Brady Bonds and Other Emerging-Markets Bonds Section - Board of

Brady Bonds and Other Emerging-Markets BondsSection 4255.1

GENERAL DESCRIPTION

In 1989, the Brady plan, named after then-U.S.Treasury Secretary Nicholas Brady, wasannounced to restructure much of the debt ofdeveloping countries that was not being fullyserviced due to economic constraints. The planprovided debt relief to troubled countries and, intheory, opened access to further internationalfinancing. It also provided the legal frameworkto securitize and restructure the existing bankdebt of developing countries into bearer bonds.Linking collateral to some bonds gave banks theincentive to cooperate with the debt reductionplan.

Brady bonds are restructured bank loans.They comprise the most liquid market for below-investment-grade debt (though a few Bradycountries have received investment-grade debtratings) and are one of the largest debt marketsof any kind. Banks are active participants in theBrady bond market. Once strictly an interbankmarket, the Brady market has evolved into onewith active participation from a broad investorbase.

CHARACTERISTICS ANDFEATURES

Brady bonds have long-term maturities, andmany have special features attached. Callablebonds or step-up coupons are among the mostcommon features. Others pay additional sourcesof income based on various economic factorsor the price of oil. Listed below are the indi-vidual characteristics of several types of Bradybonds:

• Par bonds have fixed coupons or couponschedules and bullet maturities of 25 to30 years. Typically, these bonds have principal-payment and rolling interest-rate guarantees.Because pars are loans exchanged at facevalue for bonds, debt relief is provided by alower interest payment.

• Discount bondshave floating-rate couponstypically linked to LIBOR. These bonds haveprincipal and rolling interest-rate guarantees.Bond holders receive a reduced face amountof discount bonds, thereby providing debtrelief.

• Front-loaded interest-reduction bondspro-vide a temporary interest-rate reduction. Thesebonds have a low fixed-interest rate for a fewyears and then step up to market rates untilmaturity.

• Debt conversion bonds (DCBs)andnew moneybonds are exchanged for bonds at par andyield a market rate. Typically, DCBs and newmoney bonds pay LIBOR +7⁄8. These bondsare amortized and have an average life ofbetween 10 and 15 years. DCBs and newmoney bonds are structured to give banks anincentive to inject additional capital. For eachdollar of new money bond purchased, aninvestor converts existing debt into a newmoney bond at a fixed proportion determinedby the Brady agreement. DCBs and newmoney bonds are normally uncollateralized.

The terms of local debt market instrumentsalso vary widely, and issues are denominated ineither local or foreign currency such as U.S.dollars. Brief descriptions of instruments inArgentina, Brazil, and Mexico follow.

Argentina

Letes are Argentine Treasury bills. They areoffered on a discount basis and have maturitiesof 3, 6, and 12 months. Auctions are held on amonthly basis.

Brazil

Currently, the primary internal debt instrumentsissued in Brazil are so-called BBC bonds, whichare issued by the central bank. As of mid-1996,BBC bonds were being issued in 56-day denomi-nations, up from 35-, 42-, and 49-day denomi-nations. Total outstandings as of June 30, 1996,were U.S.$49.9 billion, and these instrumentsare highly liquid. The central bank also issuesbills and notes known as LTNs and NTNs thathave maturities up to one year (though one NTNhas been issued as of this writing with a two-year maturity). LTNs and NTNs are less liquidand have smaller outstandings (U.S.$34.4 andU.S.$18.2 billion, respectively) than BBC bonds.

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Mexico

Ajustabonos

Though issuance of these bonds has been halted,ajustabonos are peso-denominated Treasurybonds. They are indexed to inflation and pay areal return over the Mexican consumer priceindex (CPI). These bonds are longer-term instru-ments with maturities of 1,092 days (threeyears) and 1,820 days (five years). Ajustabonospay a quarterly real rate coupon over the CPIand are tax exempt to foreign investors. As ofMay 1996, U.S.$5.6 billion ajustabonos remainedoutstanding.

Bondes

Bondes are floating-rate, peso-denominated gov-ernment development bonds. They have matu-rities of 364 and 728 days. Bondes pay interestevery 28 days at the higher of the 28-day cetesrate or the retail pagares rate, calculated by thecentral bank. They are auctioned weekly and aretax exempt to foreign investors. The total amountoutstanding as of mid-1996 was approximatelyU.S.$5 billion.

Cetes

Cetes are government securities and are theequivalent of Mexican T-bills. They are denomi-nated in pesos and are sold at a discount. Ceteshave maturities of 28, 91, 182, 364, and 728days (though this maturity is presently discon-tinued). Cetes are highly liquid instruments andhave an active repo market.

The capital gain for these instruments isdetermined by the difference between the amor-tized value and the purchase price; the day-count convention is actual/360-day. Auctionsare held weekly by the central bank for the 28-through 364-day maturities. Foreign investorsare exempted from paying taxes on theseinstruments.

Tesobonos

Though these instruments are not currently beingissued, they comprised the majority of debtofferings in the time leading up to the 1994 pesocrisis. Tesobonos are dollar-indexed govern-

ment securities with a face value of U.S.$1,000.At the investors’ option, they are payable indollars, and they are issued at a discount.Maturities include 28, 91, 182, and 364 days.

UDIbonos

During the week of May 27, 1996, the Mexicancentral bank sold three-year UDIbonos for thefirst time. They are inflation-adjusted bondsdenominated in accounting units or UDIs (adaily inflation index), which change in valueevery day. These instruments replaced the ajust-abonos. UDIbonos pays interest semiannuallyand offer holders a rate of return above theinflation rate. They are auctioned biweekly andmay have limited liquidity.

USES

Brady bonds and local debt market instrumentscan be used for investment, hedging, and specu-lation. Speculators will often take positions onthe level and term structure of sovereign interestrates. Arbitragers will take positions based ontheir determination of mispricing.

DESCRIPTION OFMARKETPLACE

Issuing Practices

A Brady deal exchanges dollar-denominatedloans for an agreed-upon financial instrument.These instruments include various debt instru-ments, debt equity swaps, and asset swaps. Atthe close of a collateralized Brady deal (not allBrady bonds are collateralized), collateral isprimarily posted in the form of U.S. Treasuryzero-coupon bonds and U.S. Treasury bills. Themarket value of this collateral depends on theyield of 30-year U.S. Treasury strips and tendsto increase as the bond ages. Developing coun-tries have also used their own resources forcollateral as well as funds from internationaldonors, the World Bank, and the InternationalMonetary Fund (IMF) to support their Bradydeals. Local debt instruments are subject to theissuing practices of each individual country.

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Market Participants

The number of market participants in eachemerging market differs with the characteristicsof each market, such as regulatory barriers,liquidity constraints, and risk exposures. How-ever, there are many participants in the Bradybond market. Securitization of Brady bondsenables banks to diversify and transfer some oftheir country exposures to other banks. Newmarket participants in the Brady market includeinvestment banks as well as traditional commer-cial banks, mutual funds, pension funds, hedgefunds, insurance companies, and some retailinvestors.

Market Transparency

For many instruments, prices are available onstandard quote systems such as Bloomberg,Reuters, and Telerate. In addition, many brokerscan quote prices on less developed country(LDC) debt instruments. For all but the mostliquid Brady bonds and internal debt instru-ments, however, transparency can be verylimited.

PRICING

Pricing for the various LDC issues differs acrossinstruments and countries. The price of a Bradybond is quoted on its spread over U.S. Treasur-ies. Standard bond pricing models are often usedto price the uncollateralized bond and unsecuri-tized traded bank loans, with emphasis on thecredit risk of the issuers (sovereign risk) indetermining whether a sufficient risk premium isbeing paid. Most of the volatility of Bradybonds comes from movement in the spread overU.S. Treasuries.

HEDGING

Over-the-counter (OTC) options are the primaryvehicles used to hedge Brady bonds. Becausethe volume of the OTC options market isapproximately one-tenth that of the cash Bradybond market, liquidity is relatively poor.

Cash instruments from the identical sovereignissuer can be used to hedge positions. However,as in other hedging situations, mismatch ofterms can lead to basis risk.

Hedging strategies for Brady bonds are oftenfocused on decomposing the sovereign risk fromthe U.S. rate risk and on neutralizing the latter.For example, a long fixed-coupon Brady bondposition is exposed to the risk that U.S. rates willrise and Brady prices will fall. A hedge aimed atimmunizing U.S. rate risk can be establishedwith a short U.S. Treasury, Treasury futures, orforward position.

RISKS

Sovereign Risk

One of the most significant risks related totrading of LDC debt is sovereign risk. Thisincludes political, regulatory, economic stabil-ity, tax, legal, convertibility, and other forms ofrisks associated with the country of issuance.Real risk is that of potential controls or taxes onforeign investment. While there is no way topredict policy shifts, it can help to be familiarwith any current controls and to closely followthe trend of inflation.

Liquidity Risk

Liquidity risk is the risk that a party may not beable to unwind its position. In emerging mar-kets, liquidity risk can be significant. During theMexican peso crisis, bids on various instrumentswere nonexistent. Portfolio values of LatinAmerican instruments plunged. In the OTCmarket, options are far less liquid than cashbonds. As a result, option positions are oftenheld to expiry rather than traded.

Interest-Rate Risk

Debt issues of various countries are subject toprice fluctuations because of changes insovereign-risk premium in addition to changesin market interest rates and changes in the shapeof the yield curve. Spreads between U.S. ratesand sovereign rates capture this sovereign-riskpremium. In general, the greater the uncertaintyof future payoffs, the greater the spread betweencountry rates and U.S. rates. This spread will notnecessarily be stable, however, making interest-rate risk at least equivalent to that found in U.S.Treasury instruments.

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ACCOUNTING TREATMENT

LDC debt that remains in the form of a loan anddoes not meet the definition of a security in theFinancial Accounting Standards Board’s State-ment of Financial Accounting Standards No.115 (FAS 115), ‘‘Accounting for Certain Invest-ments in Debt and Equity Securities,’’ shouldbe reported and accounted for as a loan. Ifthe loan was restructured in a troubled-debtrestructuring involving a modification of terms,and the restructured loan meets the definition ofa security in FAS 115, then the instrumentshould be accounted for according to the provi-sions of FAS 115.

The accounting treatment for investments inforeign debt is determined by FAS 115, asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities.’’ Accountingtreatment for derivatives used as investments orfor hedging purposes is determined by State-ment of Financial Accounting Standards No.133 (FAS 133), ‘‘Accounting for Derivativesand Hedging Activities,’’ as amended by State-ment of Financial Accounting Standards Nos.137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)

RISK-BASED CAPITALWEIGHTING

Claims that are directly and unconditionallyguaranteed by an OECD-based central govern-ment or a U.S. government agency are assignedto the zero percent risk category. Claims that arenot unconditionally guaranteed are assigned tothe 20 percent risk category. A claim is notconsidered to be unconditionally guaranteed bya central government if the validity of theguarantee depends on some affirmative actionby the holder or a third party. Generally, secu-rities guaranteed by the U.S. government or itsagencies and securities that are actively tradedin financial markets are considered to be uncon-ditionally guaranteed.

Claims on, or guaranteed by, non-OECDcentral governments that do not represent localcurrency claims that are unconditionally or con-

ditionally guaranteed by non-OECD central gov-ernments to the extent that the bank has liabili-ties booked in that currency are assigned a100 percent risk weight. Also, all claims onnon-OECD state or local governments areassigned to the 100 percent risk category.

LEGAL LIMITATIONS FOR BANKINVESTMENT

Obligations that are guaranteed by a departmentor an agency of the U.S. government, if theobligation commits the full faith and credit ofthe United States for the repayment of theobligation, are type I securities and are notsubject to investment limitations. Also, obliga-tions guaranteed by the Canadian governmentare classified as type I securities.

Obligations guaranteed by other OECD coun-tries that are classified as investment grade aretype III securities. A bank’s investment is lim-ited to 10 percent of its capital and surplus.

Non-investment-grade LDC debt may be pur-chased under a bank’s ‘‘reliable estimates’’bucket. If a bank concludes, on the basis ofreliable estimates, that an obligor will be able toperform, and the security is marketable, it canpurchase the security notwithstanding itsinvestment-grade rating. Such securities are sub-ject to a 5 percent limit of a bank’s capital andsurplus for all securities purchased under thisauthority.

REFERENCES

Cline, William. International Debt Reexamined.Washington, D.C.: Institute for InternationalEconomics, February 1995.

Emerging Markets Traders Association. 1995Debt Trading Volume Survey. May 1, 1996.

Gosain, Varun (Paribas Capital Markets).‘‘Derivatives on Emerging Market SovereignDebt Instruments.’’ Derivatives & Synthetics.Chicago and Cambridge: Probus Publishing.

McCann, Karen, and Mary Nordstrom. TheUnique Risks of Emerging MarketsInvestments—A Perspective on Latin America.Chicago: Federal Reserve Bank of Chicago,1996.

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Foreign ExchangeSection 4305.1

GENERAL DESCRIPTION

Foreign exchange (FX) refers to the variousbusinesses involved in the purchase and sale ofcurrencies. This market is among the largest inthe world and business is conducted 24 hours aday in most of the financial centers. The majorparticipants are financial institutions, corpora-tions, and investment and speculative entitiessuch as hedge funds. Any financial institutionwhich maintainsdue frombank balances, com-monly known as ‘‘nostro’’ accounts, in foreigncountries in the local currency can engage inforeign exchange. The volume in this market hasbeen estimated to be the equivalent of $1 trilliona day.


The FX market is divided into spot, forward,swap, and options segments. Each of thesesegments is discussed in the followingsubsections.

Spot

Buying and selling FX at market rates forimmediate delivery represents spot trading. Gen-erally, spot trades in foreign currency have a‘‘value date’’ (maturity or delivery date) of twoto five business days (one day for Canada).Foreign-exchange rates that represent the cur-rent market value for the currency are known asspot rates. The risk of spot trading results fromexchange-rate movements that occur while thefinancial institution’s position in foreign cur-rency is not balanced with regard to the currencyit has bought and sold. Such unbalanced posi-tions are referred to as net open positions.

Net Open Positions

A financial institution has a net open position ina foreign currency when its assets, includingspot and forward/futures contracts to purchase,and its liabilities, including spot and forward/futures contracts to sell, in that currency are notequal. An excess of assets over liabilities iscalled a net ‘‘long’’ position, and liabilities in

excess of assets are called a net ‘‘short’’ posi-tion. A long position in a foreign currency whichis depreciating will result in an exchange lossrelative to book value because, with each day,that position (asset) is convertible into fewerunits of local currency. Similarly, a short posi-tion in a foreign currency which is appreciatingrepresents an exchange loss relative to bookvalue because, with each day, satisfaction of thatposition (liability) will cost more units of localcurrency.

The net open position consists of both balance-sheet accounts and contingent liabilities. Formost financial institutions, the nostro accountsrepresent the principal assets; however, foreign-currency loans as well as any other assets orliabilities that are denominated in foreign cur-rency, which are sizeable in certain financialinstitutions, must be included. All forward/futures foreign-exchange contracts outstandingare contingents. When a contract matures, theentries are posted to a nostro account in theappropriate currency.

Each time a financial institution enters into aspot foreign-exchange contract, its net openposition is changed. For example, assume thatBank A opens its business day with a balancednet open position in pound sterling (assets pluspurchased contracts equal liabilities plus soldcontracts). This is often referred to as a ‘‘flat’’position. Bank A then receives a telephone callfrom Bank B requesting a ‘‘market’’ in sterling.Because it is a participant in the interbankforeign-exchange trading market, Bank A is a‘‘market maker.’’ This means it will provideBank B with a two-sided quote consisting of itsbid and offer for sterling. If a different currencywas requested, European terms would be theopposite since the bid and offer would be fordollars instead of the foreign currency. In deter-mining the market given, Bank A’s trader ofsterling will determine where the market ispresently (from brokers and/or other financialinstitutions), attempt to anticipate where it isheaded, and determine whether Bank B is plan-ning to buy or sell sterling.

Forward Transactions

A forward transaction differs from a spot trans-action in that the value date is more than two to


five business days in the future. The maturity ofa forward foreign-exchange contract can be afew days, months, or even years in someinstances. In practice, dates that are two years ormore in the future are usually referred to as thelong-dated forward market or the long-term FX(LTFX) market. The exchange rate is fixed at thetime the transaction is agreed on. However,nostro accounts are not debited or credited, thatis, no money actually changes hands, until thematurity date of the contract. There will be aspecific exchange rate for each forward matu-rity, and each of those rates will generally differfrom today’s spot exchange rate. If the forwardexchange rate for a currency is higher than thecurrent spot rate, the currency is trading at apremium for that forward maturity. If the for-ward rate is below the spot rate, then thecurrency is trading at a discount. For instance,sterling with a value date of three months is at adiscount if the spot rate is $1.75 and the three-month forward rate is $1.72.

Foreign-Exchange Swaps

Financial institutions that are active in theforeign-exchange market find that interbank out-right forward currency trading is inefficient andengage in it infrequently. Instead, for futurematurities, financial institutions trade amongthemselves as well as with some corporatecustomers on the basis of a transaction known asa foreign-exchange swap. A swap transaction isa simultaneous purchase and sale of a certainamount of foreign currency for two differentvalue dates. The key aspect is that the financialinstitution arranges the swap as a single trans-action with a single counterparty, either anotherfinancial institution or a nonbank customer. Thismeans that, unlike outright spot or forwardtransactions, a trader does not incur a net openposition since the financial institution contractsboth to pay and to receive the same amount ofcurrency at specified rates. Note that a foreign-exchangeswap is different from a foreign-currency swap, because the currency swapinvolves the periodic exchange of interest pay-ments. See the discussion in section 4335.1,‘‘Currency Swaps.’’

A foreign-exchange swap allows each partyto use a currency for a period in exchange foranother currency that is not needed during thattime. Thus, the swap offers a useful investmentfacility for temporary idle currency balances of

a corporation or a financial institution. Swapsalso provide a mechanism for a financial insti-tution to accommodate the outright forwardtransactions executed with customers or to bridgegaps in the maturity structure of outstandingspot and forward contracts.

The two value dates in a swap transaction canbe any two dates. But, in practice, markets existonly for a limited number of standard maturities.One of these standard types is called aspot-against-forward swap. In a spot-against-forwardswap transaction, a trader buys or sells a cur-rency for the spot value date and simultaneouslysells or buys it back for a value date a week, amonth, or three months later.

Another type of transaction of particular inter-est to professional market-making financialinstitutions is called atomorrow-nextswap or arollover. These are transactions in which thedealer buys or sells a currency for value the nextbusiness day and simultaneously sells or buys itback for value the day after. A more sophisti-cated type of swap is called aforward-forwardin which the dealer buys or sells currency forone future date and sells or buys it back foranother future date. Primarily, multinationalbanks specialize in transactions of this type.

Options

The foreign-exchange options market includesboth plain vanilla and exotic transactions. Seesection 4330.1, ‘‘Options,’’ for a general discus-sion. Most options activity is plain vanilla.

USES

Foreign exchange is used for investment, hedg-ing, and speculative purposes. Most banks use itto service customers and also to trade for theirown account. Corporations use the FX marketmainly to hedge their foreign-exchange exposure.


Market Participants

Sell Side

The majority of U.S. banks restrict their foreign-exchange activities to serving their customers’

4305.1 Foreign Exchange


foreign-currency needs. The banks will simplysell the currency at a rate slightly above themarket and subsequently offset the amount andmaturity of the transaction through a purchasefrom another correspondent bank at marketrates. This level of activity involves virtually norisk exposure as currency positions are coveredwithin minutes. For these banks, a small profit isusually generated from the rate differential, butthe activity is clearly designated as a servicecenter rather than a profit center.

Usually, the larger the financial institution,the greater the emphasis placed on foreign-exchange activity. For instance, while servingthe needs of corporate customers is still apriority, most regional banks also participate inthe interbank market. These banks may look atthe trading function as a profit center as well asa service. Such banks usually employ severalexperienced traders and may take positions inforeign currencies based on anticipated ratemovements. These banks use their involvementin the interbank market to get information aboutthe various markets. For most of these partici-pants, the trading volume in the interbank marketconstitutes the bulk of the volume. (In somecases, the interbank volume is about 80 to90 percent of total volume). Multinational banksassume by far the most significant role in theforeign-exchange marketplace. While still serv-ing customer needs, these banks engage heavilyin the interbank market and look to their foreign-exchange trading operation for sizeable profits.These banks trade foreign exchange on a globalbasis through their international branch networks.

One of the major changes in the structure ofthe foreign-exchange market over the past fewyears has been the increase in the use of elec-tronic market-making and execution systems. Inthe past, most interbank dealing was donethrough the interbank brokers’ system; however,advances in technology have made it moreefficient for market participants to use electronicsystems. (Among the more popular systems areReuters and EBS (Electronic Brokering Sys-tems).) These developments have decreased thenumber of errors that are common in the use ofthe brokers’ market (for example, the use ofpoints and error checks) and have also cut downon the costs of doing business.

Buy Side

The buy side consists of corporate hedgers,

investors, and speculators. Corporations use thismarket to hedge their assets and liabilities in-curred as a result of their overseas operations.Investors (for example, international mutualfunds) use this market to gain exposure tomarkets and sometimes to hedge away thecurrency risk of their equity portfolios.

Market Transparency

Price transparency is very high. The prices formost of the markets are disseminated throughvarious vendors such as Reuters and Telerate.

PRICING

Two methods are used to quote foreign-exchangerates. The method used depends on the currency.

• American quote. Number of foreign-currencyunits per U.S. dollar (for example, 105 yen perdollar). Most currencies are quoted using thisconvention.

• European quote. Number of U.S. dollars perforeign-currency unit (for example, $1.60 perBritish pound sterling). British and Irishpounds and Australian and New Zealand dol-lars are the most common currencies usingthis convention.

Spot FX

Most institutions will quote both a bid and anoffer. When, for example, Bank A quotes ster-ling at $1.7115-25, it is saying that it will buy(bid) sterling at $1.7115 or sell (offer) sterling at$1.7125. If Bank B’s interest is to buy sterlingand the given quote is appealing, it will buysterling from Bank A at $1.7125 (Bank A’s offerprice). Note that while Bank B may choose tobuy, sell, or pass as it wishes, it must do businesson the terms established by Bank A. These termswill be in Bank A’s favor. As soon as Bank Bannounces it will purchase sterling at $1.7125,Bank A acquires a net open position (short) insterling. Bank A must then decide whether tohold its short position (in anticipation of adecline in sterling) or cover its position. If itwishes to cover, it may call another bank andpurchase the amount it sold to Bank B. How-ever, as the calling bank, Bank A would buy its

Foreign Exchange 4305.1


sterling from the offered side of the quote itreceives and must buy it at $1.7125 or less toavoid a loss.

Foreign-Exchange Swaps

In foreign-exchange swap transactions, the traderis only interested in the difference between spotand forward rates—the premium or discount—rather than the outright spot and forward ratesthemselves. Premiums and discounts expressedin points ($0.0001 per pound sterling orDM 0.0001 per dollar) are called swap rates. Ifthe pound spot rate is $1.8450 and the six-monthforward rate is $1.8200, the dollar’s six-monthpremium is 250 points ($0.0250). If the poundspot rate is $1.8450 and the six-month forwardrate is $1.8625, the dollar’s six-month discountis 175 points ($0.0175).

Since, in a swap transaction, a trader iseffectively borrowing one currency and lendingthe other for the period between the two valuedates, the premium or discount is often evalu-ated in terms of percent per annum. For theexamples above, the premium of 250 points isequivalent to 2.71 percent per annum, while thediscount of 175 points is equivalent to 1.90percent per annum. To calculate the percentagepremium for the first case—

• take the swap rate ($0.0250),• multiply by 12 months and divide by six

months (a per annum basis),• divide by the spot rate ($1.8450), and• multiply by 100 (to get a percent basis).

This formula can be expressed as—

% per annum =

Premium or Discount *12* 100

Spot rate * no. of monthsof forward contract

Forward rates (premiums or discounts) aresolely influenced by the interest-rate differen-tials between the two countries involved. As aresult, when the differential changes, forwardcontracts previously booked could now be cov-ered at either a profit or loss. For example,assume an interest-rate differential between ster-ling and dollars of 3 percent (with the sterlingrate lower). Using this formula, with a spot rate

of $1.80, the swap rate on a three-month con-tract would be a premium of 135 points. If thatinterest-rate differential increases to 4 percent(by a drop in the sterling rate or an increase inthe dollar rate), the premium would increase to180 points. Therefore, a trader who boughtsterling three months forward at 135 pointspremium could now sell it at 180 points pre-mium, or at a profit of 45 points (expressed as.0045).

Thus, the dealer responsible for forward trad-ing must be able to analyze and project dollarinterest rates as well as interest rates for thecurrency traded. Additionally, because forwardpremiums or discounts are based on interest-ratedifferentials, they do not reflect anticipatedmovements in spot rates.

HEDGING

Spot FX

Banks engaged in trading in the spot market willacquire net open positions in the course ofdealing with customers or other market makers.The bank must then decide whether to hold itsopen position (in anticipation of a move in thecurrency) or cover its position. If it wishes tocover, the bank may call another bank and eitherbuy or sell the currency needed to close its openposition.

Financial institutions engaging in interbankspot trading will often have sizeable net openpositions, though many for just brief periods oftime. No matter how skilled the trader, eachinstitution will have occasional losses. Knowingwhen to close a position and take a small lossbefore it becomes large is a necessary trait for acompetent trader. Many financial institutionsemploy a ‘‘stop-loss policy,’’ whereby a netopen position must be covered if losses from itreach a certain level. While a trader’s forecastmay ultimately prove correct within a day orweek, rapid rate movements often cause a losswithin an hour or even minutes. Also, access toup-to-the-minute information is vital for involve-ment in spot trading. Financial institutions thatlack the vast informational resources of thelargest multinationals may be particularly vul-nerable to sudden spot rate movements. As aresult, examiners should closely review finan-cial institutions in which foreign-exchangeactivities consist primarily of interbank spottrading.



Forwards

Active trading financial institutions will gener-ally have a large number of forward contractsoutstanding. The portfolio of forward contractsis often called aforward book. Trading forwardforeign exchange involves projecting interest-rate differentials and managing the forwardbook to be compatible with these projections.

Forward positions are generally managed on agap basis. Normally, financial institutions willsegment their forward books into 15-day periodsand show the net (purchased forward contractsless sold ones) balance for each period. Volumesand net positions are usually segregated into15-day periods for only the first three months,with the remainder grouped monthly. The traderwill use the forward book to manage his or heroverall forward positions.

A forward book in an actively traded currencymay consist of numerous large contracts but,because of the risks in a net open position, totalforward purchases will normally be approxi-mately equal to total forward sales. What mat-ters in reviewing a forward book is the distribu-tion of the positions among periods. For example,if a forward book in sterling has a long netposition of 3,200,000 for the first three monthsand is short a net 3,000,000 for the next fourmonths, the forward book is structured antici-pating a decline in dollar interest rates as com-pared with sterling interest rates since these soldpositions could be offset (by purchase of aforward contract to negate the sold forwardposition) at a lower price—either throughreduced premium or increased discount. See thesubsection below for a discussion of the risksencountered in hedging foreign-exchangeexposure.

RISKS

Exchange-Rate Risk

Exchange-rate (market) risk is an inevitableconsequence of trading in a world in whichforeign-currency values move up and down inresponse to shifting market supply and demand.When a financial institution’s dealer buys orsells a foreign currency from another financialinstitution or a nonbank customer, exposurefrom a net open position is created. Until thetime that the position can be covered by selling

or buying an equivalent amount of the samecurrency, the institution is exposed to the riskthat the exchange rate might move against it.That risk exists even if the dealer immediatelyseeks to cover the position because, in a marketin which exchange rates are constantly chang-ing, a gap of just a few minutes can be longenough to transform a potentially profitabletransaction into a loss. Since exchange-ratemovements can consistently run in one direc-tion, a position carried overnight or over anumber of days entails greater risk than onecarried a few minutes or hours.

At any time, the trading function of a financialinstitution may have long positions in somecurrencies and short positions in others. Thesepositions do not offset each other, even though,in practice, the price changes of some currenciesdo tend to be correlated. Traders in institutionsrecognize the possibility that the currencies inwhich they have long positions may fall in valueand the currencies in which they have shortpositions may rise. Consequently, gross tradingexposure is measured by adding the absolutevalue of each currency position expressed indollars. The individual currency positions andthe gross dealing exposure must be controlled toavoid unacceptable risks.

To accomplish this, management limits theopen positions dealers may take in each cur-rency. Practices vary among financial institu-tions, but, at a minimum, limits are establishedon the magnitude of open positions which canbe carried from one day to the next (overnightlimits). Several institutions set separate limitson open positions dealers may take during theday. These are called ‘‘daylight limits.’’ Formallimits on gross dealing exposure also areestablished by some institutions, while othersreview gross exposure more informally. Thevarious limits may be administered flexibly, butthe authority to approve a temporary departurefrom a limit is typically reserved for a seniorofficer.

For management and control purposes, mostfinancial institutions distinguish between posi-tions arising from actual foreign-exchange trans-actions (trading exposure) and the overallforeign-currency-translation exposure of theinstitution. The former includes the positionsrecorded by the institution’s trading operationsat the head office and at offices abroad. Inaddition to trading exposure, overall exposureincorporates all the institution’s assets andliabilities denominated in foreign currencies,



including loans, investments, deposits, and thecapital of foreign branches.

Maturity Gaps and Interest-Rate Risk

Interest-rate risk arises whenever mismatches orgaps occur in the maturity structure of a finan-cial institution’s foreign-exchange forward book.Managing maturity mismatches is an exactingtask for a foreign-exchange trader.

In practice, the problem of handling mis-matches is complex. Eliminating maturity gapson a contract-by-contract basis is impossible foran active trading institution. Its foreign-exchangebook may include hundreds of outstanding con-tracts, with some maturing each business day.Since the book is changing continually as newtransactions are made, the maturity gap structurealso changes constantly.

While remaining alert to unusually large mis-matches in maturities that call for special action,traders generally balance the net daily paymentsand receipts for each currency through the use ofrollovers. Rollovers simplify the handling of theflow of maturing contracts and reduce the num-ber of transactions needed to balance the book.Reliance on day-to-day swaps is a relativelysound procedure as long as interest-rate changesare gradual and the size and length of maturitygaps are controlled. However, it does leave thefinancial institution exposed to sudden changesin relative interest rates between the UnitedStates and other countries. These sudden changesinfluence market quotations for swap trans-actions and, consequently, the cost of bridgingthe maturity gaps in the foreign-exchange book.

The problem of containing interest-rate risk isfamiliar to major money market banks. Theirbusiness often involves borrowing short-termand lending longer-term to benefit from thenormal tendency of interest rates to be higher forlonger maturities. But in foreign-exchange trad-ing, it is not just the maturity pattern of interestrates for one currency that counts. In handlingmaturity gaps, the differential between interestrates for two currencies is decisive, making theproblem more complex.

To control interest-rate risk, senior manage-ment generally imposes limits on the magnitudeof mismatches in the foreign-exchange book.Procedures vary, but separate limits are often seton a day-to-day basis for contracts maturingduring the following week or two and for eachconsecutive half-monthly period for contracts

maturing later. At the same time, managementrelies on officers abroad, domestic money mar-ket experts, and its economic research depart-ment to provide ongoing analysis of interest-ratetrends.

Credit and Settlement Risk

When a financial institution books a foreign-exchange contract, it faces a risk, howeversmall, that the counterparty will not performaccording to the terms of the contract. To limitcredit risk, a careful evaluation of the creditwor-thiness of the customer is essential. Just as nofinancial institution can lend unlimited amountsto a single customer, no institution would wantto trade unlimited amounts of foreign exchangewith one counterparty.

Credit risk arises whenever an institution’scounterparty is unable or unwilling to fulfill itscontractual obligations—most blatantly when acorporate customer enters bankruptcy or aninstitution’s counterparty is declared insolvent.In any foreign-exchange transaction, each coun-terparty agrees to deliver a certain amount ofcurrency to the other on a particular date. Everycontract is immediately entered into the finan-cial institution’s foreign-exchange book. In bal-ancing its trading position, a financial institutioncounts on that contract being carried out inaccordance with the agreed-upon terms. If thecontract is not liquidated, then the institution’sposition is unbalanced and the institution isexposed to the risk of changes in the exchangerates. To put itself in the same position it wouldhave been in if the contract had been performed,an institution must arrange for a new trans-action. The new transaction may have to bearranged at an adverse exchange rate. The trusteefor a bankrupt company may perform only oncontracts which are advantageous to the com-pany and disclaim those contracts which aredisadvantageous. Some dealers have attemptedto forestall such arbitrary treatment through theexecution of legally recognized bilateral nettingagreements. Examiners should determine whetherdealers have such agreements in place andwhether they have a favorable legal opinion asto their effectiveness, particularly in cross-border situations.

Another form of credit and settlement riskstems from the time-zone differences betweenthe United States and foreign nations. Inevita-bly, an institution selling sterling, for instance,



must pay pounds to a counterparty before it willbe credited with dollars in New York. In theintervening hours, a company can go into bank-ruptcy or an institution can be declared insol-vent. Thus, the dollars may never be credited.Settlement risk has become a major source ofconcern to various supervisory authorities be-cause many institutions are not aware of theextent of the risks involved. The Bank forInternational Settlements (BIS) has laid out thevarious risks in a paper that was published inJuly 1996.

Managing credit risk is the joint responsibilityof the financial institution’s trading departmentand its credit officers. A financial institutionnormally deals with corporations and otherinstitutions with which it has an establishedrelationship. Dealing limits are set for eachcounterparty and are adjusted in response tochanges in its financial condition. In addition,most institutions set separate limits on the valueof contracts that can mature on a single day witha particular customer. Some institutions, recog-nizing that credit risk increases as maturitieslengthen, restrict dealings with certain custom-ers to spot transactions or require compensatingbalances on forward transactions. An institu-tion’s procedures for evaluating credit risk andminimizing exposure are reviewed by supervi-sory authorities as part of the regular examina-tion process.


The accounting treatment for foreign-exchangecontracts is determined by the Financial Account-ing Standards Board’s Statement of FinancialAccounting Standards No. 133 (FAS 133),‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


The credit-equivalent amount of a foreign-exchange contract is calculated by summing—

1. the mark-to-market value (positive valuesonly) of the contract and

2. an estimate of the potential future creditexposure over the remaining life of eachcontract.

The conversion factors are as follows.

Remaining maturityCredit-conversion

factor

One year or less 1.00%Five years or less 5.00%Greater than five years 7.50%

If a bank has multiple contracts with a coun-terparty and a qualifying bilateral contract withthe counterparty, the bank may establish itscurrent and potential credit exposures as netcredit exposures. (See section 2110.1, ‘‘CapitalAdequacy.’’) For institutions that apply market-risk capital standards, all foreign-exchange trans-actions are included in value-at-risk (VAR) cal-culations for market risk.


Foreign-exchange contracts are not consideredinvestment securities under 12 USC 24 (sev-enth). However, the use of these instruments isconsidered to be an activity incidental to bank-ing, within safe and sound banking practices.

REFERENCES

Das, Satyajit. Swap and Derivative Financing.Chicago: Probus Publishing, 1993.

Federal Financial Institutions Examination Coun-cil. Uniform Guidelines on Internal Controlfor Foreign Exchange in Commercial Banks.

The New York Foreign Exchange Committee.Reducing Foreign Exchange Settlement Risk.October 1994.

The New York Foreign Exchange Committee.Guidelines for Foreign Exchange TradingActivities. January 1996.

Schwartz, Robert J., and Clifford W. Smith, Jr.,eds. The Handbook of Currency and InterestRate Risk Management. New York Institute ofFinance, 1990.



ForwardsSection 4310.1

GENERAL DESCRIPTION

Forwards are financial contracts in which twocounterparties agree to exchange a specifiedamount of a designated product for a specifiedprice on a specified future date or dates. Banksare active participants in the forward market.Forwards differ from futures (discussed sepa-rately in this manual) in that their terms are notstandardized and they are not traded on orga-nized exchanges. Because they are individuallynegotiated between counterparties, forwards canbe customized to meet the specific needs of thecontracting parties.


Forwards are over-the-counter (OTC) contractsin which a buyer agrees to purchase from aseller a specified product at a specified price fordelivery at a specified future time. While for-ward contracts can be arranged for almost anyproduct, they are most commonly used withcurrencies, securities, commodities, and short-term debt instruments. (Forwards on short-termdebt instruments, or ‘‘forward rate agreements,’’are discussed separately in this manual.) Com-mitments to purchase a product are called longpositions, and commitments to sell a product arecalled short positions.

Foreign-exchange forward contractsconsti-tute the largest portion of the forward market.They are available daily in the major currenciesin 30-, 90-, and 180-day maturities, as well asother maturities depending on customer needs.Contract terms specify a forward exchange rate,a term, an amount, the ‘‘value date’’ (the day theforward contract expires), and locations forpayment and delivery. The date on which thecurrency is actually exchanged, the ‘‘settlementdate,’’ is generally two days after the value dateof the contract.

In most instances, foreign-exchange forwardssettle at maturity with cash payments by eachcounterparty. Payments between financial insti-tutions arising from contracts that mature onthe same day are often settled with one netpayment.

USES

Market participants use forwards to (1) hedgemarket risks, (2) arbitrage price discrepancieswithin and between markets, (3) take positionson future market movements, and (4) profit byacting as market makers. Financial institutions,money managers, corporations, and traders usethese instruments for managing interest-rate,currency, commodity, and equity risks. Whilemost large financial institutions are active in theinterest-rate and foreign-exchange markets, onlya handful of financial institutions have expo-sures in commodities or equities.

