Learning Curve

This article examines why structured finance CDOs are attractive and the structural features of the instruments. Next week's article will look at collateral and ratings.

This is the second in a two-part series examining the U.S. accounting change. Last week's article gave a general overview, this week the authors focus on hedge accounting.

Since well before the Mexican devaluation of 1994, investors and firms have had the ability to create or offset convex peso currency exposures using options. When it comes to interest rates, however, only recently have options become readily available, in the form of caps, floors and swaptions. Users now have the tools at hand to create or hedge contingent interest rate assets or liabilities denominated in Mexican pesos.

FAS 133 has generated substantial confusion and expense, especially for end-users acquiring derivatives as hedges. This article will give a general overview, whilst next week's will focus on hedge accounting. FAS 133, or Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as it is more formally known, was issued by the Financial Accounting Standards Board (FASB) in June 1998, but the board delayed its effective date to mid 2000 and twice made substantive amendments. Because of its complexity, FASB established the Derivatives Implementation Group (DIG) to address issues about its implementation and interpretation. To date, DIG has issued guidance on over 175 distinct topics with respect to FAS 133.

Nederlandse Waterschapsbank, a Dutch water board funding authority, has entered a foreign exchange and interest rate swap on a recent six-year USD1 billion bond offering. Tom Meuwissen, head of the treasury in the Hague, said it is the authority's policy to convert all foreign currency liabilities back into euros.

New York-based hedge fund manager R.G. Niederhoffer Capital Management will enter currency forwards and over-the-counter equity derivatives in its newly launched Roy G. Niederhoffer Negative Correlation Fund. Roy Niederhoffer, founder and president in New York, said over-the-counter foreign exchange and equity markets are liquid and this is particularly important due to the short-term trading horizon of the fund.

Hedge fund CFOs are one of the most recent innovations within the CDO market with the completion of the first transaction in June 2002. Unlike traditional CDOs, which are securitizations of bonds or loans, the assets securitized in hedge fund CFOs are the shares of various hedge funds. Therefore, hedge fund CFOs differ in important respects from traditional CDOs in regard to key risk factors. While the performance of a traditional CDO relies mainly on the credit performance of a pool of underlying bonds or loans, i.e., default and recovery rates, the performance of a hedge fund CFO depends on the net-asset value (NAV) of the underlying hedge fund shares at the liquidation date. The NAV of these shares depends on the performance of a potentially endless array of debt, equity, hybrid, or derivative positions, held long or short, and representing a diverse and often abstract assortment of financial risks and rewards. Below is a description of the main differences between traditional CDOs and hedge fund CFOs and how these translate when modeling these products for rating purposes. Over-Collateralization

Northern Rock, a U.K.-based lending and savings bank, has entered a foreign exchange swap on a recent USD600 million floating-rate five-year bond. Phil Horner, head of derivatives in Newcastle-Upon-Tyne, said it issued a dollar-denominated bond to increase investor diversity. Since the bank only has operations in the U.K., it enters swaps to switch foreign currency denominated liabilities into sterling debt.

A growing appetite for capital protected products and alternative investments are two of the most significant trends influencing pan-European investment product structuring at both retail and institutional level and both are, to a large extent, dependent on derivatives.

The delta of an option is the change in the value of that option for a given move in the price of the underlying asset. Because an option's delta is always less than one (in absolute value), it follows that for a given change in stock price, the option value will move accordingly for a smaller amount. This seems to contradict the general perception that options are leveraged instruments. Just as delta is the appropriate hedging ratio, however, another Greek letter lambda is the more appropriate leverage ratio for options, which incorporates both the delta factor and the gearing factor.

Imagine a speculative trading strategy that is guaranteed to make money 98% of the time. Are you interested? There are many ways to accomplish this. Here is a stylized example: You draw a card from a 52 card deck. If it comes up any card other than the ace of spades, you earn a million dollars. If it comes up as the ace of spades, you lose 52 million dollars. On average, you will lose just over USD19,000 each time you play, but you will win 51 out of 52 hands. This is what is known as a skewed trading strategy.

Banks, trading companies, leasing companies, and multinational corporations have currency convertibility risk even if they don't attempt to quantify the risk on their balance sheets. Buyers and sellers of currency convertibility protection must not only have a feel for pricing credit derivatives, they must be economists with a penchant for econometrics. These are negotiated transactions. Price, terms, conditions and size are all negotiated directly between counterparties. As there are so few counterparties for this type of protection, the broker market is usually ineffective. It is much more effective to contact well-known counterparties in the credit derivatives market and negotiate the transactions and market levels directly. This is a supply and demand driven market and prices vary from counterparty to counterparty.