DERIVATIVES DOCUMENTATION
DERIVATIVES DOCUMENTATION
Class 1
Class 1
Jonathan Ching
Jonathan Ching
Summer 2009
Class 1 - Agenda
9am – 10:15 am –SURVEY OF DERIVATIVES
10:15 – 10:30am – AM break
10:30 – 12:00pm –DERIVATIVES MARKETS
12 – 12:45pm – lunch break
12:45 – 2pm – INTRO TO DERIVATIVES
12:45 – 2pm – INTRO TO DERIVATIVES
DOCUMENTATION
2-2:15pm – PM break
2 15
3
LEGAL ISSUES AND ISDA DOCUMENTS
2:15 – 3pm – LEGAL ISSUES AND ISDA DOCUMENTS
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Part 1
Survey of Derivatives
Survey of Derivatives
Derivatives Generally
Question: What is a derivative?
A derivative is a financial contract whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event.
The term derivative refers to how the price of these contracts is derived from the price of the underlying item.
Although derivatives often require the payment of an upfront amount (such as a
'premium' for option structures), pure derivatives involve no purchase/sale of the assets – trading only takes place in the pure return profile of the underlying.
A derivative covers exposure to any income paid by the asset and/or any changes inA derivative covers exposure to any income paid by the asset and/or any changes in the capital price of the asset.
This sets them apart from cash market instruments such as stocks and bonds, which involve trading in both the cash and return profile.
It is this ability to separate out the return characteristics of the underlying that is the key driver behind the uses and applications of derivative instruments.
Derivatives in the Media
Based on recent media coverage of the credit crisis, the warning label on your swap transaction should read:
Contains Complex, Arcane Instrumentsp ,
Extremely Risky and Volatile
Difficult to Evaluate
M C t U d i d E d M C S b t ti l L
Historical Examples of Derivatives
As a testament to their usefulness, derivatives have played a role in commerce and finance for thousands of years.
Th 'C d f H bi' th f t f i t B b l i l h i i b hi h ‣ The 'Code of Hammurabi', the famous set of ancient Babylonian laws, has a provision by which
debtors can delay the payment of interest in the event of a grain failure (circa 1750 B.C.)
‣ Aristotle mentioned an option type of derivative, and how it was used for market manipulation, in the 4th century B.C. (Politics, chapter 9). y ( , p )
‣ In the early 17th century, futures and options were traded on stocks and commodities such as tulips in Amsterdam. The Dutch government was so skeptical of these 'mysterious' activities that it introduced laws making such contracts unenforceable in government courts.
‣ The Japanese traded futures-like contracts on warehouse receipts for rice in the 18th century.
In the U.S., forward and futures contracts have been formally traded on the Chicago Board of Trade since 1840’s.
Development of Derivatives in the United States
Chicago Board of Trade (1848)
‣ Grain traders created "to-arrive" contracts that permitted farmers to lock in the price and deliver the grain later
deliver the grain later.
‣ These contracts were eventually standardized around 1865, and in 1925 the first futures clearinghouse was formed.
Confederate States of America (1862)Confederate States of America (1862)
‣ The Confederate States of America, desperate for wartime funding, issued a dual currency optionable bond.
‣ Bond permitted the Confederate States to borrow money in sterling with an option to payy g p p y back in French francs.
‣ The holder of the bond had the option to convert the claim into cotton, the south's primary cash crop.
Recent History of Derivatives
1972 Æ CME launches futures contracts on currencies
1973 Æ The Black-Scholes model, as it came to be known, set up a mathematical framework that f d th b i f l i l ti i th f d i ti CBOE b i t di f formed the basis for an explosive revolution in the use of derivatives. CBOE beings trading of listed options.
1977 Æ Continental Illinois Limited (First Interstate) completed $25mm 10y (US$ / GB£) swap
1981Æ World Bank and IBN execute currency swap (US$ / DM and CHF)
1981 Æ World Bank and IBN execute currency swap (US$ / DM and CHF)
1987 Æ Black Monday and the stock market crash
1994 Æ large losses on derivatives trading announced by Procter and Gamble, Gibson Greetings, and Metallgesellschaft Orange County California declared bankruptcy due to the use of leverage and Metallgesellschaft. Orange County, California declared bankruptcy due to the use of leverage in a portfolio of short- term Treasury securities and England’s Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office.
Legal Categories
Broadly speaking, derivatives fall into two categories for legal and regulatory purposes:
‣ OTC: customized privately negotiated derivatives which are knownOTC: customized, privately negotiated derivatives, which are known
generically as over-the-counter (OTC) derivatives or, even more generically, as swaps.
‣ Exchange Traded: standardized, exchange-traded derivatives, known as futures.
In the U.S., exchange traded derivatives are generally regulated by the CFTC while OTC derivatives are exempt from this regulation provided that they meet certain legal standards The SEC monitors the OTC market for
certain legal standards. The SEC monitors the OTC market for fraud/manipulation.
In practice, both markets work alongside one another. For example, a derivatives dealer may utilize the exchange-traded market to hedge risks incurred in trading with clients in the OTC market and/or other dealers in the interbank market.
What is an OTC derivative and why do I care?
How do privately negotiated (OTC) derivatives differ from futures?
‣ First, the terms of a futures contract—including delivery places and dates, volume, technical ifi ti d t di d dit d t d di d f h t f t t specifications, and trading and credit procedures—are standardized for each type of contract. For swaps, the same characteristics are subject to negotiation by the parties to the contracts. ‣ Second, futures contracts are always traded on an exchange, while swaps are traded on a
bilateral basis.
‣ Third, those who engage in futures transactions assume exposure to default by the exchange’s clearinghouse; for OTC derivatives, the exposure is to default by the counterparty.
‣ Fourth, credit risk mitigation measures, such as regular mark-to-market and margining, are g g g g automatically required for futures but optional for swaps.
‣ Finally, futures are generally subject to a single regulatory regime in one jurisdiction, while swaps—although usually transacted by regulated firms—are transacted across jurisdictional b d i d i il d b th t t l l ti b t th ti V i boundaries and are primarily governed by the contractual relations between the parties. Various products, including futures contracts and exchange-traded options, fall within the generic
Notional Amounts
The concept of notional amount is fundamentally important to understanding derivatives. ‣ The notional amount, or notional principal, is a hypothetical underlying quantity upon which
t bli ti f d i ti t t l l t d payment obligations for derivatives contracts are calculated.
For example, an interest rate swap might involve the exchange of fixed rate payments for floating rate payments linked to 3-month Libor, each based on a notional amount of GBP 100m.
