JP Morgan - Trading Credit Curves 2

European Credit Research
21 March 2006
Trading Credit Curves II

Analysing the Drivers of P+L in Credit Curve Trading
• Trading credit curves has become part of the standard repertoire Credit Derivatives & Quantitative
for many credit investors. Credit Research
Jonny Goulden
• We introduce a framework to fully understand the factors (44-20) 7325-9582
[email protected]
impacting the P+L in curve trading.
Peter S Allen
• Slide and Convexity are often neglected and can be as important (44-20) 7325-4114
[email protected]
as Carry and Curve Moves in their impact on P+L.
Saul Doctor
• We apply our analysis to common curve trades to enable more (44-20) 7325-3699
[email protected]
profitable curve trading.
Dirk Muench
(44-20) 7325-5966
Introduction [email protected]
Credit curve trading has become an important trading strategy for Andrew Granger
many credit investors. The changing shape of credit curves (see (44-20) 7777-1025
Figure 1) can mean P+L opportunities for those who successfully [email protected]
position for this. However, analyzing how to position for a view that
'the curve for Company A will steepen' has often ignored some of Quantitative Research
the drivers of P+L in these trades. In this note we continue our series Mehdi Chaabouni
Trading Credit Curves by outlining a framework for analyzing [email protected]
curves trades. We apply our analysis to common curve trading
strategies, looking at Equal-Notional, Duration-Weighted and Carry-
Neutral trades, which have very different P+L profiles.
Figure 1: France Telecom Curve Steepening

x-axis: Maturity in years, y-axis: Spread, bp
90
80
70
60
50
40
30
20 Current Spread
10 6 Month Ago Spread
0
0 1 2 3 4 5 6 7 8 9 10
Source: JPMorgan
J.P. Morgan Securities Ltd.

See page 35 for analyst certification and important disclosures, including investment banking
relationships. JPMorgan 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.
Jonny Goulden European Credit Research
(44-20) 7325-9582 21 March 2006
[email protected]
Table of Contents
Executive Summary .................................................................3
Introduction ..............................................................................4
Drivers of P+L in Curve Trades ...............................................5
Curve Trading Strategies.......................................................13
1. Equal-Notional Strategies: Forwards................................13
2. Duration-Weighted Strategies ...........................................19
3. Carry-Neutral Strategies ....................................................24
Appendices
Appendix I: Different Ways of Calculating Slide..................27
Appendix II: Calculating Breakevens....................................29
Appendix III: The Horizon Effect ...........................................31
2
(44-20) 7325-9582 21 March 2006
[email protected]
Executive Summary
The Drivers of P+L in Curve In the first section of this note we outline our framework for analyzing the drivers of
Trades P+L in curve trades, where we look at:
• Time: The effect of the passage of time which breaks down into Carry and Slide.
• Sensitivity to Spread Changes: We breakout first-order effects of spreads
changing and look at Duration, as well as analysing second-order effects of
Convexity. We highlight the important Horizon Effect when looking at sensitivity
to spread changes at the trade horizon.
• Default Risk: Our trade exposure to our underlying credit risk.
• Breakevens & Expected Curve Movements: We put our analysis together with
our expectation of curve moves and look at our ‘Breakeven’ levels.
Common Curve Trades and In the second section we look at common curve trading strategies with this
Their Characteristics framework, with additional useful analysis in the Appendices.
1. Equal-Notional or Default-Neutral Strategies: These are like Forwards, where

both legs of the curve trade have equal notional exposure.
Table 1: Equal-Notional Strategies - Summary of Characteristics for Standard 5y/10y Curves

Carry Slide Dominant Time Effect 1bp Widening Default
Flattener Positive Low Spread = Positive Low Spread = Carry MTM Loss Neutral
High Spread = Negative High Spread = Slide
Steepener Negative Low Spread = Negative Low Spread = Carry MTM Gain Neutral
High Spread = Positive High Spread = Slide
Source: JPMorgan
2. Duration-Weighted Strategies: Where the legs of the trade are weighted to be

Mark-to-Market neutral for a 1bp parallel shift in spreads.
Table 2: Duration-Weighted Strategies - Summary of Characteristics for Standard 5y/10y Curves

Flattener Generally Negative Generally Negative Generally Slide MTM Neutral Short Risk
Steepener Generally Positive Generally Positive Generally Slide MTM Neutral Long Risk
Source: JPMorgan
3. Carry-Neutral Strategies: Where the legs of the trade are weighted to be neutral
from Carry over the trade horizon.
Table 3: Carry-Neutral Strategies - Summary of Characteristics for Standard 5y/10y Curves

Flattener Zero (by definition) Negative Slide (by definition) Mixed Short Risk
Steepener Zero (by definition) Positive Slide (by definition) Mixed Long Risk
Source: JPMorgan
3
(44-20) 7325-9582 21 March 2006
[email protected]
Introduction
Curve trading in credit involves taking a view on the relative steepness of points on
the credit curve and trading the view that the curve will either steepen or flatten. For
example, an investor may believe that the curve of Company ABC will steepen over
time (10y - 5y spread will increase). To position for this an investor could sell
protection in the 5y point and buy protection in the 10y point. If the curve moves as
the investor predicts, as in Figure 2, then the investor will hope to make money as the
curve steepens from 40bp to 48bp. Trading the curve as opposed to a single point can
be useful where an investor is not sure which point will move but has a view on the
relative steepness of the curve. Additionally, curve trading can mean an investor
avoids an outright credit (default) exposure whilst positioning for points in the curve
moving (as opposed to trading a single point where an investor must take outright
default exposure).
Figure 2: Example Curve Trade for Company ABC Figure 3: iTraxx Curve Over Time
x-axis = Time in Years, y-axis = Spread, bp iTraxx Europe Main 10y - 5y Spread, bp
180
25
160
140 10y -5y = 48bp
20
120
100 10y -5y = 40bp 15
80
10
60
40 5
Curv e at Time, t=1
20 Curv e at Time, t=2
0 0
0 1 2 3 4 5 6 7 8 9 10 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06

Source: JPMorgan Source: JPMorgan
Credit curve movements can be significant and investors can look to position for
curve trades both on a company specific basis or on the market as a whole (see
Figure 3 the curve of iTraxx Europe Main over time).
Structuring curve trades involves trying to isolate the view on the curve. This makes
it important to understand the drivers of P+L on these trades so traders or investors
can assess whether their core view of curve steepening / flattening can be turned into
a profitable strategy. Understanding these drivers of P+L in curve trades more
accurately should allow more profitable curve trading strategies. The first note in this
series, Trading Credit Curves I, examined the concepts behind understanding the
shape of credit curves. In this note we move on to the real analysis of the P+L drivers
in curve trades. We structure this as follows:
• We first outline our framework for analyzing the P+L in curve trades.
• We then apply this to common curve trades and highlight the common
characteristics of these.
Future notes in this series will examine Barbells and other curve themes.
4
(44-20) 7325-9582 21 March 2006
[email protected]
Drivers of P+L in Curve Trades

A Framework For Analysing Curve Trades
When we look at trading credit curves there are four dimensions we need to look
across to analyse the expected profitability of any trading strategy:
• Time: We need to understand how our curve trade will be affected by the passage
of time. This breaks down into the fee we earn, our 'Carry', and the way our
position moves along the credit curve over time, our ‘Slide’.
• Sensitivity to Spread Changes: We need to understand how our trade will be
affected by parallel spread changes. As a first order effect we need to look at the
P+L sensitivity to spread movements (Duration effect), but we also need to
understand the second order P+L impact as our Durations change when spreads
move giving us a Convexity effect. There is also a third order effect which models
the way our curve shape changes as a function of our 5y point. Analysing the
sensitivity to spread changes at the trade horizon needs special care due to the
Horizon Effect which shows how our position changes over the horizon.
• Default Risk: We need to understand the trade’s exposure to underlying credit
risk, as our curve trade positions may leave us with default risk.
• Breakevens & Expected Curve Movements: Once we have understood all of
the 'other' risks to our curve trade, we need to put this together with our
expectation of curve moves and look at our ‘Breakeven’ levels. I.e. given the
other risk factors that can affect the trade, how much of a curve move do we need
for our trade to breakeven over the horizon we are considering.
We tackle these dimensions in turn in this section and then turn to common curve
trading strategies to see how our framework for analysis can be applied to each
strategy to give more profitable trades.
a) Time: Carry
The Carry of a curve trade is the income earned from holding the position over time.
For example, if we constructed a simple curve flattening trade buying protection on
$10mm notional for 5 years at 50bp and selling protection on $5mm notional for 10
years at 90bp (we will discuss trade structuring further on), we would end up with net
payments, or Carry, of $-5,000 over the first year as shown in Table 41.
Table 4: Carry Example

Buy Protection Sell Protection Total 1y Carry
Maturity 5y 10y
Notional ($) 10,000,000 5,000,000
Spread 50bp 90bp
1y Carry ($) -50,000 +45,000 -5,000
Source: JPMorgan
1
We usually look at Carry without any present value discounting.
5
(44-20) 7325-9582 21 March 2006
[email protected]
To generalize, the Carry on a curve trade is calculated as:
CarryHorizon = (NtnlLeg1 × SLeg1 × Horizon) + (NtnlLeg2 × SLeg2 × Horizon) [1]
Where,
NtnlLeg n : Notional of protection bought or sold on Leg n of the trade. This will be
positive if selling protection and negative if buying protection.
SLeg n : Annual Spread on leg n of the trade, expressed in % terms (Spread in bp /
10000).
Horizon: Length of time horizon trade is being evaluated over, in years.
b) Time: Slide
Slide is the change in value of a position due to the passage of time, assuming that
our credit curve is unchanged. Intuitively, as we usually observe an upward sloping
credit curve (see Figure 4) as time passes we will ‘slide’ down the curve. So, using
the example in Figure 4, a 3y position slides down to become a 2y position and a 5y
position slides down to become a 4y position over a year horizon. If I had sold
protection in 5y and bought protection in 3y (a 3y/5y flattener), the 3y leg would
slide more than the 5y, as the 3y part of the curve is steeper than 5y in this example.
Figure 4: Slide Intuition

bp
100
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10
Source: JPMorgan
Appendix I discusses two different ways that we could calculate Slide, depending on
what we assume is unchanged over time: i) hazard rates for each maturity tenor (5y
point), or ii) hazard rates for each calendar point (year 2010). In our analysis we will
use i) and keep hazard rates constant for each maturity tenor, which is the equivalent
of keeping the spread curve constant (e.g. so that the 5y spread at 100bp remains at
100bp) and sliding down these spreads due to time passing.
Horizon Effect
Slide also leads to another effect which we will call the Horizon Effect. The effect of
the change in Spreads and lessening of maturities over the horizon both imply a
change in Risky Annuities, which we call the Horizon Effect. This will have the
impact of changing the Duration-Weighting of trade over time, meaning the trade
essentially gets longer or shorter risk over the horizon. This can have a significant
6
(44-20) 7325-9582 21 March 2006
[email protected]
impact when we look at sensitivity analysis at the horizon. We discuss these issues in
Appendix III: The Horizon Effect.
Slide and Flat Forwards

