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transcript
Betsy MettlerVice President,J.P. Morgan Securities Inc.
INTRODUCTION TOCREDIT DERIVATIVES
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE
The Explosive Growth of Credit Derivatives
180 350 586 893 1,1891,952
2,690
4,799
10,000
1997 1998 1999 2000 2001 2002 2003 2004E 2007ESource: British Banker�s Association, ISDA, McKinsey & Co.
Credit Derivatives Market Growth: Volumes Traded ($ billions)
1
Evolution of Market Participants
� Predominantly buyers of protection
� Hedge over concentrations in loan portfolios
� Sell protection to subsidize their hedging programs and diversifytheir portfolio
� Predominantly sellers of protection
� No funding requirement
� Attractive leverage
� Alternate liability class to be underwritten providing exposureto corporate credit risk
� Predominantly sellers of protection
� Relative value
� Ability to customize credit risk
� Ability to short credits
� Active as both buyers and sellers of protection
� Convertible arbitrage
� Ability to short credits
� Basis trades: bonds vs. protection
� Equity vs. Credit
Bank Portfolio Managers Insurance Cos/Asset Managers
Reinsurers/Monolines Hedge Funds
Evolution of the Credit Derivatives Market
1994 20041999
Total growth
Banks Re-insurers Hedge Funds Real MoneyIns. Co.
Asset Managers
2
Future Participants: Corporates
Improve returns onbalance sheet cash or
pension assets
Create creditcapacity for new orlong-term business
arrangements
Hedge financialassets received from
the acquirer in anasset sale
Manage variability offuture interest
expense
Improve efficiency ofhedges of cash flowsfrom/to third parties
Hedge sellerindemnities in an
acquisition structure
Credit Derivatives
3 3
Diversity of Market Participants
Insurance14%
Hedge funds13%
Banks synthetic securitization
10%
Reinsurance10%
Third-party asset managers
7%
Corporates3%
Banks38%
Source: Risk February 2003
Special Purpose Vehicles5%
4
Conduit of Information
� In sourcing and selling generic credit risk,the credit derivatives desk serves as a linkbetween many different markets
� Example activities of convertible bondfunds create positive basis andrelative value opportunities forinvestors� A corporation issues a convertible
bond� Convertible bond funds look to
purchase cheap call options on theunderlying equity
� These funds buy the bond and buyprotection stripping out the creditrisk
� Spreads in the credit derivativesmarket will widen as a result of thisincreased demand
JPMorgan CDSTrading Desk
Corporatereceivables
Equity market
Bond market
Credit DefaultSwap market
Convertiblemarket
Loan market
5
Credit Derivatives Allow Investors to Customizetheir Source of Credit Risk
� Range of tenors available
� Most liquid tenor is five-year maturity
� Quarterly end dates
� Notional size ranges
� Investment Grade: USD 5 to 20 million
� High Yield: USD 2 to 5 million
� Trade approximately 800 credits globally across:
� Countries
� Ratings categories
� Asset classes
� Synthetic Market
� Customized baskets of credit exposure6
Single Name Credit Default Swaps
Contingent payment upon a Credit Event
Reference Entity
ProtectionBuyer
Fee/premiumProtection
Seller
Risk
95% of all creditderivatives arecredit defaultswaps
� A Credit Default Swap is a contract whereby the Protection Buyer transfers the risk that a CreditEvent will occur on the Reference Entity
� In return for protection, the Buyer pays a fee to the Protection Seller
� Upon a Credit Event, the protection Seller pays par for bonds or loans of the defaulted entity.Protection Seller effectively pays 100%�Recovery Rate
� The Protection Buyer takes on the same risk profile as if they shorted a bond, also referred to asselling risk
� The Protection Seller takes on the same risk profile as if they bought a bond also referred to asbuying risk
7
Interest rate
Funding
Credit
Bond/Loan
Credit
T + 120bp
Asset Swap
Credit
Funding
Libor + 80bp 80bp
Credit Default Swap
Prices for Credit Default Swaps are InitiallyDerived from Bond/Loan Prices
� A bond or loan contains interest rate risk, funding risk, and credit risk
� Credit default swaps isolate and transfer credit risk
� To determine the theoretical price of credit risk
� Swap the bond/loan into a floating rate investment (asset swap)
� Remove the funding cost (assume a funding of LIBOR)
� Credit risk remains, which gives you the theoretical price for credit protection
8
Compare Buying a Bond with Selling Protection:5-year Par Bond Yielding 4.2%, (T + 120bp)
Bond cash flows Equal credit derivative cash flows
Principalon Bond
Interest Rate = 300bp
5yr Libor Spread = 40bp
Credit = 80bp
Credit Default Swap Spreads
Scenario #1: No default
9
Compare Buying a Bond with Selling Protection:5-year Par Bond Yielding 4.2% (T + 120bp)
Bond cash flows Equal credit derivative cash flows
Interest Rate = 300bp
5yr Libor Spread = 40bp
Credit = 80bp
Credit Default Swap Spreads
Seller of protection pays $100,receives default bond worth$40, net is loss of $60
-$100 costof bond After default,