‣ The 'notional' is used simply as a basis for payment calculations and does not actually represent ‣ The notional is used simply as a basis for payment calculations and does not actually represent
an obligation from either party to the other.
‣ Although the swap may have been entered as a hedge for the anticipated interest expense of a loan, the swap's notional amount is independent of the loan and does not change when the loan p p g is repaid or its principal amount otherwise changes.
Types of Derivatives
The two basic types of derivatives are forward and option contracts.
‣ A forward is an agreement entered into today to buy or sell a specified asset at a specified f t d t f d 'f d' i
future date for an agreed 'forward' price.
‣ Options give the holder the right, but not the obligation, to enter into a financial transaction, at some point in the future, at a predetermined level (strike or exercise price).
These two building blocks can be combined in different ways to create a myriad of derivative
These two building blocks can be combined in different ways to create a myriad of derivative contracts, or combined with other financial instruments to create structured derivative products.
Forwards
Forward contracts
‣ Forward contracts represent agreements for delayed delivery of financial instruments or diti i hi h th b t h d th ll t d li t commodities in which the buyer agrees to purchase and the seller agrees to deliver, at a specified future date, a specified instrument or commodity at a specified price or yield.
‣ Forward contracts are generally not traded on organized exchanges and their contractual terms are not standardized.
‣ Entering a forward contract typically does not require the payment of a fee.
— The buyer is said to be “Long”. The seller is said to be “Short”
— The seller is said to be Short .
‣ Cash flows are deferred until a future date when the buyer delivers cash in exchange for the asset (physical settlement), or makes/receives a payment based on the difference between the forward price and the market price of the underlying (cash settlement).
Example of a forward
‣ You enter a jewelry store and tell the owner that you want to buy a ring for your spouse, but six months from today on his/her birthday.
‣ The owner says it will cost you $25.
‣ This price is agreeable to you, you agree to come back six months later to buy the ring at $25.
— As buyer you are long forward and the owner is short forward as seller.
‣ Six months later, you return to the store, pay $25 and take the ring (called physical delivery). ‣ If the value of the ring is greater than $25, you made money on the trade. If less, you lost
Options
OPTIONS
‣ An option is an agreement that gives the buyer, who pays a fee (premium), the right—but not the obligation—to
b ll ifi d t f d l i t t d i ( t ik i i ) til
buy or sell a specified amount of an underlying asset at an agreed upon price (strike or exercise price) on or until the expiration of the contract (expiry). A call option is an option to buy, and a put option is an option to sell. ‣ Options are said to be “in the money” if it is profitable to exercise, and can be entered into on almost any asset
class, including swaps themselves – “Swaptions”., g p p ‣ Two basic types of options
— Call: a contract that gives the buyer the right to buy 100 shares of an underlying stock at a predetermined price (the strike price) for a preset period of time. The seller of a Call option is obligated to sell the underlying security if the Call buyer exercises his or her option to buy on or before the option expiration date.
— Put: a contract that gives the buyer the right to sell 100 shares of an underlying stock at a predetermined price for a preset time period. The seller of a Put option is obligated to buy the underlying security if the Put
b i hi h ti t ll b f th ti i ti d t
buyer exercises his or her option to sell on or before the option expiration date. ‣ Two basic option positions
More on options
How do options differ from swaps and forwards?
‣ In a forward or swap, the parties lock in a price (e.g., a forward price or a fixed swap rate) and bj t t t i d ff tti t bli ti I ti th b h
are subject to symmetric and offsetting payment obligations. In an option, the buyer purchases protection from changes in a price or rate in one direction while retaining the ability to benefit from movement of the price or rate in the other direction. In other words, the option involves asymmetric cash flow obligations.
Is an option a form of insurance?
‣ Options differ from insurance in that options do not require one party to suffer an actual loss for payment to occur. In addition, the owner of an option need not have an insurable interest—such
hi i th d l i t i th ti as ownership in the underlying asset—in the option.
Options also give you leverage.
‣ If you buy options, you have ‘good’ leverage, i.e. you can’t lose more than what you paid.
‣ If you write options, you have ‘bad’ leverage, i.e. you can’t make more than what you received from the buyer and your loss is potentially infinite (if you write calls).
Swaps
A swap is simply a series of forward contracts, repeated over a specified period.
Swaps market began to develop in the mid-1980’s
‣ Initial focus was on currency swaps but this was quickly replaced by interest rate swaps
— Interest rates globally were high and volatile
— Swaps allowed borrowers to manage rate and currency risk in their financing activities ‣ Market dealers switched from arranging client transactions to becoming principals
— Dealers began to take risk and to “warehouse” derivatives
— Competition forced spread compression in swap markets as they became commoditized akaCompetition forced spread compression in swap markets as they became commoditized aka “flow” trading
‣ This lead many dealers to look for profit opportunities by creating structured products.
— Structures linked to interest rates and currencies were used to provide investors with above-Structures linked to interest rates and currencies were used to provide investors with above market returns.
Recent History of OTC Derivatives
1987 Æ ISDA develops the first “master agreement” for interest rate swaps (called IRCEA).
1992 Æ ISDA publishes the 1992 ISDA Master Agreement (Multicurrency – Cross-Border).
1994 Æ the derivatives world was hit with a series of large losses on derivatives trading:g g ‣ Procter and Gamble and Metallgesellschaft.
‣ Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities.
‣ England's venerable Barings Bank declared bankruptcy due to speculative trading in futuresEngland s venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office.
1997 Æ Asian currency crisis
1998 Æ Russia defaults; LTCM collapses
2001Æ nascent CDO market collapses
2001 Æ nascent CDO market collapses
2002 Æ ISDA publishes the 2002 ISDA Master Agreement
2008 Æ AIGFP loses its AA- credit rating forcing the firm post billions of dollars in collateral to its trading partners. The U.S. government stepped in on Sept. 16, when the Federal Reserve
t d d $85 billi dit li t t “ t i f il ” If AIG h d ll d d th extended an $85 billion credit line to avert “systemic failure”. If AIG had collapsed, a dozen other big financial companies that were counterparties in its derivative trades and insurance contracts
Derivatives Markets
There are five major asset classes for the trading of derivative contracts: ‣ Interest rate derivatives
‣ Credit derivatives
‣ Foreign exchange (FX) derivatives ‣ Equity derivatives
‣ Commodity derivatives
Within most of these asset classes, there are both exchange-traded and over-the-counter (OTC) derivative instruments.
