Derivatives and Isda Agreements

DERIVATIVES AND
ISDA AGREEMENTS By Rami Alameh

A derivative is an
instrument whose value derives from an underlying asset and is dependent on the
value of the same underlying asset, which can be a commodity, a security or
even a currency.

This instrument is a
contract between two or more parties based on the underlying asset or multiple
assets. You can track its value by tracking the value of the underlying asset
itself.

Derivatives are also
considered to have characteristics that enable them to be used as hedging
tools, thus reducing the risk faced by organizations and individuals. There are
different derivatives tools :

Exchange
Traded Derivatives:

They are standardized
derivative contracts (e.g. future contracts and options) that are traded on an
organized futures exchange. They require payment of an initial deposit or
margin settled through a clearinghouse.

Over-The-Counter
(OTC) Derivatives:

OTC is a market where
derivatives are directly negotiated and traded privately between two parties
without the need for a third party intermediary. Products traded OTC are swaps,
forward rates agreements, exotic options and other exotic derivatives.

CALL AND PUT OPTIONS

Options are simply a
legally binding agreement to buy and/or sell a particular asset at a particular
price (strike price), on or before a specified date (maturity date). There are
two types of Options that can be bought (Long) and sold (Short):

CALL
Option
: Gives the owner the
right, but not the obligation, to buy a particular asset at a specific price,
on or before a certain time.

PUT
Option:
 Gives the owner
the right, but not the Obligation, to sell a particular asset at a specific
price, on or before a certain time.

Options were created
to manage one thing, risk. They can be used to hedge, speculate or simply as
insurance. What’s important to note with options trading, is that investors
should clearly define the benefits and risks of each and every position they
enter into ahead of time. Although Options are important tools for hedging and
risk management, traders could end up losing more than the cost of the option
itself.

CALL
OPTION: 
As
a Call Buyer you:

  • Acquire the right but not the
    obligation to buy the underlying at a certain price (strike) for a period
    of time
  • Have to pay a premium
  • Want the underlying price to
    increase

At
Expiry these are the scenarios that are into 
play:

Market price >
Strike. In the money [gain].

Market price <
Strike. Out of the money [loss]

Market price =
Strike. At the money [You loose the premium].

As a call Buyer, your
maximum loss is the premium already paid for buying the call option To get to a
point where your loss is zero (breakeven) the price of the option should
increase to cover the strike price in addition to premium already paid. The maximum
gain is unlimited as a call buyer given the fact that there is no ceiling to
price increase.

What
are your choices as a call buyer?

  • To exercise and buy the underlying
    when the option is in the money.
  • Trade the option also when the
    option is in the money.
  • You can walk away and not exercise
    the option.

What are your two
main objectives as a call buyer?

  • To speculate on the potential rise
    in the price of an underlying instrument.
  • To hedge a Short position on the
    same underlying.

As a Call Seller you:

  • Assume the obligation [not the
    choice] to sell the underlying when the call buyer exercises his option.
  • Will receive a premium for that
    obligation to sell [from the buyer of the option]
  • Will be willing to see the
    underlying price decreasing.

At
Expiry these are the scenarios that are into play:

Market price >
Strike. In the money [loss].

Market price <
Strike. Out of the money [gain]

Market price =
Strike. At the money [You gain the premium].

As a call seller your
maximum loss is unlimited. To reach breakeven point, the price of the option
should increase to cover the strike price in addition to premium already paid.
Your maximum gain as a call seller is the premium already received.

What
are your choices as a call seller?

In case the call
option is exercised by the buyer of the call, then the seller has the
obligation to deliver the underlying with a potential of unlimited loss.

If the underlying
price decreases, option expires worthless and the seller will keep the premium
as the maximum profit attributed to this trade.

What
is your main objective as a call seller?

To increase yield by
selling calls against positions held long.

PUT
OPTION: 
As
a Put Buyer you:

  • Have the right [but not the
    obligation] to sell the underlying at a certain price (strike) for a
    period of time.
  • Pay a certain premium for holding
    the right to exercise.
  • Want the underlying price to
    decrease.

