JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE

INTRODUCTION TO
CREDIT DERIVATIVES

Betsy Mettler
Vice President,
J.P. Morgan Securities Inc.
The Explosive Growth of Credit Derivatives
Credit Derivatives Market Growth: Volumes Traded ($ billions)

10,000

4,799

2,690
1,952
893 1,189
180 350 586

1997 1998 1999 2000 2001 2002 2003 2004E 2007E

Source: British Banker’s Association, ISDA, McKinsey & Co.

1
Evolution of Market Participants
Evolution of the Credit Derivatives Market

Total growth
Ins. Co.
Banks Re-insurers Hedge Funds Real
Asset Money
Managers
1994 1999 2004

Bank Portfolio Managers Insurance Cos/Asset Managers

n Predominantly buyers of protection n Predominantly sellers of protection

n Hedge over concentrations in loan portfolios n Relative value

n Sell protection to subsidize their hedging programs and diversify n Ability to customize credit risk
their portfolio
n Ability to short credits

Reinsurers/Monolines Hedge Funds

n Predominantly sellers of protection n Active as both buyers and sellers of protection

n No funding requirement n Convertible arbitrage

n Attractive leverage n Ability to short credits

n Alternate liability class to be underwritten providing exposure n Basis trades: bonds vs. protection
to corporate credit risk
n Equity vs. Credit
2
Future Participants: Corporates

Improve returns on
balance sheet cash or
pension assets

Create credit Hedge financial

capacity for new or assets received from
long-term business the acquirer in an
arrangements asset sale
Credit Derivatives
Improve efficiency of Hedge seller
hedges of cash flows indemnities in an
from/to third parties acquisition structure

Manage variability of
future interest
expense

3 3
Diversity of Market Participants

Special Purpose Vehicles Corporates

5% 3%
Third-party
asset managers
7%
Banks
Reinsurance 38%
10%

Banks synthetic
securitization
10%

Hedge funds
Insurance
13%
14%
Source: Risk February 2003

4
Conduit of Information

n In sourcing and selling generic credit risk,

Corporate the credit derivatives desk serves as a link
Bond market
receivables between many different markets
n Example activities of convertible bond
funds create positive basis and
relative value opportunities for
Credit Default JPMorgan CDS Convertible
investors
Swap market Trading Desk market — A corporation issues a convertible
bond
— Convertible bond funds look to
purchase cheap call options on the
underlying equity
— These funds buy the bond and buy
Equity market Loan market
protection stripping out the credit
risk
— Spreads in the credit derivatives
market will widen as a result of this
increased demand

5
Credit Derivatives Allow Investors to Customize
their Source of Credit Risk
n Range of tenors available
n Most liquid tenor is five-year maturity
n Quarterly end dates

n Notional size ranges

n Investment Grade: USD 5 to 20 million
n High Yield: USD 2 to 5 million

n Trade approximately 800 credits globally across:

n Countries
n Ratings categories
n Asset classes

n Synthetic Market
n Customized baskets of credit exposure
6
Single Name Credit Default Swaps

Reference Risk
Entity

Fee/premium 95% of all credit

Protection Protection derivatives are
Buyer Seller credit default
Contingent payment swaps
upon a Credit Event
n A Credit Default Swap is a contract whereby the Protection Buyer transfers the risk that a Credit
Event will occur on the Reference Entity

n In return for protection, the Buyer pays a fee to the Protection Seller

n Upon a Credit Event, the protection Seller pays par for bonds or loans of the defaulted entity.
Protection Seller effectively pays 100%—Recovery Rate

n The Protection Buyer takes on the same risk profile as if they shorted a bond, also referred to as
selling risk

n The Protection Seller takes on the same risk profile as if they bought a bond also referred to as
buying risk

7
Prices for Credit Default Swaps are Initially
Derived from Bond/Loan Prices
n A bond or loan contains interest rate risk, funding risk, and credit risk
n Credit default swaps isolate and transfer credit risk

n To determine the theoretical price of credit risk

n Swap the bond/loan into a floating rate investment (asset swap)
n Remove the funding cost (assume a funding of LIBOR)
n Credit risk remains, which gives you the theoretical price for credit protection

