J U LY 2 0 0 6
S T R I C T LY
P R I VAT E
AN D
C O N FI D EN TI AL
THE JOINT 14TH ANNUAL PBFEA AND 2006 ANNUAL FEAT CONFERENCE
This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including
such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or
transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes
only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this
presentation nor any of its contents may be used for any other purpose without the prior written consent of JPMorgan.
JPMorgan's policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a
rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan also prohibits its
research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to
benefit investors.
JPMorgan is a marketing name for investment banking businesses of J.P. Morgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan
arranging, financial advisory and other investment banking activities for Asian clients are performed by certain of such subsidiaries in Asia and/or J.P.
Morgan Securities Inc. and/or its banking affiliates.
T HE
1 4 T H
The information in this presentation is based upon management forecasts and reflects prevailing conditions and our views as of this date, all of which are
accordingly subject to change. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and
completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed
by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan
makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of
consummating a transaction. The information in this presentation does not take into account the effects of a possible transaction or transactions involving
an actual or potential change of control, which may have significant valuation and other effects.
J O I N T
AN N U AL
P B F E A
AN D
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New Derivatives Guideline for Insurance Co in Taiwan
Disclaimer: Asia Pacific in English
法規節錄
保險業從事衍生性金融商品交易應注意事項 :
I
AN D
P B F E A
AN N U AL
II
1.
放寬以避險為目的所投資的衍生性金融商品類型,
並納入與避險項目具有高度相關性的避險衍生性
金融商品
2.
增加保險業的避險效率, 更大幅減少保險業避險成
本
七、保險業為增加投資效益，得從事下列衍生性
金融商品交易：認購（售）權證 ,經主管機關依
期貨交易法第五條公告期貨商得受託從事之期貨
交易
1.
放寬非避險目的的投資, 也就是俗稱的套利, 投資
, 保險公司不必具有現貨, 就可以投資, 不只讓投
資彈性增加, 也增加了投資收益
2.
由於衍生性商品金融商品財務槓桿較高, 金管會規
定, 以非避險為目的的投資, 不得超過淨值40%
1.
提高投資結構型商品的限額, 投資額度部分由現行
各該保險業5%提高至10%, 對最終日未逾五年的結
構商品, 其到期本金之保本比率得為90%以上
2.
預計將有1,386億元注入國內衍生性金融商品市場
八、因增加投資效益所持有之國內或國外衍生性
金融商品，其契約總（名目）價值，合計不得超
過各該保險業業主權益之百分之四十，其中國外
部分不得超過各該保險業業主權益之百分之二十
1 4 T H
J O I N T
T HE
主要效益
五…..得基於避險目的，從事下列與前述資金運
用相關之衍生性金融商品交易:
（一）認購（售）權證。（二）選擇權或期貨。
（三）證券商經核准於營業處所經營之衍生性金
融商品。（四）銀行經許可或核准辦理之衍生性
金融商品。（五）最近一年長期債務信用評等等
級經中華信用評等公司或其他經主管機關認可之
國內外信用評等機構評定達 twA －級或相當等
級以上之國內外金融機構承作之各種標的之衍生
性金融商品。
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十、保險業投資之結構型商品應符合下列條件，
其投資總額不得超過保險業資金之百分之十
III
Agenda
Page
Synthetic Portfolio Insurance (SPI)
1
Proxy Basket SPI
8
Credit Long Short SPI
15
Equity Default Swaps
24
Equity Based Collateralized Obligations (ECOs)
28
Low Equity Barrier Enhanced Notes (LEADs)
31
T HE
J O I N T
1 4 T H
AN N U AL
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1
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Constant Proportion Portfolio Insurance (CPPI)
 Investment is comprised of two parts—
Risky Asset
Zero coupon bond
Risky asset + Risk Free Asset (Zero
coupon bonds)
 The higher the amount of risky assets
in the portfolio, higher the potential
returns over the principal amount.
