See Disclosure Appendix A1 for the Analyst Certification and Other Disclosures

April 21, 2006

Correlation Trading Strategies

Jure Skarabot Credit Derivatives Strategy Citigroup 212-816-5728 [email protected]

Credit Derivatives Strategy

Outline Structured Credit Markets Investors: Hedge Funds versus Real Money Correlation Trading Outlook for Structured Credit Products

2

Structured Credit Markets are Evolving Cash markets

u

Cash CDO market has grown by 84% from 2004 to 2005.

Data as of Mar 2006

160

84.6

80

u

50 40 29.3 20.1

20

16.7

14.5 13.1

10

2.3

3.5

0 ABS

CLO

US

4.7 0.0 CRE

4.6 1.5 Others

53.2

40.6

40

25.3

12.6

10.7

1Q 04

2Q 04

0

2005 Issuance 2006 YTD Issuance Visible Pipeline

57.8

149.2

Index Tranches

120

75.3

60

$ Billions

Source: CreditFlux 168.1

Strong issuance in 2005 and robust pipeline.

70

30

Index-linked tranche market is expanding. 200

Source: Citigroup 80

u

IndexTranches($Billion)

u

2005 global cash CDO issuance was $202 billion.

4.3 0.4 3.7

3.8

ABS

CLO EUROPE

2.6

5.8

2.6 0.0

Others

3Q 04

4Q 04

1Q 05

2Q 05

3Q 05

4Q 05

Bespoke tranche market is holding steady. Portfolio Credit Swaps ($ Billion)

u

Synthetic markets

2000

1831.5

Source: CreditFlux

1500 948.9

1000 500

280.6

196.3

125.3

294.3

0 2002

* doesn't include index tranches

2003

Notional

2004*

Risk distributed

2005*

3

Investors: Hedge Funds versus Real Money Hedge Funds Real Money

4

Hedge Funds Credit hedge funds are driving the development and growth u

Credit derivatives products have been primarily in the domain of hedge funds and proprietary desks.

u

Credit hedge funds have been expanding, searching for new relative value opportunities and opportunistic trades.

u

Volatility increase in credit markets is opening the door for new strategies, although credit hedge funds are exposed to margin calls.

u

Standardization and acceptance of credit portfolio models has been one of the main drivers of market growth, although current portfolio models have certain shortfalls.

u

Correlation players are looking for opportunities in cash CDOs and other asset classes.

u

Fundamental credit analysis is becoming important for hedge funds. 5

Real Money Real-money investors are entering the credit derivatives markets u

Real-money investors have started to focus on synthetic structured credit portfolio products.

u

Narrow spreads and low volatility pushed investors to seek alternatives to traditional credit investments and to start focusing on single-tranches, CDO-squareds, and leveraged supersenior structures.

u

Traditional investors started to use tranches to customize their directional views.

u

Real-money accounts have been setting up internal “long/short” funds to explore “hedge fund – like” strategies with credit derivatives.

u

Money managers have started to invest and to manage synthetic transactions.

u

Mark-to-market accounting rules and regulations are one of the main roadblocks for real money investors, although FAS 155 should bring changes. 6

Correlation Trading Investment Strategies The “Famous” Long/Short Tranche Trade Directional and Relative Value Trades

7

Investment Strategies Credit derivatives markets provide variety of investment opportunities u

Taking long/short market positions: •

u

Leverage strategies: •

u

Taking views on different types of risk (defaults, spreads changes, correlation…)

Relative value strategies: •

u

Enhancing yield through the leverage provided by synthetic tranche products and cash CDOs.

Directional strategies: •

u

Liquid tools to quickly express long or short macro views in credit markets.

Searching for value between different tranches, credit curves, correlation and volatilities.