Bond/Loan Asset Swap Credit Default Swap

Credit Credit Credit

Funding Funding

Interest rate

T + 120bp Libor + 80bp 80bp

8
Compare Buying a Bond with Selling Protection:
5-year Par Bond Yielding 4.2%, (T + 120bp)
Scenario #1: No default
Bond cash flows Equal credit derivative cash flows

Credit Default Swap Spreads

Principal
on Bond

Interest Rate = 300bp

5yr Libor Spread = 40bp
Credit = 80bp

9
Compare Buying a Bond with Selling Protection:
5-year Par Bond Yielding 4.2% (T + 120bp)
Scenario #2: Default in year 4, 40% recovery rate
Bond cash flows Equal credit derivative cash flows

Credit Default Swap Spreads

-$100 cost
of bond After default, Seller of protection pays $100,
sell bond for receives default bond worth
$40 $40, net is loss of $60

Interest Rate = 300bp

5yr Libor Spread = 40bp
Credit = 80bp

10
Negative Basis Trade: Example
n Example: 5-year IBM Corp. par bond yielding T + 120bp
Bond/Loan Asset Swap Credit Default Swap

Credit Credit Credit

Funding Funding

Interest rate

T + 120bp Libor + 80bp 80bp

n The credit risk component of this bond is 80bp

n If credit protection is offered at /60bp, then 20bp of negative basis exists

n An investor should buy the bond and buy protection and receive 20bp running for the
life of the trade
n Negative basis players (including trading desks) will typically take this position when
the negative basis exceeds 15bp
n These arbitrage opportunities evaporate relatively quickly and rarely exceed 30bp

11
Positive Basis Trade: Example
n Example: 5-year IBM Corp. par bond yielding T + 120bp
Bond/Loan Asset Swap Credit Default Swap

Credit Credit Credit

Funding Funding

Interest rate

T + 120bp Libor + 80bp 80bp

n The credit risk component of this bond is 80bp

n If credit protection is bid at 100bp/, then 20bp of positive basis exists

n Investors exploit positive basis as an alternative to the cash investment preferring to
sell protection over buying the bond to pick-up an extra 20bp in relative value for
taking the same credit exposure
n Positive basis opportunities can persist for a longer period of time and the spread
differential is not limited by technical reasons
n Selling bonds and selling protection is difficult because a term repo trade is difficult
to maintain
12
Standardization of Credit Default Swap Confirmation

n Standardized documentation has led to the dramatic growth

of the credit derivatives market

n Investment Grade and High Yield North American

confirmation based on the 2003 ISDA credit derivatives
definitions
n Standard 2003 contracts began trading June 20, 2003

n Contracts proved effective by Enron, Worldcom and other

defaults
n Worldcom: close to 600 contracts outstanding
— Estimated over 7 billion in notional
— No disputes or litigation
— No mechanical settlement problems
13
How the Triggering Mechanism of a Credit Default
Swap Works: Watch, Check, Deliver

Watch Check Deliver

Deliverable
Obligations Credit Events
Obligations

n Watch a predefined group of Obligations of the Reference Entity

n Check that a Credit Event has occurred, in which case

n Deliver another predefined group of Deliverable Obligations in return for par

Deliverable Obligations
Protection Protection
Buyer Seller
100% of notional

14
“Obligations” Limit which Instruments can
Trigger Protection on a Credit Default Swap

Deliver/
Watch Check
Settle
Deliverable
Obligations Credit Events
Obligations

n Borrowed Money: bond, note, loan, commercial paper, and letters of credit

Derivative “Payment” General

Contracts Creditors

Bonds “Borrowed Money” Loans

15
“Obligations” Limit which Instruments can
Trigger Protection on a Credit Default Swap

Deliver/
Watch Check
Settle
Deliverable
Obligations Credit Events
Obligations

n The standard Credit Events under ISDA definition:

n Failure to Pay
n Bankruptcy
n Restructuring

n High Yield Credit Default Swaps trade without Restructuring

as a Credit Event

16
“Deliverable Obligations” Limit which Obligations
can be Delivered upon a Credit Event

Deliver/
Watch Check
Settle
Deliverable
Obligations Credit Events
Obligations

n Deliverable Obligations means any Bond or Loan ranked senior or better in

the capital structure (i.e. senior unsecured)

Deliverable Obligations
Protection Protection
Buyer Seller
100% of Notional

17
Physical Settlement Timeline

Physical Settlement Period

(as per Section 8.6 capped
Maximum of 30 calendar days at 30 Business Days)

