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ISDA Makes the World a Little Safer for Currency Deals

Over the last few years, foreign exchange dealers privately complained that the basic framework for completing foreign exchange and currency option transactions—the “1992 International Swaps and Derivatives Association’s FX and Currency Options Definitions”—had become too vague to deal with the vicissitudes of the emerging markets. Early last year, ISDA started to do something about it. It enlisted the Emerging Markets Traders Association and the Federal Reserve Bank of New York-sponsored Foreign Exchange Committee to thresh out a plan to deal with the volatile emerging-market currency landscape.

The three groups quickly realized that developing international standards for emerging market currency transactions wasn’t enough—that a complete update of ISDA’s 1992 definitions was needed. In March, the fruits of their labor were unveiled to the world—the “1998 FX and Currency Options Definitions.”

The new definitions are designed to be used to document foreign exchange spot, forward and option deals; transactions between currencies of developed and emerging market nations; and deliverable and nondeliverable transactions. They are applicable to the ISDA Master Agreement, the International Foreign Exchange and Options Master Agreement, the International Foreign Exchange Master Agreement and the International Currency Options Market Master Agreement.

The most important innovation in the 1998 definitions is the addition of “disruption events” to the foreign exchange and currency lexicon. Disruption events allow parties to structure transactions to account for the effect of political risks or other disruptions in the market for one or both of the currencies in question. When disruption events occur, the basis for determining the settlement rate of the deal changes. Disruption events can be used in both deliverable and nondeliverable transactions, in both forward and option structures. There are several types of disruption events: those related to price, including dual exchange rates, illiquidity, price source disruptions and price materiality; those related to the inconvertibility or nontransferability of a currency; events related to other types of government or issuer actions, including benchmark obligation default, government authority default or nationalization of assets. There is also a general provision for what is called a “material change in circumstances.”

The goal of identifying disruption events was to give parties alternative ways to settle deals should exogenous market forces send a currency reeling. When a disruption event occurs, there are a number of “disruption fallbacks” that parties can exercise:

  • “Assignment of claim” allows parties affected by a nationalization event to assign their claim directly to the governmental agency responsible for the nationalization.
  • “Calculation agent determination” allows the calculation agent of a transaction, a disinterested third party, to calculate the settlement price in the wake of a disruption.
  • A “deliverable substitute” allows parties involved in nondeliverable deals to settle via delivery.
  • An “escrow arrangement” allows potential payees to set up interest-bearing escrow accounts in the event of disruptions into which the payers place the funds it owes at the settlement date. After the disruption ends, the payee receives the money.
  • In the event of a dual exchange rate disruption, a “fallback reference price” is reverted to, determined by the deal’s calculation agent.
  • “Local asset substitutes” allow payees to receives assets instead of cash payments.
  • “Local currency substitutes” allow deliverable transactions to be converted to nondeliverable transactions, in which payees receive either the settlement currency amount (for a forward) or the in-the-money amount (for an option).
  • “No-fault termination” allows deals to be terminated when specific conditions are met.
  • “Nondeliverable substitutes” allow deliverable transactions to be converted to nondeliverable at settlement.
  • “Settlement postponement” allows parties to wait until after disruption events occur to settle.

The other major addition to the documentation is the inclusion of currency spot rate definitions that can be used for nondeliverable or cash-settled deals.

For a copy of the “1998 FX and Currency Options Definitions,” call ISDA at 212-332-1200.

The Crystal Ball for 1998

Predicting the future is something derivatives people usually leave to speculators and psychics. But last month, New York-based Capital Market Risk Advisors, the derivatives consulting firm, volunteered a number of prophesies in a recent report entitled “Outlook 1998.”

