Knock-ins and Knock-outs - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions
A Jolly Contrarian owner’s manual™

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Section Knock-ins and Knock-outs in a Nutshell™

Use at your own risk, campers!
1.42. “Knock-in Price” must be specified in the Confirmation.

1.43. “Knock-out Price” must be specified in the Confirmation.
1.44. Knock-in Event.

(a) If “Knock-in Event” applies, a party’s right to exercise an Option under an Option Transaction will be conditional upon the Knock-in Event existing when it is exercised on any Knock-in Determination Day. The parties’ rights and obligations will be altered upon the such exercise as is specified in the Confirmation.
(b) “Knock-in Event” must be specified in the Confirmation. If it is not, but the Confirmation specifies a Knock-in Price for a Knock-in Reference Security that is also the specified Underlier for that Transaction, the Knock-in Event will occur:
(i) If the Knock-in Price on the Trade Date was higher than the initial level set for the Transaction: when the Knock-in Reference Security’s level at the Knock-in Valuation Time on a Knock-in Determination Day at least equals the Knock-in Price; and
(ii) If the Knock-in Price on the Trade Date was lower than the initial level set for the Transaction: when the Knock-in Reference Security‘s level at the Knock-in Valuation Time on a Knock-in Determination Day at most equals the Knock-in Price.
If the parties cannot agree whether a Knock-in Event has occurred, the Calculation Agent will decide.

1.45. Knock-out Event.

(a) If “Knock-out Event” applies, a party’s right to exercise an Option under a Transaction will be conditional upon the Knock-out Event not having occurred on any Knock-out Determination Day as of the time of such exercise, and the parties’ respective rights and obligations will be altered from the occurrence of the Knock-out Event as specified in the Confirmation.
(b) “Knock-out Event” must be specified in the Confirmation. If it is not, but the Confirmation specifies a Knock-out Price for a Knock-out Reference Security that is also the specified Index, Share or Basket for that Transaction, the Knock-out Event will occur:
(i) If the Knock-out Price on the Trade Date was higher than the initial level set for the Transaction: when the level of the Knock-out Reference Security at the Knock-out Valuation Time on any Knock-out Determination Day is at least equal to the Knock-out Price; and
(ii) If the Knock-out Price on the Trade Date was lower than the initial level set for the Transaction: when the level of the Knock-out Reference Security at the Knock-out Valuation Time on any Knock-out Determination Day is equal to or lower than the Knock-out Price.
If the parties cannot agree whether a Knock-out Event has occurred, the Calculation Agent will decide.

1.46. “Knock-in Reference Security” means, where a Knock-in Event applies, the index, share or basket specified as such in the Confirmation or, if not specified, the specified Underlier.
1.47. “Knock-out Reference Security” means, where a Knock-out Event applies, the index, share or basket specified as such in the Confirmation or, if not specified, the specified Underlier.
1.48. “Knock-in Determination Day” means each specified Scheduled Trading Day, unless it is a Disrupted Day due to an event occurring before the Knock-in Valuation Time, in which case it will be the following undisrupted Scheduled Trading Day, though if eight Scheduled Trading Days in a row are Disrupted Days, the eighth one, even though a Disrupted Day, will be the Knock-in Determination Day. In this case the Calculation Agent must determine the level of the Knock-in Reference Security as if it were an Underlier on a disrupted Valuation Date using the method set out in Section 6.6.

Unless otherwise specified the Knock-in Determination Days will be each Scheduled Trading Day from and including the Trade Date to and including the final Valuation Date, the Expiration Date or, if none, the date one Settlement Cycle prior to the final Settlement Date for the Transaction (adjusted as necessary under Sections 3.1(f) and 6.6).
1.49. “Knock-out Determination Day” means each specified Scheduled Trading Day, unless it is a Disrupted Day due to an event occurring before the Knock-out Valuation Time, in which case it will be the following undisrupted Scheduled Trading Day, though if eight Scheduled Trading Days in a row are Disrupted Days, the eighth one, even though a Disrupted Day, will be the Knock-out Determination Day. In this case the Calculation Agent must determine the level of the Knock-out Reference Security as if it were an Underlier on a disrupted Valuation Date using the method set out in Section 6.6.