Interest Rate Derivatives
Interest rate derivatives represent the largest derivatives market in the world, as shown by the graphs below (percentages relate to notional amounts). According to the Bank for International Settlements (BIS), the notional amount of interest rate derivatives outstanding in the OTC market ( ), g alone was over USD 346 trillion (as of June 2007). A further USD 71 trillion in exchange-traded futures and options contracts was outstanding.
Interest Rate Swaps
In terms of notional amounts outstanding, by far the most popular form of interest rate derivative is the interest rate swap (IRS).
A IRS i f d t d i ti t t h b t t h h fl
An IRS is a forward-type derivatives contract whereby one party agrees to exchange cash flows with another party at future dates – nothing is 'bought' or 'sold'. Traded in the OTC market, interest rate swaps are used by parties who wish to change the basis of their interest rate payments or receipts.
Interest Rate Swaps
The diagram below shows an example of a classic plain vanilla interest rate swap.
In this deal, a client is paying a series of 6-monthly fixed rate cash flows on a notional principal amount, such as GBP 100m. In exchange, the client receives a series of 6-monthly floating cash flows that are based on GBP Libor.
Other Interest Rate Derivatives
Forward Rate Agreements (FRA): A FRA defines an interest rate for a principal amount for a defined interest period that will start at a future date (3, 6, 9, or 12 months). The interest rate on which they agree (FRA rate) is the price of the FRA as it is quoted by the market. By doing so, the y g ( ) p q y y g , customer and the bank agree to compare the fixed FRA rate to a reference interest rate (e.g.
LIBOR) two days before the defined interest period (fixing date). Who receives or pays the amount due depends on whether the FRA rate is higher or lower than the reference rate at settlement date.
Futures: Standardized forward contracts traded on an exchange (CME in the US) and settled in a clearinghouse. This will reference either a government security (bills, bonds, or notes) or interest rate (LIBOR, Euribor, etc.). Many investors hedge interest rate risk with futures. Other investors will use interest rate futures to hedge forward borrowing rates.
Interest Rate Options: Option contract whose payoff depends on the future level of interest rates.
Caps, floors, and collars: Option combinations – caps payout if rates rise above a certain level; floor payout if rates fall below a certain level; and collars combine a long cap and short floor to lock in an interest band.
Credit Derivatives
Credit derivatives are privately negotiated (OTC) contracts that allow one party to 'decouple' or transfer the credit risk of an asset (such as a bond or loan) to another party, without transferring ownership of the underlying asset. p y g
There are a number of different types of credit derivative, but the most popular is the single-name
credit default swap (CDS). This is a contract in which one party (protection buyer) pays a regular
protection premium to another party (protection seller or investor) to protect against default by a particular reference entity (the 'single-name').
Growth primarily in credit index trades
However, much of that growth was driven by CDS index trading
Foreign Exchange Derivatives
Currency derivatives: There are a number of different derivatives that can hedge currency or FX exposure.
O t i ht f d ti t h h fl i t diff t i t d
‣ Outright forwards: parties agree to exchange cash flows in two different currencies at an agreed upon date in the future. The typical use of these forwards is by a corporate customer to
limit/offset currency exposures arising from cash flows in a foreign currency.
‣ FX swaps: Parties exchange currencies at the prevailing spot rate, then agree to reverse the p g p g p , g transaction at a future date at an agreed price.
‣ FX options: An option that gives the buyer the right, but not the obligation, to exchange one currency for another at a predetermined exchange rate on or until the maturity date.
‣ Cross-currency swaps: Parties swap principal and interest payments in one currency for principal and interest in another currency. This is essentially an interest rate swap in which each side is denominated in a different currency.
C f t d li t d ti C t t f th h l f f i
‣ Currency futures and listed options: Contracts for the purchase or sale of foreign currency. These contracts make up a small proportion of the exchange traded derivatives markets.
Equity Derivatives
Equity Derivatives
‣ Equity Options / Index Options: Give the buyer the right to buy/sell a particular stock or an index lik th S&P500 FTSE 100 Nikk i 225 t f t d t
like the S&P500, FTSE 100 or Nikkei 225 at a future date.
‣ Equity swaps: Parties swap the returns on a stock or index (called an “equity leg”) for a stream of payments based on some other rate, usually a fixed or floating rate of interest (called the “financing leg”).g g )
‣ Equity Forwards: Contract to buy or sell a stock or basket of stocks at a particular price on or before a future date.
‣ Customized versions or combinations of options/forwards allow for trading in different types of p g yp risk related to these indices such as volatility/variance swaps or options on the indices –
straddles, strangles, butterflies, etc.
Commodity Derivatives
A commodity derivative is one whose underlying is a commodity or commodity index. The underlying markets for commodity derivatives include oil, gas, precious and base metals, agricultural products, coal, and electricity. g p , , y
Options are the most popular instruments in the OTC market, accounting for over 50% of all
transactions (as of June 2007). Other products traded in the OTC market include forwards, swaps, and spot deferred contracts (a forward contract with a deferrable maturity date). Exchange-traded commodity futures and options are also available in numerous markets around the world.
Derivative Markets Unwind
ISDA reports that the three largest derivatives markets shrank between June 2008 and January 2009:
CDS ti l t $38 6 t illi t d 2008 d 29 t f $54 6 t illi t ‣ CDS notional amount was $38.6 trillion at year-end 2008, down 29 percent from $54.6 trillion at
mid-year 2008.
‣ Interest rate derivative notional amount was $403.1 trillion at year-end, a decline of 13 percent compared to $464.7 trillion at mid-year 2008. p y
‣ Equity derivative notional amount fell to $8.7 trillion at year-end 2008, down 13 percent from mid-year 2008, when equity derivatives notionals were $11.9 trillion.
Significant structural changes have been made to the OTC derivatives markets and more have g g been proposed by President Obama and Congress, ranging from the complete ban of OTC
P
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Part 2
Derivatives Markets
Derivatives Markets
Applications and Risks of Derivatives
Having reviewed the major categories of derivatives, we can now consider ‣ Participants in the derivatives market:
— Clients
— Intermediaries
— Broker dealers
‣ Applications of derivative products
— Hedging
— Speculation/Yield EnhancementSpeculation/Yield Enhancement
— Arbitrage
Market Players
Clients: These are the end users of derivative products, such as investors, borrowers, and speculators. Examples of such end users include fund managers, hedge funds, corporate
treasurers, and governmental and supranational entities. Clients are often referred to as the 'buy , g p y side' of the market.
Much of the growth in derivatives volumes in recent years has been driven by hedge funds. ‣ Many hedge funds are designed to be leveraged, which allows them to control large positions y g g g , g p
with smaller amounts of capital (that is, to invest a multiple of their actual assets under management).
