1 JUNE 16, 2008 VOL. XVII, NO. 24 Derivatives Attacked Former heads of the Securities and Exchange ommission have attacked derivates and said the SE should block mutual funds from investing in certain types of offerings. See story, page 2 In The News Lawyers Applaud ontract Ruling 2 Barcap Launches Mutual Fund-Linked Note 3 Bespoke Super Senior Bids Returns 3 JPM Suggests Equity Default Swaps 3 Barcap Rolls Our Inflation Index 4 European Indices See Flow Pickup 4 BofA Hires Equity Derivs Official 4 Asia Pacific redit Staffer Exits Barclays 5 ABN Pitches Longevity Mart 5 Morgan Stanley Warns Of Inflation Threat 5 Put Buys Pick Up In Japan 5 Dong NDFs Suffer 6 Macquarie To Push Infrastructure 6 Departments Learning urve 7 Markets 10 OPYRIGHT NOTIE: No part of this publication may be copied, photocopied or duplicated in any form or by any means without Institutional Investor s prior written consent. opying of this publication is in violation of the Federal opyright Law (17 US 101 et seq.). Violators may be subject to criminal penalties as well as liability for substantial monetary damages, including statutory damages up to $100,000 per infringement, costs and attorney s fees. opyright 2008 Institutional Investor, Inc. All rights reserved. ISSN# For information regarding subscription rates and electronic licenses, please contact Dan Lalor at (212) Succession Tackled? NEW DEFINITIONS FOR LDS ON THE WAY A new slate of legal definitions to clear up the persistent succession issue in credit derivatives are in the works. The definitions set for release this summer will help establish contract durations and how to proceed with unwinds in loan refinancing scenarios. Buy- and sell-side officials will also be forced to meet whenever there is a succession event to determine trading levels a first for the industry. The framework comes from a working group led by the International Swaps and Derivatives Association and The Loan Syndication and Trading Association. The (continued on page 11) HEDGE FUNDS PILE INTO VANILLA OPTIONS Hedge funds that have shied away from equity derivatives in recent weeks are now returning but demanding highly liquid vanilla trades. Bankers in the U.S. and the U.K. say March and April were extremely quiet, with equity-linked activity easing to a level described by one London-based equity derivatives salesman as dreadful. Trades have now picked up, with hedge funds snubbing complex swaps and instead sticking with trades that offer high liquidity. We are seeing people moving away from what I describe as complex derivatives, (continued on page 11) FIRMS FUME AT INDIAN ASH SETTLEMENT MOVE Reserve Bank of India draft rules requiring cash settlement of derivatives has dealers upset because it would nix using structured options to reduce the cost of a hedge restructuring. The International Swaps And Derivatives Association will be speaking to regulators next week to pick through the proposals and seek clarification. The guidelines state that, Any restructuring of the derivatives contract, including foreign exchange contracts, shall be carried out only on cash settlement basis. Angela Papesch, director of policy and head of ISDA s Singapore office, told DW the group has sent representatives to India to meet with the Securities and Exchange Board (continued on page 11) AUSSIE BANKERS WARY OF TAX HANGE FALLOUT Australian dealers are concerned recent tax changes may hit structured product sales and lead to firms pushing different types of structures. The changes, effective May 13, reduce the tax deductible on capital-protected margin loans. Market watchers estimate that these loans for equities account for about AUS3 billion (USD2.82 billion) of a margin financing market of about AUS40 billion. The offerings are a modified form of the standard margin loan where money is borrowed to buy stock. In the capital protected version, a put allows the investor to sell (continued on page 12) heck out for breaking news and updates free to subscribers.
2 Derivatives Week June 16, 2008 At Press Time Ex-SE Heads Attack Derivatives Several former leaders of the Securities and Exchange ommission want to prevent investing in derivatives that cannot be valued. At the SE roundtable of past chairmen held June 4, Richard Breeden, now head of Breeden Partners fund, spoke out against derivatives that cannot be valued. While investors have gained in the past from derivatives investments, several have suffered significant losses because of them. David Ruder, now a Northwestern University law professor, said, We need to ask if the SE itself has the ability to understand these instruments. He argued that the SE should hire in-house or third party derivatives experts, but others were skeptical because of budget issues. Lawyers: XL, Merrill Ruling Upholds ontract Law redit derivatives lawyers cheered a U.S. District ourt ruling delivered Tuesday as a confidence boost to the market that credit default swaps will hold up under contract law. Dealers were also encouraged by the news because it means that write-downs coming out of the monolines should be muted by this ruling. A U.S. District ourt judge in New York ruled that Security apital Assurance s XL apital Assurance unit will have to stand by USD3.1 billion in protection sold on collateralized debt obligations, in dispute with Merrill Lynch. The complaint first filed in March (DW, 3/28) centered around the fact MBIA had separately written protection on the A1 classes of the DOs, which are senior to the A2 classes XL was protecting, making MBIA the sole controlling party for the DOs. But one lawyer said, If the claim is that Merrill breached their contract by promising voting rights to another party, I don t think such a claim could be triggered unless Merrill actually elected to not honor any written instructions by XL. Judge Jed Rakoff in a summary judgment ruled Merrill had not repudiated its obligations under seven DS it entered with XLA, and that XLA s attempt to terminate those swaps was invalid. The judge also dismissed three XLA counterclaims as asked by Merrill. Attorneys believe Merrill likely prevailed because not all the DOs in question have hit an event-of-default, rendering XL s reason for canceling the protection that Merrill was not ready to follow XL s written instructions regarding the exercise of voting rights on the collateral irrelevant. Lawyers also said the ruling offered clarity on whether the DS contracts written between XL and Merrill superseded the indenture documents governing the underlying DOs. In the indenture for Jupiter High-Grade DO VI, one of the DOs involved in the dispute, the document lays out the right for the initial purchaser that sells protection on the A1 tranche to exercise the voting rights of the so-called controlling class. XL said in a statement, Although the Judge has not yet issued his written opinion on the case, the company disagrees strongly with yesterday's result, intends to continue defending its legal position, and is evaluating its options for appeal. 