Credit Default Swap Info

CBOT Credit Default Swap Index Futures ®

Reference Guide

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Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Contract Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Short Lifespan Rate Up, Price Up Buy Futures ≈ Buy Protection. Sell Futures ≈ Sell Protection.

Key benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Position Scalability Administrative Convenience and Low Operational Cost Transparency High-Grade Credit Exposure Capital Efficiency Off-Exchange Trading

the cdr liquid 50 index: composition and structure . . . . . . . . . . . . . . .

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Index Series and Futures Expiries Selection of Index Components Maximum Running Spread and Other Index Parameters

The CDR liquid 50 index: some Sylized Facts . . . . . . . . . . . . . . . . . . . . .

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Financials: CDR Liquid 50 versus CDX

synthetic corporate bond portfolios . . . . . . . . . . . . . . . . . . . . . . . .

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Long Corporates ≈ Long IRS Futures + Short CDS Index Futures Short Corporates ≈ Short IRS Futures + Long CDS Index Futures

Pricing cds index futures: Spot versus forward . . . . . . . . . . . . . . . . .

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Spot ≈ Forward, Generally Exceptions Depend on the Hazard Rate Rolling Down the Curve

Appendix 1 – CDS Index Futures Contract Specifications . . . . . . . . . . . . . . . . . . .

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Appendix 2 – CDS Index Futures Contract Rules . . . . . . . . . . . . . . . . . . . . . . . . 30 Appendix 3 – CDR Liquid 50 NAIG Index Construction and Maintenance Procedures . . . . . 32 Appendix 4 – CMA and CMA DataVision . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Introduction Since the birth of financial futures, market practitioners have exhorted exchanges to list “corporate bond futures”. What they envision, typically, are contracts that would be traded and transparently priced on a regulated exchange, and that would be guaranteed by a centralized clearing house, and that would (by whatever means) furnish a generic proxy for the price exposure of investment grade corporate bonds. Chicago Board of Trade Credit Default Swap (CDS) Index futures meet this need. •

CDS Index futures give institutional portfolio managers a simple means of acquiring or laying off standardized investment grade corporate bond price exposure.

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For many users, CDS Index futures should result in lower administrative costs relative to over-the-counter (OTC) alternatives.

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As with all CBOT® futures, the guarantee furnished by the Exchange’s clearing services provider consolidates and virtually eliminates counterparty credit risk, permitting contract users to easily adjust their asset exposures without tying up credit lines.

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Used in conjunction with CBOT Interest Rate Swap (IRS) futures, CDS Index futures give market practitioners a simple, flexible means to create and trade synthetic investment grade corporate bond portfolios.

This reference guide reviews the key features and benefits of CDS Index futures. It then discusses the structure of the contract’s underlying reference, the CDR Liquid 50TM North America Investment Grade Index (hereafter, CDR Liquid 50TM) and describes some of the index’s empirical features. It explores in detail how traders and investors can combine CDS Index futures with CBOT 5-Year IRS futures to achieve an operationally clean and flexible proxy for generic investment grade corporate bond exposure. It concludes with a discussion of the relationship between spot values of the CDR Liquid 50 index and the forward values reflected in CDS Index futures prices. Appendices present a summary of the terms of the CDS Index futures contract, the CBOT Rulebook chapter that formally defines the contract, the guide to index construction and maintenance procedures for the CDR Liquid 50 index, and an overview of CMA DataVisionTM, the price data source for the CDR Liquid 50 index.

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Background The dramatic growth of credit default swaps marks one of the great milestones in the saga of financial derivatives. In the short span from year-end 2004 to year-end 2006, outstanding notional amounts of US dollar-denominated credit default swaps burgeoned from around $6.5 trillion to nearly $29 trillion, clocking growth of 110 percent per annum. The share of this total that represents index-related (“multi-name”) credit default swaps has risen yet faster, from 20 percent in 2004 to nearly 35 percent in 2006. See Exhibit 1. This achievement has not come without growing pains. In recent years, regulators have become increasingly troubled by the inability of dealers’ back offices to keep pace with timely capture, confirmation, and booking of credit derivative transactions. Matters came to a head in September 2005, when the Federal Reserve Bank of New York convened the first of a series of meetings with major

derivatives market participants and regulators. The action plan that emerged from these gatherings has accomplished much, including marked reduction in the backlog of outstanding unconfirmed trades, clarification of procedures for trade assignment and novation, and widespread acceptance and adoption of more rigorous protocols for the settlement of credit derivatives when credit events actually occur. (See, e.g., Federal Reserve Bank of New York, “Statement Regarding Progress in Credit Derivatives Markets”, 27 September 2006, www.frb.ny.org.) Despite these efforts – or perhaps because of them – the operational costs of trading and managing OTC credit derivative positions have soared in league with the scale of market activity. This underscores the need for exchange-listed contracts to assist market participants in managing their risk exposures. CBOT CDS Index futures are ideally suited to play this role.

Exhibit 1

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Outstanding Notional Amounts of OTC US Dollar Credit Default Swaps

Total

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Data Source: Bank for International Settlements

10Dollar Trillions US

Multi-Name 0 Dec 04

6

Jun 05

Dec 05

Jun 06

Dec 06

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Contract Features CBOT CDS Index futures expire quarterly, in March, June, September, and December. The last trading day for expiring contracts is the so-called IMM Monday, the Monday before the third Wednesday of the expiry month. The underlying reference for CDS Index futures is the CDR Liquid 50 North America Investment Grade Index, maintained and published daily by Credit Derivatives Research LLC (CDR LLC). The CDR Liquid 50 index is simply an arithmetic average of 5-year credit default swap spreads quoted on each of the 50 most active names in the US investment grade credit default swap market. CDS Index futures are quoted as an average credit spread, directly in terms of the CDR Liquid 50 index, in basis points and hundredths of basis points. Each basis point of contract price is worth $500. Each hundredth of a basis point, the contract’s minimum trading increment, is worth $5. At expiration the CDS Index futures contract settles to the value of the CDR Liquid 50 index on the contract’s last trading day. Importantly, each futures expiry references a distinct index series. This means, for example, that a September CDS Index futures contract will expire with reference to a CDR Liquid 50 index series that may differ in composition from the index series that serves as the underlying reference for the futures contract that expires the following December. (How this relationship works, and why it is so, is explained in detail below. See “The CDR Liquid 50 Index: Composition and Structure” on page 11.)

CDS Index futures expire by cash settlement. There is no physical delivery. CDR LLC will publish the value of the pertinent CDR Liquid 50 index series for the last day of trading, on the next morning. This index value becomes the expiring contract’s final settlement price. The Exchange’s clearing services provider uses this final settlement price to determine a final mark to market (versus the futures contract’s daily settlement price on the last day of trading). Two differences between CDS Index futures and other CBOT financial futures deserve emphasis:

Short Lifespan One is that a CDS Index futures contract has an unusually abbreviated lifespan, roughly three and a half months from listing to expiration. A newly listed contract begins trading on the business day after the CDR Liquid 50 index series that corresponds to it has been constituted and announced. The newly listed contract then coexists with the previously listed contract for approximately two weeks, until the previously listed contract expires. Example: Consider a hypothetical March 2007 CDS Index futures contract. Its underlying reference would be the CDR Liquid 50 index series constituted on the last business day of November 2006 (Thursday, 30 November). The contract would begin trading on the first business day of December 2006 (Friday, 1 December) and would expire on IMM Monday in March 2007 (Monday, 19 March). It would trade alongside the (likewise hypothetical) December 2006 contract from Friday, 1 December, through Monday, 18 December, the last trading

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day in the December 2006 contract. During this time, strategic open interest holders would be able to roll their positions from the December 2006 contract to the March 2007 contract. Among the many considerations they would take into account when pricing the roll spread are the differences in composition, if any, between the two CDR Liquid 50 index series – 064 and 071, respectively -- that correspond to the December 2006 and March 2007 contracts. This listing/expiry timetable strikes a judicious balance between two goals. One is to allow each newly listed CDS Index futures contract to run in tandem with the previously listed contract, long enough to let market participants roll in orderly fashion from one expiry to the next. The other is to permit the CDR Liquid 50 index to do what it is designed to do. The futures contract’s short lifespan enables a comparably short lifespan for the index series that serves as its underlying reference. The single-name credit default swaps selected as index components will have been chosen on the basis of their trading activity. However, one of the realities of both the corporate bond and OTC credit derivatives markets is that liquidity can, and often does, migrate abruptly from one corporate reference to another. In view of this, the brief lifespan of the futures contract and its companion index series is intended to increase the chances that the 50 names in the index series might remain active through contract expiration.

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Rate Up, Price Up The other distinction is that CDS Index futures are priced with direct reference to an interest rate spread – to be precise, a forward-starting credit spread. This means that when credit spreads widen generally, the contract price is likely to rise in value. Conversely, when credit spreads become narrow generally, the contract is likely to fall. This is in contrast to other CBOT financial futures, such as Treasuries, Interest Rate Swaps, or 30-Day Fed Funds. Because those contracts trade in terms of notional asset price, rather than notional interest rate or interest rate spread, their prices tend to fall when interest rates rise, and vice versa. Several examples given below will dramatize the importance of keeping this distinction clear when constructing and trading spreads between CDS Index futures and other CBOT financial futures. (See “Synthetic Corporate Bond Portfolios” on page 17.)