‣ Derivatives, which are designed to separate cash flows associated with assets from the need to f ll f d iti i th t i t l f hi i l
fully fund positions in those assets, are a primary tool for achieving leverage.
‣ Additionally, derivatives allow investors to go short as well as long which is not always possible in the cash markets.
L d th bilit t h t th t th t i f d i ti i i f h ‣ Leverage and the ability to short means that the extensive use of derivatives is a given for much
Market Players
Most big financial institutions are organized to act as either intermediaries, broker-dealers, or both.
Intermediaries: Prime brokers and other agents act as intermediaries by buying and selling d i ti b h lf f th i li t Th k b h i i i f ti derivatives on behalf of their clients. They make money by charging a commission for executing a client order.
‣ Agents in the derivatives marketplace operate on a 'give-up' basis – if they find two
counterparties with matching needs, they introduce the two parties. If these two parties have p g , y p p documentation and credit limits in place, they will transact with each other.
Broker/dealers: A broker/dealer firm, such as a bank or securities house, operates in a dual capacity in the derivatives marketplace.
‣ As an agent advising and representing clients in the market. ‣ As a principal making markets and trading for its own account.
Broker/dealers look to make money through market making and the bid-offer spread (the difference between the purchase price of a security and the sale price of the same security). Although traders may generate income through 'calling the market', their most important role is usually that of
So why use derivatives?
Hedging – lock in forward prices to ensure a fixed return on a variable price
‣ Use of derivatives originated in physical commodities markets - farmers, buyers of commodities, i t d t
grain traders, etc.
Speculation – use forwards to sell short
‣ Derivatives require us to sell forward, i.e. nothing is due today.
‣ At a future date, you can always buy the thing and deliver it to the buyer
‣ A short seller locks in a gain between the price the buyer paid and the price he pays to buy the asset to cover the short. However, the reverse is also true if he is wrong about the price.
Leverage – buy forward to leverage returns
‣ To buy $100,000 par amount of Treasuries, you have to lay out something close to that amount, depending on the price.
‣ But to go long a Treasury futures contract representing $100,000 par amount of Treasuries, you merely have to deposit $2,025 in a margin account, and maintain at least $1,500 in the account,
Hedging
Hedging generally involves entering into a transaction where the gains/losses from the 'hedge' will offset the gains/losses in the ‘underlying' position. For example,
g y g p p ,
a long position in an asset can be hedged by selling the asset in the forward market or purchasing a put ('sell') option on the asset; either of these strategies will reduce the risk of loss from declines in the asset will reduce the risk of loss from declines in the asset price.
However, the advantage of an options hedge is that it protects the hedger from unfavorable price movements while allowing continued participation in favorable movements. The forward hedge guarantees the hedger a price at which the asset can be sold; however, the hedger forgoes the benefit from potentially favorable price changes.
Speculation and Yield Enhancement
Although not inherently speculative, derivatives can be used by speculators who are simply looking to make profits if an asset price moves in the direction expected.
A t f th ti f h di t i k tt ti f i d i ti f
Apart from the creation of such direct price exposure, a key attraction of using derivatives for speculative purposes is the absence of commitment of capital upfront.
‣ A speculator who believes the price of gold is likely to rise in three months' time could either buy the gold today in the spot market or enter into a gold futures contract. With gold at $940 per g y p g g p ounce, 100 ounces would cost $94,000 in the spot market. In contrast, the outlay in the form of initial margin for a 3-month gold futures contract – which also covers 100 ounces – on the New York Mercantile Exchange is USD 4,000.
I tit ti l i t d tf li l l d i ti t h t i ld
Institutional investors and portfolio managers can also employ derivatives to enhance asset yields. Yield enhancement strategies make use of the highly-leveraged nature of derivatives to produce potentially significant returns from relatively modest price changes.
‣ An investor could write (sell) a call option on an underlying long asset position – the premiumAn investor could write (sell) a call option on an underlying long asset position the premium received from the option buyer will increase the return (there is a risk, of course, that the option will be exercised by the buyer, which will result in the investor underperforming the asset
Arbitrage
Arbitrage is an attempt to make risk-free profits from temporary price discrepancies that may exist within or between markets.
F l i d bit i t t d i d t fit f t i diff
For example, index arbitrage is a strategy designed to profit from temporary price differences between a derivative (such as a stock index future/option) and an underlying basket of shares. By buying one and selling the other, an index arbitrageur trader can sometimes exploit market
inefficiencies. If the arbitrageur feels that a stock index future is trading below its fair value (and is thus undervalued), then it can buy the future and sell the underlying basket of shares. Conversely, if the arbitrageur feels the index future is overvalued, it will sell the future and buy the underlying basket. Index arbitrage is undertaken via computerized program trading that enables the
simultaneous execution of a large number of transactions.
Since there is a requirement to simultaneously buy and sell stocks and futures, index arbitrage can involve significant transaction costs – such costs can often render an arbitrage opportunity
unprofitable. There are a number of different arbitrage opportunities that exist from time to time, but almost all of them are temporary short-lived and caused by temporary anomalies in the
almost all of them are temporary, short-lived, and caused by temporary anomalies in the
marketplace. Because such 'free lunches' are eliminated quickly, arbitrageurs are generally market professionals who have access to fast information, convenient execution opportunities, and lower
Synthetic Asset Exposure
Synthetic asset exposure involves the use of derivatives to create exposure to the price fluctuations in an underlying asset without actually investing in the asset itself.
L t' th t XYZ 5 b d i ldi 150 b i i t t i A tf li
Let's assume that XYZ 5-year bonds were yielding 150 basis points over treasuries. A portfolio manager who wanted to get exposure to these bonds, but didn't think it was a feasible to buy the bonds in the open market (either there weren't any available, or the market was so thin that he's have to pay too high a bid-ask spread) could use CDS to accomplish the same thing:
‣ Buy 5yr treasuries and hold them as collateral and sell 5yr CDS protection on XYZ in equal amounts
The portfolio manager then receives the interest on the treasuries, and would get a 150 basis point l i th CDS If XYZ d f lt h ll th t i d th CDS b If annual premium on the CDS. If XYZ defaults, he sells the treasuries and pays the CDS buyer. If XYZ stays solvent, he keeps the treasuries and receives interest plus CDS premium for 5 years. ‣ This effectively replicates what he would have received had he bought the cash bonds.
