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Europe Credit Research

26 January 2011

CDS Options Strategies


Strategies for every investor
CDS options are liquid, high volume products that provide attractive investment opportunities for many classes of investor. Typical trades include buying out-of-the-money payer options and selling receiver options (asset managers), hedging against large moves in spread (counterparty and loan desks), hedging convexity (correlation desks) and volatility trades (hedge funds and prop desks). In this piece we look at a variety of CDS options strategies available to a wide range of investors. These strategies can be roughly split into directional strategies, range-bound strategies and more complex options trades. Directional strategies have a bullish or bearish stance and include outright payers/receivers, payer/receiver spreads and risk reversals. We also examine how these directional strategies can be used to hedge existing credit positions. Range-bound strategies will return a profit or loss depending on whether the underlying index trades inside or outside a range at maturity. Examples of these strategies include straddles, strangles, butterflies and condors. We also examine ladder strategies, which are partly directional and partly range-bound in nature. We go on to discuss more complex strategies including volatility trading, skew trades, calendar trades and relative value trades. These trades make use of CDS options to express views on a wide variety of different factors. Volatility trading allows investors to express views on the future volatility of the underlying index independent of directional moves. Trading skew allows investors to express a view on the markets perception of the probability of a large sell-off. Calendar trades involve buying and selling options with different maturities in order to express time dependent views on either the spread or volatility. Finally, CDS options can be used in relative value trades between different CDS indices to express larger macro views.
Figure 1: P&L Profile of Ladder strategy
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

European Credit Derivatives Strategy Danny White


AC

(44-20) 7325-5066 danny.c.white@jpmorgan.com J.P. Morgan Securities Ltd.

Saul Doctor
(44-20) 7325-3699 saul.doctor@jpmorgan.com J.P. Morgan Securities Ltd.

Abel Elizalde
(44-20) 7742-7829 abel.elizalde@jpmorgan.com J.P. Morgan Securities Ltd.

Harpreet Singh
(91-22) 6157-3279 harpreet.x.singh@jpmorgan.com J.P. Morgan India Private Limited

2.0% 1.0% 0.0% -1.0% -2.0% 80 88 96 104 112 120 128 136 1m to ex piry 144 152 Ex piry 160 c

3m to ex piry
Source: J.P. Morgan.

2m to ex piry

See page 38 for analyst certification and important disclosures.


J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Table of Contents
Trading CDS Options: A strategy for every investor.............3 Expressing outright bullish/bearish views with CDS options ...................................................................................................4
Outright Payers/Receivers ...........................................................................................4 Payer/Receiver Spreads ...............................................................................................7 Summary of Outright Option Strategies ....................................................................12

Hedging existing credit portfolios with options ..................13


Combining existing credit positions with payer and receiver options .......................13 Hedging with payer/receiver spreads and risk reversals ............................................15

Expressing range-bound views with options ......................17


Straddles ....................................................................................................................17 Strangles ....................................................................................................................18 Butterflies ..................................................................................................................19 Condors......................................................................................................................21

Ladders ...................................................................................23 Trading volatility and delta-hedging .....................................26 Trading skew ..........................................................................27 Calendar trades ......................................................................28 Relative value trades with CDS options ...............................30
No. 1: Sell iTraxx Main Payer, buy iTraxx Crossover Receiver ...............................30 No. 2: iTraxx Main versus CDX.IG...........................................................................32

Appendix I: The Greeks .........................................................34

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Trading CDS Options: A strategy for every investor


Background Information on CDS options Currently it is possible to trade options on iTraxx Main, iTraxx Crossover and iTraxx Senior Financials in Europe as well as CDX IG and CDX HY in the US. Typical trade size = 250mn to 500mn in iTraxx Main/CDX IG 100mn in iTraxx Xover/CDX HY. Bid/offer on iTraxx Main/CDX IG is around 3-4c. Bid/offer on iTraxx Xover/CDX HY ranges from 6-12c. All CDS options are struck in spread terms, with the exception of CDX HY which is struck on price. CDS options provide attractive investment opportunities for many classes of investor. CDS options can be used to express outright views on spreads and volatilities or to hedge existing positions and portfolios. In particular, they can be highly useful instruments for investors who may not be accustomed to trading vanilla CDS but who still have large credit exposures through other instruments. For example, investors who hold large bond portfolios may find CDS options useful as they allow the investor to express a credit view which they would not be able to do so by solely trading bond products. Figure 2 breaks down the CDS options market by counterparty and shows the large variety of investor types that make use of CDS options. Hedge funds and prop desks trade a variety of option strategies, including plays on volatility and skew. Counterparty and loan desks use CDS options to hedge against large spread moves wider or tighter. Correlation desks use options to hedge convexity (gamma) exposure. Asset managers use options to gain additional income by selling receiver options and to hedge against spread widenings by buying out-of-the-money payer options.
Figure 2: CDS options trades by counterparty

Counterparty Desk, 10% Correlation Desk, 5% Broker, 20% Asset Management, 5%

Prop Desk, 20% Loans Desk, 10% Hedge Fund, 30%

Source: J.P. Morgan.

The aim of this primer is to explain the full range of uses of CDS options, and to identify the option strategies that are most suited to each type of investor. To do this we break the large variety of options strategies down into several chapters. In the first chapter of this primer, we will examine options strategies that express an outright directional view on spreads. This type of option trading is known as deltatrading. In the second chapter we will examine how options can be combined with existing CDS or bond positions to change the payoff profile of the existing position. This section will be of particular interest to holders of credit portfolios or other investors looking to add value to existing credit positions using CDS options.
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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

In Chapter 3 we discuss range-bound options strategies; the payoff of these strategies depends on whether the underlying spread trades inside or outside a range at maturity. Next, we discuss a particular type of option strategy known as a ladder. Ladder strategies combine directional and range views and can provide investors with effective hedges at zero cost. In the fifth chapter we explain volatility strategies as well as the concept of deltahedging. Finally, we shall discuss skew trading before going on to look at how option strategies can be combined to obtain relative value trades. For a more general introduction to CDS options, An Introduction to Credit Options and Credit Volatility gives a background to the mechanics behind CDS options. In this piece we have assumed that the reader is relatively familiar with the general language of options; in particular, references to option greeks are made on several occasions. Appendix 1 gives a brief reminder of the greeks.

Expressing outright bullish/bearish views with CDS options


Options are used to express markets views as well as to hedge against unfavourable market movements. In this section we shall discuss how to express bullish/bearish sentiments using options and which strategy is optimal for which market view.

Outright Payers/Receivers
The simplest option strategy is to buy or sell an option. There are four possible variations to this, each expressing a different market view.
Figure 3: Long Payer Option P&L
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
1.0% 0.5% 0.0% -0.5% -1.0% 70 80 90 100 110 120

3m to ex piry 1m to ex piry

2m to ex piry Ex piry

Source: J.P. Morgan.

Buy a payer option. This expresses a general belief that spreads will widen, while being concerned about the possibility of large tightenings. A common strategy among many fund managers is to buy deeply out-of-the-money payer options to protect against any large widening in spreads. However, the excess demand for these high strike payer options can result in an increase in the implied volatility at these strikes, resulting in a positive skew1. This makes out-of-the-money payer options relatively more expensive than options with lower strikes. Overall view: Bearish, long volatility. Example trading strategy: Hedging against large spread widenings. Maximum profit: Unlimited. Maximum loss: Premium.

1 Skew is defined as the difference in implied volatilities for high strike and low strike options. We discuss skew in greater detail on Page 27.

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Figure 4: Long Receiver Option P&L


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
1.0% 0.5% 0.0% -0.5% -1.0% 75 85 95 105 115 125

Buying a receiver option. Buying a receiver option expresses a view that spreads will tighten, but also caps the downside in the event of spreads widening. Receiver options can be used to hedge short positions. It can be cheap to buy receiver options with low strikes if the skew is large as the implied volatilities for lower strikes will be smaller. Overall view: Bullish, long volatility. Example trading strategy Hedging against snap spread tightenings. Maximum profit: StrikeDuration-Premium. Maximum loss: Premium.

3m to ex piry 1m to ex piry

2m to ex piry Ex piry

Source: J.P. Morgan.

