DERIVATIVES DOCUMENTATION

Class 1

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
DOCUMENTATION
2-2:15pm PM break
2:15
2 15 3pm
3
LEGAL ISSUES AND ISDA DOCUMENTS
**times are approximate / subject to change**

P t1
Part
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 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:
p , Arcane Instruments
Contains Complex,
Extremely Risky and Volatile
Difficult to Evaluate
May
M Create
C t Undesired
U d i dE
Exposures and
dM
May C
Cause S
Substantial
b t ti l L
Losses

Historical Examples of Derivatives

As a testament to their usefulness, derivatives have played a role in commerce and finance for
thousands of years.
Th
The 'Code
'C d off Hammurabi',
H
bi' the
th famous
f
sett off ancient
i t Babylonian
B b l i laws,
l
has
h a provision
i i by
b which
hi h
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
y B.C. ((Politics,, chapter
p 9).
)
the 4th century
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 1840s.

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.
later
These contracts were eventually standardized
around 1865, and in 1925 the first futures
clearinghouse was formed.
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
y in sterling
g with an option
p
to p
pay
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 CME launches futures contracts on currencies
1973 The Black-Scholes model, as it came to be known, set up a mathematical framework that
f
formed
d the
th b
basis
i ffor an explosive
l i revolution
l ti iin th
the use off d
derivatives.
i ti
CBOE beings
b i
trading
t di off
listed options.
1977 Continental Illinois Limited (First Interstate) completed $25mm 10y (US$ / GB) swap
1981 World Bank and IBN execute currency swap (US$ / DM and CHF)
1987 Black Monday and the stock market crash
1994 large losses on derivatives trading announced by Procter and Gamble, Gibson Greetings,
and Metallgesellschaft
Metallgesellschaft. Orange County,
County California declared bankruptcy due to the use of leverage
in a portfolio of short- term Treasury securities and Englands 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:
customized privately negotiated derivatives,
derivatives which are known
OTC: customized,
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
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 contractincluding delivery places and dates, volume, technical
specifications,
ifi ti
and
d ttrading
di and
d credit
dit proceduresare
d
standardized
t d di d ffor each
h ttype off contract.
t t
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 exchanges
clearinghouse; for OTC derivatives, the exposure is to default by the counterparty.
g
measures, such as regular
g
mark-to-market and margining,
g
g are
Fourth, credit risk mitigation
automatically required for futures but optional for swaps.
Finally, futures are generally subject to a single regulatory regime in one jurisdiction, while
swapsalthough usually transacted by regulated firmsare transacted across jurisdictional
b
boundaries
d i and
d are primarily
i
il governed
db
by th
the contractual
t t l relations
l ti
b
between
t
th
the parties.
ti
V
Various
i
products, including futures contracts and exchange-traded options, fall within the generic
category of futures, but all have the common characteristics described above. The definitions
that follow refer exclusively to privately negotiated (OTC) derivatives.

10

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
paymentt obligations
bli ti
ffor d
derivatives
i ti
contracts
t t are calculated.
l l t d
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'
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
p notional amount is independent
p
of the loan and does not change
g when the loan
loan, the swap's
is repaid or its principal amount otherwise changes.

11

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
future
date
d t for
f an agreed
d 'forward'
'f
d' price.
i
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
contracts, or combined with other financial instruments to create structured derivative products.

12

Forwards
Forward contracts
Forward contracts represent agreements for delayed delivery of financial instruments or
commodities
diti in
i which
hi h the
th b
buyer agrees tto purchase
h
and
d th
the seller
ll agrees tto d
deliver,
li
att 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
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).

13

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
money.

14

Options

OPTIONS
An option is an agreement that gives the buyer, who pays a fee (premium), the rightbut not the obligationto
b or sellll a specified
buy
ifi d amountt off an underlying
d l i assett att an agreed
d upon price
i ((strike
t ik or exercise
i price)
i ) on or until
til
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
g swaps
p themselves Swaptions.
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
buyer
exercises
i
hi
his or her
h option
ti to
t sellll on or before
b f
the
th option
ti expiration
i ti d
date.
t
Two basic option positions
Long (buy)
Short (write)

15

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
are subject
bj t tto symmetric
t i and
d offsetting
ff tti paymentt obligations.
bli ti
IIn an option,
ti
th
the b
buyer purchases
h
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 interestsuch
as ownership
hi iin th
the underlying
d l i assetin
t i th
the option.
ti
Options also give you leverage.
If you buy options, you have good leverage, i.e. you cant lose more than what you paid.
If you write options, you have bad leverage, i.e. you cant make more than what you received
from the buyer and your loss is potentially infinite (if you write calls).