Buy Futures ≈ Buy Protection. Sell Futures ≈ Sell Protection. For those familiar with OTC credit default swaps, a convenient rule of thumb is that owning a long position in CDS Index futures is similar to owning protection. Given a general widening of credit spreads, a CDS Index futures contract price will tend to rise, and contract longs should benefit. If instead there is a general narrowing of credit spreads, then CDS Index futures prices will tend to fall, and contract longs will have to pay variation margin on the ensuing marks to market. Obviously the converse holds too: A seller of CDS Index futures assumes exposure broadly similar to a protection seller’s position in OTC credit default swaps.

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Key Benefits Users of CBOT CDS Index futures gain several important benefits from the contract design.

Position Scalability. CDS Index futures offer a convenient and standardized means to obtain exposure, long or short, to a generic investment grade corporate credit spread, without having to own either an OTC credit default swap or a spread position between, e.g., corporate bonds and plainvanilla interest rate swaps. Unlike OTC credit default swaps, positions in CDS Index futures can be entered or liquidated, scaled up or down, without extensive contractual documentation and without leaving behind a book of non-nettable or non-offsetting OTC swap contracts.

Administrative Convenience and Low Operational Cost. Using CDS Index futures eliminates the administrative (e.g., accounting, manpower, record-keeping) costs frequently required in maintaining a book of OTC credit derivatives. Moreover, cash settlement means there are no trailing contractual obligations after contract expiration. The financial obligations entailed in CDS Index futures expire with the contract, after the final mark to market. For this reason, among others, CDS Index futures make synthetic credit spread exposure readily available to market participants who cannot be, or who would prefer not to be, directly involved in OTC credit derivative transactions.

Transparency. By their nature and structure, futures markets allow participants with differing information sets and outlooks to discover the equilibrium price of the moment. By making price information available for all to see, CDS Index futures furnish a useful reference point – and a daily mark to market – with unmatched transparency.

High Grade Credit Exposure. The credit guarantee of the CBOT clearing services provider makes CDS Index futures comparable to the strongest counterparty credits in the OTC market. Among its many benefits, this obviates the need for entering into potentially cumbersome bilateral collateralization arrangements to alleviate counterparty credit exposure. Capital Efficiency. Besides virtually eliminating credit risk, the clearing house guarantee means that futures position holders need not reserve significant amounts of capital against the risk of adverse moves in credit spreads. That is, by using CDS Index futures portfolio managers and credit spread traders may substitute (inexpensive) risk management for (expensive) capital. Off-Exchange Trading. CDS Index futures are eligible for a wide variety of bilaterally negotiated off-exchange transactions. These include: •

Wholesale trades in which a buyer and seller can bilaterally trade a block of CDS Index futures at a mutually agreeable price, as long as the scale of the block transaction is large enough to qualify. The minimum admissible size for block trades in CDS Index futures is 100 contracts.

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Exchange-for-Physical (EFP) trades in which a buyer acquires CDS Index futures from a seller at a mutually agreeable price. At the same time, the futures buyer sells (and the futures seller buys) an equivalent amount of a credit spread position in cash securities, for which the credit spread dynamics are reasonably correlated with the price dynamics of the CDS Index futures.

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Example: The buyer of CDS Index futures might simultaneously sell a comparably scaled TreasuryAgency spread, by selling 10-year Treasury notes and buying 10-year Agency debentures. The seller of the CDS Index futures would take the other side of the cash transaction as buyer of the 10-year Treasuries and seller of the 10-year Agencies.

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Exchange-for-Swap (EFS) trades, which are similar to EFP trades, except that the buyer of CDS Index futures enters into a comparably scaled OTC credit default swap as the protection seller. Conversely, the seller of the CDS Index futures position takes the other side of the OTC credit default swap, as the protection buyer.

Example: The CDS Index futures buyer might simultaneously sell a comparably sized exposure in the Swap-Corporate yield spread, by buying corporate bonds and taking the fixed-payer side of an OTC plain-vanilla swap. The seller of the CDS Index futures would take the other side of the cash transaction, as the fixed-rate receiver on the plainvanilla interest rate swap and as the seller of the corporate bonds.

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Exchange-for-Risk (EFR) trades, which are similar to EFS trades, except that the buyer of CDS Index futures enters into an OTC option position with a delta that is negatively related to the level of credit default swap spreads. That is, he is either the purchaser of a put on protection or the seller of a call on protection. Conversely, the seller of the CDS Index futures takes the other side of the OTC option transaction: She is either the buyer of a call on protection or the seller of a put on protection. The DV01 of the CDS Index futures position is approximately the same size as the delta of the OTC option position.

The Chicago Board of Trade Rules and Regulations are the authoritative source regarding permissible off-exchange transactions. Regulation 331.05 covers wholesale trades. Regulation 331.08 governs EFP, EFR, and EFS transactions. The Rules and Regulations are found on the CBOT website at www.cbot.com.

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The CDR Liquid 50 Index: Composition and Structure As noted earlier, the underlying reference for CBOT CDS Index futures is the CDR Liquid 50 North America Investment Grade Index, maintained and published by Credit Derivatives Research LLC. In broad overview, the index mechanism is delightfully simple: an arithmetic average of standard 5-year single-name credit default swap spreads, quoted on each of the 50 corporate names represented in the index. Index components are selected on the basis of their credit quality -- all must be issuers of investment grade debt – and on the basis of trading activity in the single-name credit default swaps that reference them.

Index Series and Futures Expiries The CDR Liquid 50 index is reconstituted quarterly, such that each index series corresponds to an individual futures contract expiry. (For details, see Sections 2 and 3 of Appendix 3.) Example: Consider a hypothetical December 2008 CDS Index futures contract. Its underlying reference would be the 084 series of the CDR Liquid 50 index (where 084 refers to the fourth, or December, quarter of 2008). Index components of the 084 series would be chosen and published after close of business on the last business day of August (Friday, 29 August 2008). The next business day (Tuesday, 2 September) would be both the index roll date and the first day of trading in December 2008 futures.

This pairing – December 2008 futures and the 084 index series -- would briefly coexist with the (hypothetical) September 2008 futures and the corresponding 083 index series. Since the last trading day in September 2008 futures would be Monday, 15 September, the overlap would be just under two weeks. The composition of the two index series, 083 and 084, may differ, but this would have no direct bearing upon the expiry value of the September 2008 futures. The underlying reference for that contract would be the 083 index series, and no other. Similarly, the expiry value of December 2008 futures would rely solely upon the 084 index series, and no other.

Selection of Index Components For each new CDR Liquid 50 index series, the 50 components are selected from the universe of standard credit default swap spreads, where “standard” means any on-the-run credit default swap with 5 years to maturity, denominated in US dollars, referencing taxable bonds that are rated BBB/Baa2 or higher and that are issued by a North American corporation. (For details, see Sections 1, 4, and 5 of Appendix 3.)

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Sidenote: The rating standard requirement – Standard & Poor’s BBB and Moody’s Baa2 -- is more stringent than the requirements that apply to many other investment grade credit default swap indexes. For example, to be considered for admission to the well-known CDX.NA.IG (the CDX North America investment grade credit default swap index) a credit default swap may reference securities rated anywhere within the investment grade spectrum. (See “Index Methodology for the CDX Indices”, 22 May 2007, www.markit.com.) This means that a debt issuer rated as low as BBB-/Baa3 might be eligible to become a component of the CDX.NA.IG index, whereas the same debt issuer would be automatically ruled out for inclusion in the CDR Liquid 50 index. The index managers at CDR LLC have incorporated this tighter definition of “investment grade” into their index design in order to lend stability to the index’s composition – i.e., to reduce the rate of turnover among index components -- from one index series to another. The CDR index managers then rank all elements of the universe by trading activity, measured in terms of frequency of actionable bid-offer quotes, during the three months preceding the index roll date. The more quoting activity, the higher the rank. The quote data that CDR LLC employs in determining this ranking are furnished by CMA through its DataVision service. (For a description of CMA DataVision and an overview of its framework for data collection and preparation, see Appendix 4.) Broadly speaking, the 50 highest-ranked elements of the universe become the components of the new index series.

Maximum Running Spread and Other Index Parameters To assemble these components into a new index series, the CDR index managers begin by computing

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index component DV01s. Each index component DV01 is the dollar value of a 1 basis point change in one of the single-name credit default swap spreads serving as an index component, with the notional amount of the credit default swap assumed to be $1. The key inputs in computing this collection of parameters are the levels of credit default swap spreads for each of the 50 index components, and the level of the 5-year plain-vanilla swap rate, at the time the index series is constituted. Using these 50 index component DV01s, CDR LLC will then compute and publish various index parameters: •

the index DV01, the arithmetic average of the 50 index component DV01s. Like the index component DV01s, the index DV01 presumes a $1 notional amount.

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the notional size of the credit default swap exposure embodied in the corresponding CDS Index futures contract. This is equal to the futures contract DV01, always $500 per basis point, divided by the index DV01.

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the standard recovery rate that the index managers will employ in all subsequent index calculations. The standard recovery rate may vary from one CDR Liquid 50 index series to another, depending upon what is deemed to be market convention at the time the index series is constituted. (The recovery rate that market participants regard as customary has varied in recent years between 0.3 and 0.4, i.e., 30 to 40 percent of notional.) Setting the standard recovery rate is left to the sole discretion of CDR LLC. Once the standard recovery rate for an index series has been set, however, it remains fixed for the life of that index series.