Figure 5: Short Payer Option P&L


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
1.0% 0.5% 0.0% -0.5% -1.0% 70 80 90 100 110 120

Selling a payer option. Selling a payer option reflects a view that spreads will either remain around the same levels or will drift tighter. Sellers of payer options have their upside capped at the premium and unlimited downside, but the premium is often large enough to still make this an attractive strategy. Selling payer options is popular especially when combined with existing credit positions (see page 14). Overall view: Spreads remain constant or drift tighter. Example trading strategy: Combining with existing short risk credit position (see page 14). Maximum profit: Premium. Maximum loss: Unlimited. Selling a receiver option. As with the payer option, selling a receiver option generally reflects a view that spreads will either remain relatively constant or will drift wider. Selling receiver options is a common strategy when combined with an existing long risk credit position in order to obtain additional income (see page 14). Overall view: Spreads remain constant or drift wider. Example trading strategy: Combining with existing long risk credit position (see page 14). Maximum profit: Premium. Maximum loss: StrikeDuration-Premium.

3m to ex piry 1m to ex piry

2m to ex piry Ex piry

Source: J.P. Morgan.

Figure 6: Short Receiver Option P&L


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
1.0% 0.5% 0.0% -0.5% -1.0% 75 85 95 105 115 125

3m to ex piry 1m to ex piry

2m to ex piry Ex piry

Source: J.P. Morgan.

Single option greeks When trading CDS options investors are exposed to a number of different factors. These exposures are quantified by a set of values known as the greeks; using these an investor can obtain an instant impression of the nature of an option strategy and the risks it entails. The most intuitive exposure is that of the option's value to the underlying CDS spread; delta and gamma measure the first and second derivatives of an option's price with respect to the spread of the underlying. Furthermore, the value of the options will change as the option nears expiry and this exposure of the option's price to the passage of time is known as theta. Options are also exposed to the volatility of the underlying index; this is known as vega. The greeks are explained in further detail in Appendix I: The value of payer options will increase as the underlying moves wider, as there is a greater chance that the option will expire in-the-money. As such, buyers of payer options are long delta while sellers are short delta. Similarly, buyers of receiver options are short delta while sellers are long delta.

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Buyers of options are short theta, long gamma and long volatility. As time increases the value of the options they hold will fall. However, an investor who is long options will find that the value of the options will increase more quickly as the underlying moves in their favour and more slowly as the underlying moves against them; this characteristic is known as being long gamma. An investor who is long gamma will always be short theta; because of this theta is sometimes known as "gamma-rent"; i.e. the cost of being long gamma. Investors who hold options will also be long volatility and will have positive vega; an increase in volatility means that the expected payoff of their options position will be greater and so the value of their options will increase. Sellers of options have the opposite exposures; as time passes the value of their positions will increase but to offset this they will be short gamma. Similarly, sellers of options are short volatility.

Comparing basic option strategies The performance of these different strategies relative to one another and to a simple index position depends on the implied volatility of the options and the underlying spread. In Figure 7 we have compared three simple strategies that might appeal to a bearish investor; buying index protection, buying a payer option and selling a receiver option. In Figure 8 we have shown how implied volatility affects the payoff of a receiver option.
Figure 7: Comparison of options with index (50% implied vol)
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Figure 8: Comparison of receiver options with index)


Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 70 76 82 88 94 100 106 112 118 124 130

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 70 76 82 88 94 100 106 112 118 124 130 30% Imp Vol Short Risk Position
Source: J.P. Morgan.

Long pay er Short risk position


Source: J.P. Morgan.

Short receiv er

70% Imp Vol

Buying index protection is the most profitable strategy if spreads widen by a large amount as there is no premium to be paid; however the index will also record the biggest loss if there is a large spread tightening. Selling a receiver option will outperform buying a payer option for a range around the strike; this range is roughly equal to strike 2premium/duration (Figure 7). If volatility increases then the option premium also increases and so the range in which selling a receiver option is more profitable increases (Figure 8). As such, investors who believe that spreads will only widen slightly would be better off selling receiver options than buying payers or index protection.

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Selling a receiver option will outperform buying a payer option if spreads are in the range strike 2premium/duration at expiry.

The same holds for bullish strategies; selling payer options will outperform buying receiver options for a range approximately equal to strike 2premium/duration.

Payer/Receiver Spreads
Payer and receiver spreads combine two options to express an outright bullish or bearish view with capped upside and downside, as shown in Figure 9. The P&L profile for a payer spread is shown in Figure 10.

Figure 9: Construction of Payer Spread


Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Figure 10: Payer Spread P&L profile


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

0.6% 0.4% 0.2% 0.0% -0.2% -0.4%

2% 1% 0% -1% 60 80 100 120 140

60

68

76 3m to ex piry

84

92 2m to ex piry

100

108 1m to ex piry

116

124 Ex piry

132

140

Long 90 Pay er Short 110 Pay er 90-110 Pay er Spread


Source: J.P. Morgan. Source: J.P. Morgan.

A common use of payer or receiver spreads is to cheapen the cost of entering a payer or receiver by capping the upside; for example an investor who wished to purchase a payer option with a strike of 100bps but who was reluctant to pay the entire premium could also sell a payer option with a higher strike in order to reduce the premium. This would be an example of a payer spread. In general, a payer spread is constructed by buying a payer option with a low strike and then selling a payer option with a higher strike2. The maximum loss is equal to the premium of the higher strike option minus the premium of the lower strike option, and the maximum profit is roughly equal to (higher strike-lower strike)duration +(premium of higher strike option - premium of lower strike option). An at-the-money payer spread can also be viewed as an index position with a capped upside and downside. Payer spreads are more attractive when skew is highly positive as the investor can sell an option at a high implied volatility and buy an option at a low implied volatility. Once purchased, payer spreads will benefit from any decrease in skew. Skew trading is discussed further on page 27.

The maximum profit of a payer spread is roughly equal to (higher strike-lower strike)duration +premium of higher strike option -premium of lower strike option

Rather counter-intuitively, a payer spread payoff can also be constructed from receiver options, but it is still known as a payer spread. Similarly, receiver spreads can be constructed from payer options but are still known as receiver spreads.
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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Figure 11: Receiver Spread P&L Profile


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
0.4% 0.2% 0.0% -0.2% -0.4% -0.6% 60 76 92 108 124 Ex piry 140 3m to ex piry 1m to ex piry 2m to ex piry

Receiver spreads are the mirror equivalent of payer spreads as shown in Figure 11. They are usually constructed by buying a high strike receiver and selling a low strike receiver. In this case the maximum loss is premium of low strike option minus premium of high strike option. The maximum profit is (higher strike-lower strike) duration + premium of lower strike option premium of higher strike option. If skew is positive then receiver spreads are generally less attractive than payer spreads as investors are forced to buy an option at high implied volatility and sell an option at low implied volatility. As well as allowing investor to express outright views, payer and receiver spreads can be combined with existing index positions to give a limited hedge against underlying moves. We shall discuss this on Page 15. Payer/receiver spread greeks As payer and receiver spread strategies involve buying one option and selling another the theta, gamma and vega exposures cancel each other out to a certain extent. As such these exposures only become apparent when the options in the strategy are very close to expiry; in the strategy shown in Figure 10 for example the theta is very positive near the strike of the option being sold (at a strike of 110bps) and very negative close to the strike of the option being bought (90bps) but only when the option is close to expiry. Similarly, the gamma is highly negative close to the 110bp strike and highly positive close to the 90bp strike when the options are close to expiry. The delta is always positive for a payer spread and negative for a receiver spread. For a payer spread the initial delta is around 0.5 when the underlying is in between or around the strikes. Comparing payer/receiver spreads with outright options and index positions In terms of payoff at maturity a payer spread represents a halfway point between selling a receiver option and buying a payer option, as shown in Figure 12. Payer spreads outperform short receiver strategies when spreads are tight and long payer strategies when spreads are low-medium. As such, payer spreads are a good strategy for investors who believe that spreads should widen slightly but are worried about the possibility of large spread tightenings.
Figure 12: Comparison of payer spread and outright option positions.
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Source: J.P. Morgan.

