CH5: Principles of OTC Derivatives

Question 1

OTC derivative - most common types

Answer 1

• Swaps
• Swaptions
• Forward rate agreementa (FRAs)
• caps
• floors
• collars
• Credit derviatives

Question 2

FX forwards and swaps

Answer 2

• Small trades can see a spread of 2 cents or more. Large trades can beas low as 0.0005 dollars (5 pips). Pips are the smallest price increment
• For currencies quoted in pips, it is common to see of example 1.3000/05 meaning 1.3000/1.3005
• Any FX contract maturing one day beyond the typical T+2 is considered a forward
• Major currencies have fwds with maturities of 5 or 10 years.
• The longer the maturity, the less liquid the mkt
• Previous chapters cover IR parity
• The longer dated the forward, the wider the spread as teh dealer is exposed to more risk
• Forward markets are used to speculate on IRs as the forward rate is based on the interest rates of teh 2 currencies
• Swaps = buy one currency spot and sell it at the same time on a future/forward date so any movements in the forward points (IRs) create profit/loss

Question 3

Caps

Answer 3

• Used for interest rates
• Option product that protects the cost of floating rate borrowing over a series of settlement dates. Puts a cap on the maximum cost of each IR payment and if the IR payment exceeds the cap amount, the holder is paid the excess.

Question 4

Floors

Answer 4

• Used for interest rates
• Options that fix a minimum interest rate payable on a deposit even if the prevailling interest rate falls below the agreed minimum IR. Used to protect the income by essentially putting a minimum rate of return on teh deposit.
• Opposite to a cap
• If the prevailing IR is above the cap, nothing happens

Question 5

Collars and zero premium collars

Answer 5

• Contracts incorporating both a cap and a floor. for the borrower the cap guarantees a maximum cost and the floor secures the minimum rate. Limits losses but also limits large gains
• Lower premium because of this
• Zero premium collar = made up of the premium to buy the cap and the premium recieved when the floor is sold, cancelling each other out to $0 cost.

Question 6

Credit derivatives

Answer 6

• Value depends on agreed credit events relating to a third party.
• Used to protect against credit risk by passing any additional risk onto another party.
• Cann be used inversely be used to increase credit exposure in return for a premium
  *

Question 7

Credit default swaps - based on what agreement

Answer 7

• Party A pays party B a fee for an agreed rate of compensation if there is a credit event relating to a third party
• The credit event is determined in the agreement between A and B.
• If the credit event happens the payment is made and the contractt terminates
• Contract is based on the ISDA master agreement containing responsibilities for parties etc.

Question 8

Credit default swaps - credit event types

Answer 8

• Default - failure of the third party to pay the recipient
• Significant fall in asset price/value below a certain level
• Bankruptcy
• Debt restructuring - the creditors restructure their debt affecting the seniority of debt held by the investor
• Merger/demerger - change in the independance of the asset/comoany
• certain govt actions = nationalisation in case of a bailout in fin crisis period

Question 9

3 types of credit default swap

Answer 9

• Single name / basic = based on a credit event relating to a specific asset.
• Basket = based on a default on a basket of securities. can be triggered by 1 or any number of assets defaulting to trigger the credit event. can have 3-20 assets in the portfolio. the more assets the higher the premium
• Index = Based on movements of an equity ofr det related index and offers protection of the index falling below a certain level

Question 10

How CDSs are priced - what approach does it use, what are common measures of default probability

Answer 10

• Priced using reformed pricing approach in which the credit event process is modelled into the swaps priced based on the probability of the credit event happening (probability of default)
• Default swap/asset swap spread = most common measures of probability of default - measures the premium paid to investors compared to a cost of holding the asset (sonia for example)
• The advantage of this is that it is observable and can allow the premium to change in line with market conditions

Question 11

Credit Linked Notes (CLNs)

Answer 11

• Funded credit derivative
• Strcutured as a security with an embedded CDS meaning the issuer does not need to repay teh debt if a specific credit event occurs, removing the need for another insurance provider.
• Coupon of CLN is linked to the performance of the UA.
• Gives investors a hedge against credit risk and a higher eturn due to exposure to credit risk

