Component Adjustment - Equity Derivatives Provision
Content and comparisons
The JC invented the term “Corporate Event” to cover mergers, acquisitions and so on. It really means “Merger Event and or Tender Offer, as the case may be”. This may just confuse things — and heaven knows, they are confused enough already — but still.
Section 12.2. Consequences of Merger Events
- 12.2(a). “Alternative Obligation (Merger Events)”
- 12.2(b). “Cancellation and Payment (Merger Events)”
- 12.2(c). “Options Exchange Adjustment (Merger Events)”
- 12.2(d). “Calculation Agent Adjustment (Merger Events)”
- 12.2(e). “Modified Calculation Agent Adjustment (Merger Events)”
- 12.2(f). “Partial Cancellation and Payment (Merger Events)”
- 12.2(g). “Component Adjustment (Merger Events)”
Section 12.3. Consequences of Tender Offers
- 12.3(a) Cancellation and Payment (Tender Offers)
- 12.3(b) Options Exchange Adjustment (Tender Offers)
- 12.3(c) Calculation Agent Adjustment (Tender Offers)
- 12.3(d) Modified Calculation Agent Adjustment (Tender Offers)
- 12.3(e) Partial Cancellation and Payment (Tender Offers)
- 12.3(f) Component Adjustment (Tender Offers)
Summary
There may be some logic to how ISDA’s crack drafting squad™ mapped out the various adjustments and disruptions that might happen in an equity derivative, but the method has evaporated and the madness only remains. You could organise these events and provisions along any number of different axes and make more or less sense, but the squad appears to have chosen not to, so it falls to us to make some sense of it. Let’s take it from the top.
Adjustments and Modifications versus Extraordinary Events
Firstly, there are those events that aren’t life-threatening to the trade, but, due to some extraneous actions in the market — typically involving the Share issuer or Index provider — require some adjustments. These are, for example Dilution or Concentration Events[1] arising from corporate actions, or changes to the methodology, sponsors or constituents of an Index.
What is affected?
Note that grounds for adjustment or termination generally relate not to the Transaction or the parties to it themselves — those are generally covered by the ISDA Master Agreement — but the referenced “Underliers”[2] (being Shares, Indices and Baskets) underlying it.
How is the Underlier affected?
The event causing trouble might be intrinsic to the Underlier itself — a merger, insolvency, nationalisation, index adjustment or index cancellation — or extrinsic to the Underlier itself, but adversely affecting how it is traded and therefore hedged: illegality, hedging disruption, illiquidity, increased cost of hedging.
Will it blow up the trade?
Some events won’t necessarily blow up the trade, but just require adjustments to the terms for the trade to continue to make sense. If Tesla and Twitter merge into a new corporation called “Twisler”, for example, swaps written on Twitter and Tesla need to be adjusted to reference Twisler, and there may need to be adjustments made to notionals or strike prices to reflect the economics of the merger. These sort of adjustments shouldn’t necessarily cause an early unwind of the Transaction. Likewise, if an index formula or methodology is changed, there may be a need to adjust the economics of a swap referencing that index, but again there is no reason the Transaction itself cannot continue.
If the Hedging Party can’t hedge, on the other hand, it is a different story. This might happen if the Share is delisted (because its Issuer has hit the wall), an Index cancelled, or there is just no liquidity for any number of reasons (Russia invading Ukraine and being sanctioned — that sort of thing.
General discussion
| Action | Applies to | What it does | Comments |
|---|---|---|---|
| Calculation Agent Adjustment | Index Adjustment Event Dilution or Concentration Event Merger Event Tender Offer |
Allows the Calculation Agent discretion to determine whether the adjustment is material and if so adjust the terms of the Transaction to account for its economic effects (or if not possible, for Mergers and Tenders, to terminate the trade at Cancellation and Payment) | The Index Adjustment Events language is worded quite differently from the corresponding provision for Merger Events and Tender Offers. Note for the latter the CA may not adjust the spread or account for changes in volatility, dividends, stock loan rates or liquidity). |
| Modified Calculation Agent Adjustment | Merger Event Tender Offer |
Normal Calculation Agent Adjustment only you are allowed to adjust the spread and make changes for volatility, dividends, stock loan rates and liquidity | See comparison between Calculation Agent Adjustment and Modified Calculation Agent Adjustment |
| Options Exchange Adjustment | Dilution or Concentration Event Merger Event Tender Offer |
Calculation Agent will adjust the terms of the Transaction to reflect adjustments made to exchange-traded options on the Underlier (or that the Calculation Agent determines would have been made had there been exchange-traded options on the shares). | In a splendid economy, Merger Event and Tender Offer refers back to the Dilution or Concentration Event wording (but ignores the “diluting or concentrative effect” bit). |
| Cancellation and Payment | Index Adjustment Event Merger Event Tender Offer Nationalization, Insolvency and Delisting |
Transaction is cancelled (the timing for which depends on the event) and the CA determines the Cancellation Amount under Section 12.7 | This is the standard method where you run out of road and can’t continue the transaction. |
| Partial Cancellation and Payment | Merger Event Tender Offer Nationalization, Insolvency and Delisting |
The Affected part of the Transaction is cancelled, the remainder carries on unaffacted. | This applies where you can’t continue a part of the Transaction — which will only happen where you have a Share Basket Transaction, and the Adjustment Event affects only some of the Shares in the basket. |
| Component Adjustment | Merger Event Tender Offer |
Share-for-Combined is just a hybrid of Share-for-Share and Share-for-Other and applies where consideration for a Merger Event or Tender Offer comes partly in the shape of New Shares and partly through some other imaginative and means raising the necessary funds. Here, as you would expect, you get Share-for-Share on the New Shares, and Share-for-Other for the non-share component | Just a logical working out of the fact that, just as you might have a corporate event in the form of a Share-for-Share or a Share-for-Other, so might you have one that is a bit of both. |
See also
- Corporate Event Consideration - Equity Derivatives Provision in Article 11 of the 2002 ISDA Equity Derivatives Definitions
References
- ↑ Not an official Equity Derivatives term, but a useful one nonetheless.
- ↑ This is not a fully endorsed, ’squad-credentialised definition, but JC shorthand for “Share, Index or Basket, as the case may be”.