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Perhaps most important is the maximum running spread, which functions as an upper bound on the values that index components may take. The maximum running spread is computed as1 Maximum Running Spread = (1 – Standard Recovery Rate) / Index DV01.

For definitions and detailed explanations, see Section 6 of Appendix 3. Imposing the maximum running spread as an upper bound on index inputs might appear to be arbitrary. In fact, it is not. It plays a natural role in ensuring the stability, continuity, and responsiveness of the CDR Liquid 50 index – Stability. Suppose a credit event overtakes, or threatens to overtake, one of the 50 corporate entities in the index. Market quotes on credit default swap spreads referencing that entity are apt to widen, possibly to extreme levels, relative to credit default swap spreads for other index components. Capping the index inputs at the maximum running spread permits the distressed outlier to enter the index, while simultaneously preventing it from exerting undue “outlier” influence upon the index average.

Against this backdrop, the maximum running spread serves as a reasonable place-holder, enabling the index managers to assign plausible values to all index components, and thus to publish a valid and methodologically consistent index value each day, irrespective of discontinuities in market quote traffic. Responsiveness. Imposing a structural limit upon admissible values of index components enables the index to rely solely upon market rates as inputs. Importantly, this means index evaluation requires no arbitrary or ad hoc decisions, or speculation, on the part of the index managers as to whether a credit event may have occurred or might be imminent. Thus, paradoxically, the maximum running spread mechanism makes the CDR Liquid 50 index more directly responsive to market rates, prices, and expectations.

Continuity. Whenever a corporate entity becomes distressed, or threatens to become distressed, liquidity commonly gets patchy in single-name credit default swaps referencing that entity. Conversely, whenever market quote activity dries up in single-name credit default swaps for a given corporate debt issuer, the likeliest explanation is market apprehension that the issuer is under imminent threat of a credit event.

To appreciate the conceptual role of the maximum running spread, readers familiar with credit derivatives will want to recall the iron triangle of credit default swap valuation:

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Hazard Rate = Credit Default Swap Spread / ( 1 – Recovery Rate ) In this framework, the maximum running spread identifies the threshold at which the implied credit event hazard rate equals the basis point value of a $1 change in the value of the index portfolio.

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The CDR Liquid 50 Index: Some Stylized Facts an elaborate dealer polling procedure in the case of CDX.NA.IG – such behavioral differences are unsurprising.

Exhibit 2 shows daily readings of CDR Liquid 50 index series from late March 2006 through early June 2007. It juxtaposes them with daily values for the three coeval series of the CDX.NA.IG, widely acknowledged to be the benchmark in the US credit derivatives index arena.

Exhibits 3 and 4 demonstrate these compositional differences via comparison of on-the-run index series as of June 2007 – specifically the CDR Liquid 50 series 072, and the CDX.NA.IG Series 8 Version 1. At least three features of the comparison are worth pointing out. First, the CDR Liquid 50 index places notably more weight upon the Financial and Communications & Technology sectors. Second, its emphasis upon the liquidity of its index constituents leads it, in this example at least, to concentrate nearly

The two time series plots obviously mimic each other’s broad trends and low frequency swings. Just as clearly, however, they are far from identical. The correlation between their daily changes is a modest 0.67. Given the differences in their index composition procedures – rule-based selection on the basis of trading activity in the case of CDR Liquid 50, versus

CDR 062

CDR 063

CDR 064

CDX 6

CDX 7

CDX 8

CDR 071

Exhibit 2

CDR 072

CDR Liquid 50 and CDX, Daily, 21 March 2006 to 11 June 2007

Index Credit Spread (Bps)

45

Data Sources: CDR LLC, CMA, Markit Group Ltd.

35

Notes: CDX.NA.IG index components are as given by Markit Group Ltd. CDX.NA.IG index values are computed with single-name credit default swap spread data furnished by CMA.

Index Credit Spread (Bps)

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-0 7

-0 7

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pr

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20 -A

Ja n 9-

ov -0 6 -N

ct -0 6 O

06

17 -

pSe

5-

ul -0 6 -J

-0 6

25

13 -J un

ay -0 6 M

15 -

28

9-Jan-07 5-Sep-06 3-Apr-07 25-Jul-06 2-May-06 13-Jun-06 17-Oct-06 20-Feb-07 21-Mar-06 28-Nov-06 15-May-07 2-

21 -

M

ar

-0 6

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all of its sectoral exposure in just four sectors: Consumer Cyclicals and Noncyclicals, in addition to Financials and Communication & Technology. Third, for the same reason, the CDR Liquid 50 index accords relatively little or no weight to Industrials, Materials, Energy, Utilities, and Government (i.e., Fannie Mae and Freddie Mac). 30

Exhibit 3

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Sector Composition as Percent of Index Weight: CDR Liquid 50 versus CDX

CDX CDR Liquid 50

24 22 18

(CDR Liquid 50 Series 072 and CDX.NA.IG Series 8 Version 1, Maturing 20 June 2012)

14

14 12

11 9 6

Data Sources: CDR LLC, Markit Group Ltd

5 2

Financial

Cons Cyclical

Comm + Tech

Cons Noncyclical

2

Industrial

Materials

Utilities

Energy

2

2

Govt

Other

Among sectors that dominate the CDR Liquid 50 index make-up, the degree of overlap with corresponding sectors in the CDX.NA.IG is generally high. For example, as Exhibit 4 shows, of 14 corporate names from the Consumer Cyclicals sector that serve as CDR Liquid 50 index components, 11 also stand as CDX.NA.IG index components. As a general rule, approximately three quarters of each sector’s weight in the CDR Liquid 50 index signifies overlap with the CDX.NA.IG. The one glaring exception is the Financials sector. 15 C DR L iquid 50 NA I G Sector T otals

Exhibit 4

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7 11 Overlap with C DX .NA .I G

Index Overlap Between CDR Liquid 50 and CDX: Numbers of Index Components

CDR Liquid 50 NAIG Index, Series 072: 30 of 50 index components also appear in CDX.NA.IG expiring 20 June 2012

9 5

4

1

1

2

(CDR Liquid 50 Series 072 and CDX.NA.IG Series 8 Version 1, Maturing 20 June 2012)

2

6 17

8 15

11 14

C DX .NA .I G Sector T otals

Data Sources: CDR LLC, Markit Group Ltd

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Industrial Materials

Energy

Govt

Other

Utilities

Govt

Energy

Utilities

Materials

Industrial

Cons Noncyclical

Financial

Comm + Tech

Cons Cynical

Financial

27 Other

Cons Cyclical Comm + Tech Cons Noncyclical

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Financials: CDR Liquid 50 versus CDX The sharp divergence between the two indexes in their emphasis on Financials arises directly from the CDX. NA.IG index constitution procedures. The composition of the CDX indexes is decided collectively by the consortium of 16 credit derivative dealers who support the CDX family. This roster includes ABN AMRO, Bank of America, Barclays Capital, Bear Stearns, BNP Paribas, Citigroup, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. (Source: Markit Ltd.) Not only do these dealers decide CDX index composition, they also serve as the main price-makers and liquidity-providers for the vast OTC derivatives market that has grown up around the CDX indexes. Potential conflict of interest considerations dictate that no consortium member should be eligible for inclusion as a CDX index component. Because the consortium membership encompasses most of the leading issuers of investment grade US financial corporate debt, this means the CDX.NA.IG index is thus structurally tilted toward under-representation of Financials. Lehman US Corporate

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CDR Liquid 50

The CDR Liquid 50 index is not so encumbered, because its composition, maintenance, and data sourcing are performed by neutral parties (namely CDR LLC and CMA). Insofar as its representation of the Financials sector is unconstrained, the CDR Liquid 50 makes a potentially closer match for the sector mix held by many corporate bond portfolio managers. Exhibit 5 suggests as much, via comparison of the CDR Liquid 50 and CDX.NA.IG indexes with the Lehman Brothers US Corporate Index. Sidenote: A popular proverb in market folklore holds that, for any index of credit default swap spreads, the more weight the index accords to Financials, the less volatile the index should be. The time series data portrayed in Exhibit 2, however, reveal just the opposite: The median of absolute values of daily changes in the CDR Liquid 50 index is 0.44 basis points versus 0.38 basis points for the CDX.NA.IG index.

CDX

Exhibit 5 Sector Composition as Percent of Index Weight: Lehman Brothers US Corp, CDR Liquid 50, and CDX

74

47

(Lehman Brothers US Corporate Index, 31 Dec 2006, CDR Liquid 50 Series 072, and CDX.NA.IG Series 8 Version 1)

43 30 18 10

Industrials

16

Financial

Utilities

6

2 Govt

Data Sources: CDR LLC, Lehman Brothers Inc, Markit Group Ltd

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Synthetic Corporate Bond Portfolios By combining appropriate numbers of CBOT CDS Index futures with CBOT 5-Year IRS futures, an investor or trader can assemble a futures position that mimics the price exposure of a generic portfolio of liquid investment grade US corporate bonds. This synthetic portfolio is both simple and flexible in terms of the mechanics of futures position management and pricing. The two component contracts cease trading on the same day and at the same time. Both contracts expire by cash settlement. At contract expiry, the underlying references for both contracts signify maturity exposure of 5 years. Moreover, toggling back and forth between contract price exposure and implied yield exposure is unusually straightforward. The 5-Year IRS futures contract is designed so that there is a one-to-one mapping from its price to the implied forward-starting plain-vanilla swap rate2. CDS Index futures are priced with direct reference to a forward-starting market-average 5-year credit default swap spread, quoted as a yield spread versus the 5-year plain-vanilla swap rate. Thus, the implied forward-starting yield for the synthetic portfolio is the sum of (a) the implied yield for 5-Year IRS futures and (b) the CDS Index futures price. Exhibit 6 shows the resultant implied corporate bond portfolio yields, daily from late March 2006 to early June 2007, and how they compare with the Moody’s Aaa Industrial/Utility average and the Moody’s Baa average. CBOT Synthetic Corporate

M oody's Aaa Ind&Utility

M oody's Baa

CBOT Synthetic Corporate Bond Yields vs Moody’s Aaa Industrial/Utility and Baa Averages (CBOT synthetic corporate bond yield equals (a) the forward-starting swap rate implied by the nearby 5-Year IRS futures price plus (b) the average credit spread reflected in the CDR Liquid 50 index.)

