Learning Curve

Last week's Learning Curve dealt with new legislation and supervisory regulations and directives, while this week's will look at judicial decisions, tax and accounting.

Recent months have heralded change on many fronts for the derivatives industry in Germany. New legislation and supervisory regulations and directives together with recent judicial decisions and developments in the fields of tax and accounting spell a time of opportunity and new challenges for market participants.

There are four generic forms of rated synthetic collateralized debt obligations: (1) Balance Sheet Static Synthetic CDOs, (2) Managed Static Synthetic CDOs, (3) Balance Sheet Variable Synthetic CDOs and (4) Managed Variable Synthetic CDOs. This article describes the structure of each synthetic CDO, highlights some of the features that an investor may prefer with respect to each and describes some of the documentation issues that may arise when structuring each type of CDO.

In February the French regulator enacted a decree operating an in-depth reform and update of the legal framework for French funds, known as organismes de placement collectif en valeurs mobilières (OPCVMs), to enter into derivatives transactions. This follows the European Union's Council of Finance Ministers directives on harmonised investment funds, know as undertakings for collective investment in transferable securities (UCITS). The 2002 Decree further amended the provisions of decree (no. 89-624 September, 1989).

Although we get droughts, floods, fire, cyclones, snow and ice, economic adversity is not restricted to disaster conditions. A mild winter can ruin the earnings of ski resorts, dry weather can reduce crop yields, and rain can shut-down the entertainment and construction industries. Weather risk is one of the biggest uncertainties facing businesses.

Insurance transformer transactions are structured to transform a potential liability under a credit-default swap into an insurable loss falling within the scope of an insurer's permitted activities. As such, they are amongst a number of products used to transfer risk from the banking sector to the insurance markets (and to a lesser extent vice versa), which have been the subject of a discussion paper, Cross sector risk transfers, published this month by the U.K. Financial Services Authority. This article briefly considers some of the legal issues associated with this type of transaction.

Various indicators are commonly used to gauge relative value in the volatility market. Amongst those we can mention volatility cones and the spread between implied and historical volatility. In particular, these two indicators tend to be difficult to use in isolation: for instance, a volatility in the middle of its cone and far above realised levels will look relatively expensive while a volatility in the middle of its cone and far below realised levels will look relatively cheap. In other words, we need to look at a combination of indicators to try and identify value. In this article, we have studied extreme values of the volatility risk premium and found that large readings were symptomatic of large mis-pricings in the market. As such, our new indicator gives us an indication of the best currency pairs to look at to try and extract value.

Asset management (or managed) synthetic CDOs effectively securitize investment-grade corporate credit risk. A managed synthetic CDO combines the structure of a traditional asset management cash flow CDO with the cost-effective risk transfer of a static synthetic CDO. The result is a portfolio credit product that provides investors with an efficient investment strategy in an actively managed, diversified pool of investment-grade corporate credit. The advantage of managed synthetic CDOs for investors is the same as it is for other actively managed CDO products: a tailored exposure to an expert manager's performance in the selected asset class. Although the market has not yet converged on a standard managed synthetic CDO structure, the broad characteristics have been established.

Most international private and official institutions and professional observers were surprised by the abruptness of the 1997-98 Asian financial crisis and its subsequent contamination. There is also a broad consensus that neither multilateral agencies nor international investors anticipated the full scope of the crisis.

The Australian government initially used installment receipts as part of the privatizations of CBA and Telstra. Installment warrants were listed on the Australian Stock Exchange soon after and are now issued by most major Australian and international banks and each year hundreds of new installment warrants are created.

Valuing options on a fixed exchange rate, or on any asset price set by official decree, is problematic. To the casual observer, such options may seem illogical, since the cash rate does not move. Yet active markets have existed on such options despite explicitly pegged exchange rate regimes. Exchange rate crises in which currency pegs were abandoned, such as Mexico (1994), Russia (1998), Brazil (1999), and Argentina (2002) have also shown that options with strikes outside the band are not worthless. Such options can offer valuable information about the probability of a peg holding over a given period. Following is a basis for pricing and evaluating such options using practical methods, and some simple estimation techniques for relative valuation.

It was Samuel Johnson who said "Depend upon it, sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully." Trading losses may not be up there with being hanged in a fortnight, but they can certainly concentrate the mind.