Arnold Kan, JP Morgan Chase Bank, Taiwan

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  • Arnold Kan, JP Morgan Chase Bank, Taiwan

    1. 1. J   U   LY     2   0   0   6 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E   S   T   R   I   C   T   L   Y     P   R   I   V   A   T   E     A   N   D     C   O   N   F   I   D   E   N   T   I   A   L
    2. 2. This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contents may be used for any other purpose without the prior written consent of JPMorgan. The information in this presentation is based upon management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. The information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects. JPMorgan's policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors. JPMorgan is a marketing name for investment banking businesses of J.P. Morgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, f inancial advisory and other investment banking activities for Asian clients are performed by certain of such subsidiaries in Asia and/or J.P. Morgan Securities Inc. and/or its banking affiliates. T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    3. 3. Disclaimer: Asia Pacific in English New Derivatives Guideline for Insurance Co in Taiwan T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E   <ul><li>提高投資結構型商品的限額 , 投資額度部分由現行各該保險業 5% 提高至 10%, 對最終日未逾五年的結構商品 , 其到期本金之保本比率得為 90% 以上 </li></ul><ul><li>預計將有 1,386 億元注入國內衍生性金融商品市場 </li></ul>十、保險業投資之結構型商品應符合下列條件,其投資總額不得超過保險業資金之百分之十 III <ul><li>放寬非避險目的的投資 , 也就是俗稱的套利 , 投資 , 保險公司不必具有現貨 , 就可以投資 , 不只讓投資彈性增加 , 也增加了投資收益 </li></ul><ul><li>由於衍生性商品金融商品財務槓桿較高 , 金管會規定 , 以非避險為目的的投資 , 不得超過淨值 40% </li></ul>七、保險業為增加投資效益,得從事下列衍生性金融商品交易:認購(售)權證 , 經主管機關依期貨交易法第五條公告期貨商得受託從事之期貨交易 八、因增加投資效益所持有之國內或國外衍生性金融商品,其契約總(名目)價值,合計不得超過各該保險業業主權益之百分之四十,其中國外部分不得超過各該保險業業主權益之百分之二十 II <ul><li>放寬以避險為目的所投資的衍生性金融商品類型 , 並納入與避險項目具有高度相關性的避險衍生性金融商品 </li></ul><ul><li>增加保險業的避險效率 , 更大幅減少保險業避險成本 </li></ul>保險業從事衍生性金融商品交易應注意事項 : 五… .. 得基於避險目的,從事下列與前述資金運用相關之衍生性金融商品交易 : (一)認購(售)權證。(二)選擇權或期貨。(三)證券商經核准於營業處所經營之衍生性金融商品。(四)銀行經許可或核准辦理之衍生性金融商品。(五)最近一年長期債務信用評等等級經中華信用評等公司或其他經主管機關認可之國內外信用評等機構評定達 twA -級或相當等級以上之國內外金融機構承作之各種標的之衍生性金融商品。 I 主要效益 法規節錄
    4. 4. Synthetic Portfolio Insurance (SPI) Low Equity Barrier Enhanced Notes (LEADs) Equity Based Collateralized Obligations (ECOs) Equity Default Swaps Credit Long Short SPI Proxy Basket SPI 1 1 1 2 8 3 15 4 24 5 28 6 31 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    5. 5. Constant Proportion Portfolio Insurance (CPPI) Risky Asset <ul><ul><li>Investment is comprised of two parts—Risky asset + Risk Free Asset (Zero coupon bonds) </li></ul></ul><ul><ul><li>The higher the amount of risky assets in the portfolio, higher the potential returns over the principal amount. </li></ul></ul><ul><ul><li>This fraction of the risky asset in the Dynamic Basket is referred to as “Exposure” </li></ul></ul><ul><ul><li>The exposure is adjusted from time to time to maximize potential return and ensure principal protection </li></ul></ul>CPPI rebalances between an investment in the Risky Asset and a zero­coupon  bond to provide principal protection Variable investment Investment in Risky Asset Investment in Zero Bond Zero coupon bond Dynamic Basket 2 S   Y   N   T   H   E   T   I   C     P   O   R   T   F   O   L   I   O     I   N   S   U   R   A   N   C   E       (   S   P   I   )
    6. 6. Constant Proportion Portfolio Insurance — an e xample <ul><ul><li>In order to guarantee a certain principal on maturity, we can invest an amount equal to the principal discounted by the risk free rate </li></ul></ul><ul><ul><li>For Example, to ensure a return of $100 after 10 years, it is sufficient to invest in a risk free zero coupon bond trading at $60 if risk-free rate is 5.3% </li></ul></ul><ul><ul><li>The remaining $40 can be invested in risky assets to generate additional returns (Cushion) </li></ul></ul><ul><ul><li>This creates a portfolio of risk-less assets (Zero Coupon Bonds) and Risky assets and is referred to as the “Dynamic Basket” </li></ul></ul>Principal assurance through risk-less assets 3 S   Y   N   T   H   E   T   I   C     P   O   R   T   F   O   L   I   O     I   N   S   U   R   A   N   C   E       (   S   P   I   ) 100 60 Time to maturity Value of assets Cushion Risk-less bonds Assured principal value Bond Floor Year 1 Year 2 Year 3 Year 4 Year 10