Credit CEN & PAI delivered Buyer delivers Physical

Event by Buyer or Seller NoPS to Seller Settlement
occurs (must be before the Date
14th day after
Scheduled
Termination Date)

Notes: CEN = Credit Event Notice

PAI = Publicly Available Information
NoPS = Notice of Physical Settlement
Section 8.6 of the 2003 Credit Derivative Definitions provides the Physical Settlement Period should be “the longest
number of Business Days for settlement in accordance with then current market practice” of the obligations being
delivered

18
Valuing a Credit Default Swap Position Using CDSW

n Enables user to perform mark-to-market valuation on vanilla Credit Default Swap

n Model type set to J for JPMorgan

n Three sections make up CDSW

n Deal Information: original trade details
n Spreads: current market spreads
n Calculator: valuation of position
19
This material is not a product of J.P. Morgan Securities Inc.’s (“JPMSI”) Research Departments, and you should not regard it as
research or a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of
the individual author and may differ from the views or opinions expressed by JPMSI’s Research Departments or other
departments or divisions of JPMorgan and its affiliates. Research reports and notes produced by the Firm’s Research
Departments are available from your salesperson.

This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment by
JPMorgan to enter into any transaction. No reliance should be placed on the information herein, which is preliminary and does
not constitute all the information necessary to evaluate investing in any financial instrument or participating in any transaction.
This material may also include information obtained from sources believed to be reliable, but JPMorgan does not warrant its
completeness or accuracy. Any decision to invest in any financial instrument, or participate in any transaction, described
herein should be based solely on the final documentation related thereto. Nothing herein is a recommendation to invest in any
financial instrument or participate in any transaction or legal, tax, regulatory or accounting advice, and each prospective
investor or transaction participant must make an independent assessment of such matters in consultation with its own
professional advisors. Additional information is available upon request. JPMorgan is the marketing name for J.P. Morgan
Securities Inc. (member, NYSE/NASD) and its investment banking affiliates.
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE

CREDIT DERIVATIVES PRICING

AND RESEARCH

Eric Beinstein*
Vice President,
J.P. Morgan Securities Inc.
Measures of Spread for Bonds

21
Basis Report

22
Yield to Maturity: Premium Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (105) 10 10 110

YTM 105 = 10 + 10 + 110

(1 + YTM) (1 + YTM)^2 (1 + YTM)^3

YTM = 8.06%

23
Z-Spread: Premium Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (105) 10 10 110

Z-Spread 105 = 10 + 10 + 110

(1 + 0.005 + Z) (1 + 0.010 + Z)^2 (1 + 0.020 + Z)^3

Z-Spread = 6.17%

24
I-Spread: Premium Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (105) 10 10 110

I-Spread = YTM - Swap Rate at Bond Maturity

I-Spread = 8.06% - 2.00% = 6.06%

25
Asset Swap Spread: Premium Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (105) 10 10 110

Asset Swap Spread = (Fair Value Bond Price – Actual Bond Price) / Duration
Fair Value bond price assumes bond had no credit risk, i.e., discounted at swap rate
Fair Value 123.41 = 10 + 10 + 110
(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Duration 2.92 = 1 + 1 + 1
(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Asset Swap Spread = (123.41 - 105) / 2.92 = 6.31%

26
In Summary…

Premium
Bond
YTM 8.06%
Z - Spread 6.17 Best measure of comparable bond value as
adjusts for shape of Swap curve
I - Spread 6.06 Not as good as Z spread as ignores Swap
curve shape, but usually a reasonable
approximation for high grade bonds
Par ASW 6.31 A tradable value, not a good value measure for
Spread bonds far from par