Variable
investment
S Y N T HE T I C
P O R T F O L I O
I N S U R AN C E
(S P I )
 This fraction of the risky asset in the
Dynamic Basket is referred to as
“Exposure”
 The exposure is adjusted from time to
Dynamic Basket
Investment in
Risky Asset
time to maximize potential return and
ensure principal protection
Investment in
Zero Bond
CPPI rebalances between an investment in the Risky Asset and a zerocoupon
bond to provide principal protection
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Constant Proportion Portfolio Insurance—an example
Principal assurance through risk-less assets
 In order to guarantee a certain
principal on maturity, we can invest
an amount equal to the principal
discounted by the risk free rate
 The remaining $40 can be invested
assets (Zero Coupon Bonds) and
Risky assets and is referred to as
the “Dynamic Basket”
S Y N T HE T I C
I N S U R AN C E
in risky assets to generate
additional returns (Cushion)
Cushion
Value of assets
$100 after 10 years, it is sufficient
to invest in a risk free zero coupon
bond trading at $60 if risk-free rate
is 5.3%
P O R T F O L I O
(S P I )
 For Example, to ensure a return of
Assured principal value
100
Bond Floor
60
Risk-less bonds
 This creates a portfolio of risk-less
Year 1
Year 2
Year 3
Year 4
Year 10
Time to maturity
3
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Using crash size to define threshold for downside
protection
Principal protection under crash
 The amount by which the risky asset can depreciate
Proxy Basket
in one single day is also estimated and is referred to
as the “Crash Size”
 Suppose we assume a Crash Size of 15%
Initial
investment
 We will use Crash Size to increase the exposure to
S Y N T HE T I C
P O R T F O L I O
I N S U R AN C E
(S P I )
Initial Portfolio (1)
 With this estimate, we can invest (100—60)/(0.15) 
$270 in risky assets
After Crash (2)
 If a 15% crash occurs, then value of the risky asset
reduced to $230
Principal
protection
100%
15% Crash of proxy basket
Value of Dynamic Basket
the proxy basket beyond the the initial cushion
Risk-less Asset
60%
Reallocation
0%
Reallocated
At
Dynamic Basket maturity
(3)
 The risky asset is sold off at this reduced market
Negative Values
indicate Leverage
value and reinvested in riskless asset
(170)%
Reallocated Dynamic Basket (3)
 Investment in the riskless asset = 230—170 = $60
(1)
Initial allocation
(2)
After crash
 This amount ensures principal guarantee at maturity
4
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Introduction to Synthetic Portfolio Insurance (SPI)
What if SPI?
 Developed by JPMorgan as an OTC replication of the traditional Constant Proportion
Portfolio Insurance (CPPI) strategy
 In a standard CPPI structure, the investor buys units of a fund that is created and
managed by the Asset Manager for the purpose of the CPPI structure
 Equity exposure can fall to zero
 Currency protection is not necessarily possible
 The underlying funds value is not verifiable
 In the JPMorgan SPI structure there is no fund vehicle involved and the investor buys
a zero coupon bond plus a call option on the NAV of the notional portfolio which
synthetically replicates an enhanced CPPI strategy
S Y N T HE T I C
P O R T F O L I O
I N S U R AN C E
(S P I )
 This arrangement gives rise to the following limitations
5
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SPI structural diagram
Structural diagram: Investor invests 100% in SPI structure
Funding
100%
Investor
Issuer
Fund
Allocation
JPM
SPI basket
ZC
Funding
100%
S Y N T HE T I C
P O R T F O L I O
I N S U R AN C E
(S P I )
Instrument
SPI structure
Payoff at maturity: Investor receives higher of 100% Principal invested and SPI Dynamic Basket Return
Max (SPI Dynamic
Basket, 100%)
Investor
Max (SPI Dynamic
Basket - 100%, 0)
Issuer
SPI Dynamic
Basket
JPM
SPI basket
100%
Instrument
SPI structure
6
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Benefits of SPI
Capital Protection
 Participation in underlying while maintaining capital protection.
Flexible Underlying
 Risk-return optimised portfolio can be diversified across fund managers, investment
Minimum Equity Exposure
 Prevents the synthetic portfolio from becoming ‘cash-locked’ by setting a minimum
strategies or asset classes
S Y N T HE T I C
P O R T F O L I O
I N S U R AN C E
(S P I )
proportion of assets that will be held in equity; This allows the portfolio to participate
in a market rebound, without affecting the capital guarantee.