    7. 7. Using crash size to define threshold for downside protection Principal protection under crash Value of Dynamic Basket Proxy Basket Risk-less Asset (170)% 100% Initial allocation After crash 60% At maturity Risk-Free rate 15% Crash of proxy basket Reallocation Reallocated Dynamic Basket Principal protection Initial investment (1) (2) (3) 0% <ul><ul><li>The amount by which the risky asset can depreciate in one single day is also estimated and is referred to as the “Crash Size” </li></ul></ul><ul><ul><li>Suppose we assume a Crash Size of 15% </li></ul></ul><ul><ul><li>We will use Crash Size to increase the exposure to the proxy basket beyond the the initial cushion </li></ul></ul><ul><li>Initial Portfolio (1) </li></ul><ul><ul><li>With this estimate, we can invest (100 — 60)/(0.15)  $270 in risky assets </li></ul></ul><ul><li>After Crash (2) </li></ul><ul><ul><li>If a 15% crash occurs, then value of the risky asset reduced to $230 </li></ul></ul><ul><ul><li>The risky asset is sold off at this reduced market value and reinvested in riskless asset </li></ul></ul><ul><li>Reallocated Dynamic Basket (3) </li></ul><ul><ul><li>Investment in the riskless asset = 230 — 170 = $60 </li></ul></ul><ul><ul><li>This amount ensures principal guarantee at maturity </li></ul></ul>Negative Values indicate Leverage 4 S   Y   N   T   H   E   T   I   C     P   O   R   T   F   O   L   I   O     I   N   S   U   R   A   N   C   E       (   S   P   I   )
    8. 8. Introduction to Synthetic Portfolio Insurance (SPI) <ul><li>What if SPI? </li></ul><ul><ul><li>Developed by JPMorgan as an OTC replication of the traditional Constant Proportion Portfolio Insurance (CPPI) strategy </li></ul></ul><ul><ul><li>In a standard CPPI structure, the investor buys units of a fund that is created and managed by the Asset Manager for the purpose of the CPPI structure </li></ul></ul><ul><ul><li>This arrangement gives rise to the following limitations </li></ul></ul><ul><ul><ul><li>Equity exposure can fall to zero </li></ul></ul></ul><ul><ul><ul><li>Currency protection is not necessarily possible </li></ul></ul></ul><ul><ul><ul><li>The underlying funds value is not verifiable </li></ul></ul></ul><ul><ul><li>In the JPMorgan SPI structure there is no fund vehicle involved and the investor buys a zero coupon bond plus a call option on the NAV of the notional portfolio which synthetically replicates an enhanced CPPI strategy </li></ul></ul>5 S   Y   N   T   H   E   T   I   C     P   O   R   T   F   O   L   I   O     I   N   S   U   R   A   N   C   E       (   S   P   I   )
    9. 9. SPI structural diagram Structural diagram: Investor invests 100% in SPI structure Issuer Investor JPM 100% Instrument Funding Funding 100% SPI basket Allocation Fund ZC Issuer Investor JPM Instrument Max (SPI Dynamic Basket - 100%, 0) 100% SPI basket SPI Dynamic Basket Max (SPI Dynamic Basket, 100%) Payoff at maturity: Investor receives higher of 100% Principal invested and SPI Dynamic Basket Return SPI structure SPI structure 6 S   Y   N   T   H   E   T   I   C     P   O   R   T   F   O   L   I   O     I   N   S   U   R   A   N   C   E       (   S   P   I   )
