1.What are credit default swaps (CDS)?

Credit default swaps are bilaterally negotiated agreements that transfer credit risk of a reference entity or obligation from a protection buyer to a protection seller.  The swaps are typically priced as a yield spread over the corresponding interest rate swap rate.  The protection buyer pays the protection seller a premium based upon the yield spread.  If a credit event occurs, the protection seller pays the settlement amount.  In the case of physical settlement, the protection buyer delivers the deliverable obligation to the protection seller.

Example:

Investor ABC owns $10 million face value of notes issued by Company XYZ.  Investor ABC wants to hedge the credit exposure on this asset position by buying protection with a five-year CDS.  Suppose five-year CDS spreads referencing Company XYZ are quoted at 0.5% (i.e., 50 basis points) per annum.  Dealer DEF offers to sell Investor ABC $10 million of protection on Company XYZ in a five-year CDS at a price (or premium) of 50 basis points.  Investor ABC, the protection buyer, agrees to pay $50,000 each year for five years to Dealer DEF.

If Company XYZ suffers no credit events, such as bankruptcy, during the term of the contract, then Dealer DEF keeps the annual premium payments that it has collected from Investor ABC and, at the end of five-years, the contract expires. Suppose instead that Company XYZ experiences a credit event:

•  If the CDS contract calls for physical delivery, then Dealer DEF must pay $10 million cash to Investor ABC.  Investor ABC will deliver $10 million face value of XYZ debt securities to Dealer DEF.
  
• If the CDS calls for cash settlement, then Dealer DEF will pay Investor ABC the difference between the face value and the market value of XYZ debt securities.  If, for example, XYZ debt securities are valued 60 percent of face value following the credit event, then Dealer DEF will pay $4 million to investor ABC (i.e., the difference between $10 million face value and $6 million market value).

2.What are the current trends in the credit derivatives market that prompted the CBOT to list a futures contract on a CDS index?

The credit derivatives market has been one of the fastest growing markets over the last two years.  According to the British Bankers Association (BBA) 2006 Credit Derivatives Survey, the global credit derivatives market has grown from $5 trillion notional outstanding in 2004 to $26 trillion in 2006, and it is projected to grow to $33 trillion by 2008.  The largest contributor to this growth has been CDS index trading, which accounts for at least 30 percent of the credit derivatives volume in the over-the-counter (OTC) market.  The survey further indicates that 59 percent of CDS transactions are investment grade. The CBOT CDR Liquid 50 NAIG Index futures contract presents an opportunity for the CBOT to facilitate the growth of the CDS market.

3.Who are the primary users of credit derivatives?

Banks, hedge funds, and insurance companies are the largest users of credit derivatives.  According to the BBA 2006 Credit Derivatives Survey:

• Hedge funds’ share of credit derivatives volume has nearly doubled over the last two years.
  
• Approximately two-thirds of banks’ credit derivatives volume is attributable to trading, and the other one-third is related to their loan book.
  
• Insurance companies tend to be protection sellers.

4.Who is Credit Derivatives Research LLC (CDR)?

CDR is a leading developer and tracker of credit market indicators for use in identifying market opportunities and trading strategies.  CDR provides independent trading ideas and research for active and new participants in the credit derivatives market.

5.What is the CDR Liquid 50^TM North American Investment Grade Index (NAIG), and why was it selected as the underlying index?

The CDR Liquid 50^TM NAIG is an average of the five-year CDS spreads of the 50 most liquid investment-grade names in the North American CDS market.  The CBOT chose this index due to the many benefits it offers relative to the comparable OTC CDS indices:

• Construction -- The CDR Liquid 50 NAIG has a transparent, unbiased selection process based upon liquidity.
• Composition – The CDR Liquid 50 NAIG has a larger representation of financials based upon the construction criteria.
• Frequency of Reconstitution -- CDR Liquid 50 NAIG rolls every three months.

6. What are the key benefits of CBOT CDR Liquid 50 NAIG Index futures?

The CBOT CDR Liquid 50 NAIG Index futures contract provides a transparent investment grade benchmark that can be traded in a centralized marketplace with substantial reductions in counterparty and operational risk. In addition, an exchange cleared product brings new participants to the marketplace by removing the need for ISDA (International Swaps Dealers Association), which are required to trade OTC products.

7.What is the notional protection implied by the CDR Liquid 50 NAIG?

The notional protection currently implied by the CDR Liquid 50 NAIG is slightly more than $1 million.

8.How is the CBOT CDR Liquid 50 NAIG Indexfutures contract quoted? How is this different from the manner in which CBOT Treasury and Interest Rate Swap futures trade?

The CBOT CDR Liquid 50 NAIG Index futures contract trades as a yield spread, expressed in basis points, whereas CBOT Treasury and Swap futures are quoted in price terms.

9.What is the value of a one basis point change in the futures contract? What is the minimum price increment?

The dollar value of a one basis point change in the price of the futures contract is $500.  The minimum price increment (tick size) is 1/100^th (0.01) of a basis point, and each tick (or minimum price increment) has a value of $5.

10.How are the final settlement prices determined?

The final settlement prices of the CBOT CDR Liquid 50 NAIG Index futures are calculated by referencing five-year CDS prices of the index components.  The price data is provided by CMA through CMA DataVision™.  The price of the underlying CDR Liquid 50 NAIG Index is the sum of the products of each index component weight and the corresponding index component spread.  At the time of index composition, the number of index components is fifty (50) and each index component weight is 2%.  The settlement price of the CBOT CDR Liquid 50 NAIG Index futures is rounded to the nearest one one-hundredth (1/100) of one basis point, with half-hundredths rounded up to the nearest hundredth of one basis point.

11.Who is CMA and what is CMA DataVision™? 

CMA pioneers ways to increase the efficiency of OTC credit market professionals. CMA’s real-time pricing services (CMA QuoteVision™) and data (CMA DataVision™) are used by investment professionals in over 130 leading Investment Banks, Hedge Funds and Asset Managers worldwide to improve trading performance and provide valuable information not only for the front-office but also risk, finance and research groups.

CMA DataVision™ provides same day consensus based pricing for CDS, Indices and Tranches (with historical data from 2002).  DataVision is sourced from CMA’s Buy-Side Data Consortium of 30 leading buy-side firms who continuously provide average CDS spreads based on indicative observed quotes. It is available to more than 250,000 users around the world via the Bloomberg Professional^® service.

12.Will there be market makers for CBOT CDR Liquid 50 NAIG Index futures?

Yes, the CBOT will institute a liquidity provision program to support the launch and growth of CBOT CDR Liquid 50 NAIG Index futures.

13.Is off-exchange trading available for CBOT CDR Liquid 50 NAIG Index futures?

Yes, CBOT CDR Liquid 50 NAIG Index futures are eligible for Exchange for Physical (EFP), Exchange for Swap (EFS), and Exchange for Risk (EFR) trades.  In addition, wholesale transactions are available in amounts greater than 100 contracts (i.e., approximately $100 million notional value). This allows market participants to negotiate trades in an OTC environment with the streamlined clearing and operational efficiencies of an exchange-traded contract.

Please view full PDF below.

 - CDR Liquid 50 NAIG Index Futures FAQs - 06.19.2007