Exotic DerivativesRobert Schiller makes the following arguments eloquently:1

“For most individuals, the biggest risks are not euro-dollar exchange rate or oil prices. Instead, they are

their pay packets or price of their home. It is reasonable to support that in coming years, our personal

financial services software, with the assistance of professional organizations or trade union and pension

funds will allow people to make essential contracts to reduce income risk. Individuals may be able to create

financial swaps of average income in their region (as measured by a regional income index), thereby

reducing risk.”

1 The Economist March 22nd 2003.

credit spread forward CSF

CSF is a contract where two parties agree to pay or receive a future spread that depends on the difference between the yield on two indices at the origination and that prevails at the settlement of the contract.

Suppose an investor entered into a CSF transaction in three months over a period of 182

days with GS on notional principal of $5 million. Assume that in three months the

LIBOR is at 3.75 percent and the GSCI is at 2530. The GSCI is equal to 2565 at the end

of the contract. The investor at the settlement of the contract pays $93,750 and receives

$31,669.96 for a net payment of –$62,080.04 as follows:

Pay: (.0375). 1/2 (5,000,000) = $93,750

Receive: {[2565/2530 –1]-1/2 (.0150)}(5,000,000) = $31,669.96

Net: -$62,080.04

Credit Spread Option

This OTC option contract allows two parties to enter into a contract where the buyer/writer pays/receives an upfront fee for contingent cash flow in the future if the spread, that is, the difference between the yield on two financial instruments, widens/tightens above the strike price agreed at the origination and that of the settlement period.

Exhibit 12.1 Call/Put Credit Spread on XYZ Bonds Due July 10, 2022 as of February 14, 2002 Spread/call put buyer: Investor Spread/call put writer: Bank Notional Principal NP: $25 million Current spread: 2.25 % Strike (exercise) spread call/put: 2.15 % (out of the money forward call, in the money forward put) Duration DUR: 12.5 years Exercise date: 6 months from today Call option premium: 55 bps of the notional principal payable by investor to the bank Put option premium: 105 bps of the notional principal payable by investor to the bank Settlement date: Today, February 14, 2002 Underlying index: XYZ bonds due July 10, 2022 Reference benchmark Index: 5.785 % U.S. Treasury bond offer yield due September 2022 Index credit spread: the yield to maturity of the underlying index 6.25 % coupon is estimated as (bid price net of any accrued interest) bid yield less the offer yield of the U.S. Treasury bonds at 12.00 PM New York EST time two days prior to exercise date. Call option payment: NP x DUR x Max (2.15 % - index spread, 0) Put option payment: NP x DUR x Max (Index credit spread –2.15%, 0)

For example, if the spread tightens to 200 basis points (XYZ credit improves) in the above example in the next six months, the call is in the money and the call option buyer receives $468,750, that is equal to the duration times the notional principal times 15 basis points.

The buyer of the call has paid an upfront fee of $137,500, .0055 x $25 million for this option. This is an off balance sheet transaction that is highly leveraged, with a small probability of an enormous upside potential and downside risk limited to the amount of premium paid upfront.

Selling/buying an asset contingent on its widening/tightening its spread against say LIBOR with an agreement to buy/sell another asset is an option to enter into an asset swap swap (also known as asset swap switch).

Long put in one asset plus short put in another asset conditional on widening of the spread produces asset swap switch.

Long call in one asset plus short call in another asset conditional on tightening of the spread produces asset swap switch.

Asset Swap Switch

Asset Swap Switch

30 bps Conditional on widening of Argentina spread to LIBOR +500 bps The parties exchange bonds. Argentina Bonds Asset Swap New Zealand Bonds Asset Swap LIBOR + 450 bps LIBOR + 120 bps

Bank Swap CounterParty

Long put in one asset plus short put in another asset conditional on widening of the spread produces asset swap switch.

Callable Step up

This over the counter option was developed in the late 1990s by large banks for window dressing the balance sheet for a short period and realized benefits of regulatory capital relief on the portfolio of credit risks denominated in dollars or foreign currency on transactions of $1 to $3 billion.

The bank having exposure to investment grade credits or unfunded commitment can reduce the risk-based capital by buying an option on default protection that may reduce the risk weight from 100 percent of the 8 percent required reserve capital to 20 percent of the 8 percent for a short period of time.

Consider a German bank with a portfolio of credit risks Baa2/Bbb rated with the weighted average coupon (WAC) of LIBOR + 40, weighted average maturity (WAM) of 7.2 years and duration of 5.3 years. The market value of the portfolio is $2.5 billion.