No External Investment vehicle
 No requirement to set up purpose built investment vehicle, hence very fast delivery of
Full Currency Protection
 Standard CPPI structures can be offered with currency hedging overlays, but these do
the product in the market
not offer the same transparency and efficiency as the full quanto protection that the
JPMorgan SPI structure offers.
Verifiable & Transparent Pay-off
 Re-balancing of the portfolio can be tracked using market data, on a daily basis.
JPMorgan will actively reallocate the notional portfolio according to a ‘Dynamic
Allocation Strategy’ in line with the predefined principles. Thus SPI is not a ‘blackbox’ fund unit product
ISDA Documentation
 The product is delivered in an efficient OTC format. Exposure may be delivered in
Swap or option format or in combination with guaranteed cash-flows traded and
confirmed as a regular OTC derivative using standard ISDA format
7
Agenda
Page
Synthetic Portfolio Insurance (SPI)
1
Proxy Basket SPI
8
Credit Long Short SPI
15
Equity Default Swaps
24
Equity Based Collateralized Obligations (ECOs)
28
Low Equity Barrier Enhanced Notes (LEADs)
32
T HE
J O I N T
1 4 T H
AN N U AL
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AN D
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8
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What is a Proxy Basket strategy?
 The Risky Asset in the Dynamic Basket is a basket of currencies
referred to as the “Proxy Basket”
 The strategy synthetically replicates an asset which is
Basket of
currencies
constructed using currency pairs denominated vs. JPY
 The weights assigned to currency pairs in the asset are
optimized based on historical data in a way that the
movements of the currency pairs offset each other
Offset
 Assuming optimal offset the basket maintains the same value
while earning a high carry based on the interest rate
differential of the underlying currency pairs
JPY
 JPMorgan believes that there is a low probability of a
P R O X Y
B AS KE T
S P I
significant mismatch in the offset of the currency pairs
9
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Proxy Basket construction
Overview
 JPMorgan believes a basket of foreign
currency can be constructed to track the
movement of JPY closely
 JPMorgan has performed rigorous analysis to
construct the appropriate combination of
different currencies to give optimal yield and
correlation to JPY appreciation/depreciation
 The weightings are shown in the table on the
right as an example of the Synthetic Asset
Construction
Currency
Weighting
Australian Dollar (AUD)
(5.314)% (SHORT)
South Korean Won (KRW)
31.034% (LONG)
European Union Euro (EUR)
(1.703)% (SHORT)
Singapore Dollar (SGD)
(16.255)% (SHORT)
British Pound (GBP)
20.558% (LONG)
Thai Baht (THB)
19.911% (LONG)
Swiss Franc (CHF)
(23.455)% (SHORT)
Indian Rupee (INR)
88.608% (LONG)
P R O X Y
B AS KE T
S P I
 The basket is optimized to grow at 5%¹ carry
¹ Basket-Carry is 5.5%. An embedded fee of 50bp is charged to cover replication costs
10
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Proxy Basket correlated to JPY
High correlation between JPY and basket
Correlation JPY and Basket
145
140
Basket depreciation
135
130
125
120
115
110
105
100
P R O X Y
B AS KE T
S P I
100
105
110
115
120
125
130
135
140
JPY depreciation
Source: JPMorgan, as of 4/6/06
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Historical spot price of JPY and Basket equivalent spot
Spot price of JPY and Basket Equivalent spot show very similar movements
JPY spot
145
Basket Eqv. spot
140
135
130
125
120
115
110
P R O X Y
B AS KE T
S P I
105
100
01/01/99
03/02/00
05/02/01
07/02/02
09/01/03
10/31/04
12/31/05
Source: JPMorgan, as of 4/6/06
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Growth of Proxy Basket via SPI strategy
Mechanics
 The Proxy Basket grows
Growth
3.0%
270%
Initial leverage
(Realized
at
maturity)
Carry
5.0%
fee are paid to the client
 The whole structure
initially leverages
through the CPPI payoff
by 270%
Fee paid
2.0%
Guaranteed
1.0%
payable
quarterly
 Out of this growth 2%
270%
Initial leverage
Annual
payout
5.4%
 Guaranteed payment of
1% per annum on the
notional payable
quarterly
P R O X Y
B AS KE T
S P I
Growth of Proxy Basket
Growth
8.1%
at the rate of the carry
of 5% (assuming there
are no tracking errors)
13
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Credit Long-Short – Structure Overview
Credit Long-Short Strategy
The credit long-short strategy will take exposure to (i) a long Junior Mezzanine CSO Tranche
and (ii) a selected short portfolio of single name corporate credit derivatives
Single Name Credits
Credit 1
CDS
A
“Super Senior”
Credit 2
Portfolio
Actively managed
mezzanine CSO
tranche
Credit 3
Credit 4
CDS
B
CDS
C CDS
X
Mezzanine
Credit...