6 Yield (Percent)

15-May-07

3-Apr-07

20-Feb-07

9-Jan-07

28-Nov-06

17-Oct-06

5-Sep-06

25-Jul-06

13-Jun-06

2-May06

5 21-Mar-06

Yield (Percent)

7

9-Jan-07 5-Sep-06 3-Apr-07 25-Jul-06 2-May-06 13-Jun-06 17-Oct-06 20-Feb-07 21-Mar-06 28-Nov-06 15-May-07

2

Exhibit 6

Data Sources: Board of Governors of the Federal Reserve System, CBOT, CDR LLC

Translation from price to yield in CBOT IRS futures is facilitated by lookup tables furnished by the Exchange at www.cbot.com/swaps.

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As the scatter plots in Exhibit 7 suggest, daily changes in the CBOT synthetic corporate bond yield are reasonably well correlated with these market averages: 0.87 for the Moody’s Aaa Industrial/Utility, 0.89 for the Moody’s Baa. By no means is either a perfect fit. But given the absence of any other exchange-listed contract or contract spread that might be remotely suitable for hedging or replicating corporate bond exposure, the CBOT synthetic portfolio makes an attractive and useful addition to any credit product trader’s risk-management toolkit.

Daily Changes in Moody’s Bond Yields (Bps)

20 Exhibit 7

15

5

Daily Yield Changes: CBOT Synthetic Corporate Bond Portfolio, Moody’s Aaa Industrial/Utility, and Moody’s Baa

0

(21 March 2006 to 11 June 2007)

Baa Corr = 0.89 Aaa Corr = 0.87

10

-5

Data Sources: Board of Governors of the Federal Reserve System, CBOT, CDR LLC

-10 -15 Daily Changes in Moody's Bond Yields (Bps) -20 -20

-15

-10

-5

0

5

10

Daily Changes in CBOT Synthetic Bond Yield (Bps)

18

15

20

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Long Corporates ≈ Long IRS Futures + Short CDS Index Futures A few examples should make this concrete. To begin, consider a portfolio manager who anticipates buying $1 billion of 5-year Aaa corporate bonds. Between now and when she actually acquires the bonds, she faces two primary sources of yield risk: changes in the 5-year benchmark yield (here, the 5-year plain-vanilla swap rate) and changes in the corporate credit spread, the spread between the 5-year benchmark yield and 5-year corporate bond yields. To manage this exposure, she creates a synthetic place-holder portfolio by combining CBOT CDS Index futures and 5-Year IRS futures. Properly structured, this should serve adequately both as an anticipatory hedge and as a means of avoiding cash drag on the portfolio’s returns. If market conditions are as shown in Exhibit 8, then the appropriate DV01-weighted hedge should consist of two components: Long 9,798 5-Year IRS futures = $430,897/($43.98 per contract) Short 862 CDS Index futures = $430,897/($500 per contract) Exhibit 8 Market Conditions on Day 1 Price Yield DV01 5-Year Aaa Corporate Bonds

$1 billion (par)

5.60

$430,897

CBOT 5-Year IRS Futures

102-19/32nds

5.401

$43.98/contract

CBOT CDS Index Futures

36.00 bps

0.36

$500/contract

Note that the long position in the synthetic portfolio comprises a long position in IRS futures (which references a notional asset price) and a short position in CDS Index futures (which references a notional interest rate spread). Now suppose market interest rates fall 50 bps, with credit spreads holding steady. Exhibit 9 summarizes the change in market conditions. Exhibit 9 Change in Market Conditions from Day 1 to Day 2

Day 1

Day 2

Price Yield Price Yield

Price Change ($)

5-Year Aaa Corporates

$1 billion (par)

5.60

$1,021,823,737

5.10

21,823,737

Long 9,798 5-Year IRS Futures

102-19/32nds

5.401

104-26.5/32nds

4.901

21,892,406

36.00 bps

0.36

36.00 bps

0.36

Zero

Short 862 CDS Index Futures

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Bonds that would have cost $1 billion to purchase at par previously are now $21.8 million more expensive. The anticipatory hedge has generated sufficient proceeds, however, for the portfolio manager to keep up with market valuations. Specifically, the 50 bps drop in yields translates into a jump of 2 points and 7.5/32nds in the price of 5-Year IRS futures. The corresponding mark to market on that portion of the hedge structure is: $21,892,406.25 = 71.5/32nds x $31.25 per 32nd per contract x 9,798 contracts Now, suppose instead that benchmark market rates hold steady, but that investment grade corporate credit spreads narrow by 5 bps. Exhibit 10 details the change in market conditions. Exhibit 10 Change in Market Conditions from Day 1 to Day 2

Day 1

Day 2

Price Yield Price Yield

Price Change ($)

5-Year Aaa Corporates

$1 billion (par)

5.60

$1,002,157,249

5.55

2,157,249

Long 9,798 5-Year IRS Futures

102-19/32nds

5.40

102-19/32nds

5.40

Zero

36.00 bps

0.36

36.00 bps

0.31

2,155,000

Short 862 CDS Index Futures

As before, the rise in bond prices might compel the portfolio manager to chase after the market. Without the protection afforded by her anticipatory hedge structure, she would find herself paying nearly $2.2 million more for the same bonds today than she would have paid previously. However, the “protection seller” exposure to corporate credit spreads that she established by selling CDS Index futures keeps her overall portfolio in synch with market conditions. The mark to market on the CDS Index futures component of her hedge structure comes reasonably close to matching the move in bond prices:

20

$2,155,000 = -5 bps x $500 per bp per contract x -862 contracts

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Short Corporates ≈ Short IRS Futures + Long CDS Index Futures The same strategy applies to more elaborate hedge structures. Thus, consider another portfolio manager who intends to sell $1 billion of 8-year Baa corporate bonds. Rather than exiting the position abruptly, he decides to hedge his exposure by selling a synthetic corporate bond portfolio consisting of CBOT futures. Exhibit 11 Market Conditions on Day 1 Price Yield DV01 8-Year Aaa Corporate Bonds

$1 billion (par)

6.50

$616,218

CBOT 5-Year IRS Futures

102-19/32nds

5.401

$43.98/contract

CBOT 10-Year IRS Futures

103-24.5/32nds

5.505

$77.88/contract

36.00 bps

0.36

$500/contract

CBOT CDS Index Futures

Assume market conditions are as in Exhibit 11. Because the portfolio manager is concerned about adverse portfolio impacts from both increases in the outright level of benchmark yields and changes in the slope of the yield curve, he decides to combine a short position in an IRS futures barbell with a long “protection buyer” position in CDS Index futures. Using conventional DV01 weights to set the wings of his IRS futures barbell3, he determines that the benchmark yield component of his hedge structure should consist of 48 percent 5-Year IRS futures and 52 percent 10-Year IRS futures. Thus his hedge structure is: Short 6,720 5-Year IRS futures Short 4,118 10-Year IRS futures Long 1,232 CDS Index futures = $616,218/($500 per contract) As before, note the mix of long and short contract positions: The short synthetic portfolio comprises a short position in the IRS futures barbell and a long position in CDS Index futures. Now, suppose a sudden burst of buoyant economic conditions pushes the yield curve into inversion, with rising short- and intermediate-term yields pivoting around unchanged long-term yields: 5-year swap rates increase 40 bps, 8-year swap rates gain 16 bps, and 10-year swap rates hold steady. Suppose moreover that corporate credit spreads across the curve narrow by 5 basis points. The combined impact is an 11 bps rise in 8-year corporate yields (16 bps increase in benchmark 8-year yields, minus 5 bps decline in credit spreads). Exhibit 12 summarizes. Let D10, D5, and D, respectively, represent DV01s for a 10-Year IRS futures contract, a 5-Year IRS futures contract, and $100,000 face value of the cash 8-year corporate bonds, and note that a $1 billion par position in corporate bonds contains 10,000 units of $100,000 par value. Then the 5-Year IRS futures wing of the butterfly is computed as

3

10,000 x (D/D5) x (D10 – D)/(D10 – D5) The (D10 – D)/(D10 – D5) term, which plays the principal role in shaping the wing, takes the value of 0.48 in the example above. Similarly, the 10-Year IRS futures wing of the butterfly is equal to 10,000 x (D/D10) x (D – D5)/(D10 – D5) The (D – D5)/(D10 – D5) term, which shapes this wing, equals 0.52 in the example above.