Question 12

Credit Spread Opions

Answer 12

• Credit spread = difference between the yeild of an asset compared to a particular benchmark.
• CSOs set a ‘strike rate’ where the buyer of the option pays the premium and recieves the difference between the asset and the agreed benchmark strike price.
• Pay off is based on whether the price of the UA is above or below the benchmark strike rate on the day of maturity
• Can be strucutred american and european style and are desgined to hedge changes in credit spread for the buyer and profit from credit spread changes for the seller
• if the credit spread rises and exceeds a pre-defined benchmark level, the holder receives a payout for example hold bonds in ABC PLC and use T bills as a benchmark. If the credit spread rises between the 2 the holder receives a payout to make up for the loss of credit worthiness

Question 13

Credit default options

Answer 13

The option to buy (payer option) / sell (reciever option) protection on a CDS based on a specific reference credit with specific maturity.
* Typically or European style options
* CD options on single credits are terminated upon default without any cash flows other than the premium.
* Only provides protection against the increase in credit spread rather than the actual default
* Very illiquid for the above reason
* Priced based on very high implied volatilities

Question 14

Collateralised debt obligations

Answer 14

• Structured ABS with value based on payments from an underlying pool of fixed income assets. The UAs are split into tranches based on their risk and the more senior tranches are considered safer debt, so pay a lower IR etc.
• A corporate entity is created to hold the assets as collateral and sell the packages of CDO cash flows to investors. Basicaly SPVs
• The risk and return of CDOs for the investor is mostly linked to how the tranches are defined and not the UA performance
• CDOs take credit risk away from the issuer and pass it on to investors. In return for taking on the risk, the investors recieve teh cash flows. the issuer then takes commision.

Question 15

Collateralised bond obligation

Answer 15

Derivative creating an investment grade bond from a pool of high risk junk bonds. They achieve this risk rating as they are considered diversified eough due to the number of different rated/origin junk bonds in the portfolio.

The returns on CBOs are considered lower than risk than the individual UA bonds.

Question 16

Exotic OTC option structures

Answer 16

• Asian option - pays the investor the difference between the average rate of the UA’s price and the preagreed strike price. Cheaper than european style
• Average strike option - strike price is set at maturity date to be the avergae price of the UA over the period. the investor than makes money from the spread of the UA price at maturity and the avergae UA price.
• Cliquet/ratchet option - series of ATM options that settle periodically and reset the strike price of the option to the price of the UA at the at the periodic maturity. profit is made if the UA price is greater than the new strike set at the previous maturity
• Lookback option - can be exercised at a previous price in the options life. High risk to the writer and carry a high premium.

Question 17

Barrier options - exotic OTC options - down/up and in/out

Answer 17

• Barrier option - pay out only happens if the price of the UA crosses a certain predefined barrier price.
  2 main types
  1. Knock-in options = are activated when agreed and come into exisitence when the UA crosses the barrier price
  2. Knock out options = exist when the contract is agreed and terminate when the UA crosses the barrier price
• Barrier options are sold as puts and calls with specific expiration dates. Usually cheaper than normal options as they are less likely to exist
• Down and in (knock in option) = activated when UA price falls to/below the barrier
• Down and out (knock out) = cancelled when UA priced reachs or is below the barrier
• Up and In (knock in) = activated when UA exceeds the barrier
• Up and out (knock out) = cancelled when UA exceeds barrier

Question 18

Factors used in calculating Black-Sholes and binomial models

Answer 18

• Strike price
• UA asset price
• time to expiry
• UA asset volatility or implied volatility
• Risk free IR

Question 19

Reason for an option premium to rise

Answer 19

• Time to expiry increases
• volatility of the UA rises
• greater IV

Question 20

Drawbacks of the Black-Scholes model and volatility smile - what is the VS based on

Answer 20

• Assumes the UA’s volatility is constant which is not the case for a number of different assets/options.
• Options that are more ITM/OTM have higher implied volatility (since the market price was higher than expected when the contract was written) if the UA’s implied volatility remained constant..
• This means apn option’s implied volatility is based on the strike price (which isn’t constant) and forms the volatility smile/volatility skew

