COMMON DERIVATIVE PRODUCTS

Derivatives – Product Training

Facilitator – Krishnan-V Iyer

Objective

At the end of this training session you will be able to

know what is Derivatives

differentiate between OTC Vs Exchange Traded Derivatives

understand the common types Rates Derivatives

understand the common types Credit Derivatives

understand the common types Equity Derivatives

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Derivatives

What are Derivatives ?

The term “Derivative” indicates that it has no independent value, i.e. its value is entirely “derived” from the value of the underlying asset.

The underlying asset can be securities, commodities, currency, live stock or anything else.

In other words

The word “Derivative” originates from the mathematics and refers to variable, which has been derived from another variable. Derivatives are so called because they have no value for their own.

They derive their value from the value of some other asset, which known as the underlying.

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Derivatives

Example

What will be the value of derivative if the underlying is 100 shares of Infosys which is traded at Rs.1,500

100 * 1500 = Rs.150,000

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Derivatives

OTC Derivatives :

Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

The OTC derivatives market is huge. According to the Bank of International Settlements, the total outstanding notional amount is over USD 600 trillion (as of April 2008)

Exchange Traded :

All potential sellers and buyers assemble at a place called the ‘Exchange’ where everyone can publicly negotiate with any other trader.

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Classification of Derivatives

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Exchange Trade vs Over the Counter

Features Over the Counter Exchange Traded

Examples Forwards, Caps, Floors, Collars, Swaps, etc Futures and Options

Market Networks consisting of market makers who exchange price information and negotiate

transactions

Organized exchanges in Chicago, New York, Kansas City, and other capital markets around the world.

AgreementCustom-tailored to meet specific needs of counter-parties within accepted guidelines

Standardized contracts

Risk Default/credit risk to the counter-parties. Guaranteed contract performance

Regulation Not formally regulatedU.S exchanges regulated by Commodity Futures Trading

Commission (CFTC)

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Rates

Options

Credits

Types

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Rates

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A swap is a contract between two parties agreeing to exchange payments on regular future dates for a agreed period of time, wherein the two payment legs are calculated on a different basis.

Interest Rate Products:

Vanilla Swap (fixed for float) Basis Swap (float for float) Cross Currency Swaps Forward Rate Agreement Over-night Index Swap (OIS) Options:

Swaptions – Straddle & Strangle Interest Rate Options (Caps, Floors and Collars) Misc – Call & Put, Long & Short

Interest Rate Swap (IRS)

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Vanilla (Fixed for float):

One party in a contract pays fixed rate of interest calculated on the notional amount and another floating rate as per floating rate option

Features

The notional is fixed at the outset and remains unchanged till maturityThe notional amount is never exchangedOne party pays fixed on an agreed future datesAnother party pays interest on a variable rate of interest on agreed future dates.

Application of Interest Rate Swap:

A company has borrowed funds by issuing a bond that pays a fixed coupon, but believes that market interest rates will fall sharply and will lose out the resulting cheaper borrowing costs.Then the company enters into an IRS receiving fixed and pays float to enjoy the floating rate decline.


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Basis (Float for float) Swaps:

The only difference in the case of Basis swap, as compared to Vanilla swap, is that either parties of the contract pays interest on floating rate basis taken from different floating rate option.

(Ex: Party “A” pays interest based on rate from EUBOR + bps and Party “B” pays interest based on LIBOR rate sources)


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Cross currency Swaps (XCY swap) & Mark to Markets

Cross currency swap is a contract where one party pays interest on notional borrowed in one currency and receives interest on notional lent in different currencies on agreed dates.

The principal amounts are exchanged at the start of the swap and re-exchanged at the maturity.

The XCY swaps are extension to vanilla and basis swaps. Hence, The XCY Swap can be studied in the following ways.


Swap Kind of Swap Party A Party B

Vanilla / Xcy Swaps Fixed-for-float Pays fixed/float Pays Float/fixed

Basis / Xcy Swaps Float-for-float Pays float Pays float

Only Xcy Swaps Fixed-for-fixed Pays fixed Pays fixed

Classification of Interest rate swaps

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Mark to Market

Fixed for Fixed

Fixed for Float

Float for Float

Cross Currency Swap

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Mark to Market (MTM)

It is a method of adjusting the value of variable currency, as compared to base currency, in line with the spot rate in the market. Principal amount of one currency in the transaction remains static whilst the other foreign currency amount is periodically revalued against it.

