to-market, income fluctuations

Regulatory issues
- Replication, linking with funded assets

Capital and tax issues Need for liquidity (cash) in case of credit event Systems constraints Headline Risk

Regulatory Issues for Insurance Companies Using Credit Derivatives



Regulatory Overview and Challenges for Credit Derivatives

Credit derivative market is global Banks and financial guarantors (often subsidiaries of banks) are the major

During this topic we will - Identify the global regulatory participants and their roles - Describe U.S. regulation for credit derivatives - Discuss key developments - Describe the regulatory environment for U.S life insurers

Global Regulation
Central Banks - Each countrys Central Bank controls the activities of its market participants - Permitted activities - Risk management policies and controls - Minimum capital requirements - Remedial actions Bank for International Settlements (BIS) - Based in Switzerland is majority owned by Central Banks around the world - Provides Central Banks with a range of financial services and promotes
cooperation among Banks

- Helps in the implementation of international financial agreements


Global Regulation (Contd)

Basel Committee on Banking Supervision - Committee under BIS - Developed Basel Capital Accord I in 1988 - Developing Basel Capital Accord II - Expected to be completed by year-end 2003 - Implementation targeted for year-end 2006

International Swaps and Derivatives Association (ISDA) - Global trade organization for privately negotiated derivatives - Developed ISDA Master Agreement for derivative contracts - Standardized definitions of credit events, contract terms, and documentation

Global Regulation (Contd)

Accounting - Each market participant operates under the accounting standards of its countrys - International Accounting Standards Board (IASB) - Striving to achieve uniform accounting standards internationally - Has established International Accounting Standards - Developing new standards based on asset and liability approach - IAS 39 addresses derivatives - EU has committed to adopt IAS standards by 2005


U.S Regulation
Regulation of U.S Banking Organizations - Board of Governors of Federal Reserve System (FED) - Office of Comptroller of Currency (OCC) - Federal Deposit Insurance Corporation (FDIC) - Office of Thrift Supervision - Interagency Capital Requirements Accounting - FASB, including FAS 133 Accounting for Derivative Instruments and Hedging Activities

Key Regulatory Issues and Developments

Disputes over terms of contract and definitions - ISDA continually working to update standardize definitions and documentation - Buyer of credit protection wants the most liberal definition of default and the most liberal definition of securities deliverable to protection seller upon default - Seller of credit protection wants restrictive definitions of default and deliverable securities


Key Regulatory Developments

Example: Railtrack, a UK provider of railroad services - Nomura Securities purchased Credit Default Swap (CDS) on Railtrack from Credit Suisse First Boston (CSFB) in 2000 - In late 2001 Railtrack went into receivership - Nomura had bought Railtrack convertible bonds and tried to deliver to CSFB in consideration for payment of face amount - CSFB refused to accept convertibles, forcing Nomura to purchase and deliver plain debt - Nomura sued and prevailed in court - While dispute in progress ISDA clarified (prospectively) when convertible debt can be delivered to satisfy contract

Basel II Capital Accord

Capital requirements critical in pricing and availability of credit derivatives Basel I Capital Accord - Published in 1988 - Requires at least 8% ratio of capital to risk-weighted surplus - Risk weights depend on whether borrowers are sovereign, banks, or corporate



Basel II Capital Accord (Contd)

Risks defined too broadly and can lead to capital arbitrage - All corporate debt has a 100% weighting - Bank A can buy credit protection from Bank B - Counterparty exposure to Bank B will have a weighting of 20% - In order to optimize capital utilization, Bank A can purchase CDS on its better corporate credits and retain exposure to riskier (and presumably higher yielding) credits.

Basel II Capital Accord (Contd)

Basel II makes several improvements

- More granular risk differentiation - Maintains minimum 8% capital to risk-weighted assets - Flat 8% capital ratio in Basel I can effectively vary from 1.6% to 12%,
depending on borrower credit evaluation

- Uses both standardized approach and internal rating based approach to risk

- Includes supervisory review process and market discipline - Initially, the goal is too require the same amount of aggregate capital - Implementation targeted for 2006
U.S intends to adopt Basel II for large banks ($250 billion) and for internationally active banks


Accounting Developments
For U.S GAAP credit derivatives fall under the scope of FAS 133, Accounting for Derivative Instruments and Hedging Activities

- Credit derivatives would generally satisfy the definition of derivative

under FAS 133

- Carried on balance sheet at fair value with changes in fair value going
through income statement

- Hedge accounting permitted in certain circumstances - Fair value or cash flow hedge - Must demonstrate hedge effectiveness - Some assets, such as credit linked notes, are not derivatives. However, in
this case FAS 133 requires the credit derivative that is part of the credit linked be split out from the host contract and treated separately as a derivative