Unless otherwise specified the Knock-out Determination Days will be each Scheduled Trading Day from and including the Trade Date to and including the final Valuation Date, the Expiration Date or, if none, the date one Settlement Cycle prior to the final Settlement Date for the Transaction (adjusted as necessary under Sections 3.1(f) and 6.6).
1.50. “Knock-in Valuation Time” means the specified time on any Knock-in Determination Day or, if there is none, the Valuation Time specified in the related Confirmation, or if none, the Scheduled Closing Time on the relevant exchange for the Knock-in Reference Security on any Knock-in Determination Day

If an exchange closes early and before the specified Knock-in Valuation Time, the Knock-in Valuation Time will be that actual closing time.
1.51. “Knock-out Valuation Time” means the specified time on any Knock-out Determination Day or, if there is none, the Valuation Time specified in the related Confirmation, or if none, the Scheduled Closing Time on the relevant exchange for the Knock-out Reference Security on any Knock-out Determination Day

If an exchange closes early and before the specified Knock-out Valuation Time, the Knock-out Valuation Time will be that actual closing time.

Full text of Section Knock-ins and Knock-outs

Section 1.42. Knock-in Price. “Knock-in Price” means, in respect of a Transaction that is subject to a Knock-in Event, the level, price or amount specified as such in the related Confirmation.

Section 1.43. Knock-out Price. “Knock-out Price” means, in respect of a Transaction that is subject to a Knock-out Event, the level, price or amount specified as such in the related Confirmation.
Section 1.44. Knock-in Event.

(a) If “Knock-in Event” is specified as applicable to a Transaction, then unless otherwise specified in the related Confirmation, a party’s right to exercise an Option under an Option Transaction and its right to receive, or its obligation to make, a payment or delivery under an Option Transaction (once exercised or deemed exercised), a Forward Transaction or Equity Swap Transaction where such right or obligation is subject to a Knock-in Event shall be conditional upon the occurrence of the Knock-in Event on any Knock-in Determination Day as of the time of such exercise, deemed exercise, payment or delivery, and the parties shall have any other rights and obligations set forth in the related Confirmation from and after the occurrence of the Knock-in Event.
(b) “Knock-in Event” means the event or occurrence specified as such in the related Confirmation. In the event that the related Confirmation does not specify such an event or occurrence but specifies a Knock-in Reference Security and/or a Knock-in Price, a Knock-in Event shall occur for a Transaction for which such Knock-in Reference Security is also the Index, Share or Basket specified in the related Confirmation:
(i) where, on the Trade Date, the Knock-in Price is greater than the Initial Price, Strike Price, Forward Price or other initial level set for the Transaction, when the level, price or amount of the Knock-in Reference Security determined as of the Knock-in Valuation Time on any Knock-in Determination Day is greater than or equal to the Knock-in Price; and
(ii) where, on the Trade Date, the Knock-in Price is less than the Initial Price, Strike Price, Forward Price or other initial level set for the Transaction, when the level, price or amount of the Knock-in Reference Security determined as of the Knock-in Valuation Time on any Knock-in Determination Day is less than or equal to the Knock-in Price.
In the event of a dispute between the parties as to whether a Knock-in Event has occurred, the Calculation Agent shall determine whether a Knock-in Event has occurred.

Section 1.45. Knock-out Event.

1.45(a) If “Knock-out Event” is specified as applicable to a Transaction, then unless otherwise specified in the related Confirmation, a party's right to exercise an Option under an Option Transaction and its right to receive, or its obligation to make, a payment or delivery under an Option Transaction (once exercised or deemed exercised), a Forward Transaction or Equity Swap Transaction where such right or obligation is subject to a Knock-out Event shall be conditional upon the Knock-out Event not having occurred on any Knock-out Determination Day as of the time of such exercise, deemed exercise, payment or delivery, and the parties shall have any other rights and obligations set forth in the related Confirmation from and after the occurrence of the Knock-out Event.
1.45(b) “Knock-out Event” means the event or occurrence specified as such in the related Confirmation. In the event that the related Confirmation does not specify such an event or occurrence but specifies a Knock-out Reference Security and/or a Knock-out Price, a Knock-out Event shall occur for a Transaction for which such Knock-out Reference Security is also the Index, Share or Basket specified in the related Confirmation: (i) where, on the Trade Date, the Knock-out Price is greater than the Initial Price, Strike Price, Forward Price or other initial level set for the Transaction, when the level, price or amount of the Knock-out Reference Security determined as of the Knock-out Valuation Time on any Knock-out Determination Day is greater than or equal to the Knock-out Price; and (ii) where, on the Trade Date, the Knock-out Price is less than the Initial Price, Strike Price, Forward Price or other initial level set for the Transaction, when the level, price or amount of the Knock-out Reference Security determined as of the Knock-out Valuation Time on any Knock-out Determination Day is less than or equal to the Knock-out Price. In the event of a dispute between the parties as to whether a Knock-out Event has occurred, the Calculation Agent shall determine whether a Knock-out Event has occurred.