The maximum profit of a receiver spread is roughly equal to (higher strike-lower strike)duration + premium of lower strike option premium of higher strike option

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 70 76 Long 90 Pay er


Source: J.P. Morgan. 8

82

88

94

100

106

112

118

124

130

Short 110 Receiv er

90-110 Pay er Spread

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Figure 13: Comparison of payer spread with short risk index position
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Likewise, receiver spreads are a strategy that suits investors who believe that spreads should tighten slightly but are still worried about the possibility of extreme widenings. Figure 13 compares the payoff of a short risk index position and a payer spread; the exact level of the payoff of the short risk index position depends upon the entry level but it can be seen that the gradient of the payoff at maturity is the same for both the payer spread and the index for a range between the two strikes. Payer Spreads Overall view:

1.0% 0.5% 0.0% -0.5% -1.0% 80 88 96 104 112 120

Example trading strategy: Maximum profit:

Pay er spread Short Risk Position


Source: J.P. Morgan.

Maximum loss:

Spreads likely to drift wider, but still concerned about extreme tightenings. Short skew. Combine with short index protection position to give hedge against limited moves in underlying. (Higher strike-lower strike)duration +premium of higher strike option - premium of lower strike option Premium of lower strike option minus premium of higher strike option.

Receiver Spreads Overall view: Example trading strategy: Maximum profit:

Maximum loss:

Spreads likely to drift tighter, but still concerned about extreme widenings. Long skew. Combine with long index protection position to give hedge against limited moves in underlying. (Higher strike-lower strike)duration + premium of lower strike option premium of higher strike option. Premium of higher strike option minus premium of lower strike option.

Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Risk reversals
Figure 14: Construction of risk reversal
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Risk reversals are constructed by buying (selling) a payer option at a high strike and selling (buying) a receiver option. The construction of a bearish risk reversal is shown in Figure 14. The payoff of such a strategy is shown in Figure 15.
Figure 15: Bearish risk reversal P&L Profile.
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

2% 1% 0% -1% -2% 60 80 100 120 140

Short 90 Receiv er Long 110 Pay er Bearish Risk Rev ersal


Source: J.P. Morgan.

0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% 90 93 96 99 102 105 108 Ex piry 111 114 117 120

1m to ex piry
Source: J.P. Morgan.

Figure 16: Bullish risk reversal P&L profile


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
0.5% 0.0% -0.5% -1.0% 90 96 102 108 114 120 Ex piry

Similarly, buying a low strike receiver option and selling a high strike payer option results in a bullish risk reversal. Risk reversals can be used to cheapen the costs of entering receiver or payer options by selling an out of the money option. For example; an investor who wanted to buy a 110bp payer option but was unwilling to pay the entire premium could sell a 90bp receiver option thus lowering the cost of entry and increasing the payoff should the underlying be above 90bps at expiry. These strategies are known as risk-reversals as when combined with an underlying CDS position or credit portfolio they convert the position from a bearish position to a bullish one or vice versa, thus reversing the risk while capping the upside and downside of the position. We shall discuss this use of risk reversals in the next chapter. By tailoring the strikes of the options in the risk reversal it is possible to achieve a P&L profile in which the flat part of the profile is positive; in this case the P&L profile begins to resemble that of a simple short payer/receiver position. Risk reversal greeks The greeks of a risk reversal depend upon how closely the strikes are positioned; if the strikes are very close together then the risk reversal will behave very much like an index position with negligible gamma, vega and theta and near constant delta. If the strikes are widely separated then the risk reversal greeks will resemble those of a long/short option strategy as the underlying approaches the relevant strike. Comparing risk reversals and outright risk positions Figure 17 compares the payoff at maturity of a bear risk reversal with a short risk index position; it can be seen that the risk reversal has a similar exposure to market moves for spreads outside the range set by the strikes.

1m to ex piry

Source: J.P. Morgan.

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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Figure 17: Comparison of bearish risk reversal with outright short risk position
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

2.0% 1.0%
Risk reversals are less bullish (bearish) than outright long risk (short risk) index positions.

0.0% -1.0% -2.0% 60 68 76 84 Bull cy linder


Source: J.P. Morgan.

92

100

108

116

124

132

140

Short Risk Position

Bearish Risk Reversals Overall view: Example trading strategy: Maximum profit: Maximum loss:

More bearish than long payer option, less bearish than outright long protection. Long skew. Combine with short index protection position to give hedge against limited moves in underlying. Unlimited Lower strikeduration + (Premium of lower strike Premium of higher strike)

Bullish Risk Reversals Overall view:

Example trading strategy: Maximum profit: Maximum loss:

More bullish than long receiver option, less bullish than outright short protection. Short skew. Combine with long index protection position to give hedge against limited moves in underlying. Lower strikeduration + (Premium of higher strike Premium of lower strike) Unlimited

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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Summary of Outright Option Strategies


Table 1: Summary of bullish options strategies
Bullish Strategies Bullish-ness (1 is most bullish, 5 is least bullish) Long risk index 1 Bullish risk reversal 2 Long receiver 3 Short payer 4 Receiver Spread 5 Strategy
Source: J.P. Morgan.

Maximum Profit Limited by entry level only Limited by strike only Limited by strike only Limited by premium Limited

Maximum Loss Unlimited Unlimited Limited by premium Unlimited Limited

Volatility Exposure Short skew Long volatility Short volatility Long skew

Default Exposure Exposed to default Exposed to default before expiry Exposed to default before expiry

Table 2: Summary of bullish options strategies


Bearish Strategies Bearish-ness (1 is most Strategy bearish, 5 is least bearish) Short risk index 1 Bearish risk reversal 2 Long payer 3 Short receiver 4 Payer spread 5
Source: J.P. Morgan.

Maximum Profit Unlimited Unlimited Unlimited Limited by premium Limited

Maximum Loss Limited by entry level only Limited by strike only Limited by strike only Limited by strike only Limited

Volatility Exposure Long skew Long volatility Short volatility Short skew

Default Exposure Benefits in event of default Benefits in event of default before expiry Benefits in event of default before expiry

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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Hedging existing credit portfolios with options


Options can be attractive hedges against market downturns for bond investors.

So far we have discussed the use of options in a stand-alone role. However, investors will also use CDS options in conjunction with existing credit positions. In this chapter we shall consider the different strategies available to investors who already hold credit positions, as well as which strategy suits them best depending on their current market outlook. Hedging credit portfolios with CDS options relies on there being a correlation between the portfolio and the underlying CDS index of the option. For example, an investor who holds a portfolio of high yield euro denominated bonds could make use of options on iTraxx Crossover, as the correlation between the two is likely to be high. However, an investor who holds a single bond of a single corporate would not necessarily be able to use CDS options as an effective hedge for that one bond because the correlation between that single bond and a CDS index may not be high. Nevertheless, CDS options could still be useful in order to hedge out market risk.

Combining credit portfolios with CDS options requires a correlation between the credit portfolio and the underlying CDS index for the option to be an effective hedge.

Combining existing credit positions with payer and receiver options


Investors holding credit positions can use single CDS options to enhance their strategies in a number of ways. The first way is to buy out-of-the-money options in order to hedge against large moves in spreads. A common example of this is holders of bond portfolios buying out-of-the-money payer options in order to hedge against any large widening in spreads. The further out of the money the option is the cheaper it will be but the less likely it will expire in-the-money. For example, if spreads are currently at 100bp a bond investor could buy a payer option with a strike of 130bps for a few cents. The delta of the option before expiry means that the investor will have limited protection against any widening in spreads before expiry, not just widenings beyond 130bps. Figure 18 overlays the P&L profile of a long risk position and out-of-the-money receiver and Figure 19 shows the combined long risk position and payer option compared against a stand alone long credit position. From Figure 19 we can see that the effect of the out-of-the-money payer option is to cap the downside at 130bps at the expense of a slightly smaller P&L for spreads tighter than 130bp.

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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

Figure 18: Overlay of P&L profiles for long risk credit position and out- Figure 19: Comparison of P&L profiles for long risk credit position of-the-money payer option with attached payer option and stand-alone long risk credit position
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp) Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

2.0% 1.0% 0.0% -1.0% -2.0% -3.0% 80 88 96 104 112 120 128 136 144 152 160

2.0% 1.0% 0.0% -1.0% -2.0% -3.0% 80 88 96 104 112 120 128 136 144 152 160

Long 130bp Pay er


Source: J.P. Morgan.

Long risk credit position


Source: J.P. Morgan.