Accounting Developments (Contd)


- FAS 133 interpretation of Mod-Co contracts as containing credit derivatives - FAS 133 can and has caused earnings volatility
International Accounting Developments

- Currently banks in many European countries account for derivatives off

balance sheet

- IAS 39 (many similarities to FAS 133) would require derivatives to be

treated as assets and liabilities and carried at fair value (with hedge treatment exceptions)

- EU banks feel that this will create undue earning volatility and are
indicating reluctance to adopt this standard, despite previous EU indication of adopting IAS in 2005. Financial guarantees vs. credit derivatives


Credit Derivative Challenges for U.S Life Insurers

Each U.S. life insurer is subject to the life insurance investment laws of its domicile state

- One of the problems that have faced life insurers for many years is the lack
of uniform state insurance laws, including investments laws.

- Investment laws are becoming more standardized, but important differences

exist. State derivative investment laws differ, but generally allow derivatives for the following purposes

- Hedging - Income generation - Asset replication

Credit Derivative Challenges for U.S Life Insurers (Contd)

Specific limitations for derivative activities - Hedging - Aggregate statement value of options, caps, and floors may not exceed,
say, 7.5% of admitted assets

- Aggregate statement value of options, caps, and floors written may not
exceed, say 3% of admitted assets


Credit Derivative Challenges for U.S Life Insurers (Contd)

Income generation
- Limitations apply to statement value of fixed income assets subject to call or put. Limitation commonly 10% of admitted assets - A key limitation is that income generation only applies to covered calls or puts

Asset replication
- Based on limitations for authorized asset type being replicated

Credit Derivative Challenges for U.S Life Insurers (Contd)

Note that the limitation on income generation transactions precludes life insurers from writing naked CDS, such as the super senior trances of synthetic CDS. Life insurers engaging in derivative activities must have a derivative use plan

- Purpose of each derivative transaction - Risk measurement and management policies and procedures - Governance - Documentation - Infrastructure and systems controls


Credit Derivative Challenges for U.S Life Insurers (Contd)

Statutory Accounting

- Statement of Statutory Accounting Principles No. 86, Accounting for

Derivative Instruments and Hedging, Income Generation, and Replication (Synthetic Asset) Transactions Hedging

- SSAP 86 allows fair value hedges and cash flow hedges - Hedge effectiveness must be regularly demonstrated - Insurer can hedge specific components of risk, such as credit risk

Credit Derivative Challenges for U.S Life Insurers (Contd)

Income generation - Strict limitations apply - Can only be used in covered situations in which an asset owned by the insurer hedges the derivative risk - Derivative premium treated as deferred liability - Carrying valued depends on accounting for covering asset


Credit Derivative Challenges for U.S Life Insurers - Accounting

Statutory Accounting - Asset Replication (Synthetic Assets) - Asset replication means using a set of derivatives and cash instruments to replicate the investment characteristics of permissible assets - An example would be a credit linked note or a synthetic CDO that is constructed of default-free bonds and Credit Default Swaps to replicate exposure to a basket of corporate credits - In this case statutory accounting would treat the note or CDO as a regular fixed income asset, based on the rating of the security. - Unlike FAS 133, the embedded derivative (CDS) would not be bifurcated from the host contract

Credit Derivative Challenges for U.S Life Insurers Risk-Based Capital

NAIC RBC Formula does not explicitly address modern uses of credit derivatives For example, assume an insurer purchases a CDS on Company A (on which the insurer holds a bond) from Bank B. Ideally, the insurer would substitute the credit quality of Bank B for the credit quality of Company A in determining its RBC. This assumes that the terms of the CDS afford appropriately afford protection on the bond However, the NAIC formula does not appear to provide this treatment. Need for convergence of economic capital and RBC


Credit Derivative Challenges for U.S Life Insurers

Summary of Needed State Regulatory Improvement
Uniform investment laws - Permitted activities - Numerical limits Address growing uses of credit derivatives RBC

Pricing Credit Default Swaps (CDS)

Assume that a 5-year corporate bond rated BBB2 trades at 200 basis points over the 5-year Treasury. Moodys annual corporate bond default study indicates that the average annual default cost (annualized cumulative default probability times 1 minus recovery rate) is 25 basis points. If the credit default swap cost is around 25 basis points, an investor can buy the bond, purchase a credit default swap, and earn a spread of about 175 bp. The default risk of the bond issuer is replaced by the counter party risk of the protection seller (investment bank), which is probably a much smaller risk. Actually, credit default swap pricing is much different than our above assumption indicates.