The way we model our hazard rates and Forward curves also impacts how we
calculate Slide. As we have seen in Trading Credit Curves I, we model the Forward
curve as a Flat Forward curve. This means that the Forward spread (and hazard rates)
are taken as constant between points on the curve where spreads change. In terms of
our Slide, this could mean that we have no Slide over a given 1 month horizon if we
are on a flat part of the curve and larger Slide over a given 1 month horizon if we are
on a part of the curve where there is a step down. In order to account for this we tend
to have a method of interpolating between our step points, so that this is not just a
'jump’ down. The method of interpolation may lead to some of the Slide calculations
requiring a little thought as they can be as much to do with the way we model the
curves as they are to do with the intuition or reality we are trying to capture.
Time Summary
Putting our Carry and Slide together we get the Time (=Carry + Slide) effect, which
is the expected P+L of our curve trade from just time passing. Time is somewhat of a
bottom line for curve trades in that it is the number you need to compare your likely
P+L from curve movements against. For upward-sloping curves, Carry can dominate
Slide in Equal-Notional strategies, but Slide tends to dominate Carry in Duration-
Weighted trades. We will see more of this later.
Time analysis of our curve trade assumes nothing changes, so we now need to
understand our likely profit if the spread environment does change as we turn to
sensitivity analysis looking at Duration and Convexity.
c) Sensitivity to Spread Changes

Risky Duration (DV01) &
Risky Annuity First Order Effects: Duration
We define Risky Duration A curve trade positions for a credit curve to flatten or steepen. But what happens if
(DV01) as the change in MTM of the curve moves in a parallel fashion? Practically, we might think that the curve on
a CDS position for a 1bp change
Deutsche Telecom (for example) looks too steep, but are concerned that new M&A
in Spreads. We define the Risky
Annuity as the present value of a events occur in the telecoms sector could cause all telecom curves to shift wider in a
1bp annuity given a Spread parallel movement. We may want to immunize our curve trade for this movement as
curve. our core view is that the curve is too steep in Deutsche Telecom.
These are discussed in detail in The first order effect that we need to consider is that of spread moves, which is
Credit Curves I, where we show captured by our (Risky) Duration / Risky Annuity (see Grey Box). Longer dated
that for a par CDS contract we
can approximately say that:
CDS contracts have higher Risky Annuities than shorter dated contracts. This means
Risky Duration ≈ Risky Annuity. that the impact on P+L of a 1bp move in spreads is larger for longer dated CDS
contracts as Table 5 shows for a +1bp move in iTraxx Main 5y and 10y contracts.
To accurately Mark-to-Market a
CDS contract we need to use the Table 5: iTraxx Main Europe Long Risk (Sell Protection) Sensitivities to Parallel Curve Shift
Risky Annuity. iTraxx Main 5y iTraxx Main 10y
Spread (bp) 34.25 58.5
Risky Annuity 4.38 7.91
Notional ($) 10,000,000 10,000,000
Approx P+L for 1bp widening ($) -4,380 -7,910
Source: JPMorgan
7
(44-20) 7325-9582 21 March 2006
[email protected]
This is because the Mark-to-Market of a CDS contract struck at par is given by:
MTMt,t+1 = (St+1 – St) . Risky Annuityt+1 . Ntnl [2]
Where: St = Par CDS Spread at time t
If we have a parallel move wider in spreads ((St+1 – St) is same for both legs) the
MTM of a curve trade buying protection in 10y and selling protection in 5y in equal
notionals of $10mm will be negative as the Risky Annuity is larger in the 10y leg
than the 5y leg. To immunize a curve trade against parallel moves in the curve
we need to look at Duration-Weighting the legs of our curve trade, i.e. sizing
both legs so that the MTM on a parallel spread move is zero. We will discuss
structuring these trades in the Curve Trading Strategies section.
Duration analysis is intended to immunise our curve trade for market spread moves.
However, looking at this first order Duration effects is not the full story and we need
to consider second order effects by looking at Convexity.
Second Order Effects: Convexity

We define Convexity as the change in MTM of a curve trade coming from changes
in Risky Annuity due to spreads moving. It measures the second order effect of how
our curve trade is affected due to Durations (or Risky Annuities) changing when
spreads change.
Why is there convexity in CDS positions?

We have seen that the Mark-to-Market of a CDS contract (in Equation [2]) is the
Change in Spread × The Risky Annuity, and:
n
RiskyAnnuity ≈ 1. ∑ ∆ .Ps .DF
i =1
i i i [3]
Where,
Psi,is the Survival Probability to period i.2
DFi is the risk-free discount factor for period i
∆i is the length of period i
n is the number of periods.
If the spread curve parallel shifts (widens) by 100bp, this means that credit risk has
risen and survival probabilities have fallen. For a given spread widening, survival
probabilities decrease more for longer time periods as the impact of higher hazard
rates is compounded. This is illustrated in Figure 5 and Figure 6 where we can see
that the Probability of Survival decreases proportionately more at longer maturities
for a 100bp spread change.
2
See Trading Credit Curves I for a more complete explanation of Survival Probabilities and
Risky Annuities.
8
(44-20) 7325-9582 21 March 2006
[email protected]
Figure 5: Parallel Shift in Par Spread Curve Figure 6: Survival Probabilities for Parallel Shift in Spreads
x-axis: Maturity Date; y-axis: Spread, bp x-axis: Maturity Date; y-axis: Survival probability, %
100%
300
90%
250 80%
200 70%
150 60%
50%
100 Spreads at t
40% Surv iv al Probabilities at t
50 Spreads at t+1 30% Surv iv al Probabilities at t+1
0 20%
Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb-
06 07 08 09 10 11 12 13 14 15 16 06 07 08 09 10 11 12 13 14 15 16
Looking at Equation [3], we can see this has the effect of making our Risky
Annuities decrease more for longer maturity CDS contracts as Figure 7 shows.
Figure 7: Risky Annuity Changes for Parallel Shift in Spreads

x-axis: Maturity Date; y-axis: Duration
7.00
6.00
5.00
4.00
3.00
2.00
Risky Annuities at t
1.00
Risky Annuities at t+1
0.00
Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb-
06 07 08 09 10 11 12 13 14 15 16
Source: JPMorgan
Spreads Risky Annuities The upshot of this is that if we have weighted a curve steepener (sell protection in
shorter maturity, buy protection in longer maturity, for an upward sloping curve) so
Spreads Risky Annuities that the curve trade is Duration-Neutral, if spreads widen our Risky Annuity in the
10y will fall more that that of the 5y meaning we will have a negative Mark-to-
Market (our positive MTM in the 10y declines as the Risky Annuity is lower). We
call this Negative Convexity, meaning that the Duration-Weighted position loses
value for a given parallel shift in spreads due to the impact of Risky Annuities
changing. Figure 8 illustrates the impact of this convexity in a curve steepener. The
trade was Duration-Weighted, i.e. the P+L should be zero for a 1bp parallel move in
spreads. We can see for changes larger than 1bp we have a Convexity effect as Risky
Annuities change.
9
(44-20) 7325-9582 21 March 2006
[email protected]
Figure 8: Convexity in a Duration-Weighted Curve Steepener

y-axis = MTM in $, x-axis = parallel spread widening (bp)
0
-40 -20 -1,000 0 20 40
-2,000
-3,000
-4,000
-5,000
Source: JPMorgan
When looking at the risks to any curve trade over a particular scenario, we will need
to analyse the P+L impact from Convexity as it can have an impact on the likely
profitability of a trade.
Sensitivity Analysis at Horizon

The sensitivity analysis we have been looking at is for instantaneous parallel moves
in spreads. When we look at sensitivity analysis at the horizon of our trade we will
also have to consider what we call the Horizon Effect. This Effect means that our
curve position can get longer or shorter risk over the life of the trade and so our
sensitivity analysis will reflect this. We discuss this in more detail in Appendix III:
The Horizon Effect where we show that it can mean we get a negative MTM for
spread widening and a positive MTM for spread tightening at the trade horizon.
Third Order Effects: Including a Curve Model

We have shown in previous work (see The Curve of DJ Trac-x Europe, Due,
McGinty, Jan 2004 and Revisiting Credit Maturity Curves, Due, McGinty, Nov
2004) that the shape of the credit curve for single names can be modeled as a
function of the 5y point (see Figure 9). Given this, the assumptions that we have
made when looking at the risks to our curve trades ‘if the curve parallel shifts by
xbp’ should be unrealistic of what we would expect to see in the market. More
specifically, our model shows that if the 5y point is at xbp the 10y point will be at
ybp, where this 10y Spread is a function of the 5yr Spread. This function should tell
us how much the 10y point will shift for a given move in the 5y point.
Figure 9: iTraxx Constituents 10y-5y Slope as a Function of 5y Spread - JPMorgan Model

x-axis 5y spread (bp), y-axis 10y-5y spread (bp)
100
80
60
40
y = -0.0004x 2 + 0.3217x + 12.706