Combined long risk credit positon and 130bp Pay er Long risk credit position

Similarly, investors with short risk credit exposures can purchase out-of-the-money receivers in order to cap their downside in the event of a large tightening in spreads. As well as buying options, holders of credit portfolios can also sell options to add value to their positions. Consider a long risk credit investor who has the intention of holding his or her portfolio and collecting the carry. At certain points, the investor may feel that any significant spread tightening is unlikely but is unwilling (or unable) to unwind the position. Here the investor could sell a CDS receiver option to generate additional income. Figure 20 shows the P&L profiles of the short receiver and long credit position separately, while Figure 21 compares the P&L profile at maturity of a combined long credit position and short receiver with an outright long credit position.
Figure 20: Long risk credit position and short receiver option P&L profile
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Figure 21: Comparison of short risk credit position with combined short risk position and short receiver.
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

2.0% 1.0% 0.0% -1.0% -2.0% 60 68 76 84 92 100 108 116 124 132 140

2.0% 1.0% 0.0% -1.0% -2.0% 60 68 76 84 92 100 108 116 124 132 140

Short receiv er option


Source: J.P. Morgan.

Long risk position


Source: J.P. Morgan.

Combined long risk position and short receiv er Long risk position

The long risk position with the additional short receiver will outperform the standalone long risk position as long as spreads do not tighten beyond a certain point. The strike of the receiver can be altered to give a higher or lower premium given the level with which the investor is confident that spreads will not tighten beyond.
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Furthermore, if an investor with a long credit exposure did not want to completely remove his or her exposure to spreads tightening but wished to reduce the total long exposure in the event of a tightening the investor could sell receiver options with a notional value equal to a percentage of the total long exposure the investor holds. For example, if the investor has a portfolio of 100 million EUR and then sells receiver options with a strike of 90bps on a notional of 30 million EUR then the net notional exposure of the portfolio will be reduced to 70 million EUR in the event of spreads tightening below 90bp. In addition to this the investor will receive an additional premium from selling the receiver options.
Figure 22: Comparison of short risk position with position that had been combined with short payer
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Similarly, for investors who hold short risk credit positions it would be possible to sell a payer option to obtain additional income. However, this strategy tends to be less popular as holding a short risk credit position is usually with the expectation that spreads will widen by enough to offset the negative time value of the position. As such, capping the upside of the position by selling an option is not necessarily an attractive strategy. Combined long risk position and short receiver Underlying position: Long risk credit position. Options used: Short receiver. Motivation: Gain additional income from selling option with expectation that spreads will not tighten much.

2.0% 1.0% 0.0% -1.0% -2.0% 60 80 100 120 140

Short risk & short pay er Short risk position


Source: J.P. Morgan.

Combined short risk position and short payer Underlying position: Short risk credit position. Options used: Short payer. Motivation: Gain additional income from selling option with expectation that spreads will not widen much.

Hedging with payer/receiver spreads and risk reversals


As mentioned in the previous chapter, existing credit positions can be combined with both payer/receiver spread and risk reversal strategies to give a new payoff profile. Combining credit portfolios with payer/receiver spreads gives an investor a payoff profile equivalent to that of a risk reversal, while combining an index position with a risk reversal gives an investor the payoff of a payer/receiver spread. Another important point is that combining an underlying credit position switches the exposure from long risk to short risk, or vice versa. Figure 23 summarises the different combinations of index positions and payer/receiver spreads and risk reversal hedges. Hedging index positions with risk reversals is a popular strategy as it in effect creates a payer/receiver spread like payoff, thus locking in any unrealised profit within a certain range.

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Figure 23: Summary of hedging index positions with payer/receiver spreads and risk reversals

Source: J.P. Morgan.

Hedging convexity exposure using options For investors such as correlation and ABS desks whose positions have highly convex profiles, CDS options are one way to hedge out this exposure by making use of the gamma exposure of options. Any residual delta position from these options could then be hedged out using the underlying index.

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Expressing range-bound views with options


In addition to taking outright bullish or bearish views, options allow investors to take views on spreads trading inside or outside a certain range at expiry. For example, an investor may believe that spreads will trade within a range of 20bp of the current spread for the next 3 months and wants to execute a trade that expresses this view. These types of trade always have an inherent volatility position as well; strategies that involve buying options will in general be long volatility and those involving selling options will be short volatility. Many investors enter these trades in order to express views on volatility itself without wanting to be exposed to moves in the underlying. These investors will usually delta-hedge to remove any exposure to the level of the underlying; this is done by buying or selling index protection in an amount that offsets the delta of the option. In this section we shall consider strategies for investors who want to express nondirectional views on spreads; we discuss volatility strategies and delta hedging on Page 26.

Straddles
The simplest non-directional view is what is known as a straddle. A short straddle position involves selling a payer option and a receiver option at the same strike. The P&L profile for a short straddle position is shown in Figure 24. The upfront premium from a straddle is equal to the sum of the premiums of the two options. In a short straddle strategy, a profit will be made if the underlying trades inside a certain range at expiry; this range is roughly equal to strike premium/duration.
Figure 24: Short straddle P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 60 68 3m to ex piry


Source: J.P. Morgan.

76

84

92

100

108

116

124

132

140

2m to ex piry

1m to ex piry

Ex piry

Similarly, if an investor believes that spreads will be outside a range at expiry, he can buy a straddle, the P&L profile of which is shown in Figure 25.

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As premiums increase with implied volatility, the range in which straddles are in or out-of-the-money depends greatly upon the implied volatility of the options being bought or sold. Higher implied volatilities will result in wider straddles. Straddle greeks Selling straddles results in a positive theta; the mark-to-market of the position increases with time especially if the underlying is close to the strike. The downside to this is that selling straddles leaves the investor with a negative vega and gamma, meaning that any large moves in the underlying away from the strike or any increases in implied volatility will decrease the mark-to-market of the position.
Figure 25: Long straddle P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
2.0% 1.0% 0.0% -1.0% -2.0% 60 76 92 108 124 140

Short straddle Maximum profit: Maximum loss: Overall view:

Premium Unlimited Spreads will trade inside a range at maturity.

Long straddle Maximum profit: Maximum loss: Overall view:


3m to ex piry 1m to ex piry 2m to ex piry Ex piry

Unlimited Premium Spreads will trade outside a range at maturity.

Strangles
A strangle is a very similar strategy to a straddle, except that the options in a strangle do not have the same strike. In a strangle strategy the investor will minimise the upfront premium paid by increasing the range of spreads for which the strategy is out-of-the-money at expiry. For example, while a straddle might consist of a payer and a receiver option both with a strike of 100bp, a strangle could be constructed from payer option with a strike of 110bp and a receiver option of 90bp. The P&L profile for such a strangle in shown in Figure 26. Figure 27 compares the payoff of straddles and strangles.

Source: J.P. Morgan.

Figure 26: Short strangle P&L profile


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

Figure 27: Comparison of straddle and strangle strategies


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 60 68 76 84 92 100 108 116 124 132 140

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 60 68 76 84 92 100 108 116 124 132 140 100 Straddle 80-120 Strangle
Source: J.P. Morgan.

3m to ex piry
Source: J.P. Morgan.

2m to ex piry

1m to ex piry

Ex piry

90-110 Strangle

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As can be seen from Figure 27, straddles outperform strangles for underlying spreads close to the centre of the strategies. To offset this, strangles outperform straddles for a constant amount outside of this small range around the centre. Strangle greeks Similar to straddles, selling strangles results in a highly positive theta as well as negative gamma and vega exposures.
Figure 28: Long strangle P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 60 76 3m to ex piry 1m to ex piry 92 108 124 140

Short strangle Overall view: Maximum profit: Maximum loss: Long strangle Overall view: Maximum profit: Maximum loss:

Spreads will trade inside a range at maturity. Premium Unlimited

2m to ex piry Ex piry

Spreads will trade outside a range at maturity. Unlimited Premium

Source: J.P. Morgan.

Butterflies
A butterfly strategy is constructed out of four options. Due to put-call parity there are several ways to construct a butterfly, but perhaps the method which is the most intuitive is to consider a straddle strategy in which the unlimited downside has been capped by buying two additional options, one below the straddle strike and one above. The P&L profile for a long butterfly strategy is shown in Figure 29.
Figure 29: Long butterfly P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

0.5% 0.4% 0.3% 0.2% 0.1% 0.0% -0.1% 60 68 76 84 2m to ex piry 92 100 108 116 124 Ex piry 132 140

3m to ex piry
Source: J.P. Morgan.

