Principles of OTC derivatives

Question 1

Interest rate swaps: Jargon

Answer 1

• Also known as ‘vanilla swaps’ (fixed-for-floating) or ‘basis swaps’
(floating-for-floating)
• ‘Swaption’ = OTC option on a swap
• ‘Payer’ – long the interest rate
• ‘Receiver’ – short the interest rate

Question 2

IRS variants:

Answer 2

• Amortising
• Accreting
• Rollercoaster

Question 3

Asset swap

Answer 3

A bond combined with an interest rate swap
• Can be used to create a synthetic floating rate note
• Makes it easier for an investor to choose an asset based on availability and then change its exposure using the interest rate swap

Question 4

Total return swap

Answer 4

A transfer of exposure on a portfolio without the actual purchase or sale
Structure and motivation of payer:
• May own a portfolio of assets and believes prices may fall
• Total returns on an asset exchanged for an interest rate based on a notional
amount
• No longer exposed to the uncertainty on the portfolio but does not have to sell
Structure and motivation of receiver:
• Would like an exposure to portfolio for a period of time without the purchase
• Pays an interest rate on a notional amount in exchange for the total returns on
an asset
• Now exposed to the return (both positive and negative) of the asset

Question 5

Credit default swap

Answer 5

• Credit event
- Failure to pay (default)
- Significant fall in asset price/value (typically index)
- Bankruptcy
- Debt restructuring
- Merger or demerger
- Governmental intervention
• Payout
- Physically delivered: Bond exchanged for bond value
- Cash-settled: Investor receives bond value less recovery rate

Question 6

Credit linked note

Answer 6

• A funded credit derivative
• Transferring the risk of a debtor
• Seller has no obligation to pay if a specified event occurs
- E.g. default of the referenced asset

Question 7

Other instruments

Answer 7

• Asset backed securities
- Secured by a pool of assets, e.g. property, loans
- Underlying assets securitised
• Collateralised bond obligations (CBOs)
• Collateralised debt obligations (CDOs)
• Synthetic CDOs

Question 8

OTC Options

Answer 8

• European and American style
• Asian style (called a trade average-price option (TAPO) on the LME)
- A cash settled option where the payoff is based on an average price of the underlying asset over a set period of time
• Average strike option
• Barrier (knock-out/knock-in) option
- Options that are activated/deactivated at a particular price of the underlying
• Lookback (or path dependent) options
- Enables the long to choose the best available price over the life of the option
• Ratchets/cliquets
- A series of options able to lock in profits at the end of each interval and reset ATM for the next interval
• Compound Option
- An option giving the right to buy or sell another option

Question 9

Structured Products

Answer 9

• Callable/Putable bonds
- Callable – can be redeemed early at the discretion of the issuer
- Putable – can be redeemed early at the discretion of the holder
• Convertible bonds
- Convertible loan stock – convertible into ordinary shares
- Convertible gilts – convertible into other gilts
• Index-linked notes
- Both coupon and capital linked to an inflation index
- Inflation protection
• Equity-linked note
- Yield determined by performance of equity
• Capital-protected products
- E.g. zero coupon bond and a long option

Question 10

Caps, Floors and Collars

Answer 10

• Caps
- OTC call on an interest rate or asset
• Floors
- OTC put on an interest rate or asset
• Collars
- Cap and a floor combined
- Potentially zero cost
- Can be used to limit volatility

Question 11

ISDA master agreements

Answer 11

• Aims of ISDA
- Provide standard market terms
- Minimise administration
- Facilitate cross-border selling
• Master agreement
- Termination events and default events
- Netting off of payments and positions
• Confirmations
- Refer to the Master Agreement, set out the specific terms of the deal
- Master confirmations are also possible which incorporates standard terms for specific types of
transactions e.g. equity options
- Confirmations can be very short

Question 12

Protocols

Answer 12

• A term used to describe a set of documents widely used by the market
- E.g. master agreements
• Regularly updated when necessary
- E.g. adoption of the Euro or implementation of EMIR

Question 13

Market Platforms and Trade Processing

Answer 13

Recent developments
• Increasing use of electronic processing and clearing services
• Greater communication between systems
- Improving straight through processing (STP)
Straight through processing
• Linking
- Trade allocation systems
• DTCCs Omgeo OASYS
- Trade capture and confirmation systems
• E.g. MarkitWire/MarkitSERV
- Clearing
• Central counterparty service, e.g. SwapClear
- Allows for standardised margining
- May require standardised contracts