sell bond for$40
Scenario #2: Default in year 4, 40% recovery rate
10
Negative Basis Trade: Example
� Example: 5-year IBM Corp. par bond yielding T + 120bp
� The credit risk component of this bond is 80bp
� If credit protection is offered at /60bp, then 20bp of negative basis exists
� An investor should buy the bond and buy protection and receive 20bp running for thelife of the trade
� Negative basis players (including trading desks) will typically take this position whenthe negative basis exceeds 15bp
� These arbitrage opportunities evaporate relatively quickly and rarely exceed 30bp
Interest rate
Funding
Credit
Bond/Loan
Credit
T + 120bp
Asset Swap
Credit
Funding
Libor + 80bp 80bp
Credit Default Swap
11
Positive Basis Trade: Example
� Example: 5-year IBM Corp. par bond yielding T + 120bp
� The credit risk component of this bond is 80bp
� If credit protection is bid at 100bp/, then 20bp of positive basis exists
� Investors exploit positive basis as an alternative to the cash investment preferring tosell protection over buying the bond to pick-up an extra 20bp in relative value fortaking the same credit exposure
� Positive basis opportunities can persist for a longer period of time and the spreaddifferential is not limited by technical reasons
� Selling bonds and selling protection is difficult because a term repo trade is difficultto maintain
Interest rate
Funding
Credit
Bond/Loan
Credit
T + 120bp
Asset Swap
Credit
Funding
Libor + 80bp 80bp
Credit Default Swap
12
Standardization of Credit Default Swap Confirmation
� Standardized documentation has led to the dramatic growthof the credit derivatives market
� Investment Grade and High Yield North Americanconfirmation based on the 2003 ISDA credit derivativesdefinitions
� Standard 2003 contracts began trading June 20, 2003
� Contracts proved effective by Enron, Worldcom and otherdefaults
� Worldcom: close to 600 contracts outstanding� Estimated over 7 billion in notional� No disputes or litigation� No mechanical settlement problems
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How the Triggering Mechanism of a Credit DefaultSwap Works: Watch, Check, Deliver
Watch Deliver
ProtectionBuyer
Deliverable ObligationsProtection
Seller
100% of notional
� Watch a predefined group of Obligations of the Reference Entity
� Check that a Credit Event has occurred, in which case
� Deliver another predefined group of Deliverable Obligations in return for par
Check
Obligations Credit EventsDeliverable Obligations
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�Obligations� Limit which Instruments canTrigger Protection on a Credit Default Swap
� Borrowed Money: bond, note, loan, commercial paper, and letters of credit
DerivativeContracts
GeneralCreditors
�Payment�
�Borrowed Money�Bonds Loans
Watch Deliver/SettleCheck
Obligations Credit EventsDeliverable Obligations
15
�Obligations� Limit which Instruments canTrigger Protection on a Credit Default Swap
� The standard Credit Events under ISDA definition:
� Failure to Pay
� Bankruptcy
� Restructuring
� High Yield Credit Default Swaps trade without Restructuringas a Credit Event
Watch Deliver/SettleCheck
Obligations Credit EventsDeliverable Obligations
16
�Deliverable Obligations� Limit which Obligationscan be Delivered upon a Credit Event
� Deliverable Obligations means any Bond or Loan ranked senior or better inthe capital structure (i.e. senior unsecured)
Watch Deliver/SettleCheck
Obligations Credit EventsDeliverable Obligations
ProtectionBuyer
Deliverable ObligationsProtection
Seller
100% of Notional
17
Physical Settlement Timeline
CreditEventoccurs
Buyer deliversNoPS to Seller
PhysicalSettlementDate
Physical Settlement Period(as per Section 8.6 capped
at 30 Business Days)Maximum of 30 calendar days
CEN & PAI deliveredby Buyer or Seller(must be before the14th day afterScheduledTermination Date)
Notes: CEN = Credit Event NoticePAI = Publicly Available InformationNoPS = Notice of Physical SettlementSection 8.6 of the 2003 Credit Derivative Definitions provides the Physical Settlement Period should be �the longestnumber of Business Days for settlement in accordance with then current market practice� of the obligations beingdelivered
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Valuing a Credit Default Swap Position Using CDSW
� Enables user to perform mark-to-market valuation on vanilla Credit Default Swap
� Model type set to J for JPMorgan
� Three sections make up CDSW
� Deal Information: original trade details� Spreads: current market spreads� Calculator: valuation of position
19
This material is not a product of J.P. Morgan Securities Inc.�s (�JPMSI�) Research Departments, and you should not regard it asresearch or a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those ofthe individual author and may differ from the views or opinions expressed by JPMSI�s Research Departments or otherdepartments or divisions of JPMorgan and its affiliates. Research reports and notes produced by the Firm�s ResearchDepartments are available from your salesperson.