Question 21

Volatility smiles - what must brokers do as options move ITM

Answer 21

• Implied volatility patterns that arise in options with specific expriation dates, options where the price of the UA is very different (higher) compared to the strike price, options that are deep OTM/ITM
• SABR model is the best one for these varying volatility options
• Premium oayments are typically T+1 or or T+2
• As teh buyer is exposed to the most credit risk so some banks/broekr require clients to post collateral as the option moves ITM and exercise becomes more liekly

Question 22

Flexible exchange options (FLEX Options)

Answer 22

• Combine the benefits of the customisation of OTC derivs with the advantages of exchange traded derivs
• Allow the buyer to customise expiration date, exercise style, strike and position limits.
• Differ to normal ET derivs as they are customisable
• Benefit from clearing houses eliminating credit risk
  *

Question 23

What are structured products - who builds them

Answer 23

• Securities with cashflows based on other securities and typically have embedded derivatives.
• Very complex
• Banks hire structurers who build the products in line with the client’s demands to meet the client’s needs

Question 24

Callable and puttable bonds

Answer 24

• An option is embedded with the bond
• Puttable bonds - put option embedded in the bond - bond can be exercised by the holder under certain circumstances or time periods. Allows the holder to insist on early redepmtion of the bond for example if IRs rise
• Callable bonds - call option embedded in the bond - the issuer of the bond can buy the bond back under certain circumstances or in certain time periods. If IRs fall, they can issue new bonds at a lower IR, lowering financing costs

Question 25

Convertible bonds and put/call features

Answer 25

• Allows the holder to exercise and convert a bond into another security (usually equity in the issuer) at given times or circumstances.
• Holder can exercise if the shares in the company spike in price to crystalise profit
• Issuers create these bonds with lower IRs because of the upside to the holder of having the ability to convert the bond.
• Valued based on the bond and the embedded option to cconvert
• Put features = exchange for company’s shares/repayment
• call features = issuer can repay the bond earlier

Question 26

Index linked notes

Answer 26

• Instrument with returns linked to a specific index
• Index could be an equity index, inflation index, basket of shares, mkt index etc

Question 27

Capital protected products - a___with an embedded___, use leverage for what?

Answer 27

• A loan with an embedded put option for another security
• Associated with buying and holding securities such as single warrants.
  1. Uses leverage to buy shares and use those shares as security on a loan
  2. If the price falls the holder can transfer the securities back (put option) or use the money to settle any debt with the loan issuer.
  3. This guarantees a minimum price of the shares for the investor
• Capital protected loans usually have higher IRs or additional fees.
• Can be used to obtain credit and use securities as collateral and the shares are protected from a fall in their price

Question 28

Master agreements - aims, allows for what in the event of default

Answer 28

• International swaps and derivatives association (ISDA) developed standardised agreements to reduce potential disagreements during swap transactions.
  Aims:
• Provide std mkt terms, encourgaing growth and confidence in OTC products
• Minimse transactions admin
• Facilitate cross boarder trading

Provides an umbrella framework for all relevant OTC deals. Allows for all transactios covered under the MA to be closed out together in the event of a default.
* Once the master agreement is in place, transactions need to be confirmed in the usual way but do not need to repeat the legal BS.
* Allows all transactions to be netted in the event of a defualt.
* Legally binding and provides mutual protection for both parties
* Flexible as no specific transaction details are mention in teh MA

Question 29

Master Agreement - main focusses with regards to defaults, 2 netting types

Answer 29

• Termination events - external circumstances like changes in laws (outside of the parties control) allow contreacts to be terminated early.
• Events of default - failure to pay the other party due to bankrupty allows the contract to terminate early.
• Netting - for capital adequacy and credit risk. 2 types
  1. Payment netting - netting amounts due in the same currency fr the same day
  2. Close out netting - netting all amounts between both parties at early terminatin. Values all transactions and converting amounts to a termination currency. Important to be sure this is supported in a court of law in each counterparty’s jurisdiction. ++legal support