20
R 2 = 0.936
0
0 200 400 600 800 1000
Source: JPMorgan
10
(44-20) 7325-9582 21 March 2006
[email protected]
The impact on our risk analysis of curve trades could be significant. Instead of
looking at scenario analysis for a parallel curve movement, we should look at
scenario analysis for a given move in our 5y point and then use our model to show
how the 10y point will move for this 5y move. We could then look at Duration and
Convexity analysis including this expected curve shift. We have not included this
analysis in this curve trade analysis framework and hope to develop it further in
future notes.
So far we have seen how to analyse the likely P+L of our curve trade for no change
in Spreads (Time) and for a given parallel shift in Spreads (Duration, Convexity and
the Horizon Effect). We now move on to consider the Default Risk we take on in our
curve trades.
d) Default Risk
Default risk is the company default exposure that we take when putting on our curve
trade. This is relatively simple to analyse for curve trades and will have one of two
consequences:
• For Equal-Notional strategies, economically there is no default exposure initially

as you have a long default risk and a short default risk position in each leg of the
curve trade in equal notional size. However, the curve trade will have a time
element to the default risk there will be a residual CDS contract remaining once
the first leg matures. Typically this is not of large concern as curve trade horizons
are often of lengths below one year.
• For strategies with differing notional weights in each leg (e.g. Duration-Weighted
trades) there will be default risk for the life of the curve trade which forms part of
the risks to the trade being profitable. Depending on their view on the underlying
credit, investors may not wish to put on a curve view if it results in a default
exposure they are uncomfortable with.
e) Breakevens & Curve Steepening / Flattening

The point of our framework for understanding the drivers of P+L in a curve trade is
to understand the likely profitability of curve trades given our view of future curve
moves. We therefore need to look at the breakeven curve movements that are needed
for our curve trade to be profitable.
In general, the Breakeven on a trade tells us what market move we need to ensure
Bid-Offer Costs
that it makes zero profit. In that sense the Breakeven is the bottom line or our
In our analysis we simplify our
Breakevens by ignoring bid-offer minimum condition for putting on a trade. For example, if the 10y point is trading at
costs. In practice these trading 100bp and the 5y point is trading at 75bp, the ‘curve steepness’ (10y minus 5y
costs also need to be considered spread) is 25bp. An investor putting on a curve flattener trade, buying protection in
when accessing likely the 5y point and selling protection in the 10y point is working on the assumption that
profitability and Breakevens. the curve steepness will fall lower than 25bp. So, how much does the curve need to
flatten in order to breakeven on the trade over the trade horizon? If we calculate that
given all the other drivers of P+L in the trade, if the curve flattens 5bp the trade will
breakeven over 3 months, then 5bp is our bottom line flattening. An investor can
then assess whether this 5bp is really reasonable given their view of the company and
the market, or whether 5bp is too much of a move to expect and therefore the trade
will most likely lose money even if the curve does flatten a little.
11
(44-20) 7325-9582 21 March 2006
[email protected]
We have two Breakevens we may want to look at for our trade:
Breakeven from Time

This is the breakeven curve change needed to ensure our curve trade MTM is zero
over the horizon given the Time (=Carry + Slide) P+L.
The Breakeven from Time is the curve change needed so that:
MTMTime, t to t+1 + MTMCurve, t to t+1 =0 [4]
Or in long hand (for a curve flattener):
Carry t to t+1 + Slide t to t+1 + ∆S5y.A5y,t+1.Ntnl5y - ∆S10y.A10y,t+1.Ntnl10y = 0 [5]
Breakeven for a Given Spread Change

The Breakeven for a given spread change gives the curve change needed to
breakeven from both the Time element and from the P+L effect of a given Spread
change.
Table 6: Breakeven Curve Movements Analysis – Where Current 10y-5y Curve = 77.4bp, Slide Implied 10y-5y = 99.3bp
5y / 10y Curve Movement (in bp) Needed to Breakeven With a Duration-Weighted Flattener Over 3 Months
Chg in 5y 5Y (Slide Implied) 10Y Breakeven Breakeven Curve (10Y-5Y) Breakeven Curve Chg Breakeven Curve Chg
(vs Slide Implied) bp bp bp bp (vs current curve) bp (vs Slide implied) bp
-10 228 303 74.8 -2.7 -24.6
0 238 312 73.8 -3.6 -25.5
10 248 321 73.0 -4.5 -26.4
Source: JPMorgan
Appendix II shows that we cannot find a single Breakeven number due to Convexity
effects. Rather we analyse Breakevens by setting the Spread at horizon of one leg of
our trade and calculating the curve move needed in the other leg to breakeven over
the horizon. Typically we set the shorter leg, for example we will set our 5y Spread
and calculate how the 10y point needs to move (and hence curve moves) to
breakeven. This is illustrated in Table 6, for a 5y/10y trade where the 5y is currently
at 200bp and the Slide implied spread at horizon is 238bp. The grey row is our
Breakeven from Time, i.e. 5y is constant over the horizon and we therefore need
3.6bp of flattening of our current curve to breakeven (column 5), which is really
Curve Trade Analysis 25.5bp of flattening given the implied curve due to Slide. The other rows are our
Framework Summary:
Breakevens for a Given Spread Change, for example if the 5y widens 10bp (to 248bp
1. Time: P+L from just time passing. at horizon) then the 10y needs to flatten 26.4pp for the trade to breakeven. This
a) Carry incorporates the Convexity effects of a change in Spread.
b) Slide
2. Spread Changes: P+L if spreads Appendix III: The Horizon Effect explains how we understand sensitivity analysis at
change trade horizon where the Horizon Effect will mean we can have more or less market
a) Duration exposure over the life of the trade – as we will see, this will help us understand our
b) Convexity Breakeven analysis at horizon.
c) Horizon Effect
Summary
Default Risk
In this section we have outlined our framework for properly analysing P+L in curve
Breakevens trades looking at Time (Carry & Slide), Sensitivity Analysis (Duration, Convexity
and Horizon Effects), Default Risk and Breakevens. We now move on to common
curve trading strategies to see how we apply this in practice.
12
(44-20) 7325-9582 21 March 2006
[email protected]
Curve Trading Strategies

Two-Legged Curve Trades
In the first section of this note we outlined a framework for analysing the drivers of
P+L in trades. We now turn to common curve trading strategies to understand what
typically are the largest factors that influence profitability in these trades. We
concentrate our analysis here on two-legged trades involving buying protection at
one point in the curve and selling protection at the second to express a view on the
way the shape of the curve will change. To express a view on the shape of the curve
with a two-legged trade an investor can choose from: Equal-Notional Strategies
(Forwards), Duration-Weighted Strategies or Carry-Neutral Strategies.
1. Equal-Notional Strategies: Forwards

Equal-Notional curve trades involve buying and selling protection on equal notional
at two different maturities (i.e. points on the curve). For example, an investor can buy
protection on a notional of $10mm for 5 years and sell protection on a notional of
$10mm for 10 years (an equal-notional flattener). This trade is effectively Default
Neutral for the life of the first (earlier maturity) leg of the trade – if a default happens
within the first 5 years, the investor will pay out on default for the 10y contract and
will receive back equal to this on the 5y contract.
We refer to a two-legged equal notional strategy as a Forward, as the position is

economically equivalent to having entered a forward-starting CDS contract (see
Trading Credit Curves I for a full explanation of this and the derivation of the
Forward equation). The 5y/5y Forward Spread (S5y/5y) is calculated as:
S 10 y. A10 y − S 5 y. A5 y
S5y / 5y =
A10 y − A5 y
Market Exposure
Equal-notional strategies are default-neutral for the life of the first leg, however
they do have a significant market exposure, since the Mark-to-Market for a 1bp
spread move on each leg is:
10y: MTM10y = 1bp . Risky Annuity10y . Notional10y
5y: MTM5y = 1bp . Risky Annuity5y . Notional5y where the Notionals are equal.
Equal-Notionals are Forwards Given that Risky Annuity 10y will be greater than Risky Annuity 5y, for any parallel
and are Therefore Market spread widening the 10y leg will gain / lose much more than the 5y leg. For this
Directional
reason equal-notional curve trades leave a significant market exposure. This is
important for investors looking to position a curve view with an equal-notional trade.
A 5y/10y equal-notional flattener is long forward-starting risk or long (risk in) the
Forward. This Forward is a directional position and given that market moves tend to
be larger than moves in curves (Average Absolute 5y 3m Change = 5.6bp, Average
Absolute 10y-5y Curve 3m Change = 2.4bp, over the last 2 years on iTraxx Main),
investors should be aware they are taking on this market exposure with an equal-
notional curve trade, or Forward.
13
(44-20) 7325-9582 21 March 2006
[email protected]
Carry
As an equal-notional strategy will pay or receive spread payments on equal notional
in each leg, the Carry earned or paid by the longer dated leg will be greater than that
for the shorter dated leg for upward sloping curves. That means we can say for
upward sloping curves, equal-notional Flatteners will be Positive Carry and
Steepeners will be Negative Carry.
Equal Notional Strategies Analysed

We will use as an example of a typical upward-sloping curve Fiat SPA, the Italian
car manufacturer, to show how we apply our curve trading analysis framework. We
will take the curve as of December 17th 2004 for illustration, which is shown in
Figure 10.
Figure 10: Fiat SPA CDS Curve (as at Dec 17th 2004)
bp
500 404
355
400
300
200
100
0
0 1 2 3 4 5 6 7 8 9 10
Source: JPMorgan
Using a trade horizon of 6 months and putting on a 5y/10y curve flattener (buy
protection in 5y, sell protection in 10y), with an equal notional of $10mm in each
leg, we can illustrate the characteristics of an equal-notional strategy in Table 7:
Table 7: Equal Notional 5y / 10y Flattener

6 month trade horizon
Spread Notional ($) Carry ($) Slide ($) Time ($)
Tenor Position bp (Default Exposure) Over Horizon Over Horizon Over Horizon
5Y Buy Protection 355 -10,000,000 -177,972 -75,419 -253,390
10Y Sell Protection 404 +10,000,000 202,687 14,660 217,347
Flattener 0 24,715 -60,759 -36,043
Source: JPMorgan
14
(44-20) 7325-9582 21 March 2006
[email protected]
Time (Carry + Slide)

