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occurs, investors in the SPV will receive gross returns equal to the triple-A
rated investments and the default swap premium.
Aside from differences in how synthetic and nonsynthetic CDOs can be
created, synthetic CDOs are not subject to the same legal and regulatory
requirements as regular CDOs. For example, on the legal front, requirements


with matters like making notice to obligors are less an issue since the issuer
is retaining a synthetic CDO™s underlying securities. On the regulatory
front, and as already alluded to above, it has been held that for purposes of
risk-based capital, an issuer of a synthetic CDO may treat the cash proceeds
from the sale of credit-linked notes as cash that is designated as collateral.
This then permits the reference assets”the loans carried on the books of the
issuing bank”to be eligible for a zero percent risk classification to the extent
that there is full collateralization. This treatment may be applied even when
the cash collateral is transferred to the general operating funds of the bank
and not deposited in a segregated account.
Table 3.7 shows credit derivatives in the context of their relationship to
underlying securities. As shown, cost, the desired credit exposure or trans-

TABLE 3.7 Credit Derivative Profiles
Credit Derivative Underlying Spot Pros/Cons

Credit put/call options Single reference Offers a tailor-made hedge,
and forwards security though may be expensive owing
to its unique characteristics as
created by buyer and seller
Credit default swap Usually a portfolio Typically created with unique
of securities securities as defined by buyer
and seller, so may be more
expensive than a total rate of
return swap
Total rate of Index (portfolio) Generally seen as less of a
return swap of securities commodity than credit-linked
notes, and may be more
expensive as a result
Credit-linked notes Single reference Often a more commoditized
security or portfolio product relative to individual
of securities options and forwards, so may
not be as expensive
Synthetic CDO Portfolio of Blend of a CDO, credit-linked
securities note, and credit default swap in
terms of cost, and may offer
issuer certain legal and
regulatory advantages
Interest rate swap Reference credit Perhaps the least expensive of
rate (typically a Libor credit derivatives, but also
rate) relative to a non- considerably less targeted to a
credit-sensitive rate single issuer or issuer-type
(typically a Treasury
or sovereign rate)


fer of credit exposure, and various legal and regulatory considerations all
can come into play in differing ways with these products. Chapter 6 pre-
sents more detail pertaining to the particular tax and legal issues involved.
The following chapters make reference to these products, and highlight
ways in which other security types may be considered to be credit deriva-
tives even if they are not conventionally thought of as such.

This chapter examined how credit permeates all aspects of the financial mar-
kets; issuers, counterparties, and the unique packaging of various financial
products are all of relevance to investors concerned about managing their
overall credit exposures. While rating agencies can rate companies and their
financial products, there are limitations to what rating agencies or anyone
else can see and judge. Cash flows can be used to redistribute credit risk. Cash
flows cannot eliminate credit risk, but they can help to channel it in innov-
ative ways. And finally, a variety of innovations are constantly evolving in
response to investors™ needs for creating and transferring credit exposures.
As perhaps more of a conceptual way of summarizing the first three
chapters, please refer to Figure 3.9. As shown, there can be creative ways

Cash flow Product: Ginnie Mae pass-
Spot through bond
Cash flows: Collateralized spot
Credit: Guaranteed by U.S.
government (triple-A)
Product: Preferred stock
Cash flows: Spot
Credit: Single-A rated

Dividing point
between equity
and bond; as we
move farther from
the origin, the
seniority of the
O increases
AAA Bond


FIGURE 3.9 Conceptualizing risk relative to various cash flows and products.


of linking the first three triangles of products, cash flows, and credit.
Consider how other products might be placed in such a three-dimensional
context, not only as an academic exercise to reinforce an understanding of
financial interrelationships, but also as a practical matter for how portfo-
lios are constructed and managed.
Chapter 5 explores how credit and other risks can be quantified and


Financial Engineering,
Risk Management, and
Market Environment


Financial Engineering

Product Portfolio
creation construction

Strategy development

This chapter shows how combining different legs of the triangles presented
in Chapters 1, 2, and 3 can facilitate the process of product creation, port-
folio construction, and strategy development.

Strategy development

This section presents three strategies: a basis trade from the bond market,
a securities lending trade from the equity market, and a volatility trade from
the currencies market.
Generally speaking, a basis trade (see Figure 4.1) is said to exist when
one security type is purchased and a different security type is sold against
it. Assume that an investor goes long spot and simultaneously sells a for-
ward or futures contract against the long position. For a forward contract,
this may be mathematically expressed as

Basis trade = S F.



= Basis trade
Spot Forwards
or future
Buy Sell

FIGURE 4.1 Combining spot and futures to create a basis trade.

Since we know that F S SRT for an underlying spot with no cash
flows, we can rewrite the above with simple substitution as

Basis trade = S S SRT.

The two spot terms cancel since one is a plus and the other is a minus,
and we are left with

Basis trade = SRT.

The minus sign in front of our SRT term simply reminds us that in this
instance of going long the basis, we become short SRT (cost of carry). When
we are short anything”an equity, a bond, or a bar of gold”we want the
price of what we have shorted to go down. In this way the trade will be prof-
Since basis refers to those instances where one security type (e.g., spot)
is somehow paired off against another security type (e.g., futures), basis risk
is said to be the risk of trading two (or more) different security types within
a single strategy. The basis risk with the basis trade above is that prior to expi-
ration of the futures contract, the value of SRT can move higher or lower.
Again, since we want SRT to go lower, if it moves higher anytime prior to
expiration of the futures contract (as with a higher level of spot), this may be
of concern. However, if we are indifferent to market changes in the intervening
time between trade date and expiration, then our basis risk is not as relevant
as it would be for an investor with a shorter-term investment horizon.
If we know nothing else about SRT, we know that T (time) can go only
toward zero. That is, as we move closer and closer to the expiration date,
the value of T gets less and less. If we start the trade with 90 days to matu-
rity, for example, after 30 days T will be 60/360, not 90/360. And at expi-
ration, T is 0/360, or simply zero. Thus, it appears that we are virtually
assured of earning whatever the value is of SRT at the time we go long the
basis”that is, as long as we hold our basis trade to expiration.

Financial Engineering

Chapter 2 discussed how futures differ from forwards in that the latter
involve a marking-to-market as well as margin accounts. To take this a step
further, futures contract specifications can differ from one contract to
another as well. For example, in the simple case of gold, gold is a stan-
dardized homogeneous product, and there is a lot of it around. Accordingly,
when investors go long a gold futures contract and take delivery at expira-
tion, they are reasonably assured of exactly what they will be receiving.
In the world of bond futures, things are a little different. While gold is
homogeneous, bonds are not. Coupons and maturity dates differ across secu-
rities, outstanding supplies of bonds are uneven, and bond issuers embody
varying credit exposures. Accordingly, even for a benchmark Treasury bond
futures contract like the Chicago Board of Trade™s (CBOT™s) 10-year
Treasury bond future, there is some uncertainty associated with the deliv-
ery process for trades that actually go to that point. Namely, the CBOT deliv-
ery process allows an investor who is short a futures contract to decide
exactly which spot Treasury securities to deliver. However, the decision
process is narrowed down by two considerations:


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