27
Yield to Maturity: Discount Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (92.13) 5 5 105

YTM (92.13) = 5 + 5 + 105

(1 + YTM) (1 + YTM)^2 (1 + YTM)^3

YTM = 8.06%

28
Z-Spread: Discount Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (92.13) 5 5 105

Z-Spread (92.13) = 5 + 5 + 105

(1 + 0.005 + Z) (1 + 0.010 + Z)^2 (1 + 0.020 + Z)^3

Z-Spread = 6.12%

29
I-Spread: Discount Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (92.13) 5 5 105

I-Spread = YTM - Swap Rate at Bond Maturity

I-Spread = 8.06% - 2.00% = 6.06%

30
Asset Swap Spread: Discount Bond

Year 0 Year 1 Year 2 Year 3

Swap rates 0.50% 1.00% 2.00%
Bond flows (92.13) 5 5 105

Asset Swap Spread = (Fair Value Bond Price – Actual Bond Price) / Duration
Fair Value bond price assumes bond had no credit risk, i.e., discounted at swap rate
Fair value 108.82 = 5 + 5 + 105
(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Duration 2.92 = 1 + 1 + 1
(1 + 0.005) (1 + 0.010)^2 (1 + 0.020)^3

Asset Swap Spread = (108.82 - 92.13) / 2.92 = 5.72%

31
In Summary…

Premium Discount
Bond Bond
YTM 8.06% 8.06%
Z - Spread 6.17 6.12 Best measure of comparable bond
value as adjusts for shape of Swap
curve
I - Spread 6.06 6.06 Not as good as Z spread as ignores
Swap curve shape, but usually a
reasonable approximation for high
grade bonds
Par ASW 6.31 5.72 A tradable value, not a good value
Spread measure for bonds far from par

32
Dollar Price Effect and Expected Value

33
Bond Pricing and Probability: The Framework

A simplified example:
Cash at
108 maturity
Price
today 100 Assumed
Value if
40 default

Discount factor = 2%
34
Bond Pricing and Probability: The Framework (cont’d)

Probability of
Cash at
no default
24%
108 maturity
9 1.

Price
today 100 8.76
Assumed
% Value if
40 default

108 X 0.98 X 0.9124 + 40 X 0.98 X 0.0876 = 100

No Default path Default path

Discount factor = 2%
35
Bond Pricing and Probability: The Framework (cont’d)
Asset A Asset B

91.24% 108 105

100 ?
8.76% 40 40

We know the “fair value” of another asset with a different coupon,

based on the probability of default determined with the first asset

36
Bond Pricing and Probability: The Framework (cont’d)
Asset A Asset B

91.24% 108 91.24% 105

100 97.32
8.76% 40 8.76% 40
105 X 0.98 X 0.9124 + 40 X 0.98 X 0.0876 = 97.32
No Default path Default path

We know the “fair value” of another asset with a different coupon,

based on the probability of default determined with the first asset

37
Bond Pricing and Probability: The Framework (cont’d)
Asset A Asset B

91.24% 108 91.24% 105

100 97.32
8.76% 40 8.76% 40

100 = 108/(1+YTM) 97.32 = 105/(1+YTM)

YTM = 8.00% YTM = 7.89%

38
Bond Pricing and Probability: The Framework (cont’d)
So… If have $500 to invest
Asset A Asset B
Price $100 $97.32
Number purchased 5 5.138
Maturity payment 108 105
Recovery per asset 40 40

If no default
Dollars after 1 year 540 539.46 0.54

If default
Dollars remaining 200 205.51 (5.51)

Basis of zero does NOT mean owning A or B will give the same return

39
Bond Pricing and Probability: The Framework (cont’d)
The expected value is the same
Asset A Asset B

Probability of
no default
If no default
Dollars after 1 year 540 X 0.9124 539.46 X 0.9124
+ +
If default
Dollars remaining 200 X 0.0876 205.51 X 0.0876

Expected value = 510.21 = 510.21

Note: figures above exclude discount factor for simplicity. If multiply each term above by 0.98 expected values = 500.00

40
Bond Pricing and Probability: The Framework (cont’d)
Asset A Asset B

91.24% 108 91.24% 105

100 97.32
8.76% 40 8.76% 40
The goal: A metric which tells us these two assets are of equal value
Asset A Asset B
Yield 800bp 789bp
Spread over LIBOR (Z-Spread) 600bp 589bp
Asset Swap Spread 600bp 573bp
Par Equivalent CDS Spread 600bp 600bp

41
Structuring a Bond Versus CDS Trade

42
Basis Report

43
Basis Report (cont’d)

n Trade strategies: positive basis (CDS is cheaper than bond)

n Switch from bond position to default swap position (sell
protection)
n Short bond and sell protection
n Investigate why markets pricing same risk differently

n Trade strategies: negative basis (Bond is cheaper than CDS)

n Buy bond, buy protection for credit-risk-free position with
positive carry
n As such positions are credit risk neutral, the credit doesn’t
matter—it’s a quantitative exercise
n Investigate why markets pricing same risk differently