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3 June 16, Derivatives Week Super-Seniors Back In Line With Value Super-senior DX tranches traded in line with their model values for the first time in several weeks on Monday as the rest of the standardized tranches saw spreads tightening. The top of the capital structure has been trading cheap to its intrinsic value for at least a month, spurring some investors to finally step up and take advantage by buying protection. As equity and senior tranches tightened, value moved into the junior mezzanine piece. These movements in the standardized indices also inspired a light burst of bespoke activity, traders reported although the market was slow overall due to several conferences in Europe. In mezzanine tranches, the 3-7% closed seven basis points tighter at the seven-year point and four bps tighter at the 10-year while the 7-10% closed three bps tighter at the seven-year and 10- year. The % super-senior closed three quarters of a basis point tighter at the seven-year and a quarter basis point tighter at the 10-year, according to data from Natixis apital Markets. Barap Moves Into Mutual Funds Barclays apital has launched its first mutual fund-linked offering in the U.S. and the firm says that more are on the way. The structured note is linked to Alternative Investment Partners Alpha Hedged Strategies Fund, an alternatives strategy fund in a mutual Antti Suhonen fund format. It is capital protected at maturity and offers 110% participation in the averaged performance of the underlying fund. Maturity is six years. The note does not have a specific marketing name. This has been a long-term development for us, said Antti Suhonen, head of fund-linked derivatives structuring at Barap, of the push into the mutual fund space. He said the timing of the launch related to Barap resolving regulatory issues the note is registered with the Securities and Exchange ommission. Suhonen said that there would be many more mutual fundlinked launches, adding that five more launches this year was possible. There s a huge variety of underlying sectors and management styles out there, he said. While the firm is talking to its broker-dealer distributors of the notes for ideas about future offerings, Suhonen suggested that at a time of market volatility, offerings with alts or fixed-income would be attractive. The notes will be sold to mass retail investors. Suhonen said he thought they would appeal to investors not familiar with the increasing range of areas covered by mutual funds, such as alts. Our experience is that in those situations, investors want principal protection, said he said. Senior Bespoke Bid Returns Bids for bespoke super-senior tranches returned on Tuesday after a brief hiatus as rumors of unwinds returned to the market. With idiosyncratic risk back in play and implied equity correlation set to lower, the middle of the credit correlation capital structure will gain if the super-senior bid continues, according to traders. Investors in the U.S. came back to the market to print new deals in anticipation that premiums will tick up. Implied correlation moves inversely with trading price. The rumors of unwinds are not believed to be linked to the downgrades of monolines MBIA and Ambac due to efforts to trade out of the names several months ago, according to traders. Both companies were referenced in a lot of bespokes because their credit default swap spreads traded wider than their ratings implied. Despite the large amount of deals that referenced the credits, many recent restructurings have focused on trading out of specific trouble names in addition to moving up the capital structure. One structurer in New York said the monolines were among the first names to go. He added that most structures were also robust enough to withstand the two downgrades without trading out but that some investors insisted on doing the trades several months ago. JPM Touts Equity rash Trades JPMorgan is touting crash puts and equity default swaps as ways for investors to take equity risk but minimize the downside. While uptake on such trades is said to be minimal bankers say they are too expensive and that investors are instead turning to highly liquid vanilla trades in a research note JPMorgan looks at the various trades and how today s market compares to previous crashes. It considers risks such as the tightening credit availability, falling property prices and rising inflationary pressures against positives such as the U.S. Federal Reserve s aggressive response to contracting credit markets. The report notes companies earnings are at a record high proportion of GDP and adds, There is potential for several years of margin compression and sub-trend earnings growth to limit market performance. The report points to the equity default swap as a way of trading unusually rare events. This trade pays a continual fee in exchange for a pre-agreed rebate if the barrier, when the product knocks out, is reached. The report adds that the barrier needs to be low, for example at 50%. [The equity default swap] is the cleanest and most effective way of selling a view that the market will never fall to a certain level, it says. The report also looks at crash puts, which trigger a To receive alerts or online access, call