The bank contemplates laying off the credit risk of the portfolio over the next reporting period to Bundes Bank by purchasing an over the counter option for 60 days.

The annualized premium is 60 basis points. The bank pays an upfront premium of 10 basis points to the

protection seller for assuming the credit risk. The protection seller realizes $2.5 million premium for taking the

credit risk of the portfolio of 200 obligors in this highly leveraged transaction that is booked in the bank’s trading desk. The protection seller assumes the risk of default in any one of the referenced credits however small in probability of default but substantial in severity of loss.

Example

Light service de Electricidade Brazil secured a $23 million loan from foreign investors to upgrade electricity services to Rio de Janeiro and the surrounding low-income areas recently. The loan was guaranteed against T&C restrictions and expropriation.

Example

Transfer & Convertibility Protection

Convertibility Events: As outlined in the master agreement under the International

Swaps and Derivatives Association (ISDA) as any defined event that affects the exchange

of the real for the dollar. These events includes:

1: Failure of the Brazil Central Bank to exchange real at spot for dollars.

2: War and civil unrest in which Brazil is a party.

3: Expropriation and confiscation or nationalization of foreign-owned assets in Brazil

4: Imposition of material exchange control that limits the ability of the protection buyer

to transfer and convert the Brazilian real at spot exchange rate to the U.S. dollar.

5: Run in the Brazilian banking system.

Electricidade Brazil

Foreign Investor

Multi Lateral Investment Guarantee

Dividend, interest and Principal

$23 million

Annual Premium

T & C Protection

Sovereign Credit Default Protection versus Convertibility Protection Prices, Bid/Ask Broker Indications (basis points per annum) 6-month 6-month 1-Year 1-Year Default Convertibility Default Convertibility Argentina 70/NA NA/140 Brazil 60/80 110/NA 70/95 120/170 Mexico 65/75 NA/110 Russia NA/195 150/185 Source: Prebon Yanmane, Tullett Capital Markets, July 14, 1997.

Local and Foreign Currency Rating Country FC Rating LC Rating India BB+ BBB Malaysia BBB- BBB+ Philippines BB+ BBB South Korea BBB A- Thailand BB+ BBB Source: Duff & Phelps Credit Rating Co, “Political risk Insurance for Asian Issuers to Breach Sovereign Ceilings ”August 24, 1999 at www.dcrco.com.

Investors investing in the emerging market bonds have double exposure to:

sovereign risk, as well as the exposure to the U.S. interest

rates risk. For example, tightening a sovereign spread as

a result of improvement in the sovereign rating increases the value of the Brady bonds, however, rising U.S. interest rates is likely to adversely affect the value of the these bonds other things remaining the same.

Tightening or widening credit spreads of Brady bonds over U.S. Treasuries provide opportunities for arbitrage profit.

Example:Currently the Argentine spread is 230 basis points and the investor believes that the

spread is likely to tighten to 160 basis points (the price of Brady will go up) in the next

six months. The investor can buy at the money call option at the strike price of 230 for 50

basis points. Assuming Brady tightens to 165 basis points, the call buyer will make a

profit of 15 basis points or dollar profit of (DUR x .0015 x NP) where DUR and NP are

respectively duration and notional principal of the bond.

Alternatively, buying the put option produces a profit if the credit spread widens. In

this scenario the buyer, expecting deterioration of the Argentine spread over Treasuries

due to weaker economic fundamentals and the likelihood of downgrade, has the option of

putting the bond to the writer at strike price for a profit.

Emerging Market Bonds

The financial markets in Eastern Europe, Latin America, and Asia (Japan not included) make up what is known as the emerging markets.

The sovereign nations as well as firms in these economies issue mostly dollar denominated and some euro denominated debts to undertake various projects.

Like other bonds issued in the major industrial countries these bonds are rated by rating agencies and due to higher credit risk and sovereign risk the yield is at significant spread over the U.S. Treasuries.

Problems in Emerging Market Finance

Emerging markets economies are plagued with: lack of an orderly secondary market, transparency, higher price volatility, wider bid/ask spread, and the absence of reliable price quotes among

other things. The development of an orderly financial market hinges on the ability of the banks, financial institutions, and finance and insurance companies to effectively securitize their financial assets.

Brady Bonds

Some of the secondary market trading of the emerging economies debts is in the repackaged sovereign debts whose principal and some interest is backed by long-term Treasury zero-coupon bonds known as Brady Bonds.

Brady Bonds represent the repackaging and restructuring of nonperforming bank loans into marketable securities collateralized by long dated zeros when former Treasury Secretary Nicholas Brady worked out a plan in 1989 with Mexico to mitigate a huge concentration of risk that U.S financial institutions faced.