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Exhibit 12 Change in Market Conditions from Day 1 to Day 2

Day 1

Day 2

Price Yield Price Yield 8-Year Baa Corporates

$1 billion (par)

6.50

$993,249,765

6.61

-6,750,235

Short 6,720 5-Year IRS Futures

102-19/32nds

5.401

100-27.5/32nds

5.801

11,655,000

Short 4,118 10-Year IRS Futures 103-24.5/32nds 5.505

103-24.5/32nds

5.505

Zero

31.00 bps

0.31

-3,080,000

Long 1,232 CDS Index Futures

36.00 bps

0.36

Hedge Total

The updraft in short- and intermediate-term yields hands the portfolio manager a $6.8 million loss on his core bond position. Fortunately, the hedge affords more than enough protection, generating proceeds of nearly $8.6 million, for a net gain of $1.8 million. Three remarks warrant mention. The first is simply to note the relative accuracy that the portfolio manager achieves by using an IRS futures barbell to hedge his benchmark interest rate exposure. If instead he had used a DV01-equivalent number of 10-Year IRS futures alone (7,912 contracts in this case), he would have found himself underhedged and consequently nursing a $9.8 million net loss (comprising the $6.75 million loss on the core bond position and the $3.1 million margin payout on the CDS Index futures position). Had he used a DV01-equivalent number of 5-Year IRS futures alone (here, 14,011 contracts), he would have been lavishly overhedged. Gains on his hedge position would have exceeded triple the loss on his core bond position ($21.2 million, comprising $24.3 million margin collects on 5-Year IRS futures, less $3.08 million in margin pays on CDS Index futures). That’s a gratifying outcome, at least in this case, but any market practitioner who takes risk management

22

Price Change ($)

8,575,000

seriously would warn that such an imbalanced hedge (in essence, the yield curve exposure between 5-year and 8-year swap rates) might just as easily hurt you as help you. Second, the CDS Index futures hedge ratios in the examples above are set on the rudimentary assumption that the credit spread exposure in the hedge target and the CDS Index futures price move in lockstep, basis point for basis point. Generally, this presumption would be unrealistic. A more refined approach might incorporate the credit spread analogue to stock index betas. That is, in setting the credit spread component of the hedge structure, the portfolio manager might take explicit account of systematic differences in volatility between the CDS Index futures contract price and the hedge target’s credit spread. Third, at first blush, the sizes of the futures transactions in the examples above may appear imprudently large. In fact, given that both IRS futures and CDS Index futures are eligible for a wide array of bilaterally negotiated off-exchange trades, including block trades, such magnitudes are neither unrealistic nor infeasible. (See “Off-Exchange Trading” on pages 9 and 10.)

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Pricing CDS Index Futures: Spot versus Forward Each day CDR LLC publishes the spot value of the CDR Liquid 50 index. As noted earlier, this is the average of on-the-run 5-year single-name credit default swap spreads quoted that day, for spot settlement, for each of the 50 index components. In contrast, the index value reflected in the price of the companion CBOT CDS Index contract is a forward value, the market expectation of the pertinent CDR Liquid 50 index series on the contract’s last day of trading.

Spot ≈ Forward, Generally As with any other pair of spot and forward market rates or prices, these two will seldom be identical, except when the futures contract expires. In practice, however, the difference between spot and forward typically will be negligible. To make this clear, consider the three primary linkages in the pricing of a credit default swap: •

•

The recovery rate, the percentage of face value that a bond holder would expect to recover from the bond issuer in the event that the issuer defaults, enters bankruptcy, or suffers some other credit event that impairs timely payments to his debt holders. The hazard rate (or, when cumulated, the survival function) which determines the probability per unit of time that the bond issuer will suffer a credit event.

•

The credit default spread – essentially the price of the credit default swap itself -- which dictates the amount, measured in basis points per annum, that the protection buyer pays to the protection seller to guarantee coverage of the portion of asset exposure not covered by the recovery rate.

In a world where the yield curve is flat and the hazard rate is constant, these three elements form the wellknown iron triangle of credit default swap pricing: Credit Default Spread = (1 – Recovery Rate) x Hazard Rate Example: Assume the representative “average” member of the CDR Liquid 50 index features a credit default swap spread of 39 basis points. Assume as well a standard recovery rate of 40 percent and a hazard rate of 0.65 percent per year. Then the iron triangle takes shape as: 39 bps = 0.0039 percent = ( 1 - 0.40 ) x 0.0065 Given the assumptions underpinning the iron triangle – flat yield curve and flat survival function -- spot and forward-starting credit default swap spreads should be identical. More generally, even though yield curves are seldom flat, and the hazard rate is seldom constant, spot and forward-starting credit spread values will tend to be quite close, if not indistinguishable.

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Exceptions Depend on the Hazard Rate On those occasions when spot and forward do deviate significantly, the most likely cause is apt to be a nonconstant hazard rate. To see this, consider the pricing of 5-year protection on the CDR Liquid 50 index portfolio, and assume the following hypothetical market conditions – •

Arbitrarily, “today” is 18 June 2003.

•

Spot rates quoted “today” are for T+2 settlement on 20 June 2003. (In fact, this signifies standard settlement for interest rate swaps, but “skip day” settlement for credit default swaps.)

•

The LIBOR/plain-vanilla interest rate swap curve is flat at 5 percent

•

The assumed standard recovery rate is 40 percent.

•

For spot settlement, market participants value protection on the CDR Liquid 50 index portfolio at 100 bps per annum.

If the hazard rate were constant, then given these market conditions, the iron triangle would imply a hazard rate of 1.666 percent for the representative “average” member of the index portfolio: 100 bps = 0.01 percent = ( 1 - 0.40 ) x 0.01666 Assume instead that market participants believe (a) that the average hazard rate will be zero over the coming year -- reflecting perhaps the very strong presumption of a benign credit environment -- and (b) that the hazard rate will run thereafter at a constant 2.156 percent per annum. The two far left-hand columns of Exhibit 13 summarize this set-up. The two main panels Exhibit 13 illustrate, on the left, the valuation of a hypothetical 5-year credit default swap for spot settlement on 20 June 2003 and, on the right, the valuation of forward-starting 5-year credit default swap that is constructed to mimic a hypothetical September 2003 CDS Index futures contract. The settlement date for this hypothetical forward-starting swap is IMM Wednesday, 17 September 2003. Valuation is elementary and, to market practitioners active in credit derivatives, quite familiar. The present value of the swap’s premium leg (the stream of fixed protection payments weighted by the cumulative probability that there is no credit event) must equal the present value of the swap’s recovery leg (the probability that the protection seller will be obliged to pay the protection buyer if a credit event occurs): Protection Leg Recovery Leg Spread x ∑ [ai x zi x (1-pi)] = (1 – Recovery) x ∑ [zi x (pi -pi-1)]

24

right

“Spread” is the credit default swap spread, in interest rate percentage points per annum “Recovery” is the recovery rate, assumed to be 40 percent, or 0.40 ai are daycount terms. Any ai represents the interval from payment date i-1 to payment date i, measured in actual/360 terms, and it determines exactly how the credit default swap spread is apportioned to quarterly protection payments. zi are present value discount factors, bootstrapped from the plain-vanilla interest rate swap curve. Note that in the left-hand panel of the table, these are spot discount factors, denoting present value as of the spot settlement date (20 June 2003) of one dollar on date i. In the right-hand panel, they are forward discount factors, giving the arbitrage-free present value as of the forward settlement date (17 September 2003) of one dollar on date i. pi represent the survival function. Each pi signifies the probability that a credit event occurs prior to date i. Exhibit 13 Spot versus Futures-Equivalent Forward Settlement: How the Hazard Function Matters Spot Settlement on 20 Jun 2003 Forward Settlement on 17 Sep 2003 Premium Leg Protection Leg Premium Leg Protection Leg Date p

Spot a

Spot Spread 100 bps

Recovery Rate 0.4

Spot z a *z*(1-pi) (1-0.4)*z*(pi - pi-1)

Spot Spread 107 bps

Forward Forward a z a *z*(1-pi)

Recovery Rate 0.4

(1-0.4)*z*(pi - pi-1)

20-Jun-03 17-Sep-03 0.9878 22-Sep-03 0.0000 0.26 0.9871 0.2577 0.0000 0.01 0.9993 0.0139 0.0000 22-Dec-03 0.0000 0.25 0.9749 0.2464 0.0000 0.25 0.9870 0.2495 0.0000 22-Mar-04 0.0000 0.25 0.9631 0.2434 0.0000 0.25 0.9750 0.2465 0.0000 21-Jun-04 0.0000 0.25 0.9517 0.2406 0.0000 0.25 0.9635 0.2435 0.0000 20-Sep-04 0.0054 0.25 0.9401 0.2363 0.0031 0.25 0.9517 0.2393 0.0031 20-Dec-04 0.0108 0.25 0.9286 0.2322 0.0030 0.25 0.9401 0.2351 0.0030 21-Mar-05 0.0162 0.25 0.9172 0.2281 0.0030 0.25 0.9286 0.2309 0.0030 20-Jun-05 0.0216 0.25 0.9060 0.2241 0.0029 0.25 0.9172 0.2268 0.0029 20-Sep-05 0.0269 0.26 0.8948 0.2225 0.0029 0.26 0.9058 0.2253 0.0029 20-Dec-05 0.0322 0.25 0.8839 0.2162 0.0028 0.25 0.8948 0.2189 0.0028 20-Mar-06 0.0374 0.25 0.8731 0.2101 0.0027 0.25 0.8839 0.2127 0.0028 20-Jun-06 0.0427 0.26 0.8623 0.2110 0.0027 0.26 0.8730 0.2136 0.0028 20-Sep-06 0.0480 0.26 0.8517 0.2072 0.0027 0.26 0.8622 0.2098 0.0027 20-Dec-06 0.0531 0.25 0.8413 0.2014 0.0026 0.25 0.8517 0.2038 0.0026 20-Mar-07 0.0582 0.25 0.8311 0.1957 0.0025 0.25 0.8413 0.1981 0.0026 20-Jun-07 0.0634 0.26 0.8208 0.1964 0.0025 0.26 0.8309 0.1989 0.0026 20-Sep-07 0.0686 0.26 0.8106 0.1930 0.0025 0.26 0.8206 0.1953 0.0025 20-Dec-07 0.0736 0.25 0.8007 0.1875 0.0024 0.25 0.8106 0.1898 0.0025 20-Mar-08 0.0786 0.25 0.7910 0.1842 0.0024 0.25 0.8007 0.1865 0.0024 20-Jun-08 0.0837 0.26 0.7812 0.1829 0.0024 0.26 0.7909 0.1852 0.0024 22-Sep-08 0.0888 0.26 0.7809 0.1858 0.0024

