Learning Curve

This article examines the impact of removing restructuring as a trigger event in the credit-default swap contract. It concludes that removing restructuring would be constructive and lead to greater market liquidity. It would likely shave off 10-20% of the premium. However, it is looks at alternatives for market participants who need restructuring.

Risk And Return In Intrinsic Time

This is the first in a two part series that demonstrates how the short-term view of day traders can contribute to the formation of a market bubble. This week's article focuses on risk and return in neoclassical finance and next week's looks at risk and return in intrinsic time.

Recent events, including the default of Argentina, have emphasized the fundamental importance of incorporating the relatedness between the credit quality of a counterparty and the underlying market dependencies of a derivative transaction's mark-to-market value in calculations of credit exposure. More and more we view relatedness as a pervasive aspect of counterparty exposure in the credit and equity derivative markets, not only for foreign exchange derivatives. Though we acknowledge the view of David Rowe, group executive and v.p. for risk management at SunGard Trading and Risk Systems (DW, 4/14)) that a qualitative understanding of wrong-way risks in a portfolio can be achieved via a stress analysis, it is much more challenging to coherently integrate results generated in this fashion with a mark-to-market based hedging strategy.

Creating A Suitable Basket

Valuation Inputs

The International Swaps and Derivatives Association is working on a revised version of the 1992 Master Agreement. Parties should carefully consider the proposed changes because these agreements have become the market standard for documenting over-the-counter derivatives.

A common misconception in the analysis of collateralized debt obligations is the assumption that the underlying collateral pool performs just like the market or an index. Such generalizations make historical stress analyses easy, since all one has to do is observe the historical performance of the market or index. However, CDO collateral pools tend to have far fewer securities than any broad measure of the market. As such, there is a significant risk that the collateral pool behaves differently from the market, even if aggregate risk measures, such as ratings, are similar.

When hedge funds were primarily of interest to high-net-worth individuals the need to understand the types of exposures taken on by these investment vehicles was practically non-existent. A hedge fund manager who now has over a USD1 billion under management told me four years ago that his prospective investors were only interested in receiving a one-page summary of his performance numbers. The ensuring discussions would then focus on the nuances of how the performance numbers were calculated. There was no interest in discussing the underpinnings of the firm's investment process.

Hong Kong Exchanges and Clearing recently announced changes to the stock exchanges listing rules. The principal changes include the broadening of the rules to cover structured products, which include derivative warrants and equity linked instruments (ELIs) and the streamlining of the rules applicable to such structured products. The new rules became effective on July 1.

The low interest-rate environment and the tightening in Asian credits have caused many investors to start considering structured investment products for yield enhancement by taking either market risk or credit risk. Usually, a structured investment product can offer yield enhancement based on a specific market view. A LIBOR corridor is a typical example. A LIBOR corridor note will offer extra return if LIBOR evolves according to the range determined at the outset of the transaction while the downside is a loss in coupon or part of the principal if the actual market movement goes against the view. This kind of structured note is usually issued from the European medium-term note program of reputable issuers, with payment of coupon or sometimes principal linked to the evolution of one or more market parameters, such as an exchange rate or interest rate.

In a stochastic volatility world where the volatility is bound to stay below a certain level, Nicole El Karoui1 has shown that it is possible to delta hedge a convex position, such as a call option, with the Black Scholes model and make sure that the profit and loss from this strategy is almost surely positive. This gives a non-competitive upper replication price.