Application of Xcy – MTM Swap:

Americo, is a US company with a top credit rating. The other party, Britco, is a less highly-rated UK company. Both sides wish to borrow money on a fixed-rate basis. Americo wishes to borrow £100 million and to pay interest in sterling to finance its UK operations. Britco wishes to borrow $150 million and to pay interest in dollars, to fund activities in the USA. The spot foreign exchange rate is £/$1.5, that is, 1 pound sterling buys 1.5 US dollars. Interest in all cases is payable once a year, in arrears.


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It can be observed from above, that if Americo wants to raise finances in the UK Market, it will have to pay more interest than Britco

And similarly, If Britco wants to raise funds in US Market, it will end up paying more interest than Americo.


Borrower US $ fixed rate UK £ fixed rate

Americo 5.00 % 6.00 %

Britco 6.50 % 5.75 %

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The dealer does a transaction for them in the following fashion with slight margin for himself in the transaction.


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It is an agreement between two parties to exchange the difference between the fixed rate (agreed at the time of executing the contract) and reference or benchmark rate as per floating rate option . The cashflow is settled upfront on the effective date of the deal.(Present Value of the interest payable at Maturity)

Buyer and Seller of a FRA?

It is normally the corporate borrowers who prefer buying the FRA to hedge against rising interest rates

and

Money market investors (short-term investors) prefer selling FRA to protect against decline in interest rates on deposits.

?

Forward Rate Agreement (FRA)

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Let’s Understand:

1. Seller of Swap

2. Buyer of Swap

3. Notional Amount

4. Trade Date

5. Effective Date

6. Maturity / Termination Date

7. Reset Date / Fixing Date

8. Floating rate option

9. Fixed rate

10.FRA Discounting

0 x 3 FRA Trade

56

32

1

4

7

8

10


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Example FRA contract – Broker confirmation


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2 x 3 FRA contract means trade that is starting 2 months forward from the trade date of the transaction and ending 3 months from the trade dateTrade date + 2 months = Start Date ; Trade date + 3 months = Maturity date

Note: coupon is calculated for only one month i.e. from 2nd month till 3rd month


DB is the Seller on this trade

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Let’s consider few examples about notation and interpretation of FRA trades


NotationEffective Date

from Trade date

Termination Date from trade

date

Underlying Rate (LIBOR)

1 x 3 1 month 3 months 3-1 = 2 months

1 x 7 1 month 7 months 7-1 = 6 months

3 x 6 3 months 6 months 6-3 = 3 months




taking the below details as the example, FRA coupon amount is calculated as shown in the next page:

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Taking the above example, Below will be the calculations.


FORWARD RATE AGREEMENT

Deutsche Bank [/] Purchase (P)

Notional 130,000,000.00

Currency USD

Trade Date 24/02/2009

Start Date 29/06/2009

End Date 29/09/2009

Fixed Rate 1.2122

Floating rate 0.60125

Act/360 360

Days 92

If settled at maturity 202,971.17

DB Pays - If upfront 202,659.77

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Over-night index swap is the contract wherein one party agrees to pay the fixed rate of interest for a defined period of time and another party agrees to pay Interest compounded daily.

How is OIS different from a Vanilla Swap?

OIS is all the same as a plain vanilla swap except in the following terms1. Accrual of coupon - Compounding 2. Fixing dates

Let’s take a look at each concept to draw a satisfactory understanding on OIS, though they co-relate.

Coupon is compounded on a daily basis taking the rates from markets on all good business days till the coupon settlement or maturity.

Now it is apparent that fixing date in the case of OIS will be everyday which is falling within a calculation period.

Overnight Index Swap (OIS)

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Hypothetical Example of how OIS works:

Let’s take a sample how a coupon is calculated:Say, Overnight rates are as follows:

And the notional amount is assumed to be INR 1,000,000.00 with start date: 02-Aug and maturing on 11-Aug 2008. INR is a non-deliverable currency and is subject to conversion while settling.Note: Rates published on Saturday are not considered for compounding .i.e. rates published between Monday and Friday are only considered.


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Coupon Calculation on the float leg:

Date Notional Rate Days DCF - Act/365 Coupon

02-Aug-08 10,000,000.00 9.46 2 0.005479452 5,183.56

04-Aug-08 10,005,183.56 9.34 1 0.002739726 2,560.23

05-Aug-08 10,007,743.79 9.3 1 0.002739726 2,549.92

06-Aug-08 10,010,293.71 9.21 1 0.002739726 2,525.89

07-Aug-08 10,012,819.60 9.21 1 0.002739726 2,526.52

08-Aug-08 10,015,346.12 9.2 1 0.002739726 2,524.42

09-Aug-08 10,017,870.53 9.18 2 0.005479452 5,039.13

11-Aug-08 22,909.66 Settlement Date


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Similarly, Every market has a rates published ,say, BBA –LIBOR; SAFEX– JIBOR etc,


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Option

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Option

PutCall

Long Put Short PutLong Call Short Call

American Bermudan European

Option

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An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms.