Pricing Credit Default Swaps

Hull and White1 describe a process for valuing credit default swaps, assuming no counter party risk: - First, it is assumed that the value of a Treasury Bond (risk-free) exceeds the value of the reference corporate bond solely due to the possibility of defaults. Also, temporarily assume no counter party risk. - Value of Treasury Bond Value of Corporate Bond= Present Value of Cost of Defaults - If the reference issuer has a sufficient range of bond maturities that are actively traded, we can estimate the probability of the issuer defaulting at different future times. - If this is not the case we can use bonds from other issuers that have the same default risk as the reference entity.

Valuing Credit Default Swaps I (2000)

Pricing Credit Default Swaps (Contd)

- Note that default probabilities are risk-neutral, not historical default probabilities. - In order to determine default probabilities, we need to make an assumption about recovery amounts upon default. - Assuming a given difference between the value of a corporate bond and its corresponding maturity Treasury bond, higher recovery amounts imply higher risk-neutral default probabilities. - Inductively, we can calculate the default density at each time interval. - Then, (A) the present value of the expected payoff from the credit default is calculated.


Pricing Credit Default Swaps (Contd)

- Also, (B) the present value of $1per year credit default swap periodic fees (premium) is calculated. - The credit swap premium is the spread that equates (A) and (B).

Example of CDS Pricing, Ashland Inc July 13, 2000

Maturity Actual Bond Yield Spread to Treasuries in bp CDS Spread (Premium) from Hull and White Model 1 5 10 20 199 213 240 269 189 209 227 253


Pricing Credit Default Swaps

Note that the credit default swap premium is close to the actual bond yield spread. If the credit default swap premium is materially higher than the yield spread, the investor would short the corporate bond, sell the credit default swap, and buy the Treasury bond. Conversely, if the credit default swap spread is materially lower than the bond yield spread, the investor would buy the bond, buy the credit default swap, and short the Treasury bond.

Pricing Credit Default Swaps

There are situations in which the CDS spread calculated in the model differs somewhat from the bond yield spread - The Treasury curve is very steep - The bond is trading at a deep discount or premium - Recovery rates are assumed to be well above 50% - Liquidity


Pricing Credit Default Swaps Extension to Multiple Reference Entities

For many CDS applications more than one reference entity will be used. Also, the value of the payoff from the CDS may depend on the distribution of defaults on a pool of, say N, reference bonds. The model we previously discussed can be extended to price a CDS based on a the distribution of default losses for N reference bonds, by constructing correlations of credit indices between each pair of reference bonds.

CDS Pricing Example

Multiple Reference Entities Payoff on First Default Spread in bp*
Number of Reference Entities (all BBB rated) 1 2 5 10 194 386 946 1842 194 351 707 1122 194 289 444 580

Cred index Corr 0 0.4 0.8

5-Year Swap: Recovery Rate: 30%

*Source: Hull and White Valuing Credit Default Swaps II (2001)


Pricing Credit Default Swaps Counter party Risk

CDS Spread in bp* Counterparty Rating AA A AAA Cred index Corr 0 194.3 194.3 194.3 0.4 187.4 185.2 181.3 0.8 177.1 170.5 156.8 5-Year Swap: Recovery Rate: 30% Reference Entity is BBB *Source: Hull and White (2001)

BBB 194.1 174.6 134.1

Current Developments within the Credit Derivative Industry



Other CDS Uses: Informational Clarity

Credit Default Swaps (5 Year Offer Side) Sector Spread Correlations (3 Months) April 30, 2003

Automotive Manufacturers Vehicle Parts Transportation Aerospace/Defense Banks Securities Finance Insurance (Life) Insurance (P&C) General Industrials Chemicals Paper/Forest Products Electric/Other Utilities Oil & Gas Gaming/Lodging/Leisure Info/Data/Elec. Technology Cable/Media & Publishing Telecommunications Retail Stores (Food & Drug) Retail Stores (Other) Tobacco Consumer Products Buildings/Construction REIT Health Care Pharmaceuticals