    10. 10. Benefits of SPI 7 S   Y   N   T   H   E   T   I   C     P   O   R   T   F   O   L   I   O     I   N   S   U   R   A   N   C   E       (   S   P   I   ) Capital Protection <ul><ul><li>Participation in underlying while maintaining capital protection. </li></ul></ul>Flexible Underlying <ul><ul><li>Risk-return optimised portfolio can be diversified across fund managers, investment strategies or asset classes </li></ul></ul>Minimum Equity Exposure <ul><ul><li>Prevents the synthetic portfolio from becoming ‘cash-locked’ by setting a minimum proportion of assets that will be held in equity; This allows the portfolio to participate in a market rebound, without affecting the capital guarantee. </li></ul></ul>No External Investment vehicle <ul><ul><li>No requirement to set up purpose built investment vehicle, hence very fast delivery of the product in the market </li></ul></ul>Full Currency Protection <ul><ul><li>Standard CPPI structures can be offered with currency hedging overlays, but these do not offer the same transparency and efficiency as the full quanto protection that the JPMorgan SPI structure offers. </li></ul></ul>Verifiable & Transparent Pay-off <ul><ul><li>Re-balancing of the portfolio can be tracked using market data, on a daily basis. JPMorgan will actively reallocate the notional portfolio according to a ‘Dynamic Allocation Strategy’ in line with the predefined principles. Thus SPI is not a ‘black-box’ fund unit product </li></ul></ul>ISDA Documentation <ul><ul><li>The product is delivered in an efficient OTC format. Exposure may be delivered in Swap or option format or in combination with guaranteed cash-flows traded and confirmed as a regular OTC derivative using standard ISDA format </li></ul></ul>
    11. 11. Proxy Basket SPI Low Equity Barrier Enhanced Notes (LEADs) Equity Based Collateralized Obligations (ECOs) Equity Default Swaps Credit Long Short SPI Synthetic Portfolio Insurance (SPI) 8 1 1 2 8 3 15 4 24 5 28 6 32 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    12. 12. What is a Proxy Basket strategy? <ul><ul><li>The Risky Asset in the Dynamic Basket is a basket of currencies referred to as the “Proxy Basket” </li></ul></ul><ul><ul><li>The strategy synthetically replicates an asset which is constructed using currency pairs denominated vs. JPY </li></ul></ul><ul><ul><li>The weights assigned to currency pairs in the asset are optimized based on historical data in a way that the movements of the currency pairs offset each other </li></ul></ul><ul><ul><li>Assuming optimal offset the basket maintains the same value while earning a high carry based on the interest rate differential of the underlying currency pairs </li></ul></ul><ul><ul><li>JPMorgan believes that there is a low probability of a significant mismatch in the offset of the currency pairs </li></ul></ul>9 P   R   O   X   Y     B   A   S   K   E   T     S   P   I Basket of currencies JPY Offset
    13. 13. Proxy Basket construction <ul><ul><li>JPMorgan believes a basket of foreign currency can be constructed to track the movement of JPY closely </li></ul></ul><ul><ul><li>JPMorgan has performed rigorous analysis to construct the appropriate combination of different currencies to give optimal yield and correlation to JPY appreciation/depreciation </li></ul></ul><ul><ul><li>The weightings are shown in the table on the right as an example of the Synthetic Asset Construction </li></ul></ul><ul><ul><li>The basket is optimized to grow at 5% ¹ carry </li></ul></ul>Overview ¹ Basket-Carry is 5.5%. An embedded fee of 50bp is charged to cover replication costs 10 P   R   O   X   Y     B   A   S   K   E   T     S   P   I
    14. 14. Proxy Basket correlated to JPY High correlation between JPY and basket Source: JPMorgan, as of 4/6/06 Correlation JPY and Basket 11 P   R   O   X   Y     B   A   S   K   E   T     S   P   I
    15. 15. Historical spot price of JPY and Basket equivalent spot Source: JPMorgan, as of 4/6/06 Spot price of JPY and Basket Equivalent spot show very similar movements 12 P   R   O   X   Y     B   A   S   K   E   T     S   P   I
