The nature and utilisation of the main types of contracts for differences. The ISDA Master Agreement and risk management

LLM International Corporate and Financial Law

 

 

 

Law Relating to Capital Markets and International Banking

Assignment

 

“The nature and utilisation of the main types of contracts for differences. The ISDA Master Agreement and risk management.“

 

 

 

 

 

 

 

 

 

 

 

 

 

2011 

Introduction.

1. The nature and utilisation of the main types of contracts for differences.
1. Interest Rate Swap
2. Currency Swaps
3. Commodity Swap
4. Credit Swaps
5. Forward Rate Agreements

 

2.   The ISDA Master Agreement and risk management.

2.1. Master agreements

2.2. Credit risk management

2.3. Legal risk management

Conclusion

Bibliography

 

Introduction

 

Today over 30% of all London Stock Exchange transactions are CFD related. It may sound unbelievable but more and more professional and retail investors and traders switch to contracts for difference (CFDs) to take advantage of the leverage provided by the product. Now practically every bank in the UK provides CFD trading¹.

The rapid growth and complexity of the over-the-counter (OTC) derivatives market, particularly swaps, and the perceived risks to the financial system, continue to stimulate debate on regulatory controls. Too often minimized in these debates are the industry’s own efforts and incentives to produce superior mechanisms for controlling risks- in terms of both effectiveness and efficiency than those imposed through regulation. While product innovation is certainly a hallmark of the derivatives industry, so too has been its ability to develop market-based solutions for addressing risk.

Derivatives have become an indispensable component of global financial markets, yet their ever increasing complexity, combined with the tremendous upsurge in the volume of derivatives transactions, made it essential that the risks associated with them are identified, managed and monitored. To a great extent, self-preservation and the fear of loss of reputation motivate dealers and end-users to manage derivatives risk. Moreover, dealers and end-users are in a position to appreciate the risks specific to their derivatives activities (Hu, 1993). Hence, the dealers and end-users who actually use derivatives are also best able to establish and implement a comprehensive framework of derivatives risk management and controls that are tailored to their situation. The hope is that these entities live up to that ideal, but reality often falls short of this goal. 

1. The nature and utilisation of the main types of contracts for differences.

 

CFDs or contracts for difference is in essence an agreement between the buyer and seller to exchange the difference in the current value of a share, currency, commodity or index and its value at the end of the contract. If the difference is positive, the seller pays the buyer. If it is negative, the buyer is the one who loses money. There are two types of agreement: swaps and forward rate agreement. There are a number of ways in which financial institutions may utilize derivatives. These are: speculation, hedging and arbitrage.

The difference between a forward contract and a swap is that a swap involves a series of payments in the future, whereas a forward has a single future payment².

 

1. Interest Rate Swap

 

In general, an interest rate swap is an agreement to exchange rate cash flows from interest-bearing instruments at specified payment dates. Each party's payment obligation is computed using a different interest rate. Although there are no truly standardized swaps, a plain vanilla swap typically refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating rate (usually LIBOR).

For each party, the value of an interest rate swap lies in the net difference between the present value of the cash flows one party expects to receive and the present value of the payments the other party expects to make. At the origination of the contract, the value for both parties is usually zero because no cash flows are exchanged at that point. Over the life of the contract, it becomes a zero-sum game. As interest rates fluctuate, the value of the swap creates a profit on one counterparty's books, which results in a corresponding loss on the other's books.

Interest rate swap is a derivative which provides a company protection from the ever fluctuating interest rates in the market. Thus your company will benefit from a long term contract without having to factor in market uncertainties which are often caused by the flux in interest rates. A stable rate of payment and debt provides a stable and strong financial background for future transactions and long term planning. Acquiring business transaction deals at a lower interest rate also helps reduce costs and transactional expenses in both the long term as well as short term scenarios.

Figure 1. Interest Rate Swap

 

The uncertainty of future cash flows is also eliminated with the help of a set rate of interest. Also, your company will be hedged from the interest rate exposure. Establishing an interest rate swap will also benefit your company in its global expansion as it helps you seal international deals globally by bringing in a common factor. As both the companies involved get to benefit from this scenario, you can expect better future relations with your international clients and business partners.

Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates³.

 

2. Currency Swaps

 

Like an interest rate swap, a currency swap is a contract to exchange cash flow streams from some fixed income obligations (for example, swapping payments from a fixed-rate loan for payments from a floating rate loan). In an interest rate swap, the cash flow streams are in the same currency, while in currency swaps, the cash flows are in different monetary denominations. Swap transactions are not usually disclosed on corporate balance sheets.  

As we stated earlier, the cash flows from an interest rate swap occur on concurrent dates and are netted against one another. With a currency swap, the cash flows are in different currencies, so they can't net. Instead, full principal and interest payments are exchanged.  

Currency swaps allow an institution to take leverage advantages it might enjoy in specific countries. For example, a highly-regarded German corporation with an excellent credit rating can likely issue euro-denominated bonds at an attractive rate. It can then swap those bonds into, say, Japanese yen at better terms than it could by going directly into the Japanese market where its name and credit rating may not be as advantageous.

At the origination of a swap agreement, the counterparties exchange notional principals in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. At maturity, each makes a final exchange (at the same spot rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each party in the agreement has a comparative advantage over the other with respect to fixed or floating rates for a certain currency. A typical structure of a fixed-for-floating currency swap is as follows:

Figure 2. Currency Swaps⁴.

 

3. Commodity Swap

 

A swap in which exchanged cash flows are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity.

The vast majority of commodity swaps involve oil. So, for example, a company that uses a lot of oil might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price (usually an oil price index).

On the other side, if a producer of oil wishes to fix its income, it would agree to pay the market price to a financial institution in return for receiving fixed payments for the commodity⁵.

 

4.  Credit Swaps

 

A credit swap exists when a party who is exposed to a credit risk, i.e. the risk that a counterparty will fail to settle, uses a swap transaction to move that risk to another party. Credit swap arrangements can be found in a number of forms:

Credit default swaps

Credit default swaps, or CDS, are insurance against the risk of default on a debt (such as loan, bond etc.). The writer (seller) of these swaps receive regular payments from the buyer (in most cases, in addition to an upfront payment), and in turn assumes the risk that the underlying debt will not be repaid. In the event of default, the seller of the contract has to reimburse the buyer for the unpaid interest and the principal of the debt.

Credit default swaps are non-standardized private contracts between the buyer and the seller. They are not traded on any exchange, and have remained unregulated by any government body. The International Swaps and Derivatives Association (ISAD) publishes guidelines and general rules that can be used to write CDS contracts.

The International Swaps and Derivatives Association estimates the total notional amount of outstanding credit default swaps to be around $ 62.2 trillion, making these contracts the most widely traded credit derivative product, as of December 2007. ISDA Market Survey Historical Data, Retrieved 9/22/08). However as it is the case with other derivative instruments, notional amounts don't represent the actual amount that is exchanged through CDS.

Due to the lack of regulation in the market for CDS, these instruments had been underwritten by almost any financial institution. Large insurers such as American International Group (AIG) and Ambac Financial Group (ABK) have been major players in the market in the past. However, such contacts are also written by hedge funds, mutual funds and banks such as Merrill Lynch (MER), Citigroup (C) and Morgan Stanley (MS).

Underlying assets can theorically be any type of assets. Sovereign debt and financial companies' debt are the most commonly used assets with Italy, Spain and General Electric Company (GE) being the top-three entities in term of net notional amount.

Credit default swaps have a buyer who pays a seller in exchange for protection against default on a loan.

Typically, payments (i.e. the seller would have to pay the buyer) under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong.

For example, suppose an investor owns a corporate bond from Apple that yields 8%. The investor is exposed to a number of risks that could lead to default (e.g. the bond issuer goes bankrupt). In order to protect himself, investor purchases CDS on Apple bonds from AIG on this bond. In exchange, he agrees to pay out a portion of the bond's yield to AIG. Now, for some reason, if Apple is unable to pay its interest on the bond, AIG has to pay the CDS holder the entire par value of the bond.

