Learning Curve

The Korean government approved a long-awaited amendment to the presidential decree to the Securities and Exchange Act in February, which will permit certain qualified securities companies in Korea to enter the over-the-counter derivatives business, starting from this July. Although KOSPI (an index for Korean companies) index futures and options and certain currency and other futures products have been traded on the Korea Stock Exchange and the Korea Futures Exchange for years, OTC derivatives have been off limits to securities companies in Korea, except in very limited circumstances. This is in sharp contrast to the treatment of commercial banks in Korea that have engaged in various OTC derivatives transactions. Foreign securities and commercial banks with a large capital base and expertise in foreign currency related products also have been active in this business, although they were subject to foreign exchange regulatory approvals or reports. Such favorable treatment of commercial banks and foreign companies over domestic securities companies has been a source of complaint. By opening up this market to securities companies, such criticism will be lessened. In addition, the Korean government hopes that the competitiveness and profitability of securities companies is enhanced and their customers better served in their financing and risk management needs.

ISDA master agreement negotiations are often never-ending, expensive and tedious. Negotiations can take months as parties battle over legal, business and credit terms. Although much has been done to standardize the documentation process, there are still numerous issues that parties must negotiate prior to executing the ISDA master agreement. In addition, parties often insist on making additional amendments to the ISDA master agreement that they believe are necessary to minimize legal and credit risks.

Finance houses in Australia have been making changes to their internal arrangements because of new regulations, which came into effect March 11. It is quite clear that these changes will create uncertainty and discomfort, and there will be a period of settling-in. When the industry looks back on the changes, the adjustment and readjustment, particularly to over-the-counter derivative transactions, the hope is that the end result will be better than the previous law.

The growth of the credit derivatives market has created new relative value opportunities for credit investors. One such opportunity is trading the default swap basis in which investors may take a relative value view on the spread between a bond issued by some entity, and the spread demanded by a default swap contract linked to that same entity. While there is a theoretical relationship between these two spreads, there are a number of factors that may cause this relationship to break down which have been described in a previous Learning Curve (DW, 12/17). In certain cases this can present clear investment opportunities to investors.

Galileo Galilei wrote: "Enumerate what is numerable. Measure what is measurable and make measurable what is not measurable."

This article introduces mixing theorems, a theoretical and computational approach to certain advanced option models. To begin, the Black-Scholes-Merton family of models is a well-known and sensible starting framework for understanding option prices. The framework relies on the assumption that the underlying stock price (or security price) follows a process known as geometric Brownian motion (GBM). This model has some very strong points in its favor: (i) it's consistent with stocks as limited liability securities and so the prices never fall below zero, (ii) it has uncorrelated returns, which have strong statistical support over many time scales, and (iii) it's very tractable computationally.

Traditional collateralized debt obligation (CDO) investment structures may not be flexible enough to meet the objectives of all investors. CDO combination securities have arisen to address this need. Combination securities can be tailored for each investor based on the desired credit rating, minimum coupon, yield target, and capital guidelines.

The increase in the number and scope of CDO downgrades highlights the need for investors to understand how CDOs are evaluated in stressful environments. The purpose of this article is to describe Fitch Ratings' approach to evaluation of its ratings of CDOs in light of changing market conditions. The article will not address the reasons underlying the defaults and downgrades of corporates and sovereigns.

Those who trade equity derivatives for a living are familiar with the complexities of trading volatility. In general, traders seek to exploit option mispricings through delta-neutral strategies in which a hedge position in the underlying stock is dynamically adjusted through the life of the option. While the Black-Scholes framework provides a straight forward formula with regard to initiating (delta) and adjusting (gamma) the stock hedge, the process of realizing profits from volatility trading is far from exact. Profit uncertainty arises from the path dependent nature of an option's gamma and vega. These Greeks are a complex function of the relationship of the spot price to the strike price, time, and volatility.

Close-Out Netting

This Learning Curve will focus on the empirical application of option replication rather than the theoretical foundation. We restrict ourselves to the foreign exchange markets where transaction costs are low and liquidity high. These two factors are indeed the necessary conditions for the use, if at all, of dynamic strategies.

The Stock Exchange of Hong Kong recently announced changes to the listing rules relating to derivative warrants. The principal changes include the relaxation of certain restrictions in placing guidelines for derivative warrants, the introduction of a requirement for warrant issuers to provide liquidity for derivative warrants listed on the exchange and the simplification of certain disclosure requirements for listing documents.