Exchange Traded(ET) or Over The Counter(OTC):Options can be ET or OTC. Below is the list, though not exhaustive, of underlying for ET and OTC contracts:

Exchange Traded Over the counter

Equities – Individual Stocks Bonds

Index Equities – Individual stocks

Futures Swaps

Interests Exotic products – CDS, ABS, Bespoke

Currencies Currencies

Option

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Option TerminologyExpiration Date - Day when the option expires as agreed in the

contract. Exercise - When the option

buyer converts the option to a futures position at the strike

price. Can occur anytime prior to the option expiration date.Intrinsic Value- The amount of

money, if any, that could currently be realized by

exercising an option with a given strike price.In-the-money - If option lead to

a positive cash flow to the holder if it were exercised

immediatelyAt-the-money - If option lead to a zero cash flow to the holder if it were exercised immediatelyOut-of-the-money- If option

lead to a Negative cash flow to the holder if it were exercised

immediately

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Call - An option that gives the right to buy the

underlying futures contract

Put Option - An option granting the right to sell the underlying futures contract. Straddle - Purchase or sale of an equal number of puts

and calls with the same terms at the same time. i.e.

strikes are same.Strangle – Purchase or sale of an equal number of puts and calls with the different

terms at the same time. i.e. strikes are different.

Long - One who has bought a contract(s) to establish a market position and who

has not yet closed out this position through an

offsetting sale; the opposite of short.

Short - One who has sold a contract to establish a

market position and who has not yet closed out this

position through an offsetting purchase; the

opposite of a long position.

Option Terminology

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Exercise

American •The option can be exercised at any time up to the expiration

European •The option can be exercised only on the expiration date

Bermudan •The option can be exercised on a few specific dates prior to expiration. “The name was chosen because Bermuda is half way between America and Europe

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A trader who believes that a stock's price will increase might buy the right to purchase the stock ( a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a much larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.

Example: If ABC is priced at Rs.60 and the trader anticipates it to rise, Suppose if the price of the underlying increases to Rs.75, He shall exercise the option and make a profit. If the price decreases to 50 he shall not exercise the right. Trader shall just lose the amount of premium for the option.

Long Call

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A trader who believes that a stock price will increase can buy the stock or instead sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock.

Example: If ABC is priced at Rs.520 and the trader expects it to increase. Suppose if the price increases to Rs.590, He shall exercise the option and make a profit. If the price increases to 50 he shall not exercise the right. Trader shall just lose the amount of premium for the option.

Short Put

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A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.

Example: If ABC is priced at Rs.520 and the trader expects it to decrease. Suppose if the price decreases to Rs.490, He shall exercise the option and make a profit. If the price increases to 550 he shall not exercise the right. Trader shall just lose the amount of premium for the option.

Long Put

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A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited

Example: If ABC is priced at Rs.120 and the trader expects it to decrease. Suppose if the price decreases to Rs.90, He shall exercise the option and make a profit. If the price increases to 150 he shall not exercise the right. Trader shall just lose the amount of premium for the option.

Short Call

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Settlement

Physical Settlement

• Physically-settled options require the actual delivery of the underlying security. Examples of physically settled contracts include U.S.-listed exchange-traded equity options.

Cash Settlement

• Cash-settled options do not require the actual delivery of the underlier. Instead, the corresponding cash value of the underlier is netted against the strike amount and the difference is paid to the owner of the option. Examples of cash-settled contracts include most U.S.-listed exchange-traded index options.

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A Swaption is an OTC option on a swap. Usually, the underlying swap is a interest rate swap or even a credit default swap. Unless stated otherwise, that is how we will use the term in this article. However, the term "Swaption" might be used to refer to an option on any type of swap.

In case you are wondering why anyone would want to buy a Swaption, the answer is often that they don't want to. Frequently, they want to sell a Swaption. Consider a corporation that has issued debt in the form of callable bonds paying a fixed semiannual interest rate. The corporation would like to swap the debt into floating rate debt. The corporation enters into a fixed-for-floating swap with a derivatives dealer. To liquidate the call feature of the debt, it also sells the dealer a Swaption. For derivatives dealers, clients often want to sell them Swaptions while other clients want to buy caps from them. The dealers then face the challenge of hedging the short caps with the long Swaptions.