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

If an investor buys a CDS from a financial firm with good credit, the CDS does indeed act as a hedge against default risk.

In exchange for the protection against default, the insurer receives a regular payment from the buyer. This is typically a percentage of the coupon payments on the bond. Effectively, while the buyer receives protection, he gives up a portion of his interest receipts to the insurer.

CDS does not have to be bought in conjunction with the underlying bond. Since, in the event of a default, the writer of the CDS reimburses the buyer the entire principal amount, these contracts can be used for speculative purposes. For example: if an investor believes that Lehman Brothers (LEH) would be unable to pay its creditor, he could just buy a CDS to bet on this position. This has led to use of these swaps for speculative activities⁶.

Total Return Swap (TRS)

A Total Return Swap (TRS) is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets in exchange for periodic cash flows, typically a floating rate such as LIBOR +/- a basis point spread and a guarantee against any capital losses.  A TRS is similar to a plain vanilla swap except the deal is structured such that the total return (cash flows plus capital appreciation/depreciation) is exchanged, rather than just the cash flows.

A key feature of a TRS is that the parties do not transfer actual ownership of the assets, as occurs in a repo transaction.  This allows greater flexibility and reduced up-front capital to execute a valuable trade.  This also means Total Return Swaps can be more highly leveraged, making them a favorite of hedge funds⁷. 

 

 

 

 

 

The structure of a total return swap is as follows:

Figure 3. Return swap⁸.

 

Credit Spread Swap

Credit Spread Swap (CSS) is a type of a swap contract in which one contractual party makes a fixed payment to the other counterpart in the trade, that will in exchange pay the floating spread that corresponds to the actual underlying credit spread of a third party⁹.

 

5.  Forward Rate Agreements

 

Forward Rate Agreements, or FRAs, are a way for a company to lock in an interest rate today, for money the company intends to lend or borrow in the future.

FRAs are cash-settled forward contract on interest rates. This means that no loan is actually extended, even though a notional principal amount mentioned in the contract. Instead, the borrower (buyer) and the lender (seller) agree to pay each other the interest difference between the agreed-upon rate (the "Forward Rate") and the actual interest rate on the future date (the "Floating Rate"). The cash settlement occurs on the day the loan is set to begin.

Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.

FRAs trade over the counter (OTC), and because they are not exchange traded, both the notional amount of the loan and the FRA rate can be negotiated and customized. Also, since the contract is cash settled, no loan is actually given or received, but rather the contracts are settled on the first day of the underlying loan.

The fixed rate, also called the FRA rate, is negotiated and agreed upon by both parties before the contract is entered into. The floating rate, also known as the reference rate, is an interest rate that will fluctuate between when the contract is agreed upon, and when the loan is set to begin. The two most common floating rates used in FRAs are LIBOR and Euribor.

FRAs are quoted in the format AxB, with (A) representing the number of months until the loan is set to begin, and (B) representing the number of months until the loan ends. To find the length of the loan, subtract A from B. For example, 1x4 quote would mean a 3 month loan, set to begin 1 month in the future. Common formats for these quotes include 1x4, 1x7, 3x6, 3x9, 6x9 and 6x12¹⁰.

 

2. The ISDA Master Agreement and risk management.

 

2.1. Master agreements

 

The ISDA master agreements are legal documents used to set up industry standards for many over-the-counter global derivatives markets. Published by the International Swaps and Derivatives Association, the ISDA master documents are a set of complex documents that specify the economic terms of transaction in various over the counter derivatives. They emphasize the terms and obligations of derivatives contracts. They also contain many definitions as well as basic legal, credit and mechanical terms. Their original scope was mainly interest rate derivatives, but they now include FX, commodity equity and credit derivatives markets. Central to the ISDA Master agreements, are the 1992 Master agreements and its 2001 supplements, based on the ISDA following documentation:

- ISDA Definitions: 1991 Definitions (as amended by the 1998 Supplement), 1992 ISDA Municipal Counterparty Definitions, 1993  Commodity Derivatives Definitions, 1996 Equity Derivatives Definitions, 1997 Government Bond Option Definitions, 1997 Bullion Definitions, 1998 FX and Currency Option Definitions, 1998 Euro Definitions, 1999 Credit Derivatives Definition