4 Derivatives Week June 16, 2008 payment in the case of a large single day sell-off in the underlying asset. The trade is constructed as a cliquet of daily put options. In effect the protection seller is short a 1-day maturity [out of the money] put every day, with the strike set to a fixed percentage...of the previous day s closing level, says the report. Barap Launches Inflation Index Barclays apital has unveiled an index that allows users to make inflation plays. The Algorithmic Inflation Momentum Switching index will go long or short on Treasury inflationprotected securities using the Barclays TIPs Index as the underlying. The AIMS index will use a quantitative approach based on year-on-year inflation and the steepness of the yield curve. Because the nominal bond market is so much larger than the TIPs market, changes in inflationary expectations lead to exaggerated demand or supply in the TIPs market and this then leads to strong price pressures, said Pradeep Jhanjee, director. That is what we intend to capture. He said that as far as Barap is aware, AIMS is the first such index. Barap is not launching any offerings that reference the index, but Jhanjee said AIMS exposure could be delivered in a variety of ways, including principal protected structures and over-the-counter derivative formats. DS Indices Find Flow A sleepy start to European credit default swaps this week has seen an uptick in trading on indices. Some movement has been seen on names such as the U.K. s Kingfisher and British Energy. The price of DS on British Energy tightened by 50 basis points Monday on the back of a takeover offer from Electricité de France. But London traders say more flow is being seen on indices as investors take into account more general factors such as inflation. According to one trader, the volatility of the skew the difference between the theoretical value of an index and its market value reflects the difference between DS and index trading. In the past, DS and indices have traded much more in unison with each other. Now indices such as the main, rossover 8 vol and financial index, are trading more and being used as a macro instrument. The rossover 8 vol was trading at around 500 bps Monday. Friday morning, it was trading at 450 bps, rising to 480 bps by late afternoon, reflecting a bearish market. People have been focusing on [indices] not because there is an issue with the credit market, but because the market is very bearish, said the trader. BoA Beefs Up Equity Mktg Team The Bank of America has appointed Alex aramella as a managing director in corporate equity derivatives marketing in London. aramella was previously with HSB and started his new job this week. He will report to Yann Le Garrec, the bank s head of marketing for corporate equity derivatives and products in Europe, Middle East and Africa. Further details could not be immediately ascertained. This week the firm also tapped Ki Myung Hong, head of global markets in Asia, to be its president for the region following the retirement of olm Mcarthy, who has been with the bank almost 30 years. Hong will report to Jonathan Moulds, president of Europe, Middle East, Africa and Asia. Equity Derivatives Vol Spikes, Investors Trade Big Names With volatility spiking in recent days, twitchy investors are turning to variance swaps trades on the main indices and large-cap single names. Macro issues such as nervousness around the financial sector and the U.S. economy have helped push the VIX index to 24.12% since its slump to 16.36% just under a month ago. Bankers report activity on the main indices, such as the Euro STOXX 50, S&P500 and Nikkei 225, with interest in large-cap names such as in the FTSE 100 s top 15 companies. Stephen Einchcomb, equity derivatives strategist of JPMorgan in London said investors were trading a range of variance swap maturities, with December having the greatest liquidity. Activity was being driven by investors and options desks hedging broad volatility exposures, Einchcomb said, adding hedge funds were trading volatility spreads between stocks and credit and to a lesser degree correlation. Asia Pacific Barap redit Staffer Exits Mark Wan left Barclays apital recently. He was a director of credit derivatives and worked on structuring in the firm s Hong Kong office. Wan reported to Eric Slighton, managing director and head of Asia Pacific for structured credit, who left in April amid a round of global axe wielding by Barap (DW, 4/15). The firm has not replaced Slighton. Angie Tang, spokeswoman, confirmed the departure, declining further comment. Wan s future moves could not be established. 4 Institutional Investor News Reproduction requires publisher s prior permission.
5 June 16, Derivatives Week iti Readies ountry Quant Structures itigroup has launched a quantitative index that balances investments between different countries. The firm plans to take a variety of structures that reference the index, including notes and funds, to clients including high-net-worth, retail and Harold Kim insurance companies in Asia. The iti ountry Selection Index ranks 22 equity markets according to expected future performance, with the ranking updated monthly. It uses 17 factors to determine the ranking, including macroeconomic changes and fundamental research. Exposure is based on the MSI Daily Total Return Net Index for each country, except the U.S., which is referenced to the S&P 500 Total Return Index. The index takes exposure to the top five ranked countries selected by the model. Harold Kim, managing director of Asia Pacific equity derivatives, said that quant strategies is an emerging business in Asia and that Asian investors seem receptive. The more difficult challenge, given current market volatility, is actually convincing them to invest in equities, he said. Kim declined to give specific details of roll-out of structures based on the index, but said they would start to emerge over the next couple of months. Kim said the global index would appeal because there is an interest in diversification in Asia, in particular in newer markets such as Malaysia and Thailand. He added that markets that have historically invested only in local underlyings, such as Korea, have become increasingly receptive to the idea too. ABN Pushes Longevity Risk To Asian Investors ABN AMRO has started pitching the concept of longevity risk to Asian institutional and private wealth investors. The bank is not pushing specific offerings, instead it is educating potential investors. We are finding private banks and institutional investors in Asia are a lot more interested in the product than, say, six months ago, said hris Hodgeman, head of structured credit and alternative derivative marketing. Henry Kus, head of credit alternatives insurance, said if the market takes off in Asia it will most likely begin in the cash market, though the synthetic market would soon likely