Not chief executives. Stupid. Collateralised equity-default obligations - one variety of financial alphabet soup which Barclays Capital reckons might offer a useful replacement for widely discredited CDOs and the like.
But what are they? From Aaron Brask and Min Tang at BarCap:
The basic building block of a CEO is the equity default swap (EDS). While there is no universally-accepted definition or standard, an EDS is essentially an out-of-the-money (OTM) binary put. The strike or trigger is chosen far OTM, generally around 30% of the current spot level, and the maturities are longer to make these strikes reasonably attainable. A default event is then linked to the equity breaching that strike level, though the frequency of monitoring the underlying stock price for these breaches can vary. The contingent payout upon default is generally 100% of notional2 which can be interpreted as a zero recovery rate.
That’s an EDS. What’s a CEO?
Capital structure: Integrating a long-short approach
As with the standard CDO, a CEO has a capital structure whereby defaults affect the equity tranche first and then more senior tranches according to their subordination. In a long-short framework, we call the long portfolio the risk portfolio and the short portfolio the protection portfolio. The protection portfolio provides an extra potential buffer whereby defaults are netted between the risk and protection portfolios. However, in the case where the protection portfolio experiences more defaults than the risk portfolio, the net defaults is taken to be zero. That is, the protection portfolio can provide protection against potential losses in the risk portfolio, but does not benefit investors otherwise (in any part of the capital structure).
Structuring
As illustrated in Figure 2, a CEO investment is structured with two primary components: AAA collateral and CEO tranche risk. Risks aside, an investor in a CEO note will be paid interest and receive principal back at maturity. The level of interest will depend on the coupons from the AAA collateral and an additional spread for the CEO tranche risk. This interest is paid regardless of any equity defaults events and only the additional spread is subject to Barclays Capital credit risk. The principal paid back at maturity depends on the collateral and any contingent payout for the linked CEO tranche. In particular, the principal returned to the investor will be inversely proportional to the net defaults in the linked tranche. For example, an investment linked to the 15-20% tranche where the net defaults amount to 16% of total notional would receive 80% of the principal back since one fifth of the 15-20% tranche defaulted.
Don’t say we didn’t warn you.
Related links:
Equity default swaps shunned - FT from 2004
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