Adjustments and Modifications Affecting Indices, Shares and Transactions - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions

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Article 11 Adjustments and Modifications Affecting Indices, Shares and Transactions

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.

Section 11.2. Adjustments to Share Transactions and Share Basket Transactions.

11.2(a)Method of Adjustment” means a method for determining the appropriate adjustment to make to the terms of a Share Transaction or Share Basket Transaction upon the occurrence of an event having, in the determination of the Calculation Agent, a diluting or concentrative effect on the theoretical value of the relevant Shares.
11.2(b) If “Options Exchange Adjustment” is specified as the Method of Adjustment in the related Confirmation of a Share Transaction or Share Basket Transaction, then following each adjustment to the exercise, settlement, payment or other terms of options on any relevant Shares traded on any Options Exchange, the Calculation Agent will make the corresponding adjustments, if any, to any one or more of:
(i) in respect of a Share Option Transaction or a Share Basket Option Transaction, the Strike Price, the Number of Options, the Option Entitlement, the Knock-in Price, the Knock-out, and the relevant Number of Shares;
(ii) in respect of a Share Forward Transaction or a Share Basket Forward Transaction, the Forward Price, the Forward Floor Price, the Forward Cap Price, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
(iii) in respect of a Share Swap Transaction or a Share Basket Swap Transaction, the Initial Price, the Equity Notional Amount, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
and, in any case, any other variable relevant to the exercise, settlement, payment or other terms of that Transaction, as determined by the Calculation Agent, which adjustment will be effective as of the date determined by the Calculation Agent to be the effective date of the corresponding adjustment made by the Options Exchange. If options on the relevant Shares are not traded on the Options Exchange, the Calculation Agent will make such adjustment, if any, to any one or more of the relevant variables referred to above or any other variable relevant to the exercise, settlement, payment or other terms of the Transaction as the Calculation Agent determines appropriate, with reference to the rules of and precedents (if any) set by the Options Exchange, to account for the diluting or concentrative effect of any event that, in the determination of the Calculation Agent, would have given rise to an adjustment by the Options Exchange if such options were so traded.
11.2(c) If “Calculation Agent Adjustment” is specified as the Method of Adjustment in the related Confirmation of a Share Transaction or Share Basket Transaction (or if no Method of Adjustment is specified in the related Confirmation for such Transaction), then following the declaration by the Issuer of the terms of any Potential Adjustment Event, the Calculation Agent will determine whether such Potential Adjustment Event has a diluting or concentrative effect on the theoretical value of the relevant Shares and, if so, will
(i) make the corresponding adjustment(s), if any, to any one or more of:
(A) in respect of a Share Option Transaction or a Share Basket Option Transaction, the Strike Price, the Number of Options, the Option Entitlement, the Knock-in Price, the Knockout Price, and the relevant Number of Shares;
(B) in respect of a Share Forward Transaction or a Share Basket Forward Transaction, the Forward Price, the Forward Floor Price, the Forward Cap Price, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
(C) in respect of a Share Swap Transaction or a Share Basket Swap Transaction, the Initial Price, the Equity Notional Amount, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
and, in any case, any other variable relevant to the exercise, settlement, payment or other terms of that Transaction as the Calculation Agent determines appropriate to account for that diluting or concentrative effect (provided that no adjustments will be made to account solely for changes in volatility, expected dividends, stock loan rate or liquidity relative to the relevant Share) and
(ii) determine the effective date(s) of the adjustment(s).
The Calculation Agent may (but need not) determine the appropriate adjustment(s) by reference to the adjustment(s) in respect of such Potential Adjustment Event made by an options exchange to options on the relevant Shares traded on such options exchange.
11.2(d)Options Exchange” means the exchange or quotation system specified as such in the related Confirmation, any successor to such exchange or quotation system or any substitute exchange or quotation system to which trading in options contracts relating to the relevant Share has temporarily relocated (provided that the Calculation Agent has determined that there is comparable liquidity relative to such options contracts on such temporary substitute exchange or quotation system as on the original Options Exchange) or, if no such exchange or quotation system is specified in the related Confirmation, the Related Exchange (if such Related Exchange trades options contracts relating to the relevant Share) or, if more than one such Related Exchange is specified in the related Confirmation, the Related Exchange selected by the Calculation Agent as the primary market for listed options contracts relating to the relevant Share.
11.2(e)Potential Adjustment Event” means any of the following:
(i) a subdivision, consolidation or reclassification of relevant Shares (unless resulting in a Merger Event), or a free distribution or dividend of any such Shares to existing holders by way of bonus, capitalization or similar issue;
(ii) a distribution, issue or dividend to existing holders of the relevant Shares of (A) such Shares, or (B) other share capital or securities granting the right to payment of dividends and/or the proceeds of liquidation of the Issuer equally or proportionately with such payments to holders of such Shares, or (C) share capital or other securities of another issuer acquired or owned (directly or indirectly) by the Issuer as a result of a spin-off or other similar transaction, or (D) any other type of securities, rights or warrants or other assets, in any case for payment (cash or other consideration) at less than the prevailing market price as determined by the Calculation Agent;
(iii) an Extraordinary Dividend;
(iv) a call by the Issuer in respect of relevant Shares that are not fully paid;
(v) a repurchase by the Issuer or any of its subsidiaries of relevant Shares whether out of profits or capital and whether the consideration for such repurchase is cash, securities or otherwise;
(vi) in respect of the Issuer, an event that results in any shareholder rights being distributed or becoming separated from shares of common stock or other shares of the capital stock of the Issuer pursuant to a shareholder rights plan or arrangement directed against hostile takeovers that provides upon the occurrence of certain events for a distribution of preferred stock, warrants, debt instruments or stock rights at a price below their market value, as determined by the Calculation Agent, provided that any adjustment effected as a result of such an event shall be readjusted upon any redemption of such rights; or
(vii) any other event that may have a diluting or concentrative effect on the theoretical value of the relevant Shares.