16

Swaps
A swap is simply a series of forward contracts, repeated over a specified period.
Swaps market began to develop in the mid-1980s
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 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 aboveabove
market returns.

17

Recent History of OTC Derivatives

1987 ISDA develops the first master agreement for interest rate swaps (called IRCEA).
1992 ISDA publishes the 1992 ISDA Master Agreement (Multicurrency Cross-Border).
g losses on derivatives trading:
g
1994 the derivatives world was hit with a series of large
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
s venerable Barings Bank declared bankruptcy due to speculative trading in futures
England
contracts by a 28- year old clerk in its Singapore office.
1997 Asian currency crisis
1998 Russia defaults; LTCM collapses
2001 nascent CDO market collapses
2002 ISDA publishes the 2002 ISDA Master Agreement
2008 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
extended
t d d an $85 billi
billion credit
dit liline tto avertt systemic

t i failure.
f il If AIG had
h d collapsed,
ll
d ad
dozen other
th
big financial companies that were counterparties in its derivative trades and insurance contracts
might have gone down along with it. By the end of 2008, more than $60 billion was paid to AIG
counterparties.

18

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.

19

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
), the notional amount of interest rate derivatives outstanding
g in the OTC market
Settlements ((BIS),
alone was over USD 346 trillion (as of June 2007). A further USD 71 trillion in exchange-traded
futures and options contracts was outstanding.

There is a whole range of interest rate derivatives available, and they can be used to cover interest
rate exposures from overnight out to 50 years. Apart from hedging (risk management), interest rate
derivatives can also be used for speculative (risk taking) purposes.

20

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
An IRS is
i a fforward-type
dt
derivatives
d i ti
contract
t t whereby
h b one party
t agrees to
t exchange
h
cash
h fl
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.

In terms of notional amounts outstanding, by far the most popular form of interest rate derivative is the interest rate swap (IRS).

21

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.

22

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
y agree
g
((FRA rate)) is the p
price of the FRA as it is q
quoted by
y the market. By
y doing
g so,, the
which they
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.
Swaptions: OTC options to enter into a specified interest rate swap at a future date.

23

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
p of the underlying
y g asset.
ownership
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').
From 2003-2007 credit derivatives were the fastest growing segment of the derivatives market.

24

Growth primarily in credit index trades

However, much of that growth was driven by CDS index trading
between primarily dealers.

25

Foreign Exchange Derivatives

Currency derivatives: There are a number of different derivatives that can hedge currency or FX
exposure.
O
Outright
t i ht forwards:
f
d parties
ti agree to
t exchange
h
cash
h fl
flows in
i ttwo different
diff
t currencies
i att an agreed
d
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.
p Parties exchange
g currencies at the p
prevailing
g spot
p rate,, then agree
g
to reverse the
FX swaps:
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
Currency ffutures
t
and
d listed
li t d options:
ti
C
Contracts
t t ffor the
th purchase
h
or sale
l off fforeign
i currency.
These contracts make up a small proportion of the exchange traded derivatives markets.

26

Equity Derivatives
Equity Derivatives
Equity Options / Index Options: Give the buyer the right to buy/sell a particular stock or an index
lik th
like
the S&P500
S&P500, FTSE 100 or Nikkei
Nikk i 225 att a future
f t
date.
d t
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
g leg).
g)
financing
Equity Forwards: Contract to buy or sell a stock or basket of stocks at a particular price on or
before a future date.
p
allow for trading
g in different types
yp of
Customized versions or combinations of options/forwards
risk related to these indices such as volatility/variance swaps or options on the indices
straddles, strangles, butterflies, etc.
2002 Equity Derivatives Definitions are incorporated by reference.

27

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,
g
p
products,, coal,, and electricity.
y
agricultural
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.

28

Derivative Markets Unwind

ISDA reports that the three largest derivatives markets shrank between June 2008 and January
2009:
CDS notional
ti
l amountt was $38.6
$38 6 trillion
t illi att year-end
d 2008
2008, d
down 29 percentt ffrom $54
$54.6
6 ttrillion
illi att
mid-year 2008.
Interest rate derivative notional amount was $403.1 trillion at year-end, a decline of 13 percent
p
to $464.7 trillion at mid-year
y
2008.
compared
Equity derivative notional amount fell to $8.7 trillion at year-end 2008, down 13 percent from midyear 2008, when equity derivatives notionals were $11.9 trillion.
g
structural changes
g have been made to the OTC derivatives markets and more have
Significant
been proposed by President Obama and Congress, ranging from the complete ban of OTC
derivatives to the requirement that standardized derivatives be centrally cleared and processed.