Hedging Interest-Rate Exposure

Financial institutions use forwards to managethe risk of their assets and liabilities, as well asoff-balance-sheet exposures. Asset-liability man-agement may involve the use of financial for-wards to lock in spreads between borrowing andlending rates. For example, a financial institu-tion may sell an interest-rate forward contract inadvance of an anticipated funding to lock in thecost of funds. If LIBOR subsequently increases,the short position will increase in value, offset-ting the higher spot interest cost that the finan-cial institution will have to pay on its funding.

Forward contracts may be used to hedgeinvestment portfolios against yield curve shifts.Financial institutions can hedge mortgage port-folios by selling GNMA forwards, and govern-ment bond dealers may sell forwards to hedgetheir inventory. Pension and other types ofbenefits managers may hedge a fixed futureliability by selling forwards or may hedge anexpected receipt by buying forwards. Whenoffsetting swaps with the necessary terms cannotbe found, interest-rate swap dealers may alsouse forwards, as well as Eurodollar futures andTreasury futures, to hedge their unmatchedcommitments.

Hedging Foreign-Exchange Exposure

Corporations engaged in international trade mayuse foreign-currency contracts to hedge pay-ments and receipts denominated in foreign cur-rencies. For example, a U.S. corporation that


exports to Germany and expects payment indeutschemarks (DM) could sell DM forwards toeliminate the risk of a depreciation of the DM atthe time that the payment arrives. A corporationmay also use foreign-exchange contracts tohedge the translation of its foreign earnings forpresentation in its financial statements.

Financial institutions use foreign-exchangeforwards to hedge positions arising from theirforeign-exchange dealing businesses. An insti-tution that incurs foreign-exchange exposurefrom assisting its customers with currency riskmanagement can use offsetting contracts toreduce its own exposure. A financial institutioncan also use forwards to cover unmatched cur-rency swaps. For example, a dealer obligatedto make a series of DM payments could buy aseries of DM forwards to reduce its exposure tochanges in the DM/$ exchange rate.

Arbitrage

Risk-free arbitrage opportunities in which atrader can exploit mispricing across related mar-kets to lock in a profit are rare. However, forbrief periods of time, pricing in the forwardmarket may not be consistent with pricing in thecash market. For example, if DM forwards areoverpriced relative to the rates implied byinterest-rate parity relationships, a trader couldborrow dollars, sell them against spot DM,purchase a DM deposit, and sell the DM for-ward. This arrangement would lock in a risk-free return.


Primary Market

Forward contracts are not standardized. Marketmakers such as banks, investment banks, andsome insurance companies arrange forward con-tracts in various amounts, including odd lots, tosuit the needs of a particular counterparty. Bro-kers, who arrange forward contracts betweentwo counterparties for a fee, are also active inthe forward market. End-users, including banks,corporations, money managers, and sovereigninstitutions, use forwards for hedging and specu-lative purposes.

Secondary Market

Once opened, forwards tend not to trade becauseof their lack of standardization, the presenceof counterparty credit risk, and their limitedtransferability.

Market Transparency

The depth of the interest-rate and foreign-exchange markets and the interest-rate parityrelationships help ensure transparency of for-ward prices. Market makers quote bid/askspreads, and brokers bring together buyers andsellers, who may be either dealers or end-users.Brokers distribute price information over thephone and via electronic information systems.

PRICING

In general, the value of a long forward contractposition equals the spot price minus the contractprice. For example, forward (and spot) foreign-exchange rates are quoted in the number of unitsof the foreign currency per unit of the domesticcurrency. Forward foreign-exchange rates dependon interest-rate parity among currencies. Interest-rate parity requires the forward rate to be thatrate which makes a domestic investor indifferentto investing in the home currency versus buyingforeign currency at the spot rate, investing it ina foreign time deposit, and subsequently con-verting it back to domestic currency at theforward rate. The interest-rate parity relation-ship can be expressed as—

F = S × [1 + r(F)] / [1 + r(D)],

whereF is the forward rate,S is the spot rate,r(D) is the domestic interest rate, andr(F) is theforeign interest rate. Currency rates are foreigncurrency per unit of domestic currency. Forexample, assume the 180-day dollar ($) interestrate is 5 percent, the 180-day DM interest rate is10 percent, and the DM/$ spot rate is 1.3514(DM per dollar). A dollar-based investor canborrow dollars at 5 percent, sell them againstDM at the DM/$ spot rate of 1.3514, and investthe DM at a 10 percent rate of return. When theinvestment matures, the DM proceeds can bereconverted to dollars at the forward rate of1.4156 DM for each dollar, giving the investor atotal dollar return of 5 percent, which is the

4310.1 Forwards


same return available in dollar deposits. In thisinstance, the forward rate is higher than the spotrate to compensate for the difference betweenDM- and dollar-based interest rates. The differ-ence between the domestic and foreign interestrates is referred to as the ‘‘cost of carry.’’

HEDGING

Positions in forwards can be offset by cash-market positions as well as by other forward orfutures positions. A financial institution’s expo-sure from a foreign-exchange forward contractcan be split into a spot-currency component andan interest-rate differential between the twocurrencies. For the spot foreign-exchange com-ponent, consider a three-month long forwardposition that receives sterling (£) and paysdollars (in three months, the institution receivessterling and pays dollars). This position is com-parable to the combination of receiving a three-month dollar deposit and making a three-monthsterling loan. The forward position implicitlylocks in a spread between the lending andborrowing rates while exposing the institution tofuture sterling-dollar spot rates.

To eliminate the currency and interest-rateexposure, the financial institution can eitherenter into an offsetting forward or take a shortposition in sterling. By entering into a three-month forward contract to deliver sterling againstdollars, the financial institution could virtuallyeliminate its currency exposure. Alternatively,the institution could borrow three-month ster-ling, sell it, and invest the dollar proceeds in athree-month deposit. When the long sterling-dollar forward comes due, the institution can usethe maturing dollar deposit to make its paymentand apply the sterling proceeds to the repaymentof the sterling loan.

RISKS

Users and providers of forwards face variousrisks, which must be well understood and care-fully managed. The risk-management methodsapplied to forwards and futures may be similarto those used for other derivative products.

Credit Risk

Generally, a party to a forward contract facescredit risk to the degree that its side of the

contract has positive market value. In otherwords, credit risk in forwards arises from thepossibility that a contract has a positive replace-ment cost and the counterparty to the contractfails to perform its obligations. The value of acontract is generally zero at inception, but itchanges as the market price of the productunderlying the forward changes. If the institu-tion holds a contract that has a positive marketvalue (positive replacement cost) and if thecounterparty defaults on the contract, the insti-tution would forfeit this value. To counter thisrisk, weak counterparties may be required tocollateralize their commitments. Counterpartiesdealing with financial institutions may berequired to maintain compensating balances orcollateral. Because of their credit risk and thelack of standardization, forwards generally can-not be terminated or transferred without theconsent of each party.

As part of their risk management, financialinstitutions generally establish credit lines foreach trading counterparty. For foreign exchange(spot and forward), the lines are most oftenexpressed in notional terms. These credit linesinclude global counterparty limits, daily coun-terparty settlement limits, and maturity limits.Some sophisticated financial institutions usecredit-equivalent risk limits rather than notionalamounts for their foreign-exchange exposure.For interest-rate risk, financial institutions usu-ally express their exposure in credit equivalentsof notional exposure. Financial institutions mayrequire a less creditworthy counterparty to pledgecollateral and supplement it if the positionmoves against the counterparty.

Market Risk

The risk of forward contracts should be evalu-ated by their effect on the market risk of theoverall portfolio. Institutions that leave posi-tions in the portfolio unhedged may be moreexposed to market risk than institutions that‘‘run a matched book.’’ A financial institutionmay choose to leave a portion of its exposureuncovered to benefit from expected price changesin the market. However, if the market movesagainst the institution’s prediction, the institu-tion would incur losses.

Basis Risk

Basis risk is the potential for loss from changes

Forwards 4310.1


in the price or yield differential between instru-ments in two markets. Although risk fromchanges in the basis tends to be less than thatarising from absolute price movements, it cansometimes represent a substantial source of risk.Investors may set up hedges, which leave themvulnerable to changes in basis between thehedge and the hedged instrument.

Yield-curve risk may also arise from holdinglong and short positions with equal durations butdifferent maturities. Although such arrange-ments may protect against a parallel yield-curveshift, they may leave investors exposed to therisk of a nonparallel shift causing uneven pricechanges. In foreign currency, basis risk arisesfrom changes in the differential between interestrates of two currencies.

Liquidity Risk

Forwards are usually not transferable withoutthe consent of the counterparty and may beharder to liquidate than futures. To eliminate theexposure of a contract, a customer may have tobuy an offsetting position if the initial dealerdoes not want to unwind or allow the transfer ofthe contract.

Clearing and Settlement Risk

In OTC markets, clearing and settlement occuron a bilateral basis thereby exposing counter-parties to intraday and overnight credit risks. Toreduce these risks and transactions costs, manyfinancial institutions have bilateral nettingarrangements with their major counterparties.Position netting allows counterparties to nettheir payments on a given day but does notdischarge their original legal obligations for thegross amounts. Netting by novation replacesobligations under individual contracts with asingle new obligation.


The accounting treatment for foreign-exchangeforward contracts is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138

(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


The credit-equivalent amount of a forward con-tract is calculated by summing—



The conversion factors are below.


factor


If a bank has multiple contracts with a counter-party and a qualifying bilateral contract with thecounterparty, the bank may establish its currentand potential credit exposures as net creditexposures. (See section 2110.1, ‘‘ Capital Ade-quacy.’’ ) For institutions that apply market-riskcapital standards, all foreign-exchange transac-tions are included in value-at-risk (VAR) calcu-lations for market risk.


Forwards are not considered investments under12 USC 24 (seventh). The use of these instru-ments is considered to be an activity incidentalto banking, within safe and sound bankingpractices.

REFERENCES

Andersen, Torben. Currency and Interest RateHedging. Simon and Schuster, 1993.

Beidleman, Carl. Financial Swaps. Dow Jones-Irwin, 1985.

Hull, John C. Options, Futures and OtherDerivative Securities. 2d ed. Prentice Hall,1989.

4310.1 Forwards


Forward Rate AgreementsSection 4315.1

GENERAL DESCRIPTION

A forward rate agreement (FRA) is an over-the-counter (OTC) contract for a cash payment atmaturity based on amarket (spot) rateand aprespecifiedforward rate. The contract specifieshow the spot rate is to be determined (this issometimes called thereference rate). If the spotrate is higher than the contracted rate, the selleragrees to pay the buyer the difference betweenthe prespecified forward rate and the spot rateprevailing at maturity, multiplied by anotionalprincipal amount. If the spot rate is lower thanthe forward rate, the buyer pays the seller. Thenotional principal, which is not exchanged, rep-resents a Eurocurrency deposit of a specifiedmaturity or tenor, which starts on the day theFRA matures. The cash payment is the presentvalue of the difference between the forward rateand the spot rate prevailing at the settlementdate times the notional amount. This payment isdue at the settlement date. Buying and sellingFRAs is sometimes calledtaking and placingFRAs, respectively. FRAs with maturities longerthan a year are calledlong-datedFRAs.

FRAs are usuallysettledat the start of theagreed-upon period in the future. At this time,payment is made of the discounted present valueof the interest payment corresponding to thedifference between the contracted fixed rate (theforward rate at origination) and the prevailingreference rate (the spot rate at maturity). Forexample, in a six-against-nine-month (6x9) FRA,the parties agree to a three-month rate that is tobe netted in six months’ time against the pre-vailing three-month reference rate, typicallyLIBOR. At settlement (after six months), thepresent value of the net interest rate (the differ-ence between the spot and the contracted rate) ismultiplied by the notional principal amount todetermine the amount of the cash exchangedbetween the parties. The basis used in discount-ing is actual/360-day for all currencies exceptpounds sterling, which uses an actual/365-daycount convention.


An FRA can be entered into either orally or inwriting. Each party is, however, required to

confirm the FRA in writing. FRAs are custom-ized to meet the specific needs of both parties.They are denominated in a variety of currenciesand can have customized notional principalamounts, maturities, and interest periods. TheBritish Bankers’ Association (BBA) has devel-oped standards for FRAs, calledForward RateAgreements of the BBA (FRABBA) terms, whichare widely used by brokers and dealers. Thestandards include definitions, payment and con-firmation practices, and various rights andremedies in case of default. Under these stan-dards, counterparties execute a master agree-ment, under which they agree to execute theirFRA transactions.

USES

Hedging

FRAs are often used as a hedge against futuremovement in interest rates. Like financial futures,they offer a means of managing interest-rate riskthat is not reflected on the balance sheet and,therefore, generally requires less capital.

FRAs allow a borrower or lender to ‘‘lock in’’an interest rate for a period that begins in thefuture (assuming no change in the basis), thuseffectively extending the maturity of its liabili-ties or assets. For example, a financial institutionthat has limited access to funds with maturitiesgreater than six months and has relatively longer-term assets can contract for a six-against-twelve-month FRA, and thus increase the extent towhich it can match asset and liability maturitiesfrom an interest-rate risk perspective. By usingthis strategy, the financial institution determinestoday the cost of six-month funds it will receivein six months’ time. Similarly, a seller of anFRA can lengthen the maturity profile of itsassets by determining in advance the return on afuture investment.

Trading

Banks and other large financial institutionsemploy FRAs as a trading instrument. Marketmakers seek to earn the bid/ask spread throughbuying and selling FRAs. Trading may also takethe form of arbitrage between FRAs and interest-rate futures or short-term interest-rate swaps.



Primary Market

Commercial banks are the dominant player inthe FRA market, both as market makers andend-users. Nonfinancial corporations have alsobecome significant users of FRAs for hedgingpurposes. Most contracts are originated inLondon and New York, but all major Europeanfinancial centers have a significant share ofvolume. Market transparency is high in the FRAmarket, and quotes for standard FRA maturitiesin most currencies can be obtained from sourcessuch as Telerate and Bloomberg.

A significant amount of trading in FRAs isdone through brokers who operate worldwide.The brokers in FRAs usually deal in Euros andswaps. The principal brokers are Tullet & TokyoForeign Exchange; Garvin Guy Butler; Godsell,Astley & Pearce; Fulton Prebon; and Eurobrokers.

Secondary Market

The selling of an existing FRA consists ofentering into an equal and opposite FRA at aforward rate offered by a dealer or other party atthe time of the sale. The secondary market inFRAs is very active and is characterized by asignificant amount of liquidity and markettransparency.

PRICING

Initial Cost

When an FRA is initiated, the FRArate isset such that the value of the contract is zero,since no money is exchanged, except perhapsa small arrangement fee (which may not bepayable until settlement). Forward rates aredirectly determined from spot rates. For exam-ple, the rate on a 6-against-12-month FRA willbe derived directly from rates on 6- and 12-month deposits. (This rate derived from theyield curve is termed animplied forward rate.)As an example, suppose the 6-month Eurodollardeposit rate is 6.00 percent and the 12-monthEurodollar deposit rate is 7.00 percent. The rateon a 6-against-12-month FRA would be derivedby finding the 6-month forward rate, 6 monthshence (6R12):

(1.07) = (1.06).5(1 + 6R12).5

6R12 = 8.00%

There is little evidence that arbitrage opportuni-ties exist between the FRA and deposit marketsafter taking into account bid/offer spread andtransactions costs.

Valuation at Settlement

Settlement on an FRA contract is made inadvance, that is at the settlement date of thecontract. The settlement sum is calculated bydiscounting the interest differential due from thematurity date to the settlement date using therelevant market rate.

Let f = the FRA rate (as a decimal),s = thespot rate at maturity (as a decimal),t = the tenorof the notional principal in number of days,P =the notional principal, andV = the sum due atsettlement. Assume that the basis is actual/360-day. The interest due the buyer before discount-ing is (s − f)P(t/360). The discount factor is 1−s(t/360).V is the sum due at settlement:

V = [(s − f)P(t/360)][1 − s(t/360)]

For example, consider a $10 million three-against-six-month FRA with a forward rate of6.00 percent and a spot rate at maturity of 6.50percent.

V = [$10mm(.065− .06)(91/360)][1 − ((.065)(91/360))]

V = $12,431.22

A payment of $12,431.22 would be made by theseller to the buyer of the FRA at settlement.

HEDGING

Market Risk

Eurodollar futures are usually used to hedge themarket risk of FRA positions. However, the onlyperfect economic hedge for an FRA is anoffsetting FRA with the same terms.

Credit Risk

Letters of credit, collateral, and other credit

4315.1 Forward Rate Agreements


enhancements can be required to mitigate thecredit risks of FRAs. In practice, however, this israrely done because the credit risk of FRAs isvery low.

RISKS

Interest-Rate Risk

The interest-rate risk (or market risk) of an FRAis very similar to a short-term debt instrumentwhose maturity is equal to the interest period ofthe FRA. For example, a six-against-nine-monthFRA has a price sensitivity similar to that of athree-month debt instrument (approximate dura-tion of one-fourth of a year).

Liquidity Risk

Liquidity risk (the likelihood that one cannotclose out a position) is low. The FRA marketsare very liquid, although generally not as liquidas the futures markets.

Credit Risk

The credit risk of FRAs is small but greater thanthe credit risk of futures contracts. The creditrisk of futures is minimal because of dailymargining and the risk management of thefutures clearing organizations. If an FRA coun-terparty fails, a financial institution faces a lossequal to the contract’s replacement cost. Therisk of loss depends on both the likelihood of anadverse movement of interest rates and thelikelihood of default by the counterparty. Forexample, suppose a financial institution buys anFRA at 10 percent to protect itself against a risein LIBOR. By the settlement date, LIBOR hasrisen to 12 percent, but the counterparty defaults.The financial institution therefore fails to receiveanticipated compensation of 2 percent per yearof the agreed notional principal amount for theperiod covered by the FRA. Note that thefinancial institution is not at risk for the entirenotional principal amount but only for the netinterest-rate differential.

FRAs raise the same issues about measuringcredit-risk exposure as interest-rate swaps.Because the periods covered by FRAs are typi-cally much shorter, many institutions calculatethe credit exposure on FRAs as a flat rate againstthe counterparty’s credit limit, for example,

5 percent (sometimes 10 percent) of the notionalprincipal amount. The 5 percent credit exposureis a rule of thumb adopted for administrativeease, and it represents the approximate potentialloss from counterparty default if the referenceinterest rate for a three-month future periodmoves against the financial institution by 20percentage points before the settlement date. Foran agreement covering a six-month future inter-val, the 5 percent charge to a counterparty’scredit limit represents exposure against approxi-mately a 10 percentage point movement in thereference interest rate.


The accounting treatment of single-currencyforward interest-rate contracts, such as forwardrate agreements, is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


The credit-equivalent amount of an FRA con-tract is calculated by summing—





factor


If a bank has multiple contracts with a coun-terparty and a qualifying bilateral contract withthe counterparty, the bank may establish itscurrent and potential credit exposures as netcredit exposures. (See section 2110.1, ‘‘Capital

Forward Rate Agreements 4315.1


Adequacy.’’) For institutions that apply market-risk capital standards, all foreign-exchange trans-actions are included in value-at-risk (VAR) cal-culations for market risk.


FRAs are not considered investments under12 USC 24 (seventh). The use of these instru-ments is considered to be an activity incidentalto banking, within safe and sound bankingpractices.

REFERENCES

Andersen, Torben. Currency and Interest RateHedging. Simon and Schuster, 1993.


Francis, Jack, and Avner Wolf. The Handbookof Interest Rate Risk Management. Irwin Pro-fessional Publishing, 1994.

Stigum, Marcia. The Money Market. Dow Jones-Irwin, 1990.

4315.1 Forward Rate Agreements


Financial FuturesSection 4320.1

GENERAL DESCRIPTION

Futures contracts are exchange-traded agree-ments for delivery of a specified amount andquality of a particular product at a specifiedprice on a specified date. Futures contracts areessentially exchange-traded forward contractswith standardized terms. Futures exchangesestablish standardized terms for futures con-tracts so that buyers and sellers only have toagree on price.

Unlike the over-the-counter (OTC) derivativemarkets, futures contracts are required by U.S.law to trade on federally licensed contract mar-kets that are regulated by the Commodity FuturesTrading Commission (CFTC). Banks may investin futures for their own account or act as afutures broker through a futures commissionmerchant (FCM) subsidiary. The two generictypes of futures contracts are commodity futures(such as coffee, cocoa, grain, or rubber) andfinancial futures (that is, currencies, interestrates, and stock indexes). This section focuseson financial futures.


Terms

All futures contracts have the following stan-dardized terms: specific product, quality (orgrade), contract size, pricing convention, anddelivery date. The following is an example ofthe terms on a futures contract for U.S. Treasurynotes traded on an exchange such as the ChicagoBoard of Trade (CBOT).

Product: 10-year Treasury notesContract size: $100,000Price quoted: 32nds of 100 percentDelivery date: Any business day of delivery

month (March, June, Septem-ber, or December, depending onthe particular contract)

Deliverablegrade: Any U.S. Treasury notes with

maturity of 61⁄2 to 10 years

Margin

In addition, all exchanges require agood faithdeposit or margin in order to buy or sell afutures contract. The amount of margin will varyfrom contract to contract and from exchange toexchange. The required margin deposit may alsovary depending on the type of position held. Themargin requirement is meant to ensure thatadequate funds are available to cover losses inthe event of adverse price changes. Marginrequirements are determined and administeredby the exchange’s clearinghouse.

As an example of how margin requirementsoperate, consider a deutschemark (DM) 125,000futures contract against the dollar with a price of$.68/DM. One trader takes a long DM position,meaning that it will receive DM 125,000 andpay $85,000 in December. Another trader takesa short DM position, such that it will pay theDM 125,000 in return for $85,000. Each traderputs up an initial margin of $4,250, which isinvested in U.S. Treasuries in margin accountsheld at each trader’s broker. Time passes and the$/DM rate increases (the DM decreases in value)so that the trader with the long DM positionmust post additional margin. When the spot ratesubsequently reaches $.61/DM, the long traderdecides to cut his losses and close out hisposition. Ignoring the limited effect of priorfluctuations in margin, the long trader’s cumu-lative loss measures $8,750 ($.68/DM− $.61/DM) × DM 125,000).

Exchanges

Futures contracts are traded on organizedexchanges around the world. Exchanges for themajor futures contracts in currencies, interestrates, and stock indexes are discussed below.

Currency Futures

In the United States, futures contracts trade inthe International Monetary Market (IMM) of theChicago Mercantile Exchange (CME) in themajor currencies, including the deutschemark,Japanese yen, British pound, Canadian dollar,and Swiss franc. Overseas, the most activecurrency futures exchanges are the London


International Financial Futures Exchange(LIFFE) and the Singapore International Mone-tary Exchange (SIMEX).

Interest-Rate Futures

The IMM and the CBOT list most of thefixed-income futures in the United States. Con-tracts on longer-term instruments, such as Trea-sury notes (2-, 5-, and 10-year) and Treasurybonds (30-year), are listed on the CBOT. Futureson short-term instruments such as Eurodollardeposits and Treasury bills trade on the IMM.There are also futures on bond indexes such asthose for municipal bonds, corporate bonds,Japanese government bonds, and British gilts.As with currencies, the most active overseasexchanges are in London and Singapore.

Stock-Index Futures

In the United States, stock-index futures areavailable for the S&P 500 (CME), Major MarketIndex (CME), New York Stock Exchange Com-posite Index (New York Futures Exchange), andNikkei 225 Index (CME). Overseas, there arefutures on many of the major equity markets,including the Nikkei (Osaka and SingaporeFutures Exchanges), DAX (LIFFE), and FTSE100 (LIFFE).

Clearinghouses

Clearinghouses provide centralized, multilateralnetting of an exchange’s futures contracts. Cen-tralized clearing, margin requirements, and dailysettlement of futures contracts substantiallyreduce counterparty credit risk. A futuresexchange operates in tandem with a clearing-house that interposes itself between a contract’scounterparties and, thus, guarantees payment toeach.

In addition, customers in futures markets postcollateral, known as initial margin, to guaranteetheir performance on the obligation. At the endof each day, the futures position is marked tomarket with gains paid to or losses deductedfrom (variation margin payments) the marginaccount. The balance in a margin account cannotfall below a minimum level (known as mainte-nance margin). If the position falls below the

maintenance margin, the counterparty must putup additional collateral.

Under some circumstances, traders that havepositions in a variety of futures and options onfutures can have their margin determined on aportfolio basis. This process takes into accountthe natural offsets from combinations of posi-tions which may reduce the total margin requiredof a market participant. The industry has devel-oped a scenario-based portfolio margining sys-tem called SPARTM which stands for the Stan-dard Portfolio Analysis of Risk.

Many futures contracts specify settlement incash, rather than by physical delivery, uponexpiration of the contract. Cash settlement hasthe advantage of eliminating the transactioncosts of purchasing and delivering the under-lying instruments. Examples of cash-settled con-tracts are futures on Eurodollars, municipalbond indexes, and equity indexes.

USES

Market participants use futures to (1) hedgemarket risks, (2) arbitrage price discrepancieswithin and between markets, (3) take positionson future market movements, and (4) profit byacting as market makers (forwards) or brokers(futures). Financial institutions, money manag-ers, corporations, and traders use these instru-ments for managing interest-rate, currency,commodity, and equity risks. While most largefinancial institutions are active in the interest-rate and foreign-exchange markets, only a hand-ful of financial institutions have exposures incommodities or equities.

Hedging

Futures are used to hedge the market risk of anunderlying instrument. For example, financialinstitutions often face interest-rate risk fromborrowing short-term and lending long-term. Ifrates rise, the institution’s spread will decreaseor even become negative. The institution canhedge this risk by shorting a futures contract ona fixed-income instrument (such as a Treasurysecurity) maturing at the same time as the asset.If rates rise, the futures position will increase invalue, providing profit to offset the decrease innet interest spread on the cash position. If ratesfall, however, the value of the futures contract

4320.1 Financial Futures


will fall, offsetting the increase in the institu-tion’s interest-rate spread.

Arbitrage

Risk-free arbitrage opportunities in which atrader can exploit mispricing across related mar-kets to lock in a profit are rare. For brief periodsof time, pricing in the futures market may beinconsistent with pricing in the cash market. Forexample, if DM futures are overpriced relativeto the rates implied by interest-rate parity rela-tionships, a trader could borrow dollars, sellthem against spot DM, purchase a DM deposit,and sell the DM future. This arrangement wouldlock in a risk-free return.

Positioning

Traders and investors can use futures for specu-lating on price movements in various markets.Futures have the advantage of lower transac-tions costs and greater leverage than manycash-market positions. Speculators may makebets on changes in futures prices by havinguncovered long or short positions, combinationsof long and short positions, combinations ofvarious maturities, or cash and futures positions.Speculators may profit from uneven shifts in theyield curve, fluctuations in exchange rates, orchanges in interest-rate differentials.

For example, a speculator expecting stockprices to increase buys 10 contracts on the S&P500 index for March delivery at a price of $420.Each contract covers 500 times the price of theindex, thereby giving the speculator immediatecontrol of over $2.1 million (420 × 500 × 10) ofstock. By February, the index increases to 440,giving the speculator an unrealized profit of$100,000 ((440− 420) × 500 × 10). The marketis still bullish, so the speculator decides to holdthe contract for several more weeks, anticipatingmore profits. Instead, negative economic newsdrives the index down to 405 and induces thespeculator to close out his position, leaving aloss of $75,000.

Money managers use financial futures as anasset-allocation tool. Futures allow managers toshift the fixed-income, currency, and equityportions of their portfolios without having toincur the costs of transacting in the cash market.A fixed-income manager may use bond futures

to readjust the composition of a fixed-incomeportfolio in response to a particular outlook oninterest rates. For example, a manager anticipat-ing an increase in interest rates can shortenportfolio duration to reduce the risk of loss byselling Treasury bond or bill futures. Currencyfutures could be used to reduce or increasecurrency risk in an international portfolio. Equityindex futures can be used to adjust a portfolio’sexposure to the stock market.

Market Making or Brokering

A financial institution can also attempt to profitby holding itself out as a market maker orbroker, providing two-way prices (bid and offer)to the market. While earning the bid offerspread, the institution will either hedge theresulting positions or choose to hold the positionto speculate on expected price movements.


The combination of contract standardization,centralized clearing, and limited credit riskpromotes trading of futures on exchanges suchas the CBOT, CME, and LIFFE. In the UnitedStates, futures exchanges traditionally use the‘‘open outcry’’ method of trading, wherebytraders and floor brokers, standing in pits on thetrading floor, shout out or use hand signals toindicate their buy and sell orders and prices.Technological innovation and the desire forafter-hours trading have fostered the develop-ment of electronic trading systems. These sys-tems have become quite popular overseas, espe-cially on newer exchanges. For example,GLOBEX is an electronic trading system thatcurrently provides after-hours trading of con-tracts listed on the CME and the MATIF (Marchea Terme International de France) in Paris. TheLIFFE after-hours trade-matching system iscalled APT, and the CBOT system is calledProject A. In addition to these electronic tradingsystems, several exchanges have extended trad-ing hours through exchange linkages. The oldestand most well-known linkage is the mutualoffset system between the CME and the SIMEXfor Eurodollar futures contracts. SIMEX hassimilar arrangements with the InternationalPetroleum Exchange (IPE). LIFFE has announced

Financial Futures 4320.1


plans for futures linkages with the CBOT andthe CME.

Customers submit their buy or sell ordersthrough registered commodity brokers known asFCMs. Several large domestic and foreign banksand bank holding companies have establishedtheir own FCM subsidiaries. Most of thesesubsidiaries are also clearing members of themajor commodity exchange clearinghouses andhave an established floor staff working on theclearinghouse’s associated futures exchange. In-stitutional customers often place their ordersdirectly with the FCM’s phone clerks on theexchange floor. The clerk signals the order to apit broker (usually an independent contractor ofthe FCM). The pit broker completes the trans-action with another member of the exchange andthen signals a confirmation back to the phoneclerk who verbally relates the trade informationback to the customer. The trade is then pro-cessed by the FCM for trade matching, clearing,and settlement. An FCM’s back-office clerksusually recap the customer’s transactions at theend of day with the customer’s back-office staff.Paper confirmation is mailed out the followingday; however, on-line confirmation capability isbecoming increasingly common.

PRICING

As with forward rates, futures prices are derivedfrom arbitrage-free relationships with spot prices,taking into account carrying costs for correspond-ing cash-market goods. With commodities,carrying costs include storage, insurance, trans-portation, and financing costs. The cost-of-carryfor financial instruments consists mostly offinancing costs, though it may also include somefixed costs such as custody fees. The cost-of-carry concept when referred to in the context offutures contracts is known as thebasis(that is,the difference between the cash price for acommodity or instrument and its correspondingfutures price).

In the case of fixed-income, interest-ratefutures, the cost-of-carry represents the differ-ence between the risk-free, short-term interestrate and the yield on the underlying instrument.The price of a fixed-income future can beexpressed by the formula:

F = P + [P × (r − y)],

whereF is the futures price,P is the cash priceof the deliverable security,r is the short-termcollateralized borrowing rate (or repo rate), andy is any coupon interest paid on the securitydivided by P. To understand the relationshipbetween spot and futures prices, imagine aninvestor who borrows at the repo rate, takes along position in the underlying bond, and sells abond future. At the maturity of the futurescontract, the investor can deliver the bond tosatisfy the futures contact and use the cashproceeds from the short futures position to repaythe borrowing. In competitive markets, thefutures price will be such that the transactiondoes not produce arbitrage profits.

For foreign-exchange futures, the cost-of-carry can be derived from the differentialbetween the interest rates of the domestic andforeign currencies. When foreign interest ratesexceed domestic rates, the cost-of-carry is nega-tive. The spread that could be earned on thedifference between a short domestic positionand a long foreign position would subsidize thecombined positions. For the no-arbitrage condi-tion to hold, therefore, a comparable futuresposition (domestic per foreign) must cost lessthan the cash (spot) position.

HEDGING

Hedge Ratio

The hedge ratio is used to calculate the numberof contracts required to offset the interest-raterisk of an underlying instrument. The hedgeratio is normally constructed by determining theprice sensitivity of the hedged item and the pricesensitivity of the futures contract. A ratio ofthese price sensitivities is then formulated todetermine the number of futures contracts neededto match the price sensitivity of the underlyinginstrument.

Interest-Rate Exposure

Financial institutions use futures to manage therisk of their assets and liabilities, as well asoff-balance-sheet exposures. Asset/liability man-agement may involve the use of futures to lockin spreads between borrowing and lending rates.For example, a financial institution may sellEurodollar futures in advance of an anticipated



funding to lock in the cost of funds. If LIBORsubsequently increases, the short futures posi-tion will increase in value, offsetting the higherspot interest cost that the financial institutionwill have to pay on its funding.

These contracts may be used to hedge invest-ment portfolios against yield-curve shifts. Finan-cial institutions can hedge mortgage portfoliosby selling futures contracts (or GNMA for-wards), and government bond dealers may sellTreasury futures to hedge their inventory. Pen-sion and other types of benefits managers mayhedge a fixed future liability by selling futures,or they may hedge an expected receipt bybuying futures.

Interest-rate swap dealers use futures (or for-wards) to hedge their exposures because directlyoffsetting swaps with the necessary terms cannotbe found easily. The dealers rely on Eurodollarfutures, Treasury futures, and floating-rate agree-ments (a type of interest-rate forward) to hedgetheir unmatched commitments. For example, adealer obligated to pay LIBOR may sell Euro-dollar futures to protect itself against an increasein interest rates.

Foreign-Exchange Exposure

Corporations engaged in international trade mayuse foreign-currency contracts to hedge pay-ments and receipts denominated in foreign cur-rencies. For example, a U.S. corporation thatexports to Germany and expects payment in DMcould sell DM futures (or forwards) to eliminatethe risk of lower DM spot rates at the time thatthe payment arrives. A corporation may also useforeign-exchange contracts to hedge the transla-tion of its foreign earnings for presentation in itsfinancial statements.

Financial institutions use foreign-exchangefutures (or forwards) to hedge positions arisingfrom their businesses dealing in foreign exchange.An institution that incurs foreign-exchangeexposure from assisting its customers with cur-rency risk management can use offsetting con-tracts to reduce its own exposure. A financialinstitution can also use futures (or forwards) tocover unmatched currency swaps. For example,a dealer obligated to make a series of DMpayments could buy a series of DM futures (orforwards) to reduce its exposure to changes inthe DM/$ exchange rate.

RISKS

Users and brokers of futures face various risks,which must be well understood and carefullymanaged. The risk-management methods appliedto futures (or forwards) may be similar to thoseused for other derivative products.

Credit Risk

Unlike OTC derivative contracts, the credit riskassociated with a futures contract is minimal.The credit risk in futures is less because theclearinghouse acts as the counterparty to alltransactions on a given exchange. An exchange’sclearinghouse may be a division of the exchange,as in the case of the CME, or may be aseparately owned and operated entity, such asthe Chicago Board of Trade Clearing Corpora-tion (BOTCC) or the London Clearing House(LCH). In addition to the credit protection afutures clearinghouse receives from prospective(initial) margin and the daily contract revalua-tions and settlement (marking to market), aclearinghouse is usually supported by loss-sharing arrangements with its clearing memberfirms. These loss-sharing provisions may takethe form of limited-liability guarantees (‘‘pass-the-hat rules’’ (BOTCC, LCH)) or unlimited-liability guarantees (‘‘good-to-the-last-droprules’’ (CME, NYMEX, SIMEX)). Because ofthese safeguards, no customer has lost moneydue to default on a U.S. futures exchange.

In addition, customer-account segregationsignificantly reduces the risk a customer faceswith regard to excess margin funds on depositwith its FCM. Segregation is required for U.S.futures brokers but is less common overseas.However, even with customer-account segrega-tion, FCM customers are exposed to the per-formance of the FCM’s other customers. Unlikea U.S. broker-dealer securities account, thefutures industry does not have a customer insur-ance scheme such as the Securities InvestorProtection Corporation (SIPC). The exchangesand their clearinghouses often maintain smallcustomer-guarantee funds, but disbursementfrom these funds is discretionary.

Finally, clearinghouses maintain their marginfunds in their accounts at their respective settle-ment banks. These accounts are not unique andcarry the same credit risks as other demanddeposit accounts at the bank. For this reason, the



European Capital Adequacy Directive assignsfutures and options margins a 20 percent risk-based capital treatment.

Market Risk

Because futures are often used to offset themarket risk of other positions, the risk of thesecontracts should be evaluated by their effect onthe market risk of the overall portfolio. Institu-tions that leave positions in the portfoliounhedged may be more exposed to market riskthan institutions that ‘‘run a matched book.’’ Afinancial institution may choose to leave a por-tion of its exposure uncovered to benefit fromexpected price changes in the market. If themarket moves against the institution’s predic-tion, the institution would incur losses.

Basis Risk

Basis risk is the potential for loss from changesin the price or yield differential between instru-ments in two markets. Although risk fromchanges in the basis tends to be less than thatarising from absolute price movements, it cansometimes represent a substantial source of risk.

With futures, basis may be defined as theprice difference between the cash market and afutures contract. As a contract matures, the basisfluctuates and gradually decreases until thedelivery date, when it equals zero as the futuresprice and the cash price converge. Basis oninterest-rate futures can vary due to changes inthe shape of the yield curve, which affects thefinancing rate for holding the deliverable secu-rity before delivery. In foreign currency, basisrisk arises from changes in the differentialbetween interest rates of two currencies.

Investors may set up hedges with futures,which leave them vulnerable to changes in basisbetween the hedge and the hedged instrument.For example, Treasury note futures could besold short to hedge the value of a medium-termfixed-rate corporate loan. If market forces causecredit spreads to increase, the change in value ofthe hedge may not fully offset the change invalue of the corporate bond.

