Template:M summ Equity Derivatives Knock-ins and Knock-outs

If you have forgotten what it is like to have a tension headache, and for some reason feel like being reminded, the sterling work of ISDA’s crack drafting squad™ on Sections 1.44, for Knock-in Events, and Section 1.45, for Knock-out Events, might just be the aneurysm you are looking for.

It is hard not to have some grudging admiration for the rock-jawed consistency of it: having strangled their way through the language once, the inverse is identical but for “-in” becoming “-out” and a single reference to the event having occurred, for a Knock-in Event, and having not occurred (for a Knock-out Event), as this comparison ably illustrates.

With a Knock-in Event, nothing happens until the event — the Transaction “knocks in” — and then you’re in business. With a Knock-out Event, everything happens until the event, and then pop, you’re out.

The concept of Knock-ins and Knock-outs is, thus, basically simple but good GOD ISDA’s crack drafting squad™ make a meal of it. If you stipulate a Knock-in Price below your strike price, if the Underlier falls far enough to hit that price, or go below it, you have a Knock-in Event. If your Knock-in Price is above your initial strike, then the Underlier has to go up to hit it. Whether you have hit it is measured at specified certain Knock-in Valuation Times on Knock-in Determination Days.

Exactly the same goes for Knock-outs, only in mirror image.

Can we envisage a circumstance in which the Knock-in Reference Security is not the Underlier? Well, I can’t but I am sure someone at Goldman could think of one.

Determination Days

So it starts out easily enough: unless otherwise specified (everything in an ISDA definitions booklet is “unless otherwise specified”), every Scheduled Trading Day on an Exchange is a “Knock” Determination Day.

The whatiffery starts if a related Exchange is not trading at all — a Disrupted Day by the designated Knock Valuation Time. (if trading becomes disrupted afterwards, no harm done - your “knock” has already happened and the Transaction can carry serenely on with whatever it was doing).

If there is a disruption you have eight days to sit it out, after which you damn the torpedoes and value the reference Security using the valuation methodology under Section 6.6 (Consequences of Disrupted Days). The drafting somewhat implies that at this stage there will only be one Knock Determination Date, on that eighth day, but this is not, at least in theory, the case: the Determination Date only works out whether a Knock-in Event or Knock-out Event has happened; if it hasn’t you fold away your tent and come back the next Scheduled Trading Day — whether or not disrupted — and do it all again.

Valuation Time

As specified in the Confirmation, effectively, falling back to Scheduled Closing Time if you don’t.

The only funny is what you do if you set your Valuation Time at a point in the day later than the time the Exchange in question actually closes — you know, if they unexpectedly call Smoko and all go to the pub early. It is not clear how often this happens in practice, but all we need know is that it might, and if it does, ISDA’s crack drafting squad™ has your back: the actual closing time is the point at which you run your valuation. Figures, really.