    16. 16. Growth of Proxy Basket via SPI strategy <ul><ul><li>The Proxy Basket grows at the rate of the carry of 5% (assuming there are no tracking errors) </li></ul></ul><ul><ul><li>Out of this growth 2% fee are paid to the client </li></ul></ul><ul><ul><li>The whole structure initially leverages through the CPPI payoff by 270% </li></ul></ul><ul><ul><li>Guaranteed payment of 1% per annum on the notional payable quarterly </li></ul></ul>Mechanics 13 P   R   O   X   Y     B   A   S   K   E   T     S   P   I Carry 5.0% Growth of Proxy Basket Fee paid 2.0% Growth 3.0% 270% Initial leverage 270% Initial leverage Growth 8.1% (Realized at maturity) Annual payout 5.4% Guaranteed 1.0 % payable quarterly
    17. 17. Credit Long-Short – Structure Overview Credit Long-Short Strategy <ul><ul><li>The strategy attempt to achieve a “delta neutral” state and maintain a “convex” return profile, thus making returns relatively neutral to movements in credit spread </li></ul></ul><ul><ul><li>The credit long-short strategy will take exposure to (i) a long Junior Mezzanine CSO Tranche and (ii) a selected short portfolio of single name corporate credit derivatives </li></ul></ul>14 P   R   O   X   Y     B   A   S   K   E   T     S   P   I Single Name Credits Portfolio Mezzanine “ Super Senior” Equity Credit 1 Credit 2 Credit 3 Credit 4 Credit... Actively managed mezzanine CSO tranche Short portfolio CDS A CDS B CDS C CDS X Long tranche Long portfolio
    18. 18. Credit Long Short SPI Low Equity Barrier Enhanced Notes (LEADs) Equity Based Collateralized Obligations (ECOs) Equity Default Swaps Proxy Basket SPI Synthetic Portfolio Insurance (SPI) 15 1 1 2 8 3 15 4 24 5 28 6 31 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    19. 19. Credit Long-Short - Rationale <ul><ul><li>To achieve a convex return profile neutralising movements in credit spreads </li></ul></ul>Continued lack of apparent trend in credit spreads 1 Idiosyncratic risk still high Correlation levels for tranched Junior Mezzanine at historical lows <ul><ul><li>Leveraged and M&A bids </li></ul></ul><ul><ul><li>Oil price and commodity price effects </li></ul></ul><ul><ul><li>Auto sector uncertainty </li></ul></ul>Macro considerations <ul><ul><li>Not take exposure to “first loss” Equity Tranches </li></ul></ul><ul><ul><li>Give short credit exposure to “bearish” names </li></ul></ul><ul><ul><li>Take Junior Mezzanine Tranche exposure to benefit from any correlation increases </li></ul></ul>Strategy 1 Source: JPMorgan, Morgan Markets, M&G as of April 2006 16   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I
    20. 20. Spread risk profile – An illustration Leverage 2 ¹ Spreads move on the 1st day ² Illustrative leverage used in order for the portfolio to remain in a delta neutral state; Tranche leverage of 2.5 times used; CDS portfolio leverage of 9 times the tranche notional used; The chart above shows hypothetical change in MTM (mark-to-market) of a chosen CSO tranche and Single name CDS portfolio and their combination in ”M&G Credit Fund” 17   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I Illustrative sensitivity to instantaneous spread change 1 Illustrative Long Mezzanine tranche—Change in MTM 1 Illustrative short CDS Portfolio—Change in MTM 1
    21. 21. Credit Long-Short – A case study ¹Principal protection provided by AAA rated collateral Short portfolio Prudential M&G Credit SPI overview Actively managed junior mezzanine CSO tranche Credit Fund Principal protection¹ M&G Credit Fund SPI Notes¹ SPI (Synthetic Portfolio Insurance) CDS A CDS B CDS C CDS X Long tranche <ul><ul><li>M&G is the trading name of M&G Investment Management Limited , a wholly owned subsidiary of Prudential plc. M&G has over €2371 billion assets under management and employs over 1481 investment professionals </li></ul></ul><ul><ul><li>M&G Credit Fund SPI Notes will provide investors with principal protected exposure to the M&G Credit Fund (“The Fund”) </li></ul></ul><ul><ul><li>The Fund will take exposure to (i) a long Junior Mezzanine CSO tranche referencing a portfolio of primarily investment grade corporates and (ii) a selected short portfolio of single name corporate credit derivatives </li></ul></ul><ul><ul><li>M&G will attempt to maintain a convex return profile for The Fund, thus making returns relatively neutral to movements in credit spread whilst focusing on idiosyncratic default risk </li></ul></ul><ul><ul><li>The Notes returns will be determined by The Fund’s performance in addition to leverage which will be provided through the application of Synthetic Portfolio Insurance (“SPI”) technology </li></ul></ul>18   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I