According to the plan, the U.S. government and lending institutions agreed to provide some relief in the form of forgiving some of the principal and interest provided that Mexico implemented certain structural reforms.

The U.S. financial institutions, having written off some of the nonperforming loans, reduced their concentration risk and cleaned up their balance sheet. The Brady plan did not pay off the defaulted bank loans, however, it provided a plan where these loans could be paid off in the distant future.

Past due interest bonds cover interest due on restructured loans and do not have collateral except in the case of Costs Rica.

Front loaded interest reduction bonds (FLIRBs) have a rolling interest guarantee (RIG) that covers 12 months of interest over the first 5 year period. However FLIRBs have no guarantee of principal.

The principal bonds cover the principal owed on the bank loans and there are two types of par or discount bonds. Principal par bonds are long dated instrument with a 25 to 30 year maturity with a fixed rate coupon.

Investors investing in the emerging market bonds have double exposure to

sovereign risk as well as the exposure to The U.S. interest rates risk. For example, tightening a sovereign spread

as a result of improvement in the sovereign rating increases the value of the Brady bonds, however, rising U.S. interest rates is likely to adversely affect the value of the these bonds other things remaining the same.

Daily HDD = Max (0, 65° Fahrenheit – daily average temperature)

Daily CDD = Max (0, average daily temperature - 65° Fahrenheit)

Daily HDD and CDD as defined in the CME contracts are respectively the put and call options at the strike price of 65° Fahrenheit and are priced using a standard option pricing formula assuming the cumulative degree-day distribution is normal.

Atlanta HDD futures

globex® quotes as of 01/21/03 10:12 am (cst) MTH/ --- SESSION --- PT EST ---- PRIOR DAY ----

STRIKE OPEN HIGH LOW LAST SETT CHGE VOL SETT VOL INT

J AN03 ---- ---- ---- ---- ---- UNCH 765.0 20

FEB03 ---- ---- ---- ---- ---- UNCH 498.0 10

MAR03 ---- ---- ---- ---- ---- UNCH 360.0 10

APR03 ---- ---- ---- ---- ---- UNCH 140.0

OCT03 ---- ---- ---- ---- ---- UNCH 118.0

NOV03 ---- ---- ---- ---- ---- UNCH 355.0

DEC03 ---- ---- ---- ---- ---- UNCH 595.0

TOTAL 40 EST. VOL Source: www.CME.com

The HDD index for February 2003 is valued at 49,800 (498 times $100). Suppose ice cream chain Baskin Robbins is concerned about falling

revenue due to a forecast of 10° F which is colder than average temperature in the month of February.

The chain is likely to hedge this risk by selling February 2003 CDD futures at CME or buying put options. Alternatively the chain can buy February 2003 HDD futures or buy call options in mitigating the risk of below average temperature that hurts the bottom line that could be offset with the futures or options that produces positive cash flow in the event the expectation of the hedger materialized.

However, had the hedger been proven wrong and the average temperature exceeds the forecast, the hedger enjoys an increase in profits and the hedge proves to be a minor nuisance with a cost that will be written off against the gains. The number of contracts to sell/buy depends on the amount of decrease in sales revenue by the chain in the month of February for every 1point drop in temperature.

The historical past observations on sales revenue and temperature has revealed that the correlation is nearly -90 percent between the two parameters during the cold season and 1 HDD point drop in temperature translates into nearly $5,000 loss in revenue.

Suppose the chain expects the revenue to fall by $500,000 due to cold weather forecast as demand for ice cream is reduced.

The chain is likely to buy 50 HDD February 2003 futures contract to hedge against the risk of 100 degree-day drop in temperature.

The hedge is zero net present value at the origination and is likely to change as the temperature and its volatility changes over time producing positive or negative cash flow for the hedger at the time the hedge is unwind or at the expiration of the contract.

In the above example suppose the HDD index for February 2003 closes at 585 as the hedger expected colder than average month. Each future contract will produce profit of $8,700 (87 x $100) or $435,000 that offsets the lost revenue due to colder than average temperature.

Weather Derivatives

According to WRMA, nearly 70 percent of businesses in the United States are exposed to some type of weather related financial risk.

The U.S. department of commerce estimated the corporate weather exposure at nearly $1 trillion or one eighth of gross domestic product

Mitigating weather related risk is expected to reduce the volatility of earnings and enhance value for shareholders as well as improve the credit ratings of the firm as most analysts in Standard & Poor’s, Moody’s, and Goldman Sachs concur.

The Weather Risk Management Association (WRMA), formed in 1999, is a trade association dedicated to serving and promoting this industry.