Equity
Long portfolio
Short portfolio
P R O X Y
B AS KE T
S P I
Long tranche
The strategy attempt to achieve a “delta neutral” state and maintain a “convex” return profile,
thus making returns relatively neutral to movements in credit spread
14
Agenda
Page
Synthetic Portfolio Insurance (SPI)
1
Proxy Basket SPI
8
Credit Long Short SPI
15
Equity Default Swaps
24
Equity Based Collateralized Obligations (ECOs)
28
Low Equity Barrier Enhanced Notes (LEADs)
31
T HE
J O I N T
1 4 T H
AN N U AL
P B F E A
AN D
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15
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Credit Long-Short - Rationale
Macro considerations
Continued lack of apparent trend in
credit spreads1
800
700
Average
 Oil price and commodity price effects
35%
 Auto sector uncertainty
30%
20%
500
15%
400
10%
300
5%
200
0%
Sep-04
Oct-03 Apr-04 Oct-04 Apr-05 Oct-05
Strategy
3-7 CDX Tranche
3-6 iTraxx Tranche
25%
600
neutralising movements in credit
spreads
SP I
Correlation levels for tranched Junior
Mezzanine at historical lows
 Leveraged and M&A bids
iTraxx 3-6 mid spread levels
 To achieve a convex return profile
 Not take exposure to “first loss”
Equity Tranches
 Give short credit exposure to
Mar-05
Sep-05
Apr-06
 Take Junior Mezzanine Tranche
exposure to benefit from any
correlation increases
“bearish” names
C R E D I T
L O N G
SHO R T
Idiosyncratic risk still high
1
Source: JPMorgan, Morgan Markets, M&G as of April 2006
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Spread risk profile – An illustration
Illustrative Long Mezzanine tranche—Change in MTM1
Illustrative sensitivity to instantaneous spread change1
50%
100%
50%
40%
0%
(50%) 50%
75%
(100%)
100%
125%
150%
175%
200%
30%
Spreads as % of current spreads
Illustrative short CDS Portfolio—Change in MTM1
Leverage2
C R E D I T
L O N G
Change in MTM
SHO R T
SP I
150%
100%
10%
50%
80%
102%
130%
160%
190%
(10%)
0%
(100%)
20%
(0%)
50%
(50%) 50%
Change in MTM
Change in MTM
150%
75%
100%
125%
150%
175%
200%
(20%)
Spreads as % of current spreads
Spread as % of current spreads
¹ Spreads move on the 1st day
² Illustrative leverage used in order for the portfolio to remain in a delta neutral state; Tranche leverage of 2.5 times used; CDS portfolio leverage of 9 times the tranche
notional used; The chart above shows hypothetical change in MTM (mark-to-market) of a chosen CSO tranche and Single name CDS portfolio and their combination in ”M&G
Credit Fund”
17
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Credit Long-Short – A case study
 M&G is the trading name of M&G Investment Management Limited , a wholly owned subsidiary of Prudential plc.
