Exotic Derivatives

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Exotic Derivatives
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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.

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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.

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• 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.

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Asset Swap Switch

• 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.

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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.

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Example

• 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
  banks 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.

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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 TC restrictions
and expropriation.
Example
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Transfer Convertibility Protection
Annual Premium
Multi Lateral Investment Guarantee
Foreign Investor
Electricidade Brazil
23 million
T C Protection
Dividend, interest and Principal
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• 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.

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

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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.

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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.

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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.

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• 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.

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• 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.

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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.
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• 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.

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• 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.

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