Professional Documents
Culture Documents
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.
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.
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
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
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
In terms of notional amounts outstanding, by far the most popular form of interest rate derivative is the interest rate swap (IRS).
21
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
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
25
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
29
P t2
Part
Derivatives Markets
30
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
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
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
38
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
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
51
52
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
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
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
single
i l name CDS on European,
E
North
N th A
American
i
&A
Asia-Pacific
i P ifi E
Entities
titi
DTCC
Automation
64
DTCC
65
DTCC
67
68
69
70
71
72
P t4
Part
Legal Issues in
Derivatives Documentation
73
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
76
77
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
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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
84
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.
2.
3.
4.
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87
88
89