follow. Investors can get access to longevity risk using a pass through structure that replicates the cashflows of an index, of which the underlying is a pool of U.S. life settlements. A life settlement is an insurance policy which has been sold into the secondary market. When a death occurs in the pool, investors receive a payment equivalent to the death benefit minus the cost of premium financing. In the structuring process investors can ask for capital protection and currency hedges. Inflation Threat Seen For Asian DS Rising inflation is potentially the biggest risk to Asian credit spreads, a Morgan Stanley credit analyst has warned. Viktor Hjort, primary analyst in Hong Kong, said if inflation does not level off it will have a negative impact on the performance of the itraxx Asia index. Asia ex-japan headline inflation is close to a nine-and-a-half year high of 7.5% according to EI Data and Morgan Stanley research. Morgan Stanley believes that if inflation becomes a problem globally, Asia ex-japan has far more to worry about than the U.S. or Europe, and the macro imbalances it creates will weigh heavily on Asian credit default swap spreads, which have already taken a battering. In early May, the itraxx Asia (IG9) was trading in the 90 basis point range while this week it is trading at about 136 bps. Hjort said, We ve seen a substantial widening over the past month, coinciding with inflation becoming a theme across the Asia ex-japan region and also U.S. Federal Reserve hairman Ben Bernanke talking tough about U.S. inflation and flattening the U.S. yield curve. Put Buying Pushes Japanese Equity Vol Investors are searching out puts to hedge their exposures on the Japanese equity indexes. The interest is coming from a range of sources, including hedge funds and long-only funds allowed by their mandates to buy puts, but also retail investors via the warrants market. Winner Lee, Asian equity derivatives strategist at BNP Paribas in Hong Kong, said the buying is likely to be the cause of rising three-month implied volatility on the Japanese indices. This week the implied volatility term structure of the Nikkei 225 rose by more than one volatility point. There were similar rises in the Topix and the Topix ore 30. Lee said the demand for Japanese puts was being driven by concerns over the U.S. slowdown hitting Japan and rising inflation hitting earnings for a broad range of Japanese firms. She added that hedges were typically being taken on baskets of stocks investors are holding long, meaning that a small profit will still be made if the stocks fall. Meanwhile, BNP is continuing to recommend investors such as hedge funds go long on variance swaps on the Hang Seng and HSEI indices. It began recommending a return to the strategy several weeks ago on the back of an expectation that markets would correct and volatility would spike (DW, 5/23). To receive alerts or online access, call
6 Derivatives Week June 16, 2008 Malaysian Bank Pitches Multi-Product Fund Malaysian bank Permodalan Nasional Bhd is taking a MYR3 billion (USD917 million) structured product fund to Malaysian private banking clients and institutions. The fund invests in a mix of three asset classes, including the firm s own REITs, structured products and cash. ash will make up a minimum of 2% of the fund s investment, while structured products will form up to 80%, and REITs up to 50%. Nik Hazim Nik Mohamed, head of marketing in Kuala Lumpur, said PNB is buying the structured products from Deutsche Bank, using a mixture of interest rate and equity structures to form a portfolio of about seven. Nik Hazim said the structured products will be capital protected, will seek alpha and be market neutral. The fund is actively managed and will rebalance each quarter. The closed-end fund has a maturity of five years, was launched May 12 and closes June 25. Nik Hazim added that the REITs were not publicly listed and that at first they would only be used by the fund. All the property is in Malaysia. The payout on the fund will be each year rather than at maturity a feature which has been popular on other PNB funds and which the firm has decided to expand to structured investment funds and is offered by competitors. Nik Hazim added that in Malaysia, the majority of structured product funds only reference one structure. He said PNB s portfolio of structures approach is similarly intended to help guarantee regular returns, because in any one period an underperforming asset will be bolstered by others. Dong NDFs Plummet On Econ Fears Vietnam s faltering economy has seen the dong swoon against the U.S. dollar in the non-deliverable forward market this past week, as investors fear the specter of inflation. Against the dollar, spot yesterday was VND16,613 and 12-month NDF was priced in at VND22,675, a 38% mark down on the spot. Access to the dong market by offshore investors is through the NDF market. The dong is managed by the State Bank of Vietnam, which each day quotes a mid-point for dollar versus the dong and then allows onshore markets to fluctuate within a band of plus or minus 1%. Patrick Bennett, Asia fx and rates strategist for Societe Generale in Hong Kong, said, [The NDF pricing] reflects not only the speculation on what might be the future track of the dong, it also reflects a lack of liquidity as everyone is making a rush for the exits at the same time. According to Societe Generale, matters turned sour in the NDF market in mid-march. Since December 2006, the 12-month NDF market has rarely traded far from the spot quote. Vietnam s economy and asset markets are in the midst of a spectacular fall from grace, said Bennett. Inflation has reached 25% year-onyear, trade and current account deficits are ballooning [and] the stock market is off by 58% year to date. Macquarie To Roll Out Infrastructure Offerings Macquarie will push its infrastructure structured products globally, on the back of a new index formed by the firm s Hong Kong office. The Macquarie Emerging Markets Infrastructure and Development Index takes exposure to the 50 largest infrastructure-related companies in emerging markets. Nick Thompson, head of non-flow structured product sales in Hong Kong, said Macquarie would take a mix of capital guaranteed structures and delta one certificates referencing the index. apital protected structures may come as a standard bond plus call option, or a constant proportion