Increased Cost of Hedging - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Definition of 12.9(a)(vi) in a Nutshell™
Use at your own risk, campers!
Full text of Definition of 12.9(a)(vi)
Content and comparisons
When you are done here proceed immediately to 12.9(a)(vi) for Consequences of Increased Cost of Hedging.
Compare with Increased Cost of Stock Borrow, the equivalent provision where the Hedging Party is short.
Part of the famed “triple cocktail” of protections against unexpected problems hedging and risk managing Transactions, together with Hedging Disruption and Change in Law. Note also references to Hedging Party.
Excluding own credit deterioration
Increased Cost of Hedging excludes costs a Hedging Party incurs through the deterioration of its own credit — so it will tend to capture market wide cost increases, and exclude those that are personal to the Hedging Party. Assiduous sell-side brokers will try to cut out the “deterioration of own credit” wording. Muscular asset managers will tell them where to go.
Triple Cocktail — a trilogy in five parts
Should a Hedging Party have trouble hedging an equity derivative the 2002 ISDA Equity Derivatives Definitions contain a “triple cocktail” of protections:
- Change in Law: due to a change in law after Trade Date it becomes (a) flat-out illegal [or (b) materially more expensive] for the Hedging Party to “deal with its hedge”.
- Hedging Disruption: The Hedging Party can’t deal with, or recover the proceeds of a hedge.
- Increased Cost of Hedging: the Hedging Party would incur material additional costs in (a) dealing with its hedge or (b) realising its proceeds, excluding costs due to the deterioration of its own credit;
- Loss of Stock Borrow: The Hedging Party cannot maintain the stock borrow it needs to put on a short position on swap;
- Increased Cost of Stock Borrow: The cost to the Hedging Party of maintaining the stock borrow it needs to hedge a short position on swap exceeds the Initial Stock Loan Rate, being a kind of “at this point the pips squeak” kind of threshold for the dealer.
The parties’ rights as a result of each differ, and are set out in Section 12.9(b). Plenty more chat there.
However a Transaction is terminated the Determining Party (i.e., and not the Calculation Agent determines the Cancellation Amount, depending on whether Cancellation and Payment or Partial Cancellation and Payment applies.
The three elements cover different bases (hence why the “material costs” in Change in Law is often omitted: it is really just a specific case of “Increased Cost of Hedging”).
- Change in Law is about the regulations governing the Hedging Party. There may be plenty of liquidity in hedge-appropriate investments, they may be inexpensive, but Hedging Party isn’t allowed to buy any of them.
- Hedging Disruption is about liquidity and the outright absence of assets to buy as a hedge. It’s perfectly legal to hedge, the financing costs of cracking out a hedge are tolerable, but no-one is selling a hedge.
- Increased Cost of Hedging: is about the cost to the Hedging Party of acquiring a hedge — not the asset price itself — your counterparty wears that, so what do you care? — but the costs to the Hedging Party of acquiring it: financing costs, capital costs, stamp duties, transaction costs and so on. Largely, it will be financing costs. If the market has gone all September 2018, suddenly credit spreads on on the Hedging Party’s financing operation are have gone through the roof, and when it lends out its hedges as collateral for upgrade trades Agent Lenders are haircutting them by how much did you say??
Loss of Stock Borrow
A Loss of Stock Borrow which would also be a Hedging Disruption will be treated as a Loss of Stock Borrow and not a Hedging Disruption.
- Consequences of an Additional Disruption Event in particular 12.9(b)(vi).
- ↑ Note that the industry has moved towards omitting the increased cost component: see Change in Law for more information.
- ↑ “Dealing with a hedge” is shorthand for “establishing, maintaining or liquidating a hedge”.
- ↑ “recovering the proceeds” refers to a situation where the Hedging Party can’t get its hands on the proceeds of terminating a hedge due to circumstances beyond its control (e.g., local currency controls, market dislocation or even just counterparty default)
- ↑ see 12.8(f) for commentary.
- ↑ 12.9(b)(vii)