Yield-curve risk may also arise from holdinglong and short positions with equal durations butdifferent maturities. Although such arrange-ments may protect against a parallel yield-curveshift, they may leave investors exposed to the

risk of a nonparallel shift causing uneven pricechanges.

Liquidity Risk

Because of the multilateral netting ability of afutures clearinghouse, futures markets are gen-erally more liquid than their equivalent OTCderivative contracts. However, experience varieswith each product and market. In the futuresmarkets, most liquidity is found in near-termcontracts and can be rather thin in the moredistant contracts.

Clearing and Settlement Risk

In OTC markets, clearing and settlement occurson a bilateral basis, exposing counterparties tointraday and overnight credit risks. To reducethese risks as well as transactions costs, manyfinancial institutions have bilateral nettingarrangements with their major counterparties.Position netting allows counterparties to nettheir payments on a given day, but does notdischarge their original legal obligations for thegross amounts. Netting by novation replacesobligations under individual contracts with asingle new obligation.


The accounting treatment for foreign-currencyfutures contracts is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


The credit-equivalent amount of a financialfutures contract is calculated by summing—







factor


If a bank has multiple contracts with a counter-party and a qualifying bilateral contract with thecounterparty, the bank may establish its currentand potential credit exposures as net creditexposures. (See section 2110.1, ‘‘CapitalAdequacy.’’)


Banks may invest in any futures contract. How-

ever, in taking delivery of nonfinancial products,the bank may need to place the physical com-modity in other real estate owned (OREO). Inaddition, the bank may not engage in the buyingand selling of physical commodities or holditself out as a dealer or merchant in physicalcommodities.

REFERENCES

Fabozzi, Frank, and Dessa. The Handbook ofFixed Income Securities. 4th ed. Irwin Profes-sional Publishing, 1995.

Kolb, Robert. Inside the Futures Markets. KolbPublishing Co. 1991.

Stigum, Marcia. The Money Market. 3rd ed.Dow Jones-Irwin, 1990.



Interest-Rate SwapsSection 4325.1

GENERAL DESCRIPTION

Interest-rate swaps are over-the-counter (OTC)derivative contracts in which two parties agreeto exchange interest cash flows or one or morenotional principal amounts at certain times inthe future according to an agreed-on formula.The cash flows may be in the same currency ora different currency. The formula defines thecash flows using one or more interest rates andone or more hypothetical principal amountscallednotional principal amounts.

As an example, suppose that Company Aand Bank B enter into a three-year interest-rate swap, in which Bank B agrees to pay a6 percent fixed rate (quoted on a 30/360-day count basis) on a notional principal of$100 million, every six months, on January 1and July 1. In return, Company A agrees to payU.S. dollar six-month LIBOR on the same dates,on the same notional principal. Thus, the cashflows on the swap will have semiannual fixed-rate payments of $300,000 going to Company Aon each January 1 and July 1, and floatingpayments based on the prevailing level of U.S.dollar six-month LIBOR on each January 1 andJuly 1 going to Bank B. These semiannual cashflows will be exchanged for the three-year lifeof the swap.

Banks, corporations, sovereigns, and otherinstitutions use swaps to manage their interest-rate risks, reduce funding costs (fixed or float-ing), or speculate on interest-rate movements.Banks (commercial, investment, and merchant)also act asswaps dealersor brokersin their roleas financial intermediaries. As a dealer, a bankoffers itself as a counterparty to its customers.As a broker, a bank finds counterparties for itscustomers, in return for a fee.

The interest-rate swaps market has grownrapidly since its inception in the early 1980s. Asof March 1995, interest-rate swaps accountedfor 69 percent of the market in interest-ratederivatives, in terms of notional principaloutstanding. The notional principal outstandingin swaps at this date was $18.3 trillion. Thegross market value of these swaps was $562 bil-lion, or 87 percent of all interest-rate derivativecontracts.


Swap Terminology and Conventions

An interest-rate swap is an off-balance-sheet,OTC contractual agreement in which two coun-terparties agree to make interest payments toeach other, based on an amount called thenotional principal. In an interest-rate swap, onlythe interest payments are exchanged; the notionalprincipal is not exchanged, it is used only tocalculate the interest payments. Each counter-party’s set of payments is called aleg or sideofthe swap. The fixed-rate payer hasbought theswap, or is long the swap. Conversely, thefloating-rate payer hassold the swap, or isshortthe swap. The counterparties makeservice pay-mentsat agreed-on periods during the swap’stenor. The payer of a fixed leg makes servicepayments at a fixed price (or rate). The payer ofa floating leg makes payments at a floating pricethat is periodicallyresetusing areference rate,which is noted on specific reset dates. The actualdates on which payments are made are paymentdates.

The reference floating rate in many interest-rate swap agreements is theLondon InterbankOffered Rate (LIBOR). LIBOR is the rate ofinterest offered on short-term interbank depositsin Eurocurrency markets. These rates are deter-mined by trading between banks, and theychange continuously as economic conditionschange. One-month, three-month, six-month,and one-year maturities are the most commonfor LIBOR quoted in the swaps market. Otherfloating-rate indexes common to the swaps mar-ket include prime, commercial paper, T-bills,and the 11th District Cost of Funds Index(COFI).

A day count convention for the fixed-rate andfloating-rate payments is specified at the begin-ning of the contract. The standard convention isto quote the fixed leg on a semiannual 30/360-day basis, and to quote LIBOR on an actual/360-day basis. The fixed and floating legs,however, can be quoted on any basis agreed toby the counterparties.

The date that the swap is entered into is calledthe trade date. The calculation for the swapstarts on itssettlement date(effective or valuedate). Unless otherwise specified in the agree-


ment, the settlement date on U.S. dollar interest-rate swaps is two days after the trade date. Theswap ends on itsterminationor maturity date.The period of time between the effective andtermination dates is the swap’stenoror maturity.

Swap Agreement

Swaps are typically initiated through telephoneconversations and confirmed by fax, telex, orletter (aconfirmation). Both parties are legallybound by the initial agreement and completedocumentation is not exchanged until later. Swapcontracts are usually executed according to thestandards of the International Swaps and Deriva-tives Association (ISDA) or the British BankersAssociation’s Interest-Rate Swaps (BBAIRS).The complete documentation of a particularswap consists of the confirmation; a paymentschedule (in a format standardized by ISDA orBBAIRS); and amaster swap agreementthatuses standard language, assumptions, and pro-visions. As a rule, counterparties execute onemaster agreement to cover all their swaps. Thus,two different swaps may have different confir-mations and payment schedules but may use thesame master agreement. The master agreementscover many issues, such as (1) terminationevents; (2) methods of determining and assess-ing damages in case of default or early termina-tion; (3) netting of payments; (4) payment loca-tions; (5) collateral requirements; (6) tax andlegal issues; and (7) timely notification ofchanges in address, telex numbers, or otherinformation.

Types of Swaps

This general swap structure permits a widevariety of generic swaps. Common types ofinterest-rate swaps are outlined below.

• Thegeneric(or plain vanilla) swaphas a fixedand a floating leg; the notional amount andpayments are all in the same currency.

• The basis (or floating-for-floating) swaphastwo floating legs, each tied to a differentreference rate. These instruments are oftenused to reduce basis risk for a balance sheetthat has assets and liabilities based on differ-ent indexes.

• The forward swaphas a settlement at someagreed-on future date. A forward swap allows

counterparties to lock in a fixed rate (as apayer or receiver) at the time of contractorigination, but to postpone the setting of thefloating rate and the calculation of cash flowsuntil some time in the future. These swaps areoften used to hedge future debt refinancings oranticipated issuances of debt.

• The amortizing swaphas a notional principalwhich is reduced at one or more points in timebefore the termination date. These swaps areoften used to hedge the interest-rate exposureon amortizing loans, such as project-financeloans.

• The accreting swaphas a notional principalwhich is increased at one or more points intime before the termination date. These swapsare often used to hedge the interest-rate expo-sure on accreting loans, such as the draw-down period on project-finance loans.

• The zero-coupon swapis a fixed-for-floatingswap in which no payments are made on thefixed leg until maturity. These swaps are oftenused to hedge the exposure on a zero-couponinstrument.

• Callable, putable,and extendible swapsareswaps with embedded options in which oneparty has the right, but not the obligation, toextend or shorten the tenor of the swap. Asthe counterparty has sold an option to theswap dealer in these transactions, the swapswill have a lower fixed rate in the case of afixed-rate payer and a higher fixed rate inthe case of a fixed-rate receiver. The counter-party is, however, subject to call or extensionrisk.

• The seasonal swaphas different paymentdates for the two legs (which may both befixed), usually tied to the counterparties’ cash-flow needs. These swaps are often used tocreate synthetic cash flows when actual cashflows change over time. This technique iscalled deseasoning. For example, supposeFirm A expects to make $120 million a year,or on average $10 million a month, but alsoexpects to earn on average $15 million amonth in June, July, and August; $5 million amonth in May, September, and October; and$10 million a month in the remaining months.It can enter into a seasonal swap in which itpays $5 million a month in June, July, andAugust, when its revenues are high, andreceives $5 million a month in May, Sep-tember, and October, when its revenues arelow.

4325.1 Interest-Rate Swaps


USES

Interest-rate swaps are used for hedging, invest-ment, and speculative purposes. Interest-rateswaps are also used to reduce funding costs andarbitrage purposes. Examples of how banks useinterest-rate swaps for asset/liability manage-ment, investment purposes, and speculation areshown below.

Asset/Liability Management: Closingthe Balance-Sheet Gap

Suppose a bank has a $30 million, five-year,fixed-rate loan asset with a semiannual couponof 12.5 percent which it has funded with $30 mil-lion of money market deposits. The bank isfaced with a balance-sheet gap—the asset has afixed rate of interest, but the cost of the under-lying liability resets every week. The risk facedby the bank is that a rise in short-term interestrates will cause the cost of its liabilities to riseabove the yield on the loan, causing a nega-tive spread. The bank can use a fixed-for-floating interest-rate swap to achieve a closermatch between its interest income and interestexpense, thereby reducing its interest-rate risk(see figure 1).

As shown in figure 1, the bank has enteredinto a five-year interest-rate swap in which itpays a dealer 12 percent and receives three-month U.S. dollar LIBOR. In effect, the bankhas locked in a positive spread of 50 basispoints.

Cash Flows on Transaction

Assumed cost of moneymarket deposits (pays) −3-month LIBOR

Swap inflow (receives) +3-month LIBOR

Swap outflow (pays) −12.00%Loan interest inflow

(receives) +12.50%

Net position with hedge +50 basis points

While the bank has effectively locked in apositive 50 basis point spread, it remains subjectto basis risk between the three-month U.S. dollarLIBOR rate which it is receiving in the swapand the weekly money market rates which itpays to its depositors.

Investment Uses: Transforming aFixed-Rate Asset into a Floating-RateBasis

Interest-rate swaps are often used by investmentmanagers to create synthetic assets, often inresponse to temporary arbitrage opportunitiesbetween the cash and derivative markets. Aplain vanilla interest-rate swap can be used totransform the yield on a fixed- (floating-) rateasset such as a corporate bond into a floating-(fixed-) rate asset.

As an example, suppose that the investmentmanager of Company B has a five-year fixed-rate bond which yields 13.5 percent. Also,suppose that the investment manager has astrong view that interest rates will rise, but doesnot want to sell the bond because its creditquality could improve substantially in the future.To position the portfolio for a rise in rateswithout selling the bond, the investment man-ager can enter into an interest-rate swap inwhich Company B pays a fixed rate of 12 per-

Figure 1

ASSET

$30m five-yearfixed-rate loanat 12.5% semiannual

Fixed rate 12%semiannualfive years

BANK

Three-month$ LIBOR

COUNTERPARTY

LIABILITY

$30m money marketrates set weekly

Figure 2

Fixed-rate assetYield 13.5%

Fixed rate 12%

COMPANY B

90-day T-bill

BANK

Interest-Rate Swaps 4325.1


cent and receives a floating rate based on the90-day T-bill rate, effectively creating a syn-thetic floating-rate security yielding the 90-dayT-bill rate plus 150 basis points (see figure 2).

Cash Flows on Transaction

Fixed rate on bond (receives) +13.50%Fixed rate on swap (pays) −12.00%Floating-rate 90-day T-bill

(receives) +90-day T-bill

Net Rate Received byCompany B 90-day T-bill + 1.50%

Speculation: Positioning for theExpectation of Rate Movements

Interest-rate swaps can be used to take a positionon interest-rate movements. In this example, anend-user establishes positions with swaps,believing that interest rates will fall in a six-month period. The end-user believes that short-term interest rates will decrease, but does notwant to sell its floating-rate asset. The end-usercan therefore enter into an interest-rate swap toreceive a fixed rate of interest and pay a floatingrate of interest, thereby converting the floating-rate asset to a fixed-rate basis.

Figure 3 shows the cash flow to an end-userwho has a $100,000 asset indexed to LIBOR,under various interest-rate scenarios for a periodof six months. The vertical axis shows theend-user’s net cash flow after six months, andthe horizontal axis shows different interest-rateexposure strategies, ranging from holding theasset without entering into interest-rate swaps toentering into swaps to pay LIBOR and receive afixed rate.

In each of the three clusters of bars on thehorizontal axis, the return to the end-user underdifferent interest-rate scenarios is displayed (fromleft to right) for no change in interest rates, a2.00 percent decrease in interest rates, and a2.00 percent increase in interest rates. As can beseen from the middle bar in the first cluster (the‘‘no swaps’’ scenario), if the investor is correctand short-term interest rates decrease, the returnon the asset will fall dramatically.

The second cluster of bars on the horizontalaxis (the ‘‘1 swap’’ scenario) shows the assetreturn after the investor has entered into one

swap based on a notional principal amount of$100,000 (equal to the amount invested in theasset), in which the investor pays a floating rateand receives a fixed rate. This swap is effec-tively a hedge which transforms the floating-rateasset return to a fixed-rate basis so that the assetreturn remains constant under all interest-ratescenarios.

The third cluster of bars on the horizontal axis(the ‘‘3 swaps’’ scenario) demonstrates the returnfrom the investor’s ‘‘leveraged’’ speculation thatshort-term interest rates will decrease. Here, theinvestor enters into three interest-rate swapsbased on a notional principal of $100,000 (whichis equivalent to one swap based on a notionalprincipal of $300,000), in which the investorpays a floating rate and receives a fixed rate.Again, the first swap effectively transforms thefloating-rate asset to a fixed-rate basis; in thesecond and third swaps, the investor receives(pays) the differential between the fixed andfloating rates in the swap. Hence, if interest ratesdecrease 2.00 percent and the investor hasentered into three interest-rate swaps (the middlebar in the third cluster), the asset return isincreased substantially compared to just holdingonto the asset (the middle bar in the first cluster).However, if the investor is wrong, and interestrates increase 2.00 percent after three interestrates have been entered into, the return on theasset will be zero.

Figure 3—Using Plain Vanilla Swaps toLeverage Interest-Rate Exposure

Net cash flow for asset holder, thousands of dollars5

4

3

2

1

00

No swaps 1 swap 3 swaps

Change in Interest Rates

Interest rates unchangedInterest rates decreaseInterest rates increase 2%

End-user has $100,000asset indexed to LIBOR.In the swaps, the end-user pays LIBOR andreceives fixed con-verts asset to fixed-ratebasis.




Primary Market

The primary market for interest-rate swapsconsists of swap dealers, swap brokers, andend-users.

Brokers and Dealers

Financial institutions, such as commercial banks,investment banks, and insurance companies, actas dealers in interest-rate swaps. Banks area natural intermediary in the swaps marketbecause of their exposure to interest-rate move-ments and their expertise in analyzing customercredit risk.

Swap brokersare paid a fee for arranging aswap transaction between two counterparties.Swap brokers do not take positions and do notact as a counterparty to a swap transaction.

End-Users

End-users of interest-rate swaps include finan-cial institutions, corporations, sovereigns,government-sponsored enterprises (GSEs), andmoney managers. Banks who are dealers oftenalso use swaps in an end-user capacity forasset/liability management, funding, and invest-ment purposes. End-users use interest-rate swapsfor hedging, investment, and speculative pur-poses. They also often use interest-rate swaps toreduce funding costs.

The nature of an end-user’s business oftendetermines whether he or she will wish to be afixed-rate receiver or a fixed-rate payer. Fixed-rate payers are often firms whose minimum cashflows are reasonably predictable regardless ofthe level of interest rates. This class includesmanufacturing and distribution firms in thedeveloped countries, financial institutions withlarge portfolios of fixed-rate assets, and nationalagencies of certain developed countries thathave difficulty accessing fixed-rate funds.

Fixed-rate receivers are often highly sensitiveto changes in short-term market rates of interest.This class includes large money-center orregional banks that have large portfolios offloating-rate assets. The interest rates on theassets held in their loan portfolios may beindexed to U.S. prime rates, LIBOR, or other

short-term market rates. The class also includesborrowers who have fixed-rate debt outstandingand prefer to convert it to floating-rate debt.Institutions such as life insurance companies,pension funds, wealthy investors, and managedtrust accounts are notable examples of naturalfixed-rate receivers.

Secondary Market

If a counterparty wishes to terminate, orunwind,an existing swap position in the secondarymarket, it must do so by one of three methods:swap reversal, swap assignment,or swap buy-back (also calledclose-outor cancellation).

In a swap reversal, a counterparty of a swapenters into an offsetting swap with the sameterms as the original swap. For example, if FirmA is in a fixed-for-floating swap, paying 10 per-cent on $10 million notional for U.S. dollarthree-month LIBOR, with one year to maturity,the offsetting swap would be a one-year floating-for-fixed swap, paying U.S. dollar three-monthLIBOR for 10 percent on $10 million notional.If market rates have changed since the positionwas initiated, which is likely, amirror offsettingposition cannot be established unless a fee ispaid to establish the off-market mirror transac-tion. For instance, in the example above, ifone-year rates at the time that the mirror swap istraded are 8 percent, the counterparty will haveto pay a fee of approximately $185,000 to enterinto the mirror trade ((10 percent− 8 percent) ×$10 million discounted at 8 percent). The coun-terparty does not cancel the first swap; it adds asecond swap to its books at the cost of increas-ing default risk.

In a swap assignment, a counterparty finds anew counterparty who is willing to assume itsposition in the swap. Swap assignments requirethe acquiescence of the other counterparty to theswap. At the time of the assignment, a paymentrepresenting the net present value of the swap ismade either to or from the new assigned coun-terparty. For example, using the example abovein which Firm A is in a 10 percent one-yearfixed-for-floating swap, Firm A can assign itsposition in the swap to a new counterparty—Counterparty B (usually a dealer). In this case,as the swap has a negative mark-to-market valuefor Firm A, Firm A will be required to make apayment of $185,000 to Counterparty B. Coun-terparty B then assumes Firm A’s position in the



swap with the original counterparty. A key issuein swap sales is the creditworthiness of the firmor dealer who will assume the swap. If thecreditworthiness is poor, the other counterpartymay not agree to the sale.

In a buy-back, one of the counterparties to aswap sells the swap to the other counterparty.Unlike the swap assignment example above,buy-backs are between the original counterpar-ties and do not involve a third party. Buy-backsusually involve a payment which is based on themark-to-market value of the swap at the time ofthe buy-back. In the example above, Firm Awould be required to make a payment of$185,000 to the other original counterparty toterminate the swap.

Market Transparency

Market transparency in the swaps market isgenerally high. Market quotes are readily avail-able on sources such as Telerate and Bloomberg.Increased competition has, in part, led to thenarrowing of bid/offer spreads on plain vanilladeals. For instance, in the early 1980s, bid/offerspreads were in the 40 to 50 basis point rangefor deals under five years, and liquidity wasalmost nonexistent for deals beyond 10 years.Today, spreads have narrowed to 1 to 3 basispoints for swaps under 10 years, and liquidityhas increased significantly on swaps beyond10 years.

Liquidity in the secondary market is high butis somewhat less than in the primary marketbecause it is cumbersome to unwind existingpositions. To make the secondary market moreliquid, several people have proposed the cre-ation of a clearing corporation similar to theclearing corporations for futures and options. Ifthis happens, the disadvantages for end-userswould be less customization and more regula-tion. The advantages would be reduction indefault (credit) risk and increased transparency.

PRICING

Market Conventions and Terminology

The market convention for pricing swaps is toquote the fixed rate in terms of a basis pointspread over the Treasury rate (usually quoted

on a semiannual bond-equivalent yield basis)as the price for receiving the floating-interest-rate index flat (no basis points are added to orsubtracted from the floating rate). For example,if an investor wants to receive a floating rate,such as LIBOR, the fixed rate it will have to paywould be the currenton-the-runTreasury yieldfor the appropriate maturity category of theswap, plus a basis point spread over that yield(on-the-runs are the securities of the relevantmaturity that were most recently auctioned).This basis point spread over the relevant Trea-sury is called the swap spread. For example,assuming that the on-the-run two-year Treasuryyield is 6.00 percent and a two-year swap isquoted at 18/20 (bid/offer), then a fixed-ratereceiver would pay the dealer LIBOR and receivea fixed rate of 6.18 percent, and a fixed-ratepayer would pay the dealer 6.20 percent toreceive LIBOR flat.

It is important to distinguish between theswap spread and the bid/offer spread (discussedabove in the primary market information). Theswap spread is the spread over the Treasuryyield to pay or receive fixed while thebid/offerspreadis the difference between the fixed ratewhich must be paid to the market maker andthe fixed rate that the market maker will pay.The swap spread represents the differencebetween investment-grade spreads (from Euro-dollar futures and corporate bond markets) andthe risk-free rate of Treasury securities. Thisspread adjustment is appropriate because non-U.S.-government swap counterparties typicallycannot borrow at risk-free Treasury rates. Thesupply and demand for fixed-rate funds alsoinfluences the swap spread. For instance, if thereis a predominance of fixed-rate payers in themarket, swap spreads will increase as the demandfor paying fixed on swaps will exceed the supplyof dealers willing to book these swaps, thusbidding up the spread.

Swaps are priced relative to other funding andinvestment vehicles with the same type ofexposure. For shorter maturities, in which liquidinterest-rate futures contracts are available, swapsare priced relative to futures contracts. Swaps ofone- to five-year maturities are generally pricedrelative to Eurodollar futures.

At longer maturities, swaps are priced relativeto rates in alternative traditional fixed- andfloating-rate instruments. For instance, swapspreads for 5- to 10-year maturities are roughlyequivalent to investment-grade (single A orhigher) corporate spreads over U.S. Treasuries.



Pricing Using Eurodollar FuturesContracts

An interest-rate swap can be thought of asa series of forward contracts. As such, if for-ward rates are observable, a swap can be pricedas a series of these forward contracts. Eurodollarfutures contracts are observable, liquid marketforward rates for U.S. dollar LIBOR. As thefixed rate on a swap is simply the blendedforward rates for each floating reset date, swapscan be priced by reference to the Eurodollarstrip (a series of Eurodollar futures contracts)out to the maturity date of the swaps contract.For example, consider a hypothetical one-yearswap starting March 19, 1997, and terminatingMarch 18, 1998 (March to March contractdates).

Step 1: Determine forward rates by reference tothe one-year Eurodollar strip.

Month Futures Price Rate

March ’97 5.75%(spot 3-month

LIBOR)

June ’97 94.07 5.93%(100 − 94.07)

September ’97 93.82 6.18%(100 − 93.82)

December ’97 93.60 6.40%(100 − 93.60)

Step 2: Calculate the swap rate based on thefollowing formula:

R = ([1 + R0(D0/360)]

× [1 + F1(D1/360)]

× . . .

× [1 + Fn(Dn/360)] − 1)

× 360/365

where

R= Eurodollar strip rate (swap rate) stated asan annualized money market yield

R0 = spot LIBOR to first futures expirationF1 = first futures contract (100− futures price)Fn = futures rate for the last relevant contract

in the stripDi = actual number of days in each period

R = ([1 + .0575(91/360)]

× [1 + .0593(91/360)]

× [1 + .0618(91/360)]

× [1 + .064(91/360)]− 1)

× 360/364

R = 6.21%

The above example is simplified because theswap begins and terminates on contract expira-tion dates. However, a similar methodologyincorporating stub periods can be used to priceswaps which do not fall on contract expirationdates by using the following generalized formula:

[1 + R0(D0/360)]

× [1 + F1(D1/360)]

× . . .

× [1 + Fn(D/360)]

= [1 + R(365/360)]N

× [1 + R(Dr /360)]

where

Dr = total number of days in the partial-yearperiod of the strip

N = number of whole years in the strip

Swaps are often priced using the Eurodollarstrip for maturities of five years or less whenliquidity in the Eurodollar strip is high.

Pricing Using Zero-CouponMethodology

A zero-coupon methodology, another methodused to value swap contracts, is often used tovalue swaps with maturities greater than fiveyears. Unlike a yield-to-maturity (YTM) methodin which each cash flow is valued at a constantdiscount rate, a zero-coupon methodology dis-counts each cash flow by a unique zero-coupon(spot) rate. A zero-coupon rate (zero) can be



thought of as theYTM of a zero-coupon bond.As such, the return in periodn on a zero-couponbond can be derived by makingn period invest-ments at the current forward rates. For instance,the discount factors for a three-period instru-ment priced on aYTMbasis would be derived asfollows.

YTM discount factors:

[1/ (1 + YTM)] + [1/ ( YTM)2] + [1/ ( YTM)3],

whereYTM= constant yield-to-maturity rate.

The discount factors for a three-period instru-ment priced on a zero-coupon basis would bederived as follows.

Zero-coupon discount factors:

[1/ (1 + S0)] + [1/ (1 + S0)(1 + 1 f2)]

+ [1/(1 + S0)(1 + 1 f2)(1 + 2 f3)],

where

S0 = Spot zero rate at time 0

1 f2 = forward rate for time period 1 to 2

2 f3 = forward rate for time period 2 to 3.

Zero-coupon swap rates can be calculatedeither from the price of an appropriate zero-coupon swap or from a series of forward ratessuch as the Eurodollar futures strip. The marketin zero-coupon swaps, however, is not activeand zero-coupon prices are not observable. How-ever, zero-coupon swap rates can be derivedfrom observable coupon-bearing swaps tradingin the market using a technique calledbootstrap-ping. Once zero-coupon swap rates have beenderived, an interest-rate swap can be pricedsimilar to a fixed-rate bond by solving for theswap rate which, when discounted by the appro-priate zero-coupon rates, will equate the swap topar.

The first step in the bootstrapping method isto construct a swap yield curve based on coupon-paying swaps trading in the market. Once thisyield curve has been constructed, the couponrates on the swaps can be used to calculate zeroswap rates. Based on the observable first-periodswap rate, a zero rate can be derived for the firstperiod. Often, this rate may already be stated ona zero-coupon basis, such as six-month LIBOR(coupons are not paid on the instrument). Thefirst period zero rate (z1) is derived by discount-

ing the coupon rate on the first-period instru-ment by the zero-coupon rate which gives aprice equal to par.

100 = (100 +c1)/(1 + z1),

where

c1 = coupon rate on first-period instrumentz1 = zero coupon rate for first period.

The first-period zero rate and the second-periodcoupon swap rate are then used to calculate thesecond-period zero rate (z2) using the followingrelationship:

100 = [c2/ (1 + z1)] + [(100 + c2)/ (1 + z2)2],

where

c2 = coupon rate on second-period instrumentz1 = zero-coupon rate for period 1z2 = zero-coupon rate for period 2.

This process is then continued to calculate anentire zero-rate curve. Zero rates for all otherdates can then be calculated by interpolation.

As an example of the zero-coupon pricingmethodology, consider the following simplifiedexample for a $100 million two-year amortizingfixed-for-floating interest-rate swap, quoted onan annual basis. The swap amortized by $50 mil-lion at the end of year one, and amortizes to zeroat the end of year two.

Step 1: Construct the cash-swap yield curve fortwo years.

Maturity

On-the-Run

TreasuryYield

SwapSpread

Swap Rate(Offer)

1 year 4.80% .18%–.20% 5.00%2 year 5.70% .28%–.30% 6.00%

Step 2: Derive the zero-coupon rates by thebootstrap method.

Using the coupon swap rates from the swapyield curve above, the first-period zero-couponrate can be solved using the bootstrap method:

100 = 105/(1 +z1)

z1 = 5.00%



Likewise, using the above cash-market swaprates to solve for the zero rate in year 2 by thebootstrap method:

100 = [6.00/ (1.05)] + [106/(1 + z2)2

z2 = 6.02%

Step 3: Using iteration, solve for the swap-coupon rate which equates the cash flows onthe swap to par using the zero rates obtained instep 2 as the discount factors.

$100mm = [$50mm

+ (100mm * Swap Coupon)

÷ (1.05)]

+ [$50mm

+ (50mm * Swap Coupon)

÷ (1.0602)2]Swap-Coupon Rate = 5.65%

Pricing Unwinds

After a swap has been entered into, the mark-to-market (MTM) value can be calculated bydiscounting the remaining cash flows on theswap by the appropriate zero-coupon rates pre-vailing at the time of the termination of theswap. The resulting value, above or below par,would then represent the amount which wouldbe either received or paid to terminate the swap.

For example, using the amortizing swap exam-ple above, suppose that after one year, thecounterparty who is a fixed-rate payer in theswap wishes to terminate the swap. At the time,one-year swap rates are 7.00 percent. The mark-to-market value of the swap would be calculatedas follows:

Step 1: Determine the one-year (time remainingto maturity) zero-coupon rate.

100 = 107/(1.07)

z1 = 7.00%

Step 2: Discount remaining cash flows on theswap by the zero rate obtained in step 1.

Price of Swap = [$50mm + ($50mm × .0565)]

÷ (1.07)

Price of Swap = $49.37 mm

MTM Value = $50 mm − $49.37 mm = $630,000

In this example, as rates have risen since theinception of the swap, the fixed-rate payerwould receive a fee of $630,000 for terminatingthe swap.

HEDGING

Any firm that has a position in swaps is exposedto interest-rate, basis, and credit risks (discussedbelow). From a dealer standpoint, these risks areideally hedged by entering immediately intomirror (offsetting) swaps, which eliminate expo-sure to these risks. However, in practice, dealerswarehouse swap positions and hedge residualexposure with Eurodollar futures, forward rateagreements, or Treasuries until offsetting swapscan be established. End-users who have a swapsbook face the same risks, and apply the sametechniques, as dealers.

Hedging Interest-Rate and Basis Risk

Interest-rate risk in a swap portfolio is the riskthat an adverse change in interest rates willcause the value of the portfolio to decline. Basisrisk arises from an imperfect correlation betweenthe hedge instrument and the instrument beinghedged. Interest-rate and basis risk can be hedgedone swap at a time (‘‘microhedging’’), or aportfolio (set) of swaps can be hedged (‘‘mac-rohedging’’). Microhedging is rare today. Inmacrohedging, the overall risks of the portfolio(or subsets of it) are evaluated and hedged usingoffsetting interest-rate swaps and other interest-rate derivatives. Residual exposures are hedgedin the Eurodollar futures or Treasury markets.Most dealers dynamically hedge the residualexposure of their swap portfolio by adjusting thehedge position as interest rates change.

Risk managers usually take into account theeffect of various interest-rate changes on theprofitability of a swap book—for example, wheninterest rates change by 5, 10, 50, or 100 basispoints. Dealers usually hedge for an arbitrarymovement in rates, such as 50 basis points,which generally depends on senior manage-ment’s risk appetite.

Hedging Credit Risk

The main techniques by which credit risk ishedged are (1) to require collateral if a counter-



party is out of money; (2) to establish termina-tion clauses in the master agreement for assess-ment of damages in the event of default; (3) tonet payments (when several swaps are outstand-ing with the same counterparty), according toterms established in a master netting agreement(or master agreement); and (4) to sell the swapto another party.

Hedging the credit risk of a swap book isdifficult for a number of reasons. First, sincethere is no formal secondary market in swaps, itmay not be immediately possible to trade out ofa position. Second, assumptions about the cer-tainty of cash flows and the level and termstructure of interest rates are implicit in swapvaluation. If these assumptions do not hold, thevalue of a swap book may not behave asexpected, depending on how it is hedged. Third,to the extent to which some contracts are cus-tomized, they may be difficult to value accu-rately and to hedge.

If risk models are used to estimate a marketmaker’s potential future credit exposure, theassumptions between the risk-management modeland the credit-risk model should be consistent.As is the case for risk management, it is impor-tant to understand the assumptions in the modelin order to estimate potential credit risk.

RISKS

The principal risks in swap contracts are interest-rate, basis, credit, and legal and operating risk.For participants entering into highly customizedtransactions, liquidity risk may be importantbecause hedging or an assignment of the con-tract may be difficult.

Interest-Rate Risk

Interest-rate risk for swaps is the risk that anadverse change in interest rates causes the swap’smarket value to decline. The price risk ofinterest-rate swaps is analogous to that of bonds.In fact, a swap can be described as an exchangeof two securities: a hypothetical fixed-rate bondand a floating-rate note. The swap involves thesimultaneous exchange of these two securitiesof equal amount and maturity, in which nettingof principal payments at origination and matu-rity results in no principal cash flow. Alongthese lines, a swap dealer who makes fixed-ratepayments is considered to be short the bond

market. This dealer has established the pricesensitivities of a longer-term liability and afloating-rate asset. The price risk here is that ifshort-term interest rates decrease, the dealerwould be receiving less on the asset but stillpaying out the same amount on the liability.This interest-rate exposure could be hedged bybuying Eurodollar futures (or by being longTreasuries of the same maturity as the swap).Then, if short-term interest rates decrease, thegain on the hedge should offset the loss on theswap.

Basis Risk

A major form of market risk that dealers areexposed to is basis risk. Dealers have to hedgethe price exposure of swaps they write untiloffsetting swaps are entered into, and the hedgesmay not be perfect.

Basis risk affects profitability. The bid/offerspread is the profit a dealer can make on ahedged swap book, but the dealer can earn lessthan this due to basis risk.

Sources of Basis Risk

When a dealer hedges swaps that have somecredit risk with instruments of little or no creditrisk (Treasuries), it creates basis risk. Forinstance, dealers often hedge swaps with matu-rities of five or more years with Treasuries. Therisks in the swaps usually include credit risks,which are reflected in the floating rate(s). SinceTreasuries are credit-risk-free securities, they donot provide a perfect hedge; this is a source ofbasis risk for the dealer, since there can bedivergence between the two rates. Dealers areexposed to TED (Treasury-Eurodollar) spreadrisk when they hedge swaps of shorter maturi-ties with Treasuries. In essence, the price ofEurodollar futures can change, which will causeswap spreads to change even if Treasury pricesremain the same, since the swap spread is linkedto the difference between the Eurodollar andTreasury markets.

Credit Risk

After the swap is executed, changes in interestrates cause the swap to move in the money forone counterparty and out of the money for the



other. For example, an increase in market inter-est rates would increase the floating-rate pay-ments from a swap, causing the value of theswap to the fixed-rate payer to rise and the valueof the swap to the floating-rate payer to fall.

As no principal amount is exchanged in aninterest-rate swap contract, credit risk is signifi-cantly less than it is on instruments in whichprincipal is at risk. Credit-related loss can occurwhen the counterparty of an in-the-money swapdefaults. The credit loss would be limited to thepresent value of the difference between theoriginal and current market rates over the remain-ing maturity of the contract, which is called thereplacement cost of the swap. For example, if adealer had originally swapped fixed payments at8.5 percent for six-month LIBOR for sevenyears, and the current market rate for the sametransaction is 10 percent, the actual loss when acounterparty defaulted at the end of the first yearwould be the present value of 1.5 percent oversix years on the notional principal amount of theswap.

Credit risk is a function of both current creditexposure and potential future credit exposure.The example above only illustrates current creditexposure. Potential future exposure dependsprimarily on the volatility of interest rates. Oneapproach to estimating peak potential creditexposure (PkCE) is to perform a full-blownMonte Carlo simulation on a counterparty’sportfolio. This strategy has many appealingfeatures and is the most statistically rigorous. Inessence, the model is calculating ‘‘maximum’’potential market value of the transaction, givena set of market conditions and a set confidenceinterval. However, problems arise from havingto assume desired correlations among variableswhen making multiple simulations of marketconditions. These correlations need to hold trueover the life of the contract and be adjusted forthe introduction of new instruments. Aside fromthese methodology problems, it is almost impos-sible to run the necessary number of simulatedportfolio market values within response timesacceptable to the trading floor. Also, MonteCarlo simulations do not readily highlight thespecific sources of potential exposure or suggestways to neutralize this exposure.

An alternative to the full-blown Monte Carlostrategy can be characterized as the ‘‘primary-risk-source approach.’’ This approach attemptsto identify the market variable that is the pri-mary source of changes in the contract’s valueand then simulate values based on changes in

this variable. In practice, a single market vari-able is not usually the only factor that causes acontract’s value to change. However, other fac-tors that might affect the value are generallyof secondary importance. In addition, if thesecondary-market variables are not highly cor-related with the primary risk source, their impacton market value is further reduced.

Estimating PkCE for a single contract can becomplex. Accurately estimating PkCE for aportfolio of contracts executed with one coun-terparty can be so analytically difficult or com-putationally intensive that it is not alwaysfeasible. A tradeoff has to be made betweenthe ideal methodology and the computationaldemands.

Other factors that affect potential credit expo-sure include the shape and level of the yieldcurve, the frequency of payments, the maturityof the transaction, and whether collateral hasbeen posted. In addition, the changing creditquality of counterparties can affect potentialcredit risk.

Legal Risk

Legal risk arises from the possibility that aswap contract will not be enforceable or legallybinding on the counterparty. For instance, theenforcement of netting agreements with foreigncounterparties varies by country and may exposea counterparty to risk in case of nonenforce-ability. As such, the adequacy of legal documen-tation, including master swap agreements andnetting agreements, should be reviewed.