Hedging strategies: •

Hedging individual default risk and/or market spread risk, minimize mark-to-market volatility. 8

The “Famous” Tranche Trade Long equity tranche, short mezzanine tranche u

With the growth of synthetic tranche markets, hedge funds took large portion of the first-loss tranche risk from dealers.

u

In 2004, many investors were comfortable holding default risk, but nervous about spread selloff.

u

Common strategy to hedge against the spread risk was to to buy the protection on mezzanine/senior tranches (which carry proportionally more spread risk than default risk versus the equity tranches).

u

May 2005 turmoil in the tranche markets sparked by the GM/Ford downgrade was a painful lesson for number of market players that implemented this strategy.

9

What Went Wrong? Equity and senior tranches reacted differently to single-name shocks u

Single-name shocks and the sell-off in the equity part hurt mark-to-market investors.

u

Mezzanine/senior tranche didn’t widen as buy-and-hold investors held their positions.

0%-3% Tranche vs. Index

55

75 5Y CDX (right)

100

7%–10% (left)

80

90

5Y CDX (right)

75

70

50

65

45

60

40

55

35

50

30

45

25 40 3 Jan 05 2 Feb 05 4 Mar 05 5 Apr 05 4 May 05 6 Jun 05

70 80 Spread (bp)

Points Upfront (%)

60

80

65

70

60 55

60

Spread (bp)

0%–3% (left)

Spread (bp)

65

7%-10% Tranche vs. Index

50 50

45

40 40 3 Jan 05 2 Feb 05 4 Mar 05 5 Apr 05 4 May 05 6 Jun 05 Source: Citigroup

10

Tranche Strategies Directional and relative value trades u

Long the equity risk

u

Directional view on a sector

u

Dispersion tranche trades

u

Cost-efficient shorts

u

Tranche flatteners

u

Relative value between indexes

u

Tranche steepeners

u

Default-straddle tranche trades

u

“January effect” trade

u

Tranches versus swaptions

11

Aftermath of May 2005 Bottom fishing in trade markets – long equity u

Effect of GM/Ford downgrade and the turmoil in tranche markets led to new investment opportunities.

u

At the peak, five-year IG CDX equity tranche was cheap on a fundamental basis (trading above 60 points upfront).

u

Bullish investors, who were able to move in quickly, were able to make a significant profit on the back of price adjustment. IG CDX4 Index

0%-3% IG CDX4

65 60

IG CDX4 Index (bps)

75

55 65

50

55

45 40

45

35 35

Source: Citigroup

25 3/21/05

30

0%-3% IG CDX4 Tranche (points)

85

25 6/21/05

9/21/05

12/21/05

3/21/06

Trade recommendation: “Bottom Fishing in Tranche Markets,” Arvind Rajan, Jure Skarabot Ji Hoon Ryu, Leverage, Citigroup, May 11, 2005. Trade unwind recommendation: “Unwind the Long Position in 0%-3% IG CDX Five-Year Tranche,” Arvind Rajan, Jure Skarabot Ji Hoon Ryu, Citigroup, Jun 22, 2005.

12

Dispersion Tranche Trades Directional trade after the index roll u

At the last index roll we recommended buying protection on the 3%-7% seven-year IG CDX 5 tranche and selling protection on the 10%-15% seven-year IG CDX 5 tranche (delta-neutral position) in addition to neutralizing the spread exposure to two widest credits in IG CDX 5.

u

The Sep 2005 roll improved overall IG CDX credit quality, but blow-up risk has remained as some of the new names in the index appear to have considerable LBO risk.

u

Dispersion trade position with seven-year IG CDX 5 tranches generated substantially smaller cost than the same trade with IG CDX 4 tranches.