    22. 22. Illustrative Fund return profile <ul><ul><li>The net asset value (“NAV”) of The Fund will reflect the mark-to-market of the combination of the long junior mezzanine and short CDS portfolio </li></ul></ul><ul><ul><li>Returns on The Fund will represent a combination of carry and mark-to-market changes </li></ul></ul><ul><ul><li>M&G will manage The Fund within preset limits 6 </li></ul></ul><ul><li>Note: The above analysis shows hypothetical returns based on certain assumptions. </li></ul><ul><ul><li>1 Includes a Delta adjusted execution cost of 2% of the WAS and a 1% administrative cost charged by the swap counterparty </li></ul></ul><ul><ul><li>2 These return results are based on a hypothetical leverage of 2.5 times within The Fund </li></ul></ul><ul><ul><li>3 Implied spreads (as of valuation date March 31, 2006) for a delta hedged 3.5%-5.5% 10Y tranche were used; CDS Portfolio leverage of (22.5) required to maintain delta neutral state </li></ul></ul><ul><ul><li>4 Delta slide represents the change in Mark to Market value as a result of the decrease in the time to maturity; Premium represents the Spread received/paid for selling/buying protection </li></ul></ul><ul><ul><li>5 Assumed to be the 10 year EUR swap rate as of April 2006 </li></ul></ul><ul><ul><li>6 JPMorgan monitors the level of leverage allowed within The Fund by running several scenarios on a daily basis. The process allows the Fund to maximise the exposure to equivalent of a 30% crash size. More detail on the scenarios applied can be given upon request </li></ul></ul><ul><ul><li>Long Junior Mezzanine Tranche 3 </li></ul></ul><ul><ul><ul><li>Delta slide (10Y to 9Y) 4 = 4.7% </li></ul></ul></ul><ul><ul><ul><li>Premium 4 = 11.0% </li></ul></ul></ul><ul><ul><ul><li>Hypothetical carry = 15.7% </li></ul></ul></ul><ul><ul><li>CDS Portfolio 3 </li></ul></ul><ul><ul><ul><li>Delta slide (10Y to 9Y) 4 = 0.20% </li></ul></ul></ul><ul><ul><ul><li>Premium 4 = 0.80% </li></ul></ul></ul><ul><ul><ul><li>Hypothetical carry = 1.00% </li></ul></ul></ul>Fund return assumptions (preliminary strategy) <ul><ul><li>Underlying portfolios </li></ul></ul><ul><ul><ul><li>Long Junior Mezzanine: 10Y WAS = 93bp </li></ul></ul></ul><ul><ul><ul><li>CDS portfolio: 10Y WAS = 87bp </li></ul></ul></ul><ul><ul><li>Tranches </li></ul></ul><ul><ul><ul><li>Long mezzanine attachment = 3.5—5.5% </li></ul></ul></ul>Illustrative calculation of Carry Hypothetical Fund Return computation 2 (1Y) <ul><ul><li>Tranche returns (1Y) </li></ul></ul><ul><ul><li>Long Junior Mezzanine 3 </li></ul></ul><ul><ul><li>CDS Portfolio return 3 </li></ul></ul><ul><ul><li>Operational Costs 1 </li></ul></ul><ul><ul><li>Gross Fund return 1 (A + B+C) 13.0% </li></ul></ul><ul><ul><li>Annual Portfolio Management Fee (1.5)% </li></ul></ul><ul><li>Collateral Spread/yield 5 4.1 % </li></ul><ul><li>Net Fund return 15.6% </li></ul>1 year return Carry x x 2.5 (22.5) 1.0% 15.7% Leverage = = = x 39.0 % (22.5)% (3.5)% 19   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I