This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment byJPMorgan to enter into any transaction. No reliance should be placed on the information herein, which is preliminary and doesnot constitute all the information necessary to evaluate investing in any financial instrument or participating in any transaction.This material may also include information obtained from sources believed to be reliable, but JPMorgan does not warrant itscompleteness or accuracy. Any decision to invest in any financial instrument, or participate in any transaction, describedherein should be based solely on the final documentation related thereto. Nothing herein is a recommendation to invest in anyfinancial instrument or participate in any transaction or legal, tax, regulatory or accounting advice, and each prospectiveinvestor or transaction participant must make an independent assessment of such matters in consultation with its ownprofessional advisors. Additional information is available upon request. JPMorgan is the marketing name for J.P. MorganSecurities Inc. (member, NYSE/NASD) and its investment banking affiliates.
Eric Beinstein*Vice President,J.P. Morgan Securities Inc.
CREDIT DERIVATIVES PRICINGAND RESEARCH
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE
Measures of Spread for Bonds
21
Basis Report
22
Yield to Maturity: Premium Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (105) 10 10 110
YTM 105 = 10 + 10 + 110(1 + YTM) (1 + YTM)^2 (1 + YTM)^3
YTM = 8.06%
23
Z-Spread: Premium Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%
Bond flows (105) 10 10 110
Z-Spread 105 = 10 + 10 + 110(1 + 0.005 + Z) (1 + 0.010 + Z)^2 (1 + 0.020 + Z)^3
Z-Spread = 6.17%
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I-Spread: Premium Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (105) 10 10 110
I-Spread = YTM - Swap Rate at Bond Maturity
I-Spread = 8.06% - 2.00% = 6.06%
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Asset Swap Spread: Premium Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%
Bond flows (105) 10 10 110
Fair Value 123.41 = 10 + 10 + 110(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3
Duration 2.92 = 1 + 1 + 1(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3
Asset Swap Spread = (123.41 - 105) / 2.92 = 6.31%
Asset Swap Spread = (Fair Value Bond Price � Actual Bond Price) / DurationFair Value bond price assumes bond had no credit risk, i.e., discounted at swap rate
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In Summary�
PremiumBond
YTM 8.06%
Z - Spread 6.17 Best measure of comparable bond value asadjusts for shape of Swap curve
I - Spread 6.06 Not as good as Z spread as ignores Swapcurve shape, but usually a reasonableapproximation for high grade bonds
Par ASWSpread
6.31 A tradable value, not a good value measure forbonds far from par
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Yield to Maturity: Discount Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (92.13) 5 5 105
YTM (92.13) = 5 + 5 + 105(1 + YTM) (1 + YTM)^2 (1 + YTM)^3
YTM = 8.06%
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Z-Spread: Discount Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%
Bond flows (92.13) 5 5 105
Z-Spread (92.13) = 5 + 5 + 105(1 + 0.005 + Z) (1 + 0.010 + Z)^2 (1 + 0.020 + Z)^3
Z-Spread = 6.12%
29
I-Spread: Discount Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%Bond flows (92.13) 5 5 105
I-Spread = YTM - Swap Rate at Bond Maturity
I-Spread = 8.06% - 2.00% = 6.06%
30
Asset Swap Spread: Discount Bond
Year 0 Year 1 Year 2 Year 3Swap rates 0.50% 1.00% 2.00%
Bond flows (92.13) 5 5 105
Fair value 108.82 = 5 + 5 + 105(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3
Duration 2.92 = 1 + 1 + 1(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3
Asset Swap Spread = (108.82 - 92.13) / 2.92 = 5.72%
Asset Swap Spread = (Fair Value Bond Price � Actual Bond Price) / DurationFair Value bond price assumes bond had no credit risk, i.e., discounted at swap rate
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In Summary�
PremiumBond
DiscountBond
YTM 8.06% 8.06%
Z - Spread 6.17 6.12 Best measure of comparable bondvalue as adjusts for shape of Swapcurve
I - Spread 6.06 6.06 Not as good as Z spread as ignoresSwap curve shape, but usually areasonable approximation for highgrade bonds
Par ASWSpread
6.31 5.72 A tradable value, not a good valuemeasure for bonds far from par
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Dollar Price Effect and Expected Value
33
Bond Pricing and Probability: The Framework
100
108
40
Cash atmaturity
AssumedValue ifdefault
Pricetoday
Discount factor = 2%
A simplified example:
34
Bond Pricing and Probability: The Framework (cont�d)
100
108
40
Cash atmaturity
AssumedValue ifdefault
Pricetoday
Discount factor = 2%
91.24%
8.76%
Probability of no default
108 X 0.98 X 0.9124 + 40 X 0.98 X 0.0876 = 100
No Default path Default path
35
Bond Pricing and Probability: The Framework (cont�d)
100108
40
91.24%
8.76%
?