The firm believes that historians will point to 1998 as the “year of credit models,” for a variety of reasons. Broker-dealers and banks are eager to come up with ways to reduce the capital they need to support their exposures, fueling a great deal of interest. Credit derivatives, moreover, have become sufficiently liquid to establish a market, making modeling increasingly necessary. The Asian crises sent actual and likely future credit losses skyrocketing and called into question the adequacy of regulation and disclosure. Newly released credit models such as CreditRisk+ and CreditMetrics have also added to the interest. There has also been growing concern over consumer credit, asset-backed exposures, subprime lending and other market and credit risk issues.

In 1998 there will be a dramatic increase in the use of derivatives by institutional investors, hedge funds and money managers.

In the coming year, CMRA sees a dramatic increase in the use of derivatives by institutional investors, hedge funds and money managers. The 1996 Risk Standards for Institutional Investors and Institutional Investment Managers, which will be implemented widely this year, opened the door to derivatives usage for many players. Moreover, the volatility of the global equity markets has sparked a reallocation of investment dollars from Asian, South American and Eastern European markets to fixed-income-based products in the more exotic sectors of the U.S. capital markets. “Capitalizing on this trend,” the report says, “are several derivatives pros who have left the Street to start new derivatives hedge funds.”

The report also predicts that most financial institutions will choose value-at-risk methodologies over tabular data or sensitivity analyses to meet the SEC’s disclosure rules, and that different VAR calculation methods will make interpretation of disclosures “difficult at best.”

CMRA also predicts that new risk measures will soon be developed to examine emerging market risks. These will combine quantitative and qualitative measures such as “the rate of change of financial reform given a change in leadership” to present fuller pictures of the risks involved in emerging market transactions.

The report goes on to predict that “dealers will revisit the trade-off between executing trades within jurisdictions to ensure netting and the increased concentration risk that often results,” and that financing structures issued by municipalities and others will become markedly more sophisticated this year.

For a copy of the report, see www.cmra.com.

Playing Earnings Surprises

Even Main Street mutual fund investors know that unexpected quarterly earnings announcements can have dramatic effects on stock prices. The rule of thumb is, the bigger the surprise in the announcement—that is, the more the company’s performance diverges from earnings predictions—the bigger the price effect on its stock.

Salomon Smith Barney analysts have gone to great lengths to quantify this phenomenon—and even recommend options strategies—in a March paper called “Earnings Surprise Outlook.” The authors begin by determining the precise price impact of earnings surprises. During the last six years, they found, the price impact of earnings surprises has been significant. Stocks with the largest “positive” surprise—in which earnings exceeded predictions by the greatest amount—performed the best over the 24 week period from 12 weeks before announcement to 12 weeks after announcement. And stocks with the largest “negative” surprise performed the worst.

That’s particularly valuable information because the stocks with the most positive surprises outperformed the Standard & Poor’s 500 by 10.6 percent in 1997, compared with 11.4 percent the previous five years. But stocks with the most negative surprises underperformed the S&P 500 by 13.4 percent, up from 10.7 percent the previous five years, as investors refused to tolerate poor performance in a rallying market. The report also finds that growth stocks exhibit more price sensitivity to earnings surprises than value stocks.

To help investors predict when a surprise is imminent, Salomon Smith Barney introduced an earnings surprise model in 1996. Since the model was introduced, 78 percent of the stocks it identified as positive surprise candidates delivered a positive surprise, and 45 percent of the negative surprise candidates surprised on the downside. That’s a pretty good record considering that only 54 percent and 23 percent of the Russell 1,000 exhibited surprises on the upside and downside, respectively.

How could investors have taken advantage of this information? The best way, says Salomon Smith Barney, would have been to use long-term option strategies. Stocks with significant earnings surprises showed a dramatic rise in implied volatility leading up to the announcement. The rise in volatilities would make any attempt to take a view with short-term options pricey. By contrast, more forward-thinking players would have purchased options well in advance of the announcement date, when premiums would have been relatively low. “Investors who successfully trade early would be able to lock in a relatively low implied volatility and participate in any potential early price reaction,” says the report. “On the one hand, the risk of trading earlier is the loss of time premium. On the other hand, rising implied volatility will partly compensate for the time loss.”