25

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If one knew everything about the market landscape except the credit default spread itself, one could then use the framework above to solve for it4: Spread = { (1 – Recovery) x ∑ [zi x (pi -pi-1)] } ∑ [ai x zi x (1-pi)] Exhibit 13 does precisely this. That is, to get the credit default swap spread for spot settlement, in the lefthand panel of table one would divide the sum of the Protection Leg column by the sum of the Premium Leg column. Similarly, to obtain the forward-starting credit default swap spread, in the right-hand panel one would divide the sum of the Protection Leg column by the sum of the Premium Leg column. Unlike the spot spread, which is fairly valued at 100 bps, the forward-starting spread is fairly valued at 107 bps. Intuitively, this is because the level of credit event insurance furnished by the forward-starting swap is greater than the coverage provided by the spot swap: •

•

Given the survival function’s shape, the 5-year interval spanned by the spot credit default swap comprises relatively more moments when the probability of a credit event is presumed to be zero. Conversely, the 5-year interval spanned by the forward-starting credit default swap comprises relatively more moments when credit events might occur.

In short, the shape of the hazard rate function in this example dictates that the spread for the forward-

starting credit default swap should have higher fair value than for the spot swap. With the passage of time, the two must converge, so that on 15 September 2003 they will be identical. That is, given our maintained assumption of a T+2 timetable for spot settlement, both the forward-starting swap and a spot swap quoted on Monday, 15 September, would be intended for settlement on Wednesday, 17 September5. Moreover, if the other assumptions above regarding market conditions were to remain static, then convergence would be achieved through a gradual increase in the spot spread, until it reaches 107 bps on Monday, 15 September.

Rolling Down the Curve On occasion, market practitioners may observe discontinuities in the time series plots of spot values for individual CDR Liquid 50 index series. Such discontinuities, when they occur, are apt to coincide with the standard quarterly payment dates in the OTC single-name credit default swap market (i.e., on or just after the 20th of March, June, September, and December). Example: Consider the hypothetical credit default swap sketched in the main left-hand panel of Exhibit 13. It corresponds to the hypothetical 032 series of the CDR Liquid 50 index, which would have been constituted on Friday, 28 February 2003. (The equally hypothetical companion CDS Index futures would have been the June 2003 contract, listed for trading on Monday, 3 March 2003.) Between 3 March and 18 March, the on-the-run credit default swap spreads that CDR LLC uses

Students of the credit derivatives market will recognize that this computation incorporates not merely the assumption of a flat hazard rate function, but also the assumption of a stationary copula scheme governing the manner in which credit events occurring among the 50 index components might, or might not, occur in bunches.

4

This clarifies precisely how the forward-starting swap “corresponds” to the hypothetical September 2003 CDS Index futures contract: Monday, 15 September, would also be the last day of trading in futures.

5

26

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to evaluate the index would be quoted for spot settlement, with 5-year term to maturity extending to 20 March 2008. That is, the index’s inputs would be swap spreads with terms to maturity that are actually close to 5 years. By contrast, from 19 March through 16 June 2003 (the last day of trading in the June 2003 futures), CDR LLC would evaluate the index components with quotes for on-the-run spot-settled credit default swaps that mature on 20 June 2008. Note that, at the outset of this interval, the index’s inputs abruptly become swap spreads with terms to maturity of approximately 5.25 years. Now suppose the hazard rate function is not constant. That is, suppose the survival function is either upward sloping or downward sloping. The switch in data for index evaluation that occurs on 19 March -- from on-the-run quotes with 5 years to maturity, to on-the-run quotes with 5.25 year to maturity – may produce a corresponding break in the time series of spot index values. Whether the break is up or down, large or small, will depend upon the slope and pitch of the term structure of the survival function. Users of CDS Index futures may note with relief that there should be no such valuation “notch” in the daily progression of futures prices, because fair valuation of the futures contract is independent of the mechanics of spot index valuation. Thus, in the example above, market participants would assess fair value in June 2003 CDS Index futures on the presumption that, at contract expiry, the underlying CDR Liquid 50 index would be evaluated with market quote data for credit default swaps that mature in June 2008. Moreover, they would knowingly entertain this presumption throughout the entire interval from first day of trading in June 2003 futures until contract expiration.

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28

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Appendix 1 CDS Index Futures Contract Specifications Underlying

The corresponding series of the CDR Liquid 50TM North American Investment Grade Index

Index Methodology

Average of the five-year single-name credit default swap spreads of the 50 most actively traded corporate names in the North American investment grade credit default swap market. Initially all index components are equally weighted (i.e., 2 percent index weight per component).

Contract Multiplier

$500 per one basis point

Contract Value

The index value in basis points multiplied by the contract multiplier

Price Quotation



The index value in basis points and hundredths (1/100) of basis points. For example, a futures price quotation of 38.10 implies an index value of 38.10 basis points.

Minimum Trading Increment

1 tick = 0.01 basis points = $5

Expiration Months

Generally, the nearest month in the March-June-September-December quarterly cycle

Last Trading Day

The IMM Monday of the contract expiration month (i.e., the second London business day preceding the third Wednesday of the contract expiration month)

Final Settlement Day The business day following the last trading day. Final Settlement Price

The index value, measured in basis points and hundredths (1/100) of basis points, evaluated with single-name credit default swap spread quotes, as of close of business on the last trading day, as furnished by CMA through CMA DataVisionTM

Settlement

Cash settlement based on the final settlement price

Trading Hours

6:02 pm to 4 pm Chicago time, Sunday through Friday

Wholesale Trading Ticker Symbol

Minimum wholesale transaction is 100 contracts. Permissible hours for wholesale transactions are 7 am to 4 pm Chicago time, Monday through Friday. Consult www.cbot.com for wholesale trading procedures. CX

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Appendix 2 CDS Index Futures Rules For the current and authoritative version of the CBOT Rulebook, visit the CBOT website at www.cbot.com

The designated index provider shall constitute and maintain a distinct CRI for each distinct CDS Index futures contract month.

Chapter 61 Credit Default Swap Index Futures

CRI shall be an arithmetic average of interest rate credit default spreads, as reflected in prices of overthe-counter credit default swap contracts with five (5) years to expiry as of the CDS Index futures contract’s last day of trading. Each interest rate credit default swap spread that serves as a CRI component shall reference senior, unsecured, taxable, investment grade debt securities that are denominated in US dollars and that are issued by a firm domiciled in the US.

Ch61 Trading Conditions 6101.01 Authority - Trading in Credit Default Swap Index futures may be conducted under such terms and conditions as may be prescribed by regulation. 6102.01 Application of Regulations - Credit Default Swap Index futures shall be referenced hereafter as CDS Index futures. Transactions in CDS Index futures shall be subject to the general rules of the Exchange as far as applicable and shall also be subject to the regulations contained in this chapter, which are exclusively applicable to trading in CDS Index futures. CDS Index futures are listed for trading by the Exchange pursuant to Commodity Futures Trading Commission exchange certification procedures. 6104.01 Unit of Trading - The unit of trading shall be the Contract Reference Index. The Contract Reference Index shall be referenced hereafter as CRI. CRI shall be constituted and maintained by the Exchange’s designated index provider.

30

6105.01 Months Traded In - Trading in CDS Index futures may be scheduled in such months as determined by the Exchange. 6106.01 Price Basis - The price of CDS Index futures contracts shall be quoted in interest rate basis points and hundredths (1/100) of basis points. One basis point shall equal $500. The minimum price fluctuation shall be one one-hundredth (1/100) of one basis point ($5 per contract). Contracts shall not be made on any other price basis.

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6107.01 Hours of Trading - The hours of trading in CDS Index futures shall be determined by the Exchange. Trading in an expiring CDS Index futures contract shall cease at 4:00 pm Chicago time on the last day of trading in said futures contract. 6109.01 Last Day of Trading - The last day of trading day in a CDS Index futures contract shall be the second London business day before the third Wednesday of the contract’s delivery month. 6109.02 Liquidation During the Delivery Month - After trading has ceased in expiring contracts (in accordance with Regulation 6109.01 of this chapter), outstanding contracts shall be liquidated by cash settlement as prescribed in Regulation 6142.01.