1m to ex piry

In straddle and strangle strategies a short position will result in the investor receiving an upfront premium (as the investor is purchasing two options). However, in a butterfly strategy the premium can go to either the buyer or seller depending on exactly how the butterfly is constructed. For example, if the butterfly is constructed from buying an ATM straddle and selling two OTM options then the seller of the straddle will receive the initial premium. However, if the butterfly is constructed with four payer options (selling a low strike payer, buying two ATM payers and selling a higher strike payer) then the long will receive the initial premium. The mark-to19

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market is identical no matter how the strategy is constructed, but the additional degree of control over the timing of cash flows and the flexibility that brings can make the butterfly attractive to certain investors. Whereas a straddle is either a long-option or short-option strategy, a butterfly is always constructed from buying and selling equal numbers of options. Therefore, the cashflows from a single straddle will always be far greater in magnitude than those from a single butterfly. This comparison is shown in Figure 30. However, this means that for a given premium many more butterfly strategies than straddles can be purchased. Figure 31 compares the butterfly and straddle strategies for a given upfront premium (here we have assumed that the butterfly is constructed from selling an ATM straddle and buying two options).
Figure 30: Comparison of Butterfly and Straddle strategies (unadjusted)
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Figure 31: Comparison of Butterfly and Straddle strategies (adjusted for premium)
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 60 68 76 84 92 100 108 116 124 132 140

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 60 68 76 84 92 100 108 116 124 132 140

Straddle
Source: J.P. Morgan.

Butterfly
Source: J.P. Morgan.

Straddle

Butterfly

As we can see from Figure 31, the spread range for which the butterfly loses money at expiry is much larger than that for the straddle but with the upside that the payoff is capped and so will outperform a straddle for more extreme spreads. The butterfly is therefore a suitable strategy for investors who believe that spreads will trade outside a range, but that that range is not wide enough to justify a straddle strategy. Unlike a straddle, the size of this range can be dictated by the investor by altering the strikes of the two options being sold; the wider the range, the higher the potential payoff will be. Butterflies can also be combined to enlarge the range in which the strategy is in-themoney; a common strategy is to add low-cost out-of-the-money butterflies to a current position as the range for which the strategy is now in-the-money is greatly increased for little extra cost. An example of this is shown in Figure 32 and Figure 33.

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Figure 32: Butterfly strategy with underlying at 100bps


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

Figure 33: Double butterfly strategy after underlying has tightened


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

0.5% 0.4% 0.3% 0.2% 0.1% 0.0% -0.1% 50 60 70 80 90 100 110 120 130 140 150

0.40% 0.30% 0.20% 0.10% 0.00% -0.10% -0.20% 50 60 70 80 90 100 110 120 130 140 150 Ex piry

3m to ex piry
Source: J.P. Morgan.

2m to ex piry

1m to ex piry

Ex piry

3m to ex piry
Source: J.P. Morgan.

2m to ex piry

1m to ex piry

After a tightening in the underlying, the investor can add another butterfly at a wider strike at a low cost. This strategy can be continued by adding further butterflies at different strikes. Butterfly greeks Like straddles, a butterfly position has positive theta. However, depending on how wide the strikes of the outer options are the positive time value can be highly concentrated into the last few days before expiry. If the strikes of the options are very close together then the value of the butterfly will not change much for weeks before rapidly increasing as the options approach expiry. Butterflies also have negative gamma and vega exposure but due to the downside being capped these exposures are much less than they would be for a comparative straddle strategy. Long butterfly Overall view:
Figure 34: Short butterfly P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
0.1% 0.0% -0.1% -0.2% -0.3% -0.4% -0.5% 50 70 90 110 130 150

Maximum profit: Maximum loss:

Spreads will trade inside a range at maturity. This range depends upon the strikes of the options used. Limited Limited

Short butterfly Overall view:

3m to ex piry 1m to ex piry

2m to ex piry Ex piry

Maximum profit: Maximum loss:

Spreads will trade outside a range at maturity. This range depends upon the strikes of the options used. Limited Limited

Condors
Source: J.P. Morgan.

Condors are to strangles what butterflies are to straddles. In a long condor strategy, instead of selling a straddle and buying two options, the central strategy is a strangle. Figure 35 shows the P&L profile for an example condor, with strikes at 85, 95, 105 and 115.

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Figure 35: Long condor strategy P&L profile


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

0.4% 0.3% 0.2% 0.1% 0.0% -0.1% -0.2% 50 60 70 80 90 100 110 120 130 140 Ex piry 150

3m to ex piry
Source: J.P. Morgan.

2m to ex piry

1m to ex piry

The exact payoff profile of a condor can be tailored by changing the strikes of any one of the four options used to construct the condor. Moving the two outer options to wider strikes will increase the payoff, but will mean that there is a smaller chance of the option finishing ITM. A condor would be suitable for an investor with the same motivations as those for a butterfly, but who wishes to have slightly more control over the exact P&L profile of the strategy.
Figure 36: Short condor strategy P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)
0.2% 0.1% 0.0% -0.1% -0.2% -0.3% -0.4% 50 70 90 110 130 150

Long condor Overall view:

Maximum profit: Maximum loss:

Spreads will trade inside a range at maturity. This range depends upon the strikes of the options used. Limited Limited

Short condor Overall view:

3m to ex piry 1m to ex piry

2m to ex piry Ex piry

Source: J.P. Morgan.

Maximum profit: Maximum loss: .

Spreads will trade outside a range at maturity. This range depends upon the strikes of the options used Limited Limited

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Ladders
Ladder strategies are halfway between range-bound and outright directional strategies. This makes ladders versatile trades that can be used for a wide range of roles. An example P&L profile for a ladder is shown in Figure 37; this ladder has been constructed from buying a payer option with a strike of 80 and selling two payer options with strikes of 100. As the investor would be buying one option and selling two this is known as a 21 ladder3. With ladders, a relatively common practice is to structure the strategy such that the initial premium is zero; this is done by selling exactly enough options to cancel out the premium of the option that was bought. For example, in the strategy shown in Figure 37 we have sold two options at strike 100 for every option we bought at strike 90. If we reduce this ratio from 2:1 to 1.7:1 the premiums cancel out exactly, and the payoff at expiry is zero for spreads of less than 80. Another advantage of this is that the breakeven point now increases from 125 to 130, meaning that the investor is now more protected against extreme spread moves. An example of a zero-premium ladder is shown in Figure 38.
Figure 37: 2x1 ladder strategy P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

Figure 38: Zero-premium ladder strategy P&L profile


Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% 50 60 70 80 90 100 110 120 130 140 150

1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 50 60 70 80 90 100 110 120 130 140 150

3m to ex piry

2m to ex piry

1m to ex piry

Ex piry

3m to ex piry
Source: J.P. Morgan.

2m to ex piry

1m to ex piry

Ex piry

Source: J.P. Morgan.

Why are ladders attractive hedges? Low/zero cost to enter High time value if spreads stay range bound Constant payoff in case of spread tightening,. Positive P&L for limited spread widening.

Ladders are often used to hedge against small widenings or tightenings in spreads; for example, if spreads were currently at 80bps an investor may enter the ladder shown in Figure 37, and will be ITM as for any spread widening of up to 45bps. Similarly, ladders can also be used to protect against any tightening in spreads. Zero-premium ladders are particularly attractive hedges as they are an effective hedge against limited spread widenings while still giving a flat payoff for an unlimited amount of tightening. The downside is the negative exposure to widening spread levels past the breakeven point. Past this point the ladder will outperform or underperform the index depending on the exact structure of the ladder; a 21 strategy will match the performance of the index whereas a 31 strategy will underperform the index. Figure 39 compares a zero-premium ladder and a long risk index position; in this case the zero-premium ladder has a weighting of 1.71 and so outperforms the index past the breakeven point.
Ladders can also be referred to as spreads; for example the 21 ladder will often be referred to as the 21 spread.
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An investor can extend the range for which a ladder strategy is in-the-money by changing the strike of one of the options being sold; Figure 40 compares the payoff at expiry of the zero-cost ladder from Figure 38 with a ladder strategy consisting of options with strikes at 80, 100 and 120bps. The 80-100-120 ladder extends the range for which the strategy is in-the-money and the expense of a more negative payoff for wider spreads.
Figure 39: Comparison of zero-premium ladder and long risk index position
Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

Figure 40: Comparison of 80-100 and 80-100-120 ladders


Y-axis: P&L as % of Notional at expiry; X-axis: Spread of underlying CDS index (bp)

3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% 50 60 70 80 90 100 110 120 130 140 150

1.0% 0.5% 0.0% -0.5% -1.0% 50 60 70 80 90 100 110 120 130 140 150

Zero-premium ladder
Source: J.P. Morgan.