The accounting treatment for swap instrumentsis determined by the Financial Accounting Stan-dards Board’s Statement of Financial Account-ing Standards No. 133 (FAS 133), ‘‘Accountingfor Derivatives and Hedging Activities,’’ asamended by Statement of Financial AccountingStandards Nos. 137 and 138 (FAS 137 and FAS138). (See section 2120.1, ‘‘Accounting,’’ forfurther discussion.)


The credit-equivalent amount of an interest-rateswap contract is calculated by summing—







factor


If a bank has multiple contracts with a counter-party and a qualifying bilateral contract withthe counterparty, the bank may establish itscurrent and potential credit exposures as netcredit exposures. (See section 2110.1, ‘‘CapitalAdequacy.’’)


Swaps are not considered investments under12 USC 24 (seventh). The use of these instru-ments is considered to be an activity incidentalto banking within safe and sound bankingpractices.

REFERENCES

Arditti, Fred D. Derivatives. Harvard BusinessSchool Press, 1996.

Beidelman, Carl R., ed. Interest Rate Swaps.Homewood, Ill.: Dow Jones-Irwin, 1990.


Fabozzi, Frank J., ed. The Handbook of FixedIncome Securities. 2d ed. Homewood, Ill.:Dow Jones-Irwin, 1987.

Global Derivatives Study Group. Derivatives:Practices and Principles. The Group of Thirty,July 1994.

Hull, John C. Options, Futures and OtherDerivative Securities. 2d ed. Prentice-Hall,1993.

Marshall, John F., and Kenneth R. Kapner. TheSwaps Market. 2d ed. Miami, Fla.: KolbPublishing, 1993.

Smithson, C., C. Smith, and S. Wilford.Managing Financial Risk: A Guide to Deriva-tive Products, Financial Engineering andValue Maximization. Richard D. Irwin, 1995.



OptionsSection 4330.1

GENERAL DESCRIPTION

Options transfer the right but not the obligationto buy or sell an underlying asset, instrument, orindex on or before the option’s exercise date ata specified price (thestrike price). A call optiongives the option purchaser the right but not theobligation to purchase a specific quantity of theunderlying asset (from the call option seller) onor before the option’s exercise date at the strikeprice. Conversely, aput optiongives the optionpurchaser the right but not the obligation to sella specific quantity of the underlying asset (to theput option seller) on or before the option’sexercise date at the strike price.

The designation ‘‘option’’ is only applicableto the buyer’s status in the transaction. Anoptionsellerhas an obligation to perform, whilea purchaserhas an option to require perfor-mance of the seller and will only do so if itproves financially beneficial.

Options can be written on numerous instru-ments. Commercial banks are typically involvedmost with interest-rate, foreign-exchange, andsome commodity options. Options can be usedin bank dealer activities, in a trading account, orto hedge various risks associated with the under-lying instruments or portfolio.


A basic option has six essential characteristics,as described below.

1. Underlying security. An option is directlylinked to and its value is derived from aspecific security, asset, or reference rate.Thus, options fit into the classification of‘‘derivative instruments.’’ The security, asset,index, or rate against which the option iswritten is referred to as the option’sunder-lying instrument.

2. Strike price. The strike price is the price atwhich an option contract permits its owner tobuy or sell the underlying instrument. Thestrike price is also referred to as the exerciseprice. A call option is said to be in the moneywhen the price of the underlying asset exceedsthe strike price. A put option is in the money

when the price of the asset is less than theexercise price.

3. Expiration date. Options are ‘‘wasting assets’’;they are only good for a prespecified amountof time. The date after which they can nolonger be exercised is known as theexpira-tion date.

4. Long or short position. Every option contracthas a buyer and a seller. The buyer is said tohave a long option position, while the sellerhas a short option position. This is not thesame as having a long or short position in theunderlying instrument, index,or rate. A bankwhich is long putson government bonds hasbought the rightto sellgovernment bonds ata given strike price. This gives the bankprotection from falling bond prices. Con-versely, if the bank wereshort puts, it wouldbe obligating itselfto purchasegovernmentbonds at a specific price.

5. American or European. The two major clas-sifications of options are American and Euro-pean. American options can be exercised onany date after purchase, up to and includingthe final expiration date. European optionscan be exercised only on the expiration dateof the contract. Because American optionsgive the holder an additional privilege ofearly exercise, they will generally be morevaluable than European options. Mostexchange options are American, while mostover-the-counter (OTC) options are European.

6. Premium. The price paid for an option isreferred to as the option’spremium. Thispremium amount is a dynamic measure ofthe factors which affect the option’s value.Therefore, options with identical contractterms can trade at a multitude of differentpremium levels over time. Premium has twocomponents:time valueand intrinsic value.Intrinsic value refers to the amount of valuein the option if it were exercised today. Timevalue is the difference between the totalpremium and the intrinsic value; it encom-passes the uncertainty of future price moves.The time value of an option is a function ofthe security’s volatility (or risk); the currentlevel of interest rates; and the option’smaturity (or time to expiration). The option’spositive time value gradually approaches zeroat expiration, with the option price at expi-ration equal to its intrinsic value.


For example, a long call option with astrike price of $50 on an underlying securitywhich is trading at $52 has an intrinsic valueof $2. If the option is trading for atotal priceof $3.50, $1.50 of the price ($3.50− $2.00)would be time value, reflecting the fact thatthe underlying security may further increasein value before the option’s expiration. Notall options will have an intrinsic value com-ponent; often the entire premium amount istime value.

Exotic Options

In the past few years, the growth of so-called‘‘exotic’’ derivative products has been signifi-cant. Options have been no exception, and manyvaried types of exotic options exist today whichare traded in the OTC markets. Some of themore common exotic options are discussedbelow.

In general, markets for many of the exoticoptions are not as liquid as their more genericcounterparts. Thus, a quoted price may not be agood indication of where actual liquidation ofthe trade could take place.

Asian options, also called average-priceoptions, depend on theaverage priceof theunderlying security during the life of the option.For example, a $60 call on a security whichsettled at $65 but traded at an average price of$63.5 during the option’s life would be worthonly $3.50 at expiration, not $5. Because of thisfeature, which essentially translates into lowervolatility, Asian options tend to trade for a lowerpremium than conventional options. Theseoptions are generally cash settled, meaning thatthe actual underlying does not change hands.They belong in the category known aspath-dependent options, meaning that the option’spayoff depends on the path taken by the under-lying security before the option’s expiration.

Barrier options, are options which eithercome into existence or cease to exist based on aspecified (or barrier) price on the underlyinginstrument. This also puts them in the categoryof path-dependent options. The two basic typesof barrier options are knock-in and knock-out. Aknock-in option, either put or call, comes intoexistence only when the underlying asset’s pricereaches a specified level. A knock-out option,either put or call, ceases to exist when the barrierprice is reached.

A typical knock-in put option has a barrierprice which is higher than the strike price. Thus,the put only comes into existence when andif the barrier price is reached. A knock-out call barrier price is generally below thestrike price. A $60 call with a $52 barrier wouldcease to exist if at any time during the option’slife the security traded $52 or lower. Becauseof this cancelable feature, barrier optionstrade for lower premiums than conventionaloptions.

An important issue for barrier options is thefrequency with which the asset price is moni-tored for the purposes of testing whether thebarrier has been reached. Often the terms of thecontract state that the asset price is observedonce a day at the close of trading.

Bermudan optionsgive the holder the right toexercise on multiple but specified dates over theoption’s life.

Binary options, also called digital options, arecharacterized by discontinuous payoffs. Theoption pays a fixed amount if the asset expiresabove the strike price, and pays nothing if itexpires below the strike price. Regardless ofhow much the settlement price exceeds thestrike price, the payoff for a binary option isfixed.

Contingent-premium optionsare options onwhich the premium is paid only if the optionexpires in the money. Because of this feature,these premiums tend to be higher than those forconventional options. The full premium is alsopaid at expiration, regardless of how in themoney the option is. Thus, the premium paidcan be significantly higher than the profitreturned from the option position.

Installment optionsare options on which thetotal premium is paid in installments, with theactual option issued after the final payment.However, the buyer can cancel the paymentsbefore any payment date, losing only the pre-mium paid to date and not the full premiumamount.

Lookback options, also in the category ofpath-dependent, give call buyers the right topurchase the security for the lowest price attainedduring the option’s life. Likewise, put sellershave the right to sell the security for the highestprice attained during the option’s life. Theunderlying asset in a lookback option is often acommodity. As with barrier options, the value ofa lookback can depend on the frequency withwhich the asset price is monitored.

4330.1 Options


USES

Options can be used for hedging or speculativepurposes. Hedgers can use options to protectagainst price movements in an underlyinginstrument or interest-rate exposure. Speculatorscan use options to take positions on the level ofmarket volatility (if delta-hedged with the under-lying instrument) or the direction and scope ofprice movements in the underlying asset.

The asymmetric payoff profile of an option isa unique feature that makes it an attractivehedging vehicle. For example, an investor with along position in an underlying asset can buy aput option to offset losses from the long positionin the asset if its price falls. In this instance, theinvestor’s position in the asset will be protectedat the strike price of the option, and yet theinvestor will still gain from any rise in theasset’s value above the strike price. Of course,this protection against loss combined with theability to gain from appreciation in the asset’svalue carries a price—the premium the investorpays for the option. In this sense, the purchase ofan option to hedge an underlying exposure isanalogous to the purchase of insurance.1

Options may also be used to gain exposure toa desired market for a limited amount of capital.For instance, by purchasing a call option on aTreasury security, a portfolio manager can cre-ate a leveraged position on a Treasury securitywith limited downside. For the cost of the optionpremium, the portfolio manager can obtainupside exposure to a movement in Treasuryrates on the magnitude of the full underlyingamount.

Many banks sell interest-rate caps and floorsto customers. Banks also frequently use capsand floors to manage their assets and liabilities.Caps and floors are essentially OTC interest-rateoptions customized for a borrower or lender.Most caps and floors reference LIBOR (and thusare effectively LIBOR options). Eurodollaroptions are essentially the exchange-tradedequivalent of caps and floors.

A cap, which is written independent of aborrowing arrangement, acts as an insurancepolicy by capping the borrower’s exposure (fora fee, the option premium) to higher borrowingcosts if interest rates rise. This is equivalent tothe cap writer selling the purchaser a call oninterest rates. Above the cap rate, the purchaseris entitled to remuneration from the cap writerfor the difference between the higher market rateand the cap rate. Often caps have a sequence of(three-month) expiration dates. Each of thesethree-month pieces is known as acaplet. A banklooking to ensure that it does not pay above aspecified rate on its LIBOR-based liabilities canachieve this objective by purchasing an interest-rate cap.

A floor is the opposite of a cap and sets aminimum level on interest rates. Thus, it is likea put option on interest rates. If interest rates fallbelow the floor rate, the purchaser is entitled toremuneration from the floor writer for the dif-ference between the lower market rate and thefloor rate. An asset manager with floating-rateLIBOR assets can purchase a floor to ensure thathis or her return on the asset does not fall belowthe level of the floor.

An option strategy consisting of selling afloor and buying a cap is referred to as aninterest-rate collar. Collars specify both theupper and lower limits for the rate that will becharged. It is usually constructed so that theprice of the cap equals the price of the floor,making the net cost of the collar zero. Caps andfloors are also linked to other indexes such asconstant maturity Treasury rates (CMT), com-mercial paper, prime, 11th District Cost ofFunds Index (COFI), and Treasury bills.


Options trade both on exchanges and OTC. Thevast majority of exchange options are American,while most OTC options tend to be European.Exchange-traded (or simply traded) options aregenerally standardized as to the underlying asset,expiration dates, and exercise prices. OTCoptions are generally tailored to meet a custom-er’s specific needs.

Banks, investment banks, and certain insur-ance companies are active market makers inOTC options. End-users of options includebanks, money managers, hedge funds, insurance

1. Note that the investor’s position in this example, a longposition in the underlying asset and a purchased put option,has exactly the same payoff profile as a position consisting ofonly a purchased call option. This example illustrates theability to combine options and the underlying asset in com-binations that can replicate practically any desired payoffprofile. For example, a purchased call combined with a writtenput, both with the same exercise price, have the same exposureprofile as a long position in the underlying asset.

Options 4330.1


companies, corporations, and sovereigninstitutions.

PRICING

In terms of valuation and risk measurement,instruments with option characteristics differsignificantly from other assets. In particular,options require an assessment of the probabilitydistribution of possible movements in therelevant market-risk factors. Changes in theexpected volatility of an instrument’s price willaffect the value of the option. Option values notonly vary with the degree of expected volatilityin the price of the underlying asset, but also varywith the price of the underlying in a decidedlyasymmetric way.

Although the supply and demand for optionsis what directly determines their market prices,option valuation theory plays a crucial role ininforming market participants on both sides ofthe market. A number of valuation techniquesare used by market participants and are describedbelow.

Approaches to Option Valuation

Black-Scholes

The ‘‘standard’’ model used to value options isthe Black-Scholes option pricing model. Basedon a few key assumptions—including that assetprices follow a ‘‘random walk’’ (they fluctuaterandomly up or down), the risk-free interest rateremains constant, and the option can be exer-cised only at expiration—the Black-Scholesmodel can incorporate all the main risk conceptsof options and, therefore, provides a useful basisfor discussion. In practice, many financialinstitutions use more sophisticated models, insome cases proprietary models.

The Black-Scholes formula for the value of acall option depends on five variables: (1) theprice of the underlying asset, (2) the time toexpiration of the option, (3) the exercise price,(4) the risk-free interest rate (the interest rate ona financial institution deposit or a Treasury billof the same maturity as the option), and (5) theasset’s expected volatility. Of the five variables,only four are known to market participants. Theasset price and the deposit or Treasury bill rateof the appropriate maturity can be ascertained

from dealers or a public information source. Thematurity of the option and the strike price areknown from the terms of the option contract.

Assuming that the price of an asset follows arandom walk, Black and Scholes derived theirformula for pricing a call option on that assetgiven the current spot price (St) at time t, theexercise price (X), the option’s remaining timeto maturity (T), the probability distribution (stan-dard deviation) of the asset price (σ), and aconstant interest rater. Specifically, the priceCat timet of a call option with a strike price ofXwhich matures at timeT is—

C(St ,t;X,T,σ,r) = StN(d + σ√T − t)

− Xe−r (T − t)N(d),

whereN(d) is the probability that a standardizednormally distributed random variable takes on avalue less thand, and

d =ln(St /X) + (r − σ2/2)(T − t)

σ√T − t.

The easiest way to understand this formula isas the present value of the expected differencebetween the future price of the underlying assetand the exercise price, adjusted for the probabil-ity of exercise. In other words, it is the expectedvalue of the payoff, discounted to the present atthe risk-free rate. The first term in the Black-Scholes equation is the present value of theexpected asset price at expiration given that theoption finishes in the money. The standardnormal term,N(d), is the probability that theoption expires in the money; hence, the entiresecond term,Xe − r(T − t)N(d), is the presentvalue of the exercise price times the probabilityof exercise.

The key unknown in the formula is futurevolatility of the underlying asset price. There aretwo ways of estimating this price. First, it can beestimated directly from historical data on theasset price, for example, by calculating thestandard deviation of daily price changes oversome recent period. When calculating volatilityusing historical prices, different estimates ofvolatility may be arrived at (and consequently,also different estimates of an option’s value),depending on the historical period chosen andother factors. Hence, the historical period usedin volatility estimates should be chosen withsome care.

4330.1 Options


Alternatively, volatility can be estimated byusing the Black-Scholes formula, together withthe market prices of options, to back out theestimate of volatility implicit in the market priceof the option, given the four known variables.This is called the implied volatility of the option.Note that the use of implied volatility may notbe appropriate for thinly traded options due tothe wide variation of options prices in thinmarkets.

Some institutions use a combination of bothhistorical and implied volatilities to arrive at anappropriate estimate of expected volatility.Examiners should determine if management andthe traders understand the benefits and shortcom-ings of both the estimated implied volatility andhistorical methods of calculating volatility, con-sidering that the values derived under either orboth methods may be appropriate in certaininstances and not appropriate in others. In anycase, the method used to estimate volatilityshould be conservative, independent of indi-vidual traders, and not subject to manipulationin risk and profitability calculations. The lastpoint is especially important because volatilitiesare a critical component for calculating optionvalues for internal control purposes.

Other Closed-Form Models

Since the publication of Black-Scholes, otherwidely-used formula-based valuation techniqueshave been developed for use by market makersto value European options as well as options oninterest-bearing assets. These techniques includethe Hull and White model and the Black,Derman, and Toy (BDT) model. These modelsare often described asno-arbitrage modelsandare designed so that the model is, or can bemade, consistent with the current term structureof interest rates. Other models, such as the Cox,Ingersoll, and Ross (CIR) model, apply otherdisciplines to the term structure but allow pricesto evolve in a way that need not be consistentwith today’s term structure of interest rates.

Binomial Model

An alternative technique used to value options isthe binomial model. It is termed ‘‘binomial’’because it is constructed as a ‘‘tree’’ of succes-sive event points in which each branch has twopossible events: the asset price either rises or

falls. The amount of the rise or fall at each eventpoint depends on the volatility of the underlyingasset price. Each path of the variable—from thevaluation date through each event point untilexpiration—then leads to an ultimate profit orloss for the option holder. The value of theoption is then the ‘‘average’’ present value ofthese various ultimate outcomes.

The binomial approach is attractive because itis capable of pricing a wider variety of optionsthan Black-Scholes. For example, a binomialmodel can allow for a different value function tobe applied at different points in time or foroptions with multiple exercise dates. The bino-mial model is used by some to value optionsbecause it is perceived to be a more reasonablerepresentation of observed prices in particularmarkets. It is also used to check the accuracy ofmodifications to the Black-Scholes model. (TheHo-Lee model of interest-rate options, for exam-ple, is an elaboration of a binomial model.) Inaddition, although it requires more computingtime than the Black-Scholes model, the bino-mial model can be more easily adapted forcomputer use than other still more rigoroustechniques. Under the same restrictive assump-tions described above, the binomial model andthe Black-Scholes formula will produce identi-cal option values.

Monte Carlo Simulations

A final approach to valuing options is simply tovalue them using a large sample of randomlydrawn potential future movements in the assetprice, and calculate the average or expectedvalue of the option. The random draws are basedon the expected volatility of the asset price sothat a sufficiently large sample will (by the Lawof Large Numbers) accurately portray theexpected value of the option, considering theentire probability distribution of the asset price.

The advantage of this technique is that itallows for different value functions under differ-ent conditions, particularly if the value of aninstrument at a point in time depends in part onpast movements in market-risk factors. Thus, forexample, the value of a collateralized mortgageobligation security at a point in time will dependin part on the level of rate-motivated mortgageprepayments that have taken place in the past,making Monte Carlo simulation the valuationtechnique market participants prefer. Because ofthe time and computer resources required, this

Options 4330.1


technique is generally reserved for the mostcomplex option valuation problems.

Sensitivity of Market Risk forOptions

Given the complexity of the market risk arisingfrom options, and the different models of optionvaluation, a set of terms has evolved in themarket and in academic literature that nowserves as a common language for discussingoptions risk. The key terms (loosely known as‘‘the greeks’’) are described below. Each term islinked to one of the key variables needed toprice an option, as described earlier; however,there is no ‘‘greek’’ for the exercise price.

Delta and Gamma

Delta and gamma both describe the sensitivityof the option price with respect to changes in theprice of the underlying asset. The delta of anoption is the degree to which the option’s valuewill be affected by a (small) change in the priceof the underlying instrument. As such, the esti-mate of an instrument’s delta can be used todetermine the appropriate option hedge ratio foran unhedged position in that instrument.

Gamma refers to the degree to which theoption’s delta will change as the instrument’sprice changes. The existence of gamma riskmeans that the use of delta hedging techniques isless effective against large changes in the priceof the underlying instrument. While a delta-hedged short option position is protected againstsmall changes in the price of the underlyingasset, large price changes in either direction willproduce losses (though of smaller magnitudethan would have occurred had the price movedagainst a naked written option).

Vega

The vega of an option, or a portfolio of options,is the sensitivity of the option value to changesin the market’s expectations for the volatility ofthe underlying instrument. An option value isheavily dependent upon the expected price vola-tility of the underlying instrument over the lifeof the option. If expected volatility increases, forexample, there is a greater probability that an

option may become in the money (profitable forthe holder to exercise); thus the vega is typicallypositive. As noted above, market participantsrely on implied rather than historical volatility inthis type of analysis and measurement.

Theta

The theta of an option, or a portfolio of options,is the measure of how much an option position’svalue changes as the option moves closer to itsexpiration date (simply with the passage oftime). The more time remaining to expiration,the more time for the option to become profit-able to the holder. As time to expiration declines,option values tend to decline.

Rho

The rho of an option, or a portfolio of options, isthe measure of how much an option’s valuechanges in response to a change in short-terminterest rates. The impact of rho risk is moresignificant for longer-term or in-the-moneyoptions.

HEDGING

Financial institutions using options may choosefrom basically three hedging approaches:

1. hedging on a ‘‘perfectly matched’’ basis,2. hedging on a ‘‘matched-book’’ basis, and3. hedging on a portfolio basis.

Hedging on a Perfectly MatchedBasis

Some financial institutions prefer to trade andhedge options on a perfectly matched basis. Inthis instance, the financial institution arrangesan option transaction only if another offsettingoption transaction with exactly the same speci-fications (that is to say, the same underlyingasset, amount, origination date, and maturitydate) is simultaneously available. The trade-offin trading options on a perfectly matched basisis that the financial institution may miss oppor-tunities to enter into deals while it is waiting tofind the perfect match. However, many risks arereduced or eliminated when options and other

4330.1 Options


instruments are traded on a perfectly matchedbasis. In any event, the financial institutioncontinues to assume credit risk when hedging ona perfectly matched basis.

Hedging on a Matched-Book Basis

As a practical matter, managing a portfolio ofperfectly matched transactions is seldom pos-sible because of the difficulty in finding twocustomers with perfectly offsetting needs. Lessthan perfectly matched hedging, called matched-book hedging, attempts to approximate the per-fectly matched approach. In matched-book hedg-ing, all or most of the terms of the offsettingtransactions are close but not exactly the same,or transactions are booked ‘‘temporarily’’ with-out an offsetting transaction.

For example, a financial institution may enterinto an option transaction with a customer evenif an offsetting OTC option transaction withsimilar terms is not available. The financialinstitution may temporarily hedge the risk asso-ciated with that option by using futures andexchange-traded options or forward contracts.When an appropriate offsetting transactionbecomes available, the temporary hedge isunwound. In reality, it may be some time beforean offsetting transaction occurs, and it maynever occur. Typically, institutions that run amatched book establish position limits on theamount of residual exposure permitted. Byoffering transactions on a matched-book basis,financial institutions are able to assist theircustomers without waiting for a counterpartywith simultaneous offsetting needs to appear.

Hedging on a Portfolio Basis

More sophisticated institutions usually find itmore practical to hedge their exposure on aportfolio basis when they trade options (andother traded instruments) in more liquid mar-kets, such as those for interest rates and foreignexchange. Portfolio hedging does not attempt tomatch each transaction with an offsetting trans-action, but rather attempts to minimize andcontrol the residual price exposure of the entireportfolio.

Risk-management or hedging models deter-mine the amount of exposure remaining in theportfolio after taking into consideration offset-ting transactions currently in the book. Offset-ting transactions using futures, swaps, exchange-traded options, the underlying asset, or othertransactions are then entered into to reduce theportfolio’s residual risk to a level acceptable tothe institution. Portfolio hedging permits finan-cial institutions to act more effectively as marketmakers for options and other traded instruments,entering into transactions as requested by cus-tomers. It is also more efficient and less costlythan running a matched book since there is lessneed to exactly match the particulars of atransaction with an offsetting position.

RISKS

Credit Risk

One of the key risks in an option transaction isthe risk that the counterparty will default on itsobligation to perform.2 Accordingly, credit riskarises when financial institutions purchaseoptions, not when they write (sell) options. Forexample, when a financial institution sells a putor call option, it receives a premium for assum-ing the risk that it may have to perform if theoption moves in the money and the buyerchooses to exercise. On the other hand, when afinancial institution purchases a put or calloption, it is exposed to the possibility that thecounterparty may not perform if the optionmoves in the money.

When estimating the credit risk associatedwith an option contract, some institutions calcu-late credit risk under a worst-case scenario. Todevelop this scenario, financial institutions typi-cally rely on statistical analysis. In essence, thefinancial institution attempts to project, within acertain confidence level, how far, in dollarterms, the option can move in the money. Thisamount represents the ‘‘maximum potential lossexposure’’ if the counterparty (option seller)defaults on the option contract and the financialinstitution is required to replace the transactionin the market. For a discussion of other waysfinancial institutions measure credit risk, see

2. This discussion of credit risk is relevant for over-the-counter products. Exchange-traded options are guaranteed bya clearing organization and have minimal credit risk.

Options 4330.1


section 2020.1, ‘‘Counterparty Credit and Pre-settlement Risk.’’

Settlement Risk

The importance of settlement risk may varymaterially among countries, depending on thesettlement procedures used. In the United States,for example, transactions are typically settled ona net payment basis, with payment being madeto only one party to the contract. The beneficiaryof the payment incurs the credit risk that thecounterparty will not make payment and willdefault, but does not face the greater settlementrisk that a one-sided exchange of securities willoccur. Examiners should determine what settle-ment procedures are used by the markets inwhich the financial institution participates andshould determine what procedures the financialinstitution takes to minimize any settlement risk.For further discussion of settlement-risk issues,see section 2020.1, ‘‘Counterparty Credit andPresettlement Risk.’’

Liquidity Risk

The financial institution’s ability to offset orcancel outstanding options contracts is animportant consideration in evaluating the useful-ness and safety and soundness of its optionsactivities. OTC options contracts are often illiq-uid since they can only be canceled by agree-ment of the counterparty. If the counterpartyrefuses to cancel an open contract, the financialinstitution must either find another party withwhich to enter an offsetting contract or go to oneof the exchanges to execute a similar, butoffsetting, contract. On the other hand, if acounterparty defaults and the financial institu-tion is unable to enter into an offsetting contractbecause of market illiquidity, then the defaultwill expose the financial institution to unex-pected market risk.

Exchanges also do not ensure liquidity. First,not all financial contracts listed on exchangesare heavily traded. While some contracts havegreater trading volume than the underlying cashmarkets, others trade infrequently. In addition,even with actively traded futures and optionscontracts, the bulk of trading occurs in the firstor second expiration month. Thus, to be able tooffset open contracts quickly as needs change,the financial institution must take positions in

the earlier expiration months when the bulk oftrading occurs.

Some exchange-traded contracts limit how farprices can move on any given day. When themarket has moved ‘‘limit up’’ or ‘‘limit down’’for the day, trading ceases until the next day.These limits cause illiquidity in certain instances.Hedging contracts with such limited price-movement potential may not adequately protectthe holders against large changes in the value ofunderlying asset prices. Examiners should reviewthe financial institution’s policies and proce-dures to determine whether the financial institu-tion recognizes problems that these limits couldcreate (for example, ineffective hedges). Thisreview should also determine whether the finan-cial institution has contingency plans for dealingwith such situations.


The accounting treatment for option contracts isdetermined by the Financial Accounting Stan-dards Board’s Statement of Financial Account-ing Standards No. 133 (FAS 133), ‘‘Accountingfor Derivatives and Hedging Activities,’’ asamended by Statement of Financial AccountingStandards Nos. 137 and 138 (FAS 137 and FAS138). (See section 2120.1, ‘‘Accounting,’’ forfurther discussion.)

Purchased Options

The purchaser of an option has the right, but notthe obligation, to purchase a fixed amount of theunderlying instrument according to the terms ofthe option contract. If a purchased option is heldas a trading asset or otherwise does not qualifyfor hedge accounting, it should be marked tomarket. Options that qualify for hedge account-ing should record unrealized gains and losses inthe appropriate period to match the recognitionof the revenue or expense item of the hedgeditem. The premium paid on options qualifyingas hedges generally are amortized over the lifeof the option.

Written Options

The writer of an option is obligated to performaccording to the terms of the option contract.Written options are generally presumed to be

4330.1 Options


speculative and, therefore, should be marked tomarket through the income statement.


The credit-equivalent amount of an option con-tract is calculated by summing—



The conversion factors are listed below.

Remaining maturityInterest

rateExchange

rate

One year or less 0.00% 1.00%Five years or less 0.50% 5.00%Greater than five years 1.50% 7.5%

If a bank has multiple contracts with a counter-party and a qualifying bilateral contract with the

counterparty, the bank may establish its currentand potential credit exposures as net creditexposures. (See section 2110.1, ‘‘CapitalAdequacy.’’)


Options are not considered investment securitiesunder 12 USC 24 (seventh). However, the use ofthese contracts is considered to be an activityincidental to banking within safe and soundbanking principles.

REFERENCES

Hull, John C. Options, Futures, and OtherDerivative Securities. 2d ed. New York: Pren-tice Hall, 1993.

McCann, Karen. Options: Beginning and Inter-mediate Issues. Federal Reserve Bank ofChicago, November 1994.

McMillan, Lawrence G. Options as a StrategicInvestment. 2d ed. New York: Institute ofFinance, 1986.

Options 4330.1


Currency SwapsSection 4335.1

GENERAL DESCRIPTION

A currency swap is a private over-the-counter(OTC) contract which commits two counterpar-ties to exchange, over an agreed period, twostreams of interest payments denominated indifferent currencies, and, at the end of theperiod, to exchange the corresponding principalamounts at an exchange rate agreed upon at thestart of the contract. The term ‘‘currency swap’’can sometimes be used to refer to foreign-exchange swaps. Foreign-exchange swaps refersto the practice of buying or selling foreigncurrency in the spot market and simultaneouslylocking in a forward rate to reverse that trans-action in the future. Foreign-exchange swaps,unlike currency swaps, do not involve interestpayments—only principal amounts at the startand maturity of the swap.


The term ‘‘currency swap’’ is used to describeinterest-rate swaps involving two currencies.The strict application of the term is limited tofixed-against-fixed interest-rate swaps betweencurrencies. Cross-currency swaps, a genericvariation of the currency swap, involve anexchange of interest streams in different curren-cies, at least one of which is at a floating rate ofinterest. Those swaps that exchange a fixed rateagainst a floating rate are generally referred to ascross-currency coupon swaps, while those thatexchange floating-against-floating using differ-ent reference rates are known as cross-currencybasis swaps.

Other types of cross-currency swaps includeannuity swaps, zero-coupon swaps, and amor-tizing swaps. In cross-currency annuity swaps,level cash-flow streams in different currenciesare exchanged with no exchange of principal atmaturity. Annuity swaps are priced such that thelevel payment cash-flow streams in each cur-rency have the same net present value at theinception of the transaction. Annuity swaps areoften used to hedge the foreign-exchange expo-sure resulting from a known stream of cashflows in a foreign currency. For example, a U.S.corporation which receives a deutschemark (DM)

2 million semiannual dividend payment from itsGerman subsidiary can execute an annuity swapwith a dealer in which it will make semiannualpayments of DM 2 million and receive semi-annual payments of $300,000—thus locking in adollar value of its DM-denominated dividendpayments.

A zero-coupon swap involves no periodicpayments (representing ‘‘coupon’’ payments).Rather, these cash flows are incorporated intothe final exchange of principal. Cross-currencyzero-coupon swaps are equivalent to a long-dated forward contract and are used to hedgelong-dated currency exposures when theexchange-traded and OTC foreign-exchangemarket may not be liquid.

An amortizing cross-currency swap is struc-tured with a declining principal schedule, usu-ally designed to match that of an amortizingasset or liability. Amortizing cross-currencyswaps are typically used to hedge a cross-borderproject-financing loan in which the debt is paiddown over a series of years as the project beginsto generate cash flow.

Plain Vanilla Example

Figure 1 illustrates the most simple example ofa currency swap. An institution enters into acurrency swap with a counterparty to exchangeU.S. dollar interest payments and principal foroffsetting cash flows in German DM.

As illustrated, there are three stages to a cur-rency swap. The first stage is an initial exchangeof principal at an agreed rate of exchange,usually based on the spot exchange rate. Theinitial exchange may be on either anotionalbasis (no physical exchange of principal) or aphysical exchangebasis. The initial exchange is

Figure 1—Plain Vanilla CurrencySwap

DM interest

End-user $ interest Dealer

DM principal at maturity

$ principal at maturity


important primarily to establish the quantity ofthe respective principal amounts for the purposeof calculating the ongoing payments of interestand for the re-exchange of principal amountsunder the swap. Most commonly, the initialexchange of principal is on a notional basis.

The second stage involves the exchange ofinterest. The counterparties exchange interestpayments based on the outstanding principalamounts at the respective fixed interest ratesagreed on at the outset of the transaction. Thethird stage entails the re-exchange of principal.On maturity, the counterparties re-exchange prin-cipal at the original exchange rate agreed on atthe execution of the swap.

USES

Currency swaps create exposures to the risk ofchanges in exchange rates and interest rates.Therefore, they can be used to take risk posi-tions based on expectations about the directionin which the exchange rate, interest rates, orboth will move in the future. Firms can alter theexposures of their existing assets or liabilities tochanges in exchange rates by swapping theminto foreign currency. Also, a reduction in bor-rowing costs can be achieved by obtaining morefavorable financing in a foreign currency andusing currency swaps to hedge the associatedexchange-rate risks. Conversely, a firm canenhance the return on its assets by investing inthe higher-yielding currency and hedging withcurrency swaps.


Market Participants

Sell Side

Most of the major international financial insti-tutions are willing to enter into currency swaps.However, the group of those institutions actingas market makers (that is, quoting firm buyingand selling prices for swaps in all tradingconditions) is limited to a handful of the mostactive swap participants who make markets forinterest-rate swaps in the major currencies. Eventhis group is focused largely on swaps involvingU.S. dollar LIBOR as one of the legs. Further-

more, because of the credit risk involved, manycustomers prefer only to deal with the highest-rated institutions. In fact, most of the investmentbanking dealers book these swaps in special-purpose, ‘‘AAA’’-rated, derivative productsubsidiaries.

Buy Side

The end-users of currency swaps are mainlyfinancial institutions and corporations. Thesefirms can enter into a swap either to alter theirexposures to market risk, enhance the yields oftheir assets, or lower their funding costs.

Quoting Conventions

Currency swaps are generally quoted in terms ofall-in prices, that is, as absolute annual fixedpercentage interest rates. Swap intermediariesmay quote two all-in prices for each currencyswap, for example, 6.86–6.96 percent for theU.S. dollar leg and 7.25–7.35 percent for theDM leg. This is a two-way price, meaning a dualquotation consisting of a buying and sellingprice for each instrument. The terms buying andselling can be ambiguous in the case of swaps;the terms paying and receiving should be usedinstead. In currency swaps, that is, fixed-against-fixed swaps, both sides of the swap should bespecified. It may not be obvious which side of atwo-way price is being paid and which is beingreceived.

Trading

Since the market for currency swaps is a highlycustomized OTC market, most of the trading isdone by telephone. In negotiating swaps, keyfinancial details are agreed on orally betweendealers. Key details are confirmed in writing.

In the early days of the swaps market, inter-mediaries tried to avoid the risk of acting asprincipals by acting as arrangers of swap dealsbetween end-users. Arrangers act as agents,introducing matching counterparties to each otherand then stepping aside. Arrangers were typi-cally merchant and commercial banks. Arrange-ment continues to be a feature of currencyswaps. Brokers act as agents, arranging deals bymatching swap counterparties, but they do not

4335.1 Currency Swaps


participate in the actual transactions. Brokers donot earn dealing spreads, but are paid a flat feebased on the size of the deal. Brokers discloseindicative swap price information over networkssuch as Reuters and Telerate.

The market for currency swaps has becomemore complex and diverse. Commercial bankshave begun entering this market as principalintermediaries to provide their expertise inassessing credit risk to end-users of swaps.Many end-users lack credit analysis facilitiesand prefer having credit exposure to a largefinancial intermediary rather than to anotherend-user counterparty. However, in several cases,the credit rating of the financial intermediary isnot strong enough for a particular end-user. Forthis reason, a large number of these swaps arebooked in the AAA subsidiaries.

The secondary market for currency swaps ismore limited than the market for single-currencyinterest-rate swaps due to the credit risk involved.There are cases in which a buyer of a swap hasassigned it to a new counterparty (that is, thebuyer substitutes one of the original counterpar-ties). Recently, assignment has been by nova-tion, meaning that the swap contract to beassigned is in fact terminated and a new butidentical contract is created between the remain-ing counterparty and the assignee.

Market Transparency

A large volume of currency swaps consists ofcustomized transactions whose pricing is sensi-tive to credit considerations. Consequently, theactual pricing of these swaps is less transparentthan it is for single-currency interest-rate swaps.Price information is distributed over screen-based communication networks, such as Reutersand Telerate, but this consists primarily ofbroker’s indicative prices for plain vanilla cross-currency transactions.

PRICING

A currency swap is valued as the present value(PV) of the future interest and principal pay-ments in one currency against thePV of futureinterest and principal payments in the othercurrency, denominated in the same currency:

Value of currency swap =

PVcurrency A cash flow−PVcurrency B cash flow

Exchange rateB/A

The cash flows above (the streams of interestand principal payments) are functions of thecurrent market exchange rate, which is used totranslate net present values into the same cur-rency, and the current market interest rates,which are used to discount future cash flows.