Dispersion Trade, Seven-Year IG CDX Series 5

Buy protection on 3%-7% Sell protection on 10%-15%

10 75

Spread Delta/ Carry ($000) (bp) Hedge Ratio

252 28

9 1.2

Net (tranches)

(252) 210 (42)

Sell protection on American Axle Sell protection on Albertsons Net (tranches and single-name)

0.35 0.28

365 320

0.035 0.028

12.6 9.0 (20.4)

IG CDX 5

25 Spread Premium (bp)

Notional ($ Million)

50

0 -25 -50 -75

-100 -125 -150 11 Jul 05

IG CDX 4 4 Aug 05

28 Aug 05

21 Sep 05

Source: Citigroup Trade recommendation: ‘Dispersion Trades After the Index Roll,’ Jure Skarabot Gaurav Bansal, Leverage, Citigroup, Sep. 21, 2005. Trade unwind recommendation: ‘Unwind Tranche Dispersion Trade,’Jure Skarabot Gaurav Bansal, Citigroup, Oct 7, 2005.

13

Tranche Flatteners Go long ten-year mezz, hedge with the five-year u

Tranche flatteners have been some of the most popular trades in the correlation markets, mostly driven by the technical factors.

u

At the time of trade recommendation, the 5s/10s IG CDX curve stayed unchanged, long-term tranche has initially tightened and later widened, while the five-year has stayed unchanged.

u

Such dislocations are usually associated with variation in the synthetic pipeline across maturities and related dealers hedging needs. 104

7-10 (left)

80

5Y CDX (right)

75

94

70 84

65 60

74

105 100

260

95

7-10 (left) 10Y CDX (right)

240

90 85

220

80 200

75

55

64

50 54 44

3 Jan 05 2 Feb 05 Source: Citigroup

280

4 Mar 05

5 Apr 05

4 May 05

70

180

45

160

40

140 3 Jan 05

65 60 55 2 Feb 05

4 Mar 05

5 Apr 05

4 May 05

Trade recommendation: “Sell Protection on the 7%-10% Ten-Year IG CDX, Hedge with the Five-Year,” Jure Skarabot Ji Hoon Ryu, Leverage, Citigroup, May 25, 2005. Trade unwind recommendation: “Unwind 5s/10s 7%-10% IG CDX Tranche Trade,” Jure Skarabot, Ji Hoon Ryu, Citigroup, Oct 7, 2005.

14

Opposite View: Tranche Steepener 5s/10s mezzanine tranche trade u

Technicals (anticipated synthetic pipeline and correlation positions of dealers and leveraged accounts) has been one of the the key drivers in index-tranche space in the recent past.

u

Ten-year 7%-10% IG CDX tranche has been trading on top of five-year 3%-7% IG CDX tranche as the market was expecting stronger hedging needs in the longer-term maturity.

u

At the time of trade recommendation, the new synthetic issuance has been less than anticipated and to capture that view we have recommend to sell protection on the five-year 3%-7% IG CDX tranche and buy protection on the same notional of the ten-year 7%-10% IG CDX tranche. 3%–7% Five-Yr IG CDX

40 20

250

0 200

-20

150

-40 -60

100

-80

50

Source: Citigroup

21 Mar 05

Tranche Spread Difference (bps)

Tranche Spread (bps)

300

5s/10s Difference 7%–10% 10-Yr IG CDX

-100 21 May 05

21 Jul 05

Trade recommendation: “5s/10s Mezzanine Tranche Trade,” Jure Skarabot, Leverage, Citigroup, Aug. 10, 2005 Trade unwind recommendation: “Unwind 5s/10s Mezzanine Tranche Trade,” Jure Skarabot Gaurav Bansal, Citigroup, Aug 30, 2005.

15

Anticipated Demand For Risk Position to benefit from the “January effect” In an anticipation of the possible “January effect” in the tranche markets, we recommended to sell protection on equity tranche and delta-hedge it with the index.

u

This trade recommendation was based on the anticipation that after the start of the new year, leveraged accounts in credit space will be looking for positive-carry, high-yield strategies.

u

The equity tranche has moved in direction we predicted, but the negative carry eliminated most of the profits after taking the bid/ask costs into the account. 0%-3% IG CDX 5YR Correlation