6142.01 Delivery on Futures Contracts - Delivery against expiring CDS Index futures shall be made by cash settlement through the Clearing Services Provider following normal variation margin procedures. The final settlement price shall be $500 times the final settlement value of the CRI for the Last Day of Trading, as furnished by the Exchange’s designated index provider. The final settlement price for an expiring CDS Index futures contract shall be determined on the business day following the Last Day of Trading. For exceptions to this schedule, see Regulation 6136.01. 6147.01 Payment - (See Regulation 1049.04.)

6110.01 Margin Requirements - (See Regulation 431.03.) 6112.01 Position Limits and Reportable Positions - (See Regulation 425.01 and Appendix 4C.)

Ch61 Delivery Procedures 6136.01 Standards - The contract grade shall be the final settlement value of the Unit of Trading (as defined in Regulation 6104.01) for the Last Day of Trading (as defined in Regulation 6109.01), as determined and furnished to the Exchange by the Exchange’s designated index provider. The value of the CRI shall be represented in interest rate basis points and hundredths (1/100) of basis points. If the Exchange’s designated index provider fails to report a value for the CRI for the Last Day of Trading, then the contract final settlement price shall be based upon the value of the CRI for the first preceding US business day for which a value has been reported by the Exchange’s designated index provider.

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Appendix 3 PROPRIETARY INFORMATION OF CREDIT DERIVATIVES RESEARCH LLC. REPRODUCTION WITHOUT EXPRESS WRITTEN CONSENT OF CREDIT DERIVATIVES RESEARCH LLC IS PROHIBITED.

CDR Liquid 50 NAIG Index Construction and Maintenance Procedures TM

The CDR Liquid 50 North America Investment Grade Index (“the Index”) is an arithmetic average of 5-year credit default swap (CDS) spreads for the 50 most actively traded names in the North American CDS market.

1.

1.1

CDS reference securities: Taxable bond issues of North American corporations

1.2

Priority of CDS reference securities: Senior, unsecured

1.3

Maturity of CDS contracts: Five years

1.4

Type of restructuring of CDS contracts: Modified restructuring

1.5

Currency denomination of CDS contracts: US dollar

2.

Index Roll Dates First business day of March, June, September, or December

Eligibility Evaluation Period: The three-month interval immediately preceding the Roll Date.

4.2

Data Universe: Actionable bid-offers on fiveyear CDS spreads delivered by dealers directly to their customers or to inter-dealer brokers during the Eligibility Evaluation Period.

4.3

Credit Rating Filter: Reference securities must be rated BBB/Baa2 or higher by two of the three primary US Nationally Recognized Statistical Rating Organizations throughout the Eligibility Evaluation Period.

5. Selection of Index Components The following procedure will govern the selection of Index Components for any reconstitution of the Index. 5.1

Names that satisfy the Eligibility Criteria for Index Components, given in Section 4, will form the pool of eligible names (the “eligible pool”).

5.2

For each business day during the Eligibility Evaluation Period (4.1), for each eligible name, compute the number of actionable bid-offer quotes (4.2).

5.3

For each business day during the Eligibility Evaluation Period (4.1), rank all eligible names in descending order according to each name’s number of actionable bid-offer quotes (5.2).

Index Roll Procedures The Index will be reconstituted each quarter. The components of each new constitution of the Index, as well as various Index characteristics (6.1), will be publicly announced following close of business on the business day preceding the Roll Date (i.e., on the last business day of the month preceding the month of the Roll Date).

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4.1

Index Components Index components are based upon CDS spreads with the following characteristics --

3.

4. Eligibility Criteria for Index Components

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5.4

Compute the top-50 count for each eligible name. For any eligible name, the top-50 count is defined as the number of days during the Eligibility Evaluation Period (4.1) on which that name appears among the 50 highest-ranked eligible names, as determined in 5.3.

5.5

Rank all eligible names in descending order according to their top-50 counts (5.4).

5.6

Eligible names that share a parent corporate entity (“sibling names”) are filtered from the ranking determined in 5.5 as follows:

5.6.1 If an eligible name serves as an Index Component in the previous Index constitution, it will remain in the eligible pool for the new Index constitution, and all of its other sibling names will be eliminated from the eligible pool. 5.6.2 If, within a group of sibling names, none appears as an Index Component in the previous Index constitution, then the sibling name with the highest top-50 count within said group of sibling names will remain in the eligible pool for the new Index constitution, and all of the other sibling names in said group will be eliminated from the eligible pool. 5.6.3 If, within a group of sibling names, more than one appears as an Index Component in the previous Index constitution, then the Component sibling name with the highest top-50 count among said Component sibling names will remain in the eligible pool for the new Index constitution, and all of the other Component sibling names will be eliminated from the eligible pool. 5.7

If the resultant eligible pool has fewer than 60 names, then proceed directly to 5.8. If the resultant eligible pool has 60 or more eligible names, then reduce it to those 60 names with the highest top-50 counts, as determined in 5.5 and 5.6.

5.8

Of the remaining names in the eligible pool, the 40 names with the highest top-50 counts shall be automatically selected for inclusion as Index Components in the new Index constitution.

5.9

Of the remaining names in the eligible pool, those names that appear as members in the previous Index constitution shall be admitted as Index Components in the new Index constitution, in descending order of their top50 counts. If and when 50 Index Components have been identified, then the new Index constitution is complete. Proceed to Section 6. If fewer than 50 Index Components have been identified, then proceed to 5.10.

5.10 Admit remaining names in the eligible pool as Index Components in the new Index constitution, in descending order of their top-50 counts, until 50 Index Components have been identified.

6.

Index Calculation

6.1

At the time a new Index is constituted, the following Index characteristics and parameters shall be published:

6.1.1 Standard Recovery Rate: A parameter with value between zero and unity that is set arbitrarily by the Index manager, at his sole discretion, at the time of each Index constitution, and shall be used in the calculation of all other Index characteristics pertaining to the new Index constitution. The Index manager, at his sole discretion, may change the value of the Standard Recovery Rate from one Index reconstitution to the next, in accord with changes in prevailing market practice and/or market conditions. For any given Index constitution, the value of the Standard Recovery Rate that the Index manager sets shall (a) remain fixed throughout the lifespan of that Index constitution and (b) serve as the only value of the Standard Recovery Rate that the Index manager employs in maintaining that Index constitution.

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6.1.2 Index DV01: The arithmetic average of Index Component DV01s, based on $1 notional. The Index DV01 will be computed using the following approximation for Index Component DV01s: 1 50 ∑ Index Component DV01i 50 i =1 1 1 − exp(− (r + λi )* T ) Index Component DV01i = (r + λi ) 10,000 Index DV01 =

T = 5 years r = 5 - Year US Dollar Plain - Vanilla Swap Rate On - the - Run 5 - Year CDS Spread for Index Component i λi = 1 - Standard Recovery Rate

The Index DV01 and all Index Component DV01s shall be rounded to seven decimal places, with half increments in the eighth decimal place rounded up. 6.1.2.1 Example: Assume that the 5-year plain-vanilla swap rate is 5 percent, that the on-the-run CDS spread for the ith Index Component is 65 basis points, and that the Standard Recovery Rate has been set at 40 percent. Then: λi =

0.0065 = 0.010833 1 - 0.4

Index Component DV01i =

1 1 − exp(− (0.05 + 0.010833)* 5) = 0.0004311 (0.05 + 0.010833) 10,000

6.1.3 Contract Value of a Basis Point: The dollar value of a one basis point change in the price of a CBOT CDS Index futures contract. Note that this remains constant from one Index Construction date to the next. The Contract Value of a Basis Point should not be confused with the Index DV01. Contract Value of a Basis Point =

Tick Value $5 = = $500 /bp Tick Size 0.01bp

6.1.4 Implied CDS Notional: The notional underlying value of the CBOT CDS Index futures contract implied jointly by the Index DV01 and the Contract Value of a Basis Point. The Implied CDS Notional shall be rounded to the nearest dollar, with half-dollars rounded up to the nearest dollar: Implied CDS Notional =

Contract Value of a Basis Point × $1 Index DV01

6.1.4.1 Example, contd: Assume the Index DV01 is $0.0004311/bp. By definition the Contract Value of a Basis Point is $500/bp. Then: Implied CDS Notional =

$500/bp × $1 = $1,159,824 $0.0004311/bp

6.1.5 Maximum Running Spread: The maximum admissible value for any Index Component, through the life of the Index. The Maximum Running Spread shall be established at the time of Index constitution as:

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Maximum Running Spread =

(1 − Standard Recovery Rate )* Implied CDS Notional Contract Value of a Basis Point The Maximum Running Spread shall be rounded to the nearest one one-hundredth (1/100) of one basis point, with half-hundredths rounded up to the nearest hundredth of one basis point. In any subsequent computation of the Index Value (6.4), any Index Component that exceeds the Maximum Running Spread shall be replaced by the Maximum Running Spread. 6.1.5.1 Example, contd: Assume as in 6.1.4.1 that the Standard Recovery Rate is 40 percent and that the Implied CDS Notional is $1,159,824. Then the Maximum Running Spread will be: Maximum Running Spread =

(1 − 0.4) * $1,159,824 = 1391.79 bps $500/bps

6.2

Index Component Weight: At the time of Index constitution, each Index Component shall be assigned index weight of one fiftieth (1/50), i.e., a 0.02 share of the Index composition.

