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The State of the Credit Derivative Market

As the credit crisis lingers into 2009, credit derivatives have come under increased scrutiny. Credit default swaps have been indentified as a culprit due to counterparty issues, lack of transparency, insufficient collateral requirements, and inefficient trade processing. Extensive measures have been taken to alleviate these problems. Various legislative efforts have been initiated and several exchanges are working to enact proposals that would alleviate counterparty concerns and increase transparency. However, exchanges and legislators have been unable to deliver timely solutions, for a myriad of reasons. These delays have prolonged the credit freeze, perpetuating the clog in the credit cycle that is preventing economic recovery from unfolding.

(Reprinted with permission from Financial Times, January 13, 2008)

Meanwhile, a viable, liquid alternative to CDS exists that more investors should consider. Specifically, the alternative exists in the listed equity options market. Deep Out-Of-the-Money put options (DOOMSMOptions) possess many of the same protective characteristics as CDS, but they do not come along with all of the baggage. DOOM Options are centrally cleared through the AAA-rated Options Clearing Corporation. They are fully transparent with easy-to-access bids and offers. And they are operational efficient with T+1 settlement, thus avoiding the onerous trade backlogs that have been plaguing the CDS market.

Why DOOM Options?

DOOM Options track CDS spreads closely, especially in times of severe credit deterioration, the moments when credit protection is most necessary. DOOMs and CDS track well because they both contain components that measure investor sentiment. CBOE’s VIX is a measure of stock implied volatility and is widely known as “the investor fear gauge”. As equity investors become more concerned about decreasing share prices, they tend to be more aggressive in obtaining downside protection, thus pushing up implied volatilities and, consequently, VIX. Similarly, as credit investors become concerned about a firm’s ability to repay its debts, they demand greater yield for their risk, resulting in credit spread widening.

A credit derivative market alternative Deep Out-Of-the -Money Put OptionsSM

VIX vs. Investment Grade Credit SpreadsSources: Markit & CBOE

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DOOM Quick Reference Guide Chicago Board Options Exchange - March 2009

Several examples over the past year demonstrate the close relationship between DOOM Options and Credit Default Swaps. Indeed, the following examples indicate that:

• DOOM Options behave almost identically to CDS, especially in times of severe credit deterioration• It is sometimes cheaper to obtain protection via DOOM Options instead of CDS• Credit deterioration is sometimes recognized sooner in DOOM Option markets

Moreover, DOOM Options are:• Centrally cleared through the AAA-rated Options Clearing Corporation• Completely transparent• Traded in a securities account (no ISDA documentation required)

Example 2, Visteon: It is sometimes more capital effi cient to hedge credit risk with DOOM Options, as compared to CDS

Assuming a particular recovery rate and that share prices go to zero upon bankruptcy, the same payoff of a CDS can be replicated with DOOM Options. On May 16, 2008, imagine an investor looking for $1 million worth of protection for the next several months on Visteon. VC stock was trading at $4.75, its 5-year CDS was 1137 bps, and the December 2008 2.5 put had a mid-market price of $0.275.

Assuming a 40% recovery rate, the CDS would pay $600,000 in the event of default. Assuming VC goes to zero in the event of default, the investor would need to purchase 2,400 2.5 struck puts to obtain a $600,000 payoff. The cost of the listed equity option position would be $66,000. The cost of the CDS position over the same time frame would be $66,325. (CDS costs calculated using today’s convention of a ‘running spread’. However, OTC practice will soon change to trading in points upfront + a fi xed running spread, thereby making the VC CDS trade even more costly at the onset).

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A credit derivative market alternative Deep Out-Of-the -Money Put OptionsSM

Example 1, Lehman: DOOM Options track CDS especially well in times of severe credit deterioration

Several academic studies have been conducted examining linkages between CDS spreads and equity options. Most notably, Dr. Peter Carr (Head of Quantitative Financial Research at Bloomberg) concluded in a 2007 paper entitled Simple Robust Linkages Between CDS and Equity Options, that “…default probabilities can be directly expressed in terms of American bear put spreads…”

As bankruptcy became increasingly likely at the beginning of September, 2008, Lehman’s CDS spread and the January 2009 25.0 / 15.0 put spread behaved almost identically:

DOOM Quick Reference Guide Chicago Board Options Exchange - March 2009