90 80 70 60 50 40 30 20 10 0 Nov-03 Mar-04

25% 20% 15% 10% 5% 0% Aug-04 Dec-04

Apr-05

Sep-05

Long 0%-3% 5YR, Short IG CDX 5YR

Net Payments (%)

IG CDX 5YR

0%-3% IG CDX 5YR Corr. (%)

IG CDX 5YR (bps)

u

14 12 10 8 6 4

14 Nov 05

y = 3E-14x + 5.5463

2 0 30

40

50

60

70

80

90

IG CDX 5YR (bp)

Source: Citigroup Trade recommendation: “Position for a January Effect in the Tranche Markets,” Jure Skarabot, Gaurav Bansal, Leverage, Citigroup, Nov. 16, 2005 Trade unwind recommendation: N/A

16

Directional View on Auto Sector Short auto names with zero-carry u

For investors who want to express bearish views on the auto sector while avoiding the cost of an outright short, we recommended buying protection on IG CDX4 equity tranche and selling protection on IG CDX5 equity tranche.

u

This trade had low exposure to the market-wide spread and correlation risks and it should benefit if auto sector spreads blow up.

u

Soon after the recommendation, IG CDX5 tranches have rallied, but IG CDX4 equity tranche has lagged behind.

Source: Citigroup

CDX4/CDX5 Index Diff

GMAC

7.00

600

6.00

500

5.00

400

4.00 300

3.00 2.00

200

1.00 11/1/2005

100 12/1/2005

1/1/2006

Spread(bps)

0%-3% Tranche Diff.(%)/Index Diff.(bps)

CDX4/CDX5 0%-3% Diff

2/1/2006

Trade recommendation: “How to Short Auto Names Through a Zero-Carry Trade,” Jure Skarabot, Gaurav Bansal, Citigroup, Feb. 9 , 2006 Trade unwind recommendation: “Unwind the CDX4/CDX5 Equity Tranche Trade,” Jure Skarabot Gaurav Bansal, Citigroup, Feb. 24, 2006

17

Cost-Efficient Short in HY Short HY CDX through a carry-neutral trade u

For investors who are looking for cost-efficient shorting strategies in HY, we recommended buying protection on the HY CDX 15%-25% tranche and selling protection on the HY CDX index in an amount to create a carry-neutral trade.

u

The trade should benefit if high yield spreads widen: The 15%-25% HY CDX tranche has higher sensitivity to the spread moves than the HY CDX index.

u

The key risk in the trade is the exposure to a further rally in high yield. Also, after the roll ofthe-run tranches could drop in liquidity. 400 380

500

HY CDX Index (bps)

15%-25% HY CDX (bps)

600

15%-25% HY CDX

360 450

340 400 350 12/1/2005

Source: Citigroup

320 300 1/1/2006

2/1/2006

15%-25% HY CDX (bps)

HY CDX Index 550

y = 1.8687x - 182.04 R 2 = 0.8497

550 500 450 400

Feb 21, 06

350 320

340

360

380

400

HY CDX Index (bps) Trade recommendation: “Short HY CDX Through a Carry-Neutral Trade,” Jure Skarabot, Gaurav Bansal, Citigroup, Feb 21, 2006 Trade unwind recommendation: N/A

18

iTraxx Versus CDX Tranches Relative value between different indexes u

Hedging activity led ten-year CDX and iTraxx mezz tranches to diverge.

u

We recommended buying protection on ten-year 7%-10% IG CDX and selling protection on ten-year 6%-9% iTraxx.

u

Main risk is the difference in portfolios and the continuation of the technical pressure. 150 7-10% CDX

140 130 120 110 100 90

6-9% iTraxx

80

Source: Citigroup

70 23-Sep

28-Oct

02-Dec

06-Jan

10-Feb

17-Mar

21-Apr

Trade recommendation: “Long/Short iTraxx vs CDX 10yr Mezz Before the Roll,” Olivier Renault, Citigroup, Mar. 8, 2006 Trade unwind recommendation: N/A