The Carry on the equal-notional flattener is positive ($24,715) as we are receiving
404bp (10y spread) and paying 355bp (5y spread) on an equal notional (Table 7).
The Slide on our equal-notional flattener is negative (-$60,759) which can be
characteristic of higher spread names.
Positive Slide in Equal Notional Equal-notional Flatteners on lower spread names mostly have Positive Slide since
Flatteners: lower Spread curves are often fairly linear in shape (meaning the roll down in the 5y
is around the same as that in the 10y). Given that the Slide for a 6 month horizon is
The positive Slide condition can be
shown to be: calculated as:
( S 10 y − S 9.5 y ) A4.5 y
> Slide5y = (S5y – S4.5y) . A4.5y . Ntnl5y and
( S 5 y − S 4.5 y ) A9.5 y
Slide10y = (S10y – S9.5y) . A9.5y . Ntnl10y
Since the 9.5y Annuity is usually
around 2 × larger that the 4.5y
Annuity, we need the (S5y - S4.5y) to and since the Risky Annuity of the 9.5y will be much higher than the 4.5y Risky
be less than twice (S10y - S9.5y) to be Annuity, the P+L from Slide on the 10y will greater than that from the 5y in lower
Positive Slide for a Flattener. spread names, as the change in spread can be roughly equal in both legs. Lower
Where we have a steep curve in the Spread equal-notional Flatteners are therefore generally Positive Slide (see Grey
short-end and a flat curve in the long Box.)
end we can therefore get Negative
Slide for equal-notional Flatteners.
For higher spread names, the curve can often be much steeper in the short end than
the long end, which makes equal-notional Flatteners generally Negative Slide for
higher spread names. This is the case in our example (see Figure 10), since we have
a steep curve in the short end of the curve compared to a flat long end we get a
Negative Slide (as in Table 7).
For this curve trade Slide dominates Carry in the Time (Carry + Slide) part of the
analysis, showing that just looking at the Carry on this trade may make it look
attractive, but adding in the Slide shows it will have Negative Time. Generally for
equal-notional trades, with low Spread names Carry is larger than Slide, but for
higher Spread names Slide can dominate the Carry component.
Sensitivity to Spread Changes (Duration & Convexity)

Having understood the Time component if nothing else changes, we now need to
understand how our trade will perform should spreads change – we first look at the
sensitivity to immediate or instantaneous changes in spreads.
Table 8: Sensitivity to Instantaneous Spread Changes

-40bp Spread Chg -20bp Spread Chg 0bp Spread Chg 20bp Spread Chg 40bp Spread Chg
1) MTM 5Y (Buy) -172,604 -85,614 0 84,262 167,192
2) MTM 10Y (Sell) 271,344 133,728 0 -129,958 -256,260
3) Curve Trade 98,740 48,113 0 -45,696 -89,068
4) Spread Chg × Current Annuity 5Y -169,869 -84,934 0 84,934 169,869
5) Spread Chg × Current Annuity 10Y 263,646 131,823 0 -131,823 -263,646
6) Curve Trade 93,778 46,889 0 -46,889 -93,778
7) Convexity Effect (Row 3 – Row 6) 4,962 1,224 0 1,193 4,709
Source: JPMorgan
15
(44-20) 7325-9582 21 March 2006
[email protected]
Table 8 shows the MTM of our trade to parallel spread changes. We first look at the
actual MTM of the trade in rows 1-3, where we can see that this trade has a large
directionality to it. Figure 11 shows this graphically and we have a negative MTM
for spread widening and positive MTM for spread tightening. Given the 5y/10y
equal-notional Flattener is long Forward-starting risk, we should imagine a market-
directionality to this position. Investors looking to position for curve moves using
an equal-notional strategy, should be aware they are taking this market risk
position by trading the Forward.
Rows 4-7 of Table 8 show the Convexity effect in the trade, which is much smaller
compared to the first order effect of spreads moving. In order to illustrate Convexity,
we keep the Risky Annuities constant and look at the predicted MTM from the
spread change and compare that to the actual MTM to get the MTM gain / loss from
changes in Risky Annuity, i.e. the Convexity. This trade has Positive Convexity as it
has a relative MTM gain for spreads tightening or widening due to changes in the
Risky Annuities (Durations). Equal-Notional Flatteners have Positive Convexity
and Steepeners have Negative Convexity.
Figure 11: Sensitivity to Instantaneous Spread Changes

x-axis: bp spread changes, y-axis: MTM ($)
150,000
100,000
50,000
0
-40 -20 -50,000 0 20 40
-100,000
Source: JPMorgan

We can also analyse our trade’s sensitivity to spread changes at horizon. This is a
more complex analysis as the Horizon Effect on the trade affects our market
exposure over the life of the trade, as we examine in Appendix III: The Horizon
Effect. Table 9 shows us the sensitivity of the position to a 20bp move in spreads
wider or tighter at horizon (Carry not included). The large Negative Slide (-$60,759)
means that we have a negative MTM for a spread widening and 20bp tightening at
horizon, although we have a positive MTM if spreads tighten 40bp at horizon (row
3). If we look at the MTM net of Slide (row 4) we can see the market position that
we have in the curve trade. In order to look at just the market position we gain over
time, we finally look at the MTM effect less the Instantaneous MTM, in order to get
just our Horizon Effect.
Table 9: Sensitivity Analysis AT HORIZON for Equal Notional Flattener (Carry Not Included)
1) MTM 5Y (Buy) -233,428 -153,783 -75,419 2,103 78,377
2) MTM 10Y (Sell) 275,938 143,497 14,660 -110,704 -232,672
3) Curve Trade MTM at Horizon 42,509 -10,286 -60,759 -108,601 -154,295
4) Curve Trade MTM at Horizon minus Slide 103,268 50,473 0 -47,842 -93,536
5) Instantaneous MTM 98,740 48,113 0 -45,696 -89,068
6) Horizon Effect (Row 4 - Row 5) 4,528 2,360 0 -2,146 -4,468
Source: JPMorgan
16
(44-20) 7325-9582 21 March 2006
[email protected]
In this case, we have a larger risk position due to the Horizon Effect and so lose more
for spread widening and gain for spread tightening at horizon (as shown in the last
row of Table 9).
Equal Notional 5y/10y Flatteners generally have increasing risk over the life of
the trade due to the Horizon Effect and Steepeners have decreasing risk due to
the Horizon Effect.
Default Risk
This trade has equal notional exposure in each leg so is effectively Default-Neutral
over the trade horizon.
Breakeven Analysis
Putting all this analysis together, the bottom line is whether our curve will flatten
enough to at least breakeven. Table 10 shows this Breakeven analysis. Given we
have a flattener on, if the spread curve is constant (i.e. the 5y leg rolls down the
current spread curve to its Slide-implied level) we need the 10y point to move to
397bp, as in Row 3. This looks like a steepening of 11.7bp vs the current 10y-5y
Spread, but is really a 5.4bp curve flattening versus the Slide-implied curve steepness
(as shown in the final column). The shaded row shows this Breakeven for Time. This
intuitively makes sense as we need some curve flattening to counterbalance the
negative Time (Slide –Carry). If Spreads do widen in the 5y point by 20bp then we
need curves to flatten 13.4bp to breakeven on the trade over the 6 month horizon as
we have greater negative MTM for spread widening due to the Horizon Effect
making the trade longer risk, so need a larger flattening to breakeven. The key
decision in putting on this trade is therefore whether we can expect -5.4bp if spreads
are unchanged or if we think spreads are widening 20bp do we think curves will
flatten 13.4bp.
Table 10: Breakevens for Equal-Notional Flattener
Current 10y-5y curve = 49bp, Slide Implied 10y-5y curve = 66bp.
-40 296 373 77.2 27.9 10.7
-20 316 385 69.1 19.8 2.6
0 336 397 61.0 11.7 -5.4
20 356 409 53.0 3.7 -13.4
40 376 421 45.1 -4.2 -21.3
Source: JPMorgan
Trade Performance Analysis

We can finally look at the likely trade performance for different spread levels in our
5y and 10y legs over the horizon in Table 11.
Table 11: Trade Performance Analysis
Vertical spreads are centered around Slide Implied 5y Spreads (bp) at horizon, Horizontal are centered
around 10y Spreads at horizon (bp). Data is trade MTM ($) incl. Carry at horizon
Current 10y at Horizon**
362 382 402 422 442
296 70,765 -60,563 -190,330 -318,544 -445,212
316 147,036 16,917 -111,651 -238,676 -364,166
Current 5y at Horizon* 336 221,867 92,929 -36,043 -160,337 -284,679
356 295,295 167,511 41,254 -83,484 -206,707
376 367,359 240,703 115,560 -8,074 -130,208
Source: JPMorgan. * Slide Implied spread of current 5y at Horizon, ** Slide Implied spread of current 10y at Horizon.
17
(44-20) 7325-9582 21 March 2006
[email protected]
We can see that this trade performs well for curve flattening (10y spread decreases or
5y spread increases) and due to the Negative Time, if spreads are unchanged it loses
money over the horizon. This is what we would expect from a flattener trade – it
profits as the curve flattens and will lose money increasingly as the curve steepens.
Importantly we now have a way to accurately assess this P+L and so can take a view
on whether we think the curve will flatten enough to make the trade profitable.
Summary of Equal Notional Characteristics

The P+L and Sensitivity characteristics for equal-notional curve trades (for 5y/10y trades on typical upward sloping curves)
are summarised in Table 12 and Table 13.
Table 12: P+L Characteristics for Equal Notional Curve Trades

Carry Slide Dominant Time Effect (Carry or Slide) 1bp Instantaneous Widening Default
Flattener Positive Low Spread = Positive Low Spread = Carry MTM Loss Neutral
High Spread = Negative High Spread = Slide
Steepener Negative Low Spread = Negative Low Spread = Carry MTM Gain Neutral
High Spread = Positive High Spread = Slide
Source: JPMorgan
Table 13: Sensitivity Summary for Equal Notional Curve Trades

