Template:M summ Equity Derivatives Trade Features

Section 1.38

This is your classic equity derivative: given that much of the point of equity swaps is to invest synthetically in securities you either don’t want to, or cannot, own physically — or instruments like indices that you can’t own.

Section 1.39

Just a brief irked note to ask whether, without obviously mocking the entire process, one could have created a more tortured way of explaining that “physically-settled” means, you know, physically-settled?

Not only is was this poor semantic concept unfairly harassed by ISDA’s crack drafting squad™ as it went about its peaceable business, but it was then taken in to the cells and tortured, too. Mean.

Section 1.40

The Determining Party only ever has to determine a Cancellation Amount, Cancellation and Payment or Partial Cancellation and Payment under 12.8, and that will only happen in only when a Transaction terminates following an Extraordinary Event or an Additional Disruption Event.

Calculation Agent vs. Determining Party

Why: The Equity Derivatives recognise that while most calculations could be performed by whoever is appointed Calculation Agent, determination of a Cancellation Amount is inextricably related to the hedge and — especially where there is a disrupted market – this is best to be calculated by the one whose problem it is to unwind that hedge: namely, the Hedging Party.

In theory (though almost never in practice) the Hedging Party might not be the Calculation Agent.

In theory, too, the Hedging Party might not be named the Determining Party. Which is kind of awkward, since the Cancellation Amount is couched in terms of the cost to the determining Party of unwinding, liquidating or re-establishing its hedge — which it would only do if it was, like, hedging.

Lastly, note that if your investment bank is as left-handedly configured as some the JC has come across, the group entity writing the equity swaps might not be the same as the one doing the physical hedging of those swap obligations (with a back-to-back trade between them, for example), so the Hedging Party/Determining Party might not be either party to the actual ISDA Master Agreement at all.

The User’s Guide

We have noted elsewhere that the User’s Guide is less forthcoming than one might like it to be on what the Determining Party is for, and when (or why) there might ever be two. But it does say this:

“In calculating a Cancellation Amount, a Determining Party is required to act in good faith and to use commercially reasonable procedures. It should be noted that quotations are not necessarily required, as depending on the Transaction in question, the cost of liquidating hedges may be a more appropriate basis for determining a Cancellation Amount than soliciting quotations.

Parties should note that the Determining Party is the party that will be calculating its own cost of replacing or providing the economic equivalent of a terminated Transaction. The Calculation Agent may be a party to the Transaction, but when performing its duties as Calculation Agent it is acting as a neutral party. The Calculation Agent as such will not have a replacement cost or economic equivalent and therefore should not be designated as the Determining Party.”

If this is meant to help, it singularly fails to, except to recognise that the Determining Party is acting in its capacity as a Hedging Party, and not in its gnomic, wise, dispassionate role as impartial determiner of abstract values. This explains, maybe, why ISDA’s crack drafting squad™ thought it worthwhile to have distinct roles of Calculation Agent and Determining Party — it is not saying (as far as we can tell) that the party who is Calculation Agent cannot be Determining Party at all, but only that when it is being a Determining Party it is not being Calculation Agent: the two roles wear different trousers, so to speak.

But what it does confirm is that the Determining Party is meant to refer to the person who is actually hedging the trade, and that what they will be doing is liquidating hedges to get prices.

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.