Learning Curve

A December regulation change was the last in a series under which French managers have been given an increasing capacity to trade over-the-counter derivatives, well in advance of the implementation of the "UCITS III" directive, which is due to be implemented by member states within a year.

This column will discuss the option-like exposures of a number of hedge fund strategies based on a review of the current literature. Specifically, recent academic articles have argued that implicit options arise in hedge fund products due to the following factors: * The tailoring of return-to-risk profiles to certain classes of

A threshold structure is an intuitively appealing alternative to standard equity put options for creating a guarantee. An investor defines a target asset that needs downside protection. This target asset is often an equity index but it could also be a pool of hedge funds or almost any other type of investment that can be traded. Downside protection is achieved by systematically rebalancing the investor's portfolio into a security that will mature at some desired threshold level (e.g. the zero coupon bond) whenever the portfolio declines in value relative to that threshold. If the target asset rises in value, all else being equal, then funds are rebalanced out of the bond back into the target asset in order to maximize upside participation.

Introduction Currency fund and currency overlay programs have become the flavor of the month for investors. These products both utilize bespoke and often confidential trading models to take advantage of the volatile currency markets. Funds use models to predict when spot, forward or sometimes option trades should be placed to generate return, while overlay programs use the same models to make hedging decisions. The fund products can, at their best, generate healthy annual returns (in some cases 7%-10% of the face value of the trades), while good overlay programs offer option-like protection and the possibility of 1%-3% return enhancement. These are the results from the best, of course. Choosing the right overlay provider or currency fund is a critically important decision.

By accessing foreign credit markets, credit investors can add diversity to their portfolios and take advantage of relative value opportunities. While investors can do this using the cross currency asset swap, investors concerned about the associated default contingent risk can use the perfect asset swap structure.

This article describes some of the most important steps before, during and after entering into derivatives transactions. It may help build long-term relationships and help you avoid some of the difficult problems that have beset derivatives marketers and traders. However, this is just a guide. It highlights issues rather than answers them.

A recent survey of the weather risk management industry has indicated a global increase of 43% in the number of weather-based financial transactions and 72% in the notional value for such contracts, in comparison with the previous year.* In order to maintain this rapid expansion market participants have sensed the need to enhance the legal environment in which such trades are executed and, in particular, to create a standardized documentation structure for weather transactions. Such a structure would expedite trades and enable companies to dedicate resources to weather risk management in order to improve market liquidity. Nevertheless, the nature of the underlying presents a series of obstacles, which renders the standardization process a challenging task and requires industry participants to openly discuss ideas and experiences in order to reach documentary uniformity.

The Restructuring Debate Rumbles On The restructuring credit event is currently the most controversial issue in credit derivatives documentation as it can be much softer than failure to pay or bankruptcy. Soft credit events can expose the protection buyer to Cheapest-to-Deliver risk. In hard restructurings it is likely that same seniority debt will trade at a similar cash price irrespective of maturity or currency. However, in a soft scenario debt may still trade on a yield basis and cash prices may not converge. The protection buyer's Cheapest-to-Deliver (CTD) option is therefore of greater value in soft restructuring scenarios where the protection seller could be delivered an obligation trading substantially lower than the restructured obligation. The Conseco case led the U.S. market to adopt modified restructuring (mod-R) although this has not gained traction in Europe.

The International Swaps and Derivatives Association published a new Master Agreement in December to replace the 1992 agreement. The new agreement represents the work of ISDA's Documentation Committee, with over 100 different members reviewing earlier drafts and providing comments. The trade association has already arranged for netting opinions on the new agreement in 36 different jurisdictions.

The 2002 definitions are based on the 1996 International Swaps and Derivatives Association's equity derivatives definitions and, like the 1996 definitions, are primarily intended to be incorporated into confirmations documenting equity derivatives transactions. Trades executed under the 1996 definitions will not, without further action by the parties, be affected by the adoption of the new definitions. This article will discuss the key areas in which the 2002 definitions modify the 1996 version, including the expansion of product coverage, separation of settlement mechanics from product type, expansion of the consequences of merger and other events impacting the underlying shares and refinement of the consequences of market disruptions. Like the 1996 definitions, the 2002 definitions are intended to reflect a global standard of current market practice and are not necessarily meant to deal with issues that only relate to certain specific jurisdictions.

The publication of the 1999 ISDA Credit Derivatives Definitions represented an important step in addressing issues of legal, operational and basis risk in the credit-default swap market. However, since that publication, a series of credit events affecting the relatively limited universe of frequently-traded names has highlighted areas where the 1999 definitions are overly permissive or insufficiently precise. This resulted in the publication by the ISDA Credit Derivatives Market Practice Committee of three supplements, relating to the identification of successors to reference entities, the scope of the insolvency credit event, the treatment of exchangeable and convertible debt securities and, most controversially, the vexed issue of restructuring.

Many institutional market participants enter into derivatives transactions through multiple affiliates. By designating these affiliates as "Specified Entities" for the purposes of Section 5(a)(v)--"Default under Specified Transaction"--of the 1992 International Swaps and Derivatives Association master agreement, a party is able both to book trades in the most advantageous location and to have maximum flexibility in the event its counterparty defaults.