1 2 3 4 5 6 1 1.00 2 0.97 1.00 3 0.82 0.89 1.00 4 0.97 0.96 0.81 1.00 5 0.76 0.84 0.97 0.73 1.00 6 0.76 0.82 0.93 0.68 0.97 1.00 7 0.81 0.87 0.96 0.76 0.97 0.97 8 0.84 0.75 0.57 0.76 0.56 0.59 9 0.63 0.71 0.93 0.58 0.94 0.91 10 0.59 0.68 0.92 0.55 0.96 0.94 11 0.95 0.95 0.90 0.93 0.84 0.83 12 0.76 0.82 0.93 0.72 0.92 0.91 13 0.43 0.53 0.83 0.37 0.89 0.89 14 0.57 0.68 0.92 0.57 0.92 0.87 15 0.75 0.82 0.87 0.71 0.89 0.89 16 0.57 0.65 0.89 0.50 0.94 0.94 17 0.64 0.70 0.89 0.57 0.94 0.95 18 0.38 0.44 0.76 0.30 0.82 0.83 19 0.65 0.63 0.50 0.63 0.57 0.59 20 0.64 0.71 0.89 0.59 0.94 0.94 21 -0.37 -0.48 -0.69 -0.37 -0.78 -0.76 22 0.86 0.76 0.52 0.85 0.37 0.37 23 0.65 0.75 0.93 0.60 0.96 0.94 24 0.41 0.50 0.80 0.35 0.86 0.86 25 -0.22 -0.13 0.21 -0.15 0.18 0.14 26 0.23 0.34 0.71 0.18 0.77 0.76


















1.00 0.63 0.92 0.92 0.90 0.93 0.84 0.86 0.91 0.93 0.95 0.79 0.60 0.94 -0.74 0.46 0.95 0.83 0.13 0.71

1.00 0.42 0.37 0.77 0.59 0.25 0.30 0.66 0.42 0.52 0.28 0.83 0.56 -0.35 0.78 0.42 0.25 -0.23 0.03

1.00 0.96 0.76 0.94 0.94 0.96 0.87 0.96 0.94 0.87 0.37 0.92 -0.72 0.26 0.98 0.93 0.31 0.86

1.00 0.72 0.88 0.97 0.95 0.82 0.98 0.95 0.92 0.39 0.93 -0.79 0.18 0.97 0.95 0.31 0.91

1.00 0.86 0.57 0.71 0.83 0.72 0.77 0.53 0.61 0.77 -0.52 0.76 0.78 0.57 -0.06 0.40

1.00 0.83 0.88 0.95 0.89 0.90 0.73 0.55 0.92 -0.66 0.44 0.93 0.85 0.24 0.69

1.00 0.93 0.75 0.96 0.91 0.95 0.30 0.90 -0.79 0.01 0.93 0.97 0.42 0.96

1.00 0.79 0.93 0.88 0.85 0.30 0.88 -0.77 0.20 0.94 0.90 0.35 0.87

1.00 0.85 0.87 0.65 0.69 0.91 -0.69 0.41 0.88 0.77 0.13 0.60

1.00 0.98 0.94 0.46 0.97 -0.84 0.15 0.97 0.96 0.33 0.90

1.00 0.91 0.55 0.98 -0.83 0.22 0.96 0.92 0.23 0.82

1.00 0.32 0.88 -0.81 -0.03 0.86 0.94 0.43 0.93

1.00 0.64 -0.59 0.43 0.43 0.34 -0.04 0.13

1.00 -0.87 0.23 0.94 0.92 0.30 0.79

1.00 0.04 -0.77 -0.78 -0.39 -0.76

1.00 0.24 -0.02 -0.34 -0.18

1.00 0.92 1.00 0.25 0.50 1.00 0.84 0.94 0.54 1.00

Correlation is defined as linear correlation between weekly changes of sector default swap spread indices over a 3-month trailing period

Improvements: ISDA/Restructuring

Hard defaults (Enron, WorldCom) have proven viability of settlement mechanisms and functionality of the market

Soft defaults have forced tighter documentation; the definition of Restructuring has been retooled and acceleration has been dropped as a credit event

Restrictions have been placed on the allowable maturity of bonds that can be delivered to protection sellers as the result of a credit event


Improvements: Liquidity

There are now over 500 investment grade names that trade in the CDS market Names are always available, no need to find a willing seller that owns the bonds Higher quality names often trade in 5 basis point bid/ask markets Broad indices are often quoted in 2 basis point bid/ask markets, e.g., 76/78 bps

Improvements: STCDOs

Many dealers now offer Single Tranche CDOs (STCDOs) STCDOs allow investors to select a custom portfolio of credits, and to go long or short exposure to any tranche of the portfolio Investors do not have to wait until other tranches of the CDO are sold Investors can substitute underlying credits and even go long or short credits within the structure


Closing Thoughts

It took until 2001 for the first managed synthetic CDO to be executed Today, you could transact a customized, managed, single tranche CDO that would allow you to go long and short credits within the structure Most insurance company asset portfolios have been built based on the new issue calendar Credit Default Derivatives, and there many extensions have a great deal of applicability for Insurance Companies that are able to analyze and manage credit risk.