Swaption

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To specify a Swaption, we must indicate three things:

Expiration date of the option

Fixed rate on the underlying swap

Tenor (time to maturity at exercise of the option) of the swap.

The purchaser of the Swaption pays an up front premium. If he exercises, there is no strike price to pay. The two parties simply put on the prescribe swap. Note, however, the fixed rate specified for the Swaption plays a role very similar to that of a strike price. The holder of the Swaption will decide whether or not to exercise based on whether swap rates rise above or fall below that fixed rate. For this reason, the fixed rate is often called the strike rate.

A payer Swaption is a call on a pay-fixed swap—the Swaption holder has the option to pay fixed on a swap.

A receiver Swaption is a call on a receive fixed swap—the Swaption holder has the option to receive fixed on a swap.

Swaption

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Option

Straddle

Call

Strangle

Put

Collar

Long Straddle Short Straddle Long Strangle Short Strangle

Interest rate Options

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It’s a combination of call and a put option at the same exercise price, often called as double option

A straddle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle.

Straddle

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It's a combination of call and a put option at different exercise price.

A strangle is an strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, with relatively minimal exposure to the direction of price movement. The purchase of particular option derivatives is known as a long strangle, while the sale of the option derivatives is known as a short strangle. It is related to a similar option strategy known as a straddle.

Strangle

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A collar is an investment strategy that uses options to limit the possible range of positive or negative returns on an investment in an underlying asset to a specific range. To do this, an investor simultaneously buys a put option and sells (writes) a call option on that asset. The strike price on the call needs to be above the strike price for the put, and the expiration dates should be the same.

After establishing the portfolio in this manner, the return on the portfolio will be between the strike price on the call (potential profit), and the strike price on the put (potential loss), meaning the possible gains and losses will always be within a preset limit.

Collar

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An interest-rate cap is an OTC derivative that protects the holder from rise in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) exceeds a specified strike rate (the "cap rate"). Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate

Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period. If a payment is due on a USD Libor cap, it is calculated as

Cap

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Let’s say a client has a two year floating rate €100m loan, which resets every 6 months (3 month resets are also common).

The client faces an interest rate risk. If rates go up, the client loses. If rates go down, the client gains (see figure below).

The client therefore wants to hedge against interest rate risk.

InterestExpense

Future Libor

Unhedged

Cap

Caps

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A cap allows the client to protect against rising interest costs, whilst at the same time taking advantage of a reduction in rates (having paid a premium)

The diagram below shows that a two year cap is actually made up a several ‘caplets’

6 12 18 240

Caplet 1

Caplet 2

Caplet 3

Two Year Interest Rate Cap

Caps

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The first period (0 to 6 months) does not contain a caplet as the rate for this period is already known

If the two year cap has a strike of 5.5%, and at the start of the 6 to 12 month period six month Euribor turns out to be 6%, under the terms of the cap the client will receive from the bank the difference of 0.5% on €100m multiplied by 180/360 = €250,000

The payment would be received by the client at the end of twelve months - this fits in with the payment on the loan also typically being at the end of the period

Let’s say that at the beginning of the 12 to 18 month period, six month Euribor sets at 5%. This is below the strike of the cap so no payments are made - but of course the client benefits from lower borrowing costs

[NB. Note that the borrowing can be with a completely separate bank from the bank that sold the cap

If, in the 18 to 24 month period six month Euribor sets at 5.9% then the client will again receive a payment under the terms of the cap (the difference between 5.9% and 5.5% on €100m for 6 months), paid at the end of 24 months

Caps

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If you are happy that you understand caps, then floors are pretty easy

The simplest use for a floor that you might come across is a depositor trying to protect returns (the depositor would buy a floor)

If rates go below the strike on the floor then the depositor receives a payment

If rates go up then the depositor takes the benefit.

Floor

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A CAP Floor Straddle is buying a cap and buying a floor at the same exercise price, thus the cap and the floor rate are at the same rate of the interest

A Cap Floor Strangle is buying a cap and buying a floor at different exercise prices, thus cap rate and the floor rate are at different rate of interest

A Cap Floor Collar combines buying a cap and selling a floor, or vice versa. Depending on the trade, usually premium paid is the same as premium received, or there is only a small difference in cash amount between premium paid and premium received

Cap & floor

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Credits

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Credit default swaps are trades used by companies to protect against specific entities defaulting. These can be used to hedge against existing exposure with the underlying entities . These could be traded on a single name, Index, Loans, Bonds, Basket of Companies. And further in different tranches as well.