    23. 23. Illustrative Fund sensitivity—Single name spread widening Illustrative tranche leverage of 2.5 times used; 1 This is achieved using an average name in the portfolio 2 Graphically represents the MTM effect of a spread increase of 200bp for an average name in the portfolio of the long Junior Mezzanine tranche at the end of the 1st year of trading; The return for the 1st year does not include Management costs 0f 1.5% and Collateral returns Note: The charts above shows hypothetical changes in MTM (mark-to-market) of the NAV of The Fund. Performances can vary significantly depending on the assumptions taken. 20   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I Hypothetical Fund Return—200bp single name spread tweak on Day 1 1 (0.02%) (1.0%) CF MTM change (%) Spreads as % of current spreads Hypothetical Fund Return—200bp single name spread after one year 12 13.0% 11.0% Spreads as % of current spreads CF MTM change (%)
    24. 24. Illustrative Fund sensitivity—Correlation spike Hypothetical CF MTM change v Correlation and spread tweak 1 Spreads as % of current spreads <ul><ul><li>Hypothetical scenarios have been devised to replicate a potential distortion in the correlation market </li></ul></ul><ul><ul><li>Scenario mechanics </li></ul></ul><ul><ul><li>Defining the “15% Correlation tweak” example </li></ul></ul><ul><ul><ul><li>The correlation level for the lower attachment point is shifted to 85% of the current value </li></ul></ul></ul><ul><ul><ul><li>The correlation level for the Upper attachment point is shifted to 115% of the current value </li></ul></ul></ul><ul><ul><li>Defining the “-15% Correlation tweak” example </li></ul></ul><ul><ul><ul><li>The correlation level for the lower attachment point is shifted to 115% of the current value </li></ul></ul></ul><ul><ul><ul><li>The correlation level for the Upper attachment point is shifted to 85% of the current value </li></ul></ul></ul><ul><ul><li>Spread levels for the entire portfolio are proportionately shifted to generate the convex return structure </li></ul></ul><ul><li>¹ The MTM effects are consistent with a Gross Fund return where the Tranche leverage is 2.5 </li></ul><ul><ul><li>Note: The charts above shows hypothetical changes in MTM (mark-to-market) of the NAV of The Fund. Performances can vary significantly depending on the assumptions taken. </li></ul></ul>21   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I
    25. 25. Illustrative 10yr SPI Coupon format sensitivity EUR Note IRRs for given fund return Hypothetical IRRs—EUR Notes USD Note IRRs for given fund return Hypothetical IRRs—USD Notes <ul><ul><li>1 Hypothetical Fund returns on an annual basis, assumed to be constant through the life of the trade. </li></ul></ul><ul><ul><li>2 Hypothetical IRR for SPI Notes. Gross IRR before considering 1% Principal protection fee; Net IRR after considering 1% Principal protection fee. Quanto adjustment are included in the calculation of both Gross and Net Note IRRs. Performances can vary significantly depending on the assumptions taken. </li></ul></ul>22   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I
    26. 26. Equity Default Swaps: How does it work? Equity Default Swaps Credit Default Swaps Risk Reference entity Protection buyer Fee/premium Protection seller Contingent payment on Default (losses) <ul><ul><li>A credit default swap is essentially a guarantee whereby the protection buyer transfers the risk that the reference entity will be subject to a credit default event </li></ul></ul><ul><ul><li>In return for the protection, the buyer pays a protection fee to the seller (in a similar manner to an insurance premium or guarantee fee) </li></ul></ul><ul><ul><li>On a credit default event , the buyer delivers a portfolio of obligations of the reference entity, and receives par (or settles a net cash amount) </li></ul></ul><ul><ul><li>A credit default event is defined as one of the following: bankruptcy , failure to pay , restructuring </li></ul></ul><ul><ul><li>It is market practice to agree on a physical delivery of a reference security </li></ul></ul>Risk Reference stock Protection buyer Fee/premium Protection seller Contingent payment on Equity Default Event <ul><ul><li>An equity default