44
Positive Basis: Switch from Bond into Protection

n Determine amount of protection to sell to have equivalent

risk profile as owning the bond:
Amount at risk = Bond Price + ¼ of coupon - Recovery

n In GMAC 6.750% 2006 example: Bond price: $107.01,

Assumed Recovery 50%

= (107.01 + 6.750/4 - 50) = $58.70

n How much protection do I sell to have same default risk as

I had when holding the bond?
= Amount at risk / (1- Recovery Rate)
$58.70 / (1 – 0.5) = $117.40

45
Positive Basis: Switch from Bond into Protection
(cont’d)

n In GMAC 6.750% 2006 example:

Not at risk (recovery value) Amount at risk

Bond dirty price $108.70

Credit
exposure $50.00 $58.70
Rate $108.70
exposure

CDS equivalent $117.40

Credit
exposure $58.70 $58.70
Rate $108.70
exposure
46
Positive Basis: Bond Return on $100 Notional Position

n Credit earnings = Spread over swaps (Z-Spread) X Cash invested

n Rate earnings = Swap spread X Cash invested

Credit
exposure $50.00 $58.70
Rate $108.70
exposure

Credit earnings = 104bp X 108.70 = $1.13

Rate earnings = 353bp X 108.70 = $3.84
Bond return on $100 notional position $4.97

47
Positive Basis: CDS and Swap Return with
Equal Risk to Bond

n Credit earnings = Spread over Swaps (Z-Spread) X Cash invested

n Rate earnings = Swap spread X Cash invested

Credit
exposure $58.70 $58.70
Rate $108.70
exposure

Credit earnings = 124bp X 117.40 = $1.46

Rate earnings = 353bp X 108.70 = $3.84
Clean swap -7bp X 104.24 = $(0.07)
CDS and swap return with equal risk to bond $5.23

48
Positive Basis: Unwinding the Position
n With an upward sloping yield curve, unwinding the swap before maturity
will probably incur a loss to the client

5.5%
Expected 3-month rate client is paying JPMorgan
5.0%
4.5%
4.0%
Actual fixed rate JPMorgan is paying client
3.5%
3.0%
2.5%
2.0%
1-yr 2-yr 3-yr 4-yr

49
Positive Basis: Pick-Up in Return from
Equal-Risk Switch

Pick-up in return from equal-risk switch $0.26

Summary numbers No default Default
Bond + $4.97 $(58.70)
CDS + Swap + 5.23 (58.70)
$0.26 $0.00

50
Positive Basis: Summary

Short protection (on

equal default risk
position)
Long a bond
Risk free
Risky credit
credit
Rate exposure = +
Receiving fixed on a
credit contingent
swap

51
Par CDS Calculator

52
The analyst(s) denoted by an asterisk ("AC") hereby certifies 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 analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views
expressed by the analyst(s) in this research.

Copyright 2004 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co., and its subsidiaries and affiliates worldwide. J.P.
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"Dow Jones" and the Dow Jones TRAC-X Indices are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain purposes by
JPMorganChase Bank. The DJ TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representation regarding the
advisability of investing in such product(s).

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Energy Corp., Eastman Chemical Company, Electronic Data Systems Corp., FirstEnergy Corp., General Electric Capital Corp, General Motors, Hallibutron Co., International
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53
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE

DOW JONES TRAC-X

Betsy Mettler
Vice President,
J.P. Morgan Securities Inc.
Overview

55
Dow Jones TRAC-XSM

No. of credits Launch date Next roll date

Dow Jones TRAC-XSM Europe 100 June 2003 March 2004
Dow Jones TRAC-XSM North America 100 July 2003 March 2004
Dow Jones TRAC-XSM Japan 50 July 2003 March 2004
Dow Jones TRAC-XSM North America High Yield 100 July 2003 May 2004
Dow Jones TRAC-XSM Emerging Markets 19 August 2003 March 2004
Dow Jones TRAC-XSM Australia 25 September 2003 March 2004
Dow Jones TRAC-XSM Asia 25 October 2003 March 2004 (exp)

n Dow Jones has signed agreements to be responsible for the operation, development, marketing and
licensing of all the DJ TRAC-X indices

n As one now views the Global Stock Markets via indices like S&P 500, FTSE and NIKKEI, so will credit be
viewed in the future via DJ TRAC-X North America, DJ TRAC-X Europe and DJ TRAC-X Japan

n The Future for credit will allow

n Options on credit
n Tranched risk
n Exchange trading
Note: “Dow Jones” and “Dow Jones TRAC-XSM” are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain
purposes by JPMorgan Chase. The Dow Jones TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes
no representation regarding the advisability of investing in such product(s)