The buyer of the protection is covered for the duration of the trade against the underlying company (single name) or market quoted group of companies (index) defaulting.For this protection, the buyer must pay a periodic fee (coupon) until the maturity of the CDS or until default (whichever occurs first) to the seller.

Credit Default Swap

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The seller of protection has to compensate the buyer in the event of the underlying entity defaulting. Some reasons for entities defaulting are

Bankruptcy

Failure to pay/obligation default

Ratings downgrade below given threshold.

The defaulting of an underlying entity is known as a CREDIT EVENT.

Types of Default

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Single Name credit default swaps are the buying/selling of protection of an individual underlying entity (reference entity) for example GM, General Motors

Should the company default the seller of protection must reimburse the buyer on the total notional of the protection, this reimbursement or compensation is determined by the notional x (1 – recovery rate).

Single Name CDS

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An Index CDS is protection sold on multiple underlying entities, commonly 100 or 125 entities making up a percentage of the total notional, eg CDX.B.4 was made up of 100 companies from a variety of industries including aviation, power and car manufacturing companies.

Should any of the companies default, the seller of the index must reimburse the buyer for the percentage of the notional represented by the defaulting company adjusted by the recovery rate.

Example reference entity CKC represented 1% of the CDX.B.4 index and defaulted. The seller must compensate the buyer of the protection for 1% of the notional adjusted by the recovery rate. The CDX index trade will then continue but with only 99 reference entities and the notional of the CDS is reduced going forward by 1%.

Index CDS

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Upfront fee – Cashflow exchanged between the buyer and seller of the protection, this is affected by the current market value of the CDS as well as any accrued interest.

Effective Date – This date determines the date the period of protection begins

Termination Date – The date that the period of protection ends

Notional – The cash value of the protection

Coupon Date – The value date that the periodic fee for the protection is due to the seller

Fixed Rate – The interest rate upon which the periodic fee is calculated.

Underlying Entity – The entity to which the protection relates.

CDS Terminology

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Buyers and Sellers of protection once entered into a trade are bound until the trade matures, or the underlying entity defaults. Companies may only want protection for a shorter period of time, or may want to cancel a trade dependent on their views on the underlying entities.Companies can arrange directly with their original trade counterparties to terminate part or all of the protection on previously traded CDS trades. This is known as a trade UNWIND.

To partially or fully unwind a trading position a termination fee is payable between both parties.

Alternatively companies can ‘sell on’ their trading positions to a third party for a fee, this is known as ASSIGNING or NOVATING trades.

The company assigning is known to be ‘stepping out’ and is known as the Assignor/transferor.

The third party taking on the trade is known to be ‘stepping in’ and is known as the assignee/transferee.

The original counterparty who now face a new counterparty is the ‘ever-present’ or ‘remaining’ party.

When an assignment or novation takes place a fee is due between the transferor and transferee, no fee is due to the remaining party.

Ways to eliminate CDS exposure

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CDS Trade Tickets – Bloomberg

CDS Bloomberg Ticket

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This is an unwind (cancellation) of an existing trade with Forest.Forest Sells protection in the index CDX.B.4 traded 06Sep05, effective 07Sep05 (date shown is effective date of original trade), termination date is 20Jun10, notional $5m, price 100.7500%. Fee quoted is $74,805.56.Fee is made up of accrued interest plus the price fee calculation.Fee calculation Notional * (Price – 100)%5,000,000.00 * (100.75 – 100)% = USD 37,500.00Accrued Interest (reasons, full coupon)Notional * days between effective date and last coupon date / 360 * coupon5,000,000.00 * 79 (07Sep05 – 20Jun05) / 360 * 3.40% = 37,305.56Fee calculation $37,500.00 + $37,305.56 = 74,805.56This is an unwind fee, but upfront fees work in exactly the same way

CDS Trade – BBG Verification

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Effective dates on new trades are generally T+1, ie 1 business day after the trade date. Be careful, effective dates on assignments can fall on a non-working day.

Fees, upfront, unwind and assignment fees are due to be paid T+3, ie 3 business days after the trade date.

CDS trades generally will accrue 1 extra days interest on the final coupon period up to and including the termination date.

Short/Long Stubs – a single name CDS traded less than 30 days before the next scheduled roll date will generally have an extended first coupon period called a long stub. This is a general market rule but is overruled by any agreement between traders.

