Learning Curve

Comments on the Basel Committee on Banking Supervision's proposed New Basel Capital Accord for banks are due on May 31. The proposed accord would include much more detailed treatment than current international risk-based capital standards for banks that offer or purchase credit derivatives, or that perform various roles in synthetic securitizations effected through credit derivatives. The Basel Committee is continuing to discuss many issues in these areas, particularly regarding synthetic securitizations.

Granting rehypothecation or "use rights" with respect to pledged collateral is common in the over-the-counter derivative market. In fact, subject to the pledgor's consent, the credit support annex to the International Swaps and Derivatives Association master agreement provides the secured party with the right to rehypothecate, or use for its own purposes, collateral pledged to it---subject only to the obligation to return the collateral once the pledgor has satisfied its obligations. Customers, however, are often alarmed to learn that the dealer requires such an unrestricted right to use and sell the pledged collateral.

Options derive their value from underlying assets. In the case of traded underlyings, the option value is affected by the asset liquidity. The impact of liquidity on equities and bonds is a well-known phenomenon: selling the asset pushes the price down, buying the asset moves the price up. Option hedging is nothing but selling and buying some quantity of the underlying asset. Liquidity can be viewed as part of a chain reaction in hedging: changes in the asset value result in the option owner re-hedging which in turn impacts the asset's liquidity and so on. Therefore, liquidity has to be taken into account when pricing traded options.

Uncertainty continues over derivatives transactions with counterparties in the People's Republic of China following rejection of swap claims in October 1999 by the liquidation committee of Guangdong International Trust & Investment Corp., despite recent clarification by the State Administration of Foreign Exchange.

The Commodity Futures Modernization Act of 2000 authorizes trading, on a delayed basis, stock futures, meaning single-stock and narrow-based stock index futures, and options on such futures. As a result, the tax laws were also amended to make sure that stock futures would not get a tax advantage over equity products currently traded in both the over-the-counter and exchange-traded markets. With the CFMA changes to the tax laws, the tax treatment of stock futures is made similar to the current tax treatment of OTC and exchange-traded options on single stocks and narrow-based stock indices.

Evaluating weather derivatives requires a different approach from that used for evaluating common financial products. One reason is the difficulty of replication, as temperature, rainfall or wind is not a traded asset. Consequently delta neutral techniques cannot be used and, in addition, there is a lack of liquidity in some temperature contracts. Therefore a number of market participants have started to use an actuarial approach when dealing with weather derivatives. Extracting and de trending heating degree days or cooling degree days from data, and then fitting a distribution to the events, makes valuation possible based on the expectation of the loss plus a given risk premium that reflects the sensitivity to risk. However, in doing so, a number of problems arise. These stem from the fact from that, in most cases, a maximum of 40 years of data is available. Some of these issues include:

A market for options exists because options have a unique, calculable price. For this price to exist, the market must have a mechanism for ignoring the different risk tolerances of the different players in the market. Risk neutral probabilities is a tool for doing this and hence is fundamental to option pricing. While most option texts describe the calculation of risk neutral probabilities, they tend to gloss over their importance. Failing to incorporate risk neutral probabilities can lead to incorrect conclusions.

At the end of last year, the four primary federal banking regulatory agencies (the Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and Office of Thrift Supervision) issued a proposal to amend their capital standards for banks, bank holding companies and savings associations to reduce the risk weighting applied to claims on, or guaranteed by, qualifying securities firms. If adopted, this proposal could have a significant effect on the credit derivatives market.

The interest-rate implied volatility surface exhibits a maturity and smile or skew (strike dependent) structure. This observation means that the interest rate market does not follow the Black-Scholes model.

This series of Learning Curves examines the ability of interest rate models to capture relevant market information, in particular the observed market-implied volatility surface. Part I investigates the interest rate derivatives available in the market.

Copulas are an innovative tool in finance to separate marginal distributions, for example of single asset returns, from their dependence structure in modelling multivariate distributions. In principle this allows for the whole variety of univariate distributions that have been developed and introduced into finance in recent years, for example, heavy-tailed distributions, to be used as marginals. Merging the marginals and describing co-movements is left to the copula. Dependence structures expressed by copulas are not fully determined by linear correlation, as is the case with the multivariate normal distribution. Some classes of copulas additionally allow for capturing so-called tail dependence, describing, such as co-movements of asset returns conditional on one being (extremely) negative or positive. With this feature, copulas extend the notion of multivariate normals that is widely used for multi-dimensions, yet the complexity regarding parameters needed to describe certain copulas does not increase proportionately.

Conversion and call rights are common embedded optionality in financial instruments. For example, a convertible bond entitles the holder to convert the bond into common shares of the bond issuer's company. On the other hand, in order to cap the unlimited upside potential of the bond value, the bond indenture usually includes a clause where the bond issuer can call the bond at a predetermined call price. Upon calling, the bondholder either chooses to receive the cash amount equivalent to the call price or to convert into the common shares (this is called forced conversion).