Section 1.46. Knock-in Reference Security. “Knock-in Reference Security” means, in respect of a Transaction for which a Knock-in Event is specified as being applicable, the index, share, other security or basket specified as such in the related Confirmation. In the event that the related Confirmation does not specify a Knock-in Reference Security, the Knock-in Reference Security will be deemed to be the same Index, Share or Basket, as the case may be, specified in the related Confirmation.
Section 1.47. Knock-out Reference Security. “Knock-out Reference Security” means, in respect of a Transaction for which a Knock-out Event is specified as being applicable, the index, share, other security or basket specified as such in the related Confirmation. In the event that the related Confirmation does not specify a Knock-out Reference Security, the Knock-out Reference Security will be deemed to be the same Index, Share or Basket, as the case may be, specified in the related Confirmation.
Section 1.48. Knock-in Determination Day. “Knock-in Determination Day” means, in respect of a Transaction for which a Knock-in Event is specified as being applicable, each Scheduled Trading Day specified as such in the related Confirmation, unless such day is a Disrupted Day due to the occurrence of an event giving rise to a Disrupted Day prior to the Knock-in Valuation Time on such day. If such day is a Disrupted Day due to the occurrence of such an event, then the Knock-in Determination Day shall be the first succeeding Scheduled Trading Day that is not a Disrupted Day, unless each of the eight Scheduled Trading Days immediately following the original date that, but for the occurrence of a Disrupted Day, would have been the Knock-in Determination Day is a Disrupted Day. In that case, that eighth Scheduled Trading Day shall be deemed to be the Knock-in Determination Day, notwithstanding the fact that such day is a Disrupted Day, and the Calculation Agent shall determine the level, price or amount of the Knock-in Reference Security in the same manner that it would determine a level, price or amount of an Index, Share or Basket on a deemed Valuation Date that is also a Disrupted Day in accordance with the provisions of Section 6.6(a)(ii), (b) or (c), as the case may be. In the event that the related Confirmation does not specify any Knock-in Determination Days, each Scheduled Trading Day from and including the Trade Date to and including the final Valuation Date, the Expiration Date or, if there is no such Valuation Date or Expiration Date, the date that is one Settlement Cycle prior to the final Settlement Date in relation to the Transaction (adjusted, if applicable, as provided in Sections 3.1(f) and 6.6) shall be deemed to be Knock-in Determination Days in relation to the Transaction.
Section 1.49. Knock-out Determination Day. “Knock-out Determination Day” means, in respect of a Transaction for which a Knock-out Event is specified as being applicable, each Scheduled Trading Day specified as such in the related Confirmation, unless such day is a Disrupted Day due to the occurrence of an event giving rise to a Disrupted Day prior to the Knock-out Valuation Time on such day. If such day is a Disrupted Day due to the occurrence of such an event, then the Knock-out Determination Day shall be the first succeeding Scheduled Trading Day that is not a Disrupted Day, unless each of the eight Scheduled Trading Days immediately following the original date that, but for the occurrence of a Disrupted Day, would have been the Knock-out Determination Day is a Disrupted Day. In that case, that eighth Scheduled Trading Day shall be deemed to be the Knock-out Determination Day, notwithstanding the fact that such day is a Disrupted Day, and the Calculation Agent shall determine the level, price or amount of the Knock-out Reference Security in the same manner that it would determine a level, price or amount of an Index, Share or Basket on a deemed Valuation Date that is a Disrupted Day in accordance with the provisions of Section 6.6(a)(ii), (b) or (c), as the case may be. In the event that the related Confirmation does not specify any Knock-out Determination Days, each Scheduled Trading Day from and including the Trade Date to and including the final Valuation Date, the Expiration Date or, if there is no such Valuation Date or Expiration Date, the date that is one Settlement Cycle prior to the final Settlement Date in relation to the Transaction (adjusted, if applicable, as provided in Sections 3.1(f) and 6.6) shall be deemed to be Knock-out Determination Days in relation to the Transaction.
Section 1.50. Knock-in Valuation Time. “Knock-in Valuation Time” means, in respect of a Transaction that provides for a right to receive, or obligation to make, a payment or delivery that is subject to a Knock-in Event, the time on any Knock-in Determination Day specified as such in the related Confirmation. in that the event that the related Confirmation does not specify a Knock-in Valuation Time, the Knock-in Valuation Time shall be the Valuation Time specified in the related Confirmation, or if no Valuation Time is specified, the Scheduled Closing Time on the relevant exchange for the Knock-in Reference Security on any Knock-in Determination Day, in relation to the index, share, other security or basket to be valued. If the relevant exchange closes prior to its Scheduled Closing Time and the specified Knock-in Valuation Time is after the actual closing time for its regular trading session, then the Knock-in Valuation Time shall be such actual closing time.