swap is a contract whereby the protection buyer transfers the risk that a reference stock will be subject to an equity default event </li></ul></ul><ul><ul><li>In return for protection, the protection buyer pays a per annum fee to the protection seller </li></ul></ul><ul><ul><li>On an equity default event , the protection seller pays a recovery value to the protection buyer. the swap is settled and there are no further cashflows </li></ul></ul><ul><ul><li>An equity default event occurs if the closing price of the reference stock is at or below 30% of its value at inception </li></ul></ul><ul><ul><li>It is market practice to fix the recovery value at 50% of the notional amount </li></ul></ul>23   C   R   E   D   I   T     L   O   N   G     S   H   O   R   T     S   P   I
    27. 27. Equity Default Swaps Low Equity Barrier Enhanced Notes (LEADs) Equity Based Collateralized Obligations (ECOs) Credit Long Short SPI Proxy Basket SPI Synthetic Portfolio Insurance (SPI) 24 1 1 2 8 3 15 4 24 5 28 6 31 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    28. 28. Equity Default Swaps: How does it work? Credit default event and equity default event <ul><ul><li>The equity default event is very transparent, as it is based on the closing share price of the reference name and whether it is at or below 30% of the share price at EDS inception </li></ul></ul><ul><ul><li>Similar to ‘traditional’ credit derivatives, where the occurrence of a credit default event will trigger a payment from the protection seller to the protection buyer </li></ul></ul><ul><ul><li>For traditional credit derivatives, the credit default event is normally defined as the occurrence of either: </li></ul></ul><ul><ul><ul><li>Bankruptcy </li></ul></ul></ul><ul><ul><ul><li>Failure to pay </li></ul></ul></ul><ul><ul><ul><li>Restructuring </li></ul></ul></ul><ul><ul><li>Due to the complexity of definition, it is sometimes difficult to determine whether a credit default event has occurred or not </li></ul></ul>25 E   Q   U   I   T   Y     D   E   F   A   U   L   T     S   W   A   P   S   Barrier (354 x 0.30) = 106.2 Swissair [Bloomberg: SRN VX] Equity default event at 104.5 (23 April 2001) Inception at 354 (3 May 1999) Bankruptcy filed 2 October 2001
    29. 29. Equity Default Swaps: How does It Work? EDS Cashflows—No Equity Default Event EDS Cashflows—Equity Default Event Protection Seller receives Protection Seller pays 3 m 6 m 9 m 1 Y 2 Y 3 Y 4 Y 5 Y EDS Spread Accrued up to the Equity Default Date Equity Default Event 1-Recovery Value=50% Protection seller receives Protection seller pays 3 m 6 m 9 m 1 Y 2 Y 3 Y 4 Y 5 Y EDS Spread: Paid quarterly in arrears EDS of 500bp p.a. 125bp per quarter 26 E   Q   U   I   T   Y     D   E   F   A   U   L   T     S   W   A   P   S  
    30. 30. <ul><li>Investor Sells equity protection on an ECO tranche referencing a number of equities </li></ul><ul><li>JPM risk-manages through entering into a number of Equity Default Swaps in the market to offset </li></ul><ul><li>Losses are allocated bottom-up as per tranche seniority i.e. First Loss to Mezzanine to Senior tranche </li></ul><ul><li>The events observed are Equity Default Events </li></ul>Equity based collateralised obligations—ECOs The mechanics of ECO Super-senior Mezzanine First loss risk JPMorgan SPV Tranched risk Equity Default Risk Stock 1 Stock 2 Stock 3 Stock ... Stock n-2 Stock n-1 Stock n ECOs 27 E   Q   U   I   T   Y     D   E   F   A   U   L   T     S   W   A   P   S  