Calculating the present value of the stream offixed interest payments is done as follows:

PVfixed interest + principal= Σ Cn+

PN

n=1 Vn Vn,

where Vn = [1 + (day count /360 × I)]nand Cn = fixed interest cash flow at timen

P = principal cash flowI = prevailing annual market interest

rateN = years to maturityn = settlement period number

day count = number of days between regularcoupon payments

For example, a $/DM currency swap is usedwith these specifications:

Remaining life = 3 years$ fixed interest rate = 5% APRDM fixed interest rate = 9% APR$ principal = $100 millionDM principal = DM 170 millionAgreed-upon swap

exchange rate = 1.700 DM/$Current prevailing rates:

3-year DM interest rate = 8% APR3-year $ interest rate = 6% APR

Spot exchange rate = 1.5 DM/$

The PV of the deutschemark part of the trans-action would be—

PV = DM 174,381,065.

To find the PV of the dollar cash flow, thefollowing constants are known:

N = 3 (years)I = 6% APR

Currency Swaps 4335.1


such that—

PV = $97,326,988.

The value of the swap is the differencebetween thePVs of the deutschemark and dollarcash flows. To calculate the difference, firstconvert the DM leg to dollar amounts, using thespot exchange rate of 1.5:

(DM 174,381,065/1.50 =) $116,254,043− $97,326,988 = $18,927,055.

The pricing of currency swaps is similar tothat used for interest-rate swaps, with the differ-ence that the exchange rate has to be accountedfor in assessing cash flows. A currency swap inwhich the two counterparties are both payingfixed interest should have a net present value ofzero at inception. The fixed interest rate is set atinception accordingly. For a cross-currency swapin which at least one side is paying a floatinginterest rate, implied forward interest rates areused to price the swap.

HEDGING

Currency swaps are used to manage interest-raterisk and currency risk. A company with mainlydeutschemark revenues that has borrowed fixed-rate dollars is faced with the prospect of cur-rency appreciation or depreciation, which wouldaffect the value of its interest payments andreceipts. In this example, the prospect of a dollarappreciation would mean that the DM revenuewould have to increase in order to raise enough(stronger) dollars to repay the fixed-rate (dollar)loan. The German firm could hedge its exposureto the appreciating dollar by entering into aDM/$ currency swap.

Furthermore, if the German company expectsnot only that the dollar will appreciate but thatGerman interest rates will fall, then a cross-currency swap could be used. The German firmcould swap fixed-rate dollars for floating-ratemarks to take advantage of the expected fall inGerman interest rates, as well as hedge againstexchange-rate risk.

In the example above, initial exchange ofprincipal is not needed. Exchange of principal isneeded only when a swap counterparty needs toacquire foreign currency or needs to convertnew borrowing from one currency to another. If

the foreign currency of a liability is expected todepreciate (in the example above, if the dollar isexpected to depreciate) or the domestic currencyis expected to appreciate, a currency swapwould restrict currency gains. In such cases, theonly risk that would need to be hedged againstwould be interest-rate risk, in which case engag-ing in a domestic currency interest-rate swapwould be appropriate. (In these hedges, assump-tions must be made about the movement of theexchange rate. The swap counterparty is stillexposed to exchange-rate risk, but is hedgingonly interest-rate risk based on an assumptionabout the exchange rate.)

RISKS

Market Risk

A currency swap that is not hedged or used as ahedge exposes the institution to dual marketrisks: exchange-rate risk and interest-rate risk.Exchange-rate risk refers to movements in theprices of a swap’s component parts (specifically,the spot rate), while interest-rate risk is causedby movements in the corresponding marketinterest rates for the two currencies.

Liquidity Risk

As stated earlier, the market for currency swapsis confined to a small number of institutions andis very credit intensive. Reversing out of a tradeat short notice can be very difficult, especiallyfor the more complicated structures. Occasion-ally, an institution can go to the original coun-terparty, resulting in the cancellation or novationof the trade, which frees up credit limits neededfor some other transaction.

Credit Risk

Credit risk in currency swaps may be particu-larly problematic. Whereas interest-rate swapsinvolve the risk of default on interest paymentsonly, for currency swaps, credit and settlementrisk also extends to the payment of principal.The consequences of an actual default by acurrency-swap counterparty depends on whatthe swap is being used for. If the currency swapis being used to hedge interest-rate and currency

4335.1 Currency Swaps


risk, the default of one counterparty would leavethe other counterparty exposed to the risk beinghedged. This could translate into an actual costif any of those risks are actually realized. If theswap is held to take advantage of expected ratemovements, the default of a counterparty wouldmean that any potential gains would not berealized.


The accounting treatment for foreign-currencytransactions, including currency swaps, is deter-mined by the Financial Accounting StandardsBoard’s Statement of Financial Accounting Stan-dards No. 133 (FAS 133), ‘‘Accounting forDerivatives and Hedging Activities,’’ as amendedby Statement of Financial Accounting StandardsNos. 137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)


The credit-equivalent amount of a currency-swap contract is calculated by summing—





factor


If a bank has multiple contracts with a coun-terparty and a qualifying bilateral contract withthe counterparty, the bank may establish itscurrent and potential credit exposures as netcredit exposures. (See section 2110.1, ‘‘CapitalAdequacy.’’) For institutions applying market-risk capital standards, all foreign-exchange trans-actions are included in value-at-risk (VAR) cal-culations for general market risk.


Currency swaps are not considered investmentsunder 12 USC 24 (seventh). However, the use ofcurrency swaps is considered to be an activityincidental to banking, within safe and soundbanking practices.

REFERENCES

Balducci, V., K. Doraiswami, C. Johnson, andJ. Showers.Currency Swaps: Corporate Appli-cations and Pricing Methodology. SalomonBrothers, September 1990.

Coopers & Lybrand.Currency Swaps. IFRPublishing, 1993.

New York Foreign Exchange Committee.Guide-lines for Foreign Exchange Trading Activities.March 1996.

Smith, Clifford W., Jr., Charles W. Smithson,and D. Sykes Wilford.Managing FinancialRisk. New York: Harper Collins, 1990.

Schwartz, Robert J., and Clifford W. Smith, Jr.,eds.The Handbook of Currency and InterestRate Risk Management. New York Institute ofFinance, 1990.

Currency Swaps 4335.1


SwaptionsSection 4340.1

GENERAL DESCRIPTION

Options on swap contracts (swaptions) are over-the-counter (OTC) contracts providing the rightto enter into an interest-rate swap. In exchangefor a one-time, up-front fee, the buyer of theswaption has the right, but not the obligation, toenter into a swap at an agreed-on interest rate ata specified future date for an agreed-on period oftime and interest rate. As such, swaptionsexhibit all of the same characteristics inherent inoptions (including asymmetric risk-returnprofiles).

In general, an interest-rate call swaption givesthe purchaser the right to receive a specifiedfixed rate, the strike rate, in a swap and to paythe floating rate for a stated time period. (Inaddition to interest rates, swaptions can betraded on any type of swap, such as currencies,equities, and physical commodities.) An interest-rate put swaption gives the buyer the right to paya specific fixed interest rate in a swap and toreceive the floating rate for a stated time period.Conversely, the writer of a call swaption sellsthe right to another party to receive fixed (thewriter will thus be obligated to pay fixed if theoption is exercised), while the writer of a putswaption sells the right to another party to payfixed (the writer will thus be obligated to receivefixed if the option is exercised).


Swaptions are typically structured to exchange astream of floating-rate payments for fixed-ratepayments in one currency. The fixed rate isidentified as the strike yield and is constantthroughout the life of the swaption, while float-ing rates are based on a variety of indexesincluding LIBOR, Eurodollar futures, commer-cial paper, and Treasury bills.

The swap component of a swaption is notrestricted to the fixed versus floating format.As with simple swaps, the structure of swap-tions may vary. For a discussion of swapvariations, see section 4325.1, ‘‘Interest-RateSwaps.’’

Swaption maturities are not standardized, asall swaptions are OTC transactions between the

buyer and the seller. Maturities for swaptionstypically range from one month to two years onthe option and up to 10 years on the swap. Theoption component of the swaption can be des-ignated to be exercised only at its expirationdate (a European swaption—the most commontype), on specific prespecified dates (a Ber-mudan swaption), or at any time up to andincluding the exercise date (an Americanswaption).

Swaptions are generally quoted with refer-ences to both the option and swap maturity. Forexample, a quote of ‘‘3 into 5’’ references a3-year option into a 5-year swap, for a total termof eight years. Terms can be arranged for almostany tenor from a 3-month to a 10-year option, oreven longer. In general, the 5-year into 5-yearswaption might be considered the end of thevery liquid market. Longer-tenor instruments(for example, 10-year into 20-year) are notuncommon but do not display the same degreeof liquidity. As with options, active swaptiondealers are really speculating on volatility morethan market direction.

Important Variations

Cancelable Swaps

Cancelable (callable or putable) swaps are popu-lar types of swaptions. In exchange for a pre-mium, a callable swap gives the fixed-rate payorthe right, at any time before the strike date, toterminate the swap and extinguish the obligationto pay the present value of future payments. Aputable swap, conversely, gives the fixed-ratereceiver the right to terminate the swap. (Incontrast, a counterparty in a plain vanilla swapmay be able to close out a swap before maturity,but only by paying the net present value offuture payments.) Cancelable swaptions are typi-cally used by institutions that have an obligationin which they can repay principal before thematurity date on the obligation, such as callablebonds. Cancelable swaps allow companies toavoid maturity mismatches between (1) assetsand liabilities with prepayment options and (2)the swaps put in place to hedge them. A ‘‘3x5cancelable swap’’ would describe a five-yearswap that may be terminated by one of thecounterparties after three years.


Extendible Swaps

In exchange for a premium, extendible swapsallow the owner of the option to extend the tenorof an already-existing swap. If a firm has assetsor liabilities whose maturities are uncertain, anextendible swap allows the investor to hedge theassociated price risk more precisely.

Amortizing or Accreting Swaptions

Two additional instruments, amortizing andaccreting swaptions, are useful for real estate–related or project-finance-related loans. Amor-tizing and accreting swaptions represent optionsto enter into an amortizing or accreting swap,where the principal amount used to calculateinterest-rate payments in the swap decreases orincreases during the life of the obligation. Spe-cifically, the notional amount of the underlyingswap decreases (amortizes) or increases (ac-cretes) depending on loan repayments or draw-downs. For example, the swaption can be con-structed to give the owner of the option someflexibility in reducing the prepayment risk asso-ciated with a loan.

USES

Swaptions are most commonly used to enhancethe embedded call option value in fixed-ratecallable debt and to manage the call risk ofsecurities with embedded call features. Swap-tions may be used to provide companies with analternative to forward, or deferred, swaps, allow-ing the purchaser to benefit from favorableinterest-rate moves while offering protectionfrom unfavorable moves. Swaptions are alsoused to guarantee a maximum fixed rate ofinterest on anticipated borrowing.

Enhancing Embedded Call OptionValue in Fixed-Rate Callable Debt

Through a swaption, the bond issuer sells thepotential economic benefit arising from the abil-ity to call the bonds and refinance at lowerinterest rates. This technique, known as ‘‘callmonetization,’’ is effectively the sale (or earlyexecution) of debt-related call options. Thefollowing example illustrates call monetization.

A firm has $100 million of 11 percent fixed-rate debt which matures May 15, 2002, and iscallable May 15, 1999. The company sells to abank a $100 million notional principal Europeancall swaption with a strike yield of 11, an optionexercise date of May 15, 1999, and an under-lying swap maturity date of May 15, 2002. Inreturn for this swaption, the firm receives $4 mil-lion. The company has sold to the bank the rightto enter into a swap to receive a fixed rate of 11and pay a floating rate. As a result of the sale,the firm’s financing cost is reduced by $4 mil-lion, the amount of the premium. From thebank’s perspective, a fee was paid for the rightto receive fixed-rate payments that may beabove market yields at the exercise date ofMay 15, 1999.

If, at May 15, 1999 (the call date), thecompany’s three-year borrowing rate is 10, thedebt will be called and the bank will exercise thecall swaption against the firm. The companybecomes a fixed-rate payer at 11 percent on athree-year interest-rate swap from May 15, 1999,through May 15, 2002, while receiving thefloating rate from the bank. The firm will nowattempt to refinance its debt at the same or lowerfloating rate than it receives from the bank. Aslong as the floating rate that the companyreceives does not fall below the firm’s netrefinancing cost, the monetization of the calllowers net borrowing costs because the firmstarts out paying 11 percent interest and is stillpaying 11 percent interest, but has received the$4 million premium.

If, on the other hand, the company’s three-year funding rate, as of May 15, 1999, is11 percent or higher, the bank will allow theoption to expire and the firm will not call thedebt. The company will continue to fund itselfwith fixed-rate debentures at 11 percent, but the$4 million premium will reduce its effectiveborrowing cost.

Managing the Call Risk of Securitieswith Embedded Call Features

Investors also use swaptions to manage thecall risks of securities with embedded callfeatures. For example, an investor buys aseven-year $100 million bond that has a 12coupon and is callable after five and wishesto purchase protection against the bonds’ beingcalled. Thus, in year four, the investor purchases

4340.1 Swaptions


from a bank a one-year European call swaption,with a strike yield of 12 percent and a swapmaturity of two years based on a notionalprincipal of $100 million. The firm pays thebank a $1 million up-front fee for this option. Inthis case, the higher the strike yield, the higherthe up-front fee will be.

At year five, if two-year floating rates are10 percent, the bond will be called, and theinvestor will exercise the swaption. The investorwill reinvest its money at the current floatingrate of 10 percent, pass along the 10 percentinterest to the bank, and receive 12 percent fromthe bank. Thus, the investor guarantees that itwill not earn less than 12 percent on its invest-ment. If, on the other hand, two-year floatingrates are above 12 percent, the bonds will notbe called and the investor will let the optionexpire.

Guaranteeing a Maximum InterestRate on Variable-Rate Borrowing

An additional use of swaptions is to guaranteea maximum interest rate on variable-rate bor-rowing. A company, for example, issues a two-year $10 million floating-rate note. The firmdoes not want to pay more than 10 percentinterest so it purchases from a bank a one-yearEuropean put swaption for the right to enter intoa one-year swap in which it will pay a fixed rate(strike yield) of 10 percent on a notional prin-cipal of $10 million. The bank, on the otherhand, agrees to pay floating-rate interest pay-ments to the firm if the option is exercised. Thecompany pays the bank an up-front fee of$100,000 for this option.

At the end of the first year, if the floating rateincreases to 12 percent, the firm will exercise theoption and pay 10 percent interest to the bank,and the bank will pay the current floating rate of12 percent to the company. While this optionwill cost the firm $100,000, it will save $200,000in interest costs ((12 − 10) × $10 million).Therefore, in total, the company will save$100,000. Once the option is exercised, how-ever, the firm cannot return to floating rates evenif floating rates should fall below 10 percent(unless the company reverses the swap, whichcan be very expensive). On the other hand, if thefloating rate is below 10 percent at the end of thefirst year, the firm will let the option expire andcontinue to pay a floating rate.


Swaptions are OTC-traded instruments, and theycan easily be customized to suit a particularinvestor’s needs. The market is very active andcan be loosely coupled with other markets (forexample, Eurodollar caps and floors and theOTC bond options market) in certain maturities.In addition, there is a very active secondarymarket.

In general, U.S. dollar swaptions with anoption component of less than five years can bethought of as relatively short-term; the five-yearto seven-year maturity is considered medium-term, with ten-year and longer options beingconsidered long-term and displaying relativelymore limited liquidity. A tenor such as a ten-year into ten-year swaption can be thought of asthe upper bound on the liquid market.

PRICING

The pricing of swaptions relies on the develop-ment of models that are on the cutting edge ofoptions theory. Dealers differ greatly in themodels they use to price such options, and theanalytical tools range from modified Black-Scholes to binomial lattice versions to systemsbased on Monte Carlo simulations. As a result,bid/ask spreads vary greatly, particularly frommore complicated structures that cannot be eas-ily backed off in the secondary markets. Theprice of a swaption, known as the premium,depends on several factors: the expected shapeof the yield curve, the length of the option andswap periods, the strike yield’s relationship tomarket interest rates, and expected interest-ratevolatility.

HEDGING

Swaptions are often hedged using Eurodollarfutures, Treasuries, and interest-rate swaps.Market participants have introduced a varietyof features to mitigate counterparty creditrisk, such as cash settlement and posting ofcash collateral. Of these, cash settlement, inwhich the seller pays the net present value ofthe swap to the buyer upon exercise of theoption, has been the most common. Cash settle-

Swaptions 4340.1


ment has two significant benefits: (1) it limitsthe length of credit exposure to the life of theoption and (2) banks are not required to allocatecapital for the swap, since neither party actuallyenters into the swap.

RISKS

The risks of purchasing or selling a swaptioninclude the price and credit risks associated withboth swaps and options. For a more detaileddiscussion of the risks connected with theseinstruments, see sections 4325.1 and 4330.1,‘‘Interest-Rate Swaps’’ and ‘‘Options,’’respectively.

As a hybrid instrument, a swaption generatestwo important exposures: the probability ofexercise and the credit risk emerging from theswap. The first risk is a function of the option’ssensitivity to the level and volatility of theunderlying swap rates. The swaption’s creditrisk is the cost to one counterparty of replacingthe swaption in the event the other counterpartyis unable to perform.

As mentioned earlier, liquidity risk is mostpronounced for swaptions with option compo-nents of greater than ten years. However, swap-tions with five-year option components willhave greater liquidity than those with ten-yearoption components.


The accounting treatment for swaptions is deter-mined by the Financial Accounting StandardsBoard’s Statement of Financial Accounting Stan-dards No. 133 (FAS 133), ‘‘Accounting forDerivatives and Hedging Activities,’’ as amendedby Statement of Financial Accounting StandardsNos. 137 and 138 (FAS 137 and FAS 138).(See section 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)


The credit-equivalent amount of a swaptioncontract is calculated by summing—



The conversion factors are listed below:


factor

One year or less 0.00Five years or less 0.50Greater than five years 1.50

If a bank has multiple contracts with a counter-party and a qualifying bilateral contract with thecounterparty, the bank may establish its currentand potential credit exposures as net creditexposures. (See section 2110.1, ‘‘CapitalAdequacy.’’)

LEGAL LIMITATIONS FOR BANKINVESTMENTS

Swaptions are not considered investments under12 USC 24 (seventh). The use of these instru-ments is considered to be an activity incidentalto banking within safe and sound banking prac-tices.

REFERENCES

Arditti, Fred D. Derivatives. Harvard BusinessSchool Press, 1996.

Burghardt, Belton, Lane, Luce, and McVey.‘‘Options on Swaps.’’ Eurodollar Futures andOptions. Discount Corporation of New YorkFutures, 1991.


Fabozzi, Frank, and Dessa. The Handbook ofFixed Income Securities. 4th ed. Irwin, 1995.

Hull, John C. Options, Futures and OtherDerivative Securities. 2d ed. Prentice-Hall,1993.

4340.1 Swaptions


Equity DerivativesSection 4345.1

GENERAL DESCRIPTION

The term ‘‘equity derivatives’’ refers to thefamily of derivative products whose value islinked to various indexes and individual securi-ties in the equity markets. Equity derivitivesinclude stock index futures, options, and swaps.As in the interest-rate product sector, the over-the-counter (OTC) and futures markets areclosely linked. Banks are involved in thesemarkets in a variety of ways, depending on theircustomer base. Some banks are actively involvedas market makers in all products, while othersonly use this market to satisfy customer needs oras part of a structured financial transaction.


Equity derivatives range in maturity from threemonths to five years or longer. The maturities inthe OTC market are generally longer than thosein the futures market. However, maturities in thefutures market are gradually changing with thedevelopment of the LEAPs (Long-Term EquityAnticiPation) market on the exchanges. As withother futures markets, there is a movementtowards more flexibility in the maturities andstrike prices of equity derivitives.

The following are the major instruments thatcomprise the equity derivatives market and areavailable for most major markets around theworld:

• Equity swapsare transactions in which anexchange of payments referenced to the changein a certain index and an interest rate areexchanged and are usually based on a fixednotional amount. For example, counterparty Amay pay a spread over LIBOR to counterpartyB and receive the return on a specified equityindex. These swaps are documented usingstandard ISDA documentation. Some of thesetransactions also have a currency componentand in many cases are done as quantos.1

• Stock index futuresare futures on variousstock indexes and are traded on most of themajor exchanges.

• Stock index optionsare options on either thecash value of the indexes or on the stock indexfutures.

• Equity optionsare options on the individualstocks and are also traded on most majorexchanges.

• Warrants are longer-term options on eitherindividual stocks or on certain indexes. Theyare popular in Europe and Asia (especiallyJapan).

• Equity-index-linked notesare fixed-incomesecurities issued by a corporation, bank, orsovereign in which the principal repayment ofthe note at maturity is linked to the perfor-mance of an equity index. The formula forprincipal repayment can reflect a long or shortposition in an equity index and can alsoprovide an exposure to the equity marketwhich is similar to an option or combinationof options.

• Other instrumentsinclude ADRs (AmericanDepository Receipts), and SPDRs (S&P 500Depository Receipts).

• Index arbitrageis strictly not a product, but anactivity; however, it is an important part of theequity derivatives market. As its name implies,index arbitrage is the trading of index futuresagainst the component stocks.

As these markets have developed, variousenhancements have been made to them, such asthe introduction of futures on individual stocks.Some of the more structured deals that banks areinvolved in use more than one of the aboveproducts.

USES

Equity derivatives are used for investment, hedg-

1. Quantos (guaranteed exchange-rate options/quantity-adjusting options) are cross-border equity or equity indexoptions that eliminate currency-exchange-rate exposure on anoption or option-like payout by translating the percentagechange in the underlying into a payment in the investor’s base

currency at a spot exchange rate set at the start of the contract.The investor holding a quanto option obtains participation ina foreign equity or index return, denominated in the domesticcurrency. Currency exchange rates are fixed at issuance bysetting the option payoff in the investor’s base currency as amultiple of the foreign equity or index rate of return. The rateof return determining the payoff can be positive (calls) ornegative (puts). Guaranteed-exchange-rate put options aremore common in some markets than guaranteed exchange-rate call options.


ing, and speculative purposes. The growth inthis market has coincided with developments inother derivative markets. Users and customersof the banks have shown increased interest inequity derivitive products for purposes rangingfrom hedging to speculation. Some of the majorusers of these products are investment funds.Some banks also use them to hedge their index-linked certificates of deposit (CDs) (these arelonger-term CDs, whose principal is guaranteedand whose yield is linked to the return on acertain stock index, for example, S&P 500).Some corporations also use equity derivatives tolower the yield on their issuance of securities.Some speculators (hedge funds) might use equityswaps or options to speculate on the direction ofequity markets.

Equity-index-linked swaps are often used asan overlay to a portfolio of fixed-income assetsto create a synthetic equity investment. Forexample, a portfolio manager may have a fixed-income portfolio whose yield is based on LIBOR.The manager can enter into an equity-index-linked swap with a bank counterparty in whichthe manager pays the bank LIBOR and receivesthe return on an equity index, plus or minus aspread. If the portfolio manager earns a positivespread on the LIBOR-based investments, anequity-index-linked swap may result in an over-all return which beats the market index to whichthe portfolio manager is evaluated. For example,if the LIBOR-based portfolio yields LIBOR +20 basis points, and the manager enters into anequity-index-linked swap in which he or shepays LIBOR flat and receives the return on theequity index flat, the manager will receive areturn on the equity index plus 20 basis points,thus outperforming the index. In this way, equity-index-linked swaps allow portfolio managers totransfer expertise in managing one class ofassets to another market.

Equity-index options, warrants, and futuresare often used as hedging vehicles. A portfoliomanager, for example, can protect an existingindexed equity portfolio against a decline in themarket by purchasing a put option on the indexor by selling futures contracts on the index. Inthe case of the put option, the portfolio will beprotected from a decline in the index, whilebeing able to participate in any future upsidemovement of the index. The protection of theput option, however, involves the cost of apremium which is paid to the seller of theoption. In the case of selling futures contracts onthe index, the portfolio is protected against a

decline in the index, but will not be able toparticipate in future upside movement in theindex. Unlike the put option, the futures contractdoes not involve an up-front payment of apremium.

Equity-linked options are also used by port-folio managers to gain exposure to an equitymarket for a limited amount of capital. Forinstance, by purchasing a call option on anequity index, a portfolio manager can create aleveraged position in an equity index with lim-ited downside. For the cost of the option pre-mium, the portfolio manager will obtain upsideexposure to an equity market on the magnitudeof the full underlying amount.


Sell Side

The major sell-side participants in this marketcan be divided into three groups: investmentbanks, exchanges, and commercial banks. Invest-ment banks have the greatest competitive advan-tages in these markets because of their customerbase and the nature of their businesses and,therefore, have the largest market share. Whilecommercial banks have much of the necessarytechnical expertise to manage these instruments,they are hampered by regulations and lack of acustomer base.

The underlying instruments for equity deriva-tive products are primarily the various stockindexes traded around the world. Even thoughthere is a lot of activity in the individual stockoptions, banks are mostly active in the deriva-tives market on the various indexes. Theirinvolvement in the market for individual stocksis affected by various regulations restrictingbank ownership of individual equities.

Buy Side

Buy-side participants in the equity derivativesmarket include money managers; hedge funds;insurance companies; and corporations, banks,and finance companies which issue equity secu-rities. Commercial banks are not very activeusers of equity derivatives because of regula-tions restricting bank ownership of equities.

4345.1 Equity Derivatives


PRICING

Because of the large volumes traded in equityderivatives markets, the pricing of most of theseproducts is very transparent and widelydisseminated—at least for the products that arebased on the equity markets of the major indus-trialized countries. This transparency does nothold true for the prices in some of the develop-ing countries or in those countries that arehighly regulated. The pricing of some of theseproducts is also affected by tax considerationsand regulatory constraints for certain cross-border transactions. As with some of the otherderivative markets, there is less transparency forstructured products, especially those that involvesome of the swaps that include exotic options inboth the interest-rate and index components.

HEDGING

Since banks’ activities with customers ofteninvolve nonstandard maturities and amounts,equity derivatives instruments are often hedgedusing exchange-traded instruments. The hedgestake the form of combinations of the productsthat are available on the relevant exchanges andalso involve the interest-rate markets (swaps andfutures) to hedge out the interest-rate risk inher-ent in equity derivatives.

The risks of individual equity securities or abasket of equity securities are often hedged byusing futures or options on an equity index. Thishedge may be over- or underweighted based onthe expected correlation between the index andthe individual security or basket of securities. Tothe extent that the underlying and the hedgeinstrument are not correlated as expected, thehedge may not be effective and may lead toincremental market risk on the trade.

RISKS

Market Risk

Market risk in equity derivative products arisesprimarily from changes in the prices of theunderlying indexes and their component stocks.There is also correlation risk associated withhedging certain transactions with the most liquidinstrument available, which may be less than

perfectly correlated with the instrument beinghedged.

Interest-Rate Risk

Interest-rate risk in equity derivative productscan be substantial, especially for those transac-tions with relatively long maturities. The impliedinterest rate is a very important component inthe calculation of the forward prices of theindex. For hedges that use futures to closelymatch the maturities of the transaction, interest-rate risk is minimized because the price of thefuture already has an implied interest rate.Interest-rate risk may arise in those transactionsin which the maturity of the transaction is longerthan the maturity of the hedges that are avail-able. In swap transactions, this mismatch mayaffect the hedging of implied forward cashflows. In certain cross-border transactions, addi-tional risks arise from the necessity of hedgingthe nondomestic interest-rate component.

Volatility Risk

A substantial portion of transactions in theequity derivatives market have option compo-nents (both plain-vanilla and, increasingly, vari-ous exotic types, especially barrier options). Incertain shorter-dated transactions, hedges areavailable on the exchanges. But when thematurity is relatively long, the options maycarry substantial volatility risks. These risksmay be especially high in certain developingequity markets in which the absolute level ofvolatility is high and the available hedges lackliquidity.

Liquidity Risk

Liquidity risk is not significant for most equityderivative products in the major markets and forproducts with maturities of less than a year.Liquidity risk increases for longer maturitiesand for those transactions linked to emergingmarkets.

Currency Risk

Currency risk is relevant for cross-border andquanto products. As these transactions are often

Equity Derivatives 4345.1


dynamically hedged by the market maker, cur-rency risk can be significant when there areextreme movements in the currency.


The accounting treatment for equity derivatives,except those indexed to a company’s own stock,is determined by the Financial Accounting Stan-dards Board’s Statement of Financial Account-ing Standards No. 133 (FAS 133), ‘‘Accountingfor Derivatives and Hedging Activities,’’ asamended by Statement of Financial AccountingStandards Nos. 137 and 138 (FAS 137 and FAS138). (See section 2120.1, ‘‘Accounting,’’ forfurther discussion.) Derivatives indexed to acompany’s own stock can be determined byAccounting Principles Board (APB) OpinionNo. 18, ‘‘ The Equity Method of Accounting forInvestments in Common Stock,’’ and FAS 123,‘‘Accounting for Stock-Based Compensation.’’


The credit-equivalent amount of an equityderivative contract is calculated by summing—





factor


If a bank has multiple contracts with a counter-party and a qualifying bilateral contract with thecounterparty, the bank may establish its currentand potential credit exposures as net creditexposures. (See section 2110.1, ‘‘ CapitalAdequacy.’’ )


Equity derivatives are not considered invest-ments under 12 USC 24 (seventh). A bank mustreceive proper regulatory approval before itengages in certain types of equity-linkedactivities.

REFERENCES

Allen, Julie A., and Janet L. Showers. Equity-Index-Linked Derivatives, An Investor’s Guide.Salomon Brothers, April 1991.

Federal Reserve Bank of Chicago. The EquityDerivatives Market: A Product Summary.February, 1997.

4345.1 Equity Derivatives


Credit DerivativesSection 4350.1

GENERAL DESCRIPTION

Credit derivatives are off-balance-sheet financialinstruments that permit one party (the benefi-ciary) to transfer the credit risk of a referenceasset, which it typically owns, to another party(the guarantor) without actually selling the asset.In other words, credit derivatives allow users to‘‘unbundle’’ credit risk from financial instru-ments and trade it separately.

As estimated by dealers, the market for creditderivatives approached $1 trillion in 2002;default swaps accounted for more than half ofthe market.


In general, credit derivatives have three distin-guishing features:

• the transfer of the credit risk associated with areference asset through the use of contingentpayments that are based on events of defaultand, usually, on the prices of instrumentsbefore, at, and shortly after default (a refer-ence asset is most often a traded sovereign andcorporate debt instrument or a syndicatedbank loan)

• the periodic exchange of payments or thepayment of a premium rather than the pay-ment of fees that is customary with otheroff-balance-sheet credit products, such as let-ters of credit

• the use of an International Swaps and Deriva-tives Association (ISDA) Master Agreementand the legal format of a derivatives contract

Credit derivatives fall into three basic trans-action types: total-rate-of-return swaps, credit-default swaps, and credit-default notes. Cur-rently, total-rate-of-return swaps are the mostcommonly used credit derivatives.

Total-Rate-of-Return Swaps

In a total-rate-of-return (TROR) swap, one coun-terparty (Bank A) agrees to pay the total returnon an underlying reference asset to its counter-party (Bank B) in exchange for LIBOR plus a

spread. Most often, the reference asset is acorporate or sovereign bond or a traded com-mercial loan. Since many commercial loans arebased on the prime rate, both ‘‘legs’’ of the swapfloat with market rates. In this manner, creditrisk is essentially isolated and potential interest-rate risk is generally limited to some form ofbasis risk (for example, prime versus LIBOR).

TROR swaps are intended to be an efficientmeans of transferring or acquiring credit expo-sure without actually consummating a cash trans-action. This feature may be desirable if a bank(Bank A) has credit exposure to a borrower andwould like to reduce this exposure while retain-ing the borrower as a customer, thus preservingthe banking relationship. Also, entities (such asBank B) that are not able to bear the adminis-trative costs of purchasing or administeringloans or loan participations may still acquireexposure to these loans through TROR swaps.

In the example in figure 1, Bank A receives aLIBOR-based payment in exchange for payingout the return on an underlying asset. The totalreturn payments due to Bank B include not onlythe contractual cash flows on the underlyingassets but also any appreciation or depreciationof that underlying asset that occurs over the lifeof the swap. Periodically (usually quarterly), theasset’s market price is determined by an agreed-upon mechanism. Bank B would pay Bank Afor any depreciation in the value of the under-lying asset and would receive any appreciation.Consequently, for the term of the swap, Bank B‘‘owns’’ the reference asset that resides on BankA’s balance sheet.

At the maturity of the swap or in the event ofdefault of the underlying asset, the swap is

Figure 1—Total-Rate-of-Return Swap

Bank A(beneficiary)

Cash flowand

appreciationBank B

(guarantor)LIBOR +X bp and

depreciationCashflow

Referenceasset


terminated; the underlying asset is then pricedfor purposes of determining the final swapobligations.1 The post-default price of the assetis most often determined by a poll of assetdealers or by direct market quotation, if avail-able. Often, the final price will be the average ofsample prices taken over time, which mitigatesany post-default volatility in the reference asset’svalue.

If Bank B is not satisfied with the pricing ofthe asset upon the maturity of the swap or upondefault (that is, Bank B believes the valuation istoo low), then Bank B will often have the optionof purchasing the underlying reference assetdirectly from Bank A and pursuing a workoutwith the borrower directly. However, it is notclear how often Bank B would choose to pur-chase the underlying instrument, particularly ifthe swap vehicle was used to avoid directacquisition in the first place.

The final termination payment is usually basedon the following formula:

Final payment = Dealer price − Notional amount

The notional amount is essentially the price ofthe reference asset when the credit derivative isinitiated. If the dealer price is greater than thenotional amount, then the asset has appreciated;Bank A must pay Bank B this difference to settlethe swap. On the other hand, if the dealer priceis below the notional amount, either deprecia-tion (for example, downgrade or default) orprincipal reduction (for example, amortizationor prepayment) has occurred, and Bank B owesBank A this difference. Therefore, the finalpayment (either at maturity or upon default)ultimately defines the nature and extent of thetransfer of credit risk.

Default events are described in the transactiondocumentation, usually in the trade confirma-tion. These events may include bankruptcy,payment defaults, breached covenants in loanor bond documentation, or even the grantingof significant security interests by the refer-ence obligor to one of its creditors. Often, adefault event is defined so that it applies to anyclass of outstanding securities of the referenceobligor that is in excess of a specified amount. Inother words, a default can be triggered if thereference asset defaults or if any material class

of securities issued by the underlying obligordefaults.

In an alternative structure, two banks mayexchange the total return on underlying groupsof loans. For example, a large money-centerbank may receive the total return on a concen-trated loan portfolio of a regional bank inexchange for the total return on a more diversi-fied group of loans held by the money-centerbank. These types of swaps may be readilymarketable to smaller banks that are seeking tocomply with the concentration of credit limita-tions of section 305(b) of the Federal DepositInsurance Corporation Improvement Act(FDICIA).

Credit-Default Swaps

Credit-default swaps made up over 50 percent ofthe credit derivatives market as of year-end2001. In a credit-default swap, one counterparty(Bank A) agrees to make payments of X basispoints of the notional amount, either per quarteror per year, in return for a payment in the eventof the default of a prespecified reference asset(or reference name). (See figure 2.) Since thepayoff of a credit-default swap is contingent ona default event (which may include bankruptcy,insolvency, delinquency, or a credit-rating down-grade), calling the structure a ‘‘swap’’ may be amisnomer; the transaction more closely resemblesan option.

The following market conventions are com-mon in the credit-default swap market:

• Reference entities generally are public,investment-grade companies; however, sometrading has developed for high-yield credits.

• Trades are for senior, unsecured risk.

1. Alternatively, the swap may continue to maturity withpayments that are based on quarterly changes in the post-default asset price.

Figure 2—Credit-Default Swap

Bank A(beneficiary)

X bp perquarter

Bank B(guarantor)

Contingentdefault

payment

Referenceasset

4350.1 Credit Derivatives


• Five-year contracts are most common; how-ever, one- and three-year contracts also trade.

• Prices are quoted in basis points per year.• U.S. trades generally include only bankruptcy,

failure to pay, and modified restructuring ascredit events. Modified restructuring is definedunder the May 11, 2001, ISDA RestructuringSupplement, which limited deliverables undera restructuring-only trigger and placed stricterconditions on when a restructuring is triggered.

• European trades generally include standardrestructuring credit events.

• Trades become effective in three days (T+3).

Like TROR swaps, the occurrence of default incredit-default swaps is contractually well defined.Usually, the default event must be publiclyverifiable. The default definition must be spe-cific enough to exclude events whose inclusionwould be undesirable, such as when a referencename is delinquent because the affiliated orga-nization is withholding a payment in a legaldispute that does not affect the creditworthinessof the organization. Further, a materiality thresh-old may be involved; that is, a default eventmust have occurred, and the cumulative loss onthe underlying must be greater than Y percent.The materiality thresholds increase the likeli-hood that only significant changes in creditquality will trigger the default payment (ratherthan the small fluctuations in value that tend tooccur over time).

Finally, upon default, the ‘‘swap’’ is termi-nated and a default payment is calculated. Thedefault payment is often calculated by samplingdealer quotes or observable market prices oversome prespecified period after default hasoccurred. Alternatively, the default paymentmay be specified in advance as a set percentageof the notional amount (for example, 25, 50, or100 percent). Such swaps are usually referred toas binary swaps; they either pay the prespecifiedamount or nothing, depending on whether defaultoccurs. Binary swaps are often used when thereference asset is not liquid but loss in the eventof default is otherwise subject to estimation. Forexample, if the reference asset is a senior,unsecured commercial bank loan and such loanshave historically recovered 80 percent of facevalue in the event of default, a binary defaultswap with a 20 percent contingent payout maybe appropriate.

