Learning Curve

The last few months have served as a stress test for documentation as dealers and counterparties have had to deal with a number of crises and events in a very compressed time.

Events at Tembec, Fannie Mae, Freddie Mac, Lehman Brothers, Landsbanki, Glitnir and Kaupping have focused market attention on the bankruptcy credit event set out in section 4.2 of the 2003 Credit Derivatives Definitions, the ISDA CDS Settlement Protocols and the corresponding auction process.

The State of New York is the first and, so far, the only U.S. jurisdiction to announce the implementation of guidelines for the regulation of credit default swaps.

This is the second and final installment of this Learning Curve. Part I appeared last week.

Multi-currency structured products are derivatives whose payoffs depend on multiple underlying currency pairs.

Credit default swap options (swaptions) are a natural extension of the options framework but are applied to the credit market and use CDS as underlying products. Like all options, swaptions give the buyer of the option the right, but not the obligation, to buy or sell (depending on the option) the underlying CDS contract at a pre-agreed spread at some specified future date. The following Learning Curve concentrates on the different inputs that go into pricing options and the sensitivity of the options to changes in the variables.

In last week's issue, we highlighted the risk assumed by hedge funds and other bank counterparties when banks have free use of counterparty collateral, but that banks traditionally have been reluctant to enter into third party custodial arrangements.

Hedge funds transfer billions of dollars to their trading counterparty banks and their affiliates to collateralize their obligations under derivatives transactions, and most of this collateral -- referred to as initial margin, upfront collateral or the Independent Amount in an ISDA Credit Support Annex (CSA) -- remains with the bank counterparty without regard to the mark-to-market value of the trades.

During the first couple of years, death benefits are not enough to cover for scheduled premiums.

The turmoil in the global financial markets is highlighting the existence of alternative investments.

In amongst all the turmoil engulfing the credit markets over the past year, one group has been largely unscathed --credit derivative product companies.

The U.K. Financial Services Authority has announced that it will soon require the disclosure of cash-settled contracts for difference on U.K.-listed equities.