portfolio insurance. At a later date the firm may also put together some short-term structures that short the index, as and when market movements make such a product attractive. The index taps into the predicted rise in infrastructure spending in emerging markets economies due to the movements of the so-called Generation A, a term coined by Macquarie to describe young and aspirational people who have relocated from rural areas to the cities. According to Macquarie, Generation A is fuelling the urbanization and industrialization of emerging economies. Macquarie predicts that this group will become one of the most important global economic drivers on the back of increasing wealth, sheer size of numbers and a desire to improve living standards. Thompson said globally the offering will be targeted at pension funds, sovereign wealth funds and private banking clients. He added that investment in the index is a long-term play. Pension funds understand and like infrastructure as an investment while private banking clients have some long-term plays in their portfolio as part of generational wealth transfer. 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7 June 16, Derivatives Week ;;; ;;; ;;; ;;; LEARNING URVE Sharia-ompliant Financing Over the next five years it is expected the market for Sharia-compliant offerings will grow by about 15-20% a year. This builds on growth in recent years that has seen breakthroughs in sukuk, securitization and general Islamic banking and moves by the U.K. government to develop London as a world center for Islamic finance. These developments have allowed more entities to structure their finances in a Sharia-compliant manner, which in turn has created a burgeoning interest in Shariacompliant hedging products to allow institutions to effectively manage their risk in a manner that does not offend Sharia principles. In this article we will explore the difficulties that arise with conventional derivative products from a Sharia perspective as well as looking at a case study of a Sharia-compliant cross-currency swap structure to show how innovative application of Sharia-compliant financing techniques and products can replicate the cash flows of a conventional currency swap. Sharia Law Fundamentals Sharia (Islamic law) governs social, political and economic relationships and institutions. Sharia is not a codified body of law, but a principles-based legal system that is capable of development and subject to interpretation. The legal principles underlying Sharia law are derived from a series of primary and secondary sources. The primary sources for Sharia are the Qur'an (scripture), Sunnah (practices and traditions of the Prophet Muhammad) and Ahadith (accounts of the sayings and deeds of the Prophet Muhammad). The secondary sources of Islamic law are, essentially, a series of methods, such as analogical reasoning, or consensus of scholars, that allow further rules to be extracted from the primary sources and applied to a modern context. There are five classical schools of thought (madhab), each loosely associated with a particular geographic region. These schools are broadly similar but some differences in legal interpretation between schools may mean that even if a structure has received approval from scholars affiliated with one school of jurisprudence it will not guarantee acceptance by other scholars from another madhab. Sharia Law And onventional Derivatives As discussed in Andreas Alexander Jobst's Derivatives In Islamic Finance Learning urve article (DW, 5/5), when structuring derivatives products, four main difficulties arise with respect to compatibility with Sharia law-prohibitions on, (i) Riba - the receipt and payment of interest, (ii) Gharar - Sharia does not recognise the validity of a contract if its principal terms are uncertain, for example price, quantity or material characteristics of any asset sold, (iii) Maisir - gambling or speculation in contracts and, accordingly, conventional contracts of insurance and particular futures and options contracts viewed as akin to gambling are prohibited, and (iv) debt exchange. A conventional currency swap usually consists of three stages-a spot exchange of principal, a continuing exchange of interest payments during the swap's life (essentially a series of fx forward trades) and a re-exchange of principal at the maturity of the contract, normally at the same spot rates used at the start. learly, given the Sharia prohibitions discussed above such a transaction if structured conventionally would not be Sharia-compliant. Sharia-ompliant ross-urrency Swaps The challenge when structuring Sharia-compliant derivatives is to generate cash flows that are similar to conventional derivatives products but use established Sharia-compliant financing techniques. In this cross-currency swap, two simultaneous murabaha transactions, a term and reverse murabaha, are used to generate cash flows similar to a conventional currency. A murabaha is a sale arrangement whereby a financier purchases goods from a supplier and then on-sells them to a counterparty at a deferred price that is marked-up to include the financier's profit margin. This profit margin is deemed justified because the financier takes title to the goods, albeit perhaps only briefly, and hence accepts the commercial risk of their ownership. As such, under the term and reverse murabahas, the parties agree to sell Sharia-compliant assets-often London Metal Exchange approved metals-to each other for immediate delivery but on deferred payment terms in different currencies- Derivatives Week is now accepting submissions from industry professionals for the Learning urve section. For details and guidelines on writing a Learning urve, please call Sam Mamudi in New York at , Irene happle in London at or Harry Thompson in Hong Kong at To receive alerts or online access, call