29

P t2
Part
Derivatives Markets

30

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 Enhancement
Arbitrage
Synthetic asset exposure

31

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
g
and supranational
p
entities. Clients are often referred to as the 'buy
y
treasurers,, and governmental
side' of the market.
Much of the growth in derivatives volumes in recent years has been driven by hedge funds.
y hedge
g funds are designed
g
to be leveraged,
g , which allows them to control large
g p
positions
Many
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 ffund
fully
d positions
iti
iin th
those assets,
t are a primary
i
ttooll ffor achieving
hi i lleverage.
Additionally, derivatives allow investors to go short as well as long which is not always possible
in the cash markets.
L
Leverage and
d th
the ability
bilit tto short
h t means th
thatt th
the extensive
t
i use off d
derivatives
i ti
iis a given
i
ffor much
h
of the hedge fund sector.
Because of this, product development and sales and marketing departments at brokerages and
g are constantly
y looking
g at new p
products to attract hedge
g funds.
exchanges
32

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
derivatives
on b
behalf
h lf off th
their
i clients.
li t Th
They make
k money b
by charging
h i a commission
i i ffor executing
ti a
client order.
Agents in the derivatives marketplace operate on a 'give-up' basis if they find two
p
with matching
g needs,, they
y introduce the two p
parties. If these two p
parties have
counterparties
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
facilitating client transactions.

33

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,
grain
i ttraders,
d
etc.
t
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,
as changes in the value of the contract are either added to or subtracted from it.

34

Hedging
Hedging generally involves entering into a transaction
where the gains/losses from the 'hedge' will offset the
gains/losses in the underlying'
g
y g p
position. For example,
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
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.
Derivatives provide an efficient method for end users
to manage their exposures to fluctuations in market
prices/rates
prices/rates.
35

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
Apartt from
f
the
th creation
ti off such
h direct
di t price
i exposure, a kkey attraction
tt ti off using
i derivatives
d i ti
ffor
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
gold today
y in the spot
p market or enter into a g
gold futures contract. With g
gold at $940 p
per
the g
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.
IInstitutional
tit ti
l investors
i
t
and
d portfolio
tf li managers can also
l employ
l derivatives
d i ti
tto enhance
h
assett yields.
i ld
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 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
market).
This is referred to as a covered call position. Options traded without any underlying position are
referred to as naked positions.
36

Arbitrage
Arbitrage is an attempt to make risk-free profits from temporary price discrepancies that may exist
within or between markets.
F
For example,
l index
i d arbitrage
bit
iis a strategy
t t
designed
d i
d to
t profit
fit from
f
temporary
t
price
i differences
diff
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
temporary, short-lived,
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
trading costs.

37

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
Let's
t' assume that
th t XYZ 5-year
5
b d were yielding
bonds
i ldi 150 b
basis
i points
i t over ttreasuries.
i
A portfolio
tf li
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
annuall premium
i
on th
the CDS
CDS. If XYZ defaults,
d f lt he
h sells
ll the
th treasuries
t
i and
d pays the
th CDS buyer.
b
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
Why go through
th
h allll this
thi ttrouble?
bl ? O
One reason might
i ht b
be th
thatt th
there's
' nott enough
h liliquidity
idit iin th
the market
k t
for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there
might not be any bonds available in the maturity you want. The CDS market, on the other hand, is
very flexible and extremely liquid.

38

Do Derivatives Create Risk?

The Great Derivatives Smackdown
financial weapons of mass destruction carrying dangers that, while now latent, are
potentially
t ti ll lethal.
l th l -- Warren
W
Buffett,
B ff tt 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 shouldnt be taking it to
g to and are capable
p
of doing
g so,
, -- Alan Greenspan,
p , 2003
those who are willing
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
payments
y
((assuming
g a 100% loss scenario),
) including
gp
put options
p
on the major
j stock
billion in p
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.
While
Whil Greenspan
G
has
h come under
d scrutiny
ti ffor his
hi position
iti on d
derivatives:
i ti
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
g
Governments and central banks could not have altered the course
them out before the deluge
of the boom.
39

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':
derivatives
d i ti
b
by th
their
i nature
t
d
do nott iintroduce
t d
risks
i k off a ffundamentally
d
t ll diff
differentt ki
kind
d or off a greater
t
scale than those already present in the financial markets.
Volcker's statement that derivatives risks are not 'fundamentally different' to those that exist
y y in financial markets (principally
(p
p y market,, credit,, and operational
p
risk)) is essentially
y true.
anyway
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.