105
40
Asset A Asset B
We know the �fair value� of another asset with a different coupon,based on the probability of default determined with the first asset
36
Bond Pricing and Probability: The Framework (cont�d)
100
108
40
91.24%
8.76%
97.32
105
40
91.24%
8.76%
Asset A Asset B
We know the �fair value� of another asset with a different coupon,based on the probability of default determined with the first asset
105 X 0.98 X 0.9124 + 40 X 0.98 X 0.0876 = 97.32
No Default path Default path
37
Bond Pricing and Probability: The Framework (cont�d)
100
108
40
91.24%
8.76%
97.32
105
40
91.24%
8.76%
100 = 108/(1+YTM)
YTM = 8.00%
97.32 = 105/(1+YTM)
YTM = 7.89%
Asset A Asset B
38
Bond Pricing and Probability: The Framework (cont�d)
Asset A Asset BPrice $100 $97.32Number purchased 5 5.138Maturity payment 108 105Recovery per asset 40 40
If no defaultDollars after 1 year 540 539.46 0.54
If defaultDollars remaining 200 205.51 (5.51)
Basis of zero does NOT mean owning A or B will give the same return
So� If have $500 to invest
39
Asset A Asset B
If no defaultDollars after 1 year 540 X 0.9124 539.46 X 0.9124
+ +If defaultDollars remaining 200 X 0.0876 205.51 X 0.0876
Expected value = 510.21 = 510.21
Bond Pricing and Probability: The Framework (cont�d)
The expected value is the same
Note: figures above exclude discount factor for simplicity. If multiply each term above by 0.98 expected values = 500.00
Probability of no default
40
Bond Pricing and Probability: The Framework (cont�d)
The goal: A metric which tells us these two assets are of equal value
100
108
40
91.24%
8.76%
97.32
105
40
91.24%
8.76%
Asset A Asset B
Asset A Asset BYield 800bp 789bp
Spread over LIBOR (Z-Spread) 600bp 589bp
Asset Swap Spread 600bp 573bp
Par Equivalent CDS Spread 600bp 600bp
41
Structuring a Bond Versus CDS Trade
42
Basis Report
43
Basis Report (cont�d)
� Trade strategies: positive basis (CDS is cheaper than bond)
� Switch from bond position to default swap position (sellprotection)
� Short bond and sell protection
� Investigate why markets pricing same risk differently
� Trade strategies: negative basis (Bond is cheaper than CDS)
� Buy bond, buy protection for credit-risk-free position withpositive carry
� As such positions are credit risk neutral, the credit doesn�tmatter�it�s a quantitative exercise
� Investigate why markets pricing same risk differently
44
� Determine amount of protection to sell to have equivalentrisk profile as owning the bond:
� In GMAC 6.750% 2006 example: Bond price: $107.01,Assumed Recovery 50%
� How much protection do I sell to have same default risk asI had when holding the bond?
