Increased Cost of Hedging - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions
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Resources About the Equity Derivatives Definitions | (full wikitext) | (nutshell wikitext)
Hot topics Synthetic Prime Brokerage Anatomy | The Triple Cocktail | Cancellation and Payment | Calculation Agent
TOC | 1 General Definitions | 2 Option Transactions | 3 Exercise of Options | 4 Forward Transactions | 5 Equity Swap Transactions | 6 Valuation | 7 Settlement | 8 Cash Settlement | 9 Physical Settlement | 10 Dividends | 11 Adjustments and Modifications | 12 Extraordinary Events · 12.8 Cancellation Amount · 12.9 Additional Disruption Events · 12.9 List of ADEs · 12.9(b) Consequences of ADEs | 13 Miscellaneous

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Definition of 12.9(a)(vi) in a Nutshell
Use at your own risk, campers!

12.9(a)(vi)Increased Cost of Hedging” means that the Hedging Party would incur a materially increased cost under the Transaction to:
(A) hedge its equity price risk; or
(B) realise the proceeds of its hedge.
This excludes costs arising solely from the deterioration of its own creditworthiness.

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Full text of Definition of 12.9(a)(vi)

12.9(a)(vi)Increased Cost of Hedging” means that the Hedging Party would incur a materially increased (as compared with circumstances existing on the Trade Date) amount of tax, duty, expense or fee (other than brokerage commissions) to (A) acquire, establish, re-establish, substitute, maintain, unwind or dispose of any transaction(s) or asset(s) it deems necessary to hedge the equity price risk of entering into and performing its obligations with respect to the relevant Transaction, or (B) realize, recover or remit the proceeds of any such transaction(s) or asset(s), provided that any such materially increased amount that is incurred solely due to the deterioration of the creditworthiness of the Hedging Party shall not be deemed an Increased Cost of Hedging;

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Content and comparisons

When you are done here proceed immediately to 12.9(a)(vi) for Consequences of Increased Cost of Hedging.
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Summary

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.
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General discussion

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:

Consequences

The parties’ rights as a result of each differ, and are set out in Section 12.9(b). Plenty more chat there.

Termination

However a Transaction is terminated the Determining Party (i.e., and not the Calculation Agent[4] determines the Cancellation Amount, depending on whether Cancellation and Payment or Partial Cancellation and Payment applies.

Interaction

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.[5]
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See also

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References

  1. Note that the industry has moved towards omitting the increased cost component: see Change in Law for more information.
  2. “Dealing with a hedge” is shorthand for “establishing, maintaining or liquidating a hedge”.
  3. “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)
  4. see 12.8(f) for commentary.
  5. 12.9(b)(vii)