Learning Curve

For the investor or hedger accustomed to the risk characteristics of developed markets, emerging markets may appear at times confusing, excessively risky, or may seem to offer easy money. Understanding the risks described by the implied volatility surfaces of emerging market currencies can help one to more realistically quantify the expected mean variance characteristics of these markets. There are two related phenomena that explain most of the generalized shape of emerging market volatility surfaces for free floating currencies: interest rate differentials and skewness.

Popular derivative pricing theory begins with assumptions about perfect, frictionless markets. All markets, however, are illiquid to a certain extent. Individual buy orders tend to make prices rise and sell orders tend to make prices fall. Even where the size of an order is too small to change the bid-offer spread in a security, any market (non-limit) trade reduces both the remaining order depth and, as a result, the minimum size needed for the subsequent order to cause a change in price.

Market smile gives information about the marginal distributions of the underlying. The information is enough to price all European products without any confusion. This includes for example call-spreads, risk reversals, strangles, parabola contracts, log contracts and so on.

Residential mortgage securitizations amortize at different rates, which makes hedging the interest rate risk a complicated task. This article examines what happens if the swap is terminated early.

As a result of the volatile investment climate and with the value of Australian retail and international share funds falling, a risk adverse investment strategy is becoming a vital core component of any balanced portfolio. Increasingly, investors are looking for products that provide exposure to the stock market, yet offer the security of maintaining their initial capital outlays.

In this article we introduce the construction process of Fubon Group's first managed CDO, Silk Road 2003-1. The first step was to build a reference pool of 50 credit-default swaps using our selection criteria. We then determined the size of each tranche, given the rating and spread of LIBOR, using Moody's Investors Service Binomial Expansion Technique. The final stage was to explore the effect of the diversity score on the funded size of the synthetic CDO and look at the subordination of debt tranches under different diversity score scenarios.

On May 3, the U.S. Tax Court issued its decision in Bank One Corp. v. Commissioner, the first case to address the question of how an over-the-counter derivatives dealer must value open positions at year-end under the U.S. mark-to-market tax regime, which became mandatory in 1993. As discussed below, the decision is likely to create more issues for both taxpayers and the Internal Revenue Service than it resolves. The much-awaited decision was issued against a backdrop of considerable controversy--including over such basic issues as the appropriateness of an adjusted mid-market method in valuing derivatives, and the degree of deference, if any, properly afforded to an OTC derivative dealer's specific valuation model or financial accounting methodologies. The disagreements appear to have been exacerbated over the years by a considerable gap between the OTC derivatives dealers, on the one hand, which have spent substantial resources developing their valuation models and consider those models to be proprietary technology, and the IRS, on the other hand, which is imperfectly positioned to second-guess the various technical and theoretical underpinnings of a valuation model, but nonetheless has an interest in ensuring that dealer models do not systematically undervalue positions and, consequently, taxable income. One of the more striking examples of the IRS's attempts to address this gap occurred in 1995, when the IRS commissioned the Los Alamos National Laboratory to develop software for the valuation of derivatives with the intention that the software would then be used in tax audits. The project survived long enough for the Los Alamos scientists to produce a software prototype in 1997 that was unveiled to a select group of industry participants for comments, but the project was abandoned later that year, after an intense round of industry criticism, and IRS management concerns over the project's costs.

Dealers in the U.S. and Europe will accept different forms of reference entity guarantees in credit derivatives contracts under the International Swaps and Derivatives Association's 2003 Credit Derivatives Definitions. Although ISDA sought a global standard for guarantees, a consensus to adopt a proposed compromise did not emerge. Instead, ISDA approved a more basic supplement. Dealers in New York determined it was appropriate to trade on Qualifying Affiliate Guarantees only, due to the legal uncertainty of enforcing upstream and sidestream guarantees. While aware of the legal considerations, European dealers did not want to limit the range of credit protection products they could offer.

Principal-protected securities can be attractive investments in the current market environment where investors are concerned about the loss of principal in higher-yielding investments, yet frustrated at the low returns Treasuries or other high-quality instruments offer. Protected securities assure the return of principal at maturity without limiting the upside potential of the investment. As a result, they allow investors to participate in the expected yield of hedge funds with minimal risk of losing principal.

The Indian fixed income markets have charted impressive growth in the last few years. The current markets are vastly different from the 'administered interest rate regime' used until the early-nineties. Until 1999 market participants had to reduce duration or switch to cash if they wanted to hedge interest rate exposures or had a view that interest rates were set to rise because short-selling was not allowed. Now an investor can use interest rate derivatives to hedge against a rise in interest rates or even to profit from such moves. Market Size

The transactions described in Part I centered around issuers seeking to improve their capital ratios without exposing potential investors to the typical risks of an investment in capital securities. The first example discussed in Part II involves a transaction in which a senior unsecured creditor achieves a preferred position against other senior unsecured creditors, without taking collateral from the borrower.

The valuation of a credit derivative depends on the risk of default of the reference entity and, in many cases, the rating of the protection seller, including its default correlation with the reference entity. Protection against a Mexican corporate default is clearly more valuable when the seller is the World Bank than a BBB Japanese bank, which, in turn, is more valuable than a BBB Mexican bank. But how much should the protection cost if it is bought from the corporate itself?