At
Expiry these are the scenarios that are into play:

Market price <
Strike. In the money [gain].

Market price >
Strike. Out of the money [loss]

Market price =
Strike. At the money [You loose the premium].

As a Put Buyer,
your maximum loss is the premium already paid for buying the put option. To
reach breakeven point, the price of the option should decrease to cover the
strike price minus the premium already paid. Your maximum gain as a put buyer
is the strike price minus the premium.

What
are your choices as a call buyer?

  • To exercise and sell the
    underlying when the option is in the money.
  • Trade the option, when the option
    is in the money.
  • You can walk away and not exercise
    the option [on the option seller] when your put option is out of the
    money.

 What
are your two main objectives as a call buyer?

  • To speculate on the potential drop
    in the price of an underlying instrument.
  • To hedge a long position on the
    same underlying against a market drop.

 As
a Put Seller you:

  • Assume the obligation [not the
    choice] to buy the underlying when the put buyer exercises his option.
  • For that assumption you will
    receive a premium [from the buyer of the option]
  • Will be willing to see the
    underlying price increase.

At
Expiry these are the scenarios that are into play:

Market price <
Strike. In the money [loss].

Market price >
Strike. Out of the money [gain]

Market price =
Strike. At the money [You gain the premium].

As a put seller your
maximum loss is the strike price minus the premium. To get to a point where
your loss is zero (breakeven) the price of the option should not be less than
the premium already received. Your maximum gain as a put seller is the premium
received.

What
are your choices as a put seller?

In case the buyer of
the put exercises the put option, then the seller has the obligation to deliver
the underlying with a potential loss.

If the underlying
price increases, it becomes worthless on maturity date, and the seller keeps
the premium as maximum profit.

What
is your main objective as a put seller?

As a put seller,
investors believe that the underlying stock price will rise and that they will
be able to profit from a rise in the stock price by selling puts. Investors who
sell a put are obligated to purchase the underlying stock if the buyer decides
to exercise the option. An investor who sells a put may also be selling the put
as a way to obtain the underlying security at a cheaper price. If the stock is
put to the investor, the investor’s purchase price is reduced by the amount of
the premium received.

COLLATERALIZED
DEBT OBLIGATIONS (CDOS)

CDOs the main reason
behind the financial crisis 2008 leading to more than a trillion USD in
losses.

There mechanism is
the following: When homeowners pay their mortgage every month, the money goes
to their local lender. In return, the local lender sells it to an investment
bank.

The investment bank
combines thousands of mortgages and other loans including car loans, student
loans and credit card debt to create complex derivatives called Collateralized
Debt Obligations (CDOs). The Investment bank then sells the CDOs to investors.

When homeowners pay
their mortgage, the money goes to investors all over the world.

The investment banks
pay rating agencies to evaluate the CDOs and many of them were given AAA
rating, which is the highest possible investment grade. This made CDOs popular
and attractive alongside retirement funds, which can only be purchased as
highly rated securities.

FORWARD
AND FUTURES CONTRACTS

Forward: It is an Over-The-Counter derivative contract
in which two parties agree that one party, the buyer, will purchase an
underling asset from the other party, the seller, at a later date at a fixed
price they agree on when the contract is signed.

Future: It is an exchange traded standardized
derivative contract in which two parties agree that one party, the buyer, will
purchase an underlying asset from the other party, the seller, at a later date
and at a price agreed on by the two parties when the contract is initiated and
in which there is a daily settling of gain and losses and a credit guarantee by
the futures exchange through its clearinghouse.

At the expiration
date of the contract, if the market price is above the agreed price, then the
buyer of the future contract will have incurred a profit and the seller will acquire
the loss. The buyer will be able to take delivery of the underlying at a lower
price and sell it at a higher market price locking the profit.

Conversely, if the
price is lower than the agreed price, the trader’s counter party (the future
seller) will make a profit.