40

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 p
p
payoff
y as well.
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.

41

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
were originally
i i ll struck
t k (i
(in th
the money, att th
the money, or outt off th
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
complexities, options and other complex instruments are valued using
mathematical models that incorporate factors such as volatility and other market factors.
This can introduce an entirely different risk model risk

42

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.
IIn traditional
t diti
l banking,
b ki
credit
dit risk
i k was easy tto measure. If I loaned
l
d you $100 ffor 5
5yrs, I h
had
d agreed
d
to accept $100 of exposure to you for 5yrs.
However, derivatives exposures change daily and fluctuate between the parties.
In swaps and forwards,
forwards the credit exposure at inception is zero no payments are made
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 att currentt market.
is
k t These
Th
risks
i k are mitigated
iti t d by
b th
the ISDA d
documentation.
t ti
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.
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
cash.

43

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
y
or from external events.
systems
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.
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
context of bankruptcy or insolvency).

44

Operational Risk
How does operational risk arise in derivatives?
Complexity unlike cash bonds and stocks, derivatives require some explanation to understand.
Th
Thus,
b
bank
k managers may b
be iinclined
li d tto d
defer
f tto th
their
i ttraders
d
iin tterms off risk
i k evaluation.
l ti
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
yp
position without attracting
g too much attention.
on a risky
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.

45

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,
g
including:
invalid assumptions (for instance, assuming a lognormal distribution when the true distribution is
actually fat-tailed)
p , in determining
g the formulas for valuing
g more complex
p
financial
mathematical errors ((for example,
instruments)
inappropriate parameter specification
p
market p
prices for some of the more illiquid
q
market factors
the lack of transparent
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.
The problem is exacerbated by the fact that derivatives models require users to input certain
parameters that are not directly observable, most notably the volatility of the underlying asset.
Techniques are available for estimating volatility
volatility, but such techniques will necessarily incorporate
forecast errors that add to model risk.
46

P t3
Part
Introduction to
Derivatives Documentation

47

Drafting a Derivatives Contract

So now that weve reviewed (quickly) the universe of derivatives, what comes next?
Put pen to paperdraft a contract that reflects the various economic and legal considerations.

48

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
p
around swaps.
ISDA and other bodies have made similar efforts to standardize and clarify these same issues for
other financial products.
g
forms for many
y financial p
products that create a common legal
g
There are now master agreement
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.

49

Development of documentation
The 1980s 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
market.
1987 Interest Rate and Currency Exchange Agreement or IRCEA
1992 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.
type

50

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
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

1992
2008.

51

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
pp or variation margin).
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.

52

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
Events
t off D
Default.
f lt Sec.
S
5(a)
5( ) events
t iinclude
l d F
Failure
il
tto P
Pay, D
Default
f lt U
Under
d S
Specified
ifi d T
Transactions,
ti
and Bankruptcy. Upon the occurrence of one of the Events of Default, the non-defaulting party is
allowed to terminate the ISDA Master Agreement.
( ) events include Additional Termination Events as specified
p
in the
Termination Events. Sec. 5(b)
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
calculations)
l l ti
) ffor tterminating
i ti the
th ISDA M
Master
t upon th
the d
designation
i
ti off an E
Early
l T
Termination
i ti D
Date
t
following an Event of Default or Termination Event.

53

CSAOVERVIEW
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
g in contract values,, similar to a margin
g account.
changes
Mark-to-market, calculated on a portfolio basis, allows parties to collateralize the value of a trade in
the event that it is terminated.
Keyy Terms include:
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
p
posted.
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 transactionby-transaction basis in each Confirmation.

54

CONFIRMATIONS
Standardization
Credit default swap documentation has been standardized through the publication of the 2003
C dit D
Credit
Derivatives
i ti
D
Definitions
fi iti
((and
d accompanying
i S
Supplements).
l
t )
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,
y are then agreed
g
by
y the p
parties in a one-page
p g Transaction Supplement
pp
to
and Reference Entity
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).

55

CONFIRMATIONS
Automation
DTCC-eligible trades currently include vanilla CDS on single names, indices, and standard
t
tranches.
h
DTCCs 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
trades, DTCC can be used for partial and full terminations and assignments
(if the original trade was confirmed through DTCC).