8 Derivatives Week June 16, 2008 Diagram 1 - The Murabaha Structure STEP 1 Financier buys Assets from seller for $x FINANIER (BANK) SELLER BUYER OUNTERPARTY in other words, use two parallel murabahas to generate corresponding deferred inter-party cash flows in the swapped currencies. This structure is not dissimilar to the parallel loans structure that was used by institutions in the earliest examples of conventional currency swaps. The Primary (Term) Murabaha Under this transaction the bank sells commodities-sourced from a commodity broker for the purpose of entering into the murabaha (step 1)-to the swap counterparty (step 2). The value of commodities bought and on-sold, known as the cost price, will be denominated in currency A. The commodities are delivered on the date on which the transaction is entered into. On receipt of the commodities purchased the counterparty will on-sell those commodities immediately to a different commodity broker (step 3) to generate a currency B payment. Payment by the counterparty for the commodities purchased under the Diagram 2 - Primary (Term) Murabaha 1 Bank STEP 2 Financier sells Assets to Buyer for $(x + y) (y being a tre agreed profit element) Assets Price $(X+Y) ost Price + final profit Instalment Periodic Profit Instalments 4 2 STEP 3 Buyer pays for the Assets on a deferred basis Pty 3 $B primary murabaha is on a deferred basis in instalments payable on pre-agreed payment dates in currency A (step 4). Each instalment will represent a portion of the pre-agreed profit element, except that the final instalment will also include payment in full of the cost price (step 5). The Secondary (Reverse) Murabaha On the giving of initial notification by either party that it wishes to enter into a cross-currency transaction, the counterparty will deposit an amount in currency B, equivalent in value to the currency A cost price amount, into a collateral account (step 6). To instigate the secondary murabaha, the collateral manager uses currency B to purchase commodities from its commodity broker (step 7). The commodities sold under the secondary murabaha should have the same value as those purchased under the primary murabaha. The collateral manager, acting as agent of the counterparty, on-sells these commodities to the bank for immediate delivery (step 8) and the bank then on-sells such commodities to the original commodity broker (step 9) to generate a currency A payment. Payment by the bank is on a deferred basis in instalments in currency B, such instalments to represent a portion of the pre-agreed secondary murabaha profit element (step 10). The exception is of the final instalment, which will also include payment in full of the currency B equivalent of the cost price (step 11). Instalment payment dates under the secondary murabaha will mirror those under the primary murabaha, so that on Diagram 3 - Secondary (Reverse) Murabaha 9 Broker A A Bank 8 10 Periodic Profit Instalments 11 Pty 6 7 Broker B ollateral Account 7 Broker A Where represents the flow of ommodities Broker B ost Price )urrency B Equivalent) + final profit Instalment Where represents the flow of ommodities 8 Institutional Investor News Reproduction requires publisher s prior permission.
9 June 16, Derivatives Week every date during the transaction cycle that a primary murabaha currency A payment is due a corresponding secondary murabaha currency B payment will also be due. Revisiting the cash flows under a conventional currency swap, the broker payments received by each of the counterparty and the bank (steps 3 and 9) can be analogized to the initial principal exchange, the interim instalment payments (steps 4 and 10) can be analogized to the interest payments and the repayment of cost price (steps 5 and 11) as part of the final instalment can be analogized to the final Diagram 4 - Full ross urrency Swap Structure NB. The numbering in this diagram is to show the order in which each phase takes place. It does not correspond to any numbering in the text of the article. 2 Broker A A Bank A 4 5 A 5 Pty Where represents the flow of ommodities Broker B ollateral Account 2 re-exchange. The currency swap is documented under a bespoke master agreement which, for Sharia adherence, will not incorporate debt exchange, interest payments or indemnities. This requires further innovative technology to address knock-on effects to otherwise standard provisions-for example, calculation of compensation amounts on late/deferred payment addressing how to calulate an early termination amount and new representations addressing the issue of Sharia-compliance. This structure is a good example of how well-established Islamic financing techniques are being used to create innovative structures that allow Islamic banks and corporates to effectively hedge their risks in a Sharia-compliant manner. A number of other such structures, including profit rate swaps-analogous to interest rate swaps-total return swaps and fund/index linked derivatives, have also been pioneered and are being used both in OT transactions and embedded into larger structures. As the market develops, liquidity should further increase, ensuring that its impressive growth rate continues. This week's Learning urve was written by Richard Tredgett, partner, Priya Uberoi, senior associate and Nick Evans, trainee, at Allen & Overy in London. User Strategy Arc Taps Lehman For Structured Note U.K. investment shop Arc apital & Income is marketing a structured note linked to the FTSE 100 and Standard & Poor s 500 indices. The plan was structured by Lehman Brothers. hris Powell, head of product development in London, said the previous tranche was structured by Bear Stearns. He said a handful of firms pitched to structure the new tranche and Lehman was able to offer the best terms. Arc also requires partner firms to hold an A rating or higher. Previous tranches had been able to offer 9% return but market conditions made that too difficult. We were very keen to get the 9% and 7.5%, said Powell, noting Lehman s provision of 8.6% was very, very competitive. The Fixed Income Plan 6 has a higher income or cautious income option, both with five-year maturities. The higher income plan offers 8.6% annual return or 0.69% monthly income. If the two indices are below 30% of starting levels when the plan matures, capital is cut by the corresponding amount. The cautious income offers 7.5% annual return or 0.61% monthly, with a 50% floor for both indices before capital is cut. Powell said the offering appeals to customers such as the elderly. It s nice to be able to lock in an income, he said, noting [ustomers] know what they ve got, they are going to get it monthly to pay their bills they like that certainty. The offer closes July 18. redaris Plots DS For redit Fund London-based asset manager redaris will deploy credit default swaps in a new credit fund it plans to launch in the fourth quarter. The long-short single name credit strategy has been run by the firm as an internal strategy for around three years and will be launched to third-party subscriptions at the beginning of the final quarter. Portfolio manager Sam owan says the fund will focus predominantly on situational credit. He added the post summer launch was set for when the market is focused and ready to come back to do some business. To receive alerts or online access, call