Example a CDS with coupon dates 20Mar, 20Jun, 20Sep, 20Dec traded 23Feb06 will generally have a long first coupon period between the effective date, 24Feb06 and the second roll date 20Jun06.

Index CDS trades generally settle full coupon on each and every coupon date irrespective of effective date. Any accrued interest up to the effective date is offset by the upfront fee of which the accrued interest up to effective date is factored in. For example on the CDX.B.4 trade shown earlier, if this was a new trade rather than an unwind, value 20Sep05, DB, as the buyer if the protection would pay coupon from 20Jun05 to 20Sep05 to Forest as Forest have already paid us accrued interest up to the effective date in the example. This appears to be a duplication of cashflow but it if accrued interest is settled upfront, it makes assignments and unwinds much cleaner. A company stepping into a trade does not want to pay Forest for the period 20Jun05 – 06Sep05 and Deutsche 07Sep05 to 20Sep05.

Trade Characteristics

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An ABS stands for ‘Asset Backed Security’. The description of this is:

A financial security backed by a loan, lease or receivables against assets other than real estate and

Mortgage backed securities. As an investor, asset-backed securities are an alternative to investing in corporate debt.

What is an ABS?

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There are two types of CDS of ABS

Single name.

The inception of these trades was in 2004.

ABX

These are ABS index trades which began trading in the first quarter of 2006.

Types of CDS on ABS

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As the name suggests these trades all have a single ABS as the underlying, similar to a normal

CDS trade with a single name.

Settlement:No up-front fees.Short First StubsAssignments

Generally roll monthly 25th (New York business day) with modified following business day

Convention.

Five Day London any New York Business Day Payment Lag

Single Name CDS on ABS

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Below are the characteristics of ABX trades.

As with CDS index trades the ABX is a pool of ABS put together. This is a set pool for each ABX.

A underling reference will be created in summit for all new ABX names

ABX trades do have up-front fees on them.

ABS trades have factors set on them. A factor is “a change in the outstanding principle issuance i.e. % of principle unpaid on the reference obligation” the factors are published with in 24hrs of the roll date and are to be used for the following period.

All trades should have the same booking methodology as the underlying bonds i.e same business day convention and business calendar dates

ABX

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Trade Date – the day the trader says “done” and trade is executed

Effective date of trade – Three business days after the trade date - when protection begins

Effective date of index (i.e. annex date) – date the annex was initially published or revised

Settlement date – Five business days after the trade date - when the premium is exchanged

Premium – fee exchanged when trade is initially done comprising the market value of the trade and Accrued interest since last payment date

Accrued interest (in terms of premium) – interest accumulated from and including last payment date but excluding effective date of trade

Factor - A change in the outstanding principal issuance i.e. % of principal unpaid on the reference obligation

Key Definitions and DatesCredit Default Swap

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Price based quoting – The percentage at which the bond is traded i.e. Discount or

premium

Initial Fixed rate Payer Calculation period – From and including last payment date but

excluding the next payment date of the bond

Valuable Dates

Trade date – T

Effective date of trade – T+3

Settlement date – T + 5 (This is currently being reviewed by the main broker dealers

with a view to reducing the fee settlement period to T + 3)

Markit Publish date - 24 hours or less after trustee report is published (25th).

Credit Default Swap

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Factors will be published 24 hours after trustee report is issued on MarkIt website

Reasons for valid factor changes:

Credit event

Interest shortfall

Interest reimbursement

Amortization

Two reasons for corrections in Factors:

Administrative error - factor will be adjusted and payment will be corrected on next payment date

Unknown factor at the time of trade date – factor will be updated, possible option: cancel and correct

Factors

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INTEREST SHORTFALLS

Interest Shortfalls are adjustments made on the underlying obligation.

These are published at the end of the accrual period, and are to settle net with the coupon (after the 5 day lag).

These are payable from the protection seller to the protection buyer.

These should be considered as margin calls against temporarily defaulting debtors.

INTEREST REIMBURSEMENTS

Interest Reimbursements are the repayment of the interest shortfall from the protection buyer to the protection seller, once the balance of the underlying obligation is corrected.

Interest Shortfalls and Reimbursements

Objective – Review

At the end of this training session you will be able to

- know what is Derivatives

- differentiate between OTC Vs Exchange Traded Derivatives

- understand the common types Rates Derivatives

- understand the common types Credit Derivatives

- understand the common types Equity Derivatives

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Questions

Documents

COMMON DERIVATIVE PRODUCTS