Section 1.51. Knock-out Valuation Time. “Knock-out Valuation Time” means, in respect of a Transaction that provides for a right to receive, or obligation to make, a payment or delivery that is subject to a Knock-out Event, the time on any Knock-out Determination Day specified as such in the related Confirmation. in that the event that the related Confirmation does not specify a Knock-out Valuation Time, the Knock-out Valuation Time shall be the Valuation Time specified in the related Confirmation, or if no Valuation Time is specified, the Scheduled Closing Time on the relevant exchange for the Knock-out Reference Security on any Knock-out Determination Day, in relation to the index, share, other security or basket to be valued. If the relevant exchange closes prior to its Scheduled Closing Time and the specified Knock-out Valuation Time is after the actual closing time for its regular trading session, then the Knock-out Valuation Time shall be such actual closing time.


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Content and comparisons

A JC-curated sub-division of the General Definitions section. We sub-group the Section 1 definitions into the following subgroups:

These are the Knock-ins and Knock-outs definitions:

1.42. Knock-in Price
1.43. Knock-out Price
1.44. Knock-in Event
1.45. Knock-out Event
1.46. Knock-in Reference Security
1.47. Knock-out Reference Security
1.48. Knock-in Determination Day
1.49. Knock-out Determination Day
1.50. Knock-in Valuation Time
1.51. Knock-out Valuation Time

Mechanical provisions dealing with a fairly straight forward concept in the world of options, made more laborious even that usual by repeating themselves almost entirely for Knock-out Events and Knock-in Events, simply to capture a single difference: Knock-ins start something, and Knock-outs stop it.

The JC has done the world the inestimable service of creating the hybrid definitions: Knock-in/out Price, Knock-in/out Event, Knock-in/out Reference Security, Knock-in/out Determination Day and Knock-in/out Valuation Time. This won’t entirely alleviate the tedium of wading through the mechanical sludge, but it may prevent you scooping out your eyeballs with a spoon. Or at least delay your doing so.

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Summary

Section 1.42 and 1.43 Knock-in/out Price

If your Transaction knocks in or knocks out, you will need to agree, and specify, the price at which it knocks in or out, innit.

Section 1.44 and 1.45 Knock-in/out Event

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.

Section 1.46 and 1.47 Knock-in/out Reference Security

Eine kleine uberengineering from ISDA’s crack drafting squad™ — for we delta-one synthetic equity swap simpletons, at any rate, it is hard to see why, if you are referencing an Underlier A, that your Knock-in/out Event might reference another share or index altogether — I mean, why would you? — but remember this document is a product of its time, and its time was the heady early noughties, where everyone (bar Warren Buffett) thought that derivatives had solved the problem of systemic risk in the financial markets, rather than aggravating it, and super complex packages teasing apart and allocating correlation risks were all the rage — mainly in the credit derivatives world, to be fair — but look, you never know.

Section 1.48 and 1.49 Knock-in/out Determination Day

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-in/out Determination Day.

The whatiffery starts if a related Exchange is not trading at all — a Disrupted Day by the designated Knock-in/out 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-in/out Determination Day, on that eighth day, but this is not, at least in theory, the case: the Knock-in/out Determination Day only works out whether a Knock-in/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.

Section 1.50 and 1.51 Knock-in/out 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 Knock-in/out 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.

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See also

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References

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