Long risk index position


Source: J.P. Morgan.

80-100 Ladder

80-100-120 Ladder

The reverse trade, selling a low strike payer and buying high strike payers, can also be a good bearish hedge against a snap widening. For example, if an investor entered the ladder shown in Figure 41 and the underlying index widened very suddenly in the next few days then the investor would have a positive mark-to-market even if the index had not widened to the breakeven point at 125bp. However, the highly negative theta of the strategy means that the investor would have to exit the strategy very quickly to lock in any P&L from the snap widening.
Figure 41: Short ladder strategy P&L profile
Y-axis: P&L as % of Notional; X-axis: Spread of underlying CDS index (bp)

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 50 60 70 80 90 2m to ex piry 100 110 120 130 140 Ex piry 150

3m to ex piry
Source: J.P. Morgan.

1m to ex piry

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Ladder greeks Ladder strategies such as the one shown in Figure 38 have highly positive theta while the underlying is between the strike of the two options. As such, the initial mark-tomarket while the underlying is between the two strikes may be close to zero or even negative, but the mark-to-market of the option will rapidly increase with time as long as the underlying remains within the strikes. As the theta is positive, the gamma must be negative. The delta of a ladder strategy will change as the underlying moves through the range between the option strikes. In the ladder shown in Figure 38 the delta is positive for low spreads and negative for wider spreads. Ladder Example Strategy: Maximum profit: Maximum loss:

Used to hedge against limited directional moves in spread. Limited Unlimited

Short Ladder Example Strategy:

Maximum profit: Maximum loss:

Used to hedge against limited directional moves in spread in short term. Unlimited Limited

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Trading volatility and delta-hedging


Volatility trading allows investors to express views on the future volatility of the underlying index independent of directional moves.

Many investors trade options not to express views on absolute underlying spreads but to instead trade CDS volatility. These investors are unconcerned by the direction of spread moves, and as such will hedge out any exposure to small moves in the underlying by buying or selling an exact amount of index protection; this is known as delta-hedging. To remain neutral to any moves in the underlying, an investor must re-hedge their exposure at regular intervals. This is known as dynamically delta-hedging. The frequency of delta-hedging is important; the more often an investor can delta-hedge the more closely their P&L will reflect the actual volatility of the underlying. However, in practice delta-hedging more than once a day can be costly. The simplest way to create a long volatility position is to buy an ATM option (either payer or receiver) and buy or sell enough index protection to cancel out the delta of the option. For an example, an investor can purchase an ATM payer option on a notional of 100 million EUR with a delta of 50% and then sell protection on the underlying CDS index on 50 million EUR notional in order to cancel out the entire delta of the position. Similarly, an investor can create a short-volatility position by selling an ATM option and then delta-hedging it. Volatility positions seek to benefit from the following: Changes in implied volatility: an increase in implied volatility benefits a long option position as the options become more valuable. This relies on the vega exposure of the position. Differences between implied and realised volatility over the trade horizon: realised volatility that is higher than implied should benefit a long volatility position. This represents a difference in profit from gamma and theta exposures of a position.

Long volatility positions are inherently short theta. As such, in order to breakeven an investor with a long volatility position needs the underlying to move by a certain amount each day. This amount is equal to the daily spread volatility implied by the option price, and is given in Equation 1.
Equation 1: Breakeven daily basis point move assuming 252 business days in a year.

dailyvol (bp ) =

forwardspread impliedvol 252

For example, if the implied volatility of the option is 70% and the forward spread is 100bp, then a long volatility investor needs the underlying to move by more than 4.4bp (= 70% 100bp 1 252 ) in order to make a profit on a certain day, assuming implied volatility remains constant. At the end of the day the investor will delta-hedge, thus locking in any profit from the days volatility. Furthermore, any changes in the implied volatility of the option will have a direct effect on the price of the option and therefore the overall P&L.
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Similarly, a short volatility investor will be long theta and will make a profit if spreads move less than the breakeven daily amount. P&L from volatility trading The P&L from trading volatility can be reasonably approximated using realised and implied volatilities. For a simple delta-hedged volatility position, a first order approximation of the mark-to-market of the position is given by Equation 2.
Equation 2: P&L from volatility trading

P&L =

1 2

0 0 i Forward Annuity realised implied t i t 0 + implied implied t e t i

[(

Theta/Gamma P&L Forward = CDS forward spread at expiry te = expiry date

Vega P&L ti = valuation date


0 implied

realised= realised volatility between entry and valuation dates

Annuity = Risky annuity of forward

t0 = trade entry date

= implied volatility at entry date

i implied = implied volatility at valuation date

Equation 2 is not entirely accurate as it neglects second-order terms and assumes that the position can be delta-hedged constantly, but it is a good first order approximation for volatility trading P&L.

Trading skew
Trading skew allows investors to express a view on the markets perception of the probability of a large sell-off.

In theory, options with the same underlying and expiry should trade with the same implied volatility, independent of the strike of the option. However, in practice different strike-options often trade with different implied volatilities; this is known as skew. In particular, options with wider strikes often trade at higher implied volatilities. This discrepancy is usually due to investors hedging against an extreme widening in spreads by purchasing OTM payers, pushing up the price of these options and therefore the implied volatilities. As such, skew represents a measure of how likely investors believe a sudden, extreme widening in spreads is. Figure 42 shows a range of implied volatilities for different option strikes. In this case the implied volatility increases with the strike and so the skew is positive.

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Figure 42: Implied volatilities at different strikes


Implied volatility %

85% Implied Vol (%) 80% 75% 70% 65% 60% 80 90 100 110 120 130 140 150 Strike (bp)
Source: J.P. Morgan.

It is possible to construct an options strategy that is either long or short skew; the most common way to do this is to use a risk reversal in which the notionals of the options have been chosen such that the vega of the strategy as a whole is zero. The position is then dynamically delta -hedged4. The position therefore has minimal exposure to both overall volatility levels and to the underlying, thus isolating the skew. For example, if we expected skew to increase we could enter into a vega-neutral bullish risk reversal. Similarly, an investor who believes that skew will fall could enter into a vega-neutral bearish risk reversal. Furthermore, spread and risk reversal strategies can be made more attractive by high or low skews. For example, if skew is historically high then bullish risk reversals and payer spreads are both attractive strategies as they benefit from selling a high-strike option at a high implied volatility and buying a low-strike option at a low implied volatility. Similarly, receiver spreads and bearish risk reversals are more attractive when skew is low.

When skew is high: Bullish risk reversals and payer spreads are more attractive. When skew is low: Bearish risk reversals and receiver spreads are more attractive.

Calendar trades
Calendar trades allow investors to express views across different expiry dates, or fund an option by selling an option with a different expiry.

So far in this piece we have only considered options strategies where the options used all have the same expiry. However, it is possible to combine two or more options with different expiries in order to express a time-dependent view. These types of trades are known as calendar trades. For example, if an investor believes that spreads will trade below 100bp in January but above 120bp in March the investor could purchase a 110bp January receiver and fund this by selling a 110bp March payer. Various time dependent views can be expressed using calendar trades; typically it is preferable to buy one option and sell another in order to reduce the cost.

4 The position can also be dynamically vega-hedged by buying and selling options such that the overall vega of the position is kept as close to zero at all times as possible.

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It is also possible to express time-dependent volatility views using options with different expiries. To express a view that volatility will remain low from now until January but will increase from January to March an investor could sell an option with a January expiry, buy an option with a March expiry and then dynamically deltahedge the entire position. The options strategies already discussed can all be applied to calendar trades by putting one strategy on for one expiry and a different strategy for a second expiry in order to reflect a view on how spreads will behave at each expiry.

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Relative value trades with CDS options


Investors can use the CDS option strategies discussed in this primer to create relative value trades between different CDS indices.