Wh th h ll thi t bl ? O i ht b th t th ' t h li idit i th k t
Why go through all this trouble? One reason might be that there's not enough liquidity in the market for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there
Do Derivatives Create Risk?
The Great Derivatives Smackdown
‣ “…financial weapons of mass destruction carrying dangers that, while now latent, are
t ti ll l th l ” W B ff tt 2003
potentially lethal.” -- Warren Buffett, 2003
‣ “What we have found over the years in the marketplace is that derivatives have been an
extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” -- Alan Greenspan, 2003g p g , p ,
Buffett has modified his position a bit, at least implicitly:
‣ Berkshire Hathaway has disclosed that it has 251 derivatives contracts that could require $67.29 billion in payments (assuming a 100% loss scenario), including put options on the major stock p y ( g ) g p p j indexes, credit linked notes and credit default swaps. Buffett has distinguished his portfolio from those held by others in two ways – Berkshire receives large payments upfront and never posts collateral.
Whil G h d ti f hi iti d i ti
While Greenspan has come under scrutiny for his position on derivatives:
‣ Greenspan has stated the true culprits of this crisis were the bankers whose self-interest he had once relied upon. “They gambled that they could keep adding to their risky positions and still sell
Risks are not always apparent…
Perhaps a more accurate indication of derivatives' risks can be gauged from the Chairman of the Group of Thirty, Paul Volcker, in the 1993 report on 'Derivatives: Practices and Principles':
“ d i ti b th i t d t i t d i k f f d t ll diff t ki d f t “…derivatives by their nature do not introduce risks of a fundamentally different kind or of a greater
scale than those already present in the financial markets.”
Volcker's statement that derivatives risks are not 'fundamentally different' to those that exist anyway in financial markets (principally market, credit, and operational risk) is essentially true. y y (p p y , , p ) y
These are same types of risks that banks face in their 'traditional' business lines and which are endemic to traditional financial contracts such as deposits and loans, mortgages, commercial paper, and so on.
‣ Market Risk ‣ Credit Risk
‣ Operational Risk
However, the manner in which these risks manifest themselves in derivatives transactions can be significantly different.
Market Risk
Market risk is the risk that price movements adversely affect a derivatives portfolio.
These risks vary depending on the type of investments:
‣ Linear investments – the best example of a linear investment is a portfolio of stocks. The profit/loss on a stock portfolio is linear to the size of the market movement because the payoff is a straight line. The change in the value of the position is equal to the change in the underlying prices. Forwards and futures often have a linear payoff as well.
p p y
‣ Convex instruments –Bonds have a fixed, predictable relationship – bond price and yields are inversely related. If bond price increases, the yield decreases, and vice versa.
Market Risk
Unlike stocks and bonds, options are problematic to risk manage.
‣ Options respond differently to changes in the value of the underlying depending on where they i i ll t k (i th t th t f th )
were originally struck (in the money, at the money, or out of the money).
‣ Option writers are exposed to potentially unlimited losses if they write naked options and these options end up in the money.
Because of these and other complexities options and other complex instruments are valued using
Because of these and other complexities, options and other complex instruments are valued using mathematical models that incorporate factors such as volatility and other market factors.
Credit Risk
Credit risk (also called counterparty risk) is the risk that your counterparty fails to perform its obligations in respect of a derivatives transaction.
I t diti l b ki dit i k t If I l d $100 f 5 I h d d
In traditional banking, credit risk was easy to measure. If I loaned you $100 for 5yrs, I had agreed to accept $100 of exposure to you for 5yrs.
However, derivatives exposures change daily and fluctuate between the parties.
‣ In swaps and forwards the credit exposure at inception is zero no payments are made ‣ In swaps and forwards, the credit exposure at inception is zero – no payments are made.
However once the markets move, credit exposure is generated. For instance, if I buy protection on GM from you at 100bps, and the price then moves to 200bps, I am “in the money”. However, if you are Lehman, when you default I lose the positive present value of my swap – replacement i t t k t Th i k iti t d b th ISDA d t ti
is at current market. These risks are mitigated by the ISDA documentation.
‣ In futures, credit risk is minimal because the credit risk of the counterparty is swapped for that of the central clearinghouse, initial margin is posted, and variation margin is paid as the price
changes. changes.
‣ In options, the buyer takes all the credit risk of the option writer (usually a dealer). Buyer pays upfront and takes exposure until he exercises his option AND receives the underlying asset or
Operational Risk
Operational risk is a broad category covering many different types of risk. Defined by the Basel Committee as 'the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events‘. y
Most of the significant losses to date from derivatives activities have arisen from operational failures –the cases of Barings, Daiwa, AIB/Allfirst, and National Australia Bank being prime examples.
‣ Probably the most notorious example is that of Jerome Kerviel, blamed by Societe Generale SA for its 4.9 billion-euro ($6.9 billion) trading loss in 2008. Societe Generale said the trading loss, disclosed on Jan. 24, 2008, came after it sold positions that Kerviel had taken without
authorization and hidden with faked hedges. authorization and hidden with faked hedges.
In each of these cases, derivatives traders circumvented internal risk management controls with the result that the banks suffered significant, sometimes detrimental losses from their derivative positions.
However, operational risk also incorporates the concept of legal risk – basically the risk that derivatives contracts will not be legally enforceable (which typically becomes a concern in the
Operational Risk
How does operational risk arise in derivatives?
‣ Complexity – unlike cash bonds and stocks, derivatives require some explanation to understand. Th b k b i li d t d f t th i t d i t f i k l ti
Thus, bank managers may be inclined to defer to their traders in terms of risk evaluation. ‣ Leverage – unlike cash markets, trading desks can conceal the taking of large risk positions in
derivatives because the amount of upfront cash commitment is so small. Thus, a trader can put on a risky position without attracting too much attention.y p g
‣ Volume – growth in derivatives market created new operational challenges for payment, settlement, and documentation. Every contract must be properly booked and the appropriate documentation must be negotiated.
Model Risk
Model risk can be defined as the risk of loss arising from the failure of a model to match reality sufficiently, or to otherwise deliver the required results. It can arise from a number of issues, including:g
‣ invalid assumptions (for instance, assuming a lognormal distribution when the true distribution is actually fat-tailed)
‣ mathematical errors (for example, in determining the formulas for valuing more complex financial ( p , g g p instruments)
‣ inappropriate parameter specification
‣ the lack of transparent market prices for some of the more illiquid market factors p p q ‣ errors in implementation ('implementation risk')
Because they are based on assumptions, models are always a simplified representation of what happens under real-life conditions. If these assumptions break down, as they can do particularly under extreme market conditions, then the model is rendered virtually worthless.