When the counterparty making the defaultpayment (the guarantor) is unhappy with thevaluation, the option to purchase the reference

asset is often available. On the other hand, someversions of default swaps may allow the bene-ficiary to put the asset to the guarantor in theevent of default rather than receive a cashpayment. When there is more than one under-lying instrument (or name), which is often thecase in a ‘‘basket’’ structure, the counterpartymaking the contingent default payment isexposed to only the first instrument or name todefault. Credit-default swaps are generally gov-erned by ISDA agreements and ISDA’s 2003Credit Derivatives Definitions.

Credit-Default Notes

A credit-default note is a structural note and isthe on-balance-sheet equivalent of a credit-default swap. In a credit-default note, an inves-tor purchases a note from an issuing vehicle,often a trust. The trust uses the proceeds of thenote purchase to purchase paper of the highestcredit quality: Treasuries, agencies, or AAAcorporate paper. The note is structured such thata default by the underlying reference instrumentor name results in a reduction of the repaymentof principal to the investor. (There may be morethan one reference instrument or name.) Defaultpayments are calculated in the same manner asthey are for TROR and credit-default swaps. Inreturn for the contingent default payment, thearranging bank pays a spread to the investor

Figure 3—Credit-Default Note

Market

Principal

Treasuries,agencies,AAAcorporatepaper

Bank

X bpsIssuingvehicle

Contingentdefaultpayment

PrincipalLIBOR +Y bps

Default-protectedasset(s)

Investor

Credit Derivatives 4350.1


through the issuing vehicle. The investor, mean-while, receives a premium yield over LIBOR foraccepting the default risk of the underlyinginstrument or name. (See figure 3.)

USES

Both TROR and credit-default swaps are used totransfer the credit risk of the asset (or assets)referenced in the transaction. The counterpartyseeking to transfer the credit risk (the benefi-ciary) often owns the reference asset. The coun-terparty receiving the credit risk of the referenceasset (the guarantor) is able to do so withoutpurchasing the reference asset directly.

Banks may use credit derivatives in severalways. They may elect to receive credit exposure(provide protection) for a fee. In an effort tobetter diversify their credit portfolios, banksmay also receive credit exposure in exchangefor credit exposure that they already hold. Banksmay also elect to receive credit exposure throughcredit derivatives rather than through some othertransaction structure because of the relativeyield advantage (arbitrage of cash-market pric-ing) of derivatives.

Alternatively, banks may use credit deriva-tives to reduce either individual credit exposuresor credit concentrations in their portfolios. Inother words, the banks are purchasing creditprotection from another institution. Banks mayuse credit derivatives to synthetically take ashort position in an asset that they do not wish tosell outright. From the bank customer’s perspec-tive, credit derivatives may be written to allownonbank counterparties to obtain access to bankloan exposures and their related returns, eitheras a new asset class (for credit diversification) orwithout up-front funding (perhaps to obtaingreater leverage). In the last example, the bankis essentially performing traditional credit inter-mediation using a new off-balance-sheet vehicle.

Finally, banks may seek to establish them-selves as dealers in credit derivatives. Ratherthan pursue credit portfolio efficiency or port-folio yield enhancement, dealer banks will seekto profit from buying and selling credit deriva-tives exposures quite apart from their portfolio-management goals. Dealer banks may or maynot hold the assets referenced in their creditderivative transactions, depending on the banks’risk tolerance, credit views, and (ultimately)their ability to offset contracts in the marketplace.

MARKET PARTICIPANTS

Participants in the credit-default swap marketfall into three main categories:

• Bank hedgers. Loan portfolio managers pur-chase default swap protection to offset loansin the banking book.

• Capital-markets participants. Insurers, rein-surers, and funds sell default swap protection.

• Money-center banks and brokers. Large dealerbanks connect bank hedgers to the capitalmarkets by intermediating trades in return fortrading income.

PRICING

To understand credit derivative pricing and howdifferent prices for reference assets might beobtained for different counterparties, considerthe following example. A bank offers to providedefault protection to another bank on a five-yearloan to a BBB-rated borrower. Since reliabledefault and recovery data for pricing creditderivatives are not available, credit derivativesproviders rely on credit spreads to price theseproducts. One of the more common pricingtechniques is to price an asset swap of thereference asset. In an asset swap, a fixed-for-floating interest-rate swap is used to convert afixed-rate instrument (here, a BBB-rated note)into a floating-rate instrument. The spread aboveLIBOR required for this conversion to takeplace is related to the creditworthiness of thereference borrower. That is, the lower the cred-itworthiness of the reference borrower, thegreater the spread above LIBOR will need to beto complete the asset swap. Hence, if LIBOR isviewed as a base rate at which the most credit-worthy institutions can fund themselves, thenthe spread above LIBOR represents the ‘‘creditpremium,’’ or the cost of default risk, associatedwith that particular reference asset.

The credit premium is the most fundamentalcomponent of pricing. The credit premium ismeant to capture the default risk of the referenceasset. Often, the credit premium is the periodicpayment rate required by market participants inexchange for providing default protection. In aTROR swap, LIBOR plus this credit premium ispaid in exchange for receiving the total return onthe underlying reference asset. Intuitively, theowner of the reference asset, who receives



LIBOR plus the credit premium, is being com-pensated for the funding costs and default risk ofthe reference asset.

Furthermore, assume the reference asset is aBBB-rated, senior unsecured note of five-yearmaturity yielding 6.50 percent. Assume that theasking price for a five-year, fixed-for-floatinginterest-rate swap is 6.03 percent against LIBORflat. To complete the asset swap, the interest-rateswap’s legs need to be increased by 47 basispoints each to convert the reference asset to afloating-rate instrument. (See figure 4.) Conse-quently, 47 basis points is the credit premium, orthe implied market price to be charged, per yearfor providing default protection on this BBB-rated reference asset. Alternatively, LIBOR plus47 basis points would be the price to be paid ina TROR swap for receiving the total return onthis asset for five years.

However, the borrower-specific factors thatproduced the implied market price of 47 basispoints for the default swap are not the onlyfactors considered in pricing. The spread may beadjusted for any number of factors that areunique to the counterparties. For example, thespread may need to be adjusted for counterpartycredit considerations. In the example in figure 2,if the credit quality of the guarantor counter-party (Bank B) was a concern to the beneficiary(Bank A), the beneficiary might negotiate pay-ment of a lower spread (fee) than 47 basis pointsto compensate for counterparty risk.

Often, differences in funding costs betweencounterparties affect pricing. Operational con-siderations, such as the inability of a guarantorcounterparty to actually own the asset, mayresult in a pricing premium for the risk seller(protection buyer) who can own the asset. Simi-larly, tax consequences may have an impact ontransaction pricing. For example, to avoid trig-

gering an unfavorable taxable event, such as ataxable gain or a capital loss that is not fullydeductible, a beneficiary may wish to reducecredit exposure to an obligor without actuallyselling the reference asset. Clearly, these con-siderations may have an impact on the price thatthe risk seller is willing to pay.

HEDGING

Credit derivatives may be hedged in two basicways: users may match (or offset) their creditderivative contracts, or they may use a cashposition in the reference asset to hedge theircontracts.

The ideal hedging strategy for dealers is tomatch positions, or to conduct ‘‘back-to-back’’trading. Many deals actually are conducted backto back with offsetting transactions as a result ofthe highly structured nature of these deals. Thatis, dealer banks won’t enter into a credit deriva-tive trade unless a counterparty that is willing toenter the offsetting transaction has been identi-fied. Alternatively, the credit derivative tradingfunction may conduct trades back-to-back withan internal counterparty (for example, the bank’sown loan book). Because the secondary-marketsupport for credit derivatives is characterized bysubstantial illiquidity, credit positions that aretaken through credit derivatives may be ‘‘ware-housed’’ for substantial periods of time beforean offsetting trade can be found. Banks often settrading limits on the amount and time periodover which they will warehouse reference-assetcredit exposures in credit derivative transactions.

The second basic hedging practice is to ownthe underlying reference asset. Essentially, therisk-selling bank hedges by going long thereference asset and going short the swap. Thisis the simplest form of matched trading andis illustrated by Bank A in figures 1 and 2.Generally, whether or not the bank owned thereference asset before it entered the swap isa good indication of the purpose of the swap. Ifthe bank owned the asset before executingthe swap, it has most likely entered the swapfor risk-management reasons. If the bankacquired the asset for purposes of transactingthe swap, it is more likely to be accommodatinga customer.

Interestingly, hedging a credit derivative inthe cash market is not common when the cash

Figure 4—Asset Swap

Investor

LIBOR +47 basis points

6.03% +47 basis points

Swapdealer

6.50%bondyield

Note

Cost of default protection:47 basis points

Other factors:• Taxes• Administrative costs• Funding costs• Counterparty credit• Portfolio characteristics



position required is a short. Generally speaking,going short the reference asset and long theswap is problematic. Consider what happens ina declining market: The long credit derivativeposition (TROR receiver) declines in value, andthe short cash position rises in value as themarket falls. Unfortunately, most lenders of asecurity that is falling in value will not agree tocontinually lend and receive back a security thatis undergoing a sustained depreciation in value.Since most short sales are very short term (infact, overnight), the short cash hedge becomesunavailable when needed most—when there is aprolonged decline in the value of the referenceasset. For this reason, a short credit derivativeposition may be superior to a short cash positionthat must be rolled over.

A third and less common practice is to simplyadd or subtract the notional amount of long orshort positions, respectively, to or from estab-lished credit lines to reference obligors. This isthe least sophisticated risk-management treat-ment and is inadequate for trading institutionsbecause it does not address counterparty risks.This method may be used effectively in conjunc-tion with other methods and is useful in deter-mining total potential credit exposure to refer-ence obligors.

At some point, the potential exists for creditderivatives dealers to apply a portfolio risk-management model that recognizes diversifi-cation and allows hedging of residual portfoliorisks. However, the fundamental groundworkfor quantitative modeling approaches to creditderivatives is still in development.

Finally, two other hedging issues are worthconsidering. First, it is not uncommon for banksto hedge a balance-sheet asset with a creditderivative that references a different asset of thesame obligor. For example, a bank may hedge ahighly illiquid loan to ABC Company with acredit-default swap that references the publiclytraded debt of ABC Company. The fact that thepublic debt is more liquid and has public pricingsources available makes it a better referenceasset than the loan. However, the bank is exposedto the difference in the recovery values of theloan and the debt if ABC Company defaults.Second, it is very common for the term of thecredit derivative to be less than the term of thereference asset. For example, a two-year credit-default swap could be written on a five-yearbond. In this case, the last three years of creditrisk on the underlying bond position would notbe hedged. The appropriate supervisory treat-

ment for credit derivatives is provided in SR-96-17. (See section 3020.1, ‘‘Securitization andSecondary-Market Credit Activities.’’)

RISKS

Credit Risk

Banks that use credit derivatives are exposed totwo sources of credit risk: counterparty creditrisk and reference-asset credit risk. In general,the most significant risk faced by banks in creditderivatives will be their credit exposure to thereference asset.

When a bank acquires credit exposure througha credit derivative transaction, it will be exposedprimarily to the credit risk of the reference asset.As they do with the credit risk that is acquiredthrough the direct purchase of assets, banksshould perform sufficient credit analyses of allreference assets that they will be exposed tothrough credit derivative transactions. The finan-cial analysis performed should be similar to thatperformed for processing a loan or providing aletter of credit. Further, banks should haveprocedures in place to limit their overall expo-sure to certain borrowers, industries, or geo-graphic regions, regardless of whether expo-sures are taken through cash instruments orcredit derivative transactions.

Examiners should be aware that the degree ofreference-asset credit risk transferred in creditderivative transactions varies significantly. Forexample, some credit derivatives are structuredso that a payout only occurs when a predefinedevent of default or a downgrade below a pre-specified credit rating occurs. Other creditderivatives may require a payment only when adefined default event occurs and a predeter-mined materiality (or loss) threshold is exceeded.Default payments may be based on an averageof dealer prices for the reference asset duringsome period of time after default by using aprespecified sampling procedure, or paymentsmay be specified in advance as a set percentageof the notional amount of the reference asset.Lastly, the terms of many credit derivativetransactions are shorter than the maturity of theunderlying asset and, therefore, provide onlytemporary credit protection to the beneficiary. Inthese cases, some of the credit risk of thereference asset is likely to remain with the assetholder (protection buyer).



Alternatively, a bank may own an asset whoserisk is passed on to a credit derivative counter-party. As such, the bank will only lose money ifthe asset deteriorates and the counterparty isunable to fulfill its obligations. Therefore, banksusing credit derivatives to reduce credit expo-sure will be exposed primarily to counterpartyrisk. Because the ultimate probability of a lossfor the bank is related to the default of both thereference credit and the inability of a counter-party to meet its contractual obligations, banksshould seek counterparties whose financial con-dition and credit standing are not closely corre-lated with those of the reference credit.

In all credit derivative transactions, banksshould assess the financial strength of theircounterparty before entering into the transac-tion. Further, the financial strength of the coun-terparty should be monitored throughout the lifeof the contract. In some cases, banks may deemit appropriate to require collateral from certaincounterparties or for specific types of creditderivative transactions.

Market Risk

While banks face significant credit exposurethrough credit derivative transactions, signifi-cant market risk is also present. The prices ofcredit derivative transactions will fluctuate withchanges in the level of interest rates, the shapeof the yield curve, and credit spreads. Further-more, because of the illiquidity in the market,credit derivatives may not trade at the theoreti-cal prices suggested by asset-swap pricing meth-odologies. Therefore, price risk is a function ofmarket rates as well as prevailing supply anddemand conditions in the credit derivativemarket.

The relative newness of the market for creditderivatives and the focus of some products onevents of default makes it difficult for banks tohedge these contingent exposures. For example,banks that sell default swaps will probably makepayments quite infrequently because events ofdefault are rare. Hence, the payoff profile for adefault swap includes a large probability thatdefault will not occur and a small probabilitythat a default will occur with unknown conse-quences. This small probability of a defaultevent is difficult for banks to hedge, especiallyas the reference asset deteriorates in financialcondition.

Liquidity Risk

Typically, liquidity risk is measured by the sizeof the bid/ask spread. Similar to other newproducts, credit derivatives may have higherbid/ask spreads because transaction liquidity issomewhat limited. Banks that are buying creditderivatives should know that their shallow mar-ket depth could make it hard to offset positionsbefore a credit derivative’s contract expires.Accordingly, banks that are selling creditderivatives must evaluate the liquidity risks ofcredit derivatives and assess whether someform of reserves, such as close-out reserves, isneeded.

Banks that use credit derivatives shouldinclude the cash-flow impact of credit deriva-tives into their regular liquidity planning andmonitoring systems. Banks should also includeall significant sources and uses of cash andcollateral related to their credit derivative activ-ity into their cash-flow projections. Lastly, thecontingency funding plans of banks should assessthe effect of any early-termination agreementsor collateral or margin arrangements, along withany particular issues related to specific creditderivative transactions.

Legal Risk

Because credit derivatives are new products thathave not yet been tested from a legal point ofview, many questions remain unanswered. At aminimum, banks should ensure that they andtheir counterparties have the legal and regula-tory authority to participate in credit derivativetransactions before committing to any contrac-tual obligations. Moreover, banks should ensurethat any transactions they enter into are inagreement with all relevant laws governing theiractivities.

ISDA published 2003 Credit DerivatiesDefinitions that reflect the growth in the creditderivatives market. The 2003 Definitions amend,among other things, various credit eventsand provide alternatives for restructuring. Banksshould have their legal counsel review allcredit derivative contracts to confirm thatthey are legally sound and that all terms,conditions, and contingencies are clearlyaddressed.



EXAMINER GUIDANCE

When reviewing credit derivatives, examinersshould consider the credit risk of the referenceasset as the primary risk. A bank that providescredit protection through a credit derivative canbecome as exposed to the credit risk of thereference asset as it would if the asset were onits own balance sheet. Thus, for supervisorypurposes, the exposure typically should betreated as if it were a letter of credit or otheroff-balance-sheet guarantee. For example, thistype of treatment would apply for determiningan institution’s overall credit exposure to aborrower when evaluating its concentrations ofcredit.

In addition, examiners should perform thefollowing procedures.

• Review SR-96-17.• Note the bank’s credit derivative activities and

ascertain (1) the level of credit derivativeactivity, (2) the types of counterparties, (3) thetypical underlying reference assets, (4) thestructures and maturities of the transactions,(5) why management is using these instru-ments, and (6) whether the bank’s creditexposure is being increased or reduced.

• Evaluate whether the bank subjects its creditderivatives activities to a thorough, multi-functional new-product review and determineif senior management is aware of and approvesthe activities undertaken.

• Ensure that credit derivatives are reportedcorrectly for regulatory purposes. Examinersshould determine that any transfer risk receivedor passed on in a credit derivative structure iscaptured in the bank’s regulatory transfer-riskreports.

• Ensure that the bank maintains documentationfor its accounting policies for credit deriva-tives. Determine whether the bank has con-sulted with outside accountants when devel-oping these policies and procedures. Assessthe bank’s mark-to-market, profit recognition,and hedge accounting practices.

• Review management’s strategy for using creditderivatives, assess the impact of these deriva-tives on the bank’s risk profile, and ensure thatadequate internal controls have been estab-lished for the conduct of all trading andend-user activities in credit derivatives.

• Review risk-management practices to ensurethat bank systems capture all credit exposures

and that trading desks report these exposures,including counterparty and reference-assetexposures from credit derivatives, to seniormanagement.

• Ensure that risk-management reports are com-pleted on a timely basis and are disseminatedto the appropriate personnel.

• Assess the bank’s treatment of credit deriva-tives for purposes of legal lending limits.(That is, when should the bank use creditderivatives to lower borrower concentrationsand which type of credit derivative should thebank use?) Ensure that the bank is in compli-ance with all regulatory lending limits.

• Review the bank’s asset-quality and loan-lossreserve policies for credit derivatives and anyreference assets owned. Ensure that assetsprotected by credit derivatives that are non-performing are recognized in internal creditreports. Assess how the bank’s loan-lossreserves are affected by the use of creditderivatives. Ensure that the bank’s classifica-tion system is reasonable given the types ofcredit derivatives structures used, the degreeto which credit risk is transferred, and thecreditworthiness of its credit derivativecounterparties.

• Procure and review relevant marketing mate-rials and policies on sales practices. Dealersshould assess the financial character andsophistication of all counterparties. Since creditderivatives are new and complex instruments,dealers should provide end-users with suffi-cient information to enable them to under-stand the risks associated with particular creditderivative structures.


The accounting treatment for certain creditderivatives is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


The appropriate risk-based capital treatment for



credit derivative transactions is discussed inSR-96-17. The appropriate treatment for creditderivatives under the market-risk capital amend-ment to the Basel Accord is not finalized as ofthis writing. As a general rule, SR-96-17 pro-vides the appropriate capital treatment for creditderivatives that are carried in the banking bookand for institutions that are not subject to themarket-risk rules.

Under SR-96-17, credit derivatives generallyare to be treated as off-balance-sheet direct-credit substitutes. The notional amount of thecontract should be converted at 100 percent todetermine the credit equivalent amount to beincluded in risk-weighted assets of the guaran-tor.2 A banking organization providing a guar-antee through a credit derivative transactionshould assign its credit exposure to the riskcategory appropriate to the obligor of the refer-ence asset or any collateral. On the other hand,a banking organization that owns the referenceasset upon which credit protection has beenacquired through a credit derivative may, undercertain circumstances, assign the unamortizedportion of the reference asset to the risk categoryappropriate to the guarantor, for example, the20 percent risk category if the guarantor is abank or the 100 percent risk category if theguarantor is a bank holding company.

Whether the credit derivative is considered aneligible guarantee for purposes of risk-basedcapital depends on the degree of credit protec-tion actually provided. As explained earlier, theamount of credit protection actually provided bya credit derivative may be limited depending onthe terms of the arrangement. For example, arelatively restrictive definition of a default eventor a materiality threshold that requires a com-parably high percentage of loss to occur beforethe guarantor is obliged to pay could effectivelylimit the amount of credit risk actually trans-ferred in the transaction. If the terms of thecredit derivative arrangement significantly limitthe degree of risk transference, then the benefi-ciary bank cannot reduce the risk weight of the‘‘protected’’ asset to that of the guarantor bank.On the other hand, even if the transfer of creditrisk is limited, a banking organization providing

limited credit protection through a credit deriva-tive should hold appropriate capital against thereference exposure while the organization isexposed to the credit risk of the reference asset.See section 3020.1, ‘‘Securitization andSecondary-Market Credit Activities.’’

Banking organizations providing a guaranteethrough a credit derivative may mitigate thecredit risk associated with the transaction byentering into an offsetting credit derivative withanother counterparty, a so-called back-to-backposition. Organizations that have entered intosuch a position may treat the first credit deriva-tive as guaranteed by the offsetting transactionfor risk-based capital purposes. Accordingly, thenotional amount of the first credit derivativemay be assigned to the risk category appropriateto the counterparty providing credit protectionthrough the offsetting credit derivative arrange-ment (for example, to the 20 percent risk cate-gory if the counterparty is an OECD bank).

In some instances, the reference asset in thecredit derivative transaction may not be identi-cal to the underlying asset for which the bene-ficiary has acquired credit protection. For exam-ple, a credit derivative used to offset the creditexposure of a loan to a corporate customer mayuse a publicly traded corporate bond of thecustomer as the reference asset; the credit qual-ity of the bond serves as a proxy for theon-balance-sheet loan. In such a case, the under-lying asset will still generally be consideredguaranteed for capital purposes as long as boththe underlying asset and the reference asset areobligations of the same legal entity and have thesame level of seniority in bankruptcy. In addi-tion, banking organizations offsetting creditexposure in this manner would be obligated todemonstrate to examiners that (1) there is a highdegree of correlation between the two instru-ments; (2) the reference instrument is a reason-able and sufficiently liquid proxy for the under-lying asset so that the instruments can bereasonably expected to behave similarly in theevent of default; and (3) at a minimum, thereference asset and underlying asset are subjectto mutual cross-default provisions. A bankingorganization that uses a credit derivative, whichis based on a reference asset that differs from theprotected underlying asset, must document thecredit derivative being used to offset credit riskand must link it directly to the asset or assetswhose credit risk the transaction is designed tooffset. The documentation and the effectivenessof the credit derivative transaction are subject to

2. Guarantor banks that have made cash payments repre-senting depreciation on reference assets may deduct suchpayments from the notional amount when computing credit-equivalent amounts for capital purposes. For example, if aguarantor bank makes a depreciation payment of $10 on a$100 notional total-rate-of-return swap, the credit-equivalentamount would be $90.



examiner review. Banking organizations thatprovide credit protection through such arrange-ments must hold capital against the risk expo-sures that are assumed.


While examiners have not seen credit derivativetransactions involving two or more legal entitieswithin the same banking organization, the pos-sibility of such transactions exists. Transactionsbetween or involving affiliates raise importantsupervisory issues, especially whether sucharrangements are effective guarantees of affiliateobligations or are transfers of assets and their

related credit exposure between affiliates. There-fore, banking organizations should considercarefully the existing supervisory guidance oninteraffiliate transactions before entering intocredit derivative arrangements involving affili-ates, especially when substantially the sameobjectives could be achieved using traditionalguarantee instruments.

Legal lending limits are established by indi-vidual states for state-chartered banks and by theOffice of the Comptroller of the Currency (OCC)for national banks. Therefore, the determinationof whether credit derivatives are guarantees tobe included in the legal lending limits are thepurview of the state banking regulators and theOCC.



Collateralized Loan ObligationsSection 4353.1

GENERAL DESCRIPTION

Collateralized loan obligations (CLOs) aresecuritizations of large portfolios of secured orunsecured corporate loans made to commercialand industrial customers of one or more lendingbanks. CLOs offer banking institutions a meansof achieving a broad range of financial objec-tives, including, but not limited to, the reductionof credit risk and regulatory capital require-ments, access to an efficient funding source forlending or other activities, increased liquidity,and increased returns on assets and equity.Furthermore, institutions are able to realizethese benefits without disrupting customer rela-tionships. CLO structures generally fall into twocategories: cash-flow structures and market-value structures. Cash-flow structures are trans-actions in which the repayment and ratings ofthe CLO debt securities depend on the cash flowfrom the underlying loans. Market-value struc-tures are distinct from cash-flow structures inthat credit enhancement is achieved throughspecific overcollateralization levels assigned toeach underlying asset. Most bank CLOs havebeen structured as cash-flow transactions.

To date, most bank-sponsored CLOs havebeen very large transactions—typically rangingfrom $1 billion to $6 billion—undertaken bylarge, internationally active banking institutions.However, as the CLO market evolves and therelative costs decline, progressively smallertransactions may become feasible, and the uni-verse of banks that can profitably use the CLOstructure will increase significantly.


In a CLO transaction, loans are sold, partici-pated, or assigned into a trust or other bankruptcy-remote special-purpose vehicle (SPV), which,in turn, issues asset-backed securities consistingof one or more classes, or tranches. Alterna-tively, a CLO may be synthetically createdthrough the use of credit derivatives, for exam-ple, default swaps or credit-linked notes, that areused to transfer the credit risk of the loans intothe trust or SPV and, ultimately, into the capitalmarkets.

Typically, the asset-backed securities issuedby the trust or SPV consist of one or moreclasses of rated debt securities, one or moreunrated classes of debt securities that are gener-ally treated as equity interests, and a residualequity interest. These tranches generally havedifferent rates of interest and projected weightedaverage lives to appeal to different types ofinvestors. They may also have different creditratings. It is common for the bank to retain asubordinated or equity interest in the securitizedassets to provide the senior noteholders withadditional credit enhancement. This provision ofcredit support by the sponsoring bank triggersregulatory ‘‘low-level recourse’’ capital treatment.

Conceptually, the underlying assets collater-alizing the CLO’s debt securities consist ofwhole commercial loans. In reality, the under-lying assets frequently consist of a more diversemix of assets which may include participationinterests, structured notes, revolving creditfacilities, trust certificates, letters of credit, andguarantee facilities, as well as synthetic forms ofcredit.

One or more forms of credit enhancement arealmost always necessary in a CLO structure toobtain the desired credit ratings for the mosthighly rated debt securities issued by the CLO.The types of credit enhancements used by CLOsare essentially the same as those used in otherasset-backed securities structures—‘‘internal’’credit enhancement provided by the underlyingassets themselves (such as subordination, excessspread, and cash collateral accounts) and‘‘external’’ credit enhancement provided by thirdparties (principally financial guaranty insuranceissued by monoline insurers). In the past, mostbank CLOs have relied on internal creditenhancement.

Figure 1—Collateralized LoanObligation

Transferor/Bank

SPV(Trust or

Corporation)

LoanPortfolio

Money Market

Senior

Mezzanine

Subordinated

Equity

Trading and Capital-Markets Activities Manual March 1999Page 1

Bank CLOs can be further divided into linkedand de-linked structures. In a linked structure,the sponsoring bank provides some degree ofimplicit or explicit credit support to the transac-tion as a means of improving the credit rating ofsome or all of the tranches. While such creditlinkage may improve the pricing of a transac-tion, the bank’s provision of credit support mayconstitute recourse for risk-based capital pur-poses, thus increasing the capital cost of thetransaction. In contrast, the CLO issuer in ade-linked structure relies entirely on the under-lying loan assets and any third-party creditenhancement for the credit ratings of the debtsecurities.

CLO transactions are evolving into highlycustomized and complex structures. Some trans-actions that may appear similar on the surfacediffer greatly in the degree to which credit riskhas been transferred from the bank to the inves-tor. In some cases, the actual transference ofcredit risk may be so limited that the securitiza-tion meets the regulatory definition of ‘‘assetsales with recourse,’’ thus requiring the bank tohold capital against the securitized assets.

TYPES

CLOs Using the Master TrustStructure

CLOs are complex transactions that typicallyuse a master trust structure. Historically, themaster trust has been used for revolving, short-term assets such as credit card receivables. Thisformat affords the issuer a great deal of flexibil-ity in structuring notes with different repaymentterms and characteristics, and provides for theongoing ability to transfer assets and offer mul-tiple series, which allows for greater diversifi-cation and minimized transaction costs. Conse-quently, securitizations through a master truststructure are often assigned series numbers, suchas 1998-1, 1998-2, etc., to identify each specificsecuritization. These transactions may have manyinterrelated components that make them particu-larly difficult to analyze.

CLO master trust applications need to becarefully designed. In contrast to typical mastertrust assets such as credit card receivables,corporate loan portfolios are less diversified,cash flows are not as smooth, and lower yields

generate less excess spread. The CLOmaster trust also needs to be structured tomitigate the resulting mismatches between thematurities of heterogeneous collateral assets andliabilities, and to pay all series by their statedmaturities.

The master trust structure can be contrastedwith other types of trusts, such as the grantor’sand owner’s trusts, that restrict the types ofasset-backed securities that can be issued orhave other limitations. The simplest trust formrequires the straight pass-through of the cashflows from trust assets to investors without anyrestructuring of those cash flows.

A distinguishing feature of CLOs using themaster trust structure is the transferor’s (seller’s)interest, which represents the selling bank’srequired retained interest in the assets trans-ferred to the master trust. One purpose of thetransferor’s interest in credit card securitizationsis to ensure that the principal balance of assets inthe trust is more than sufficient to match theprincipal balance of notes that have been issuedto investors. In addition, the transferor’s interestis essentially a ‘‘shock absorber’’ for fluctua-tions in principal balances due to addi-tional draws under credit facilities and principalpaydowns, whether scheduled or not. In defini-tional terms, the transferor’s interest is equalto the total trust assets less the investors’ inter-est, or that portion of the pool allocated tobacking the notes issued to investors. The issu-ing bank is usually required to maintain itstransferor’s interest at a predetermined percent-age of the overall trust size, usually 3 to 6 per-cent in a CLO transaction. As such, the transf-eror’s interest within the master trust frameworkis on an equal footing with the investors’interest.

However, the use of a master trust structureand the creation of a transferor’s interest in aCLO transaction may create some unique prob-lems. The very existence of the two interests(transferor’s and investors’), the nonhomogene-ity of the loans being securitized, and thecomparatively concentrated nature of commer-cial loan portfolios suggest that the distributionof those loans between the two interests must bereviewed and monitored carefully. It is critical tounderstand the basis for the distribution ofcredits between the two interests and the condi-tions under which this distribution may changeover the life of the securitization in order todetermine whether the transaction containsembedded recourse to the bank.

4353.1 Collateralized Loan Obligations

March 1999 Trading and Capital-Markets Activities ManualPage 2

Common Features of CLO Master-TrustStructures

In order for issuers of CLOs to attract institu-tional investors, for example, insurance compa-nies and pension funds, the securities beingissued are often rated. Rating agencies considerthe credit quality and performance history of thesecuritized loan portfolio in determining thecredit rating to be assigned, as well as thestructure of the transaction and any creditenhancements supporting the transaction.

In CLO transactions, the three most commonforms of credit enhancement are (1) subordina-tion, (2) the funding of a cash-collateral account,and (3) the availability of any excess spread onthe transaction to fund investor losses. Subordi-nation refers to securitization transactions thatissue securities of different seniority, that is,senior noteholders are paid before subordinatednoteholders. It is common for the issuing bankto retain the most junior tranche of the investornotes. This interest is included in the investors’interest. It is distinct from the transferor’s inter-est and is held on the transferor’s balance sheetas an asset. Thus, third-party investors gainassurance that the bank will maintain the creditquality of the loans when the bank retains thefirst-loss exposure in the investor interest.

In addition to retaining the most junior trancheof investor notes, the bank may fund a cash-collateral account. The cash-collateral accountfunctions as another layer of credit protectionfor the investors’ interest. If there is a shortfallin loan collections in any period that preventsasset-backed noteholders from being paid, thecash collateral account may be drawn down.

Finally, the yield of the loans placed in thetrust often exceeds the total coupon interest

payments due investors on the asset-backednotes issued. The residual yield is called excessspread and is usually available to fund investorlosses.1

Synthetic CLO Securitizations

Recent innovations in securitization design haveresulted in a class of synthetic securitization thatinvolves different risk characteristics than thestandard CLOs described above. One type ofsynthetic securitization uses credit derivatives totransfer a loss potential in a designated portfolioof credit exposures to the capital markets. Theintent of the transaction is to transfer credit riskon a specific reference portfolio of assets to thecapital markets and to achieve a capital chargeon the reference portfolio that is significantlylower than 8 percent.

In the example in figure 3, the bankingorganization identifies a specific portfolio ofcredit exposures, which may include loan com-mitments, and then purchases default protectionfrom a special-purpose vehicle. In this case, the

1. Note that any loss position that a bank retains in its ownsecuritization is subject to low-level-recourse capital treat-ment. A loss position would include retention of the mostjunior investor notes, the cash-collateral account, and excessspread, if recorded as an asset on the bank’s balance sheet.(See Statement of Financial Accounting Standards No. 140(FAS 140), ‘‘Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,’’ formore information on the sale of assets and the recording ofresulting assets and liabilities on the balance sheet.)

Figure 2—CLO Master-TrustStructure

Transferor’s Investors’ InterestPriorityInterest

Money Market

SeniorMezzanine

Subordinated

Equity

Cash-Collateral Account

Excess Spread

Reflects exposure typically retained by issuing bank.

Figure 3—Synthetic CLOSecuritization

Issuing Bank

Credit Portfolio

Fees

DefaultProtection

SPV Conduit

PledgedTreasuries

CashProceeds Notes

Investors

Aaa NotesBa2 Notes

Collateralized Loan Obligations 4353.1

Trading and Capital-Markets Activities Manual September 2001Page 3

credit risk on the identified reference portfolio istransferred to the SPV through the use of credit-default swaps. In exchange for the credit pro-tection, the institution pays the SPV an annualfee.

To support its guarantee, the SPV sells credit-linked notes (CLNs) to investors and uses thecash consideration to purchase Treasury notesthat are then pledged to the banking organiza-tion to cover any default losses.2 CLNs areobligations whose principal repayment is condi-tioned upon the default or nondefault of areferenced asset. The CLNs may consist of morethan one tranche, for example, Aaa-rated seniornotes and Ba2-rated subordinated notes, and areissued in an amount that is sufficient to coversome multiple of expected losses—typically,about 7 percent of the notional amount of thereference portfolio.

There may be several levels of loss in asynthetic securitization. The first-loss positionmay be a small cash reserve that accumulatesover a period of years and is funded from theexcess of the SPV’s income (that is, the yield onthe Treasury securities plus the fee for thecredit-default swap) over the interest paid toinvestors on the notes. The investors in the SPVassume a second-loss position through theirinvestment in the SPV’s notes. Finally, thebanking organization retains the risks associatedwith any credit losses in the reference portfoliothat exceed the first- and second-loss positions.

In figure 3, default swaps on each of theobligors in the reference portfolio are executedand structured to pay the average default losseson all senior, unsecured obligations of defaultedborrowers. Typically, no payments are madeuntil maturity, regardless of when a referenceobligor defaults. A variation of this structureuses CLNs to transfer the credit risk from thetransferring bank to the SPV instead of usingcredit-default swaps as in the above structure. Inturn, the SPV issues a series of floating-ratenotes (‘‘notes’’) in several tranches to investors.The notes are then collateralized by a pool ofCLNs, with each CLN representing one obligorand its credit-risk exposure (such as bonds,loans, or counterparty exposure). Thus, the dol-lar amount of notes issued to investors equalsthe notional amount of the reference portfolio.

The institution has the option to call any of theCLNs before maturity so long as they arereplaced by CLNs that meet individual obligorand portfolio limits. These limits include con-centration limits, maturity limits, and credit-quality standards that must be met to maintainthe credit ratings of the notes. If the CLNs nolonger meet collateral guidelines, there are early-amortization provisions that will cause the trans-action to wind down early.

If any obligor linked to a CLN in the SPVdefaults, the institution will call the note andredeem it based either on the post-default mar-ket value of the reference security of thedefaulted obligor or on a fixed percentage of parthat reflects the average historical recovery ratefor senior unsecured debt. The fixed percentagemethod is used when the linked obligor has nopublicly traded debt. Finally, the term of eachCLN is set such that the credit exposure towhich it is linked matures before the CLN,ensuring that the CLN will be in place for thefull term of the exposure to which it is linked.

Synthetic CLO structures differ from manytraditional CLO structures in two significantways:

1. In most CLO structures, assets are actuallytransferred into the SPV. In the syntheticsecuritizations, the underlying exposures thatmake up the reference portfolio remain onthe institution’s balance sheet. The credit riskis transferred into the SPV through credit-default swaps or CLNs. In this way, theinstitution is able to avoid sensitive clientrelationship issues arising from loan-transfernotification requirements, loan-assignmentprovisions, and loan-participation restric-tions. Client confidentiality may also be main-tained. The CLN-backed synthetic CLO alsosimplifies the legal work involved by avoid-ing the transfer of collateral and the creationor perfection of a security interest in anythingother than the CLN.

2. In many CLO structures, the opportunity toremove credit risk from—or add credit riskto—the underlying collateral pool is severelylimited. In the CLN-backed CLO, the insti-tution may actively manage the pool ofCLNs, thereby managing the credit risk ofthe linked exposures on an ongoing basis. Inthis way, the structure can be used to free upcredit lines for core clients with whom theinstitution would like to conduct morebusiness.