Amount at risk = Bond Price + ¼ of coupon - Recovery
= (107.01 + 6.750/4 - 50) = $58.70
= Amount at risk / (1- Recovery Rate)
$58.70 / (1 � 0.5) = $117.40
Positive Basis: Switch from Bond into Protection
45
Positive Basis: Switch from Bond into Protection(cont�d)
Creditexposure
Rateexposure
Creditexposure
Rateexposure
$58.70$50.00
Not at risk (recovery value)
Bond dirty price $108.70
$108.70
CDS equivalent $117.40
$58.70$58.70
$108.70
Amount at risk
� In GMAC 6.750% 2006 example:
46
Positive Basis: Bond Return on $100 Notional Position
Creditexposure $58.70$50.00
$108.70Rateexposure
� Credit earnings = Spread over swaps (Z-Spread) X Cash invested
� Rate earnings = Swap spread X Cash invested
Credit earnings = 104bp X 108.70 = $1.13
Rate earnings = 353bp X 108.70 = $3.84
Bond return on $100 notional position $4.97
47
Positive Basis: CDS and Swap Return withEqual Risk to Bond
� Credit earnings = Spread over Swaps (Z-Spread) X Cash invested
� Rate earnings = Swap spread X Cash invested
$58.70$58.70
$108.70
Creditexposure
Rateexposure
Credit earnings = 124bp X 117.40 = $1.46
Rate earnings = 353bp X 108.70 = $3.84
Clean swap -7bp X 104.24 = $(0.07)
CDS and swap return with equal risk to bond $5.23
48
Positive Basis: Unwinding the Position� With an upward sloping yield curve, unwinding the swap before maturity
will probably incur a loss to the client
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
1-yr 2-yr 3-yr 4-yr
Expected 3-month rate client is paying JPMorgan
Actual fixed rate JPMorgan is paying client
49
Positive Basis: Pick-Up in Return fromEqual-Risk Switch
Pick-up in return from equal-risk switch $0.26
Summary numbers No default DefaultBond + $4.97 $(58.70)CDS + Swap + 5.23 (58.70)
$0.26 $0.00
50
Positive Basis: Summary
Risky creditRisk freecredit
Rate exposure
Long a bond
=
Short protection (onequal default risk
position)
+Receiving fixed on a
credit contingentswap
51
Par CDS Calculator
52
The analyst(s) denoted by an asterisk ("AC") hereby certifies that: 1) all of the views expressed in this research accurately reflect his or her personal views about any and all ofthe subject securities or issuers; and 2) no part of any of the analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or viewsexpressed by the analyst(s) in this research.
Copyright 2004 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co., and its subsidiaries and affiliates worldwide. J.P.Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc., is a member of the NFA. J.P. MorganSecurities Ltd. (JPMSL), J.P. Morgan Europe Limited and J.P. Morgan plc are authorized by the FSA and JPMSL is a member of the LSE. J.P. Morgan Equities Limited is amember of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the HongKong Monetary Authority. J.P. Morgan Securities Singapore Private Limited is a member of Singapore Exchange Securities Trading Limited and is regulated by the MonetaryAuthority of Singapore ("MAS"). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Services Agency in Japan. J.P.Morgan AustraliaLimited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMSAL) is a licensed securities dealer.
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"Dow Jones" and the Dow Jones TRAC-X Indices are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain purposes byJPMorganChase Bank. The DJ TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representation regarding theadvisability of investing in such product(s).
JPMSI or an affiliate has managed or co-managed an offering of securities within the past twelve months for Altria Group, Inc., Amerada Hess Corporation, American ElectricPower Company, Inc., American Express Company, Arrow Electronics, Inc., Baxter International Inc., Bristol-Myers Squibb Company, Cargill, Inc., Caterpillar FinancialServices Corp, Cendant corp, Centex Corp, CIT Group Inc., Clear Channel Communications, Inc., Comcast Corp., Computer Sciences Corp., Cox Communications, Inc., DukeEnergy Corp., Eastman Chemical Company, Electronic Data Systems Corp., FirstEnergy Corp., General Electric Capital Corp, General Motors, Hallibutron Co., InternationalBusiness Machine, Liberty Medai Corp., MBNA Corp., Monsanto Co., News America, Inc., Ryder System, Inc., Sempra Energy, SLM Corp., Target Corp., Textron FinancialCorp., Boeing Capital, Kroger Co., The Walt Disney Co., Toys "R" US Corp., Valero Energy Corp., Wells Fargo & Co., Wyeth
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53
Betsy MettlerVice President,J.P. Morgan Securities Inc.