19

Default Straddle Tranche Trade Another take on tranche flatteners u

A combination of mezzanine tranches creates straddle-like trades on the range of cumulative defaults.

u

Buying protection on the five-year 3%-7% and selling protection on the ten-year 3%-7% IG CDX tranche leads to positive-carry trade with a further payoff if realized default rate falls outside selected range. Sell Protection on 3%–7% IG CDX Ten-Year, Buy Protection on 3%–7% IG CDX Five-Year on $10 Million Equal Notional. Spread Unchanged (Left Panel), 50bp Parallel Spread Widening (Right Panel) Instantaneous Defaults Happen

4

Now 2Y 4Y

1Y 3Y 5Y

3 2 1 0

-1 -2 0.0%

Source: Citigroup

1.6%

3.2% 4.8% Loss on Portfolio

6.4%

4 P&L at the end of 5Y ($MM)

P&L at the end of 5Y ($MM)

5

3

Instantaneous Defaults Happen

Now 2Y 4Y

1Y 3Y 5Y

2 1 0 -1 -2 -3 0.0% 0.8% 1.6% 2.4% 3.2% 4.0% 4.8% 5.6% 6.4% 7.2% Loss on Portfolio

Trade recommendation: Straddle Trades on Defaults, Ji Hoon Ryu, Jure Skarabot, Leverage, Citigroup, Jun 29, 2005 Trade unwind recommendation: N/A

20

Tranches Versus Swaptions Buy HiVol payers to hedge equity tranches u

Equity tranches were relatively cheap (low correlation) and vol is cheap (low vol).

u

We recommended selling protection on the 0%-% five-year iTraxx tranche and delta-hedge it with three-month HiVol payers.

u

Features of the trade: positive theta, gain in case of spread tightening, profit if default in HiVol. Also, the drop in correlation should be offset by rise in vol. 70%

Equity 5Yrs iTraxx Base Correlation

58%

20

16

45% 12

33% Hivol implied Volatility Source: Citigroup

20%

8 28-Jul-05

26-Sep-05 22-Nov-05 23-Jan-06

21-Mar-06

Trade recommendation: Option Trades, Matt King et. al., Total Credit, Citigroup, Mar 24 2006 Trade unwind recommendation: N/A

21

Outlook and Key Challenges for Structured Credit Markets Opportunities in Structured Credit Markets What We Expect In the Future?

22

Opportunities in Structured Credit Markets State of the credit markets

Convergence of synthetics and cash

u

Tight credit spreads, but increased singlename and sector specific volatility

u

Synthetic forms of traditional cash products (CLOs, CDOs of ABS)

u

Defaults rates low, but increasing leverage in sub-prime sectors

u

Cash CDO elements in synthetic structures

u

Micro and macro risks

u

u

Technicals in correlation markets and the role of synthetic pipeline

Can you trade correlation in cash CDO markets? Can you hedge cash deals with syntehtics?

Looking beyond the primary assets

Low-cost market shorts

u

Leveraged loans: CLOs, CDS referencing secured loans

u

Buying protection on indexes and senior tranches

u

CDOs backed by alternative asset classes

u

Buying “cheap” mezz protection

u

Single-name CDS, ABX and CMBX indexes

u

Zero-carry shorts with tranches

u

Zero-cost shorts with option (buy ATM payer and sell multiple OTM receivers) 23

What We Expect In the Future? Development and changes in correlation markets u

Strong technicals continue.

u

Traditional correlation investors less active, but strong interest from the new type of investors.

u

Relative value trading of correlation skews less common, majority of investors look of opportunistic trades.

u

Did the models fail? What is the future of correlation trading?

u

What trades do we like?

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Disclaimer Disclosure Appendix A1 ANALYST CERTIFICATION I, Jure Skarabot, hereby certify that all of the views expressed in this research report accurately reflect my personal views about any and all of the subject issuer(s) or securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or views in this report.

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