2. The drivers of simple credit derivative strategies: Who's afraid of the big bad wolf? 1 March 2007 Richard Hodges-Associate Director, Fixed Income

3. Agenda  What is a Credit Default Swap?  Risk Characteristics of Protection Strategies  Dynamic Process in action  The next level  Calling the beginning of the end?

4. What is a Credit Default Swap? Protection Seller Protection Buyer Regular Fixed Premium Zero Protection Seller Protection Buyer Deliverable Obligation Notional Amount Fixed Payments cease A bilateral contractual obligation between two parties which can be thought of as an insurance policy on a risky asset In the case of default, the holder (buyer) of protection delivers an underlying obligation (bond) to the Seller and in turn receives par value of the asset (notional amount) What value do they have in modern portfolio management? Transferral of Risk

5. Risk Characteristics of Protection Strategies  Same as buying a corporate bond  Similar cashflow in the event of default  Allows the manager to create a synthetic bond where none exists at the preferred point of investment SELL BUY  Short Exposure whilst holding a underlying cash bond  Hedging of both idiosyncratic and systemic risk  Short Exposure without holding a underlying cash bond  However risk can be pre- determined and managed prior to implementation

6. A powerful tool to aid asset allocation…… and hedge systemic risk…… Credit Risk Interest Rate Risk A BC Yield

7. A dynamic process ……

8. Dynamic Process: The Evolution of a Single Strategy 30 60 90 120 150 180 210 240 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Ladbrokes PLC EUR-Senior-Mod Mod Restructuring 5 Year CDS Spread LADLN 7.125 07/11/2012 Spread to Swap Bought Protection @ 94 Sold Protection @ 180bps October 2005 Hilton Group (Baa2/BBB) confirms it has received an offer for its hotels business. S&P rating placed on review for downgrades. Against a backdrop of increased M&A activity and sector consolidation the remaining Ladbrokes gaming operation is recognised as an attractive acquisition target December 2005 Hilton Group confirms it has been approached separately by three 'Private Equity' firms interested in Ladbrokes January 2006 Investors recognise 'Change-of-Control' clause within bond covenants which would trigger debt buy-back. Investors buy bonds and buy protection and a material shift in 'basis' occurs LADLN 7.125 JUL 2012 versus LADBROKES PLC EUR 5 Year CDS -60 -40 -20 0 20 40 60 Feb-05 Mar-05Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Source: LGIM

9. Dynamic Process: Short Strategy but beware the Orphan Rentokil identified as potential LBO or takeover candidate Group displays moderate balance sheet leverage which could easily be increased given stable operating cashflows Management changes result in lack of continuity Significant non-core activities could be disposed of to refinance acquisition debt or pay dividends to new owners 22/8/05 Acquisition vehicle announces intention to make an offer for Rentokil. Rentokil shares rally 14%, bond and CDS levels widen significantly on the announcement Bought Protection A lesson learnt Rentokil Initial 1927 PLC EUR-Senior-Mod Mod Restructuring 5 Year CDS Spread 10 30 50 70 90 110 130 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Sold Protection Source: LGIM

10. The next level ……

11. Example of Strategy (2) - Buying a payer on an Index Bearish systematic transactions Expectation of systemic (market) risk increasing and spread widening Maximum loss equal to cost – cheap short in low volatile market -50 0 50 100 150 200 250 300 0

12. The end or is it? ……

13. Calling the beginning of the end Under normal assumptions the credit cycle has turned Although future implied volatility remains low Corporate and emerging market spreads breach all the records Increase in default expectations pushed further into the future albeit the curve has steepened Conclusion The end of the carry trade? ….. Again! Asset class deterioration delayed until 2008 Trade recommendation Take advantage of low volatility to place cheap Bear strategies whilst you can Source: LGIM 2003 2005 2007 Debt reduction Credit Equities The bubble bursts Credit Equities Debt growing faster than profits Credit Equities Profits growing faster than debt Credit Equities 150 250 350 450 550 650 750 850 950 1050 1150 Aug-02 Nov-02 Feb-03 May-03Aug-03 Nov-03 Feb-04 May-04Aug-04 Nov-04 Feb-05 May-05Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 5 10 15 20 25 30 35 40 45 EMBI+ Index (LH scale)HE00 Index (LH scale) VIX Index (RH scale) BPS %

14. Appendix

15. Dynamic Process in Action (3) - Event Driven Opening Transaction – Bought HVB deeply sub-ordinated cash bond (Baa3) – Bought protection in UniCredito Italiano SpA CDS 7Y EUR-Sub (A2) – UniCredito Italiano SpA announces its intention to acquire Bayerische Hypo-und Vereinsbank AG Closing Transaction − Sold HVB deeply sub-ordinated cash bond (Baa3) − Sold protection in UniCredito Italiano SpA CDS 7Y EUR-Sub (A2) Long HVB Tie1 debt versus a Buy of Protection (Short) of UniCredito Italiano SpA CDS 7Y EUR-Sub 80 100 120 140 160 180 200 13-May 15-May 17-May 19-May 21-May 23-May 25-May27-May 29-May 31-May 02-Jun 04-Jun 06-Jun 08-Jun 10-Jun 12-Jun 14-Jun16-Jun 18-Jun 20-Jun 25 27 29 31 33 35 37 39 41 43 45 HVB 7.055 Perp-12 (LH scale) UniCredito Italiano SpA CDS 7Y EUR-Sub (RH scale) 50 70 90 110 130 150 13-May15-May17-May19-May21-May23-May25-May27-May29-May31-May 02-Jun 04-Jun06-Jun 08-Jun10-Jun 12-Jun14-Jun16-Jun18-Jun20-Jun HVB 7.055 Perp-12 versus UniCredito Italiano SpA CDS 7Y EUR-Sub

16. Example of Strategy (1) – Buying a single name receiver Bullish idiosyncratic Transactions Expectation of mean revision Risk of equal to option premium Profit and loss profile at maturity -50 0 50 100 150 200 0100200300400500600 Spot 5 Year CDS BPs GMAC LLC EUR-Senior-Modified Restructuring 5 Year CDS Spread 0 100 200 300 400 500 600 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Option implementation - ASW+500bps Option Expiry Source: LGIM

17. Range trade transactions Defines our expectation of spread range Can be switched with zero cost Example of Strategy (3) – Buy and Sale of Receiver at different Strikes BPs

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