DOW JONES TRAC-X
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE
Overview
55
Dow Jones TRAC-XSM
No. of credits Launch date Next roll date
Dow Jones TRAC-XSM Europe 100 June 2003 March 2004
Dow Jones TRAC-XSM North America 100 July 2003 March 2004
Dow Jones TRAC-XSM Japan 50 July 2003 March 2004
Dow Jones TRAC-XSM North America High Yield 100 July 2003 May 2004
Dow Jones TRAC-XSM Emerging Markets 19 August 2003 March 2004
Dow Jones TRAC-XSM Australia 25 September 2003 March 2004
Dow Jones TRAC-XSM Asia 25 October 2003 March 2004 (exp)
� Dow Jones has signed agreements to be responsible for the operation, development, marketing andlicensing of all the DJ TRAC-X indices
� As one now views the Global Stock Markets via indices like S&P 500, FTSE and NIKKEI, so will credit beviewed in the future via DJ TRAC-X North America, DJ TRAC-X Europe and DJ TRAC-X Japan
� The Future for credit will allow
� Options on credit
� Tranched risk
� Exchange tradingNote: �Dow Jones� and �Dow Jones TRAC-XSM� are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain
purposes by JPMorgan Chase. The Dow Jones TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makesno representation regarding the advisability of investing in such product(s)
56
Benefits of Dow Jones TRAC-X Indexes
Use credit default swaps to maximizeliquidity�the portfolios are composed of themost liquid Credit Default Swap names fromJPMorgan and Morgan Stanley trading volumes(Dow Jones will set up advisory committees todetermine index compositions)
Cost efficient and timely access to the CreditMarkets via index swaps and credit-linkedsecurities
Daily reports on actual versus theoretical pricing
Liquidity
Diversification
Transparency
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DJ TRAC-X Participant Uses to Date Have Included:
� DJ TRAC-X is designed to be attractive to all credit market participants
� Banks� Express trading views on the overall credit market� Hedge credit exposure within loan and bond portfolios
� Fund Managers and Insurance Companies� Provides quick, cost-efficient credit diversification� Hedge credit exposure within portfolios� Hedge ramp-up risk for CSOs and large cash inflows
� Hedge Funds and Trading Accounts� Express trading views on overall credit market� Hedge credit shorts within convertible portfolio
� Corporates� Hedge credit spreads ahead of new issuance� Cost-efficient diversification for excess treasury liquidity
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Features of Dow Jones TRAC-X Global Indices
59
Dow Jones TRAC-X NA participants: 2003
20%
1%
46%
33%
Pension Funds
Dow Jones TRAC-X NA Participants
54%14%
1%2% 1%
4%4%
20%
Dow Jones TRAC-X NA HY Participants
Banks
Hedge Funds
Asset Managers
High Yield Fundsand Core Plus
Hedge Funds
Banks
Bank ProprietaryDesks
Insurance
CorporatesForeign Funds
Pension Funds
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5-year 10-year OptionsDJ TRAC-X Index Swap Funded maturity maturity Available
DJ TRAC-X North AmericaDJ TRAC-X NA x x x x xDJ TRAC-X NA High Beta x x x xDJ TRAC-X NA TMT x x xDJ TRAC-X NA FIN x x x
DJ TRAC-X North America High YieldDJ TRAC-X NA High Yield 100 x x xDJ TRAC-X NA High Yield BB x x xDJ TRAC-X NA High Yield B x x xDJ TRAC-X NA High Yield High Beta x x x
DJ TRAC-X EuropeDJ TRAC-X Europe x x x x xDJ TRAC-X Europe Corp x x x xDJ TRAC-X Europe Financial Senior x x x xDJ TRAC-X Europe Financial Sub x x x xDJ TRAC-X Europe TMT x x xDJ TRAC-X Europe Industrial x x xDJ TRAC-X Europe Consumer x x x
DJ TRAC-X Europe High Yield x x xDJ TRAC-X Asia x xDJ TRAC-X Japan x xDJ TRAC-X Australia x xDJ TRAC-X Emerging Markets x x x
Overview of Global Dow Jones TRAC-X Products
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Dow Jones TRAC-X North America Series 2
� For Dow Jones TRAC-X North America, there is usually a 1bp bid-to-offer in $50 million a side
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Dow Jones TRAC-X NA High Yield Series 2
� For Dow Jones TRAC-X NA High Yield, there is usually a 1/4 to1/2pt bid-to-offer in $10 million a side
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Dow Jones TRAC-X Structure and Mechanics
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Unfunded DJ TRAC-X NA Series 2 Mechanics:An Example
� DJ TRAC-X NA March 2009 contract with 100bp p.a. spreadQuoted spread: [65-66]bp
� Investor goes long $100 million notional
(1) Client pays 35bp running and pays accrued to enter the trade
(2) Client receives 100bp p.a. to take risk on 100 credits
Entering a long risk DJ TRAC-X NA unfunded trade
100 reference
credits
100bp p.a. = $1,000,000
[$1,861,531 + Accrued (230,556)] = 2,092,086
JPMorgan Investor
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Unfunded DJ TRAC-X NA Series 2 Mechanics:An Example (cont�d)
� If none of the 100 credits default, investor earns 100bp p.a. until the maturity ofthe trade
� Profit or loss is recognized through coupon income and capitalappreciation/depreciation based on the price of the index
(1) Investor pays 1/100th of original notional to JPMorgan