In this piece so far we have covered different options strategies and the different market views they express, as well as discussing pure volatility and skew trading. CDS options can also be used across multiple underlying CDS indexes in order to produce relative value trades. In this section we give examples of relative value trades using CDS options that we have previously suggested.

No. 1: Sell iTraxx Main Payer, buy iTraxx Crossover Receiver


This trade was originally suggested in the CD Player published 24th March 2010. It should NOT be interpreted as a current trade idea. Trade Details Sell 100m iTraxx Main Payer, buy 20m iTraxx Crossover Receiver.
Table 3: Trade Details
Index iTraxx Main S13 5y iTraxx Crossover S13 5y
Source: J.P. Morgan.

Option Payer Receiver

Expiry Jun-10 Jun-10

Buy/Sell Sell Buy

Strike 110 400

Notional -100,000,000 20,000,000

Premium (cents) 14.9 80.2

Cost -149,000 160,400 11,400

Trade Rationale iTraxx Main volatility remains expensive relative to Crossover and we believe that this offers a good opportunity to be long risk using options. Specifically we believe investors should buy a 400bp strike iTraxx Crossover receivers funded by selling five times the notional 110bp iTraxx Main Payers. This trade give 20bp of Main widening cushion versus only 45bp of Crossover tightening an attractive payoff. The trade is attractive for the following reasons 1) Main Volatility is rich relative to Crossover When we compare volatility across indices, we find that Main implied volatility is rich relative to Crossover on an adjusted basis. In Table 4 we show the results of our calculations. Since the indices trade with different spreads and volatility levels, we calculate the daily implied volatility on both indices. This is done by multiplying the annual volatility by the index forward and rebasing this to a daily levels (divide by sqrt(260). This result is then adjusted by the relative ratio of historical volatility between the two indices (beta) to arrive at a normalised level.
Table 4: Comparing Volatility across Indices
Index iTraxx Main iTraxx Crossover
Source: J.P. Morgan.

Index Level 83 465

Annual Implied Volatility 64% 54%

Implied Daily Index Move 3.3 15.7

Normalised Implied Daily Index Move 3.3 3.0

Vol Ratio 1.0 5.2

Correlation 100% 68%

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2) Volatility skew is steep in Main versus flat in Crossover Comparing the volatility skew in Main and Crossover, we find that Main skew is steeper. This makes selling high strike Main options attractive versus buying low strike Crossover options. This is shown in Figure 43.
Figure 43: Main versus Crossover Implied Volatility Skew
0.6 0.58 0.56 0.54 0.52 0.5 90%
Source: J.P. Morgan.

Crossov er

Main

0.7 0.68 0.66 0.64 0.62 0.6

95%

100%

105%

110%

3) We believe that Crossover will outperform in a tightening Should spreads tighten from here, we believe that Crossover will tighten more given the higher yields on offer. Investors search for yield will likely see buyers of Crossover risk relative to Main. While in a widening scenario, we also believe Crossover could widen more than Main, we are not exposed to this scenario having bought a Crossover receiver. Alternative Structures We have chosen to trade the Main 110 payer versus the Crossover 400 receiver. Investors looking for a more bullish trade might consider selling the 100 strike payer versus buying the 425 strike receiver. This gives less cushion in a widening, but will profit from less spread tightening. Alternatively investors concerned about spread widening could trade the 120 payer versus the 375 receiver.
Table 5: Alternative Strikes
Main Strike 100 110 120
Source: J.P. Morgan.

Cost (cents) 22.2 14.9 10.2

5 times notional 111 74.5 51

Crossover Strike 425 400 375

Cost 119.1 80.2 50.6

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No. 2: iTraxx Main versus CDX.IG


This trade was originally suggested in the CD Player published 17th November 2010. It should NOT be interpreted as a current trade idea. Sovereign stress is driving the Main versus CDX spread differential. Should this stress continue, we would buy iTraxx Main protection versus selling CDX.IG protection. We believe two alternative trades offer better payoffs: 1) Buy iTraxx Main Payer; sell CDX.IG Payer 2) Buy iTraxx Main protection; sell CDX.IG protection and hedge by selling Spain protection. These trades will benefit from the spread differential between iTraxx and CDX increasing, but will dampen losses in a rallying market. The iTraxx Main versus CDX.IG spread differential is a keenly watched indicator of the relative health of corporates in Europe versus the US. Until 2008, iTraxx traded around 10bp tighter than CDX due to its higher rated portfolio and the implicit government guarantee of it underlying portfolio. In 2008, the difference became increasingly negative as defaults and financial stress impacted US CDS more than European (Figure 44). Since the start of 2009 however, as spreads rallied and concerns over sovereign stress increased in Europe, this historic relationship has reversed to the point where iTraxx Main trades 10bp wider than CDX (Figure 45). Should Sovereign stress continue, we believe that iTraxx will continue to underperform CDX and this differential will continue to widen. This would imply that investors should buy iTraxx protection versus selling CDX protection, a trade we recommended in our year-end European Credit Outlook and Strategy. The risk in doing so, however, is that should markets recover, we believe that this will be driven by improved sentiment around European sovereigns. As such, we would expect iTraxx to outperform and the differential to return to flat if not revert completely with iTraxx trading tighter than CDX. The long iTraxx protection versus long CDX risk would lose money in this case.

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Figure 44: iTraxx minus CDX (since Jan 2005)


bp

Figure 45: iTraxx minus CDX (since Jan 2010)


bp

20.00 0.00 Jan-05 -20.00 -40.00 -60.00 -80.00 -100.00


Source: J.P. Morgan.

180 130 80 30 -20 Jan-10

Diff

CDX

iTrax x

15 10

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

5 0 -5 -10 -15 Mar-10 May -10 Jul-10 Sep-10 Nov -10 -20

Source: J.P. Morgan.

We provide two alternative trades that we believe will dampen the loss in the spread tightening scenario 1) Buy iTraxx Main Payer; sell CDX.IG Payer 2) Buy iTraxx Main protection; sell CDX.IG protection and hedge by selling Spain protection. 1) Buy iTraxx Main Payer; sell CDX.IG Payer Rather than taking exposure to the directionality of the iTraxx-CDX trade, we limit this directionality to the case where spreads widen. The trade details are shown in Table 6.
Table 6: Trade 1 Buy iTraxx Main Payer; sell CDX.IG Payer
Index iTraxx Main CDX.IG Tenor 5y 5y Index Spread 104 94 Option Payer Payer Strike 110 100 Expiry 16 March 2011 16 March 2011 Buy/Sell Buy Sell Notional (M) 100 74 Notional (M) 100 100 Cost (cents) 80 66

Source: J.P. Morgan.

The trade costs us 14 cents as an upfront cost; we will make this initial cost back should the spread differential between the two indices remain above 7bp while CDX is above the 100bp strike. Conversely, if spreads tighten below the option strikes, both options will end out-of-the-money and we will only lose our initial premium. Table 7 shows the payoff of this strategy across a variety of different spread levels for iTraxx Main and CDX.IG. We believe that spreads are likely to be in the lower left section of the table, as spread widening will be accompanied by a greater differential between iTraxx and CDX.