56
Benefits of Dow Jones TRAC-X Indexes

Use credit default swaps to maximize

Liquidity liquidity—the portfolios are composed of the
most liquid Credit Default Swap names from
JPMorgan and Morgan Stanley trading volumes
(Dow Jones will set up advisory committees to
determine index compositions)

Cost efficient and timely access to the Credit

Diversification Markets via index swaps and credit-linked
securities

Transparency Daily reports on actual versus theoretical pricing

57
DJ TRAC-X Participant Uses to Date Have Included:

n DJ TRAC-X is designed to be attractive to all credit market participants

n Banks
— Express trading views on the overall credit market
— Hedge credit exposure within loan and bond portfolios
n Fund Managers and Insurance Companies
— Provides quick, cost-efficient credit diversification
— Hedge credit exposure within portfolios
— Hedge ramp-up risk for CSOs and large cash inflows
n Hedge Funds and Trading Accounts
— Express trading views on overall credit market
— Hedge credit shorts within convertible portfolio
n Corporates
— Hedge credit spreads ahead of new issuance
— Cost-efficient diversification for excess treasury liquidity

58
Features of Dow Jones TRAC-X Global Indices

59
Dow Jones TRAC-X NA participants: 2003
Dow Jones TRAC-X NA Participants Dow Jones TRAC-X NA HY Participants

Pension Funds Corporates

2% 1% Foreign Funds
1% Insurance
Asset Managers 1% Pension Funds
Bank Proprietary
4%
Desks 4%
20% Banks
Banks 14%
46% 54%
33% 20%
Hedge Funds
Hedge Funds
High Yield Funds
and Core Plus

60
Overview of Global Dow Jones TRAC-X Products
5-year 10-year Options
DJ TRAC-X Index Swap Funded maturity maturity Available

DJ TRAC-X North America

DJ TRAC-X NA x x x x x
DJ TRAC-X NA High Beta x x x x
DJ TRAC-X NA TMT x x x
DJ TRAC-X NA FIN x x x

DJ TRAC-X North America High Yield

DJ TRAC-X NA High Yield 100 x x x
DJ TRAC-X NA High Yield BB x x x
DJ TRAC-X NA High Yield B x x x
DJ TRAC-X NA High Yield High Beta x x x

DJ TRAC-X Europe
DJ TRAC-X Europe x x x x x
DJ TRAC-X Europe Corp x x x x
DJ TRAC-X Europe Financial Senior x x x x
DJ TRAC-X Europe Financial Sub x x x x
DJ TRAC-X Europe TMT x x x
DJ TRAC-X Europe Industrial x x x
DJ TRAC-X Europe Consumer x x x

DJ TRAC-X Europe High Yield x x x

DJ TRAC-X Asia x x
DJ TRAC-X Japan x x
DJ TRAC-X Australia x x
DJ TRAC-X Emerging Markets x x x

61
Dow Jones TRAC-X North America Series 2

n For Dow Jones TRAC-X North America, there is usually a 1bp bid-
to-offer in $50 million a side

62
Dow Jones TRAC-X NA High Yield Series 2

n For Dow Jones TRAC-X NA High Yield, there is usually a 1/4 to

1/2pt bid-to-offer in $10 million a side

63
Dow Jones TRAC-X Structure and Mechanics

64
Unfunded DJ TRAC-X NA Series 2 Mechanics:
An Example
Entering a long risk DJ TRAC-X NA unfunded trade
n DJ TRAC-X NA March 2009 contract with 100bp p.a. spread
Quoted spread: [65-66]bp

n Investor goes long $100 million notional

100
reference
credits

100bp p.a. = $1,000,000

JPMorgan Investor
[$1,861,531 + Accrued (230,556)] =
2,092,086

(1) Client pays 35bp running and pays accrued to enter the trade

(2) Client receives 100bp p.a. to take risk on 100 credits

65
Unfunded DJ TRAC-X NA Series 2 Mechanics:
An Example (cont’d)
No default
n If none of the 100 credits default, investor earns 100bp p.a. until the maturity of
the trade

n Profit or loss is recognized through coupon income and capital

appreciation/depreciation based on the price of the index

One name defaults

(1) $1mm
JPMorgan Investor
(2) $1mm notional of bonds/loans

(3) 100bp on reduced notional ($99mm)