M&G has over €2371 billion assets under management and employs over 1481 investment professionals
M&G Credit Fund SPI Notes will provide investors with principal protected exposure to the M&G Credit Fund (“The
Fund”)
The Fund will take exposure to (i) a long Junior Mezzanine CSO tranche referencing a portfolio of primarily investment
grade corporates and (ii) a selected short portfolio of single name corporate credit derivatives
M&G will attempt to maintain a convex return profile for The Fund, thus making returns relatively neutral to
movements in credit spread whilst focusing on idiosyncratic default risk
The Notes returns will be determined by The Fund’s performance in addition to leverage which will be provided
through the application of Synthetic Portfolio Insurance (“SPI”) technology
Prudential M&G Credit SPI overview
Principal protection¹
C R E D I T
L O N G
SHO R T
SP I
Credit Fund
Actively managed
junior mezzanine
CSO tranche
CDS
A CDS
B CDS CDS
C
X
Long tranche
Short portfolio
SPI
(Synthetic Portfolio Insurance)
M&G Credit
Fund SPI Notes¹
¹Principal protection provided by AAA rated collateral
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Illustrative Fund return profile
 The net asset value (“NAV”) of The Fund will reflect the mark-to-market of the combination of the long junior mezzanine and short
CDS portfolio
 Returns on The Fund will represent a combination of carry and mark-to-market changes
 M&G will manage The Fund within preset limits6
Fund return assumptions
(preliminary strategy)
Hypothetical Fund Return computation2 (1Y)
 Underlying portfolios
 Long Junior Mezzanine: 10Y WAS = 93bp
 CDS portfolio: 10Y WAS = 87bp
 Long mezzanine attachment = 3.5—5.5%
Gross Fund return1 (A + B+C)
 Long Junior Mezzanine Tranche3
C R E D I T
L O N G
SHO R T
SP I
 Delta slide (10Y to 9Y)4
= 11.0%
Hypothetical carry
= 15.7%
 CDS Portfolio3
4
Carry
=
1 year
return
2.5
x
15.7%
=
39.0 %
(22.5)
x
1.0%
=
(22.5)%
(3.5)%
13.0%
= 4.7%
 Premium4
 Delta slide (10Y to 9Y)
B. CDS Portfolio return3
C. Operational Costs1
Illustrative calculation of Carry
x
Tranche returns (1Y)
A. Long Junior Mezzanine3
 Tranches
Leverage
= 0.20%
 Premium4
= 0.80%
Hypothetical carry
= 1.00%
Annual Portfolio Management Fee
Collateral Spread/yield5
Net Fund return
(1.5)%
4.1 %
15.6%
Note: The above analysis shows hypothetical returns based on certain assumptions.
1 Includes a Delta adjusted execution cost of 2% of the WAS and a 1% administrative cost charged by the swap counterparty
2 These return results are based on a hypothetical leverage of 2.5 times within The Fund
3 Implied spreads (as of valuation date March 31, 2006) for a delta hedged 3.5%-5.5% 10Y tranche were used; CDS Portfolio leverage of (22.5) required to maintain delta
neutral state
4 Delta slide represents the change in Mark to Market value as a result of the decrease in the time to maturity; Premium represents the Spread received/paid for selling/buying
protection
5 Assumed to be the 10 year EUR swap rate as of April 2006
6 JPMorgan monitors the level of leverage allowed within The Fund by running several scenarios on a daily basis. The process allows the Fund to maximise the exposure to
equivalent of a 30% crash size. More detail on the scenarios applied can be given upon request
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Illustrative Fund sensitivity—Single name spread widening
Hypothetical Fund Return—200bp single name spread after
one year12
Hypothetical Fund Return—200bp single name spread
tweak on Day 11
CF MTM
change (%)
CF MTM
change (%)
No tweak
Day one tweak sensitivity
54%
54%
47%
47%
39%
39%
32%
32%
24%
24%
17%
17%
9%
13.0%
No tweak
Day one tweak sensitivity
(0.02%)
9%
50%
(6%)
2%
75%
100%
125%
150%
Spreads as % of current spreads
175%
200%
50%
(6%)
75%
100%
125%
150%
175%
200%
(1.0%)
Spreads as % of current spreads
Illustrative tranche leverage of 2.5 times used;
1 This is achieved using an average name in the portfolio
2 Graphically represents the MTM effect of a spread increase of 200bp for an average name in the portfolio of the long Junior Mezzanine tranche at the end of the 1st year of
trading; The return for the 1st year does not include Management costs 0f 1.5% and Collateral returns
Note: The charts above shows hypothetical changes in MTM (mark-to-market) of the NAV of The Fund. Performances can vary significantly depending on the assumptions
taken.