1bp Instantaneous Widening Convexity from Spread Chg Horizon Impact for 5y/10y Trade
Flattener MTM Loss Positive Longer risk over horizon
Steepener MTM Gain Negative Shorter risk over horizon
Source: JPMorgan
18
(44-20) 7325-9582 21 March 2006
[email protected]
2. Duration-Weighted Strategies
We have seen that a major feature of equal-notional trades is the large MTM effect
from parallel curve moves which may not be particularly desirable for an investor
who is just trying to express a view on the relative movement of points in the curve.
In order to immunize curve trades for parallel curve moves we can look to weight the
two legs of the trade so that for a 1bp parallel move in spreads, the Mark-to-Market
on each leg is equal – we call this Duration-Weighting the trade. We can do this by
fixing the Notional of one leg of the trade, for example set the 10y Notional to
$10mm, and can then solve to find the Notional of the 5y leg so that the trade is
MTM neutral for a 1bp move in Spreads.
For a curve trade at Par, the Mark-to-Market of each leg for a 1bp shift in Spreads is
given by3:
MTM10y = 1bp.Duration10y.Ntnl10y, and equivalent for the 5y
The Duration-Weighted trade adjusts the Notionals so that:
MTM10y = MTM5y for a 1bp parallel move in spreads,
i.e. 1bp . Duration10y . Ntnl10y = 1bp . Duration5y . Ntnl5y
Duration10 y
Ntnl 5 y = .Ntnl10 y
Duration5 y
Default Exposure
As we have adjusted the 5y notional exposure to be larger than the 10y, we now have
default exposure over the life of the trade as a default in the first 5 years will mean
paying out or receiving (1-Recovery) on a larger notional.
Duration-Weighted Strategies Analysed

We continue with our Fiat SPA example to see how we should analyse our Duration-
Weighted trade whose structure is shown in Table 14.
Time (Carry & Slide)

Looking first at our Carry in Table 14, we can see that we have Negative Carry (-
$73,535) over the trade horizon. Duration-weighted flatteners are typically
Negative Carry unless for very steep curves (see the Grey Box for an explanation
of this).
3
See Trading Credit Curves I for a discussion of Risky Duration and Risky Annuity. For a
curve trade at Par and for a 1bp change in spreads only the MTM can be expressed using the
Risky Duration, for other moves we need to use the Risky Annuity.
19
(44-20) 7325-9582 21 March 2006
[email protected]
Table 14: Duration-Weighted 5y / 10y Flattener

6 month trade horizon
Tenor Position Spread Notional ($) Carry ($) Slide ($) Time ($)
bp (Default Exposure) Over Horizon Over Horizon Over Horizon
5Y Buy Protection 355 -15,520,593 -276,223 -117,054 -393,277
Flattener -5,520,593 -73,535 -102,394 -175,930
Source: JPMorgan
Positive Carry Duration-Weighted Flatteners

Duration10 y
To Duration-Weight a trade we set: Ntnl 5 y = .Ntnl10 y
Duration5 y
Given that the Carry in each leg is given by (e.g. for the 5y): Carry5y = S5y . Ntnl5y . Horizon
Duration10 y
We can see that: Carry 5 y = S 5 y. .Ntnl10 y.Horizon
Duration 5 y
Duration10 y
For a Duration-Weighted Flattener to be Positive Carry, we need: S 10 y > S 5 y.
Duration5 y
which is generally not the case unless curves are very steep.
We also have significant Negative Slide over the horizon as the 5y part of the curve
is much steeper than the 10y part and therefore there is larger Negative Slide here, as
Figure 10 shows.
Generally for Duration-Weighted Flatteners Slide is Negative and for

Steepeners Slide is Positive. This is because the Risky Annuity × Notional is
approximately equal in both legs (the Duration-Weighting condition), so the MTM
due to Slide is largely about whether the spread change is greater in the shorter leg or
the longer leg. As most curves are steeper in the short end, this means the short end
has a greater MTM from Slide, hence flatteners have negative Slide and steepeners
have positive Slide.
For Duration-Weighted trades Slide dominates Carry in the Time consideration

meaning Carry alone is not sufficient to assess likely profitability of a trade in an
unchanged spread environment. The Duration-Weighted 'holy grail' of the Positive
Carry Flattener will most likely be P+L negative if curves remain unchanged as
Slide will be negative and will dominate the Carry effect.

In terms of parallel curve movements (Duration effect) we have structured the trade
so that it should be MTM neutral for a 1bp parallel change in spreads of the curve.
However, there is also a Convexity impact from Spread widening to understand.
Figure 12 shows this Convexity impact for larger spread changes on our Duration-
Weighted Flattener. We can see that for large spread widening or tightening the
position has a positive MTM. We call this Positive Convexity and Duration-
Weighted Flatteners usually have Positive Convexity and Steepeners have
20
(44-20) 7325-9582 21 March 2006
[email protected]
Negative Convexity (see the first section of this note, The Drivers of P+L in Curve
Trades, for an explanation of this)
Figure 12: Convexity for Duration-Weighted Flattener

x-axis: parallel chg (bp), y-axis: P+L at horizon from curve position
4,000
3,000
2,000
1,000
0
-40 -20 0 20 40
Source: JPMorgan
Table 15 shows this analysis in more detail, where Row 3 has the actual MTM from
(instantaneous) spread moves and Row 6 shows the expected MTM from spread
moves using the current Risky Annuities – given we are Duration-Weighted this is
zero. The Convexity effect (Row 7) is then just the actual MTM minus the expected
MTM using the current Risky Annuities.
Table 15: Sensitivity Analysis for Spread Changes

1) MTM 5Y (Buy) -267,892 -132,879 0 130,779 259,492
2) MTM 10Y (Sell) 271,344 133,728 0 -129,958 -256,260
3) Curve Trade 3,452 849 0 821 3,232
6) Curve Trade 0 0 0 0 0
7) Convexity Effect (Row 3 – Row 6) 3,452 849 0 821 3,232
Source: JPMorgan

Having seen our sensitivity to instantaneous spread changes, we can now look at our
sensitivities to spread changes at the horizon of the trade. Table 16 shows the MTM
(without Carry) from the trade in both a Parallel Widening and Tightening at horizon.
The trade has negative MTM in both, which is mostly due to the large negative Slide
that we saw in this trade. However, the sensitivity to spread widening and tightening
at the trade horizon also contains a Horizon Effect. As we discuss in Appendix III:
The Horizon Effect, our Duration-Weighted trade will become market directional
over its life due to this Effect. We can see this in Table 16 as we get a market
directional position where we have relative positive MTM for spreads tightening and
negative for spreads widening (row 7 of Table 16).
Table 16: P+L Sensitivity Analysis for Duration-Weighted Flattener

1) MTM 5Y (Buy) -362,295 -238,680 -117,054 3,264 121,645
2) MTM 10Y (Sell) 275,938 143,497 14,660 -110,704 -232,672
3) Curve Trade MTM at Horizon -86,357 -95,183 -102,394 -107,440 -111,026
5) Instantaneous MTM 3,452 849 0 821 3,232
6) Horizon Effect (Row 4 – Row 5) 12,585 6,363 0 -5,867 -11,864
Source: JPMorgan
21
(44-20) 7325-9582 21 March 2006
[email protected]
Figure 13 illustrates the Horizon Effect graphically – the full workthrough of this is
detailed in Appendix III.
Figure 13: Sensitivity Analysis at Horizon (less Slide)

x-axis: parallel chg (bp), y-axis: P+L at horizon from curve position at horizon less Slide
20,000
15,000
10,000
5,000
0
-40 -20 0 20 40
-5,000
-10,000
Source: JPMorgan
5y/10y Duration-Weighted Flatteners generally get longer risk over the horizon
of the trade and steepeners get shorter risk over the horizon.
Default Risk
We can see from Table 14 that we are short default risk for the trade horizon, as we
have bought protection on a larger notional than we sold protection on, meaning we
benefit if there is a default in the first 5 years. Duration-Weighted Flatteners will
always be short default risk as they will always have a larger notional in the
shorter leg in order to balance the Duration effects; Steepeners will be long
default risk.
Breakevens
Once we have done all of our analysis, we can finally look at the Breakevens for our
Duration-Weighted Flattener in Table 17. The shaded row shows the Breakeven
curve move needed to compensate for the unchanged spread scenario, i.e. to
compensate for the Time effect. Due to the large Slide effect in Time, we need
27.2bp of curve flattening to Breakeven from Time in this trade (shaded row, column
6). We can also see the Breakeven curve moves needed for spread widening or
tightening at the 5y point (see Appendix II: Calculating Breakevens for more on how
we analyse Breakevens). As our Horizon Effect makes us longer risk over the life of
the trade, we need increasing flattening if spreads widen at horizon, as Table 17
shows.
Table 17: Breakeven for Duration-Weighted Flattener

-40 296 339 43.4 -5.9 -23.1
-20 316 357 41.2 -8.1 -25.2
0 336 375 39.3 -10.0 -27.2
20 356 393 37.6 -11.7 -28.9
40 376 412 36.0 -13.3 -30.4
Source: JPMorgan
22
(44-20) 7325-9582 21 March 2006
[email protected]
Table 18 analyses the trade performance at horizon, where we can see that our
Duration-Weighted flattener will only perform if we have larger curve flattening due
to the large negative Time for this trade. For example, if the 5y point is unchanged
(and we therefore move to the Slide Implied 5y of 336bp over the horizon, shaded
row), the 10y point needs to flatten 40bp for the trade to breakeven. A trader or
investor looking to put on this flattener would need to decide whether they think that
this magnitude of flattening is likely in order to want to put on this trade.
Table 18: Trade Performance Analysis

Vertical spreads are centered around Slide Implied 5y Spreads (bp)at horizon, Horizontal are centered
around 10y Spreads at horizon (bp). Data is trade MTM ($) incl. Carry at horizon
Current 10y at Horizon**
362 382 402** 422 442
296 -153,750 -285,390 -415,478 -544,025 -671,040
316 -34,210 -164,528 -293,301 -420,538 -546,249
Current 5y at Horizon* 336* 83,078 -45,954 -175,930 -299,418 -423,864
356 198,174 70,393 -55,862 -180,596 -303,817
376 311,138 184,574 59,526 -64,010 -186,042
Source: JPMorgan. * Slide Implied spread of current 5y at Horizon, ** Slide Implied spread of current 10y at Horizon.
Summary of Duration-Weighted Characteristics

