The News Issue Week Day

RICH AMERICA, POOR AMERICA The split nature of today's economy has been great for stock like Coach, tough for ones like Wal-Mart. Why that won't change much, even as the Democrats gain clout in Washington. he New IBM

Big Blue's shareholders have been blue for the past few years. But the tech giant has a new strategy, focused on software. Best of all, it's working.

Randall Forsyth The buck may be real loser in Iraq ...

Review&Preview A vote keeps ASMI intact. Going more nuclear ...

Storming Ahead, After run-up, a few insurers look good ...and Direct TV

Smooth Style Polo stock will stay in fashion ...

Follow the Leaders Copying smart stockpickers is one way to build a best-ideas portfolio, and it saves on management fees. A look at Oracle, Sears, AutoZone,Wendy's and other top holding of five closely watched hedge funds ...

Coming Spinoff Duke Energy's powerful idea ...

The New Big Blue Cover Story: IBM investors may soon be smiling like CEO Palmisano, as Wall Street comes to realize that Big Blue's reinvention as a software giant gives it a steadier, more profitable business with plenty of potential for further improvement ...

Spreading Joy The four rules of good giving ...

Technology Trader Microsoft stock could be ready for takeoff, now that new version of Vista and office have launched ...

13 Great Gadgets Our pick for sleek and sophisticated gadget gifts include Sony TAV-L1 all-in-one home theater, a digital SLR camera, Logitech's Harmony 1000 universal remote ...

Saturday

Chicago Hope


IN 19 YEARS, A CHILD WILL GO FROM THE TERRIBLE TWOS TO HER MAJORITY. And so it has happened With financial derivatives.

Oct. 19, 1987 is a date that lives in infamy in financial history. On what came to be known as Black Monday, the Dow Jones Industrial Average shed 22% in a single session. The culprit-or scapegoat-was program trading involving the simultaneous purchase or sales of baskets of stocks against stock-index futures, then relatively new instruments. .

In 2006, derivatives have moved to the center of the financial world from the periphery, as evidenced by the Chicago Mercantile Exchange's planned acquisition of the rival Chicago Board of Trade for $8 billion. The combination will create a behemoth that trades contracts worth an average of $4.2 trillion daily, dwarfing what changes hands on the New York Stock Exchange or Nasdaq.

Without a doubt, the exchanges have come a long way since the CBOT was known for trading grai.'1s and the Merc for meats. The end of Jixed exchange rates and the advent of interest-rate volatility were the mothers of invention for interest-rate and currency futures in the 'Seventies. Stock-index fu­ tures took off in the 'Eighties with the bull market.

But amid all the clinking of champagne glasses, the Chicago exchanges are conspicuously absent from the biggest and fastest-growing party, credit derivatives.

These instruments-principally credit-default swaps (CDSs), which provide insurance against a borrower's going bust, and collateralized debt obligations (CDOs), which slice and dice pools of corporate bonds into pieces appealing to different cohorts of inwstors-trade over the counter. The markets are made by the giant Wall Street brokers and global banks, whose trading desks are mainly situated in New York and London. By one private estimate, the size of the credit deriva­ tive5 market "ill reach $20 trillion-that's trillion, with at-this year.

Not suprisingly, the Chicago Mercantile Exchange enviously eyes the
credit-derivatives business. But for at least a couple of years, the exc;,allge is unlikely to make any significant inroads into the OTC dealer "~E'ket for CDSs, CD Os and the like. That's not because of any lack of ambition but rather attributable to the differing natme of the contracts.

The success of the CME and CBOT has been in trading conmloc1ities, not in the sense of agTicultmal goods, but by the economic definition. Interest­ rate contracts involve the trading of money, which is as homogeneous as wheat. The same goes for S&P 500 futures.

A credit default swap essentially is an insurance policy that pays off in the event a particulm' bor­ rower, usually a corporation, fails to meet its debt obligations. The premium on that policy depends on the riskiness of the borrower; writing a CDS against a shaky borrower involves a higher premium. As a result, a CDS is more of a custom job than an off-the­ rack commodity.

Buying a corporate bond means that an investor is making two bets; on interest rates and also on that corporate credit. An investor who just wants to bet on that credit can write credit protection, just as an insurer wr:tb c, on a driver-in the hopes of collecting a premium and not having to pay a claim.

A particular company whose credit you like may not have actually issued a bond. A CDS also is far cheaper to buy than an actual bond, just as buying an option costs a lot less than buying the underlying stock.

There also are indexes of credit default swaps, which are compiled by Dow Jones, the publisher of Barron's and Barron's Online. So you can bet on an entire basket of credits with one ticket.

CDOs essentially form a queue for repayment from a pool of bonds or loans. Those at the front are most likely to get paid and get the equivalent of a high-grade credit-even from a pool of low-grade credits. At the end of the line, the risk is biggest but so is the potential payoff. In between, the pie can be carved in whatever shape desired.

Owing to their flexibility, trading in credit derivatives has eclipsed trading in actual corporate bonds. Indeed, credit derivatives are transforming the corporate credit market just as the mortgage-backed securities and deriva­ tives market has revolutionized home loans in America.

But the Chicago futures exchanges, which started the revolution in finan­ cial derivatives, now are mainly spectators to the boom in credit derivatives.

By Randall W.Forsyth

Complete Archive Desember 2006

The New Cisco As technologies like Internet video take off, Cisco Systems, the king of computer networking, will be among the biggest winners. Why its shares could rally another 15%.

Survivor! GOP Will Hang On Despite a profusion of predictions to the contrary, the Republicans will keep control of Congress through just barely. So says our highly reliable seat by seat analysis of local political funding.

The New IBM Big Blue's shareholders have been blue for the past few years. But the tech giant has a new strategy, focused on software. Best of all, it's working.