10 Derivatives Week June 16, 2008 Foreign Exchange & redit Derivatives Markets Euro Faces Downward Pressure Spot on the euro/u.s. dollar sank lower last week from EUR the previous Friday to EUR Thursday morning. London traders said people are mostly buying at-themoney euro puts and dollar calls. Traders believe it is impossible to say which way the market will go this week. Thursday s Irish referendum, last weekend s G8 meeting and U.S. Federal Reserve hairman Ben Bernanke s speech this week are all factors that will affect the market. That s why volatility is so high because there s an awful lot going on and no-one really knows what that means, said the trader. One-month implied volatility has risen from 9.8% previous Friday to 10.5% on Thursday, with one-year implied volatility rising from 10.44% to 10.75% over the same period. Ian Stannard, senior strategist at BNP Paribas, said there is downside pressure for the euro. A no-vote in the referendum would have significant bearish implications for the euro, as would any dollar-boosting comments made at the G8 meeting. Bernanke has already made statements aimed at lifting the dollar. We are certainly looking for a break lower from the recent trading range, said Stannard EUR/USD Spot & One Month Implied Volatility EUR/USD Spot One-Month Imp Vol 8 5/29 5/30 6/2 6/3 6/4 6/5 6/6 6/9 6/10 6/11 6/ Source: Bloomberg Indices Steal Limelight As DS Market Remains Quiet redit default swaps trading on single names remained sluggish last week, with most of the activity centered on indices. London traders said some activity has been seen on the itraxx Europe. The index widened early Thursday morning, opening at 94 basis points before moving to 93 bps. This slight movement was in line with the market weakness, said one trader, who added that curves are settled and no structured trades are taking place. DS trading on British Energy spiked at the start of the week following a takeover bid from Electricité de France. Spreads on the name tightened by 50 bps Monday. But even the news that British Energy rejected the offer failed to trigger more DS trades. Analysts believe that DS trading has been so quiet because no clear news item has managed to provoke market interest. The market did not respond, for example, to stronger than expected European industrial production figures announced Thursday morning. Andrea icione, credit strategist at BNP Paribas, said that news coming from the U.S. may shake things up this week. Firms such as Lehman Brothers, Goldman Sachs and Morgan Stanley will be announcing results and more writedowns are expected. A question-mark remains over the extent of these writedowns. Lehman is in the spotlight but there is also speculation that Goldman may surprise Five-Year redit Spreads On itraxx Europe General 5/29 5/30 5/31 6/1 6/2 6/3 6/4 6/5 6/6 6/7 6/8 6/9 6/10 6/11 6/12 Source: Markit NOW GET derivatives week EVERY FRIDAY! Paid subscribers now have access to a PDF of the upcoming Monday s newsletter on DW s Web site every Friday afternoon before 5 p.m. DST. That s a 64 hour jump on mail delivery, even when the post office is on time! Read the news online at your desk or print out a copy to read at your leisure over the weekend. Either way, you ll be getting our breaking news even sooner and starting your week off fully informed!
11 June 16, Derivatives Week Market Data Index Variance Swap Levels 3 Mth hange 6 Mth hange 1 Yr hange 2 Yr hange US SPX 23.11% 23.1% 23.77% 23.8% 24.34% 24.3% 24.75% 24.8% NDX 27.41% 27.4% 27.70% 27.7% 27.94% 27.9% 28.45% 28.5% Asia Nikkei 29.60% 29.6% 28.61% 28.6% 28.02% 28.0% 27.33% 27.3% Kospi 26.22% 26.2% 26.04% 26.0% 26.41% 26.4% 27.19% 27.2% 3 Mth hange 6 Mth hange 1 Yr hange 2 Yr hange Europe Eurostoxx 24.91% 24.9% 25.09% 25.1% 25.43% 25.4% 25.47% 25.5% DAX 23.94% 23.9% 24.13% 24.1% 24.50% 24.5% 25.04% 25.0% Source: Bank of America NEW DEFINITIONS (continued from page 1) advent of loan-only DS and the unique refinancing scenarios that occur with loans prompted efforts to finally tackle the issue across all contracts, said Tess Weil, partner at Purrington Moody Weil, speaking at an LSTA conference last week in New York. In addition to the definitions, the working group will launch a public domain a Web site administered by Markit Group to settle what information is public or private. If a refinancing is believed to have happened, dealers will conduct a poll to determine if it did and whether to release that information. Once there is comfort in that process there will still be some orphaning risk, but not the same amount of HEDGE FUNDS (continued from page 1) observed a hedge fund sales staffer. He noted hedge funds were happy to trade indices or blue-chip single stock names, adding, Once they start getting into a situation where they are beholden to one or two banks to make a price, they are a bit more reluctant. Louis Gargour, cio at LNG apital, said, Having spoken with other hedge funds, more managers are going to use options to express their investment views, as they allow you to limit losses and play a binary outcome. He added, Given the increase in market volatility this year, people are putting on smaller positions with wider stop-losses, he added. Jeff oggshall, portfolio manager at Tiburon Partners in London, agreed, describing the growing use of options as a knee-jerk reaction to market volatility. Michael Warren, investment director at Thames River apital, said his firm is now using options defensively to take the directional bias away from its Warrior series of funds of hedge funds. Options can be a suitable instrument to implement a view in the very short-term, rather than buying and selling a large For a complete Market Data go to DW s web site cancelability risk, said Dan Kamensky managing director at Lehman Brothers. Following the declaration of a refinancing event, a new mandatory step called a successor consultation event will occur within 60 days, similar to credit event auctions. The consultation will see buy- and sell-sides