2002 ISDA Equity Derivatives Definitions
A Jolly Contrarian owner’s manual
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Section 11.1 in a Nutshell™
Use at your own risk, campers!
11.1. Adjustments to Indices.
11.1(a) Successor Indices. The Calculation Agent may deem an Index calculated by a successor sponsor to the Index Sponsor, or a “Successor Index” that replaces the Index and uses a substantially similar formula and calculation method, to be the Index.
11.1(b) Index Adjustment Events: If before any Valuation Date the Index Sponsor announces a material change to the calculation method of, or materially modifies the Index in any way not contemplated in its formula or method (an “Index Modification”), permanently cancels the Index where no Successor Index exists (an “Index Cancellation”) or fails to announce a relevant Index (an “Index Disruption” (each of these events an “Index Adjustment Event”), then:
- (A) if “Calculation Agent Adjustment” applies, then the Calculation Agent must determine whether the Index Adjustment Event materially affects the Index Transaction and, if it does, must calculate the any necessary price, using the Index level as at that Valuation Date it determines using the Index calculation method last in effect before the Index Adjustment Event, using the securities that comprised that Index at that time;
- (B) if “Negotiated Close-out” applies then the parties may terminate the Transaction on mutually acceptable terms and if they do not it will continue on the terms and conditions and using formulas and calculation methods in effect as of the time of any necessary calculations; or
- (C) if “Cancellation and Payment” applies then following an Index Adjustment Event the Transaction cancelled and valued using the Index calculation method in effect immediately before the Index Adjustment Event in question, as follows:
- (1) for an Index Disruption, the Transaction will be cancelled on the Valuation Date,
- (2) for an Index Cancellation, the Transaction will be cancelled on the Exchange Business Day before the Index Cancellation is effective (or the date the Index Sponsor announces it, if later) and
- (3) following announcement of an Index Modification, either party may elect, on two Scheduled Trading Days’ notice (or less, so that termination occurs by the Index Modification date), to cancel the Transaction by the Scheduled Trading Day before the Index Modification becomes effective and
- (X) for Option Transactions, Seller will pay to Buyer the Section 12.7(b)(ii) amount and
- (Y) for Swap and Forward Transactions, one party will pay the other the Section 12.7(c) amount.
Full text of Section 11.1
Section 11.1. Adjustments to Indices.
11.1(a) [Successor Indices]. If, in respect of an Index Transaction or Index Basket Transaction, a relevant Index is (i) not calculated and announced by the Index Sponsor but is calculated and announced by a successor sponsor acceptable to the Calculation Agent, or (ii) replaced by a successor index using, in the determination of the Calculation Agent, the same or a substantially similar formula for and method of calculation as used in the calculation of that Index, then in each case that index (the “Successor Index”) will be deemed to be the Index.
11.1(b) If (i) on or prior to any Valuation Date in respect of an Index Transaction or Index Basket Transaction, a relevant Index Sponsor announces that it will make a material change in the formula for or the method of calculating that Index or in any other way materially modifies that Index (other than a modification prescribed in that formula or method to maintain that Index in the event of changes in constituent stock and capitalization and other routine events) (an “Index Modification”) or permanently cancels the Index and no Successor Index exists (an “Index Cancellation”) or (ii) on any Valuation Date in respect of an Index Transaction or Index Basket Transaction, the Index Sponsor fails to calculate and announce a relevant Index (an “Index Disruption” and together with an Index Modification and an Index Cancellation, each an “Index Adjustment Event”), then:
- (A) if “Calculation Agent Adjustment” is specified in the related Confirmation as the consequence of any such Index Adjustment Event, then the Calculation Agent shall determine if such Index Adjustment Event has a material effect on the Index Transaction and, if so, shall calculate the relevant Settlement Price, Final Price, Strike Price, Forward Price, Forward Floor Price, Forward Cap Price, Knock-in Price or Knock-out Price, as the case may be, using, in lieu of a published level for that Index, the level for that Index as at that Valuation Date as determined by the Calculation Agent in accordance with the formula for and method of calculating that Index last in effect prior to the change, failure or cancellation, but using only those securities that comprised that Index immediately prior to that Index Adjustment Event;
- (B) if “Negotiated Close-out” is specified in the related Confirmation as the consequence of any such Index Adjustment Event, then the parties may, but are not obliged to, terminate the Transaction on mutually acceptable terms and if they do not agree to terminate the Transaction, then it continues on the terms and subject to the conditions, formulas and calculation methods in effect as of any relevant time at which calculations may be made; or
- (C) if “Cancellation and Payment” is specified in the related Confirmation as the consequence of any such Index Adjustment Event, then
- (1) in the case of an Index Disruption, the Transaction will be cancelled on the Valuation Date,
- (2) in the case of an Index Cancellation, the Transaction will be cancelled on the later of the Exchange Business Day immediately prior to the effectiveness of the Index Cancellation and the date the Index Cancellation is announced by the Index Sponsor, and
- (3) in the case of an Index Modification, either party may elect, upon two Scheduled Trading Days' notice or such lesser notice as may be required so that termination occurs not later than the effective date of the Index Modification, to cancel the Transaction at any time following the announcement of the Index Modification but no later than the Scheduled Trading Day prior to the effectiveness of such Index Modification and (X) in the case of an Index Option Transaction or an Index Basket Option Transaction, Seller will pay to Buyer the amount specified in Section 12.7(b)(ii) and (Y) in the case of an Index Swap Transaction, an Index Basket Swap Transaction, an Index Forward Transaction or an Index Basket Forward Transaction, an amount calculated in accordance with Section 12.7(c) will be paid by one party to the other. Any Transaction cancelled as a result of an Index Adjustment Event will be valued using the formula or method to calculate the Index in effect immediately prior to such Index Adjustment Event.