C R E D I T
L O N G
SHO R T
SP I
11.0%
2%
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Illustrative Fund sensitivity—Correlation spike
Hypothetical CF MTM change v Correlation and spread tweak1
 Hypothetical scenarios have been devised to
replicate a potential distortion in the correlation
market
-15% Correlation tweak
0% Correlation tweak
15% Correlation tweak
35%
Scenario mechanics
30%
 Defining the “15% Correlation tweak” example
 The correlation level for the lower attachment
25%
point is shifted to 85% of the current value
 The correlation level for the Upper attachment
point is shifted to 115% of the current value
20%
15%
 Defining the “-15% Correlation tweak” example
 The correlation level for the lower attachment
point is shifted to 115% of the current value
C R E D I T
L O N G
SHO R T
SP I
 The correlation level for the Upper attachment
point is shifted to 85% of the current value
 Spread levels for the entire portfolio are
proportionately shifted to generate the convex
return structure
10%
5%
0%
50.00%
(5%)
(10%)
70.00%
90.00%
110.00%
130.00%
150.00%
Spreads as % of current spreads
¹ The MTM effects are consistent with a Gross Fund return where the Tranche leverage is 2.5
Note: The charts above shows hypothetical changes in MTM (mark-to-market) of the NAV of The Fund. Performances can vary significantly depending on the assumptions taken.
21
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Illustrative 10yr SPI Coupon format sensitivity
Hypothetical IRRs—USD Notes
Hypothetical IRRs—EUR Notes
Hypothetical
Gross Fund
Return¹
Hypothetical Net
Fund Return¹
Gross USD
Note IRR²
Net USD
Note IRR²
Hypothetical
Gross Fund
Return¹
Hypothetical Net
Fund Return¹
Gross EUR
Note IRR²
Net EUR
Note IRR²
(10.0%)
(7.4%)
0.1%
0.1%
(10.0%)
(7.4%)
0.1%
0.1%
(5.0%)
(2.4%)
0.7%
0.5%
(5.0%)
(2.4%)
0.5%
0.3%
5.0%
7.6%
10.1%
8.7%
5.0%
7.6%
7.9%
6.7%
10.0%
12.6%
20.1%
17.6%
10.0%
12.6%
16.6%
14.3%
13.0%
15.6%
27.2%
24.4%
13.0%
15.6%
23.2%
20.7%
15.0%
17.6%
31.7%
28.7%
15.0%
17.6%
27.8%
25.3%
20.0%
22.6%
42.7%
39.9%
20.0%
22.6%
38.5%
35.5%
25.0%
27.6%
55.3%
51.9%
25.0%
27.6%
50.3%
47.6%
USD Note IRRs for given fund return
EUR Note IRRs for given fund return
Net USD SPI Note IRR
Net Fund Return
Net EUR SPI Note IRR
50%
40%
40%
SP I
SHO R T
20%
10%
0%
10%
(10%)
(10%)
0%
(2.4%)
2.6%
7.6%
12.6%
Net Fund Return
L O N G
C R E D I T
30%
30%
20%
(7.4%)
1
2
Net Fund Return
50%
17.6%
22.6%
27.6%
(7.4%)
(2.4%)
2.6%
7.6%
12.6%
17.6%
22.6%
27.6%
Net Fund Return
Hypothetical Fund returns on an annual basis, assumed to be constant through the life of the trade.
Hypothetical IRR for SPI Notes. Gross IRR before considering 1% Principal protection fee; Net IRR after considering 1% Principal protection fee. Quanto adjustment are
included in the calculation of both Gross and Net Note IRRs. Performances can vary significantly depending on the assumptions taken.
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Equity Default Swaps: How does it work?
