Learning Curve

A recent flurry of attention on the impact of new accounting regulations, Financial Accounting Standards 133 and International Accounting Standards 39, has highlighted two key questions. First, why should any accounting regulation affect derivatives trading? And second, has there been a significant change in trading?

Negotiations over the payee tax representations to be made in an ISDA Master Agreement are often confusing, acrimonious and slow. U.S. negotiators, at the urging of expensive tax counsel, often insist that their foreign counterparties make comprehensive tax representations for U.S. tax purposes and deliver certain IRS tax forms to them. Typically, foreign counterparties resist making these representations because they don't understand the purposes behind them. However, these payee tax representations, and the related delivery of tax forms, serve important purposes.

Although markets in Japanese equity derivative products started to appear at the end of the 1980s, due to the lack of a complete regulatory framework general knowledge about these products remained very limited in Japan until the start of the Japanese Big Bang in 1998. During most of the 1990s, domestic players remained virtually absent from the market, except for a handful of corporate end-users dealing in complex hybrid products. Japanese banks and securities companies rarely participated in these transactions and, as a result, foreign investment banks used the know-how that they had gained in foreign markets in order to acquire a quasi-monopoly on offshore equity derivative transactions and domestic hybrid structures.

The aim of this article is to build an easy model that explains the implied volatility structure observed in the market. In the equity market we have a very pronounced skew whereas in the foreign exchange market the smile is U-shaped. This paper presents a simple model that is easy to use for Simulations (Monte Carlo) as well as for lattices (Partial Differential Equations or Trees) and we derive closed form approximations for the implied volatilities that are very accurate. This allows a better calibration to the market data. This model is then applied to an up-and-in American-style digital option, which is very sensitive to the smile. This option becomes expensive because of the accumulation of two factors: the distributions of the stock at different maturities and the correlation between these maturities.

This article will discuss how to customize standard International Swaps and Derivatives Association documentation for special purpose, bankruptcy remote vehicles (SPVs) that issue rated securities. An SPV is often formed by the entity (the sponsor) structuring a securitization or other structured financing. In a securitization, a pool of assets is transferred to the SPV and the SPV issues rated securities backed by such assets. There are a variety of reasons a sponsor will form an SPV (e.g., off balance sheet financing or regulatory capital relief). Rating agencies often require that assets be transferred into the SPV so that the credit and bankruptcy risk of the assets will be separate from the credit and bankruptcy risk of the sponsor. Often derivatives are used in order to achieve a particular risk profile. These derivatives are typically governed by ISDA documentation.

On 31st May, 2001, Hong Kong Exchanges and Clearing Ltd. issued a consultation paper detailing proposed changes to the rules relating to the listing of warrants on the Hong Kong Stock Exchange. The exchange's objectives, which it hopes to accomplish by implementing the new rules, are to provide a more tailored regulatory regime for listed derivative products and to develop the market by continuing to provide a range of derivative products for investors.

Convertible bonds are corporate bonds which pay the holder regular coupons and may be converted into the underlying shares at the holder's discretion. Here we focus on their exposure to the credit of the issuer. At low equity prices, when the equity optionality is worth little, the convertible is essentially a pure bond and it is clearly correct to price (i.e. discount cash flows) with the full credit spread of the issuer. However, it is generally held that a company's ability to issue stock is not strongly influenced by its credit rating. Accordingly, the value contributed to the bond by its conversion rights should not be subject to the same risky discounting as the fixed payments.

Basket options are valuable tools in structuring financial products. A typical basket consists of several weighted underlyings, and the basket spot is given by:

The weather derivatives industry is one of the most rapidly growing fields of risk management today. Such instruments, whose underlyings are functions of temperature and other weather variables, enable purchasers to manage the volumetric risks associated with warmer or colder-than-average weather. The great power of weather derivatives lies in their potential for diversifying weather-related risks across the entire economic spectrum, not just between energy producers and consumers. Indeed, the range of industries susceptible to adverse weather is large, including amusement parks, beverage companies, winter apparel manufacturers, retailers, restaurants, resorts, golf courses and agricultural companies.

Real options are increasingly being used for strategic decision-making. Recently, a prominent consultant in the field estimated $30-40 billion in corporate transactions and investments were evaluated and executed last year using real option valuation technologies.

Currency overlay has grown in popularity during recent years. From being an obscure and slightly risqué product it has come to be an important weapon in the institutional hedgers' arsenal. However, there is still a degree of confusion as to the precise nature of overlay, and in particular it is easily confused with currency funds, or the use of currency as an asset class.

Ensuring liquidity should be the primary goal in negotiating an ISDA Master Agreement (the "Agreement") for smaller, non-rated customers, such as a hedge fund or a middle-market corporation. Often highly leveraged and with little room for error, these customers should focus their efforts when negotiating the Agreement with a dealer on limiting the dealer's opportunity to terminate the Agreement. Unfortunately, however, customers (typically through expensive outside counsel), often instead use up valuable negotiating capital on esoteric legal issues that may only remotely affect a customer's situation.