Template:M summ Equity Derivatives 6.3(a)

An Index is really just an glorified, overgrown dynamic Share Basket, whose constituents from time to time are determined by a third party “index calculation agent” according to pre-formulated index rules.

That being the case, one can’t directly hedge by buying the “Index”: there is no Index, in the abstract, to buy (though of course you can buy index-tracking ETFs and Index futures — though these only really push the fundamental observation down one level). At some point, to hedge the risk of a glorified, overgrown dynamic Share Basket, someone, somewhere, has to go and buy the Shares in that basket, at the prices that the index determines, and that means having access to the markets on which those index constituents trade, at the point in time at which the index rules say one should take the price of those Shares.

Another oddity is that you are not necessarily trying to hit the best available price for the Share at the time of sale; you are trying to hit the actual price determined by the Index Calculation Agent, however good or bad that price is. That price is usually the “official closing price” of the Exchange.

You cannot, of course, ever guarantee you will be able to trade at exactly the official closing price, but it helps in trying to get near it if the Exchange on which that price is determined is open at the time when that closing price is derived, is liquid, tradable, and isn’t subject to some unforeseen disruption. These are “Market Disruption Events”.

In a classic piece of ISDA’s crack drafting squad™ over-engingeering, the operative term “Market Disruption Event” is broken down into three sub-definitions — “Trading Disruption”, “Exchange Disruption” and “Early Closure” — which don’t appear to have any independent claim on existence at least insofar as the pre-printed 2002 ISDA Equity Derivatives Definitions are concerned.

Remember the underlying vibe here: this is meant to save the Hedging Party’s bacon if for some reason it can’t actually hedge its exposure. One can hedge Index exposure in multiple ways: through a total return swap, by buying futures on the index, or by trading the physical stocks underlying the index, or a combination of the above. Thus, the language is nice and loosey-goosey, allowing the flexibility to the Calculation Agent however it elects to hedge, and so contemplates a disruption whether it is because there is no market in the constituent components or index futures.

But this provides some rather odd optionality. It might be that some of the Index component Shares are disrupted, but, say, futures in the Index are not, and the Calculation Agent can in fact fully hedge its exposure, but it could technically invoke an Index Disruption anyway. At times of maximum dislocation, published Index values don’t always fabulously represent the value of their constituents, especially where those constituents are connected with countries which unexpectedly invade Ukraine. This can lead to frantic conversations between counterparties to Index Swaps, usually agreeing to flat out ignore the equity derivatives definitions and do what seems the fair thing in the unusual consequences.

Note: there are separate disruption events relating to change, cancellation or non-publication of Indices themselves. For that, see Section 11.1(b) relating to Index Adjustment Events. This is what happens if external events conspire to prevent trading in the component underliers comprising an Index — you can’t directly invest in the Index itself, of course, it being only an intellectual construct.