The P+L and Sensitivity characteristics for Duration-Weighted curve trades (for 5y/10y trades on typical upward sloping
curves) are summarised in Table 19 and Table 20.
Table 19: P+L Characteristics for Duration-Weighted Trades

Flattener Generally Negative Generally Negative Generally Slide MTM Neutral Short Risk
Steepener Generally Positive Generally Positive Generally Slide MTM Neutral Long Risk
Source: JPMorgan
Table 20: Sensitivity Summary for Duration-Weighted Curve Trades

Flattener MTM Neutral Positive Longer risk over horizon
Steepener MTM Neutral Negative Shorter risk over horizon
Source: JPMorgan
23
(44-20) 7325-9582 21 March 2006
[email protected]
3. Carry-Neutral Strategies
A third way of looking to structure two-legged curve trades in credit is to look at
putting on these trades Carry Neutral. By 'Carry Neutral' we mean that the income
earned on both legs is the same over the trade horizon.
We define the Carry on a 5y CDS contract as: Carry5y = S5y . Horizon . Ntnl5y
Where,
S5y = Par Spread on 5y maturity CDS contract
Horizon = Year fraction of trade horizon
Ntnl5y = Notional of 5y CDS contract
The Carry-Neutral condition is that: Carry Legx = Carry Legy
For a 5y / 10y flattener (buy protection 5y, sell protection 10y):
S5y.Horizon.Ntnl5y = S10y.Horizon.Ntnl10y
Therefore, to be Carry-Neutral where we want to buy $10m of notional protection in

the 10y, we need to sell protection on the following notional in the 5y leg:
S 10 y
Ntnl 5 y = .Ntnl10 y
S5y
Carry-Neutral strategies can be useful for investors who want to avoid P+L from
interim cashflows and would like pure P+L from curve movements.
Carry-Neutral Strategies with our Analysis Framework

Without going through all of the features of Carry-Neutral strategies, we can see that
the Carry-Neutral trade can have some of the characteristics to Duration-Weighted
strategies. We use our Fiat SPA trade as before to briefly show the characteristics of
Carry-Neutral Flattener trades.
Time (Carry & Slide)

Looking at Table 21, we can see that we have zero Carry over the horizon (by
definition) and negative Slide of -$71,232, which will be the Time (as Carry is zero).
Table 21: Time Analysis for Carry-Neutral Trade

Spread Notional ($) Carry ($) Slide ($) Time ($)
Tenor Position bp (Default Exposure) Over Horizon Over Horizon Over Horizon
5Y Buy Protection 355 -11,388,732 -202,687 -85,892 -288,580
Flattener -1,388,732 0 -71,232 -71,232
Source: JPMorgan
24
(44-20) 7325-9582 21 March 2006
[email protected]

We can see that our Carry-Neutral strategy is long risk for spread moves (see Row 3
of Table 22) and has negative MTM for spread widening and positive MTM for
spread tightening. If S10y/S5y is less than Duration10y / Duration5y then a Carry-Neutral
flattener will be long spread risk as it will have bought less notional protection in the
5y leg than it needs to be Duration-Weighted so will have negative MTM for spread
widening. Carry-Neutral trades on low spread names tend to be mixed in terms
of being long or short spread risk; higher spread names tend to be long risk.
Additionally, this has Positive Convexity and therefore loses relatively less for
spread widening and makes relatively more for spread tightening (Row 7).
The Horizon Effect for Carry-Neutral flatteners also makes the position longer risk,
meaning at horizon we have a negative MTM for spreads widening (relative to the
start) and positive MTM for spreads tightening (relative to the start).
Table 22: P+L Analysis for Carry-Neutral Flattener

1) MTM 5Y (Buy) -196,574 -97,504 0 95,963 190,411
2) MTM 10Y (Sell) 271,344 133,728 0 -129,958 -256,260
3) Curve Trade 74,770 36,224 0 -33,994 -65,850
6) Curve Trade 70,187 35,094 0 -35,094 -70,187
7) Convexity Effect (Row 3 – Row 6) 4,582 1,130 0 1,099 4,338
Source: JPMorgan
Default Risk
For upward sloping curves, Carry-Neutral Flatteners will be short default risk
and Steepeners will be long default risk. We tend to see lower Spread names
having a larger short default risk position than higher Spread names, as the ratio of
spreads between 10y and 5y is generally higher for lower Spread names as curves are
more linear.
25
(44-20) 7325-9582 21 March 2006
[email protected]
Summary of Carry-Neutral Characteristics

The P+L and Sensitivity characteristics for Carry-Neutral curve trades (for 5y/10y trades on typical upward sloping curves)
are summarised in Table 23 and Table 24.
Table 23: P+L Characteristics for Carry-Neutral Trades

Flattener Zero (by definition) Negative Slide (by definition) Lower Spread: Mixed Short Risk
Higher Spread: Generally Negative
Steepener Zero (by definition) Positive Slide (by definition) Lower Spread: Mixed Long Risk
Higher Spread: Generally Positive
Source: JPMorgan
Table 24: Sensitivity Summary for Carry-Neutral Curve Trades

Flattener Lower Spread: Mixed Positive Longer risk over horizon
Higher Spread: Generally Negative
Steepener Lower Spread: Mixed Negative Shorter risk over horizon
Higher Spread: Generally Positive
Source: JPMorgan
26
(44-20) 7325-9582 21 March 2006
[email protected]
Appendix I: Different Ways of Calculating

Slide
We talk of Slide as the effect from moving down the credit curve over time assuming
that the credit curve is unchanged. However, there are two ways that we could
understand that the credit curve is unchanged which would give rise to two ways of
calculating Slide:
i) Hazard Rates / Spreads for a given tenor are kept constant4
ii) Hazard Rates for a given calendar point are kept constant
i) Hazard Rates / Spreads for a Given Tenor Constant

Keeping spreads constant for each tenor means that if the 5y point is currently at
100bp (for maturity in March 2011), the 5y point will still be at 100bp at horizon. If
our trade horizon is 1 year and we have a 5y contract, our March 2011 maturity will
become a 4y over the horizon and therefore rolls down the spread curve to be at 90bp
(e.g.). This will mean that the survival probability is higher for this shorter maturity
and a long risk CDS position will have a positive MTM equal to: - (Spread 5y –
Spread 4y) × Risky Annuity 4y × Notional.
We can illustrate what this Slide means in terms of default probabilities and hazard
rates in Figure 14 and Figure 15.
Figure 14: Initial Hazard Rates at Inception of CDS Contract Figure 15: 1 Year Slide - Hazard Rates Constant at Tenors
Hazard Rates, % Hazard Rates, %
Maturity Maturity
4.00% 4.00%
3.00% 3.00%
2.00% 2.00%
1.00% 1.00%
Calendar Dates: Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Calendar Dates: Mar-07 Mar-08 Mar-09 Mar-10
Tenors: 1Y 2Y 3Y 4Y 5Y Tenors: 1Y 2Y 3Y 4Y 5Y
Keeping hazard rates constant at each tenor means keeping the hazard rate for the 1y
period constant even though we move on in time. This is the equivalent of keeping
your spreads curve constant. As you have 1 year less until maturity, there will be
lower default probability which gives you a Slide effect as you move down the
spread curve.
4
See Trading Credit Curves I for a full discussion of the role of hazard rates in CDS pricing.
27
(44-20) 7325-9582 21 March 2006
[email protected]
We could therefore look at our Slide as the P+L if the spreads for each future given
tenor stay constant.
ii) Hazard Rates Constant for Each Calendar Point

The other ‘assuming no change’ scenario that we could mean when we look at our
Slide is the hazard rates staying constant for each calendar point (e.g. between
March 2007 and March 2008). We have seen that the current spread curve implies a
hazard rate for each period. For example, it may imply that the conditional
probability of default between March 2007 and March 2008 is 2.00% and likewise
we have an implied hazard rate for each maturity point (as in Figure 16). These
hazard rates could be founded on company fundamentals – for example, Company
ABC has a large amount of outstanding debt needing refinancing around March 2007
and therefore it may have a higher probability of default at that calendar period due
to risks around refinancing this debt.
We may therefore want to keep our hazard rates constant for each calendar point so
that between March 2007 and March 2008 the hazard rate stays at 2.00% when we
slide over time, as shown in Figure 17. We could re-price our CDS contract after our
1 year horizon assuming that these hazard rates are constant for each calendar date.
This would result in a lower positive MTM than method i) for upward sloping
curves.
Figure 16: Initial Hazard Rates at Inception of CDS Contract Figure 17: 1 Year Slide - Hazard Rates Constant at Calendar Dates
Hazard Rates, % Hazard Rates, %
Maturity Maturity
4.00% 4.00%
3.00% 3.00%
2.00% 2.00%
1.00% 1.00%
Calendar Dates: Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Calendar Dates: Mar-07 Mar-08 Mar-09 Mar-10
Tenors: 1Y 2Y 3Y 4Y 5Y Tenors: 1Y 2Y 3Y 4Y 5Y
In practice, we would expect the view from the trading desk to be more i), i.e. keep
spreads constant for each tenor (e.g. 5y). The view from analysts however may be
more inclined towards ii), i.e. keep the conditional probabilities of default constant
for each future date. In our calculations we use the Slide calculated using i), keeping
spreads constant for each maturity length.
28
(44-20) 7325-9582 21 March 2006
[email protected]
Appendix II: Calculating Breakevens