56

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.
In
I this
thi way, th
the provisions
i i
off th
the agreementt govern ttransactions
ti
d
documented
t d iin C
Confirmations.
fi
ti

57

Confirmation Types
Confirmations
The use of Confirmations to document the economic terms of transactions
again illustrates the modular architecture of ISDA documentation.
documentation
Confirmations come in two forms: long-form and short-form.
Long-form: a long-form Confirmation itself contains, in full, all the terms
necessaryy to document the economic terms of the transaction. 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
necessary to
t document
d
t the
th economic
i terms
t
off the
th transaction.
t
ti
It relies
li 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
Confirmation,
and avoids the need to set out in full
f various operational
provisions. The terms and provisions contained in that other document
should broadly reflect market practice. Therefore, completing a short-form
Confirmation is a quicker task than completing a long-form Confirmation.
58

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
q
y mentioned,, although
g now superseded,
p
, is
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).
Th
Then, when
h a new market
k t has
h matured,
t d and
d a consensus has
h developed
d
l
d
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
not be productive to try to prepare a standard set off Definitions.
f
As time went on, ISDA also developed Master Confirmation forms for each
liquid flow product.

59

Confirmations Start with the ISDA Definitions

ISDA Definitions
When used in the ISDA sense, "Definitions" are the various booklets of standard definitions and
other
th tterms and
d provisions
i i
published
bli h d b
by ISDA ffor use iin d
documenting
ti diff
differentt ttypes off d
derivatives
i ti
transactions. Generally, and broadly, each set of Definitions provides relevant terms for
documenting a particular type of derivatives transaction.
p
g one or more relevant sets of definitions into the confirmation for a p
particular
Byy incorporating
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
need
d tto sett these
th
outt in
i full
f ll iin th
the confirmation.
fi
ti
2006 ISDA Definitions (interest rate swaps)
2003 ISDA Credit Derivatives Definitions (plus supplements)
2002 ISDA Equity Derivatives Definitions
1998 FX and Currency Option Definitions (plus revised Annex A)

60

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
parties to make various choices and to document the economic terms of the transaction
to the 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
representt the
th result
lt off an extensive
t
i industry
i d t consultation
lt ti process, they
th will
ill nott b
be appropriate
i t ffor
documenting all transactions without amendment or additional provisions.
Unlike ISDA's sample long-form Confirmations, which are published as standalone documents,
ISDA's
ISDA
s sample short
short-form
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.

61

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
market.
Standardization, Master Confirmations and automation have contributed
to the increase in market volume and liquidity in the credit derivatives
market.

62

ISDA/Markit Partners
Master Confirmations

Parties can negotiate a standard form confirmation for credit default swaps,
agreeing certain cross transaction terms
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
Transaction
ti Supplement,
S
l
t for
f each
h transaction
t
ti entered
t d into.
i t

For example Master Credit Derivative Confirmation Agreements are available

for:

single
i l name CDS on European,
E
North
N th A
American
i
&A
Asia-Pacific
i P ifi E
Entities
titi

CDX IG, HY and XO

CDX Emerging Markets

iTraxx Europe, Japan and Asia

LCDX, and LevX

ABX, CMBX and TABX

63

DTCC
Automation

DTCCs automated confirmation services accommodates

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
p
and full terminations and
names and indices,, partial
assignments (if the original trade was confirmed through
DTCC). The parties must have a Master Credit Derivatives
Confirmation in place.

64

DTCC

65

Deriv/SERVs Matching and Confirmation Service

Automates the legal confirmation process for OTC derivatives, including credit, equity
and interest rate derivatives.
Today
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
g the following
g options:
p
information via Deriv/SERV through
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
are fields
fi ld that
th t do
d nott match,
t h the
th system
t
automatically
t
ti ll reports
t them,
th
allowing
ll i
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
on-line
line and either accept the trade details or suggest
alleged
modifications. When modifications are
suggested, Deriv/SERV automatically
creates a new trade record, which both parties can re-examine against their original
records, continuing to suggest modifications until the trade reaches confirmed
status
status.
66

DTCC

67

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
over-the-counter
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
of each contract;
A central technology infrastructure that automates and
standardizes trade p
processing,
g, such as record keeping,
p g, p
payment
y
calculations and settlement, notional adjustments and contract term
changes over a contracts life.

