Learning Curve

The credit derivatives market underwent major reform in 2009 and more reform is yet to come. The market has certainly been moved by the changes already implemented, with CDS clearing (possible, amongst other things, as a result of the fungibility created by the dynamic protection period introduced by the Big Bang) now taking hold. Of course, many challenges for the market still remain and many politicians still retain their (often ill-informed) opposition to the use of credit derivatives. But the rapid, industry driven, reform in 2009 has rightly been recognised as a step in the right direction.

On the day when KfW wired EUR300 million to the defaulted Lehman Brothers, it became clear that a new regime for risk control and counterparty risk assessment was imminent. No longer could the middle office operate in an end-of-day or end-of-week environment while the front office operated in real-time. This article illustrates how an institution can significantly enhance its ability to actively manage counterparty credit exposure by using credit default swap information provided by the Credit Market Analysis (CMA) independent CDS data service. It will also introduce CMAs market activity indicators, which provide information that is not contained in CDS pricing, but which can have a significant and valuable impact on counterparty credit assessment.

Structured notes are useful tools for both investors and issuers because of their flexibility. They can be linked to the performance of equity securities, loans, bonds, indices, commodities or a basket of financial assets and can provide investors with a leveraged exposure to the reference asset or a hedge against particular assets to which they already have exposure. The issues an investor needs to care about will vary greatly depending on the type of the structured note and the investor's sensitivity to counterparty and structural risks. This article will focus on the issues that an investor should consider before investing in structured notes issued by special purpose vehicles (SPVs).

A number of significant changes are under way with respect to the credit default swaps market. Market participants will need to grapple with the shift away from familiar bilateral relationships and industry standard documentation to each clearinghouse's own rules and procedures.

Last year saw longevity hedging by U.K. pension plans move from theory to practice. Previously, use of such contracts to transfer longevity risk was limited primarily to life insurance companies seeking protection on their annuity books. However, in June 2009 the U.K. engineering group Babcock International PLC, confirmed that the trustees of one of their defined benefit pension plans had entered into a 50-year longevity trade, reportedly with Credit Suisse, with a notional value of GBP500 million (this was to be the first of three trades completed by pension plans within the Babcock group in 2009).

The regulation of structured products marketed to retail investors is likely to undergo major changes under proposals currently under consideration by the European Commission. The Commission plans to publish sometime in the next few months an outline of its legislative proposals for changes in the regulation of what it terms packaged retail investment products, or PRIPs.

Recently, there has been an increase in straight payout structures being priced and traded in the interest rate derivatives market. Unusual market conditions and a general aversion to conventional exotics has helped these trades evolve relatively quickly. Although they are very complex trades to value these simple exotics offer very clear and straight forward payouts and allow speculation on or hedging of very specific types of risk. Often, the more simple the payout, the more complex the initial pricing and modeling of the trade can be.

Recently, there has been an increase in straight payout structures being priced and traded in the interest rate derivatives market. Unusual market conditions and a general aversion to conventional exotics has helped these trades evolve relatively quickly. Although they are very complex trades to value these simple exotics offer very clear and straight forward payouts and allow speculation on or hedging of very specific types of risk. Often the more simple the payout, the more complex the initial pricing and modeling can be.

In response to controversial sales practices relating to reverse exchangeable securities (reverse convertibles), the U.S. Financial Industry Regulatory Authority recently issued two documents--a regulatory notice and an Investor Alert--on the instruments.

A recent decision in the U.S. Lehman Brothers bankruptcy case held that investors in a collateralized debt obligation called Dante did not have the right to jump ahead of Lehman to get repaid, contradicting an English court decision and raising questions about how similar deals will be treated.

The credit crunch has focused a lot of attention on bank capital ratios. With recent large write-downs in asset values, the implementation of Basel II's risk based capital requirements and the possible introduction of further changes following the Basel Committee's December consultation paper, banks face the prospect of holding increasing levels of regulatory capital as the assets they own deteriorate in both credit and rating quality.

This week's Learning Curve focuses on the effect of equity structured products on the market for equity index correlation.