CREDIT
DEFAULT SWAPS (CDS)

Credit Default Swaps
are credit derivative contracts between two parties where the buyer makes
periodic payments, such as a premium, over the maturity of a CDS to the seller.
This is an exchange for a payoff if a third party defaults. A third party is
usually a person who borrowed money from the banks to buy a house. By
definition, default simply means the failure to fulfil an obligation.

Buyer of a CDS: Is
usually betting against the market and wants the swaps to default. The buyer
will be benefiting with the failure of the borrowers to make payments in order
to achieve profit on those swaps. When the market defaults, the value of the
swaps increase.

Think of CDS as an
insurance policy on mortgages in the event of non-payment or default. It is
like paying insurance on a house that is going to burn out. You are going to
get a check after the house is destroyed.

Seller of a CDS: Is
betting that the market is not risky and the borrowers won’t default on their
payments. Thus, they sell CDSs in order to collect premium. The maximum profit
of a CDS seller is the premium amount paid and the maximum profit of a buyer of
a CDS is unlimited to the value appreciation of the CDS in case of any default.

ISDA
MASTER AGREEMENT

What
is an ISDA Master Agreement

An ISDA Master
Agreement is the standard document that is regularly used to govern
over-the-counter derivatives transactions. The Agreement, which is published by
the International Swaps and Derivatives Association [ISDA], outlines the terms
to be applied to a derivatives transaction between two parties, typically a
derivatives dealer and a counterparty. The Master Agreement itself is standard,
but it is accompanied by a customized schedule and sometimes a credit support
annex, both of which are signed by the two parties in a given transaction.

Over-the-counter
(OTC) derivatives are traded between two parties and not through an exchange or
intermediary. The size of the OTC market means that risk managers must
carefully oversee traders and ensure approved transactions are properly managed.
The growth of the foreign exchange and interest rate swap markets, which
together account for trillions of dollars in daily trades, prompted the
creation of the ISDA Master Agreement in 1985. It was subject to updates and
revisions in 1992 and again in 2002, both of which are currently available for
use. The agreement is widely used by banks and corporations worldwide. The ISDA
Master Agreement also makes transaction close-out and netting easier, as it
bridges the gap between various standards used in different jurisdictions.

ISDA Master
Agreement Documentation

Most multinational
banks have ISDAs in place with one another, and these usually cover all
branches that are active in foreign exchange, interest rate or options trading.
Banks require corporate counterparties to sign an ISDA in order to enter into
swaps, and some also require them for foreign-exchange transactions. While the
Master is standard, some of its terms and conditions are amended and defined in
the accompanying schedule, which is negotiated to cover either (a) the
requirements of a specific hedging transaction or (b) an ongoing trading
relationship.

A Credit Support
Annex [CSA] sometimes also accompanies the Master. The CSA allows the two
parties involved to mitigate their credit risk by stipulating the terms
and conditions under which they're required to post collateral to each
other.

When two parties
enter into a transaction, they each receive a confirmation that sets out its
details and references the signed ISDA, the terms of which then cover the
transaction.

The Master and
Schedule set out the grounds under which one of the parties can force the
closeout of covered transactions due to the occurrence of a termination event
by the other party. Standard termination events include failure to pay or
bankruptcy. Other termination events that can be added in the Schedule include
a credit downgrade below a specified level.

The Agreement
stipulates which law applies and its generally Laws of Britain or New York
State and sets out the terms for valuing, closing out and netting all covered
transactions in case of a termination event.

The ISDA
documentation for derivatives involves layers of documentation (often referred
to as the ISDA documentation architecture). It is important to understand how
each document fits within the framework in order to be able to negotiate the
documentation effectively. The key layers of documentation for a trade under
the ISDA documentation framework are:

Master agreement:
Pre-printed umbrella document which includes the boilerplate provisions [unless
varied by the schedule to the master agreement].