2. The names of corporate obligors included in the refer-ence portfolio may be disclosed to investors in the CLNs.


September 2001 Trading and Capital-Markets Activities ManualPage 4

RISK-TRANSFERENCE ISSUES

Reallocation of Cash Flows

One of the provisions commonly associatedwith complex CLOs is the provision for thereallocation of cash flows under certain circum-stances. Cash-flow reallocation may take a num-ber of forms, but is usually provided to ensurethat senior noteholders get paid before juniornoteholders. For example, if loan collections areinsufficient to fund the payments of the seniornotes of a CLO and other credit enhancementshave been exhausted, or the securitization hasentered an amortization phase, the servicer maybe required to redirect payments from juniornoteholders to senior noteholders. In some struc-tures, principal payments on loans that areoriginally allocated to paying down the principalbalance of the junior notes may be reallocated tothe payment of current (or delinquent) intereston senior notes. This recharacterization of prin-cipal to interest may be a source of recourse ifinvestor note balances are not reduced for theprincipal payment, due to the fact that a loanunderlying the investor interest has paid off andis no longer available to support outstandinginvestor principal balances. Therefore, the bankwill be required to provide new loans to back theinvestors’ interest, either from the transferor’sinterest or from its own balance sheet.

Another distinguishing feature of CLOs thatuse the master trust structure is the revolvingperiod. During the revolving period of a CLO,the investor notes are only paid interest, that is,the notes have not yet entered the amortizationphase.3 However, some of the underlying loanbalances are actually being repaid during thistime. During the revolving period, such repay-ments are automatically reinvested in new loansto maintain the principal balance of loans back-ing the investor notes. In some securitizations,this allocation of cash flows may be interrupted.Specifically, under certain conditions, such as adeteriorating collection rate, a collateral defi-ciency, or noncompliance with rating-agency

guidelines, principal repayments on loans maybe withheld from the transferor during therevolving period. Thereafter, if the deficienciesremain uncorrected, the funds thus withheldmay be available to pay down investor notes.Examiners need to carefully review the condi-tions under which cash flows are reallocated andcircumstances under which normal flows areinterrupted to determine the overall impact onthe credit-risk transference achieved in CLOs.

Early Amortization

A standard feature of CLO securitizations is aprovision for early amortization. Early amorti-zation provisions are designed to protect note-holders in the event the loans in the trustexperience significant difficulty, diminishing theprospects for repayment of investor notes. Whenan early amortization event occurs (for example,defaults in the loan pool reach a certain prede-termined level), collections on the underlyingloans are reallocated so that investors are paidoff at an accelerated rate. Typically, cash flowsare allocated based on the proportional share ofthe trust that the transferor and investor interestsrepresent when the early amortization eventoccurs. The allocation percentage thereafterremains fixed. This mechanism works to favorthe investor interest, as additional drawdownson facilities in the trust cause the transferorinterest to increase (that is, additional lendingunder existing lines participated into the trust isassigned to the transferor’s interest). Therefore,the size of the transferor interest grows rapidlyrelative to the size of the investor interest, butcash flow from the entire pool of trust assetscontinues to be allocated based on the fixedpercentage that was determined when the earlyamortization event occurred. For example,assume the current allocation based on therelative size of investors’ and transferor’s inter-est is 80 percent and 20 percent, respectively. Ifearly amortization were triggered, this percent-age would be used to allocate all future principalcollections, regardless of the actual relative sizeof the transferor and investor interests at anyfuture date. While the existence of early amor-tization provisions has not been treated asrecourse for regulatory purposes, early amorti-zation is viewed in the marketplace as a form ofcredit enhancement. Credit-rating agencies indi-

3. Investor notes may either mature at a point in time ormay amortize over a specific period, usually one year. In eithercase, principal payments on the underlying loans may begin toaccumulate a few months before maturity or the commence-ment of an amortization period in order to provide additionalassurance that contractual principal payments can be made.



cate that such provisions can reduce the amountof credit enhancements or recourse needed tosecure a given rating by more than half.

While early amortization provisions alonehave not been deemed recourse to the bank, theyhave been recognized as creating conditions thatmight result in the transferring bank’s retaininga degree of credit risk.4 When a securitizationtriggers an early amortization event, the bankhas two choices. It can allow the early amorti-zation to proceed, causing the securitization tounwind. If a bank were to allow an earlyamortization to occur, its access to the asset-backed market in the future could becomeimpaired and more expensive. Alternatively, thebank may choose to voluntarily correct thedeficiency leading to the early amortizationcondition. Banks may be willing to support theirsecuritizations, notwithstanding any legal obli-gation to do so, to preserve their name in themarketplace. However, such actions may haveregulatory capital implications.

Other Issues

In some CLO transactions, it may be unclearwhether a significant portion of underlying creditrisk has been passed along to investors in theasset-backed securities. Assume that a $4 billionCLO has been completed in which the averageunderlying loan is rated BB. Further, assumethat interests in these loans were segregated intoa traditional CLO structure (see figure 4). In thiscase, the underlying loan pool has been trans-

formed into interests in the securitization vehi-cle (trust or other SPV), and all of the securitiesissued to investors are rated equal to—or higherthan—the average rating of the loans in the pool.The only other interests in the pool are retainedby the issuing bank, that is, the subordinatedpiece of the investor interest and the transferor’sinterest. These interests are typically unrated.However, since the investor securities are allrated above the average loan rating of the loanpool, one could reasonably presume that theimplicit credit rating of the bank’s retainedinterests are lower than average. Further, sincethe dollar volume of the bank’s retained interestis usually much smaller than the investors’interest, one might reasonably conclude that theimplicit credit rating of these interests is muchlower than the investor interest. In such cases, itis not clear whether the investors have assumeda meaningful portion of the credit risk of theunderlying loans. Hence, the issue is not recoursein the traditional sense, but whether significanttransference of risk has occurred in the firstplace.

In some situations, certain trust covenantsmay function as credit support, leading torecourse to the securitizing bank. For example,the trust may require the bank to maintain theaverage credit rating of the loans in the trust.This may be accomplished by a requirement toremove deteriorating loans from the trust andreplace them with higher-quality loans. Alterna-tively, the deteriorating loans may be ‘‘reallo-cated’’ to the transferor’s interest, with the bankproviding new loans of higher quality to thetrust to back the investors’ interest. In eithercase, the potential for recourse to the issuingbank is significant.5

To obtain a favorable credit rating, covenantsmay place limitations on the amount of creditextended to a particular industry as well as onthe maximum exposure to any particular obli-gor. For example, rating agencies may requirethat total credit exposure to any particular indus-try not exceed 5 percent of the trust in order forthe notes issued to achieve a particular rating.Any exposures over the limit may be assigned to

4. See SR-97-21, ‘‘Risk Management and Capital Adequacyof Exposures Arising from Secondary Market Credit Activi-ties,’’ July 11, 1997.

5. One factor in determining whether transactions includerecourse is the sharing of loss that occurs when deterioratingassets are sold from the trust. If the loss is shared proportion-ately between investor and transferor interests, it is less likelythat the transaction will be deemed to have recourse to thebank.

Figure 4—Distribution of RisksPriority

Inv Se hs at ro er

’s

B Sa hn ak r

’s eTrust Certificates Asset Pool

Rating Characteristics Rating Characteristics

AAAA TrancheRated AAAB TrancheRated AA/AC TrancheRated BBBD TrancheRated BBE TrancheUnrated

Transferor’s InterestUnrated

Loan Portfolio

Average Rating:BB

CCC



the transferor’s interest as an ‘‘overconcentra-tion’’ amount. Because revolving credit facili-ties vary in size over time and their balancestend to be large, industry overconcentrationappears to be common in these structures. Theend result is that the investors’ interest remainswell diversified at all times, while the transfer-or’s interest absorbs all overconcentrationamounts. In this case, the risk of the transferor’sinterest and the investors’ interest is not thesame. However, such industry concentrationlimits by themselves generally will not result ina determination that the bank is providingrecourse to the trust.

Similarly, trust documents may limit theexposure of any particular obligor in the trust.Obligor concentration limits may become prob-lematic when the limit assigned is a function ofthe credit rating of the obligor. When a credit inthe trust is downgraded below a defined thresh-old level, the ‘‘excess’’ exposure to the obligormay either be removed from the trust by theissuing bank or may be assigned to an over-concentration amount within the transferor’sinterest. In this case, it is not only possible thatthe transferor is absorbing credit exposures thatexceed industry concentration limits (as describedabove), but it may also absorb exposures tocredits that are deteriorating. If these require-ments function in a manner that tends to reallo-cate deteriorating credits to the transferor’s inter-est before default, the transaction may meet theregulatory definition of asset sales withrecourse.

In addition to the common structural featuresdescribed above, there may be other conditionsunder which loan balances may be reallocatedbetween transferor and investor interests. Fur-ther, unique contractual requirements may specifyhow losses will be shared between the twointerests in the event of default (or some otherdefined credit event). Through these contractualprovisions, the bank may continue to havesignificant or contingent exposure to the securi-tized assets.

In summary, while examiners may be able tohighlight recourse issues, it is not always clearwhere the lines should be drawn, as the mecha-nisms involved in these transactions are notalways transparent. The issue is further compli-cated by the fact that banking organizationsoutside the United States are engaging in thesetransactions, and the treatment applied by for-eign bank supervisory authorities may not par-allel U.S. supervisory treatment.

USES

Banks have used CLOs to achieve a number ofdifferent financial objectives, including theimportant goal of maximizing the efficient useof their economic capital in the context of thecurrent regulatory capital rules. Considering thesmall margins on commercial loans relative toother banking assets, the high risk-based capitalrequirement of these loans, especially those ofinvestment-grade quality, makes holding them aless profitable or efficient use of capital for somebanks. Using a CLO to securitize and sell aportfolio of commercial loans can free up asignificant amount of capital that can be usedmore profitably for other purposes, such asholding higher-yielding assets, holding lowerrisk-weighted assets, making acquisitions, pay-ing dividends, and repurchasing stock. As aresult, this redeployment of capital can have theeffect of reducing capital requirements, and/orimproving return on equity and return on assets.

Issuers also obtain other advantages by usingCLOs and synthetic securitizations, includingaccessing more favorable capital-market fund-ing rates and, in some cases, transferring creditrisk; increasing institutional liquidity; monetiz-ing gains in loan value; generating fee incomeby providing services to the SPV; and eliminat-ing a potential source of interest-rate risk. Inaddition, CLOs can be used for balance-sheetmanagement and credit-risk hedging, that is,securitizations enable the sponsor to transferassets with certain credit-quality, spread, andliquidity characteristics from the balance sheetwhile preserving relationships with borrowers.In this manner, the bank can reduce its exposureto risk concentrations.

From the viewpoint of investors, CLO spreadsare attractive compared with those of other,more commoditized asset classes and can offerportfolio-diversification benefits. The varioustranches represent a significant arbitrage oppor-tunity to yield- seeking investors, and investment-grade CLOs can provide a spread premium toinvestors who are limited by regulatory or invest-ment restrictions from directly purchasing indi-vidual non-investment-grade securities. In addi-tion, the performance history of CLOs has so farbeen favorable—an important factor in attract-ing investors, especially in the lower, supportingmezzanine or equity tranches in a CLO capitalstructure. These subordinated investors demanda premium return that is commensurate with thehigher risk they bear.




The primary buyers for CLO securities havebeen insurance companies and pension fundsseeking attractive returns with high credit qual-ity. To date, banking organizations typicallyhave not been not active buyers of these secu-rities. The secondary market is less fully devel-oped and less active than the market for moretraditional types of asset-backed securities. How-ever, as the market grows and expands globallyto spread-seeking investors, CLO securities arebecoming more liquid.

Market transparency can be less than perfect,especially when banks and other issuers retainmost of the economic risk despite the securiti-zation transaction. In addition, the early amorti-zation features of some CLO transactions maynot be fully understood by potential buyers.

PRICING

Securities issued in CLOs and synthetic securi-tizations carry coupons that can be fixed (gen-erally yielding between 50 and 300 basis pointsover the Treasury curve) or floating (for exam-ple, 15 basis points over one-month LIBOR).Pricing is typically designed to reflect the cou-pon characteristics of the loans being securi-tized. The spread will vary depending on thecredit quality of the underlying collateral, degreeand nature of the credit enhancement, and degreeof variability in the cash flows emanating fromthe securitized loans.

HEDGING

CLO issuers often use a variety of hedginginstruments, including interest-rate swaps, cur-rency swaps, and other derivatives, to hedgeagainst various types of risk. For example, if theunderlying assets are not denominated in U.S.dollars, currency risk may be hedged with swaps,caps, or other hedging mechanisms. Convertibil-ity risk is considered for certain currencies inwhich the sovereign may be likely to imposecurrency restrictions. In such cases, certain cur-rencies may not be permitted in the collateralpool regardless of the hedging mechanisms inplace. Hedging instruments may also be used to

address cash-flow mismatches between the pay-ment characteristics of the CLO debt obligationsand the underlying loans, such as differences infrequency of payments, payment dates, interest-rate indexes (basis risk), and interest-rate resetrisk.

RISKS

Credit risk in CLOs and synthetic securitizationsarises from (1) losses due to defaults by theborrowers in the underlying collateral and(2) the issuer’s or servicer’s failure to perform.These two elements can blur together, for exam-ple, a servicer who does not provide adequatecredit-review scrutiny of the serviced portfolio,leading to a higher incidence of defaults. CLOsand synthetic securitizations are rated by majorratings agencies.

Market risk arises from the cash-flow charac-teristics of the security. The greatest variabilityin cash flows comes from credit performance,including the presence of wind-down or accel-eration features designed to protect the investorin the event that credit losses in the portfolio risewell above expected levels. For certain dynamicCLO structures that allow for active manage-ment, adequate disclosure should be maderegarding a manager’s ability to sell assets thatmay have appreciated or depreciated in value.This trading flexibility represents an additionallevel of risk to investors because an investor isexposed to the collateral manager’s decisions.As a result, there may be a greater risk in CLOs(versus, for example, credit card securitizations)that its rating can change over time as thecomposition of the asset pool deteriorates.

Interest-rate risk arises for the issuer from therelationship between the pricing terms on theunderlying loans and the terms of the rate paidto noteholders, as well as from the need to markto market the excess servicing or spread-accountproceeds carried on the balance sheet. For theholder of the security, interest-rate risk dependson the expected life or repricing of the security,with relatively minor risk arising from embed-ded options. The notable exception is the valu-ation of the wind-down option.

Liquidity risk can arise from credit deteriora-tion in the asset pool when early amortizationprovisions are triggered. In that situation, theseller’s interest is effectively subordinated to the



interests of the other investors by the payment-allocation formula applied during early amorti-zation. Other investors effectively get paid first,and the seller’s interest will therefore absorb adisproportionate share of losses. Also, closure ofthe securitization conduit can create liquidityproblems for the seller because the seller mustthen fund a steady stream of new receivables.When a conduit becomes unavailable due toearly amortization, the seller must either findanother buyer for the receivables or have receiv-ables accumulate on its balance sheet, creatingthe need for another source of funding. Inaddition, these factors can create an incentivefor the seller to provide implicit recourse—credit enhancement above and beyond any pre-existing contractual obligation—to prevent earlyamortization. Although incentives to provideimplicit recourse are present in other types ofsecuritizations to some extent, the early-amortization feature of CLOs creates additionaland more direct financial incentives to preventits occurrence because of concerns about dam-age to the seller’s reputation if one of itssecuritizations performs poorly.

Operational risk arises through the potentialfor misrepresentation of loan quality or terms bythe originating institution, misrepresentation ofthe nature and current value of the assets by theservicer, and inadequate controls over disburse-ments and receipts by the servicer.


Holder

The accounting treatment for investments inCLOs and synthetic securitizations is deter-mined by the Financial Accounting StandardsBoard’s Statement of Financial Accounting Stan-dards No. 115 (FAS 115), ‘‘Accounting forCertain Investments in Debt and Equity Securi-ties,’’ as amended by Statement of FinancialAccounting Standards No. 140 (FAS 140),‘‘Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabili-ties.’’ See section 2120.1, ‘‘Accounting,’’ forfurther discussion.

Seller

FAS 140 covers the accounting treatment for the

securitization of receivables. These standardsaddress (1) when a transaction qualifies as a salefor accounting purposes and (2) the treatment ofexcess spread and servicing assets arising from asecuritization transaction when a sale is deemedto have occurred.


The current capital treatment for the standardmaster-trust CLO described in this section hasthree components. First, banks use the low-level-recourse rule when calculating capital chargesagainst any first-loss exposures they retain. Thus,the most junior tranche would carry a dollar-for-dollar capital charge up to 8 percent of theinvestor interest. Second, banks receive transf-eror certificates for their investments in the trustthrough the transferor’s interest. As this repre-sents the bank’s proportional share in a largerpool of assets, 8 percent capital is held againstthe transferor’s interest. Finally, the loan facili-ties which the bank has assigned or participatedinto the trust typically are not fully drawn. Thebank maintains capital for its commitment tolend up to the limit of these facilities. If thetransferring bank that sponsors the CLO retainsa subordinated tranche that would provide creditprotection, then the low-level-recourse rulewould apply, that is, dollar-for-dollar capitalgenerally would be assessed on the retained riskexposure. This is also true if an interest-only receivable representing the future spread isbooked as a receivable on the transferring bank’sbalance sheet. If the sale of assets is accountedfor, in part or in its entirety, as a servicing assetunder FAS 140, then the capital charge takes theform of a tier 1 capital limitation. The currentcapital treatment limits the total amount ofmortgage- and nonmortgage-servicing assets thatcan be included in tier 1 capital to no more than100 percent. It further limits the amount ofnonmortgage-servicing assets that can be includedin tier 1 capital to no more than 25 percent.

Examiners should evaluate whether the trans-feror’s interest is of lower credit quality than theinvestors’ interest and, if so, determine whetherthe 8 percent capital charge against theon-balance-sheet amount is sufficient given theissuing institution’s risk exposure. If examinersdetermine that the transferor’s interest is effec-tively subordinated to the investors’ interest and



thus provides credit protection to the issuedsecurities, then the low-level-recourse treatmentmay be appropriate. SR-96-17, ‘‘SupervisoryGuidance for Credit Derivatives,’’ provides someguidance for the capital treatment of syntheticsecuritizations.

Synthetic CLOs can raise questions about theappropriate capital treatment when calculatingthe risk-based and leverage capital ratios. Capi-tal treatments for three synthetic transactionsfollow.

Transaction 1—Entire NotionalAmount of Reference Portfolio IsHedged

In the first type of synthetic securitization, thesponsoring banking organization, through a syn-thetic CLO, hedges the entire notional amountof a reference asset portfolio. An SPV acquiresthe credit risk on a reference portfolio by pur-chasing credit-linked notes (CLNs) issued bythe sponsoring banking organization. The SPVfunds the purchase of the CLNs by issuing aseries of notes in several tranches to third-partyinvestors. The investor notes are in effect col-lateralized by the CLNs. Each CLN representsone obligor and the banking organization’scredit-risk exposure to that obligor, which couldtake the form of bonds, commitments, loans,

and counterparty exposures. Since the notehold-ers are exposed to the full amount of credit riskassociated with the individual reference obli-gors, all of the credit risk of the referenceportfolio is shifted from the sponsoring bankingorganization to the capital markets. The dollaramount of notes issued to investors equals thenotional amount of the reference portfolio. Inthe example shown in figure 1, this amount is$1.5 billion.

If the obligor linked to a CLN in the SPVdefaults, the sponsoring banking organizationwill call the individual CLN and redeem it basedon the repayment terms specified in the noteagreement. The term of each CLN is set so thatthe credit exposure (to which it is linked)matures before the maturity of the CLN, whichensures that the CLN will be in place for the fullterm of the exposure to which it is linked.

An investor in the notes issued by the SPV isexposed to the risk of default of the underlyingreference assets, as well as to the risk that thesponsoring banking organization will not repayprincipal at the maturity of the notes. Because ofthe linkage between the credit quality of thesponsoring banking organization and the issuednotes, a downgrade of the sponsor’s credit ratingmost likely will result in the notes also beingdowngraded. Thus, a banking organizationinvesting in this type of synthetic CLO shouldassign the notes to the higher of the risk cate-

Figure 1—Transaction 1

Bank SPV

$1.5 billion Holds portfoliocredit portfolio of CLNs

$1.5 billion cashproceeds

$1.5 billionof CLNsissued by

bank

$1.5 billioncash proceeds

$1.5 billionof notes

X-year Y-yearnotes notes



gories appropriate to the underlying referenceassets or the issuing entity.

For purposes of risk-based capital, the spon-soring banking organizations may treat the cashproceeds from the sale of CLNs that provideprotection against underlying reference assets ascash collateralizing these assets.6 This treatmentwould permit the reference assets, if carried onthe sponsoring banking organization’s books, tobe assigned to the zero percent risk category tothe extent that their notional amount is fullycollateralized by cash. This treatment may beapplied even if the cash collateral is transferreddirectly into the general operating funds of thebanking organization and is not deposited in asegregated account. The synthetic CLO wouldnot confer any benefits to the sponsoring bank-ing organization for purposes of calculating itstier 1 leverage ratio, however, because the ref-erence assets remain on the organization’s bal-ance sheet.

Transaction 2—High-Quality, SeniorRisk Position in Reference PortfolioIs Retained

In the second type of synthetic CLO transaction,the sponsoring banking organization hedges aportion of the reference portfolio and retains ahigh-quality, senior risk position that absorbsonly those credit losses in excess of the junior-loss positions. For some noted synthetic CLOs,the sponsoring banking organization used acombination of credit-default swaps and CLNsto transfer to the capital markets the credit riskof a designated portfolio of the organization’scredit exposures. Such a transaction allowsthe sponsoring banking organization to allocateeconomic capital more efficiently and tosignificantly reduce its regulatory capitalrequirements.

In the structure illustrated in figure 2, thesponsoring banking organization purchases de-fault protection from an SPV for a specificallyidentified portfolio of banking-book credit ex-posures, which may include letters of credit andloan commitments. The credit risk on the iden-tified reference portfolio (which continues toremain in the sponsor’s banking book) is trans-ferred to the SPV through the use of credit-default swaps. In exchange for the credit pro-tection, the sponsoring banking organization

6. The CLNs should not contain terms that would signifi-cantly limit the credit protection provided against the under-lying reference assets, for example, a materiality thresholdthat requires a relatively high percentage of loss to occurbefore CLN payments are adversely affected, or a structuringof CLN post-default payments that does not adequately passthrough credit-related losses on the reference assets to inves-tors in the CLNs.


Bank

$5 billioncredit portfolio

Default payment andpledge of Treasuries

$5 billion of credit-default swapsand annual fee

SPV

Holds $400 millionof pledged Treasuries

$400 millionof CLNs

$400 millionof cash

Seniornotes

Juniornotes



pays the SPV an annual fee. The default swapson each of the obligors in the reference portfolioare structured to pay the average default losseson all senior unsecured obligations of defaultedborrowers. To support its guarantee, the SPVsells CLNs to investors and uses the cashproceeds to purchase U.S. government Treasurynotes. The SPV then pledges the Treasuries tothe sponsoring banking organization to coverany default losses.7 The CLNs are often issuedin multiple tranches of differing seniority and inan aggregate amount that is significantly lessthan the notional amount of the reference port-folio. The amount of notes issued typically is setat a level sufficient to cover some multiple ofexpected losses, but well below the notionalamount of the reference portfolio being hedged.

There may be several levels of loss in thistype of synthetic securitization. The first-lossposition may consist of a small cash reserve,sufficient to cover expected losses. The cashreserve accumulates over a period of years andis funded from the excess of the SPV’s income(that is, the yield on the Treasury securities plusthe credit-default-swap fee) over the interestpaid to investors on the notes. The investors inthe SPV assume a second-loss position throughtheir investment in the SPV’s senior and juniornotes, which tend to be rated AAA and BB,respectively. Finally, the sponsoring bankingorganization retains a high-quality, senior riskposition that would absorb any credit losses inthe reference portfolio that exceed the first- andsecond-loss positions.

Typically, no default payments are made untilthe maturity of the overall transaction, regard-less of when a reference obligor defaults. Whileoperationally important to the sponsoring bank-ing organization, this feature has the effect ofignoring the time value of money. Thus, theFederal Reserve expects that when the referenceobligor defaults under the terms of the creditderivative and when the reference asset fallssignificantly in value, the sponsoring bankingorganization should, in accordance with gener-ally accepted accounting principles, makeappropriate adjustments in its regulatory reportsto reflect the estimated loss that takes intoaccount the time value of money.

For risk-based capital purposes, the bankingorganizations investing in the notes must assignthem to the risk weight appropriate to the

underlying reference assets.8 The sponsoringbanking organization must include in its risk-weighted assets its retained senior exposure inthe reference portfolio, to the extent these under-lying assets are held in its banking book. Theportion of the reference portfolio that is collat-eralized by the pledged Treasury securities maybe assigned a zero percent risk weight. Unlessthe sponsoring banking organization meets thestringent minimum conditions for transaction 2as outlined in the subsection ‘‘Minimum Condi-tions’’ (below), the remainder of the portfolioshould be risk weighted according to the obligorof the exposures.

When the sponsoring banking organizationhas virtually eliminated its credit-risk exposureto the reference portfolio through the issuance ofCLNs, and when the other minimum require-ments are met, the sponsoring banking organi-zation may assign the uncollateralized portion ofits retained senior position in the referenceportfolio to the 20 percent risk weight. However,to the extent that the reference portfolio includesloans and other on-balance-sheet assets, thesponsoring banking organization would notrealize any benefits in the determination of itsleverage ratio.

In addition to the three stringent minimumconditions, the Federal Reserve may imposeother requirements as it deems necessary toensure that a sponsoring banking organizationhas virtually eliminated all of its credit expo-sure. Furthermore, the Federal Reserve retainsthe discretion to increase the risk-based capitalrequirement assessed against the retained seniorexposure in these structures if the underlyingasset pool deteriorates significantly.

Federal Reserve staff will make a case-by-case determination, based on a qualitative review,as to whether the senior retained portion of asponsoring banking organization’s syntheticsecuritization qualifies for the 20 percent riskweight. The sponsoring banking organizationmust be able to demonstrate that virtually all thecredit risk of the reference portfolio has beentransferred from the banking book to the capitalmarkets. As they do when banking organiza-tions are engaging in more traditional securiti-

7. The names of corporate obligors included in the refer-ence portfolio may be disclosed to investors in the CLNs.

8. Under this type of transaction, if a structure exposesinvesting banking organizations to the creditworthiness of asubstantive issuer, for example, the sponsoring banking orga-nization, then the investing banking organizations shouldassign the notes to the higher of the risk categories appropriateto the underlying reference assets or the sponsoring bankingorganization.



zation activities, examiners must carefully evalu-ate whether the sponsoring banking organizationis fully capable of assessing the credit risk itretains in its banking book and whether it isadequately capitalized given its residual riskexposure. The Federal Reserve will require thesponsoring banking organization to maintainhigher levels of capital if it is not deemed to beadequately capitalized given the retained residualrisks. In addition, a sponsoring banking organi-zation involved in synthetic securitizations mustadequately disclose to the marketplace the effectof its transactions on its risk profile and capitaladequacy.

The Federal Reserve may consider a sponsor-ing banking organization’s failure to require theinvestors in the CLNs to absorb the credit lossesthat they contractually agreed to assume to be anunsafe and unsound banking practice. In addi-tion, such a failure generally would constitute‘‘implicit recourse’’ or support to the transac-tion, which results in the sponsoring bankingorganization’s losing preferential capital treat-ment on its retained senior position.

If a sponsoring banking organization of asynthetic securitization does not meet the strin-gent minimum conditions, it may still reduce therisk-based capital requirement on the senior riskposition retained in the banking book by trans-ferring the remaining credit risk to a third-partyOECD bank through the use of a credit deriva-tive. Provided the credit-derivative transactionqualifies as a guarantee under the risk-basedcapital guidelines, the risk weight on the seniorposition may be reduced from 100 percent to20 percent. Sponsoring banking organizationsmay not enter into nonsubstantive transactionsthat transfer banking-book items into the tradingaccount to obtain lower regulatory capitalrequirements.9

Minimum Conditions

The following stringent minimum conditions arethose that the sponsoring banking organizationsmust meet to use the synthetic securitizationcapital treatment for transaction 2. The Federal

Reserve may impose additional requirements orconditions as deemed necessary to ascertain thata sponsoring banking organization has suffi-ciently isolated itself from the credit-risk expo-sure of the hedged reference portfolio.

Condition 1—Demonstration of transfer of vir-tually all the risk to third parties. Not alltransactions structured as synthetic securitiza-tions transfer the level of credit risk needed toreceive the 20 percent risk weight on the retainedsenior position. To demonstrate that a transfer ofvirtually all of the risk has been achieved,sponsoring banking organizations must—

• produce credible analyses indicating a transferof virtually all the credit risk to substantivethird parties;

• ensure the absence of any early-amortizationor other credit-performance-contingentclauses;10

• subject the transaction to market disciplinethrough the issuance of a substantive amountof notes or securities to the capital markets;

• have notes or securities rated by a nationallyrecognized credit rating agency;

• structure a senior class of notes that receivesthe highest possible investment-grade rating,for example, AAA, from a nationally recog-nized credit rating agency;

• ensure that any first-loss position they retainin the form of fees, reserves, or other creditenhancement—which effectively must bededucted from capital—is no greater than areasonable estimate of expected losses on thereference portfolio; and

• ensure that they do not reassume any creditrisk beyond the first-loss position throughanother credit derivative or any other means.

Condition 2—Demonstration of ability to evalu-ate remaining banking-book risk exposures andprovide adequate capital support. To ensure thatthe sponsoring banking organization has adequatecapital for the credit risk of its unhedged expo-sures, it is expected to have adequate systemsthat fully account for the effect of these trans-actions on its risk profiles and capital adequacy.In particular, the sponsoring banking organiza-

9. For instance, a lower risk weight would not be applied toa nonsubstantive transaction in which the sponsoring bankingorganization (1) enters into a credit-derivative transaction topass the credit risk of the senior retained portion held in itsbanking book to an OECD bank, and then (2) enters into asecond credit-derivative transaction with the same OECDbank, in which it reassumes into its trading account the creditrisk initially transferred.

10. Early-amortization clauses may generally be definedas features that are designed to force a wind-down of asecuritization program and rapid repayment of principal toasset-backed securities investors if the credit quality of theunderlying asset pool deteriorates significantly.



tion’s systems should be capable of fully differ-entiating the nature and quality of the riskexposures it transfers from the nature and qual-ity of the risk exposures it retains. Specifically,to gain capital relief sponsoring banking orga-nizations are expected to—

• have a credible internal process for gradingcredit-risk exposures, including the following:— adequate differentiation of risk among risk

grades— adequate controls to ensure the objectivity

and consistency of the rating process— analysis or evidence supporting the accu-

racy or appropriateness of the risk-gradingsystem;

• have a credible internal economic capital-assessment process that defines them to beadequately capitalized at an appropriate insol-vency probability and that readjusts, as nec-essary, their internal economic capitalrequirements to take into account the effect ofthe synthetic securitization transaction. (Inaddition, the process should employ a suffi-ciently long time horizon to allow necessaryadjustments in the event of significant losses.The results of an exercise demonstrating thatthe organization is adequately capitalized afterthe securitization transaction must be pre-sented for examiner review.);

• evaluate the effect of the transaction on thenature and distribution of the nontransferredbanking-book exposures. This analysis shouldinclude a comparison of the banking book’srisk profile and economic capital requirementsbefore and after the transaction, including themix of exposures by risk grade and by busi-ness or economic sector. (The analysis shouldalso identify any concentrations of credit riskand maturity mismatches. Additionally, thesponsoring banking organization mustadequately manage and control the forwardcredit exposure that arises from any maturitymismatch. The Federal Reserve retains theflexibility to require additional regulatory capi-tal if the maturity mismatches are substantiveenough to raise a supervisory concern. More-over, as stated above, the sponsoring bankingorganization must demonstrate that it meets itsinternal economic capital requirement subse-quent to the completion of the syntheticsecuritization.); and

• perform rigorous and robust forward-lookingstress testing on nontransferred exposures(remaining banking-book loans and commit-

ments), transferred exposures, and exposuresretained to facilitate transfers (credit enhance-ments). The stress tests must demonstrate thatthe level of credit enhancement is sufficient toprotect the sponsoring banking organizationfrom losses under scenarios appropriate to thespecific transaction.

Condition 3—Provide adequate public disclo-sures of synthetic CLO transactions regardingtheir risk profile and capital adequacy. In their10-K and annual reports, sponsoring bankingorganizations must adequately disclose to themarketplace the accounting, economic, and regu-latory consequences of synthetic CLO transac-tions. In particular, sponsoring banking organi-zations are expected to disclose—

• the notional amount of loans and commit-ments involved in the transaction;

• the amount of economic capital shed throughthe transaction;

• the amount of reduction in risk-weighted assetsand regulatory capital resulting from the trans-action, both in dollar terms and in terms of theeffect in basis points on the risk-based capitalratios; and

• the effect of the transaction on the distributionand concentration of risk in the retained port-folio by risk grade and sector.

Transaction 3—First-Loss Position IsRetained

In the third type of synthetic transaction, thesponsoring banking organization may retain asubordinated position that absorbs the credit riskassociated with a first loss in a reference port-folio. Furthermore, through the use of credit-default swaps, the sponsoring banking organiza-tion may pass the second- and senior-losspositions to a third-party entity, most often anOECD bank. The third-party entity, acting as anintermediary, enters into offsetting credit-defaultswaps with an SPV, thus transferring its creditrisk associated with the second-loss position tothe SPV.11 The SPV then issues CLNs to thecapital markets for a portion of the reference

11. Because the credit risk of the senior position is nottransferred to the capital markets but remains with theintermediary bank, the sponsoring banking organization shouldensure that its counterparty is of high credit quality, forexample, at least investment grade.



portfolio and purchases Treasury collateral tocover some multiple of expected losses on theunderlying exposures.

Two alternative approaches could be used todetermine how the sponsoring banking organi-zation should treat the overall transaction forrisk-based capital purposes. The first approachemploys an analogy to the low-level-capital rulefor assets sold with recourse. Under this rule, atransfer of assets with recourse that contractu-ally is limited to an amount less than theeffective risk-based capital requirements for thetransferred assets is assessed a total capitalcharge equal to the maximum amount of losspossible under the recourse obligation. If thisrule applied to a sponsoring banking organiza-tion retaining a 1 percent first-loss position on asynthetically securitized portfolio that wouldotherwise be assessed 8 percent capital, thesponsoring banking organization would berequired to hold dollar-for-dollar capital againstthe 1 percent first-loss risk position. The spon-soring banking organization would not beassessed a capital charge against the second- andsenior-risk positions.12

The second approach employs a literal read-ing of the capital guidelines to determine thesponsoring banking organization’s risk-basedcapital charge. In this instance, the 1 percentfirst-loss position retained by the sponsoringbanking organization would be treated as aguarantee, that is, a direct credit substitute,which would be assessed an 8 percent capitalcharge against its face value of 1 percent. Thesecond-loss position, which is collateralized byTreasury securities, would be viewed as fullycollateralized and subject to a zero percentcapital charge. The senior-loss position guaran-teed by the intermediary bank would be assignedto the 20 percent risk category appropriate toclaims guaranteed by OECD banks.13

The second approach may result in a higherrisk-based capital requirement than the dollar-for-dollar capital charge imposed by the firstapproach, depending on whether the reference

12. The sponsoring banking organization would not realizeany benefits in the determination of its leverage ratio since thereference assets remain on its balance sheet.

13. If the intermediary is a banking organization, then itcould place both sets of credit-default swaps in its tradingaccount and, if subject to the Federal Reserve’s market-riskcapital rules, use its general market-risk model and, ifapproved, specific-risk model to calculate the appropriaterisk-based capital requirement. If the specific-risk model hasnot been approved, then the sponsoring banking organizationwould be subject to the standardized specific-risk capitalcharge.


IntermediaryOECD Bank

Credit-default-swap fee

Default paymentand pledge of

Treasuries equalto $400 million tocover losses above

1% of thereference assets

SponsoringBanking

Organization

$5 billion creditportfolio

Credit-default-swapfee (basis points per year)

Default payment andpledge of Treasuries

SPV

Holds $400 millionof pledged Treasuries

$400 millionof CLNs

$400 millionof cash

Seniornotes

Juniornotes



portfolio consists primarily of loans to privateobligors or undrawn long-term commitments.The latter generally have an effective risk-basedcapital requirement one-half of the requirementfor loans because these commitments are con-verted to an on-balance-sheet credit-equivalentamount using the 50 percent conversion factor.If the reference pool consists primarily of drawnloans to private obligors, then the capitalrequirement on the senior-loss position wouldbe significantly higher than if the referenceportfolio contained only undrawn long-termcommitments. As a result, the capital charge forthe overall transaction could be greater than thedollar-for-dollar capital requirement set forth inthe first approach.

Sponsoring banking organizations will berequired to hold capital against a retained first-loss position in a synthetic securitization equalto the higher of the two capital charges resultingfrom application of the first and secondapproaches, as discussed above. Further, althoughthe sponsoring banking organization retains onlythe credit risk associated with the first-lossposition, it still should continue to monitor allthe underlying credit exposures of the referenceportfolio to detect any changes in the credit-riskprofile of the counterparties. This is important toensure that the sponsoring banking organizationhas adequate capital to protect against unex-pected losses. Examiners should determinewhether the sponsoring banking organizationhas the capability to assess and manage theretained risk in its credit portfolio after thesynthetic securitization is completed. For risk-based capital purposes, banking organizationsinvesting in the notes must assign them to therisk weight appropriate to the underlying refer-ence assets.14

LEGAL LIMITATIONS FOR BANKINVESTMENTS

Asset-backed securities can be either type IV ortype V securities. Type IV securities include thefollowing asset-backed securities that are fully

secured by interests in a pool (or pools) of loansmade to numerous obligors:

• investment-grade residential-mortgage-relatedsecurities offered or sold pursuant to section4(5) of the Securities Act of 1933 (15 USC77d(5))

• residential-mortgage-related securities asdescribed in section 3(a)(41) of the SecuritiesExchange Act of 1934 (15 USC 78c(a)(41))that are rated in one of the two highestinvestment-grade rating categories

• investment-grade commercial mortgage secu-rities offered or sold pursuant to section 4(5)of the Securities Act of 1933 (15 USC 77d(5))

• commercial mortgage securities as describedin section 3(a)(41) of the Securities ExchangeAct of 1934 (15 USC 78c(a)(41)) that arerated in one of the two highest investment-grade rating categories

• investment-grade, small-business-loan securi-ties as described in section 3(a)(53)(A) of theSecurities Exchange Act of 1934 (15 USC78(a)(53)(A))

Type V securities consist of all asset-backedsecurities that are not type IV securities. Spe-cifically, they are defined as marketable,investment-grade-rated securities that are nottype IV and are ‘‘fully secured by interests in apool of loans to numerous obligors and in whicha national bank could invest directly.’’ CLOsand synthetic securitizations are generally clas-sified as type V securities. A bank may purchaseor sell type V securities for its own accountprovided the aggregate par value of type Vsecurities issued by any one issuer held by thebank does not exceed 25 percent of the bank’scapital and surplus.