6.3

Index Component Spread: The value that the Index manager assigns to each individual Index Component in computing the Index Value (6.4). The Index Component Spread will depend upon whether single-name CDS contracts that reference the corresponding Index Component name trade running or trade upfront. An Index Component shall be identified, at the sole discretion of the Index manager, as to whether it trades upfront or trades running, according to the conventions by which bid-offer prices are quoted for the corresponding single-name CDS contracts.

6.3.1 Index Components that trade running: For any Index Component that trades running, the midpoint of each bid-offer quote for the corresponding CDS will be used in computing the Index Value, subject to the constraint that the Index Component Spread must be less than or equal to the Maximum Running Spread (6.1.5). 6.3.2 Index Components that trade upfront: For any Index Component that trades upfront, the sum of the running spread and the converted upfront percentage will be used in computing the Index Value, subject to the constraint that the Index Component Spread must be less than or equal to the Maximum Running Spread (6.1.5). The upfront percentage will be converted to an equivalent spread by multiplying the upfront percentage by the Implied CDS Notional and dividing by the Contract Value of a Basis Point. 6.3.2.1 Example, contd: Assume that the Implied CDS Notional is $1,159,824, and that the Maximum Running Spread is 1,391.79 bps. Assume further that a particular Index Component trades at 18 percent upfront, 500 bps running. Then the provisional estimate of the corresponding Index Component is: Component Spread = 500bps +

0.18 * $1,159,824 = 917.54 bps $500/bps

Because this provisional estimate is less than the Maximum Running Spread, the Index Component value shall be set at 917.54 bps. 6.3.3 Index Components that have ceased to trade: For any Index Component that ceases to trade, in the sense that actionable bid and offer prices cease to be quoted for the corresponding CDS contracts, the Index Component Spread shall be set at the Maximum Running Spread. 6.3.4 Each Index Component Spread shall be rounded to the nearest one one-hundredth (1/100) of one basis point, with half-hundredths rounded up to the nearest hundredth of one basis point.

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6.4

Index Value: The Index Value is the sum of the products of each Index Component Weight (6.2) and its corresponding Index Component Spread (6.3): N

Index Value = ∑ Index Component Weight i × Index Component Spread i i =1

N is the number of Index Components. At the time of Index constitution, N equals 50, and each Index Component Weight is 0.02. The Index Value, so computed, shall be rounded to the nearest one one-hundredth (1/100) of one basis point, with half-hundredths rounded up to the nearest hundredth of one basis point.

7. Treatment of Succession Events Following Index Constitution 7.1

If, subsequent to an Index constitution, the corporate debt issuer referenced by a given Index Component is superseded by successor corporate entities, then the original Index Component shall be removed from the Index, and the successors shall be added as Index Components, regardless of the credit ratings (4.3) that pertain to them. The Index Component Weights assigned to the successors shall sum to the Index Component Weight that applied to the original Index Component that the successors shall supersede.

7.2

The Index Component Weight that shall be assigned to each successor shall be set equal to the product of (a) the Index Component Weight that applied to the original Index Component, prior to the succession event, and (b) the percentage share of the notional amount of the original single-name CDS that is assigned to each successor. The Index Component Weights that shall be assigned to the successors shall be calculated to six decimal places, with half increments in the seventh decimal place rounded up.

7.2.1 Example: Assume Alltel Corp (AT) is an Index Component. On 17 July 2006 Alltel Corp (AT) spins off Windstream Corp (WIN). Each successor (AT and WIN) is assigned half of the notional value of singlename CDS contracts that referenced the original Index Component (AT). In accommodating this succession event, the Index manager makes the following modifications to the Index: the number of Index Components rises from 50 to 51; the Index Component Weight that had been assigned to AT is reduced from 0.02 to 0.01; and WIN is added as an Index Component with an Index Component Weight of 0.01. 7.3

In the event that the Index Component Weights assigned to the successors, so calculated, fail to sum to the Index weight that applies to the original Index Component, then the successors shall be sorted alphabetically by name, and the weight of the alphabetical first successor shall be adjusted so that the successors’ Index Component Index weights sum to the Index Component Weight that applied to the original Index Component.

7.3.1 Example: Assume that XYZ Corp is an Index Component, with an Index Component Weight of 0.02. Assume, moreover, that it has been determined that XYZ Corp will be succeeded by ABC Corp, DEF Corp, and GHI Corp. The Index manager accommodates this succession event by making the following modifications to the Index: The number of Index Components rises from 50 to 52; XYZ Corp is removed from the Index; ABC Corp is added as an Index Component with Index Component Weight of 0.006666; DEF Corp and GHI Corp are each added as Index Components with Index Component Weights of 0.006667 each. Note that the sum of the successor Index Component Weights (0.00666 + 0.006667 +0.006667) is identically equal to the Index Component Weight (0.02) that had applied to the original Index Component.

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Appendix 4 CDS and CMA DataVision Credit Market Analysis Ltd (CMA) is a credit information specialist that pioneers ways to increase the efficiency of OTC credit market professionals. Founded in 2001 by credit market practitioners, CMA (www.cmavision.com) is a privately held company headquartered in London, with offices in New York. CMA organizes CDS and bond quotes and valuation data. CMA’s product lines include QuoteVisionTM, the market’s leading real-time price discovery service, and DataVisionTM, which furnishes same-day, consensus-based price verification and price data. CMA’s products and services are used by investment professionals at more than 150 leading investment banks, hedge funds, and asset managers worldwide to improve trading performance and to provide valuable information, not only for the front office but also risk, finance, and research groups.

CMA DataVision CMA DataVision provides price information for credit default swaps (CDS), CDS indices, and CDS index tranches. DataVision price information spans the full maturity structure of CDS and CDS products for all entities. New price data are available for same-day delivery, both 5pm London time and 5pm New York time. Additionally, DataVision maintains a data history archive. DataVision is available to more than 260,000 users around the world via the Bloomberg Professional® service, from CMA directly, or via other third parties.

A Consensus-Based Pricing Service

Consortium. Thus, they provide a market consensus view of market prices. CDS spreads, updated daily on the basis of real-time indicative quotes, are combined with bond prices, terms and conditions, and ratings data from the most respected sources in the market. This enables CMA to calculate credit term structures even for less liquid entities with a proprietary issuer/ sector curve model. DataVision prices are based upon mid-market prices, computed from actionable quotes on bid/ offer spreads, collected from a consortium of data contributors. CMA DataVision’s consortium of data contributors currently numbers 30 buyside institutions, located in the US, London, or in continental Europe. Membership in the consortium is guarded by anonymity. On any given day, for any individual CDS product (single-name CDS, index, or tranche): •

DataVision requires a quorum of valid data submissions from at least 3 consortium members before it will apply its pricing process to the CDS entity.

•

To be considered “valid” for that day’s DataVision pricing process, a consortium member’s price submission, in the form of a mid-market average, must be based on bid/offer quotes from at least 3 separate independent sources.

•

CMA then creates CDS pricing curves based on spread observations for the CDS entity by averaging all valid submissions.

DataVision prices are based on aggregated, averaged, observed prices contributed by the CMA Data

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To ensure integrity of these mid-market spread observations, CMA applies several error checks and filters. The data validation process includes feeding the spread observations into a proprietary CDS term structure model. The empirical term structures generated from this model are then used to test for and to identify anomalies. The OTC nature of the credit market means that, for any given entity, tradable price levels might not be

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observed at each tenor on every day. To provide the best possible evaluation of less liquid entities, CMA has developed a sophisticated multi-step modeling process, in conjunction with several clients and a team of industry experts, to enable CMA to derive price points and to generate a full term structure with a high degree of accuracy. Using this process, CMA has more than doubled the number of data points that can be confidently provided by DataVision.

Notes

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Business Development 141 W. Jackson Boulevard Chicago, IL 60604-2994 312-341-7955 • fax: 312-341-3027

European Office St. Michael’s House 1 George Yard London EC3V 9DH United Kingdom 44-20-7929-0021 • fax: 44-20-7929-0558

Asian Market Contact 312-341-7955

Latin American Contact [email protected] 52-55-5605-1136 • fax: 52-55-5605-4381

www.cbot.com

“CDR”, Credit Derivatives Research, Creditresearch.com, CDR Liquid, CDR Liquid Global, CDR Liquid 50 North America Investment Grade, CDR Liquid 50 North America High Yield, CDR Liquid 50 Europe Investment Grade, CDR Liquid 40 Europe High Yield, and CDR Liquid 50 Asia are service marks of Credit Derivatives Research LLC (“CDR”) and have been licensed for use for certain purposes by the CBOT. The CBOT Credit Default Swap Index futures are not sponsored, endorsed, or sold by CDR, and CDR makes no representation regarding the advisability of investing in such product(s). “CMA DataVision” is a service mark of Credit Market Analysis (“CMA”) and has been licensed for use for certain purposes by the CBOT. The CBOT Credit Default Swap Index futures are not sponsored, endorsed, or sold by CMA, and CMA makes no representation regarding the advisability of investing in such product(s). The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, or any trading results, and does not constitute trading advice or constitute a solicitation for the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications, regulations, and delivery procedures. © 2007 Board of Trade of the City of Chicago, Inc. All rights reserved. CDR Liquid 50 NAIG Index Construction and Maintenance Procedures © 2007 Credit Derivatives Research LLC. All Rights Reserved. 07-XXXXX