68

Deriv/SERV Trade Information Warehouse

Why Use the Warehouse?
The Trade Information Warehouse provides a securely managed
central database of contract information
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
more efficient. Over time, the Warehouse will significantly reduce
operational risks and costs, reinforcing the safety of the market and
contributing to its expansion.

69

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
event, which may or may trigger protection on a credit contract
contract.
Todays process relies on phone calls, e-mails and faxes establish
the correct industry implementation each event.
DTCC has designed
g
ap
process that will be built the Warehouse to
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
event.

70

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,
New trade
Full or partial termination
Full or partial assignment
Increase
Amendment
Exit

71

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 are reflected
trades
fl t d as pending.
di
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 posttrade 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
a one-off
ff basis
b i from
f
the
th Deriv/SERV
D i /SERV W
Web
b application
li ti ffor d
delivery
li
overnight
i ht and
dd
downloaded
l d d
straight onto your computer.

72

P t4
Part
Legal Issues in
Derivatives Documentation

73

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 off
Credit Support and collateral enforcement
Regulatory issues
Commodities
C
diti Futures
F t
Exchange
E h
Act
A t off 2000
Bankruptcy Reform Act of 2005

74

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
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.
g opinion
p
or board resolutions typically
yp
y covers the q
question of capacity.
p
y
Legal

Outside counsel will also research local laws for specific issues especially
when the counterparty is a municipal, state or federal government agency or
affiliate.

75

Hammersmith and Fulham

During 1988/1989, the municipality entered into over 500 derivatives contracts with a total notional
value of 6 billion.
Th
The municipality
i i lit was selling
lli options
ti
on pound
d iinterest
t
t rates
t and
d using
i th
the proceeds
d tto fifinance
civic activities.
There was no clear hedging apparently these were purely speculative trades.
As rates moved against the option seller
seller, losses accrued
accrued. When the municipals were unable to
pay, the buyers sued for summary judgment.
Hammersmiths auditor asserted the trades were void ab initio due to the doctrine of ultra vires,
y didnt have the authority
y to write these options
p
in the first p
place, so they
y never existed at
i.e. they
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
these trades.

76

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)

77

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
Bankers
T
Trust,
t th
then th
the lleader
d iin th
the structured
t t d products
d t market.
k t
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 process
Ultimately, P&G (and in a separate case, Gibson Greetings) successfully sued Bankers Trust, who
had arranged the trades, claiming that the had been unable to understand the risks involved in the
trades.

78

Non-reliance language
After the P&G, Gibson Greetings and Orange County, breach of duty claims were a frequent
occurrence.
T
To address
dd
th
these ttypes off claims
l i
preemptively,
ti l ISDA published
bli h d a standard
t d d representation
t ti in
i 1996
to be inserted into the Schedule called Non-reliance

Each party states that it is acting as a principal for its own account and is not a fiduciary
for the other.
This language is included as Part 5(m) of the Schedule to the 2002 ISDA Master
Agreement.
However, as we see in Caiola, certain actions are not absolved byy disclaimer.

79

Caiola v. Citibank
Caiola involved a series of representations made by Citibank regarding a delta hedging strategy.
If Citibank chose to hedge its risk by buying and selling large positions in the underlying security, rather than
th
through
had
delta
lt h
hedging
d i strategy,
t t
such
h llarge-scale
l h
hedging
d i activity
ti it would
ld lleave unmistakable
i t k bl ffootprints
t i t iin th
the
market, resulting in the kind of market response Mr. Caiola hoped to avoid by trading synthetically.

Caiola sought and received assurances from Citibank that it would continue to delta hedge its
positions on numerous occasions.
p
However, despite its assurances, and without any notification to Mr. Caiola, Citibank stopped its delta hedging
and Caiola suffered huge losses as a result of his reliance on the material misstatements made to him by
Citibank.

The district court held that Mr. Caiola was not entitled to rely on Citibanks representations because
of the non reliance disclaimer included in the Confirmation.
Implicit in the lower courts decision is that the non reliance disclaimers included in the Confirmations insulated
Citib k from
Citibank
f
li bilit even for
liability
f
(i) intentional
i t ti
l misstatements
i t t
t made
d to
t Caiola,
C i l and
d (ii) actions
ti
completely
l t l
inconsistent with its oral assurances to him.

