OTC Derivatives OTC Derivatives – Product History and Regulation September 2009

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Text of OTC Derivatives OTC Derivatives – Product History and Regulation September 2009

  • Slide 1
  • OTC Derivatives OTC Derivatives Product History and Regulation September 2009
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  • 2 Introduction What is a Derivative? History, Purposes, Types Common Types of Swaps Swap Documentation OTC Derivatives Regulatory
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  • 3 History of Derivatives Derivatives are not really products and they are not really traded Simply views or bets on future price movements Rice derivatives traded in Japan in 15 th C Stock options traded in the 1800s Corn and wheat futures traded on the CME today
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  • 4 What is a Derivative? Definition of a Derivative a financial instrument (swap, put, call, cap, floor, collar, or similar option) for the purchase or sale of, or whose value is based on, one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind Definition of an Over-the-Counter (OTC) Derivative a derivative that is not traded through an exchange or other regulated market but through a bilateral negotiation between two parties and thus executed off-exchange The Securities Exchange Act and the Commodities Exchange Act regulate exchanges
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  • 5 Purposes and uses of OTC Derivatives Risk transfer Hedging Investment Exposure to different markets Change an assets balance sheet character Speculation Leverage
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  • 6 Common Types of Derivatives Options Futures Forwards Warrants Swaps Other
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  • 7 Options Holder can buy or sell a security/commodity at a set price on, or prior to, expiration of the option calls or puts, caps or floors European versus American Style Exercise/Strike Price Options on stocks; pork bellies Options also are embedded, for example, in Convertible Bonds Holder can convert bond into shares of stock or other securities in the issuing company Structured Notes Holder can receive a return of principal greater than original investment if Notes embedded option has adequately increased in value
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  • 8 Futures Futures contract obligates a person to buy or sell a commodity, security (equity) or financial instrument, or a basket of them (S&P 500 index), at a set price, on a set date (or dates) in the future Standardized contracts only (i.e., exchange traded) only trade specific contracts supported by the exchange contracts are usually cash settled Futures have only market risk due to daily re-margining through the exchange
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  • 9 Forwards Like a futures contract, an agreement to buy or sell an asset at a specified future time and price Customized between parties and not exchange traded Can be for any underlier Can be for any settlement date Forwards are different from futures Forwards entail credit risk exposure to your counterparty Market risk on the trade unless negotiated re-margining
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  • 10 Warrants Holder can buy securities of the issuing company at a specified price that is usually higher than the stock Usually given as consideration of another transaction; sometimes purchased outright with a premium payment Generally traded over the counter and have longer maturities than options
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  • 11 Swaps A cash settled OTC derivative between two counterparties to exchange two streams of cash flows Fundamental purpose is to change character of an asset or liability on one persons balance sheet without liquidating that asset or liability Usually subject to ISDA documentation including master agreement, confirmation, and product definitions
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  • 12 Exchange Traded vs. OTC Derivatives Exchange Traded exchange central clearing house (CCH) acts as counterparty on both sides of the transaction credit risk exposure to CCH margin as required by CCH rules limited number of standardized products Transparent end-of-day valuation simple liquidation OTC private transaction between two parties creates counterparty credit risk to be managed collateral negotiated between the parties valuation based on models using various and at times differing assumptions (witness AIGFP) negotiated liquidation and early termination thus more complex outside of bankruptcy; sometimes skewed in bankruptcy
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  • 13 Common Types of Swaps Interest Rate Swaps Currency (FX) Swaps Commodity Swaps Credit Default Swaps (CDS) Equity Swaps Total Return Swaps (TRS) Other Types
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  • 14 Interest Rate Swaps Interest rate swaps developed in 1981 to alleviate mismatch on capital rates, investment returns and improve issuer balance sheet management European companies could raise money with fixed rate Eurobonds, but European investments paid floating rates US companies often used commercial paper and other floating rate capital markets while investments, such as Treasury, paid fixed returns.