(2) JPMorgan delivers principal amount of bonds or loans to investor
(3) Investor continues to earn 100bp p.a. on a reduced notional
No default
(3) 100bp on reduced notional ($99mm)
(2) $1mm notional of bonds/loans
(1) $1mm
One name defaults
JPMorgan Investor
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Funded DJ TRAC-X NA Series 2 Mechanics: An Example
� DJ TRAC-X March 25, 2009 certificates with 4.25% coupon
� Quoted price: T + 101/99 [$102.36/102.45]
� Investor goes long $100 million notional
Entering a long risk DJ TRAC-X NA funded rate
(2) 4.25% * 1 * $100,000,000 = $4,250,000
100 reference
credits(1) ([$102.45] * 1 * $100mm) + Accrued=
$104,231,100Trust Investor
(1) Client pays ([$102.45] * 100 million * 1.00) + Accrued to enter the trade
(2) Client receives 4.25% coupon on $100 million
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Funded DJ TRAC-X NA Series 2 Mechanics: An Example(cont�d)
� If none of the 100 credits default, investor earns 4.25% for five years and receives par at maturity
� Profit or loss is recognized through coupon income and capital appreciation/depreciation based onthe price of the DJ TRAC-XSM NA
No default
(1) Remaining principal amount is 99/100 of original notional
(2) JPMorgan delivers cash value of $1 million notional of defaulted bonds or loans (recovery rate)
(3) Investor continues to earn 4.25% on a reduced notional
(4) Each subsequent default will reduce the notional of the trade by 1/100th of the original notional
Investor
4.25% on reducednotional ($99mm)
Cash value of $1 millionnotional of defaulted bonds
Trust
One name defaults
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Options on Dow Jones TRAC-X
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DJ TRAC-X North America Options: Product Details
�Put: Option to buy protection/payer optionCall: Option to sell protection/receiver option
�Exercise: European (only at the maturity of the option)
�Settlement: Physical, into DJ TRAC-X North America Series2 March 2009 upon exercise at the pre-set strike
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The analyst(s) denoted by an asterisk ("AC") hereby certifies that: 1) all of the views expressed in this research accurately reflect his or her personal views about any and all ofthe subject securities or issuers; and 2) no part of any of the analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or viewsexpressed by the analyst(s) in this research.
Copyright 2004 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co., and its subsidiaries and affiliates worldwide. J.P.Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc., is a member of the NFA. J.P. MorganSecurities Ltd. (JPMSL), J.P. Morgan Europe Limited and J.P. Morgan plc are authorized by the FSA and JPMSL is a member of the LSE. J.P. Morgan Equities Limited is amember of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the HongKong Monetary Authority. J.P. Morgan Securities Singapore Private Limited is a member of Singapore Exchange Securities Trading Limited and is regulated by the MonetaryAuthority of Singapore ("MAS"). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Services Agency in Japan. J.P.Morgan AustraliaLimited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMSAL) is a licensed securities dealer.
Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions andestimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed heremay not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes inrates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financialinstrument. JPMorgan and/or its affiliates and employees may hold a position, may undertake or have already undertaken an own account transaction or act as market maker inthe financial instruments of any issuer discussed herein or any related financial instruments, or act as underwriter, placement agent, advisor or lender to such issuer. Clientsshould contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permits otherwise. This report may have beenedited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. This report should not be distributed to others or replicated in anyform without prior consent of JP Morgan. This report has been issued, in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Servicesand Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by personswho are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only withrelevant persons. In other European Economic Area countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL does not issue or distribute this material to "retail clients." Therecipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms"wholesale client" and "retail client" have the meanings given to them in section 761G of the Corporations Act 2001.
"Dow Jones" and the Dow Jones TRAC-X Indices are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain purposes byJPMorganChase Bank. The DJ TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representation regarding theadvisability of investing in such product(s).