P
t 3
Part 3
Introduction to
Introduction to
Drafting a Derivatives Contract
So now that we’ve reviewed (quickly) the universe of derivatives, what comes next?
Derivatives Documentation
Significant efforts on the part of many industry bodies, most notably the International Swaps and Derivatives Association (ISDA), have clarified most of the broad legal and contractual issues around swaps. p
ISDA and other bodies have made similar efforts to standardize and clarify these same issues for other financial products.
There are now master agreement forms for many financial products that create a common legal g y p g framework that can be understood by all market participants.
These master agreements cover most, if not all, of the major legal points that should be agreed as part of documenting the transactions to which they relate.
Development of documentation
The 1980’s saw a dramatic rise in the use of interest rate swaps in corporate finance transactions ‣ Interest rate swaps, including caps, floors, and collars became a common feature in large
syndicated loan deals.
— Borrowers would pay a premium to ensure that their floating rate loan would never exceed a certain percentage (cap), would remain within a band like 5-8% (collar), or, if they were a company with high deposit balances, never fall below a level (floor).
‣ ISDA was formed in 1985 with 10 members to address the documentation needs of this new ‣ ISDA was formed in 1985 with 10 members to address the documentation needs of this new
market.
— 1987 – Interest Rate and Currency Exchange Agreement or IRCEA
— 1992 – first ISDA Master Agreement published1992 first ISDA Master Agreement published
— 2002 – revised ISDA Master Agreement published (actually Jan 8, 2003)
‣ Additionally, since 1991 ISDA has published 11 Definitional Booklets which provide standard terms for each product type
DOCUMENTATION FOR DERIVATIVES
ISDA “Architecture”
The three primary components of this legal framework are:
‣ ISDA Master Agreement, which governs the legal and credit relationship between the parties and can be used to document a range of different types of transactions (it is “multi-product”).
‣ Confirmation, which is the contract that covers the individual transaction and records the particular economic terms of a transaction
particular economic terms of a transaction.
‣ Definitions, which are booklets that allow the parties to streamline the documentation of transactions in the confirmations.
Standardized documentation facilitated dramatic growth in derivatives from 1992
Standardized documentation facilitated dramatic growth in derivatives from 1992–
2008.
ISDA MASTER AGREEMENT
The ISDA Master Agreement allows parties to document all derivatives transactions under a single contract. This facilitates cross-product netting, and reduces credit risk through the use of collateral (also known as credit support or variation margin).
( pp g )
The structure of the ISDA Master Agreement is:
‣ A Printed Form which makes up the first 18 pages of the agreement. The parties may elect to use either the 1992 or 2002 version.
‣ The Schedule is the part of the agreement that is negotiated between the parties. Some key terms include whether the agreement will be governed by New York or English law, and designation of Additional Termination Events.
‣ The Credit Support Annex (CSA) is a standard form mark-to-market collateral agreement used to document the conditions and mechanisms for any pledge, transfer, or substitution of collateral.
KEY SECTIONS OF THE ISDA MASTER
Netting of Payments. Sec. 2(c) allows the parties to elect whether or not they wish to provide
payment netting across transactions.
E t f D f lt S 5( ) t i l d F il t P D f lt U d S ifi d T ti
Events of Default. Sec. 5(a) events include Failure to Pay, Default Under Specified Transactions,
and Bankruptcy. Upon the occurrence of one of the Events of Default, the non-defaulting party is allowed to terminate the ISDA Master Agreement.
Termination Events. Sec. 5(b) events include Additional Termination Events as specified in the ( ) p Schedule to the ISDA Master. Upon the occurrence of a Termination Event, one or more
Transactions under the ISDA Master Agreement may be terminated.
Early Termination. Sec. 6(a) outlines the mechanisms (i.e., timing, notices, and method for
l l ti ) f t i ti th ISDA M t th d i ti f E l T i ti D t calculations) for terminating the ISDA Master upon the designation of an Early Termination Date following an Event of Default or Termination Event.
CSA—OVERVIEW
The standard ISDA Credit Support Annex is a bilateral mark-to-market security agreement. To avoid building up large counterparty risk, market participants agree to provide collateral to cover changes in contract values, similar to a margin account.g , g
Mark-to-market, calculated on a portfolio basis, allows parties to collateralize the value of a trade in the event that it is terminated.
Key Terms include:y
‣ Threshold, or the unsecured risk, is the minimum level beyond which collateral must be posted. ‣ Minimum Transfer Amount designates the minimum increments of collateral that will be
posted. p
‣ Eligible Collateral is the agreed-upon and acceptable collateral, and can be listed in a Schedule attached to the CSA. Eligible Collateral often includes cash and certain U.S. government
obligations.
‣ Independent Amount, or the initial collateral, can be specified in the CSA or on a transaction-by-transaction basis in each Confirmation.
CONFIRMATIONS
Standardization
‣ Credit default swap documentation has been standardized through the publication of the 2003 C dit D i ti D fi iti ( d i S l t )
Credit Derivatives Definitions (and accompanying Supplements).
‣ Confirmations are produced for every transaction, with many terms standardized by the market.
Master Confirmations
‣ Parties can negotiate a standard form confirmation for credit default swaps, agreeing certain cross transaction terms, such as most Credit Events and Settlement Terms. Specific transaction terms such as Trade Date, Effective Date and Scheduled Termination Date, Buyer and Seller, and Reference Entity are then agreed by the parties in a one-page Transaction Supplement to y g y p p g pp each transaction.
‣ Currently, Master Credit Derivative Confirmation Agreements are available for single name CDS, indices (CDX), standard tranches (CDX tranche), and bespoke tranches (Global Bespoke
M t ) Master).
CONFIRMATIONS
Automation
‣ DTCC-eligible trades currently include vanilla CDS on single names, indices, and standard t h
tranches.
‣ DTCC’s automated confirmation services accommodate virtually all standard CDS transactions and are fully integrated with Mark-it Partners’ reference entity data (RED).
‣ In addition to new trades DTCC can be used for partial and full terminations and assignments ‣ In addition to new trades, DTCC can be used for partial and full terminations and assignments
Confirmations
As discussed, if two market participants have entered into an ISDA Master Agreement, then, each time they enter into a transaction, they only have to negotiate and document the economic terms of the transaction.
Confirmations are the documents in which the parties record those economic terms. The ISDA Master Agreement itself provides that the agreement includes the Schedule and the documents and other confirming evidence exchanged between the parties confirming individual transactions.