officials determine the correct trading levels for the contracts. The idea is to find a solution to problems that don t have obvious answers, said Ian Sandler, managing director at Morgan Stanley. Officials stressed that the right balance of buy- and sellside participants would take part in the consultations to ensure transparency. The market wants to make sure that dealers vote based on the right answer, rather than in the interests of their books, said one buyside official. Nicoletta Kotsianas volume of stocks at a high transaction cost, said Steve Solmonson, president of Park Place apital. Pricing must be accounted for, however. It is a atch-22 situation, he observed. People want to use them when the volatility is up and they are therefore more costly. Solmonson urged caution. While they can be a tool for risk management, sometimes they can make things more risky due to their complexity and the levels of leverage they use, he said. Irene happle & Harriet Agnew FIRMS FUME (continued from page 1) of India, RBI and others to discuss the issues. We have asked members to let us know whether ISDA should take issue with the proposed guidelines and we expect to get constructive feedback over the course of the coming week, she said. The timing may work against the industry, however. Many corporates in India have in the past year hit trouble with contracts that included options with knock-out barriers to reduce premium payments, notably in fx deals (DW, 6/2). As a result, they were forced to restructure their contracts when currencies moved against them to stave off the risk of losing To receive alerts or online access, call
12 Derivatives Week June 16, 2008 protection on the option. H Jayesh, principal at Mumbai-based Juris orp Advocates and Solicitors, said, The RBI is coming from the view that senior management of a lot of corporates didn t really understand or appreciate the risks they were getting into though their chief financial officers may well have understood and in an environment such as this it is preferable not to allow them to restructure other than on a cash basis. The RBI proposed the same clause in January 2007, but after industry lobbying it was defeated. In today s environment, with the number of litigations brought by corporates against firms for these contracts, RBI may succeed. The RBI may want to be seen doing something even if it is a step backwards and in spite of the fact that many corporates did restructure their trades when they realized their calls started going wrong, said H Jayesh. The RBI did not return calls seeking comment. Danny Flatt AUSSIE BANKERS (continued from page 1) the stock back to the lender at an agreed price. Previously interest up to the Reserve Bank of Australia s indicator rate for unsecured personal loans was tax deductible at a rate of about 14.5%. But under the changes, tax deductibility is limited to the indicator rate for standard housing loans about 9.5% five percentage points lower. For example, if an investor borrows AUS100 to buy shares, the interest on this, say 17% or AUS17, would have been tax deductible for the first 14.5%, but now only to 9.5%. The investor would lose AUS5 at the end of the transaction. One Sydney-based equity structuring head said a large part of Australian retail structured products business is driven by investors seeking the added returns that a reduced tax burden provides. We ve yet to see the effect of this, he said. It could go either way. Sales could be hit hard, or the drive for investors to seek yield in this environment could keep structured products afloat. One market official agreed that the effects of the changes were yet to be felt, but said he expected them to affect the type of capital-protected structures firms will put together more than volumes it could encourage more issuance of standard bond plus call or put structured products. He added that the changes have created difficulties for issuers, with a number of firms, including big local issuer Macquarie, forced to produce supplements to their brochures to explain how the payout has changed. The official added that June is typically the most popular time for new structure issuance in Australia, and that firms had been working on their structures for several months before the tax change. Paul McBride, senior associate at Mallesons Stephen Jaques in Hong Kong, said the tax change is simply one of the government s budget measures but it may be also seeking to curb margin financing, which has been in the spotlight in Australian press along with other instruments such as securities lending, due to incidents where retail investors have lost money. Harry Thompson Quote Of The Week The idea is to find a solution to problems that don t have obvious answers. Ian Sandler, managing director at Morgan Stanley, about moves to resolve the problem of succession issues (see story, page 1). One Year Ago In Derivatives Week Property derivatives markets were emerging in Asia on the back new indexes in the region. [Despite a continued lack of liquidity, this year marked the first long-dated Asian property derivatives option transferred through Hong Kong off the back of the University of Hong Kong index. The trade was made between Goldman Sachs and Lehman Brothers global real estate group]. T RADING TALES...With Steve Spread Steve Spread made buckets of cash as an arbitrageur at a bulge-bracket firm in the early 1990s. Over-worked, over-paid and wondering what to do with his millions, The Wizard as he was known bought the remote Scottish Isle of Lucre from where he trades his own book and passes judgment on the far away financial hubs. Feel free to him at So I see that no sooner had the ink dried on my column last week than Andrew uomo and the rating agencies reached an accord (translation: rating agencies caved in) on disclosure. Now the real deja vu sets in as the Securities and Exchange ommission (Hello!!! Where have you been???) proudly announced last Wednesday greater disclosure rule proposals of its own and breathlessly noted there would be just 30 days to file comments. Rush, rush, rush!! Especially when once again a Republican-led agency has been totally embarrassed by the Democratic AG of New York State. Almost embarrasses me to be a conservative...almost. But gotta keep capital gains taxes within reason! 12 Institutional Investor News Reproduction requires publisher s prior permission.