Derivative Transactions

Question 1

What is a Derivative?

Answer 1

An instrument whose value is derived an underlying measure of value.

Lecture Notes.

In theory, the Measure of Value may be anything, but is usually an asset or a financial or economic benchmark.

Question 2

What is the Commercial Purpose of Derivatives?

Answer 2

Risk management, namely by hedging against volatility.

P. 603.

The most common types of volatility Derivatives address are asset price volatility, commodity price volatility, interest rate volatility, and currency volatility.

Question 3

What are the Two Basic Types of Derivatives?

Answer 3

1. The Option.
2. The Forward.

P. 604.

Literally every Derivative is either an Option, a Forward, or a combination thereof.

Question 4

What is an Options Contract?

Answer 4

A contract entitling the Parties to:
1. Buy or sell an asset for an upfront premium;
2. At a pre-determined price (the ‘Strike Price’);
3. Relative to the asset’s price when first valued (the ‘Valuation Date’);
4. Before a pre-determined future date (the ‘Expiration Date’).

For Forwards, the ‘Expiration Date’ is termed the ‘Maturity Date’.

Lecture Notes.

In an Option contract, the Buyer is termed the ‘Holder’, and the seller the ‘Writer’. A contract to purchase an asset is termed a ‘Call Option’, and one to sell is called a ‘Put Option’.

‘In the money’ (ITM) refers to a favorable price movment, ‘out of the money’ (OOTM) to an unfavorable price movement, and ‘at the money’ (ATM) to a neutral price movement. Parties are said to be in, out, or at the money based on which end of the transcation they are on.

Question 5

What is a Forward Contract?

Answer 5

A contract obligating the Parties to:
1. Buy or sell an asset;
2. For the Strike Price;
3. Relative to the Valuation Date;
3. At the Maturity Date.

Lecture Notes.

In a Forward contract, the Buyer is termed the ‘Long Position Holder’, and the Seller the ‘Short Position Holder’.

Question 6

What is a Futures Contract?

Answer 6

A Forward contract that is standardized so as to be exchange traded.

P. 607.

Neither Options nor Forwards are inherently OTCs or ETs, but because of the existence and nature of Futures, Forwards have become regarded as OTC.

Question 7

What is a Listed (Traded) Option Contract?

Answer 7

An Options contract that is standardized so as to be exchange traded.

Lecture Notes.

Neither Options nor Forwards are inherently OTCs or ETs, but because of the existence and nature of Listed Options Contracts, Options have become regarded as OTC.

Question 8

What is an Embedded Derivative?

Answer 8

A Derivative that is integrated into the terms of another (non-Derivative) instrument.

P. 605.

Examples include Convertible Bonds, Equity Index-Linked Bonds, and Inflation-Linked Loans.

Question 9

What is a Central Counterparty (CCP)?

Answer 9

An intermediary responsible for clearing Derivative transactions.

P. 606.

Question 10

What is Clearing?

Answer 10

The process of settling a Derivative transaction, usually by novating it to the Central Counterparty (CCP).

P. 606.

Question 11

During Clearing, what is the Legal Effect of Novation?

Answer 11

• Discharge the original transaction; and
• Replace it with two matching transactions:
  
  • One between the CCP and the Buyer; and
  • The other between the CCP and the Seller;
• Pursuant to which both Parties must post margin to minimize the risk of counterparty default.

P. 606.

In Derivatives transactions, provisions regarding Events of Defaults are otherwise known as ‘Default Provisions’ or ‘Close-Out Provisions’.

Question 12

What is the Commercial Purpose of Clearing?

Answer 12

Reduce counterparty risk by inserting the CCP as a guarantor.

P. 606

This, in turn, increases market liquidity and efficiency.

Question 13

What is the Difference between an Over-the-Counter (OTC) Derivative and Exchange-Traded (ET) Derivative?

Answer 13

Medium:
* OTC Derivatives are traded privately and directly between parties; whereas
* ET Derivatives are traded through a regulated exchange.

Clearing:
* All ET Derivatives are cleared; whereas,
* Many, but not all, OTC Derivatives are cleared.

Enforcement:
* ET transactions are subject to mandatory alternative dispute resolution, whereas
* OTC transactions, being private contracts and not trades on an exchange, are not.

P. 605-606.

Question 14

What happens if an OTC Derivative is not Cleared through a CCP?

Answer 14

The contract remains in force and settlement occurs by whatever means it stipulates, usually payment or direct delivery.

P. 606.

Settlement by delivery is termed ‘physically-settled’, and settlement by payment is termed ‘cash-settled’. Cash-settled Derivatives may otherwise be termed ‘Contracts for Difference’ (CFD).

Note that settling a Derivative trade and settling the Derivative itself are different.

Question 15

What are the Advantages and Disadvantages of Clearing a Derivative Transaction?

Answer 15

Advantages:
* Less counterparty risk.
* Less complexity, due to standardization.
* Fewer transaction costs, due to standardization.
* Greater market liquidity, as CCPs function as a quasi-exchange.
* Greater market transparency, as CCPs provide data on trade volumes, prices, and open positions.

Disadvantages:
* Less flexibility, due to standardization.
* Greater concentration of risk within a single entity.
* Greater operational complexity for exotic and sophisticated Derivatives.

Lecture Notes.

Certain types of Derivatves may need to be cleared regardless of the Parties’ intentions due to regulation.

