LO 25.5: Identify and describe termination events and discuss their potential

LO 25.5: Identify and describe termination events and discuss their potential effects on parties to a transaction.
Termination events allow institutions to terminate a trade before their counterparties become bankrupt. A reset agreement readjusts parameters for trades that are heavily in the money by resetting the trade to be at the money. Reset dates are typically linked with payment dates, but they could also be triggered after a certain market value is breached. As an example, consider a resettable cross-currency swap. With this trade, the MtM value of the swap is exchanged at each reset date. In addition, the foreign exchange rate, which influences the swaps MtM value, is reset to the current spot rate. This reset will end up changing the notional amount for one leg of the swap.
Additional termination events (ATEs), which are sometimes referred to as break clauses, are another form of a termination event, which allow an institution to terminate a trade if the creditworthiness of their counterparty declines to the point of bankruptcy. More specifically,
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Topic 25 Cross Reference to GARP Assigned Reading – Gregory, Chapter 5
a break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value. Break clauses are often bilateral, allowing either party to terminate a transaction, and are useful in providing an option to terminate transactions particularly long-dated tradeswithout cost when the quality of the counterparty declines. Events to trigger a break clause generally fall into three categories:
Mandatory. The transaction will terminate at the date of the break clause. Optional. One or both counterparties have the option to terminate the transaction at the
pre-specified date.
Trigger-based. A trigger, like a ratings downgrade, must occur before the break clause
may be exercised.
Despite their advantages, break clauses have not been highly popular. One explanation is that break clauses, in effect, represent a discrete form of collateralization; however, collateralization can be better achieved by the continuous posting of collateral. .Another explanation is known as bankers paradox, which implies that for a break clause to be truly useful, it should be exercised early on, prior to the substantial decline in a counterpartys credit quality. Entities, however, typically avoid early exercise to preserve their good relationships with counterparties.
Walkaway clauses allow an entity to benefit from the default of a counterparty. Specifically, under these clauses an entity can walk away from, or avoid, its net liabilities to a counterparty that is in default, while still being able to claim in the event of a positive MtM exposure. Walkaway clauses were popular prior to 1992, but they have been less common since the 1992 ISDA Master Agreement. They have also been criticized for creating additional costs for a counterparty in the event of a default, for creating moral hazard, and, because a walkaway feature may already be priced in a transaction, hiding some of the risks in a transaction. For these reasons, these clauses should be ultimately avoided.
As mentioned previously, multilateral netting is achieved with a central entity, such as an exchange or clearinghouse, handling the netting process, including valuation, settlement, and collateralization. An approach for utilizing multilateral netting without the need for a membership organization is trade compression. Because portfolios often have redundancies among trades with multiple counterparties, compression aims to reduce the gross notional amount and the number of trades (e.g., OTC derivatives transactions). Thus, trade compression can reduce net exposure without the need to change an institutions overall risk profile.
Trade compression requires participants to submit applicable trades for compression along with their desired risk tolerance. The submitted trades are then matched to each counterparty and netted into a single contract. For example, consider an institution with three credit default swap (CDS) contracts for the same reference entity and maturity, but with different counterparties. In this case, the three trades can be compressed into a single net contract by netting out the long and short contracts and using the weighted average of the three contract coupons as the net contract coupon. Trade compression services, such as TriOptima, help reduce OTC derivatives exposures for various credit derivatives. In addition, recent changes to the CDS market, such as standard coupons and maturity dates, also help promote the benefits of trade compression.
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Topic 25 Cross Reference to GARP Assigned Reading – Gregory, Chapter 5
K e y C o n c e p t s
LO 25.1
Standardization of terms of OTC derivatives through the ISDA Master Agreement is a key way to mitigate credit risk to improve liquidity and reduce transaction costs.
LO 25.2
Netting involves combining the cash flows from different contracts with a counterparty into a single net amount (payment netting). Close-out netting refers to netting contract values with a counterparty if the counterparty defaults. Without netting, exposures are additive; with netting, exposures of trades are not additive.
Bilateral netting is limited to two entities only. Multilateral netting involves netting between multiple parties, usually with a central entity, such as an exchange or clearinghouse, handling the netting process.