- Credit support annex: 1994, 1995, 1996 and 1997 credit documents

- The EMU protocol of 1998

- Confirmation and margin provision documents of 1992 and its margin provision document of 2001

- Users' Guides to OTC derivatives (2001)

Figure 1 summarizes the various documents and their connections

 

Figure 4. Architecture of the ISDA documentation

The ISDA definitions cover general definitions about the transaction parties, the concept of fixed and floating amounts, the terms and dates of the contract (in particular the day count fraction convention) and the payment. In particular, they define in details rates used for interest rates derivatives contracts, the price calculation for floating rate options, emphasizing the rounding, interpolation, and discounting methods. They also provide sample forms of confirmations. The scope of the 1991 ISDA Definition is mainly interest rates derivatives. It covers interest rate and currency swaps, FRAs, interest rate caps, collars and floors, cash settled and regular swaptions. These definitions have been completed to include FX, commodity, equity and credit derivatives regularly in the 1993, 1996, 1997, 1998, 1999 extensions to the definitions.

The 1998 supplements to the 1991 ISDA definitions have expanded the range of currencies, revised the terms of rate option and swaptions. They have examined cash settlement provision and provided additional forms of confirmations. The 1998 EURO Definitions supplement have given more business day and Euro rate options definition. They have outlined the provisions for equity derivatives and bond options products. Table 1 summarises the ISDA essential terminology The master agreements play an important role in the risk management of financial derivatives as they act as key references for OTC contracts. In particular, for the netting and capital adequacy questions, they serve as basic legal documents.

Table 1: Essential ISDA terminology

The ISDA master agreements eliminate any ability to interpret contracts as they define strictly the transaction terms. For instance, the school case of the fixed floating swap is explicitly examined. The two sides of the swap are calculated as follows:

- The fixed amount is equal to the notional amount times the fixed rate times the fixed rate day count fraction

- The floating amount is equal to the notional Amount times the floating rate plus eventually a spread times the floating rate day count fraction

-The floating rate is determined for a reset date by reference to a floating rate option (usually LIBOR)

- Day count fractions are used to calculate the number of days in a calculation period (see accrued interest and day count fraction)

The confirmation defines all the terms of the exchange and acts as the reference legal document in case of issues between the two parties. The ISDA master agreements leave no ambiguity in terms of the dates. Usually:

- the payment dates adjust for business days (meaning that they have to be on a business day, either using the convention of modified following, modified preceding, following or preceding)

- the period end dates adjust either to follow payment dates or for business Days

- the reset dates adjust for business days (unless this would cause the reset date to fall on the payment date)

- the termination date does not adjust

The ISDA Master agreements serve also as key reference for counterparty issues for capacity and authority issues. They have recently play an important role in setting standards for the growing business of credit derivatives, defining the different types of credit derivatives transactions and their mechanisms (for instance for credit default swap transaction, total return swap or credit-linked note). They have also outlined the concept of credit protection and its market, categorizing the designation of a reference entity and reference obligation. They also have given definitions for credit events (see credit events) as well as proper order of notices in case of a credit event and  its following payout.

Last but not least, ISDA master agreements have aim at setting up criterion for the structured finance business (repackaging and securitisation (CLOs, CBOs and CDOs)). They have stressed the influence of ratings (by rating agency) in credit derivatives transactions¹¹.

 

2.2. Credit risk management

 

Credit risk is the risk that a derivatives contract counterparty could default. The amount of credit risk a particular contract represents can be expressed as the positive value, if any, the contract has to the non-defaulting party where neither party has defaulted, less any amount that the non-defaulting party has been able to collect from the defaulting party. Thus, it is the replacement cost or market value of the contract. A related credit risk is settlement risk, the risk that funds or instruments will not be delivered to a firm when expected. In the context of OTC derivatives, an entity is exposed to the credit risk posed by its counterparty. Thus, each counterparty depends on the other’s continued financial well-being for payment on its contract. In contrast, standardized exchange-traded derivatives rely on a clearing agency, such as Options