For a copy of the report, call 212-783-7813.

Chicago Goes Electric

The Chicago Board of Trade isn’t the first place one would think to go to make plays on the energy market. The New York Mercantile Exchange, for years, has dominated the business, trading two big energy products to the tune of 53 million contracts last year. But the CBOT, in copycat mode of late, plans to challenge the NYMEX’s energy stranglehold with two new electricity contracts scheduled to launch sometime this summer.

The contracts are written against two massive electricity suppliers—Chicago-based Commonwealth Edison and the Tennessee Valley Authority. Com Ed is a regional power hub that supplies nine local utility companies, and is a part of the Mid-America Interconnect Network. The TVA supplies 13 utilities, and is part of the Southeastern Electrical Reliability Council. Like the NYMEX’s electricity contracts, the CBOT’s will be based on physical delivery, and they will be traded via open outcry.

The contracts’ main selling point, the CBOT says, is their size. Whereas the NYMEX’s contracts trade at 864 megawatts, the CBOT’s will trade at 1,680 megawatts, based on a 5 megawatt delivery rate times 16 hours a day times 21 onpeak days per month, with a 10 percent delivery variation. “To some degree we’re competing with NYMEX, but to some degree we’re not, because were offering different products in different regions,” says Eric Meier, advisory economist at the CBOT. “We chose Com Ed and the TVA because we identified their hubs as being significant in terms of potential commercial activity, transmission infrastructure and geographical location. We believe we have strong partners in the industry who are willing to make markets.”

The CBOT is hoping to capitalize on the potentially explosive profitability in energy futures as states begin deregulating their retail energy markets, which total some $230 billion. But the NYMEX is taking aggressive steps to protect its franchise product. It has already received CFTC approval to launch two more contracts later this year, which will cover the Cinergy Corp. transmission system in Ohio and the Entergy system in Louisiana. And it has applied for approval to trade futures on the Pennsylvania- New Jersey- Maryland interconnection system.

The NYMEX better watch out, however—competition is coming from all sides. Even the Minneapolis Grain Exchange is taking a shot at the business, having applied for CFTC approval to trade electricity futures covering seven Midwest states and Canada. The deregulated energy market of the near future could make the NYMEX’s dominance of the energy futures market seem like the dark ages.

Preparing for a New Europe

Here’s some advice to those who have not yet prepared themselves for the birth of the euro on January 1, 1999: buckle your seat belts. “The derivatives business has been based on having 11 different European currencies and interest rates and has developed its trading opportunities to take advantage of those differences,” says Chris Iggo, chief economist at Barclays Capital Americas. “Now, the derivatives market will have to reposition itself on the back of structural changes in the market.”

Until the financial markets become comfortable with the European Central Bank’s ability to achieve a balanced monetary policy suitable for the whole of Europe, Iggo believes, the euro bond market and the euro exchange rate are likely to be quite volatile.

He also thinks the key to developing a new European strategy will be to “refocus on credit, look at fixed-income portfolios and base asset-allocation decisions on credit rather than on relative value in currencies.” After all, it’s not a case in which a corporate can raise money at better rates in another country—it’s all going to be the same currency. Instead, the ability to borrow more cheaply or achieve higher returns will be achieved through credit-based structures. He notes, however, that the corporate bond market is much less developed in Europe than in the United States, and credit analysts will have a tough time meeting the demands the market will put on them.

In the short term, some significant differentials in interest rates remain. Italian lira rates, for example, are now about 5.5 percent, while German rates are 3.5 percent or less. Although that could fuel some swap opportunities in the near term, forward rates are moving quickly to price that convergence. By the end of the year, he predicts the single short-term interest rate for all the EMU countries will come in at about 3.75 percent, with a relatively flat yield curve.

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