LO 25.3
Netting arrangements are beneficial as long as trading instruments can have negative mark- to-market (MtM) values during their life. Netting for trades with the possibility of only positive exposures is generally not beneficial, although benefits can arise if future trades with negative MtM values could offset the positive MtM of these instruments.
LO 25.4
Walkaway clauses allow an entity to walk away from its liabilities to a counterparty that is in default, while still being able to make a claim on its own exposure. Trade compression reduces net exposure without the need to change the overall risk profile.
LO 25.5
Termination events allow institutions to terminate a trade before their counterparties become bankrupt. A break clause allows a party to terminate a trade at specified future dates at replacement values.
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Topic 25 Cross Reference to GARP Assigned Reading – Gregory, Chapter 5
C o n c e p t C h e c k e r s
1.
2.
3.
4.
5.
Riggs Resources, LLC, (Riggs) is a commodity trading firm. Riggs has numerous trades outstanding with several counterparties; however, it is concerned with presettlement risk. In order to reduce presettlement risk (the risk that Riggss counterparties would default before settlement), it would be most beneficial for Riggs to: A. have payment netting. B. have close-out netting. C. analyze potential losses as the sum of exposures. D. have netting but not set-off.
Entity XYZ is netting its trades with Entity ABC. Which of the following techniques best describe this type of netting arrangement? A. Multilateral netting. B. Bilateral netting. C. Close-out netting. D. Additive exposure netting.
Assume the following current MtM values for five different transactions for Entity ABC: +5, 4, +2, +3, and 6. What is the total exposure with and without netting, respectively? A. 0, 10. B. 20, 10. C. 10,0. D. 10,20.
Which of the following trading instruments would have the most beneficial effect on netting? A. Options with up-front premiums. B. Equity options. C. FX options. D. Futures.
Leverage, Inc., an investment bank, has numerous credit default swaps with XYZ Corp. Leverage has established a break clause with XYZ Corp. to reduce risk. The break clause is trigger-based and may be exercised once the trigger is satisfied. The CEO of Leverage is concerned about a bankers paradox. Which of the following statements best describe the CEOs concern? A. To be effective, the break clause option should not be used too early. B. The weak firm often recovers after the use of the break clause. C. The break clause option is used too late, and the weak firm gets weaker. D. The break clause option is used too early, and relations with the counterparty
suffer.
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C o n c e p t C h e c k e r An s w e r s
1. B To minimize presettlement risk, Riggs should have close-out netting. Under close-out,
contracts between solvent and insolvent counterparties are terminated and netted.
Payment netting would reduce settlement and operational risk, but not presettlement risk. Netting also means individual positive exposures are nonadditive. The terms netting and set- off are synonymous.
2. B Bilateral netting is a netting arrangement between two entities and is limited to two entities. Trades with multiple counterparties is known as multilateral netting. Close-out netting refers to netting contract values with a counterparty if the counterparty defaults.
3. A The total exposure with netting i s 0 ( 5 – 4 + 2 + 3 – 6 = 0), and the total exposure without
netting is 10 (5 + 2 + 3 = 10).
4. D A trading instrument will have a beneficial effect on netting if it can have a negative mark-to- market (MtM) value during its life. For instruments whose MtM value can only be positive during their life, the effect on netting will not be as beneficial. Instruments with only positive MtM values include options with up-front premiums such as equity options, as well as swaptions, caps and floors, and FX options. Futures can have negative MtM values.
5. C A break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value. Despite their advantages, break clauses have not been highly popular. One explanation is known as banker s paradox, which implies that for a break clause to be truly useful, it should be exercised early on, prior to the substantial decline in a counterpartys credit quality. Entities, however, typically avoid early exercise to preserve their good relationships with counterparties.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
C o l l a t e r a l
E x a m F o c u s
Topic 26
This topic examines collateral and introduces the types of collateral, the features of a collateralization agreement and a credit support annex (one-way and two-way), and the reconciliation of collateral disputes. For the exam, be familiar with the key parameters associated with collateral (e.g., threshold, initial margin, and minimum transfer amount). In addition, understand the risks associated with collateralization, focusing on market risk, operational risk, and funding liquidity risk.
C o l l a t e r a l M a n a g e m e n t