Question 30

Master agreements - confirmations

Answer 30

• Each specific deal’s terms are set out in a confirmation which refers to the master agreement. allows the confirmation to be considderbale shorter than it would be otherwise.
• If a confirmation contradicts the master agreement, it will superceed it for that deal only
• Master confirmations - template mezzanine style doc detailing std terms for a specific transaction allowing any subsequent confirmations to be very short and only detail the varying factors
• Master confirmations allow for transactions to be matched elecctronically via intermediaries like DTCC or central counter parties.
• If master agreements are not in place between counterparites then teh standard terms for a contract should be used which can cause issues with legal interpretation fo these terms in different jurisdictions

Question 31

ISDA protocols - set of docs for…,

Answer 31

• Set of docs used by mkt participants defining procedures associated to specific transactions
• Set out all legal requirements and are updated regularly.
• ISDA had protocols for when teh euro was introduced to ensure that currency swaps for example were honoured for old currencies and settled in the new euro.
• Cover a wide range of transactions

Question 32

OTC collateral process - types of valid collateral, how is credit exposure managed, what are min transfer amounts

Answer 32

• Main types of accpetable collateral= cash, bank guarantees, high quality CDs, govt bonds and tradable securities. Some exchanges only accept cash and govt bonds
• Collateral mgmt reduces the credit exposure faced by firms dealing in longer dated OTC derivs. If a client exceeds the credit limit a margin fee can be charged by the issuer.
• Banks update their credit exposure by ensuring their ops teams process all deal tickets and term sheets (non binding agreement laying outbasic terms of a trade) in a timely manner
• Banks will ask for initial margin collateral at or slightly above the value of the trade. They can ask for more if the position or collateral loses value and have to give collateral back if the collateral gains value
• Minimum transfer amounts = min. delivery amount. Useful to reduce the cost of many transfer payments between the bank and it’s parties
  *

Question 33

OTC collateral process - 2

Answer 33

• Collateral should reflect the current risk of the counterparty’s defualt and the current value of the collateral it holds after marking it to market (called the threshold amount)
• Any collateral recieved by a bank is typically held by a third party - reduces the risk they will use their own capital to settle a defaulted position
• Dispute resolution clauses outline how banks and counterparties use collateral in the event of default
• Asking for more collateral is called a margin call and can be made daily, weekly or monthly
• Haircut= bank assigns a reduced value to the collateral which refelcts the perception of riskof holding the asset to protect against mkt movements/volatility.
• It is the bank’s/broker’s decision on what kind of collateral it accepts
• Creditworthiness, volatility and liquidty are the main considerations of what collateral is acceptable
• Swaps can see mutual collateralisation where both parties post collateral at the start of a deal and add to it as their position worsens/credit rating falls. Uses a mkt benchmark like SONIA

Question 34

Summary of a bank’s requirements with respect to the management of collateral

Answer 34

• Transactions are marked to market regularly
• monitor the value of a collateral
• makes and returns margin calls as appropriate
• checks margin calls are recieved
• Pays the agreed interest rate to the counterparty on any cash collateral

Question 35

Markets platforms and trade processing for OTCs, benefit of electronic processing, specialist deriv confirmation service

Answer 35

• Electronic processing has helped reduce the cost and increasevolume and efficiency of OTC derivs
• Some platforms execute trades using straight through processing tools
• Due to the complexity of OTC dervis, regulators have strcit electronic processing rules. very large custodian banks are leading the efforts to improve the processing, servicing and valuation of OTC derivatives by building OTC processing platforms
• DTCC Deriv/SERV is a specialist OTC confirmation service

Question 36

MarkitSERV - main aims

Answer 36

• Company that owns marketwire and the DTCC’s electronic trade confirmation workflow platforms - provides gateway for OTC deriv trade processing
• MarkitSERV combines DTCC Deriv/SERV and MarkitWire to cover all major asset classes and connects market participants and execution venues to dowsntream processing platforms like the DTCC’s trade information warehouse for CDSs.
• Also connects dealers and their clients to CCPs, trade repositiories and 3rd party adminsitrators.
• main aim = increase cooperation within the industry over infrastrucuture to accelerate the adoption of electronic trade confirmation and reduce risk in OTC mkts