Further, each Confirmation is identified (or should be identified) either in its own terms or through another effective means as a "Confirmation", and states that it supplements, forms a part of, and is subject to, the ISDA Master Agreement between the parties.
I thi th i i f th t t ti d t d i C fi ti
Confirmation Types
Confirmations
The use of Confirmations to document the economic terms of transactions
again
illustrates
the
modular
architecture
of
ISDA
documentation
again
illustrates
the
modular
architecture
of
ISDA
documentation.
Confirmations come in two forms: long-form and short-form.
‣ Long-form: a long-form Confirmation itself contains, in full, all the terms
necessary to document the economic terms of the transaction.
y
This is
often the approach taken by parties who have not yet executed an ISDA
Master Agreement.
‣ Short-form: a short-form Confirmation does not contain all the terms
t d
t th
i t
f th t
ti
It
li
necessary to document the economic terms of the transaction. It relies on,
and incorporates, standard terms and provisions that are already contained
in another document (or documents), such as a set of ISDA Definitions and
a Master Confirmation. This enables the use of shorthand terms in the
C
f
f
Confirmation, and avoids the need to set out in full various operational
provisions. The terms and provisions contained in that other document
Confirmation Types
Confirmations
Why the distinction?
‣ In the past, when a market in a new type of derivatives transaction has
developed, ISDA has traditionally published a long-form Confirmation for
use in documenting that type of transaction (for example, one long-form
Confirmation that is still frequently mentioned, although now superseded, is
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y
,
g
p
,
the 1997 Confirmation of OTC Credit Swap Transaction, prepared for use
in documenting a credit default swap, which at the time was a relatively
new type of transaction).
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t
d
d
h
d
l
d
‣ Then, when a new market has matured, and a consensus has developed
among those active in that market, ISDA has traditionally prepared a set of
Definitions, together with one or more short-form Confirmations. Until the
market has matured and that consensus has developed, it would probably
f
f
not be productive to try to prepare a standard set of Definitions.
‣ As time went on, ISDA also developed Master Confirmation forms for each
liquid “flow” product.
Confirmations – Start with the ISDA Definitions
ISDA Definitions
When used in the ISDA sense, "Definitions" are the various booklets of standard definitions and th t d i i bli h d b ISDA f i d ti diff t t f d i ti other terms and provisions published by ISDA for use in documenting different types of derivatives transactions. Generally, and broadly, each set of Definitions provides relevant terms for
documenting a particular type of derivatives transaction.
By incorporating one or more relevant sets of definitions into the confirmation for a particular y p g p transaction, the parties are able to use standard shorthand terms in the confirmation (those terms being defined in the applicable definitional booklet(s)).
The definitional booklets also provide various standard operational provisions, so the parties do not d t t th t i f ll i th fi ti
need to set these out in full in the confirmation.
2006 ISDA Definitions (interest rate swaps)
2003 ISDA Credit Derivatives Definitions (plus supplements)
2002 ISDA Equity Derivatives Definitions
Confirmation Types
Confirmations
Short-form Confirmations rely on Definitions.
‣ They do this by stating that they incorporate a particular set (or sets) of Definitions. However, while they do a lot of the work for the parties, ISDA Definitions do not take care of everything. The Definitions themselves only provide a framework for documenting a transaction. It is still up to the parties to make various choices and to document the economic terms of the transaction p itself in the short-form Confirmation.
‣ The parties are also free, of course, to amend the terms of the relevant Definitions or include additional provisions in the short-form Confirmation itself. While the terms of the Definitions
t th lt f t i i d t lt ti th ill t b i t f represent the result of an extensive industry consultation process, they will not be appropriate for documenting all transactions without amendment or additional provisions.
Unlike ISDA's sample long-form Confirmations, which are published as standalone documents, ISDA's sample short-form Confirmations are published as part of a set of Definitions.
ISDA s sample short form Confirmations are published as part of a set of Definitions.
‣ So, if someone is looking for ISDA's sample short-form Confirmation for an equity swap, they will find it at the back of the 2002 Equity Derivatives Definitions.
ISDA Confirmation Templates
Confirmations - Overview
Standardization
Product documentation has been standardized through the publication of
ISDA Definitions (and accompanying Supplements).
Confirmations are produced for every transaction, with many terms
standardized by the market
standardized by the market.
Standardization, Master Confirmations and automation have contributed
to the increase in market volume and liquidity in the credit derivatives
market.
ISDA/Markit Partners
Master Confirmations
Parties can negotiate a standard form confirmation for credit default swaps,
agreeing certain cross transaction terms such as most Credit Events and
agreeing certain cross transaction terms, such as most Credit Events and
Settlement Terms among other terms. Specific transaction terms such as
Trade Date, Effective Date and Scheduled Termination Date, Buyer and
Seller, and Reference Entity are then agreed by the parties in a one page
T
ti
S
l
t f
h t
ti
t
d i t
Transaction Supplement, for each transaction entered into.
For example Master Credit Derivative Confirmation Agreements are available
for:
i
l
CDS
E
N th A
i
& A i P
ifi E titi
single name CDS on European, North American & Asia-Pacific Entities
CDX IG, HY and XO
CDX Emerging Markets
iTraxx Europe, Japan and Asia
DTCC
Automation
DTCC’s automated confirmation services accommodates
virtually all standard CDS transactions and is fully integrated
virtually all standard CDS transactions and is fully integrated
with Mark-it Partners’ reference entity data (RED) service.
DTCC eligible trades currently include vanilla CDS on single
names and indices, partial and full terminations and
, p
assignments (if the original trade was confirmed through
DTCC). The parties must have a Master Credit Derivatives
Confirmation in place.
Deriv/SERV’s Matching and Confirmation Service
Automates the legal confirmation process for OTC derivatives, including credit, equity
and interest rate derivatives.
‣ Today more than 80% of credit derivatives traded worldwide are electronically
‣ Today, more than 80% of credit derivatives traded worldwide are electronically
confirmed with Deriv/SERV.
Global dealers and buy-side firms can automatically process OTC derivatives trade
information via Deriv/SERV through the following options:
g
g p
‣ Matching: used by most firms, parties submit transaction details to DTCC
Deriv/SERV using either computer-to-computer messaging or spreadsheet Internet
upload. If the transaction fully matches, it is reported as a confirmed match. If there
fi ld
th t d
t
t h th
t
t
ti
ll
t
th
ll
i
are fields that do not match, the system automatically reports them, allowing
customers to view discrepancies in real time and submit new or enhanced data.