REFERENCES

Board of Governors of the Federal ReserveSystem. SR-96-17, ‘‘Supervisory Guidance forCredit Derivatives.’’ August 12, 1996.

Board of Governors of the Federal ReserveSystem. SR-97-21, ‘‘Risk Management andCapital Adequacy of Exposures Arising fromSecondary Market Credit Activities." July 11,1997.

Kohler, Kenneth E. ‘‘Collateralized Loan Obli-

14. Under this type of transaction, if a structure exposesinvesting banking organizations to the creditworthiness of asubstantive issuer, for example, the sponsoring banking orga-nization, then the investing banking organizations shouldassign the notes to the higher of the risk categories appropriateto the underlying reference assets or the sponsoring bankingorganization.



gations: A Powerful New Portfolio ManagementTool for Banks.’’ The Securitization Conduit.vol. 1, no. 2, 1998.

Iftikhar, Hyder U., Bolger, Rita M., and Leung,Corwin. ‘‘How S&P Evaluates CommercialLoan–Backed Securitizations.’’ The Journal ofLending & Credit Risk Management. July 1996.



Commodity-Linked TransactionsSection 4355.1

GENERAL DESCRIPTION

The termcommodity-linked transactionis usedto denote all transactions that have a returnlinked to the price of a particular commodity orto an index of commodity prices. The termcommodity-derivative transactionrefers exclu-sively to transactions that have a return linked tocommodity prices or indexes and for whichthere is no exchange of principal.

The termcommodityencompasses both tradi-tional agricultural products, base metals, andenergy products, so that all those transactionsthat cannot be characterized as interest orexchange-rate contracts under the Basle Accordare designated commodity transactions. Pre-cious metals, which have been placed into theforeign-exchange-rate category in deference tomarket convention, are not included.


A commodity-linked contract specifies exactlythe type or grade of the commodity, the amount,and the future delivery or settlement dates. Inthese transactions, the interest, principal, orboth, or the payment streams in the case ofswaps, is linked to a price of a commodity orrelated index. However, given that banks are notallowed to trade in the underlying physicalcommodity (with the exception of gold) withoutspecial permission, these contracts are settledfor cash.

Factors that affect commodity prices and riskare numerous and of many different origins.Macroeconomic conditions, local disturbances,weather, supply and demand imbalances, andlabor strikes are examples of factors that have adirect impact on commodity prices. In manyother traded markets, such factors would have amore indirect effect.

USES

Commodity-linked markets offer participants away to hedge or take positions in future com-modity prices. Market participants include com-modity producers or users, such as mining,

energy, and transportation companies, that wantto lock in future costs or revenues by enteringinto a contract at a given price.

In general, financial institutions viewcommodity-linked transactions as a financialrisk-management service for customers withcommodity-price exposure, similar to the foreign-exchange and interest-rate risk managementproducts that banks have historically offered.Over-the-counter (OTC) transactions can be tai-lored to the customer’s needs and, therefore,offer more flexibility than exchange-traded con-tracts, particularly for longer-term insurance.

Examples of commodity-linked productsoffered by banks include commodity-linkeddeposits, commodity-linked loans, commodity-linked swaps, and commodity-linked options.Examples of these products and the ways inwhich hedgers and speculators use these prod-ucts are described below.

Commodity-Linked Deposits

The following is an example of a deposit withthe return linked to a commodity index:

A $100,000 one-year deposit has a returnlinked to the price of oil. The deposit pays atmaturity either (1) a guaranteed minimum returnof 3 percent or (2) 90 percent of any gain in themarket index (relative to an index rate set at theoutset of the transaction) of oil over the life ofthe deposit, whichever is greater. The depositoris able to benefit from a rise in the price of oil(however, by only 90 percent of the rise thatwould have been received if he or she hadpurchased the physical oil). The asset is lessrisky compared to the purchase of the actualphysical oil because the principal is protectedagainst a fall in the price of oil.

Commodity-Linked Loans

The following is an example of a loan withinterest payments linked to a commodity index:

A financial institution lends an oil company$1 million for five years with interest paymentslinked to the price of oil as opposed to aconventional loan at 8 percent. The initial oil


index is set at $20 per barrel. Interest paymentsare the greater of 4 percent or the excess of anygain in the market price of oil relative to the $20per barrel base, up to a maximum of 25 percent.The borrower pays a lower interest rate com-pared to a non-commodity-linked loan when oilprices fall, but shares the upside potential of itsoil revenues with the lender when the price ofoil rises.

Commodity-Linked Swaps

Commodity-linked swaps are defined as anagreement between two counterparties to makeperiodic exchanges of cash based on the follow-ing terms:

• notional quantity (for example, number ofbarrels or tons) of the specified commodity

• index, based on a defined grade and type ofcommodity, whose prevailing price is publiclyquoted

• fixed price agreed to by the counterparties(The fixed price is usually above the spot priceper unit for the defined commodity at the datethe swap is consummated.)

• at specified intervals during the term of theswap, there are settlement dates at which thecounterparties agree to a net exchange of cash(The amount of cash to be exchanged isdetermined as follows:— One counterparty is the fixed price payer.

At each settlement date, the fixed pricepayer owes the counterparty the notionalamount of the contract multiplied by thefixed price.

— The other counterparty is the floating-rateprice payer. At each settlement date, thefloating price payer owes the counterpartythe notional amount multiplied by the indexprice prevailing on the settlement date.)

As an example, suppose an oil companywishes to protect itself against a decline in oilprices and enters into a commodity-swap agree-ment with a bank. The company will receive afixed price and pay a floating price linked to anindex of the price of oil. Thus, the companytrades the upside potential of rising oil prices forthe assurance that it will not receive a pricebelow the fixed price agreed on at the inceptionof the trade.

As a further example, suppose a utility com-pany wishes to protect itself from rising oilprices and enters into a commodity-swap agree-ment with a bank. The utility company will paya fixed price and receive a floating price linkedto an index of the price of oil. Thus, the utilitytrades its upside potential if oil prices fall for theassurance that it will not pay a price above thatagreed on at the inception of the trade.

Commodity-Linked Options

Commodity-linked options convey the right tobuy (call) or sell (put) the cash-equivalentamount of an underlying commodity at a fixedexercise price (there is no physical delivery ofthe underlying commodity). The purchase of acommodity-linked call by an oil user, for exam-ple, sets a cap on the price of oil that the userwill pay. If oil prices rise, the oil user willexercise the call option, which is the right to buyoil at the lower exercise price. The seller of acall option may have a long position in a givenunderlying commodity, thus selling off the upsidepotential of the commodity in exchange for thepremium paid by the purchaser of the call.

The purchase by an oil producer of a putoption indexed to the price of oil sets a floor onthe price of oil that the producer will receive.The bought put therefore allows the holder toestablish a minimum price level on the under-lying commodity. If the price of oil in the openmarket falls below the strike price of the option,the oil producer will exercise the put to lock inthe strike price.


Commodity-linked derivatives are traded in boththe exchange and OTC markets. There areseveral fundamental differences between thefutures exchanges and the OTC markets forcommodities. First, futures contracts may entaildelivery of the physical commodity upon expi-ration of the contract, whereas OTC contractsgenerally are settled for cash. Second, futurescontracts are standardized, while OTC contractsare tailored, often specifying commodities andmaturities that are not offered on the exchanges.Third, the OTC market typically handles onlylarge transactions, whereas exchanges may

4355.1 Commodity-Linked Transactions


accommodate transactions as small as the valueof a single contract in a given commodity. As aresult, the OTC commodity markets tend to beless liquid than the exchanges, but at the sametime they offer products that can be morecustomized to meet the users’ specific needs.

Market Participants

Primary players in the commodity markets arecommodity producers and end- users, hedgefunds and mutual funds, and investment andcommercial banks. Commercial banks are rela-tively small players in the commodity markets;it is estimated that they account for roughly 5 to10 percent of trading activity in the domesticenergy sector and even less in agricultural com-modities. However, these banks fill an importantniche by acting as intermediaries between pro-ducers and users of oil and gas products, whichis also important for market participants. Banksapply tested risk-management techniques andmarket-making skills, which has helped toincrease liquidity in the markets. Additionally,the ability of banks, acting as financial interme-diaries, to transform risks has enabled entities tohedge attendant exposures (for example, creditrisk) which are a component of energy transac-tions, though not directly related to the price ofenergy.

Market Transparency

For all exchange-traded commodity products,transparency is high. In the OTC markets, widevariations of transparency exist based on theproduct, volume traded, grade, delivery point,maturity, and other factors.

PRICING

Similar to the term structure of interest rates,commodity price curves exist which conveyinformation about future expectations. In addi-tion, they reflect the prevailing yield curve(cost-of-carry) and storage costs.

Energy prices are said to be in ‘‘contango’’when the forward prices are greater than expectedspot prices at some future date; prices are said tobe in ‘‘backwardation’’ when future spot pricesexceed forward prices. The term structure has

little forecasting power, however. Forward priceshave not been proven to be accurate forecasts offuture spot prices.

The theory of contango holds that the naturalhedgers are the purchasers of a commodity,rather than the suppliers. In the case of wheat,grain processors would be viewed as willing topay a premium to lock in the price that theymust pay for wheat. Because long hedgers willagree to pay high futures prices to shed risk, andbecause speculators require a premium to enterinto the short position, the contango theoryholds that forward prices must exceed theexpected future spot price.

The contrasting theory of contango is back-wardation. This theory states that natural hedg-ers for most commodities will want to shed risk,such as wheat farmers who want to lock infuture wheat prices. These farmers will takeshort positions to deliver wheat in the future at aguaranteed price. To induce speculators to takethe corresponding long positions, the farmersneed to offer speculators an expectation ofprofit. The theory of backwardation suggeststhat future prices will be bid down to a levelbelow the expected spot price.

Any commodity will have both natural longhedgers and short hedgers. The compromisetraditional view, called the ‘‘net hedging hypoth-esis,’’ is that the forward price will be less thanthe expected future spot price when short hedg-ers outnumber long hedgers and vice versa. Theside with the most natural hedgers will have topay a premium to induce speculators to enterinto enough contracts to balance the naturalsupply of long and short hedgers.

The future price of an energy product isdetermined by many factors. The no-arbitrage,cost-of-carry model predicts that futures priceswill differ from spot prices by the storage andfinancing costs relevant to inventory. The futurespot price is the only source of uncertainty in thebasic model. Carry is the sum of the risklessinterest rate and the marginal cost of storage.Because carry is always positive, the cost-of-carry model predicts that energy prices willalways be in contango.

Empirical evidence suggests, however, thatthe term structure of energy is not fully explainedby carry. The term structure of energy prices isnot always in contango. Oil and natural gasmarkets often become backwardated due toexternal factors or supply concerns. Further, themarket rarely shows full carrying charges. Inother words, futures prices as predicted by a

Commodity-Linked Transactions 4355.1


cost-of-carry model generally exceed thoseobserved in the market, even when prices are incontango.

HEDGING

Participants in the OTC commodity marketsmay have more difficulty hedging their positionsthan participants in the foreign-exchange andinterest-rate markets because of the shallownessand illiquidity of OTC commodity markets. It isalso difficult to match the terms and maturitiesof exchange-traded futures hedges with OTCcommodities instruments.

To hedge the spot risk associated withcommodity-linked transactions, traders will off-set a long position with a short position. Thechoice of the hedge instrument used generallydepends on (1) market conditions, that is,whether the financial institution has a naturaloffsetting position; (2) the risk appetite of theinstitution; and (3) cost. Because exchange-traded futures contracts are standardized, theyare usually cheaper than the equivalent OTCcontracts and are normally the preferred hedgeinstrument. However, the margin and collateralrequirements of exchange-traded contracts maymean that OTC contracts have lower transac-tions costs than futures traded on exchanges.Moreover, the terms of a futures contract willrarely be identical to the terms of an OTCcontract, leaving the financial institution withresidual risk.

Commodity swaps, in particular, may beentered into on a perfectly matched basis, withthe financial institution guaranteeing the pay-ments of two parties with equal and oppositeinterests. In a perfectly matched transaction, thefinancial institution writes a separate, offsettinglong-term swap contract with each party, incor-porating a margin to cover costs and the risk ofcounterparty default, and closes simultaneouslyboth sides of the transaction. When engaging inmatched commodity swaps, a financial institu-tion is exposed to commodity-price risk onlywhen the counterparty on one side of a matchedtransaction defaults, and the financial institutionmust enter the market to hedge or rebalance itsbook.

However, the need to match transactions per-fectly at all times would limit the ability offinancial institutions to serve their customersand to compete in the existing market. For

example, if a financial institution enters intoswap agreements for its own account with onecounterparty, it may not be able to establish amatching offsetting transaction immediately.Therefore, it may wish to hedge its commodity-price risk in the futures or related markets untilan offsetting swap can be written. When anexact offset is found, the two swaps are matchedand the hedge position is unwound.

Some financial institutions may seek a matchedbook by the end of the day, while others arewilling to carry an open swap for weeks or torely on other hedging techniques, such as hedg-ing on a portfolio basis. For example, a financialinstitution may hedge the commodity-priceexposure of the entire portfolio of independentlycontracted swaps without ever seeking exactlyoffsetting transactions. Hedging models help todetermine the amount of exposure already offsetby the transactions currently in the book. Theresidual exposure is then hedged using exchange-traded futures and options so that it is reduced toless than the position limits established by thefinancial institution’s management. Some of themost serious financial-institution participants inthe commodity swap market are hedging on aportfolio basis.

The use of futures and options to hedge anindividual commodity-linked transaction, or aportfolio of such transactions, does not elimi-nate the residual basis risk resulting from differ-ences between the movements in the prices oftwo commodities used to offset one another.When risk managers or traders cannot profitablyexecute a hedge in the same commodity, theymay use a second commodity whose price tendsto move in line with the first. Such a hedge isnecessarily imperfect and cannot eliminate allrisk. For example, prospective oil hedgers mayincur basis risk because of discrepancies betweenthe nature of the underlying instrument (forexample, a crude oil futures contract versus a jetfuel swap) or the location of the deliverable-grade commodity (for example, North Sea oilversus West Texas Intermediate oil).

RISKS

Many of the risks associated with commodity-linked activities are similar to those connectedwith interest-rate and foreign-exchange prod-ucts. Price, counterparty credit, and deliveryrisks all exist. In the case of commodity-linked



transactions, these risks may be further exagger-ated because of illiquidity, volatility, and for-ward pricing problems.

Basis Risk

One of the primary risks facing investors incommodity-linked transactions is basis risk—the risk of a movement in the price of a specificcommodity relative to a movement in the priceof the commodity-linked transaction. The defi-nition of commodity that is often used to signifylike, interchangeable products cannot be appliedfreely. Variances of grade, delivery location, anddelivery time frame—among other things—giverise to numerous basis issues that must becarefully managed. Price risk can be reduced byhedging with either exchange-traded or OTCcontracts. However, if contract terms are notequivalent, substantial basis risk can result.Types of basis risk include, but are not limitedto, grade risk, location risk, calendar (nearby-versus deferred-month) risk, stack-and-roll risk(hedging deferred obligations in nearby monthson a rolling basis), and, in the energy markets,risks associated with crack spreads (the pricedifferential between refined and unrefinedproducts).

Liquidity Risk

The OTC commodity derivative markets aregenerally much less liquid than the foreign-exchange and interest-rate derivative markets;commodity-linked derivative products are cur-rently offered by relatively few financial insti-tutions. As a result of the shallow nature of themarket, liquidity usually drops off for contractson forward prices beyond one year.

In addition to their relative scarcity, OTCcommodity-linked transactions are customizedto meet the needs of the user. This characteristicof the market exacerbates the ability of a finan-cial institution to hedge commodity-linkedderivative transactions; perfectly offsettinginstruments are rarely available in the OTCmarket, and there may be a significant degree ofbasis risk when hedging with exchange-tradedinstruments. For purposes of hedging long-dated

(more than one year) crude oil, the OTC marketis superior to exchange-traded markets in termsof liquidity.

Volatility Risk

Commodity prices can be much more volatilethan interest rates or foreign-currency rates,although this volatility is sensitive to the timeperiod and market conditions. The smaller sizeof the commodity markets is partially respon-sible for the heightened volatility of commodityprices. Changes in supply or demand can have amore dramatic effect on prices in smaller mar-kets, as reflected in the measured volatility.Thus, a disruption in any one source of supplymay greatly affect the price since many com-modities are dominated by only a few suppliers.In addition, the fact that only a few suppliersexist can result in prices that are subject tomanipulation. Demand for commodities can alsodepend heavily on economic cycles.


The accounting treatment for commodity-linkedtransactions is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


The credit-equivalent amount of a commodity-linked contract is calculated by summing—




Commodity-Linked Transactions 4355.1


0–1 years 1–5 years Over 5 years

Gold contracts 1.0% 5.0% 7.5%Other precious metals 7.0% 7.0% 8.0%Other commodities 10.0% 12.0% 15.0%

If a bank has multiple contracts with a coun-terparty and a qualifying bilateral contract withthe counterparty, the bank may establish itscurrent and potential credit exposures as netcredit exposures. (See section 2110.1, ‘‘ CapitalAdequacy.’’ )


Commodity derivatives are not consideredinvestments under 12 USC 24 (seventh). A bankmust receive proper regulatory approvals beforeengaging in commodity-linked activities.

REFERENCES

Bodie, Kane, and Marcus. Investments. RichardC. Irwin, Inc., 1993.


Falloon, William. ‘‘A Market Is Born.’’ Manag-ing Energy Price Risk. London: Risk Publi-cations, Financial Engineering, Ltd., 1995.

McCann, Karen, and Mary Nordstrom. EnergyDerivatives: Crude Oil and Natural Gas.Federal Reserve Bank of Chicago, December1995.



Subject Index

A

Accounting, 2060.1, 2120.1See also specific type of financial instrument.Equity investments, 3040.1Examination objectives, 2120.2Examination procedures, 2120.3Financial-statement disclosures, 2120.5Hedge accounting treatment, 2120.1Internal control questionnaire, 2120.4Mortgage-backed securities, 4110.1Securities and securitization, 3000.1, 3020.1

Accrued interest receivables, 3020.1

Adjusted trading, 3000.1

Affiliates, 3000.1

ArbitrageFinancial futures, 4320.1Forwards, 4310.1

Asset securitization, 3020.1

Audits, 2000.1Back-office trading operations, 2060.1Futures commission merchants, 3030.1Internal, 2000.1Risk management, 2000.1Securities, investment, 3000.1

B

Back-office trading operations, 2060.1Examination objectives, 2060.2Examination procedures, 2060.3Internal control questionnaire, 2060.4

Bank holding companiesCommercial paper activities, 4010.1Equity investments, 3040.1Futures commission merchant activities,

3030.1Liquidity-risk management, 3005.1, 3005.5Regulatory reports from, 2130.5

Banks and banking organizationsEquity investments, 3040.1Investments, legal limits on—See specific type

of financial instrument.

Large complex banking organizations, capitaladequacy of, 2110.1

Nonmember banks, state, 3040.1Regulatory compliance, 2140.1Regulatory reports, 2130.5Securities, restrictions on holdings of, 3000.1

Basis risk—See specific type of financialinstrument.

Board of directors and senior managementEthics oversight, 2150.1Risk-management responsibilities of, 2000.1• Equity investments, 3040.1• Futures commission merchants, 3030.1• Interest-rate risk, 3010.1• Liquidity-risk management, 3005.1• Securities and securitization, 3000.1, 3020.1

BondsBrady and emerging-markets, 4255.1Corporate, 4045.1Foreign government• Argentine, 4255.1• Australian, 4205.1• Brazilian, 4255.1• Canadian, 4210.1• French, 4215.1• German, 4220.1• Irish, 4225.1• Italian, 4230.1• Japanese, 4235.1• Mexican, 4255.1• Spanish, 4240.1• Swiss, 4245.1• United Kingdom, 4250.1Treasury, U.S., 4020.1

Brokered deposits, 3005.1

Brokers and dealers—See Securities.

C

CAMELS ratings, 3010.1Liquidity rating, 3005.1

Capital adequacy, 2110.1Asset securitizations, 3020.1Equity investments, 3040.1

Certificates of deposit, 4055.1Liquidity-risk considerations, 3005.5


Clearinghouses, futures exchange, 3030.1,4320.1

Clearing risk—See Settlement risk.

Codes of conduct, 2150.1See also Ethics of trading institutions and

personnel.

CollateralAgreements, 2070.1Arrangements, 2020.1

Collateralized loan obligations (CLOs),4353.1

Synthetic, 2110.1, 4353.1

Collateralized mortgage obligations(CMOs), 4110.1

Commercial paper, 3020.1, 4010.1Asset-backed, 4105.1

Commodities, 3030.1Contracts, calculating credit-equivalent

amounts for, 2110.1Price risk of, 2010.1Trading adviser for, 3030.1Transactions linked to, 4355.1

Compensation, 3040.1

Computer systems, 2040.1

Confidentiality, 2150.1

Confirmations, trade, 2060.1

Conflicts of interest—See Ethics of tradinginstitutions and personnel.

Contingency planningCounterparty credit risk, 2021.1Interest-rate risk, 3010.3Liquidity risk, 3005.1, 3005.5

Corporate notes and bonds, 4045.1

Counterparties, banking organizationSales practices of personnel dealing with,

2150.1Unnamed, 2020.1

Counterparty credit risk, 2020.1, 2021.1

CreditCredit-equivalent amounts, calculating for

derivatives, 2110.1Enhancements, 2020.1, 3020.1Primary and secondary, 3005.5Ratings, 3020.1Risk• See also specific type of financial

instrument.• Counterparty credit, 2020.1, 2021.1• Examination objectives, 2020.2• Examination procedures, 2020.3• Futures commission merchants, 3030.1• Internal control questionnaire, 2020.4• Large complex banking organizations,

2110.1• Liquidity, impact on, 3005.1• Off-market or prefunded derivative

transactions, 2020.1• Securities and securitization, 3000.1, 3020.1Secondary-market activities, 3020.1

Credit derivatives, 4350.1Capital treatment of, 2110.1

Currency swaps, 4335.1

Customers, banking organization, 2150.1

D

Dealers, securities, 2050.1Selection of, 3000.1

DerivativesAccounting for, 2120.1, 2120.5Capital adequacy treatment, 2110.1Credit, 4350.1• SR-letters, 3020.1Equity, 4345.1Interaffiliate derivative transactions, 3000.1Off-market or prefunded transactions, 2020.1Suitability of, 2070.1

Discount window lending, 3005.5

Documentation, 2070.1

E

Earnings—See Financial performance.

Subject Index


End-user activities—See Securities.

Equity investments, 3040.1Derivatives, 2120.1, 4345.1Equity-price risk, 2010.1Examination objectives, 3040.2Examination procedures, 3040.3Noninvestment business transactions, 3040.1

Ethics of trading institutions and personnel,2150.1

Examination objectives, 2150.2Examination procedures, 2150.3Front-office operations, 2050.1Internal control questionnaire, 2150.4

EurodollarsCertificates of deposit, 4055.1Liquidity-risk considerations, 3005.5

Examinations and examiner guidanceAsset securitization, 3020.1Credit derivatives, 4350.1Futures commission merchants, 3030.1Interest-rate risk, 3010.1Large complex banking organizations, capital

adequacy assessment, 2110.1Liquidity risk, 3005.1, 3005.3Objectives, procedures, and

questionnaires—See specific examinationtopic.

Preparation for, pre-examination review,1000.0

SEC and other agencies, 2140.1

Exchange-traded instrumentsCounterparty credit risk of, 2020.1Financial futures, 4320.1Market liquidity risk of, 2030.1

F

Federal Financial Institutions ExaminationCouncil (FFIEC)

Regulations, unsuitable investments, 4110.1Reports, 2130.1, 2130.5

Federal funds, 4005.1Liquidity-risk considerations, 3005.5

Federal Home Loan Bank (FHLB)borrowings, 3005.5

Federal Reserve Act,3000.1, 3040.1

Financial holding companies (FHCs),3040.1

Financial performance, 2100.1Examination objectives, 2100.2Examination procedures, 2100.3Internal control questionnaire, 2100.4

Financial statements,2120.5

FOCUS reports—See Securities andExchange Commission.

Foreign banking organizationsLiquidity risk, 3005.1Regulatory reporting requirements, 2130.5

Foreign-currency instruments, 2120.1,2120.5

Foreign exchange (FX),4305.1Nondeliverable forward (NDF) transactions,

legal risk of, 2070.1Risks of, 2010.1, 2021.1• See also specific type of financial

instrument.

Forms, regulatory reporting, 2130.5

Forward rate agreements,4315.1

Forwards—See Futures and forwards.

Front-office trading operations, 2050.1Examination objectives, 2050.2Examination procedures, 2050.3Internal control questionnaire, 2050.4

Funding liquidity risk, 3005.1, 3005.5See also Market liquidity risk.

Futures commission merchants,3030.1Examination objectives, 3030.2Examination procedures, 3030.3

Futures and forwards, 4310.1, 4320.1See also Futures commission merchants.Accounting for, 2120.1Exchanges, trading on, 3030.1Financial futures, 4320.1Foreign exchange, 4305.1

G

Gains trading, 3000.1

Subject Index


H

Hedge funds, 2020.1

HedgingSee also specific type of financial instrument.Equity investments, 3040.1Hedge accounting treatment, 2120.1Market liquidity risk concerns, 2030.1

Historical-rate rollovers, 2020.1

Holdback reserves, 2100.1Market liquidity risk concerns, 2030.1

I

Income, 2100.1See also Reporting, financial.

Insider information, 2150.1

Institutions, trading, 1010.1See also Board of directors and senior

management and specific area ofinstitution.

Interest-rate risk, 2010.1, 3010.1Large complex banking organizations, 2110.1Liquidity, impact on, 3005.1Management of, 3010.1• Examination objectives, 3010.2• Examination procedures, 3010.3• Internal control questionnaire, 3010.4

Interest-rate swaps, 4325.1

Internal audit—See Audits.

Internal controlsBack-office trading operations, 2060.1Equity investments, 3040.1Futures commission merchants, 3030.1Interest-rate risk, 3010.1Investment securities and end-user activities,

3000.1Liquidity-risk management, 3005.1Questionnaires for examining—See specific

examination topic.Risk management, general, 2000.1Securities and securitization, 3000.1, 3020.1

Internal models—See Models.

International trading operations andtransactions

See also Bonds, Foreign-currency instruments,Foreign exchange, Notes.

Futures commission merchants, 3030.1Liquidity-risk concerns, 3005.5Securities, 2140.1, 3000.1Settlement of foreign payments, 2060.1

InvestmentsSee also specific type of financial instrument.Equity, 3040.1Limitations on, 3000.1, 4105.1Suitability of, 2070.1

Investors, institutional, 2020.1

L

Legal risk, 2070.1, 2150.1See also specific type of financial instrument.Examination objectives, 2070.2Examination procedures, 2070.3Off-market or prefunded derivative

transactions, 2020.1Securities and securitization, 3000.1, 3020.1

Liquidity risk, 3005.1See also specific type of financial instrument.Asset securitization, 3000.1, 3020.1Examination objectives, 3005.2Examination procedures, 3005.3Futures commission merchants, 3030.1Internal control questionnaire, 3005.4Market liquidity risk, 2030.1Measurement of, 3005.5

M

Management information systems (MIS),2040.1

Counterparty credit risk, 2020.1Equity investments, 3040.1Examination objectives, 2040.2Examination procedures, 2040.3Futures commission merchants, 3030.1Internal control questionnaire, 2040.4Liquidity risk, 3005.1Operations and systems risk, 2040.1Reports to management, adequacy of, 2060.1,

2100.1, 3020.1Securities, 3000.1, 3020.1

Subject Index


Management of trading institutions—SeeBoard of directors and seniormanagement.

Margin requirements, 3030.1Financial futures, 4320.1

Market liquidity risk, 2030.1Assets, 3005.5Examination objectives, 2030.2Examination procedures, 2030.3Internal control questionnaire, 2030.4

Market risk, 2010.1See also specific type of financial instrument.Capital adequacy, 2110.1Credit derivatives, SR-letter, 3020.1Examination objectives, 2010.2Examination procedures, 2010.3Futures commission merchants, 3030.1Interest-rate risk, 3010.1Internal control questionnaire, 2010.4Large complex banking organizations, 2110.1Limits, 2010.1Liquidity risk, 2030.1, 3005.1, 3005.5Measures of, 2010.1Securities, investment, 3000.1Simulations, 2010.1

Master agreements, 2070.1

Master-trust structures, 4353.1

Merchant banking, 3030.1, 3040.1

ModelsEquity investments, 3040.1Market risk, 2110.1Options valuation, 4330.1Pricing, 2040.1, 2100.1Risk-measurement, 2040.1

Mortgage-backed securities, 4110.1

Municipal securities, 4050.1

N

Netting agreements, 2110.1Accounting for, 2120.1Legal risk, 2070.1Operational issues, 2070.1

New-product approval, 2040.1, 2070.1,2150.1, 3000.1

NotesCorporate, 4045.1Credit-default, 4350.1Foreign government• French, 4215.1• German, 4220.1• Italian, 4230.1• Japanese, 4235.1• Swiss, 4245.1Structured, 4040.1U.S. Treasury, 4020.1

O

Off-market derivative transactions, 2020.1

Operations and systems riskSee also Back-office trading operations,

Front-office trading operations,Management information systems.

Large complex banking organizations, 2110.1New products, 2040.1, 2150.1, 3000.1

Options, 4330.1Commodity-linked, 4355.1Deep-in-the-money, 2020.1Foreign-exchange, 4305.1Market risk, 2010.1

Organizational structure, 1010.1Front-office trading operations, 2050.1Risk-management operations, 2000.1

Over-the-counter (OTC) instruments—SeeSecurities.

P

Pair-offs, 3000.1

Personnel of trading institutionsBack-office roles, 2060.1Compensation of equity investment staff,

3040.1Ethics and conduct of, 2150.1Expertise and competence of, 2040.1, 2050.1Front-office roles, 2050.1Sales practices of, 2150.1

Subject Index


Political risk—See specific type of financialinstrument.

Portfolio companies, 3040.1

Pre-examination review—See Examinationsand examiner guidance.

Prefunded derivative transactions, 2020.1

Presettlement risk, 2020.1

Pricing, 2100.1See also specific type of financial instrument.

Products, tradingMarket liquidity risks of, 2030.1New, 2040.1, 2070.1, 2150.1, 3000.1Revaluation of, 2030.1, 2060.1, 2100.1Suitability of, 2070.1

Profits and losses—See Financialperformance.

R

Ratings, credit, 3020.1

Records, transaction, 2040.1, 2050.1, 2060.1,2070.1

RegulationsCompliance with, 2140.1, 3040.1, 3005.5• Examination objectives, 2140.2• Futures commission merchants, 3030.1

Regulation Y, 3030.1, 3040.1

Reporting, financial, 2120.1, 2120.5Back-office trading operations, 2060.1Equity investments, 3040.1FFIEC reports, 2130.1, 2130.5Financial performance, 2100.1Financial-statements disclosures, 2120.5Front-office trading operations, 2050.1FR Y-series reports, 2130.5Futures commission merchants, 3030.1Management, reports to, 3040.1Regulatory requirements, 2130.1, 2130.5,

2140.1• See also Regulations.• Accounting standards and guidelines for,

2120.1• Examination objectives, 2130.2

• Examination procedures, 2130.3• Internal control questionnaire, 2130.4Risk measurement and reporting, 3000.1• Futures commission merchants, 3030.1• Interest-rate risk, 3010.1

Repurchase agreements (repos), 4015.1Accounting for, 2120.1Liquidity-risk concerns, 3005.5

Reputational risk, 2150.1, 2030.1Liquidity-risk concerns, 3005.1, 3005.5Off-market or prefunded derivative

transactions, 2020.1

Reserves, 2030.1, 2100.1Liquidity-risk concerns, 3005.1, 3005.5

Revaluation, 2060.1, 2060.3, 2060.4Financial performance, verification of, 2100.1Market liquidity risk concerns, 2030.1

Risk-based capital measure, 2110.1See also specific type of financial instrument.Asset securitization, 3020.1Equity investments, 3040.1Spread accounts, SR-letter, 3020.1Synthetic collateralized loan obligations,

4353.1

Risk management, 2000.1See also specific type of risk.Asset securitizations, 2110.1, 3020.1Capital adequacy considerations, 2110.1Counterparty credit risk, 2020.1, 2021.1Equity investments, 2010.1, 3040.1Financial holding companies, 3040.1Futures commission merchants, 3030.1Liquidity risk, 3005.1, 3005.5Market liquidity risk, 2030.1Market risk, 2010.1, 2110.1Noninvestment business transactions, 3040.1Off-market or prefunded derivative

transactions, 2020.1Organization, 1010.1Overview, preparation for examination, 1000.1Securities, 3000.1Sound practices for, overview, 2000.1

S

Secondary-market credit activities, 3020.1See also specific type of financial activity.

Subject Index


SecuritiesSee also Derivatives and specific type of

financial instrument.Accounting, 2120.1Affiliates, purchased from, 3000.1Agency, U.S. government, 4035.1Asset-backed, 3020.1, 4105.1Broker-dealers, 2140.1Brokers• Brokers’ points, unacceptable trading

practice, 2050.1• Commissions and fees, 2060.1• Futures commission merchants, risks

associated with, 3030.1• Swaps, 4325.1Classifications of, 3000.1Dealers, 2050.1• Selection of, 3000.1Exchange-traded instruments• Counterparty credit risk of, 2020.1• Liquidity risk of, 2030.1Inflation-indexed, U.S. Treasury, 4030.1Investment, 3000.1• Examination objectives, 3000.2• Examination procedures, 3000.3• Internal control questionnaire, 3000.4• Practices, unsuitable, 2050.1, 3000.1• Suitability of, 2070.1Liquidity-risk considerations, 3005.5Municipal, 4050.1New products, 2040.1, 2070.1, 2150.1, 3000.1Over-the-counter instruments• Counterparty credit risk of, 2020.1• Liquidity risk of, 2030.1Recourse, implicit; provided in securitization

transactions, 3020.1Residential mortgage–backed, 4110.1Supervisory-linked covenants included in

securitization documents, 3020.1Trading, 2120.1U.S. government, 4020.1, 4025.1, 4030.1

Securities and Exchange Commission (SEC)Accounting requirements of, 2120.1, 2120.5FOCUS reports, 2130.1, 2130.5, 2140.1

Securitization of assets, 3020.1

Self-regulatory organizations (SROs),2140.1, 3030.1

Settlement risk, 2021.1Extended settlement, 3000.1Financial futures, 4320.1Forwards, 4310.1

Short sales, 3000.1

Small business investment companies,3040.1

Special-purpose vehicles (SPVs), 2020.1Synthetic collateralized loan obligations,

2110.1, 4353.1

Specific risk, 2110.1

SR-letters, Federal Reserve, 3020.1

Staff—See Personnel of trading institutions.

Stress testingInterest-rate risk, 3010.1Market risk, 2010.1Securities and securitization, 3000.1, 3020.1

STRIPS, U.S. Treasury, 4025.1

Structured notes, 4040.1

SwapsCredit-default, 4350.1Credit-equivalent amounts for, 2110.1Currency, 4335.1Interest-rate, 2120.1, 4325.1Netting of, 2110.1Off-market, 2020.1Prepaid, 2020.1Reverse zero-coupon, 2020.1Zero-coupon, 2020.1

Swaptions, 4340.1

Systems risk—See Back-office tradingoperations, Front-office tradingoperations, Management informationsystems.

T

Tickets, trading, 2060.1

Tier 1 leverage ratio, 2110.1

Trademark products, 4025.1

Subject Index


Trading transactionsConfirmation of, 2060.1Consummation of, 2050.1Discrepancies and disputed trades, 2060.1Documentation, 2070.1Income, attribution of, 2100.1Legal structure of firm engaging in, 1010.1Netting agreements, 2070.1Off-market or prefunded derivatives, 2020.1Reconciliation, 2060.1Reporting of, 2050.1Settlement, 2060.1Spot, 4305.1Suitability of, 2070.1, 2150.1Unacceptable trading practices, 2050.1, 3000.1Valuation of positions, 2100.1

Training, 2050.1Front-office operations, 2050.1

Treasury, U.S.Bills, notes, and bonds, 4020.1

Inflation-indexed securities, 4030.1STRIPS, 4025.1Tax and Loan deposit accounts, 3005.5

Trigger events, 2070.1Legal risk, 2070.1Liquidity risk, 3005.1

V

Valuation, 2100.1

Value-at-risk, 2010.1, 2110.1

W

When-issued trading, 3000.1

Subject Index


Documents

Brady Bonds and Other Emerging-Markets Bonds Section - Board of