The 2nd Circuit overturned this decision on appeal holding that the statements were not merely
p of the disclaimer.
inaccurate,, but fraudulent,, and thus did not fall within the scope
80

Suitability Knock-in, Knock-out (KIKO)

FX KIKO trades are the latest in the long series of toxic trades executed by unwitting investors
during the latest market cycle.
Renamed
R
d I
I-kill-you-laters,
kill
l t rather
th than
th Accumulators
A
l t their
th i ttraditional
diti
l pre-crisis
i i name.
Salient points of this trade are the following:
If the market goes in the clients favor, they make a little money and the trade matures in short
order
If the market goes against the client, the notional amount on the trade increases and the maturity
extends.
Exporters who did the trades claimed they were being done for hedging purposes
purposes. For example
example, a
Mexican company exporting tortillas to the US market received dollars and needed a product that
effectively made them short USD/ long MXN (i.e. they sold dollars and bought pesos in the
market). It is true that these trades positioned these companies the right way, unfortunately the
t d were done
trades
d
iin much
h llarger size
i th
than th
the h
hedging
d i operations
ti
required
i d and
d th
the titiming
i (k
(knockk
out components) plus leverage on the trades (which typically flipped from 1 to 2x the size when it
went against the client) had no fundamental bearing on the actual financial flows.

81

Suitability - KIKO
Firms in Brazil, Hong Kong, India, Indonesia, Mexico, Poland, South Korea and Taiwan posted at
least $30 billion of losses on foreign-exchange derivatives in 2008. Notable partipants include
p
like Gruma the worlds leading
g tortilla manufacturer - with $
$700mm losses on the
corporates
Mexican peso, and Citic - with losses of $2.7bn on the Aussie dollar.
However, the most interesting cases have arisen in South Korea. Over 180 lawsuits have been
filed after the government was forced to spend 3.8 trillion won ($3.4 billion) since October 2008 to
bail out exporters struck by losses tied to currency options. These suits claim banks sold KIKO
contracts without properly explaining potential risks. The options, sold as a hedge against an
appreciating currency, turned into losers as the won fell 26 percent against the dollar in 2008.
Plaintiffs received favorable decisions in four of these cases when the Seoul Central District Court,
applying the doctrine of "changed circumstances", granted the companies a preliminary injunction
allowing them to temporarily suspend the performance of the KIKO contracts pending the final
verdict of the main cases.
N
Now, a bill h
has b
been iintroduced
t d
d iin th
the S
South
th K
Korean llegislature
i l t
which
hi h would
ld fforce b
banks
k tto seek
k
approval before selling new types of derivatives. The rules would encompass products linked to
credit risk, natural or environmental or economic risks, according to legislation awaiting approval
from a National Assembly subcommittee.

82

Bankruptcy Laws
Prior to 2005, the Bankruptcy Code was amended to create exemptions from the
automatic stay provisions (Section 362). However, it was unclear whether all types of
OTC derivatives fell under the statutoryy definition of swap
p agreement.
g
In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act amended the
definitions of various safe harbor contracts have been broadened in line with the
recent developments in financial engineering to capture newly developed products and
th i combinations.
their
bi ti

swap agreement expanded to include many types of rate swaps, equity index
or equity swaps, total return, credit spread or credit swaps and weather
derivatives.
derivatives
Any combination of these undertakings, or options on them, now qualifies
under the expanded definition of swap agreement.
In addition, a master agreement, a portion of a master agreement or a security
arrangement under a swap agreement also qualifies as a swap agreement
within the meaning of the bankruptcy code.

83

Securities Laws
Securities stocks, bonds and other registered instruments

The CFMA excludes certain swap agreements from the definition of security
for purposes of the Securities Act of 1933 and the Securities Exchange Act of
1934
Swap Agreements basically any OTC derivative that does not derive its value from
price,, yyield,, value or volatilityy of a securityy
the p

Anything that is not a security-based swap agreement but is still a derivative is

a swap agreement
Securityy Based Swap
p Agreements
g

SEC is expressly prohibited from requiring registration of security-based swap

agreements
g
are explicitly
p
y subject
j
to Section 17(a)
( ) of the 33
However, these agreements
Act and Sections 10(b) and 15(c)(1) of the 34 Act dealing with fraud,
manipulation and insider trading.

84

Insider Trading and CDS Sound of Silence?