We can see that the MTM (Mark to Market) on a 5y/10y curve flattener (bought 5y
protection, sold 10y protection) is:
MTMCurve Trade, t to t+1 = (∆S5y, t to t+1 . A5y,t+1 . Ntnl5y) + (-∆S10y, t to t+1 . A10y,t+1.Ntnl10y)
Where,
S5y, t+1 = Spread for a 5y maturity as at time t+1
∆S5y = S5y, t+1 - S5y, t
∆S10y = S10y, t+1 – S10y, t
A5y,t+1 = Risky Annuity for 5y maturity at time t+1
Ntnl5y = Notional of 5y contract.
We would like to think of finding a single breakeven curve change such that this
equation gives us MTM = 0, in other words it breaks even. However, given there is
Convexity in our curve trades we cannot solve for a single number as the Risky
Annuities will change for each different change in spreads.
We can illustrate this by looking at three ways in which curves could steepen 20bp.
In scenario a) only the 10y point widens 20bp, in b) only the 5y point tightens 20bp
and in c) the curve pivots with the 10y widening 10bp and the 5y tightening 10bp.
The Mark-to-Market in all these will be different as the Risky Annuities will be
different in each scenario, so we cannot find a single number that will give us a
breakeven.
Figure 18: Illustration of a 20bp Curve Steepening Causing Different Mark to Markets
bp
a) Curve Steepening 20bp by 10y b) Curve Steepening 20bp by 5y c) Curve Steepening 20bp: 10y
only widening only tightening 100 widening 10bp & 5y tightening 10bp
100 80
80
80 60
60 60
40
40 40
Start, t Start, t Start, t
20 20 20
End, t+1 End, t+1 End, t+1
0 0 0
0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10
Source: JPMorgan
In practice, we therefore analyse Breakevens by looking at discrete changes in a

given point (say the shorter maturity leg for ease sake) and then calculate at how
much the longer maturity leg needs to move such that our trade MTM = 0.
We can therefore define Breakeven Curve t+1 | Sn, t+1 = S’ as the breakeven Curve at
time t+1 conditional on the Spread at the n year point at t+1 being S’. For example,
if the 5y point (S5, t+1,) is at 50bp (S’) at the trade horizon t+1, where does the Curve
need to be so that the 10y point ensures that the MTM = 0 for a 5y / 10y curve trade.
We can show these Breakevens as a range around the current spread as in Table 25.
The Breakeven for Time is the highlighted row where the 5y point is unchanged over
29
(44-20) 7325-9582 21 March 2006
[email protected]
the horizon and therefore our current trade moves to the Slide-Implied point. The
table shows that the 5y point will slide to 336bp and at this level the 10y breakeven is
375bp which is a breakeven curve of 39.3bp. The current curve is 49bp but the Slide
Implied curve is 66bp, which means that the curve needs to flatten 27.2bp (shaded
row, column 7) to Breakeven at horizon – this must mean the trade has negative
Time so we need quite a lot of curve flattening to breakeven. The other rows
represent Breakevens for a given 5y spread change. We change the 5y spread to see
how far the curve has to steepen or flatten at the 10y point for the trade to breakeven
given the 5y Spread change and the effect of Time. As we can see, the Breakeven
needs to show how much the curve needs to flatten or steepen versus the Slide
Implied Curve (this is shown in the final column) as the Slide will imply a natural
curve move over the life of the trade.
Table 25: Breakeven Curve Movements Analysis – Current 5y Spread = 355bp, Current 10y – 5y Curve = 49bp, Slide Implied Curve = 66bp
-40 296 339 43.4 -5.9 -23.1
-20 316 357 41.2 -8.1 -25.2
0 336 375 39.3 -10.0 -27.2
20 356 393 37.6 -11.7 -28.9
40 376 412 36.0 -13.3 -30.4
Source: JPMorgan
30
(44-20) 7325-9582 21 March 2006
[email protected]
Appendix III: The Horizon Effect

Sensitivity analysis of curve trades at their horizon can be a complex issue. In this
Appendix we examine the Horizon Effect on curve trades, which we define as the
impact of the trade horizon on a trade’s sensitivity to parallel spread changes.
The Horizon Effect can be most easily seen by the difference in our sensitivity
analysis for a Duration-Weighted trade between instantaneous changes in spread and
changes in spread at horizon. The reason we have a Horizon Effect is because our
Risky Annuities change over the life of a trade. This causes a Duration-Weighted
trade – which is intended to be neutral to directional (parallel) spread moves – to
become longer or shorter spread risk over the life of the trade. In other words, the
change in Risky Annuities (and Durations) causes the trade to be un-Duration-
Weighted over the trade horizon. So why do Risky Annuities change over the life of
a curve trade?
Changing Risky Annuities over the Trade Horizon

There are two effects that cause Risky Annuities change over a trade horizon, if the
curve itself is unchanged:
a) Impact of Maturity Decreasing

Figure 19: Maturity Effect
As the length of time to maturity decreases, Risky Annuities fall and shorter-dated
Flat Spread Curve (x-axis: Maturity, years; y-axis:
Spread, bp) Risky Annuities fall more than longer-dated Risky Annuities. For example, the effect
100 of 6 months of time passing could make the 10y Risky Annuity decrease from 8.50
to 8.25 and the 5y decrease from 4.50 to 4.00. This is easiest to illustrate by picturing
80
a flat curve as shown in Figure 19, where only the effect of time passing changes the
60 Risky Annuities.
40
20 Original Curv e As our shorter leg Risky Annuity declines faster, we will no longer be Duration-
Weighted. Essentially we will be getting longer risk in a Flattener, as we will not
0 have enough protection in our short risk leg of the trade at horizon to be Duration-
0 1 2 3 4 5 6 7 8 9 10 Weighted.
Source: JPMorgan
b) Roll Down / Slide Effect
Figure 20: Roll / Slide Effect (bp) Given that credit curves are typically upward sloping and often steeper at the short
x-axis: Maturity, years; y-axis: Spread, bp end than at the long end, the roll-down or Slide effect typically has the effect of a
120 10y Spread non-parallel tightening of a curve trade, as shown in Figure 20.
100 5y Spread
80 Spread tightening will mean that Risky Annuities rise in both legs.
60 9.5y Spread
We call the net effect of both of these factors on Risky Annuities changing over time
40
the Horizon Effect. The net effect will depend on the shape of the particular curve
20 4.5y Spread and time horizon, but for normal shaped curves (e.g. our previous example of Fiat
0 SPA) and for 5y/10y trades, maturity effect will tend to dominate the roll down
0 1 2 3 4 5 6 7 8 9 10 effect.
Source: JPMorgan
31
(44-20) 7325-9582 21 March 2006
[email protected]
A Worked Example
A real-life example will help to show how the Horizon Effect of changing Risky
Annuities affects the directional position of a trade. We will look at a our example
from the main body of the note, a Duration-Weighted curve flattener on Fiat SPA
where we buy protection in 5y and sell protection in 10y Duration-Weighted (as
shown in Table 26). We analyse this curve trade for a 6 month horizon. The curve for
Fiat SPA is shown in Figure 21.
Table 26: Worked Convexity Example – Duration-Weighted Flattener on Fiat SPA

Spread Notional ($) Risky
Tenor Position bp (Default Exposure) Annuity
5Y Buy Protection 355 -15,520,593 4.25
10Y Sell Protection 404 +10,000,000 6.59
Source: JPMorgan
Instantaneous Parallel Spread Moves

Positive Convexity from Parallel If the curve moves parallel wider or tighter Risky Annuities change in our Duration-
Spread Moves in Isolation Weighted trade giving us a Convexity impact (as shown in Figure 22). As we have
seen, a Flattener has a Positive Convexity meaning it has a positive MTM effect from
both a tightening and widening of spreads.
Figure 21: Fiat SPA Credit Curve Figure 22: Convexity Effect for (Instantaneous) 20bp Parallel Curve
x-axis: Maturity in years; y-axis: Spread, bp Shifts
500 x-axis: parallel curve move in bp; y-axis: MTM ($)
404
355 4,000
400
3,000
300
2,000
200
100 1,000
0 0
0 1 2 3 4 5 6 7 8 9 10 -40 -20 0 20 40
Horizon Effect on Risky Annuities

As the trade Slides over the trade horizon we will get both a shortening of maturity
and a non-parallel tightening of spreads. We can see this effect in Figure 23 where
we have the maturity declining 6 months and the spreads tightening from 355bp to
336bp in the 5y leg of the trade and from 404bp to 402bp in the 10y leg of the trade.
32
(44-20) 7325-9582 21 March 2006
[email protected]
Figure 23: Slide Impact on Spread and Maturity

bp
500 404
355
400
402
300 336
200
100
0
0 1 2 3 4 5 6 7 8 9 10
Source: JPMorgan
The roll (tightening) effect should make Risky Annuities rise and the Maturity effect
will mean that Risky Annuities will fall, with the 5y Risky Annuity falling more than
the 10y. The net effect these different Slide effects will differ case by case.
In our example, where the trade horizon is 6 months, the 5y Risky Annuity ends up
moving from 4.25 to 3.92 (-0.33) and the 10y Risky Annuity ends up moving from
6.59 to 6.42 (-0.17), i.e. our 5y Risky Annuity falls more than our 10y. This makes our
trade longer risk over the horizon. Table 27 shows how we work through this. We
look at the current Duration-Weighting (column 6) and then using our Slide Implied
horizon Risky Annuities look at how we should be Duration-Weighting at horizon,
assuming the curve is unchanged. The difference can be seen in the final column, the
Horizon Effect. We can see that as our 5y Risky Annuity falls more, we should be
buying more protection (shorter risk) at horizon. I.e. to be Duration-Weighted at
horizon we need to have bought protection on $16,373,090 but we have only bought
protection on $15,520,593. Essentially, we are less short than we should be in the 5y
leg (+$852,498), so we have become longer risk over the life of the trade.
Table 27: Change in Annuities and Horizon Effect

Current Spread Slide Implied Current Slide Implied Current Duration- Horizon Duration- Horizon
(bp) Spread (bp) Annuity Annuity Weighting Weighting Effect
Buy 5Y 355 336 4.25 3.92 -15,520,593 -16,373,090 +852,498
Sell 10Y 404 402 6.59 6.42 +10,000,000 +10,000,000 0
Curve 49 66
Source: JPMorgan
Isolating the Horizon Effect