Credit Default Swaps
Reference
entity
Equity Default Swaps
Risk
Reference
stock
Fee/premium
Protection
buyer




Fee/premium
Protection
seller
Protection
buyer
Contingent payment
on Equity Default
Event
Protection
seller
A credit default swap is essentially a guarantee whereby the
protection buyer transfers the risk that the reference entity
will be subject to a credit default event
 An equity default swap is a contract whereby the protection
In return for the protection, the buyer pays a protection fee to
the seller (in a similar manner to an insurance premium or
guarantee fee)
 In return for protection, the protection buyer pays a per
On a credit default event, the buyer delivers a portfolio of
obligations of the reference entity, and receives par (or settles
a net cash amount)
A credit default event is defined as one of the following:
bankruptcy, failure to pay, restructuring
It is market practice to agree on a physical delivery of a
reference security
buyer transfers the risk that a reference stock will be subject
to an equity default event
annum fee to the protection seller
 On an equity default event, the protection seller pays a
recovery value to the protection buyer. the swap is settled
and there are no further cashflows
 An equity default event occurs if the closing price of the
reference stock is at or below 30% of its value at inception
 It is market practice to fix the recovery value at 50% of the
notional amount
C R E D I T
L O N G
SHO R T
SP I

Contingent payment
on Default (losses)
Risk
23
Agenda
Page
1
Proxy Basket SPI
8
Credit Long Short SPI
15
Equity Default Swaps
24
Equity Based Collateralized Obligations (ECOs)
28
Low Equity Barrier Enhanced Notes (LEADs)
31
T HE
J O I N T
1 4 T H
AN N U AL
P B F E A
AN D
AN N U AL
Synthetic Portfolio Insurance (SPI)
2 0 06
F E AT
C O N F E R E N C E
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Equity Default Swaps: How does it work?
Credit default event and equity default event
Swissair [Bloomberg: SRN VX]
 The equity default event is very transparent, as it
is based on the closing share price of the reference
name and whether it is at or below 30% of the
share price at EDS inception
400
Inception at 354 (3 May 1999)
350
 Similar to ‘traditional’ credit derivatives, where the
occurrence of a credit default event will trigger a
payment from the protection seller to the
protection buyer
300
250
 For traditional credit derivatives, the credit default
event is normally defined as the occurrence of
either:
200
 Bankruptcy
150
Bankruptcy
 Failure to pay
E Q U I T Y
D E F AU L T
S WAP S
 Restructuring
 Due to the complexity of definition, it is sometimes
difficult to determine whether a credit default
event has occurred or not
Barrier
(354 x 0.30) = 106.2
filed 2 October 2001
100
50
Equity default event at 104.5 (23 April 2001)
0
Jan-99
Aug-99
Mar-00
Oct-00
May-01
Dec-01
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Equity Default Swaps: How does It Work?
EDS Cashflows—No Equity Default Event
EDS Cashflows—Equity Default Event
EDS Spread
Accrued up to the
Equity Default Date
Protection
seller
receives
Protection
Seller
receives
3 m6 m9 m1 Y
2Y
3Y
EDS Spread:
Paid quarterly in arrears
5Y
3 m6 m9 m 1 Y
2Y
3Y
4Y
5Y
Equity Default Event
1-Recovery Value=50%
EDS of 500bp p.a. 125bp per
quarter
E Q U I T Y
D E F AU L T
S WAP S
4Y
Protection
Seller pays
Protection
seller pays
26
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Equity based collateralised obligations—ECOs
The mechanics of ECO
JPMorgan
Equity Default Risk
Tranched risk
Stock 1
Super-senior
Stock 2
Stock 3
SPV
ECOs
Stock ...
Stock n-2
Mezzanine
Stock n-1
Stock n
First loss risk
E Q U I T Y
D E F AU L T
S WAP S
 Investor Sells equity protection on an ECO tranche referencing a number of equities
 JPM risk-manages through entering into a number of Equity Default Swaps in the market to
offset
 Losses are allocated bottom-up as per tranche seniority i.e. First Loss to Mezzanine to Senior
tranche
 The events observed are Equity Default Events
27
Agenda
Page
Synthetic Portfolio Insurance (SPI)
1
Proxy Basket SPI
8
Credit Long Short SPI
15
Equity Default Swaps
24
Equity Based Collateralized Obligations (ECOs)
Low Equity Barrier Enhanced Notes (LEADs)
28
31
T HE
J O I N T
1 4 T H
AN N U AL
P B F E A
AN D
2 0 06
AN N U AL
F E AT
