Derivatives

Types of Risk I

A number of types of risks are often identified in the context of derivatives.  Credit risk is the risk that the counterparty will not pay when due.  In the case of exchange-traded derivatives, a clearinghouse may provide a guarantee for the trades of its members.  There has been a move towards requiring use of clearinghouses to reduce risk and deleverage following the global financial crisis.

Legal and documentation risks may arise from inadequate contractual arrangements or breaches of local law.  It may arise from the inability to prove documents due to loss of paperwork or equivalent other record.

The ISDA Master Agreement governs most derivative transactions.  Typically, there is a written note only of the terms of trade which follows from a verbal agreement.  Trading rooms may record conversations as evidence of the terms.  Although verbal financial agreements are enforceable, this is not desirable, and they should be confirmed in writing or electronic form.

Types of Risks II

Market risk is the broad risk that the market may simply move, causing a loss on the transaction.  It may be covered by hedging by taking a countervailing position.  Market risk, however, is generally a fundamental commercial risk.

Liquidity risk is the risk that trades and transactions cannot be settled in cash at the requisite time due to the inability of one party to liquidate assets to meet the obligation.

Operational risk refers to inadequate structures to facilitate the settling of trades.  This may arise from a lack of internal controls, monitoring and business failure in the broader sense.

Swaps

Interest rate swaps involve a bilateral agreement between financial institutions.  Net payments only are made.  They are typically made where one institution wishes to swap a series of future variable rate receivables for a series of fixed rate receivables. Interest rate swaps may come in different structures.

In the case of an interest swap, one party pays periodic amounts in a currency at a fixed rate and the other pays the same currency based on a specified floating rate that is reset from period to period.  They are based on a notional principle.

An issuer of a bond may be unable to obtain fixed-rate funding at a competitive rate due to its credit rating.  It may borrow funds at a variable rate and enter into a simultaneous swap with a bank for the same period.  The interest periods are matched. The borrower pays the fixed interest to the bank and achieves a lower fixed interest rate than it could itself achieve.

An interest rate swap may be used to engineer a synthetic asset that does not otherwise exist.  An entity may wish to have a fixed rate investment with a particular industry or entity which may not issue notes or obligations of that kind.  It may achieve the same result by swapping floating rate obligations from that company with a fixed-rate obligation of another entity of the same credit strength.

Caps & Floors

An interest rate cap involves one entity agreeing to make a series of payments to the other by reference to the excess over the capped rate.  The payee pays a premium usually at the outset of the transaction.  In effect, this caps its interest rate and ensures against market increases over the period.

The swaps effectively secure a fixed or capped rate.  The cap requires an upfront payment.  The company potentially receives the upside if interest rates fall.  In contrast, where the fixed rate is swapped for the floating rate, the rate is fixed for the term.

Caps are much more widely available as they are purchased upfront and do not require the same assurance with respect to creditworthiness throughout the term.

A floor is the equivalent of a cap by which the investor seeks to protect against rates moving downwards below a specified minimum. A bank may seek to protect itself against falls below the floor by entering an offsetting swap with a counterparty bank.

Types of Swaps

A currency swap is generally used to hedge currency risk. It may be appropriate where a corporation has receipts in one currency and obligations in another.  It may finance purchases in currency where it is wished to hedge against the risk of the repayment obligations in that currency changing.  This would apply both to interest and capital repayment.  The currency swap fixes the exchange rate required when payment is due.

Equity derivatives are based on underlying stocks or stock indexes.  An option may be granted to buy or sell a number of units of a stock exchange index at a future date for a fixed sum. If the option is profitable to exercise, then there may be a profit relative to the premium paid.

If it is not exercised, the premium only has been paid. An equity option may put a floor on a stock market investment.

A stock option may be settled by delivery of the underlying shares or by cash settled for the difference between the option price and the actual price.

Credit Derivatives

Credit derivatives seek to transfer risk between financial market participants.  The buyer purchases credit protection against credit risks of a relevant reference entity.  In the case of a credit default swap, one party pays a fee in return for the obligation of the other in the event of default on an underlying asset.  It is in the nature of an insurance contract against specific or general obligations of an entity.

The provider may be another credit institution.  The entity selling the insurance agrees that the credit default event of the relevant debtor, it will pay an agreed amount against the obligations of the debtor.  The effect is to transfer the credit risk of the underlying debtor to the credit default seller.