‣ Affirmation: used primarily by lower volume and buy-side firms, parties view trades
“alleged” against them on-line and either accept the trade details or suggest
alleged
against them on line and either accept the trade details or suggest
modifications. When modifications are
suggested, Deriv/SERV automatically
Deriv/SERV Trade Information Warehouse
What Is the Trade Information Warehouse?
The Trade Information Warehouse is a centralized and secure global
infrastructure for processing over the counter (OTC) derivatives over
infrastructure for processing over-the-counter (OTC) derivatives over
their life cycle, which could extend for years.
It consists of two components:
‣ A comprehensive trade database containing the primary record
‣ A comprehensive trade database containing the primary record
of each contract;
‣ A central technology infrastructure that automates and
standardizes trade processing, such as record keeping, payment
p
g,
p g, p y
calculations and settlement, notional adjustments and contract term
changes over a contract’s life.
Deriv/SERV Trade Information Warehouse
Why Use the Warehouse?
The Trade Information Warehouse provides a securely managed
central database of contract information It assigns a unique DTCC
central database of contract information. It assigns a unique DTCC
transaction reference number that can be used to positively identify
each contract. This number provides the starting point for
reconciliations and processing over the life of the contract.
The existence of a central database relieves participants of the onus
of handling event processing and payment calculations, while also
offering settlement capabilities. Post-confirmation processes, such as
credit event processing and assignment processing, will be made
credit event processing and assignment processing, will be made
more efficient. Over time, the Warehouse will significantly reduce
operational risks and costs, reinforcing the safety of the market and
contributing to its expansion.
Deriv/SERV Trade Information Warehouse
Will Credit Event Processing Work?
A major challenge in the industry today is processing the effects of a
credit event which may or may trigger protection on a credit contract
credit event, which may or may trigger protection on a credit contract.
Today’s process relies on phone calls, e-mails and faxes establish
the correct industry implementation each event.
DTCC has designed a process that will be built the Warehouse to
g
p
enable firms to view the details each event, associate their accounts
and trades with a specific event, communicate with their
counterparties and view the economic effects event applied in an
automated way to both coupons and the net cash settlement for an
automated way to both coupons and the net cash settlement for an
event.
Deriv/SERV Trade Information Warehouse
How Does the Trade Information Warehouse Work?
‣ Market participants confirm a new contract or post-trade event in
Deriv/SERV such as:
Deriv/SERV, such as:
—
New trade
—
Full or partial termination
—
Full or partial assignment
—
Increase
—
Amendment
Deriv/SERV Trade Information Warehouse
How Does the Trade Information Warehouse Work?
‣ All trades confirmed on Deriv/SERV are automatically sent to the Warehouse. Unconfirmed t d fl t d “ di ”
trades are reflected as “pending.”
‣ The Warehouse assigns a unique DTCC reference identifier for each contract, and performs automated record keeping to maintain the “current state” contract terms, taking into account post-trade events.
‣ The Warehouse provides customers with a comprehensive suite of reports that gives a snapshot of all their trades registered in the Warehouse. Reports can be delivered electronically overnight for the start of business each day (through a computer-to-computer connection), or requested on
ff b i f th D i /SERV W b li ti f d li i ht d d l d d a one-off basis from the Deriv/SERV Web application for delivery overnight and downloaded straight onto your computer.
P
t 4
Part 4
Legal Issues in
Legal Issues in
Certain Legal Issues
As new products developed, there were new legal and documentation challenges to overcome: ‣ Capacity issues
— Hammersmith & Fulham ‣ Insurance / CDS
‣ Authority questions
‣ Counterparty Relationships and Duties
— P&G, Orange County
‣ Enforceability of close out netting and set offEnforceability of close out netting and set off ‣ Credit Support and collateral enforcement ‣ Regulatory issues
C diti F t E h A t f 2000
— Commodities Futures Exchange Act of 2000
Capacity
What is capacity?
‣ The legal ability of an individual or entity to enter into a legally binding contract.
Before entering into an ISDA Master Agreement and transacting with a counterparty, it
is necessary to view its organizational documentation to determine if it has explicit
powers to transact in derivatives.
Note that this is a different question than that of authority
capacity is the legal ability
Note that this is a different question than that of authority – capacity is the legal ability
of an entity or individual to transact, authority is the right of a person to act on behalf of
such entity or individual in transacting.
Legal opinion or board resolutions typically covers the question of capacity.
g
p
yp
y
q
p
y
‣ Outside counsel will also research local laws for specific issues especially
when the counterparty is a municipal, state or federal government agency or
affiliate.
Hammersmith and Fulham
During 1988/1989, the municipality entered into over 500 derivatives contracts with a total notional value of £6 billion.
Th i i lit lli ti d i t t t d i th d t fi
‣ The municipality was selling options on pound interest rates and using the proceeds to finance civic activities.
‣ There was no clear hedging – apparently these were purely speculative trades.
As rates moved against the option seller losses accrued When the municipals were unable to
As rates moved against the option seller, losses accrued. When the municipals were unable to pay, the buyers sued for summary judgment.
‣ Hammersmith’s auditor asserted the trades were void ab initio due to the doctrine of ultra vires, i.e. they didn’t have the authority to write these options in the first place, so they never existed at y y p p y all.
‣ The court found for the municipality and invalidated all transactions “other than transactions entered into for the purpose of interest rate management” – all of the money losing options. ‣ Dealers had relied on qualified legal opinions regarding ability of local authorities to execute
Counterparty Relationships and Duties
Possible causes of action arising from derivatives transactions:
‣ Breach of fiduciary duty
‣ Fraud
‣ Negligence and negligent misrepresentation
‣ Breach of implied covenant of good faith and fair dealing
‣ Suitability (lack thereof)
Proctor & Gamble
In 1993, P&G needed to refinance its maturing debt
‣ Rather than issue a bond or take a loan, it chose to enter into a structured transaction with B k T t th th l d i th t t d d t k t
Bankers Trust, then the leader in the structured products market. ‣ Transaction was $200mm for 5yrs.
— P&G received 5.30% p.a. and paid floating rates equal to CP rate – 75bps for 6 months
— After 6 months, P&G paid CP rate – 75 bps + SPREAD.
— The trick lies in the spread calculation:
• [98.5 x (5yr Constant Maturity Treasury /5.78% )– 30yr Bond Price]/100 • Trade was highly sensitive to movements at 5yr part of the yield curve
— When US Treasury rates increased, the yield curve flattened, and SPREAD shot up ‣ P&G ended up paying CP rate + 14.10% p.a., losing $157mm in the processP&G ended up paying CP rate 14.10% p.a., losing $157mm in the process