Schedule
to the master agreement
—amends
the terms of the master agreement as required by the parties

Credit
support documents
 (optional)—
credit support is a method of providing collateral or security for the
obligations under derivative transactions, either in the form of a credit
support annex which forms part of the schedule, or a credit support deed which
is a stand alone document

Confirmation—contains the economic terms of an
individual trade

The master agreement,
schedule, credit support annex (if any) and all of the confirmations together
form one single contract. The credit support deed (if any) is a stand alone
document. See Practice Note: ISDA documentation framework for a description of
the ISDA architecture.

There are two
versions of the ISDA Master Agreement in widespread use today:

  •  the 1992 ISDA Master
    Agreement
  •  the 2002 ISDA Master
    Agreement

The differences between
the two forms of master agreement are summarised in a separate article to be
found on my profile

LAYOUT
OF THE MASTERS AGREEMENT

The standardisation
of the Master Agreements has greatly facilitated the negotiation process for
over-the-counter (OTC) derivatives. As the documents
have become well known in the market, each party will have a good idea of what
the terms are and what is acceptable to them and their institution.

Section
1—Interpretation

The ISDA architecture
is set out and this Section clarifies that the Confirmation prevails over the
Master Agreement and Schedule in case of inconsistency.

Section
2—Obligations

In Section 2, the
parties commit to pay or deliver their requirements under the Confirmations,
with the obligations subject to the concept of the single Master Agreement. The
concept of netting is explained.

Section
3—Representations

Each party makes a
number of commitments to the other in this section—any misrepresentation will
give rise to an Event of Default. This Section is likely to be quite important
to negotiate. While the basic representations will not be a problem for most
entities, additional representations are often requested.

Section
4—Agreements

Here, parties agree
which documents are to be delivered to the other party when requested. Many
documents are unlikely to prove problematic for a commercial organisation to
provide. However, it is imperative that each party ensures that they shall be
in a position to deliver the documents as specified, particularly if items such
as legal opinions or audited accounts are required to be of a certain standard.
Failure to provide the documents within the required number of days of request
will constitute an Event of Default.

Section
5— Events of Default and Termination Events

This Section sets out
the grounds under which one party may terminate the outstanding transactions as
a result of the other's default. There is a total of eight Events of Default
listed in Section 5(a):

  • Failure to Pay or Deliver
  • Breach or Repudiation of Agreement
  • Credit Support Default
  • Misrepresentation
  • Default under Specified
    Transaction
  • Cross Default
  • Bankruptcy
  • Merger without Assumption

Additional
Termination Events may also be specified. Either party may wish to have the
ability to terminate the Agreement should an event occur which is likely to
impair the other party’s performance. Such events could include ratings
downgrades, change of control, break clauses, changes in documentation,
political events, key man clauses and breaches of other agreements.

What constitutes an
Event of Default is of critical importance as the occurrence of some of the
Events of Default listed above or an Additional Termination Event will enable
the non-defaulting party to close out all of the transactions made under the
Master Agreement.

Section
6—Early Termination

This Section pertains
to the results of a default and especially how the gains and/or losses that
accrue to each party are calculated in the event of the swap being terminated.

Section
7—Transfer

This Section prevents
either party from transferring its rights under the Agreement without the other
Party's consent.

Section
8—Contractual Currency

These provisions
protect each party against losses resulting from foreign exchange movements.

Section
9—Miscellaneous

This section contains
various provisions concerning the constitution of the contract between the
parties, calculation of interest payments and other material.

Section
10—Offices;- Multi-branch Parties

This provision, if
the parties opt for it to apply, provides that both parties may have recourse
to each other's branches—even if they are contracting with a branch of the head
office.

Section
11—Other Expenses

In addition to the
expenses incurred by early termination (dealt with in section 6), there are
other expenses that a defaulting party must pay.

Section
12—Notices

Section 12 sets out
the means by which any communication must be made.

Section
13—Governing law and Jurisdiction

The Parties choose
the governing law of the agreement. There is a choice of English law and the
laws of New York state.

Section
14—Definitions

All significant terms
used in the Master Agreements are either defined in section 14 or as the
parties agree in the Schedule. ISDA has prepared several specialist sets of
definitions.