The obligation kicks in upon default, bankruptcy restructuring or other defined obligations or defaults of the underlying debtor.  Credit events may be more widely defined to include acceleration of other obligations, debt moratorium, etc.

When the credit event occurs, the seller has the option to trigger a credit event in which event the seller issues a notice saying the credit event has occurred. The event must be supported by publicly available information. The buyers give notice of intention to settle the CDS within 30 days of the credit event notice.  The buyer is to fulfil and deliver the relevant obligations, e.g. the relevant security and receivables.

Credit default swaps are entered for a variety of reasons.  Although they were primarily designed to hedge credit risk, they are also capable of being used to as an alternative investment.

Total Return Swap

A total return swap involves swapping all cash flows, including income and capital gains from a particular asset, for another cash flow.  They may transfer both credit and market risk.  They may be used in respect of any asset.  They are commonly used by hedge funds to achieve leverage and obtain exposure to particular types of assets they would not otherwise have exposure to.

The buyer  of the swap purchases the underlying reference asset at the market price and funds it with borrowings.  It then undertakes a swap with an investor/credit protection seller to whom all cash flows and the underlying asset is paid.

Derivative Mechanics

A derivative transaction is usually executed by a trader.  He deals with a customer at a particular price and writes a deal ticket or terms of the deal.  A credit officer analyses the risks associated with the transaction in advance and executes the necessary credit approval.  A confirmation specialist drafts the confirmation from reviewing the inputs and returns the confirmation.

The payment settlement section is responsible for sending notices of payments due and remitting payments owing.  The legal department will draft more complex confirmations.  It may also assess counterparties.  Amendments to the ISDA agreement may be negotiated.

Collateral may be given by way of security for swap obligations.  Organisations may have collateral management units to deal with counterparts and enter into collateral arrangements.  They will require details of collateral relationships under the relevant management system.

They will reconcile the portfolios of the counterparties.  They are to monitor an exposure in collateral accepted and posted.  They will undertake the transfer of collateral and call for collateral when required. They must ensure collateral is eligible.  They must pay out cash due under collateral.

Derivatives are investment instruments under the market in the Financial Instruments  Directive.  Accordingly, all dealing with them as principal agents, advisors, arrangers, etc., requires authorisation and compliance with the conduct of business rules in MiFID.

Not Insurance & Wagering

It has been argued that some derivative contracts are, in essence, insurance arrangements.  The Central Banks and Financial Services Authority Act confirms that contracts under the netting legislation are not insurance contracts provided that they do not provide for a benefit, conditional on the occurrence of a loss or detriment to a party, the party is required to be exposed to under the contract.

Derivatives may not be enforceable due to a breach of laws in a particular jurisdiction.  Derivatives run the risk of being considered gaming or wagering contracts in some jurisdictions.

The Netting of Financial Contracts Act 1995 Allows the set off of a wide range of derivatives on a bilateral basis.  It provides that the instruments are not contracts of wagering or gaming.  It provides that contracts covered by the legislation are not insurance contracts for the purpose of insurance regulation.  See the separate sections on the Markets in Financial Investments Directive Regulations.

Insolvency

In the event of the insolvency of a party without the benefit of a netting out arrangement, there may be considerable loss in respect of the gross payment without a corresponding right of set off.  The Irish legislation on netting of contracts seeks to facilitate netting in the event of insolvency.

Famously, the UK Courts held that certain public authorities lacked the powers to enter derivative transactions with consequences in terms of recovery.

The Netting of Financial Contracts Act provides for set-off arrangements in bilateral financial contracts in the absence of fraud or malpractice.  They are enforceable notwithstanding that one party has gone into insolvency or examinership.  Set-off is permitted in relation to such contracts, notwithstanding general principles of insolvency law.

The  Central Bank legislation provides that if contracts are traded on an exchange regulated by the Central Bank, it may not be rendered void under the gaming legislation.

The Netting of Financial Contracts Act provides that contracts under it are not subject to the gaming legislation.

Contracts Covered

Financial contracts covered by the Act are

• interest rate derivatives, including single currency interest rate swaps,
• basis swaps,
• forward rate arrangements,
•  interest rate futures,
• interest rate options;
• foreign exchange and gold swaps,
• futures and options,
• securities lending and borrowing contracts;
• swap futures and option contracts in respect of equities, bonds, precious metals other than gold and commodities are the reference item.
• buy and sell agreement in relation to securities and equities i.e. repurchase agreements;
• contracts for laying off credit risk on loan and debt securities;