Section 11.3. Adjustments to Certain Share Transactions and Share Basket Transactions in European Currencies. In respect of a Share Transaction or Share Basket Transaction relating to Shares originally quoted, listed and/or dealt as of the Trade Date in a currency of a member state of the European Union that has not adopted the single currency in accordance with the EC Treaty, if such Shares are at any time after the Trade Date quoted, listed and/or dealt exclusively in euro on the relevant Exchange or, where no Exchange is specified, the principal market on which those Shares are traded, then the Calculation Agent will adjust any one or more of the Strike Price, the Forward Price, the Forward Floor Price, the Forward Cap Price, the Knock-in Price, the Knock-out Price, the Settlement Price, the Initial Price, the Final Price and any other variable relevant to the terms of the Transaction as the Calculation Agent determines appropriate to preserve the economic terms of the Transaction. The Calculation Agent will make any conversion necessary for purposes of any such adjustment as of the Valuation Time at an appropriate mid-market spot rate of exchange determined by the Calculation Agent prevailing as of the Valuation Time. No adjustments under this Section 11.3 will affect the currency denomination of any payment obligation arising out of the Transaction.
Section 11.4. Correction of Share Prices and Index Levels. In the event that any price or level published on the Exchange or by the Index Sponsor and which is utilized for any calculation or determination made under a Transaction is subsequently corrected and the correction is published by the Exchange or the Index Sponsor within one Settlement Cycle after the original publication, either party may notify the other party of that correction and the Calculation Agent will determine the amount that is payable or deliverable as a result of that correction, and, to the extent necessary, will adjust the terms of such Transaction to account for such correction.

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Overview

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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

Summary

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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.

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See also

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References

  1. Not an official Equity Derivatives term, but a useful one nonetheless.
  2. This is not a fully endorsed, ’squad-credentialised definition, but JC shorthand for “Share, Index or Basket, as the case may be”.