Content and comparisons
Article 11. Adjustments and Modifications Affecting Indices, Shares and Transactions
Section 11.1 Adjustments to Indices
- 11.1(a) (Successor Indices)
- 11.1(b) (Index Adjustment Events)
- 11.1(b)(A) (Calculation Agent Adjustment (Adjustment Events))
- 11.1(b)(B) (Negotiated Close-out (Adjustment Events))
- 11.1(b)(C) (Cancellation and Payment (Adjustment Events))
Section 11.2. Adjustments to Share Transactions and Share Basket Transactions
- 11.2(a). Method of Adjustment
- 11.2(b). Options Exchange Adjustment
- 11.2(c). Calculation Agent Adjustment
- 11.2(d). Options Exchange
- 11.2(e). Potential Adjustment Event
Section 11.3. Adjustments to Certain Share Transactions and Share Basket Transactions in European Currencies
Section 11.4. Correction of Share Prices and Index Levels
If I didn’t know them any better, I would say this is ISDA’s crack drafting squad™ in “I’ve just ended an unhappy love affair and I’m in a bad mood so you can damn well suffer, too” mood. Certainly reads like the writing of someone who has it in for the human race. Note there are cancellation options here, but also, independently, cancellation options for Index Adjustment Events in the Extraordinary Events selection. Why were these separated like this? For the sheer devil of it, most likely.
Typically, your master confirmation will set out the resolution method for each type of Index Adjustment Event separately — this figures, since depending on the type of Index Adjustment Event, the range of possibilities open to even the most imaginative Calculation Agent will differ. If the underlying Index has been cancelled, you can’t very just well make an adjustment and carry on, because there is nothing left to pay the performance of. It might have been nice had ISDA’s crack drafting squad™ programmed some of this into the definitions, but bless them, they didn’t, so let us speculate.
Cancellation and Payment
Note that “Cancellation and Payment” means different things for different Index Adjustment Events. In the unlikely event it applies to Index Disruption, the transaction is cancelled on the Valuation Date; if an Index Cancellation, then immediately before the cancellation goes live — unless the Index Sponsor didn’t announce it, in which case, as soon as it does (this protects a hedging counterparty). For an Index Modification, there is an odd lacuna: either side can cancel it, neither has to, but cancellation must take place before the adjustment event. We imagine this gets to be self-policing: if both sides are happy not to cancel, the modification is probably not that material. Customers can generally close out their risk on any day in any case.
Three things can happen to an index which are beyond the control of the parties: it can be disrupted, it can be materially changed, or it can be cancelled altogether by the Index Sponsor. In any of these cases the bargain represented by an index transaction will no longer be the one anticipated by the parties on execution, and they may wish to take some action. The possible actions are:
- Index Cancellation: This one, we humbly submit, is likely to be Cancellation and Payment, seeing as there is nothing left to modify or, really, negotiate about.
- Index Modification: Here Calculation Agent Adjustment doesn’t really make sense (as it implies a one-off adjustment), which falls to Negotiated Close-out, which is really a wishy-washy way of saying Cancellation and Payment, which, for Index Modifications, gives both parties the option to cancel the trade, but not the obligation to.
- Index Disruption: Index disruption is likely to be transitory — just a temporary failure to publish an index level — and seeing as the Calculation Agent will be hedging by transacting in the underliers of the Index, so it ought to be able to calculate, near enough, an estimated Index level by reference to the closing prices of the constituents. Here, expect Calculation Agent Adjustment, for the Calculation Agent to have a bash at figuring out what the Index would have paid had it not been altered, disrupted or cancelled.. Should things become permanent, it is likely to be an Index Calculation or Index Modification, so the disruption terms no longer would be in play.
In all cases, remember: generally the swap dealer (who is Calculation Agent) does not have a dog in the fight. It will accommodate its customer’s wishes as far as it can — that is only good business — as long as those wishes reflect genuinely hedgeable positions. If the dealer can hedge, it will, and will pass on those economics. If it can’t, it won’t, and will account for the liquidation value of its hedges.
The default option here is “Cancellation and Payment”. Negotiated Close-out is just an agreement to agree, and it would be a brave Calculation Agent indeed who volunteered to continue calculating a cancelled Index based on previous rules once it has been disestablished by the actual Index sponsor, which is what Calculation Agent Adjustment appears to require — but we have seen hopeful counterparties ask. They always seem so disappointed when you let them down.