JPMSI or an affiliate has managed or co-managed an offering of securities within the past twelve months for Altria Group, Inc., Amerada Hess Corporation, American ElectricPower Company, Inc., American Express Company, Arrow Electronics, Inc., Baxter International Inc., Bristol-Myers Squibb Company, Cargill, Inc., Caterpillar FinancialServices Corp, Cendant corp, Centex Corp, CIT Group Inc., Clear Channel Communications, Inc., Comcast Corp., Computer Sciences Corp., Cox Communications, Inc., DukeEnergy Corp., Eastman Chemical Company, Electronic Data Systems Corp., FirstEnergy Corp., General Electric Capital Corp, General Motors, Hallibutron Co., InternationalBusiness Machine, Liberty Medai Corp., MBNA Corp., Monsanto Co., News America, Inc., Ryder System, Inc., Sempra Energy, SLM Corp., Target Corp., Textron FinancialCorp., Boeing Capital, Kroger Co., The Walt Disney Co., Toys "R" US Corp., Valero Energy Corp., Wells Fargo & Co., Wyeth
A senior employee, executive officer, or director of JPMSI and/or its affiliates is a director of The Boeing Company, Bristol-Myers Squibb Company, Deere & Company,Electronic Data Systems Corporation, International Business Machines Corporation, The May Department Stores Company, McDonald's Enterprises, Motorola, Inc., ValeroEnergy Corporation, Verizon Communications, Inc.., Viacom Inc., Visteon Corporation, Wyeth (N/C FR American Home Product Corp)
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Betsy MettlerVice President,J.P. Morgan Securities Inc.
INTRODUCTION TOCORRELATION PRODUCTS
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE
Consider an FTD: Client Sells Protection
� Client receives periodic spread until Credit Event occurs
� Similar to single name CDS
� After Credit Event:
� Client is delivered defaulted bond
� Client pays par
� Transaction ends after the first Credit Event
CDS #1
CDS #2 1st Default?Buyer Seller(client) FTD
Contingentpayment
Premium
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Basket Trade (FTD) Value Drivers
� Number of Basket Components
� As number of credits increases, likelihood of one defaulting also increases
� Greater number of names, greater premium paid
� Absolute Spread Levels
� Clustered spreads provide greatest value
� Outlying credit spreads skew basket premium
� Correlation
� Lower correlation� Higher risk (expected loss),
higher spread
Correlation
Sum of individual spreads
Widest individualspread
50% 100%0%
Spread
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What Have People Actually Done?
� Example: Client sells FTD protection on five high-grade credits
� Yield enhancement
� Client chooses names to coincide with its own analysts�/in-house views
� Clustered spreads
� Credits have low correlation to maximize spread
Example
Credits 5-yr bid (bp) Summary statistics
EOP Operating Limited Partnership 48 FTD swap premium 176bp
Sears Roebuck Acceptance Corp. 46 Aggregate bid spread 220bp
SLM Corporation 42 Premium as a % of aggregatebid spread
80%
The Goldman Sachs Group Inc. 34 Premium as a % of highest bidspread
352%
Verizon Global Funding Corporation 50 Average spread 44bp
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Tranched TRAC-X: The Benchmark for Correlation
� Extends Tranche Technology to an Index
� Leverages the Index Liquidity� Lower bid/offer� Largest number of market makers
� Greater Pricing Transparency� Two-way markets quoted daily by multiple dealers
� Follow-on Step in Market Standardization� Static and widely traded portfolio� Standardized documentation between dealers and
clients
� Range of TRAC-X indices can be referenced, including
� North America (five and ten years)
� North America high-yield
� Emerging markets
� Europe
30�100%
0�3%3�7%
10�15%
15�30%
7�10%
Note: Portfolio tranches shown are not drawn to scale
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This material is not a product of J.P. Morgan Securities Inc.�s (�JPMSI�) Research Departments, and you should not regard it asresearch or a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of theindividual author and may differ from the views or opinions expressed by JPMSI�s Research Departments or other departments ordivisions of JPMorgan and its affiliates. Research reports and notes produced by the Firm�s Research Departments are availablefrom your salesperson.
This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment byJPMorgan to enter into any transaction. No reliance should be placed on the information herein, which is preliminary and doesnot constitute all the information necessary to evaluate investing in any financial instrument or participating in any transaction.This material may also include information obtained from sources believed to be reliable, but JPMorgan does not warrant itscompleteness or accuracy. Any decision to invest in any financial instrument, or participate in any transaction, described hereinshould be based solely on the final documentation related thereto. Nothing herein is a recommendation to invest in any financialinstrument or participate in any transaction or legal, tax, regulatory or accounting advice, and each prospective investor ortransaction participant must make an independent assessment of such matters in consultation with its own professional advisors.Additional information is available upon request. JPMorgan is the marketing name for J.P. Morgan Securities Inc. (member,NYSE/NASD) and its investment banking affiliates.
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