We can see the impact of this Horizon Effect when we look at sensitivity analysis at
horizon. Figure 24 shows the MTM of the trade at horizon including the Slide, which
shows the large negative Slide effect (-$102,394) in this trade dominates horizon
P+L if curves are unchanged. When we take out the Slide effect in Figure 25 we can
see the Horizon Effect as we are now long risk, so that a widening of spreads has a
MTM loss and a tightening of spreads has a MTM gain. Compare Figure 25 to
Figure 22 to see how we get a very different pattern for a change in spreads at the
start of the trade and at its horizon.
33
(44-20) 7325-9582 21 March 2006
[email protected]
Figure 24: Sensitivity Analysis at Horizon Including Slide Figure 25: Sensitivity Analysis at Horizon minus Slide
x-axis: Spread Change at Horizon (bp), y-axis: Trade MTM ($) x-axis: Spread Change at Horizon (bp), y-axis: MTM ($)
0 20,000
MTM At Horizon (minus Slide)
-40 -20 0 20 40 15,000 incl. Conv ex ity
-20,000
Pure Horizon Effect
-40,000 10,000
5,000
-60,000
0
-80,000
-40 -30 -20 -10-5,000 0 10 20 30 40
-100,000
-10,000
-120,000
-15,000
We summarise this horizon effect by looking at how the trade MTM at horizon (less
Slide) differs from the instantaneous MTM for changes in spread, as we see in the
final row of Table 28. The trade is now longer risk and so has a more negative MTM
as spread widen and a less negative MTM as spreads tighten.
Table 28: Sensitivity Analysis at Horizon

MTM from Given Spread Changes ($)
1) MTM 5Y (Buy) -362,295 -238,680 -117,054 3,264 121,645
2) MTM 10Y (Sell) 275,938 143,497 14,660 -110,704 -232,672
3) Curve Trade MTM at Horizon -86,357 -95,183 -102,394 -107,440 -111,026
5) Instantaneous MTM 3,452 849 0 821 3,232
6) Horizon Effect (Row 4 – Row 5) 12,585 6,363 0 -5,867 -11,864
Source: JPMorgan
Horizon Effect Conclusion

The Horizon Effect gives us a market directional position over the life of the trade
due to our changing Risky Annuities. This can affect our sensitivity analysis for
spread changes at the horizon. The net risk position we pick-up in a trade is difficult
to predict with certainty and will depend on:
• The shape of the underlying curve

• The time between the maturities of the trade
• The length of the horizon we are considering
We can remove the Horizon Effect in a curve trade by Forward Duration-Weighting

the trade so that it is weighted to be market-neutral at horizon, given the Slide-
implied Risky Durations. This weighting would need to be continually adjusted as
any curve movements would change our Forward Durations. Practically, many
traders will Duration-Weight their curve trades for the current Durations, but should
be aware of the how the Horizon Effect will give them a longer or shorter risk
position over the life of the trade.
34
(44-20) 7325-9582 21 March 2006
[email protected]
Analyst Certification
The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies
(or in a case where multiple research analysts are primarily responsible for this research, the research analyst named first in
each group on the front cover or named within the document individually certifies, with respect to each security or issuer
that the research analyst covered in this research) that: (1) all of the views expressed in this research 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 analyst's
compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst in this research.
JPMorgan EMEA Credit Research Ratings Distribution as at 31 December 2005
Overweight Neutral Underweight
EMEA Credit Research 5-year CDS or most liquid securitiy 30.4% 45.2% 24.4%
IB Clients* 29.0% 48.0% 23.0%
*Percentage of investment banking clients in each category.
Analysts’ Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including
the quality and accuracy of research, client feedback, competitive factors and overall firm revenues. The firm’s overall revenues include revenues from its
investment banking and fixed income business units.
Ratings System: JPMorgan 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).
JPMorgan uses the following fundamental credit recommendations: Improving (the issuer’s credit profile/credit rating likely improves over the next
six to twelve months), Stable (the issuer’s long-term credit profile/credit rating likely remains the same over the next six to twelve months), Deteriorating
(the issuer’s long-term credit profile/credit rating likely falls over the next six to twelve months), Defaulting (there is some likelihood that the issuer
defaults over the next six to twelve months).
Valuation & Methodology: In JPMorgan’s 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 issuer’s 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 issuer’s 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 issuer’s 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 issuer's balance sheet relative to the operational leverage in its business.
Other Disclosures:
Planned Frequency of Updates: JPMorgan provides periodic updates on companies/industries based on company-specific developments or announcements,
market conditions or any other publicly available information.
Legal Entities: JPMorgan is the marketing name for JPMorgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a
member of NYSE and SIPC. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services
Authority. J.P. Morgan Futures Inc., is a member of the NFA. J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is
authorized and regulated by the Financial Services Authority. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is
regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority. JPMorgan
Chase Bank, Singapore branch is regulated by the Monetary Authority of Singapore. J.P. Morgan Securities Asia Private Limited is regulated by the MAS and
the Financial Services Agency in Japan. J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMAL) is regulated by ASIC.
General: Information has been obtained from sources believed to be reliable but JPMorgan does not warrant its completeness or accuracy except with
respect to any disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer. Opinions and estimates constitute our
judgment as at the date of this material and are subject to change without notice. Past performance is not indicative of future results. The investments and
strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments
discussed may fluctuate in price or value. Changes in rates of exchange may have an adverse effect on the value of investments. This material is not
intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan and/or its affiliates and employees may act as placement
agent, advisor or lender with respect to securities or issuers referenced in this report.. Clients should contact analysts at and execute transactions through a
JPMorgan entity in their home jurisdiction unless governing law permits otherwise. This report should not be distributed to others or replicated in any
form without prior consent of JPMorgan.
U.K. and European Economic Area (EEA): Investment research issued by JPMSL has been prepared in accordance with JPMSL’s Policies for
Managing Conflicts of Interest in Connection with Investment Research, which can be found at
http://www.jpmorgan.com/pdfdoc/research/ConflictManagementPolicy.pdf. This report has been issued in the U.K. only to persons of a kind described in
Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as
"relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to
which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has
been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.
35
(44-20) 7325-9582 21 March 2006
[email protected]
Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd. Frankfurt Branch and JPMorgan Chase Bank, N.A., Frankfurt Branch
who are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht.
Australia: This material is issued and distributed by JPMAL in Australia to “wholesale clients” only. JPMAL does not issue or distribute this material to
“retail clients.” The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMAL. For
the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act
2001. JPMAL may hold an interest in the financial product referred to in this report. JPMCB, N.A. may make a market or hold an interest in the financial
product referred to in this report.
Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch.
Revised 4 January 2006
Copyright 2006 JPMorgan Chase & Co. All rights reserved. Additional information available upon request.
36
(44-20) 7325-9582 21 March 2006
[email protected]

JP Morgan - Trading Credit Curves 2

Uploaded by

Copyright:

Available Formats

JP Morgan - Trading Credit Curves 2

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

JP Morgan - Trading Credit Curves 2

Uploaded by

Copyright:

Available Formats

European Credit Research

Trading Credit Curves II

Figure 1: France Telecom Curve Steepening

J.P. Morgan Securities Ltd.

1. Equal-Notional or Default-Neutral Strategies: These are like Forwards, where

Table 1: Equal-Notional Strategies - Summary of Characteristics for Standard 5y/10y Curves

2. Duration-Weighted Strategies: Where the legs of the trade are weighted to be

Table 2: Duration-Weighted Strategies - Summary of Characteristics for Standard 5y/10y Curves

Table 3: Carry-Neutral Strategies - Summary of Characteristics for Standard 5y/10y Curves

0 1 2 3 4 5 6 7 8 9 10 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06

Drivers of P+L in Curve Trades

Table 4: Carry Example

To generalize, the Carry on a curve trade is calculated as:

CarryHorizon = (NtnlLeg1 × SLeg1 × Horizon) + (NtnlLeg2 × SLeg2 × Horizon) [1]

Figure 4: Slide Intuition

Slide and Flat Forwards

c) Sensitivity to Spread Changes

MTMt,t+1 = (St+1 – St) . Risky Annuityt+1 . Ntnl [2]

Where: St = Par CDS Spread at time t

Second Order Effects: Convexity

Why is there convexity in CDS positions?

Source: JPMorgan Source: JPMorgan

Figure 7: Risky Annuity Changes for Parallel Shift in Spreads

Figure 8: Convexity in a Duration-Weighted Curve Steepener

Sensitivity Analysis at Horizon

Third Order Effects: Including a Curve Model

Figure 9: iTraxx Constituents 10y-5y Slope as a Function of 5y Spread - JPMorgan Model

y = -0.0004x 2 + 0.3217x + 12.706

• For Equal-Notional strategies, economically there is no default exposure initially

e) Breakevens & Curve Steepening / Flattening

We have two Breakevens we may want to look at for our trade:

Breakeven from Time

The Breakeven from Time is the curve change needed so that:

MTMTime, t to t+1 + MTMCurve, t to t+1 =0 [4]

Or in long hand (for a curve flattener):

Carry t to t+1 + Slide t to t+1 + ∆S5y.A5y,t+1.Ntnl5y - ∆S10y.A10y,t+1.Ntnl10y = 0 [5]

Breakeven for a Given Spread Change

Curve Trading Strategies

1. Equal-Notional Strategies: Forwards

We refer to a two-legged equal notional strategy as a Forward, as the position is

10y: MTM10y = 1bp . Risky Annuity10y . Notional10y

Equal Notional Strategies Analysed

Table 7: Equal Notional 5y / 10y Flattener

Time (Carry + Slide)

Sensitivity to Spread Changes (Duration & Convexity)

Table 8: Sensitivity to Instantaneous Spread Changes

Figure 11: Sensitivity to Instantaneous Spread Changes

Sensitivity Analysis at Horizon

Trade Performance Analysis

Summary of Equal Notional Characteristics

Table 12: P+L Characteristics for Equal Notional Curve Trades

Table 13: Sensitivity Summary for Equal Notional Curve Trades

MTM10y = 1bp.Duration10y.Ntnl10y, and equivalent for the 5y

The Duration-Weighted trade adjusts the Notionals so that:

MTM10y = MTM5y for a 1bp parallel move in spreads,

i.e. 1bp . Duration10y . Ntnl10y = 1bp . Duration5y . Ntnl5y

Duration-Weighted Strategies Analysed

Time (Carry & Slide)

Table 14: Duration-Weighted 5y / 10y Flattener

Positive Carry Duration-Weighted Flatteners