C O N F E R E N C E
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ECO—impacts of defaults on coupon and capital redemption
Mechanisms of ECO’s
Assumptions:
 Maturity: 5 years
Senior Tranche
 Portfolio: Globally Diversified Basket
 Quarterly Coupons
10%
Mezzanine ECO
 EDS portfolio of e.g. 100 names
5%
First Loss Tranche
 Recovery rate assumed to be 50%
0%
 This example is for illustrative purposes only
and does not reflect real pricing
Coupon paid quarterly as a % of the headline coupon
100
80%
60%
40%
20%
Number of
Defaults
Capital Redemption at Maturity
100%
80%
60%
40%
20%
1
2
3
4
5
6
7
8
9
10 or more
Number of
Defaults
E Q U I T Y
B AS E D
C O L L AT ER AL I Z E D
O B L I G AT I O N S
( EC O S)
100%
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Comparison of CDOs and ECOs
Comparison of ECOs v. CDOs
Default Trigger
Synthetic CDOs
 Names publicly traded on a stock exchange
 Names traded in the CDS market
 Majority of the large and liquid single stocks
 Majority of the names with outstanding debt
Equity Default Event
Credit Default Event
 Single Stock is trading below a percentage of the share  Bankruptcy
price at inception
 Failure to pay
 Restructuring
Loss on each
reference name
 Weighting of the reference name within the portfolio
 Weighting of the reference name in the portfolio
multiplied with the loss in the reference obligation
Impact of supply
and demand in the
equity market
Yes
No
Impact of supply
and demand in the
credit market
No
Yes
Transparency of
Default Event
 High Degree of Transparency, as the Equity Default
Event is observed on the official closing share price
 Might leave some room for discussions /
interpretations
E Q U I T Y
B AS E D
C O L L AT ER AL I Z E D
O B L I G AT I O N S
( EC O S)
Reference Names
Equity based Collateralised Obligations
30
Agenda
Page
Synthetic Portfolio Insurance (SPI)
1
Proxy Basket SPI
8
Credit Long Short SPI
15
Equity Default Swaps
24
Equity Based Collateralized Obligations (ECOs)
28
Low Equity Barrier Enhanced Notes (LEADs)
31
T HE
J O I N T
1 4 T H
AN N U AL
P B F E A
AN D
2 0 06
AN N U AL
F E AT
C O N F E R E N C E
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The concept of First-to-default
First-to-default swap
N to default swap
The First to default out of the basket causes the swap
to terminate, and the protection seller pays:
(1-Recovery Rate) * Notional Amount
A
D
B
F
E
1) Stock C defaults: swap terminates
2) Stock D defaults: no impact
3) Stock E defaults: no impact
A
D
C
Protection
Seller
receives
Protection
Seller pays
N to default basket (N = 2)
B
F
E
1) Stock C defaults: no impact
2) Stock D defaults: no impact
3) Stock E defaults: swap terminates
C
Protection
Seller
receives
3m6m9m 1Y
2Y
EDS Spread Accrued
up to the Equity
Default Date
3Y
4Y
1-Recovery Value=50%
5Y
Protection
Seller pays
3m6m9m 1Y
2Y
EDS Spread Accrued
up to the Equity
3Y
4Y
5Y
1-Recovery
Value=50%
Default Date
NB: this structure is often referred to as a “First-to-Default Swap” even though it is
technically an “N to default swap”
L O W
E Q U I T Y
B AR R I E R
E N HAN C E D
N O T E S
(L E AD S )
First to default basket:
The N default out of the basket causes the swap to
terminate, and the protection seller pays:
(1-Recovery Rate) * Notional Amount
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Low Equity Barrier Enhanced Notes - LEADs
LEADs
Indicative Terms
 First-to-default Equity swaps can be
Maturity:
5 years
Coupon:
X% subject to EDE
paid semi-annually
100%
structured in a capital protected format
E N HAN C E D
Equity Default Events that have occurred so
far is calculated
 After an initial threshold, the coupon will be
date, one of the underlying shares is trading
below 30% of it’s level at inception
reduced for every additional Equity Default
Event in accordance to a specified schedule
Equity Event 2
6m 1Y
2Y
3Y
4Y
100% Notional
re-paid at
Maturity +
Final Coupon
5Y
100% Notional paid
on Start Date
L O W
E Q U I T Y
 An Equity Default Event is triggered, if at any
Equity Event 1
Note buyer receives
 At each coupon payment date, the number of
Principal protection:
Note buyer pays
is a capital protected note, where the
coupon depends on the number of Equity
Default Events during the life of the note
B AR R I E R
N O T E S
(L E AD S )
 A LEADs (Low Equity Barrier Enhanced Notes)
33