In May 2009, the SEC brought its first-ever case alleging insider trading in credit-default swaps.
SEC's civil case, brought in U.S. District Court in the Southern District of New York, hinges on a
$1 2 million
$1.2
illi profit
fit earned
d in
i the
th 2006 buyout
b
t off Dutch
D t h media
di company VNU NV.
NV The
Th SEC alleges
ll
in a civil complaint that Jon-Paul Rorech, a salesman for Deutsche Bank AG, passed confidential
information about VNU to Renato Negrin, a trader for the hedge fund Millennium Partners.
y
of VNU byy a g
group
p of six p
private-equity
q y firms. The deal
The case centers around the 2006 buyout
announced in March, but the structure changed in July. Prior to announcing the restructuring of the
deal on July 24, the SEC alleges that Mr. Rorech learned about the new financing plans from
bankers at Deutsche Bank. The SEC alleges that Mr. Rorech broke his obligation to keep the
information confidential by telling Mr. Negrin the details of the new bonds between July 14 and July
17. The new terms meant the company would take on more debt, which would push up the value of
VNU's credit-default swaps, the complaint alleges.
In a conversation the morning of July 14, the SEC alleges Mr. Rorech told Mr. Negrin about the
new bond offering for VNU. When Mr. Negrin asked to "handicap" the likelihood of the deal, Mr.
Rorech said, "You're listening to my silence, right?"
The SEC said it has jurisdiction because the swaps are "security-based," and the two traders are
based in the U
U.S.
S The complaint alleges violations of Section 10(b) of the 34
34 Act
Act.
85

Commodities Laws
Commodity Exchange Act of 1974 (CEA) generally requires that futures contracts be
traded on an exchange governed by the CFTC. Thus, if an OTC derivative is held to
be a futures contract there is a risk that it could be claimed that such transaction is
void/unenforcable.
Commodity Futures Modernization Act of 2000 (CFMA) clarified this issue by adding
the concept of an excluded swap transaction
Four factors to determine if a transaction is exempt:
1.

It is entered into by eligible contract participants (net worth of US$10million or

more)

2.

Its material terms are individually negotiated

3.

It does not involve agricultural commodities

4.

It is not executed/traded on a trading facility (an exchange like CBOT/CBOE)

86

Derivatives Regulation Proposals

H.R. 977, the Derivatives Markets Transparency and Accountability Act of 2009 (Peterson)
All prospective OTC transactions settled and cleared though a CFTC regulated designated
clearing
l i organization
i ti
Empowers CFTC to suspend trading in naked credit default swaps
Authorizes CFTC to initiate and prosecute criminal violations of Commodity Exchange Act
S.272, the Derivatives Trading Integrity Act of 2009 (Harkin)
Eliminates distinction between excluded and exempt and regulated commodities
Re-categorizes most swaps as futures contracts
Requires that all futures contracts trade on designated

87

New U.S. Regulatory Framework for OTC Derivatives

On May 13, the U.S. Department of the Treasury (the Treasury) announced its intention to seek
legislative changes that could alter the regulatory framework for OTC derivatives in the United
States.
Among other things, the letter states that the Treasury will seek:
Mandatory Clearing of Standardized OTC Derivatives
Regulation of Large Derivatives Participants
New Transparency Initiatives
Prevention of Market Manipulation, Fraud and Other Market Abuses
Reexamination of Sophistication Criteria
According to the Treasury, these changes are designed to achieve four goals: (1) prevent activities
in these markets from posing risks to the financial system; (2) promote the efficiency and
transparency of these markets; (3) prevent market manipulation
manipulation, fraud and other market abuses;
and (4) ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties.

88

What Should Regulators Do?

Regulators' ability to detect and control potential derivatives losses is clearly lacking.
But regulatory and legislative restrictions on derivatives activities are not the answer, primarily
b
because
simple,
i l standardized
t d di d rules
l mostt lik
likely
l would
ld only
l iimpair
i b
banks'
k ' ability
bilit tto manage risk
i k
effectively.
The burden of managing derivatives activities must rest squarely on trading organizations, not the
government. Such an approach
g
pp
will p
promote self-regulation
g
and improve
p
organizations'
g
internal
controls through the discipline of market mechanisms. Government guarantees will serve only to
strengthen moral-hazard behavior by derivatives traders.
Derivatives-related losses can typically be traced to one or more of the following causes: an overly
speculative
l ti iinvestment
t
t strategy,
t t
a misunderstanding
i
d t di off h
how d
derivatives
i ti
reallocate
ll
t risk,
i k an
ineffective internal risk-management audit function, and the absence of systems that simulate
adverse market movements and help develop contingency solutions.
To address those concerns, supervisory reforms should focus on increasing disclosure of
derivatives holdings and the strategies underlying their use, appropriate capital adequacy
standards, and sound risk-management guidelines.

89