Question 37

SwapClear

Answer 37

• Launched by LCH Group in 1999 - provides basic clearing for basic IR swaps and makes LCH the CCP to each half of the swap trade. Basically provides the clearing house function to the OTC mkt
• Not an STP system - banks must process the swap with the original counterparty before it is registered with swapclear
• • = provides automated MTM facility for swaps, collateral and allows ofr net payments for margin requirements

Benefits of Swapclear
* Reduces credit risk due to mulitlateral netting and margin
* Reduction in capital requirements through the capital requirements directive (CRD)
* Initial margin ofsets for certain contracts
* reduce operational risk by centralising and standardising process and adding post trade STP.
* Reduce operational and admin costs

Question 38

SwapClear clearing member and dealer requirements

Answer 38

Clearing member
* Be an LCH group shareholder
* Contribute to the LCH Group’s default fund
* meet min. resource requirements
* make regular fin. reports to LCH GROUP
* Maintain adequate systems, records and employ staff with adequate swaps knowledge

Dealer
* Principal in wholsesale mkt transactions
* SWIFT user
* Have/be a fully guaranteed subsidiary of an entity with a credit rating of BBB or greater.

Question 39

The Depository Trust & Clearing Corporation (DTCC)

Answer 39

• Largest global securities processing serivce.
• provides Deriv/SERV to match OTC derivative trades requiring mainframe-to-mainframe connections between dtcc and counterparties
• Deriv/SERV is focussed on automating the whole OTC deriv lifecycle with trade affirmation, confirmation, maching. payment processing and a trade warehouse
  Offers the below services:
• Omego OASYS - allows affirmation of credit derivs from multiple IDBs at the point of the trade.
• Omgeo central trade manager (Omgeo CTM) - platform for central matching of transactions with automated confirmation processes across multiple asset classes
• Payments - Deriv/SERV provides payment matching, bilateral netting with greater accuracy and STP
• Trade information warehouse (TIW) - databse with the most up to date details on each contract. Standardises and automates downstream processing over the life of a contract
• DTCC provides post trade clearance, settlement, custody and info servieces for a range of cash mkt and deriv equities via it’s subsidiaries
• National securities clearing corporation (NSCC) - CCP provinding trade guarantees, netting and risk mgmt for equity + debt deals from all US stock exchanges and mkts
• Depository trust company (DTC) - custody and asset servicing for millions of securities issues of issuers from more than 60 countries. clearing house for institutional post trade settlement

Many mkt participantss have desgined direct links to the DTCC’s MIS systems to increase efficiency, reduce op risk and provide better client service

Question 40

Nex TriOptima

Answer 40

• Designed to reduce capital, credit and operating costs and centrally manage counterparty risk for OTCs.
• Provides OTC deriv portfolio management serrvices - reduction in swap inventory and counterparty risk, managing disputes, automatic margin mgmt.

Question 41

Financial products markuo language (FpML)

Answer 41

• free open source protocol for electronic dealing and processing OTC communications
• Based on XML language
• Purpose = automate flow of info across the whole derivs network.
• Provides a standard data sturcuture and content to deal in derivs electronically
• NOT an ekectronic dealing/processing platform

MAin products covered by FpML:
* Interest rate derivs
* FX
* Credit
* Equity

Question 42

ICE Link

Answer 42

• FOrmally called T-Zero
• Electronic credit deriv trade mataching and processing service
• provides trade info and novation fo credit dervis on a t+0 basis, meeting the ISDA Board Oversight comittee (IBOC)

Question 43

SWIFTNet FPML

Answer 43

• allows users to send and recieve secure messages and OTC trade confirmations via the SWIFTNet system
• Real time trade matching and exception service for FX, money mkt and OTC deriv confirmations
• Main goal = enhance efficiency of user’s STP for OTC derivs
• 1 year archive service for all old trades prrocessed
  Benefits
• Reduce op risk
• lower costs
• ease of access via graphical user interface (GUI) and application programming interface (API)
• Increasing STP
• Reduce settlement risk

Question 44

re

DONE

Question 44

EurexOTC Clear

Answer 44

• Transaction mgmt serivce for OTC swaps provided by the eurex group.
• Goal = reduce counterparty, margin and collateral requirements mgmt, clearing for OTC IR swaps, FX and Zero coupin inflation swaps