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Table 7: Trade 1 Payoff


In Thousands CDX 85 90 95 100 105 110 115 120 125 130 135 140 145 85 -140 -140 -140 -140 -140 -140 89 317 544 770 995 1,219 1,442 90 -140 -140 -140 -140 -140 -140 89 317 544 770 995 1,219 1,442 95 -140 -140 -140 -140 -140 -140 89 317 544 770 995 1,219 1,442 100 -140 -140 -140 -140 -140 -140 89 317 544 770 995 1,219 1,442 105 -375 -375 -375 -375 -375 -375 -146 82 309 535 760 984 1,207 110 -609 -609 -609 -609 -609 -609 -380 -152 75 301 526 750 973 115 -842 -842 -842 -842 -842 -842 -613 -385 -158 68 293 517 740 120 -1,074 -1,074 -1,074 -1,074 -1,074 -1,074 -845 -617 -391 -164 61 285 508 125 -1,305 -1,305 -1,305 -1,305 -1,305 -1,305 -1,076 -849 -622 -396 -171 54 277 130 -1,535 -1,535 -1,535 -1,535 -1,535 -1,535 -1,307 -1,079 -852 -626 -401 -177 47 135 -1,765 -1,765 -1,765 -1,765 -1,765 -1,765 -1,536 -1,308 -1,081 -855 -630 -406 -183 140 -1,993 -1,993 -1,993 -1,993 -1,993 -1,993 -1,764 -1,536 -1,309 -1,083 -858 -634 -411 145 -2,220 -2,220 -2,220 -2,220 -2,220 -2,220 -1,992 -1,764 -1,537 -1,311 -1,086 -862 -638

Source: J.P. Morgan.

iTraxx

Appendix I: The Greeks


In this section we discuss the Greeks - the sensitivities of options - from the perspective of a product that trades on spread (i.e. the CDX High Grade index as opposed to the CDX High Yield index which trades in price terms). Delta of an option measures how much the theoretical value of an option should change if the underlying asset moves by 1 unit. A positive delta means the option should rise in value if the underlying spread widens. Receiver deltas range between -1 and 0 while payer deltas range between 0 and 1. Delta can be thought of as the approximate probability that the option ends up in the money. At-the-money options have a delta of 0.5 and around 50% chance of ending in-the-money. Deep ITM options are likely to remain ITM and therefore have a delta close to 1. Since the delta of an option is dependent largely on the price of the underlying asset relative to the strike, the delta of an option changes as the price of the asset changes. The rate of change of delta is known as gamma. Delta-hedging of an option is a process whereby we replicate the value of an option by owning a delta amount of the underlying. Since the delta of the option tells us the change in option price for a 1 unit move in the underlying, by owning a delta amount of the underlying, we can synthesize the behaviour of the option. Figure 46 shows the delta of a payer option with a strike of 100bp as a function of the underlying spread and the time left to maturity. A long way from expiry, the delta is a relatively linear parameter but as the option nears expiry delta tends to 100% for spreads above the strike and 0% for spreads below the strike. For receiver options the profile is shifted below the x-axis, such that delta nears -100% for spreads less than the strike and tends to 0% for spreads above the strike. When options are being sold the entire profile is reflected in the x-axis.

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Gamma estimates how much the delta of an option changes for 1 unit move in the price of the underlying asset. A large gamma means that the delta of an option can change very quickly for a small move in the underlying asset. Long receivers (payers) have positive gamma which means that as the underlying spread tightens (widens), the delta of the receiver (payer) becomes more negative (positive). Gamma is highest for ATM options and ATM gamma increases as we move closer to expiration. An investor who owns a delta-hedged option will have positive gamma and will benefit from fluctuations in the underlying asset. In order to remain delta-hedged, he will buy low and sell high thus making money on this position. Alternatively, an investor who is short gamma will buy high and sell low and therefore lose money on this position. However, the long gamma position which allows the investor to buy low and sell high comes with a cost. That cost is theta. Figure 47 shows the gamma of a payer option with a strike of 100bp as a function of the spread of the underlying CDS index and the time left to expiry. When there is still a long time remaining until expiry the gamma profile is flat, but as the option nears its expiry date the gamma profile will begin to resemble a Gaussian distribution in shape, centred around the strike. As such ATM options close to expiry have very high gamma. This represents the large change in delta for spreads around the strike in options close to expiry. For options being sold the gamma profile will be reflected in the x-axis.

Figure 46: Delta for a payer option


Y-axis: Delta in %; X-axis: Spread of underlying CDS index.

Figure 47: Gamma for a payer option


Y-axis: Gamma in %; X-axis: Spread of underlying CDS index.

100% 80% 60% 40% 20% 0% 70 75 80 85 90 95 100 105 110 115 120 125 130 1 month to ex piry

5% 4% 3% 2% 1% 0% 70 75 80 85 90 95 100 105 110 115 120 125 130 1 month to ex piry

3 months to ex piry 1 w eek to ex piry

3 months to ex piry 1 w eek to ex piry


Source: J.P. Morgan.

Source: J.P. Morgan.

Theta, which is also known as time decay, estimates how much the theoretical value of the option will decrease as we move 1 day closer to option expiry, all else being equal. Options that have high gamma also have high theta. In other words, the option that affords an investor the best convexity also decays at the highest rate. Theta is highest for ATM options and increases closer to option expiry. By "all else being equal", we mean that spreads rather than forwards remain constant. Since the options are priced using the forward and the forward adjustment decreases as we move closer to expiry, we may find that keeping spot spreads constant actually give a long call position positive theta.
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Figure 48 shows the theta profile for a payer option with a strike of 100bp as a function of the spread of the underlying CDS index and the time left until expiry. The theta profile is very similar to that of the gamma profile, tending to a Gaussian distribution centred around the strike as the option approaches expiry. The difference is that while gamma is positive, theta is negative and vice versa. As such short-dated options with underlying spreads very close to the strike will have highly negative theta. For a short option position the theta profile will be reflected in the x-axis. Vega and Rho are option sensitivities to implied volatility and interest rates respectively. Figure 49 shows the vega profile for a payer option with a strike of 100bp as a function of the spread of the underlying CDS index and the time left until expiry. Vega decreases as time progresses, as there is less time left for the changes in volatility to be realised; as such longer dated options have higher vega than shorter dated options Furthermore, vega is always highest close to the strike. When options are being sold the profile is reflected in the x-axis, such that vega becomes less negative as time progresses.
Figure 48: Theta for a payer option
Y-axis: Theta in cents; X-axis: Spread of underlying CDS index.

Figure 49: Vega for a payer option


Y-axis: Vega in cents; X-axis: Spread of underlying CDS index.

0.0 -0.5 -1.0 -1.5 70 75 80 85 90 95 100 105 110 115 120 125 130 1 month to ex piry

1 0.8 0.6 0.4 0.2 0 70 75 80 85 90 95 100 105 110 115 120 125 130 1 month to ex piry

3 months to ex piry 1 w eek to ex piry


Source: J.P. Morgan.

3 months to ex piry 1 w eek to ex piry


Source: J.P. Morgan.

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Pricing Is Illustrative Only Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative trading levels Risks to Strategies Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential losses. We have summarized the risks of selected derivative strategies. For additional risk information, please call your sales representative for a copy of "Characteristics and Risks of Standardized Options". We advise investors to consult their tax advisors and legal counsel about the tax implications of these strategies. Payer Sale. Investors who sell payer options will be short index protection if the CDS index spread widens above the strike of the option. Investors, therefore, will be exposed to any widening in the CDS index spread above the strike of the payer option, and they will not participate in any gains from spread tightening if the option expires unexercised. Receiver Overwrite. Investors who sell receiver options against a long risk position in the underlying CDS index give up any gains due to spread tightening below the strike of the receiver option, and they remain exposed to the downside of the underlying CDS index in the return for the receipt of the option premium. Collars (Risk Reversals). Locks in the amount that can be realized at maturity to a range defined by the payer and receiver strike. If the collar is not costless, investors risk losing 100% of the premium paid. Since investors are selling a receiver option, they give up any gains due to spreads tightening below the strike price of the receiver option. Receiver Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is below the strike price of the call option. Payer Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is above the strike price of the put option. Straddle or Strangle. The seller of a straddle or strangle is exposed to spread tightenings below the receiver strike and spread widenings above the payer strike. Payer Spread. The buyer of a payer spread risks losing 100% of the premium paid. The buyer of higher ratio payer spread (a ladder) has unlimited downside below the wider strike, dependent on the number of wider struck payer sold. The maximum gain is limited to the spread between the two payer strikes.

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Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures
Explanation of Credit Research Ratings: Ratings System: J.P. Morgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months, the recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended risk position is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgans Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating. Valuation & Methodology: In J.P. Morgans credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral) based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit rating agencies and the market prices for the issuers securities. Our credit view of an issuer is based upon our opinion as to whether the issuer will be able service its debt obligations when they become due and payable. We assess this by analyzing, among other things, the issuers credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital investment). We also analyze the issuers ability to generate cash flow by reviewing standard operational measures for comparable companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuers balance sheet relative to the operational leverage in its business.
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Represents Ratings on the most liquid bond or 5-year CDS for all companies under coverage. *Percentage of investment banking clients in each rating category.

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Danny White (44-20) 7325-5066 danny.c.white@jpmorgan.com

Europe Credit Research 26 January 2011

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analysts involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. Other Disclosures last revised January 8, 2011.

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