Market participants are working toward packaging currency volatility risk into CDO structures, according to rating agency sources.

The deals under consideration, called CFXOs, would initially issue between $50 million and $100 million in liabilities and, like similar structures, are expected to price at a premium. The move is part of a growing trend of capturing various economic risks within CDOs - a development some say is largely the result of hedge fund involvement in the space.

The so-called CFXO structure, modeled after a synthetic CDO, would essentially use swaps to reference the risk of a portfolio of currency-linked options. The deals would have a five-to-seven-year average life and reference a portfolio of about 25 options on the appreciation or depreciation of roughly 12 to 15 currencies, said Paul Vedova, a senior director at Derivative Fitch.

The deals bet on the volatility of a given currency basket by triggering a payment that depends upon a certain level of appreciation or depreciation. While some isolate the risk of a given currency, appreciating against another, such as the U.S. dollar, some of the deals in the works include such currency bets on multiple benchmarks, such as the U.S. dollar and the euro.

Most of the deal proposals utilize American-style triggers, which are tested for breaches daily throughout a structure's life.

The likelihood that a given CFXO will achieve a triple-A rating depends largely on how high or low swap triggers are set to given currency rates - that is, the likelihood a trigger will be hit - and whether the deal is managed. Fitch, the only rating agency to publicly release criteria for rating this type of deal, is planning to model volatility of a given currency by looking at its five-year price history. Certain currencies, such as those recently un-pegged, may not be suitable for inclusion in a CFXO, the rating agency said last week.

Structures place demands on ratings, managers

As rating agencies are increasingly called upon not only to assess the risk of credit, but also that of market price fluctuations, some are questioning whether they are prepared. One source pointed to what she described as a largely unaccounted for risk associated with interest rate hedges in early CDO deals as an example of why rating agencies are not prepared to evaluate risk beyond credit. "Certainly they could do the credit risk, but not the interest rate risk," the source said. "That was always a big flaw."

Yet Fitch's Vedova said the agency's recent restructuring of its derivative operations under the umbrella of Derivative Fitch exemplifies the need for rating agencies to change along with market needs. By the same token, CDO structurers in search of a range of experts across various asset classes are increasingly approaching hedge funds to manage deals.

"We are seeing asset managers that are very interested in mixing asset classes," Vedova said. Such combinations within CDO structures include exposure to commodity fluctuations and the performance of a mining company, for example, or the subprime RMBS sector and housing starts.

Barclays Capital in June of 2006 closed a roughly $100 million offering of Everest I - the first-ever managed CCO deal. It was only the second transaction backed entirely by commodity trigger swaps to be publicly rated.

The transaction priced some 100 basis points wider than most new issue CDOs, the deal's arrangers said. Everest referenced a portfolio of 100 commodity trigger swaps - similar to credit default swaps. The deal had a five-year life and an S&P AA+' weighted average rating.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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