(1) Investor pays 1/100th of original notional to JPMorgan

(2) JPMorgan delivers principal amount of bonds or loans to investor

(3) Investor continues to earn 100bp p.a. on a reduced notional

66
Funded DJ TRAC-X NA Series 2 Mechanics: An Example
Entering a long risk DJ TRAC-X NA funded rate
n DJ TRAC-X March 25, 2009 certificates with 4.25% coupon

n Quoted price: T + 101/99 [$102.36/102.45]

n Investor goes long $100 million notional

100
reference
credits
(1) ([$102.45] * 1 * $100mm) + Accrued=
$104,231,100
Trust Investor
(2) 4.25% * 1 * $100,000,000
= $4,250,000

(1) Client pays ([$102.45] * 100 million * 1.00) + Accrued to enter the trade

(2) Client receives 4.25% coupon on $100 million

67
Funded DJ TRAC-X NA Series 2 Mechanics: An Example
(cont’d)
No default
n If none of the 100 credits default, investor earns 4.25% for five years and receives par at maturity

n Profit or loss is recognized through coupon income and capital appreciation/depreciation based on
the price of the DJ TRAC-XSM NA

One name defaults

Cash value of $1 million
notional of defaulted bonds
Trust Investor
4.25% on reduced
notional ($99mm)

(1) Remaining principal amount is 99/100 of original notional

(2) JPMorgan delivers cash value of $1 million notional of defaulted bonds or loans (recovery rate)

(3) Investor continues to earn 4.25% on a reduced notional

(4) Each subsequent default will reduce the notional of the trade by 1/100th of the original notional

68
Options on Dow Jones TRAC-X

69
DJ TRAC-X North America Options: Product Details

nPut: Option to buy protection/payer option

Call: Option to sell protection/receiver option

nExercise: European (only at the maturity of the option)

nSettlement: Physical, into DJ TRAC-X North America Series

2 March 2009 upon exercise at the pre-set strike
70
The analyst(s) denoted by an asterisk ("AC") hereby certifies 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 analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views
expressed by the analyst(s) in this research.

Copyright 2004 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co., and its subsidiaries and affiliates worldwide. J.P.
Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc., is a member of the NFA. J.P. Morgan
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Limited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMSAL) is a licensed securities dealer.

Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions and
estimates constitute our judgment 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 hold a position, may undertake or have already undertaken an own account transaction or act as market maker in
the financial instruments of any issuer discussed herein or any related financial instruments, or act as underwriter, placement agent, advisor or lender to such issuer. Clients
should contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permits otherwise. 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. This report should not be distributed to others or replicated in any
form without prior consent of JP Morgan. 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
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relevant persons. In other European Economic Area countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.
Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL 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 JPMSAL. 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.

"Dow Jones" and the Dow Jones TRAC-X Indices are service marks of Dow Jones & Company, Inc. or its licensors and have been licensed for use for certain purposes by
JPMorganChase Bank. The DJ TRAC-X Products are not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representation regarding the
advisability of investing in such product(s).

JPMSI or an affiliate has managed or co-managed an offering of securities within the past twelve months for Altria Group, Inc., Amerada Hess Corporation, American Electric
Power Company, Inc., American Express Company, Arrow Electronics, Inc., Baxter International Inc., Bristol-Myers Squibb Company, Cargill, Inc., Caterpillar Financial
Services Corp, Cendant corp, Centex Corp, CIT Group Inc., Clear Channel Communications, Inc., Comcast Corp., Computer Sciences Corp., Cox Communications, Inc., Duke
Energy Corp., Eastman Chemical Company, Electronic Data Systems Corp., FirstEnergy Corp., General Electric Capital Corp, General Motors, Hallibutron Co., International
Business Machine, Liberty Medai Corp., MBNA Corp., Monsanto Co., News America, Inc., Ryder System, Inc., Sempra Energy, SLM Corp., Target Corp., Textron Financial
Corp., Boeing Capital, Kroger Co., The Walt Disney Co., Toys "R" US Corp., Valero Energy Corp., Wells Fargo & Co., Wyeth