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  • 15 Interest Rate Swaps Use and Structure Banks, funds and corporations use interest rate swaps to reduce mismatched interest exposure on other investments or speculate on interest rate movement Interest rate swaps are standardized/very liquid AB Fixed Interest Rate (e.g., 3%) Floating Interest Rate (e.g., LIBOR + 50 bps) Notional Amount= $500 million
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  • 16 Interest Rate Swap Payment Summary Each payment is based on a notional amount, but the notional amount is not transferred One party makes a stream of payments calculated like interest that would be paid on notional amount with a fixed (or floating) interest rate Other party does the same but based on another interest index (typically a floating rate such as LIBOR, but can be based even on another fixed rate interest index) Fixed and Floating payments typically match on same day (otherwise credit risk) can be made monthly, quarterly, semi-annually etc.
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  • 17 Currency (FX) Swaps Originally developed as back to back loans in the 1970s in the UK to avoid government charges on U.S. dollar based loans. In 1981, Salomon Brothers created first direct currency swap between World Bank and IBM IBM swapped U.S. dollars to the World Bank for Swiss francs and German deutschemarks
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  • 18 FX Swaps Use and Structure Banks, funds and other financial institutions use FX swaps to reduce currency risk on other investments or to speculate on currency fluctuations Currency swaps are standardized and very liquid AB 5% on $10 Million USD LIBOR + 2% on $1.2 Billion JPY
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  • 19 FX Swaps Payment Summary Parties exchange streams of payments in different currencies to reduce exposure to currency risk Multiple currency combinations are possible and some transactions have different currencies swapped based on exchange rate or other factors Often used in conjunction with interest rate swaps where underlying liabilities are financing transactions
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  • 20 Commodity Swaps The Chase Manhattan Bank introduced commodity swaps in 1986 Commodity futures were common for many years, but swaps provided advantages in products and maturity The first swaps referenced oil, but the commodity swap market has expanded natural gas, electricity, coal, other energy products, as well as metals, agriculture and other commodities
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  • 21 Commodity Swaps Use and Structure Commodity users use swaps to protect themselves from risk of price swings Banks and financial institutions use commodity swaps to hedge market exposure to such commodities or to speculate on future price movement AB Appreciation on Referenced Commodity Fixed or Floating Payment or other Commodity returns Depreciation on Referenced Commodity
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  • 22 Commodity Swap Payment Summary Transaction relates to a certain amount of a particular commodity Commodity amount may be for a one time settlement or multiple settlements at set time periods One party pays an amount based on change in price of commodity Other party pays a fixed/floating amount on each settlement date These are cash settled and commodity is almost never transferred
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  • 23 Credit Default Swaps (CDS) Developed in 1994 by JPMorgan to overcome bank capital restrictions on outstanding Exxon loans By transferring Exxon credit risk, JPM could reduce bank capital required to be held against Exxon loans Credit derivatives expanded to reference loans, corporate, sovereign and fixed income notes, indices, etc. How is it different from financial guaranty insurance? CDS buyer need not have an insurable interest
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  • 24 CDS Use and Structure Banks, funds and other financial institutions use CDS to hedge credit risk on investments gain leveraged exposure to loans, debt etc. engage in capital structure arbitrage arbitrage credit markets BuyerSeller Fixed Payments Reference Entity DEFAULT Par Value of Reference Obligation
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  • 25 Treas return + X Par Net losses Structure of Original 1994 JPM CDS (BISTrO) J.P. Morgan retains ownership of loans, but sheds credit risk Credit default swap between MGT and SPV transfers risk Investment proceeds invested in U.S. Treasuries, which collateralize credit default swap (but not entire $9.7 Bn underlying amount) BISTrO notes exposed to credit risk of larger reference portfolio US $697 MM of BISTrO notes exposed to risk of $9.7 Bn portfolio Loan portfolio ($9.7 Bn) Morgan Guaranty Trust (MGT) Special Purpose Vehicle (SPV) U.S. Treasuries Capital market