    31. 31. Equity Based Collateralized Obligations (ECOs) Low Equity Barrier Enhanced Notes (LEADs) Equity Default Swaps Credit Long Short SPI Proxy Basket SPI Synthetic Portfolio Insurance (SPI) 28 1 1 2 8 3 15 4 24 5 28 6 31 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    32. 32. ECO—impacts of defaults on coupon and capital redemption <ul><li>Assumptions: </li></ul><ul><ul><li>Maturity: 5 years </li></ul></ul><ul><ul><li>Portfolio: Globally Diversified Basket </li></ul></ul><ul><ul><li>Quarterly Coupons </li></ul></ul><ul><ul><li>EDS portfolio of e.g. 100 names </li></ul></ul><ul><ul><li>Recovery rate assumed to be 50% </li></ul></ul><ul><ul><li>This example is for illustrative purposes only and does not reflect real pricing </li></ul></ul>Mechanisms of ECO’s 0% 5% 10% 100% Coupon paid quarterly as a % of the headline coupon 10080% 20% 60% 40% Number of Defaults 29   E   Q   U   I   T   Y     B   A   S   E   D     C   O   L   L   A   T   E   R   A   L   I   Z   E   D     O   B   L   I   G   A   T   I   O   N   S     (   E   C   O   S   ) Senior Tranche Mezzanine ECO First Loss Tranche 1 2 3 9 4 5 6 7 8 Capital Redemption at Maturity 100% 80% 20% 60% 40% 10 or more Number of Defaults
    33. 33. Comparison of CDOs and ECOs Comparison of ECOs v. CDOs 30   E   Q   U   I   T   Y     B   A   S   E   D     C   O   L   L   A   T   E   R   A   L   I   Z   E   D     O   B   L   I   G   A   T   I   O   N   S     (   E   C   O   S   )
    34. 34. Low Equity Barrier Enhanced Notes (LEADs) Equity Based Collateralized Obligations (ECOs) Equity Default Swaps Credit Long Short SPI Proxy Basket SPI Synthetic Portfolio Insurance (SPI) 31 1 1 2 8 3 15 4 24 5 28 6 31 T   H   E     J   O   I   N   T     1   4   T   H     A   N   N   U   A   L     P   B   F   E   A     A   N   D     2   0   0   6     A   N   N   U   A   L     F   E   A   T     C   O   N   F   E   R   E   N   C   E  
    35. 35. The concept of First-to-default The First to default out of the basket causes the swap to terminate, and the protection seller pays: (1-Recovery Rate) * Notional Amount First-to-default swap N to default swap The N default out of the basket causes the swap to terminate, and the protection seller pays: (1-Recovery Rate) * Notional Amount 1) Stock C defaults: swap terminates 2) Stock D defaults: no impact 3) Stock E defaults: no impact 1) Stock C defaults: no impact 2) Stock D defaults: no impact 3) Stock E defaults: swap terminates NB: this structure is often referred to as a “First-to-Default Swap” even though it is technically an “N to default swap” 32 L   O   W     E   Q   U   I   T   Y     B   A   R   R   I   E   R     E   N   H   A   N   C   E   D     N   O   T   E   S     (   L   E   A   D   S   )   Protection Seller receives Protection Seller pays 3m 6m 9m 1Y 2 Y 3 Y 4 Y 5 Y EDS Spread Accrued up to the Equity Default Date 1-Recovery Value=50% A C B D F First to default basket: E Protection Seller receives Protection Seller pays 3m 6m 9m 1Y 2 Y 3 Y 4 Y 5 Y EDS Spread Accrued up to the Equity Default Date 1-Recovery Value=50% A C B D F N to default basket ( N = 2) E
    36. 36. Low Equity Barrier Enhanced Notes - LEADs LEADs Indicative Terms <ul><li>First-to-default Equity swaps can be structured in a capital protected format </li></ul><ul><li>A LEADs ( L ow E quity B a rrier Enhance d Note s ) is a capital protected note, where the coupon depends on the number of Equity Default Events during the life of the note </li></ul><ul><li>At each coupon payment date, the number of Equity Default Events that have occurred so far is calculated </li></ul><ul><li>After an initial threshold, the coupon will be reduced for every additional Equity Default Event in accordance to a specified schedule </li></ul><ul><li>An Equity Default Event is triggered, if at any date, one of the underlying shares is trading below 30% of it’s level at inception </li></ul>Maturity: 5 years Coupon: X% subject to EDE paid semi-annually Principal protection: 100% 33 L   O   W     E   Q   U   I   T   Y     B   A   R   R   I   E   R     E   N   H   A   N   C   E   D     N   O   T   E   S     (   L   E   A   D   S   )   Note buyer receives Note buyer pays 6m 1Y 2 Y 3 Y 4 Y 5 Y 100% Notional paid on Start Date 100% Notional re-paid at Maturity + Final Coupon Equity Event 1 Equity Event 2

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