Question 16

What are the Advantages and Disadvantages of using an OTC Derivative relative to an ET Derivative?

Answer 16

Advantages:
* Greater privacy.
* Greater customizability.

Disadvantages:
* Lesser price transparency.
* Greater counterparty risk (if a CCP is not involved).
* Greater complexity and transaction costs due to lack of standardization.

And vice versa.

Lecture Notes.

Question 17

What is a Swap?

Answer 17

A Forward contract that economically simulates an exchange of cashflows based on a notional principal and a given variable.

This definition does not apply neatly to Credit Default Swaps.

P. 611.

Swaps are usually, but not always, cash-settled, and like all Derivatives, are used to manage risk.

Question 18

In a Swap, what is the Notional Principal?

Answer 18

The reference value (fixed or floating) against which financial obligations are calculated.

Lecture Notes.

Question 19

In a Swap, what are the Most Common Variables used?

Answer 19

• Credit risk.
• Asset prices.
• Interest rates.
• Commodity prices.
• Currency exchange rates.

Lecture Notes.

Question 20

What is a Credit Default Swap?

Answer 20

A contingent put option on a Reference Obligation, where the right to exercise only arises if a credit event occurs regarding the Reference Entity.

P. 612.

The Reference Obligation is a debt security, and the Reference Entity is usually its Issuer.

Question 21

What is the Documentation involved in a Derivative Transaction?

Answer 21

• Legal Opinions.
• Master Agreement (MA).
• Credit Support Annex (CSA).

This list is not exhaustive.

Lecture Notes.

CSAs are otherwise referred to as Mark-to-Market Collateral Agreements.

Question 22

What is the Master Agreement?

Answer 22

The document outlining the transaction’s terms and conditions, paying particular attention to early termination and credit risk.

P. 614.

As with other financial contracts, the T&Cs aim to minimize credit, legal, regulatory, and operational risk

Question 23

What is Close-Out Netting?

Answer 23

The process of settling all outstanding obligations against each other after early termination.

P. 614.

This is the main way by which counterparites hedge themselves against credit risk.

Question 24

Under ISDA Documentation, what is the Process of Close-Out Netting?

Answer 24

1. Identification of default.
2. Termination of any outstanding obligations.
3. ‘Mark-to-Market’ valuation of the terminated obligations.
4. Determination of the net (post-set-off) amount due by the Defaulting Party.
5. Payment of the net amount.

Accordingly, non-contractual set-off rights do not obtain.

P. 614.

Question 25

What are other means by which ISDA Documentation seeks to mitigate Counterparty Risk?

Answer 25

• The Single Agreement clause, consolidating all transactions under one contract to minimize complexity and preempt claims under §178 IA.
• Repeating Conditions Precedent (for each transaction), preventing the rapid accrual of exposure to Counterparty Risk.
• Payment Netting, setting-off the Parties’ obligations on payment dates to minimize settlement risk and increase efficiency.

P. 673.

§178 allows the Liquidator to disclaim onerous property, which would include unconsolidated OOTM transactions. Consolidation, therefore, decreases exposure to a Counterparty’s credit risk.

Question 26

What is Settlement Risk?

Answer 26

• The risk that a Counterparty defaults before performing its obligations;
• On the same day a Party performs its obligations, leaving the latter empty-handed.

P. 676. Lomas v Firth Rixson [2012] EWCA Civ 419.

Question 27

Is Close-Out Netting compatible with Insolvency Law?

Answer 27

Yes, since it:
1. Forms part of a bona fide commercial transaction;
2. Is not predominantly purposed with depriving property during insolvency; and
3. Achieves the same outcome as insolvency set-off.

P. 685; Belmont Park v BNY [2012] 1 AC 383.

Question 28

Do Derivative Contracts impose an Obligation of Disclosure?

Answer 28

No. Unless expressly provided, counterparties need not disclose all material facts to their knowledge.

P. 647.

That said, it is always wise to include an express provision disclaiming any such obligations or advisory responsibilities, and to obtain Customer acknowledgment of that fact.°

° IFE v Goldman [2007] EWCA Civ 811.

Question 29

What is a Basis Clause?

Answer 29

A provision defining the basis upon which the parties transact, and which estops a party from denying that basis.

P. 653.

Question 30

What is the Commercial Purpose of a Basis Clause?

Answer 30

To clarify the non-advisory nature of a transactional relationship, and thereby contractually estop a party from claiming otherwise.

Among other things.

P. 653.

Question 31

Are Basis Clauses subject to the Test of Reasonableness?

Answer 31

No, namely because they prevent liability from arising, rather than disclaiming it if it does.

P. 654; JP Morgan v Springwell Navigaiton [2008] EWHC 1186.

Effectively, a Basis Clause says: “You cannot sue me for X because we defined our agreement as Y,” instead of, “If liability arises under Y, then I am not responsible.”

Question 32

May a Derivative Contract be construed as a Gambling Arrangement?

Answer 32

No, namely because its commercial purpose is to manage financial risk, which is not considered gambling.

P. 659-660.

Question 33

May a Derivative Contract be construed as an Insurance Arrangement?

Answer 33

No, namely because:
* Insurance requires the Insured to possess a direct interest in the underlying asset, whereas Derivatives do not; and
* Derivatives exchange risk between parties, whereas Insurance merely transfers it for a price.

P. 663.

The distinction is less clear, though, with certain Credit Derivatives.