A senior employee, executive officer, or director of JPMSI and/or its affiliates is a director of The Boeing Company, Bristol-Myers Squibb Company, Deere & Company,
Electronic Data Systems Corporation, International Business Machines Corporation, The May Department Stores Company, McDonald's Enterprises, Motorola, Inc., Valero
Energy Corporation, Verizon Communications, Inc.., Viacom Inc., Visteon Corporation, Wyeth (N/C FR American Home Product Corp)

71
JPMORGAN 2004 CREDIT DERIVATIVES CONFERENCE

INTRODUCTION TO
CORRELATION PRODUCTS

Betsy Mettler
Vice President,
J.P. Morgan Securities Inc.
Consider an FTD: Client Sells Protection
n Client receives periodic spread until Credit Event occurs
n Similar to single name CDS

n After Credit Event:

n Client is delivered defaulted bond
n Client pays par

n Transaction ends after the first Credit Event

CDS #1

Premium
Seller
Buyer FTD CDS #2 1st Default?
(client)
Contingent
payment

73
Basket Trade (FTD) Value Drivers
n Number of Basket Components
n As number of credits increases, likelihood of one defaulting also increases
n Greater number of names, greater premium paid

n Absolute Spread Levels

n Clustered spreads provide greatest value
n Outlying credit spreads skew basket premium

n Correlation Spread
n Lower correlation Sum of individual spreads
— Higher risk (expected loss),
higher spread
Widest individual
spread

0% 50% 100% Correlation

74
What Have People Actually Done?
n Example: Client sells FTD protection on five high-grade credits
n Yield enhancement
n Client chooses names to coincide with its own analysts’/in-house views
n Clustered spreads
n Credits have low correlation to maximize spread

Example
Credits 5-yr bid (bp) Summary statistics
EOP Operating Limited Partnership 48 FTD swap premium 176bp
Sears Roebuck Acceptance Corp. 46 Aggregate bid spread 220bp
SLM Corporation 42 Premium as a % of aggregate 80%
bid spread
The Goldman Sachs Group Inc. 34 Premium as a % of highest bid 352%
spread
Verizon Global Funding Corporation 50 Average spread 44bp

75
Tranched TRAC-X: The Benchmark for Correlation

n Extends Tranche Technology to an Index

n Leverages the Index Liquidity
— Lower bid/offer
— Largest number of market makers
n Greater Pricing Transparency 30—100%
— Two-way markets quoted daily by multiple dealers
n Follow-on Step in Market Standardization
— Static and widely traded portfolio
— Standardized documentation between dealers and
clients

n Range of TRAC-X indices can be referenced, including

15—30%
n North America (five and ten years)
n North America high-yield
10—15%
n Emerging markets
7—10%
n Europe
3—7%
0—3%
Note: Portfolio tranches shown are not drawn to scale

76
This material is not a product of J.P. Morgan Securities Inc.’s (“JPMSI”) Research Departments, and you should not regard it as
research or a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of the
individual author and may differ from the views or opinions expressed by JPMSI’s Research Departments or other departments or
divisions of JPMorgan and its affiliates. Research reports and notes produced by the Firm’s Research Departments are available
from your salesperson.

This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment by
JPMorgan to enter into any transaction. No reliance should be placed on the information herein, which is preliminary and does
not constitute all the information necessary to evaluate investing in any financial instrument or participating in any transaction.
This material may also include information obtained from sources believed to be reliable, but JPMorgan does not warrant its
completeness or accuracy. Any decision to invest in any financial instrument, or participate in any transaction, described herein
should be based solely on the final documentation related thereto. Nothing herein is a recommendation to invest in any financial
instrument or participate in any transaction or legal, tax, regulatory or accounting advice, and each prospective investor or
transaction participant must make an independent assessment of such matters in consultation with its own professional advisors.
Additional information is available upon request. JPMorgan is the marketing name for J.P. Morgan Securities Inc. (member,
NYSE/NASD) and its investment banking affiliates.

77