Design of Master Agreements for OTC Derivatives

182 Pages·2001·6.37 MB·English

by  Dr. Dietmar Franzen (auth.)

Lecture Notes in Economics
and Mathematical Systems 494
FoundingEditors:
M. Beckmann
H. P. KOnzi
Co-Editors:
C. D.Aliprantis,Dan Kovenock
Editorial Board:
P. Bardsley,A. Basile,M.R. Baye,T. Cason,R. Deneckere,A. Drexl,
G. Feichtinger,M. Florenzano,W GOth, M. Kaneko, P. Korhonen, M. Li Calzi,
P. K. Monteiro,Ch. Noussair,G. Philips, U. Schittko, P. SchOnfeld, R. Selten,
G. Sorger, F.Vega-Redondo,A. P.Villamil,M. Wooders
ManagingEditors:
Prof. Dr. G. Fandel
FachbereichWirtschaftswissenschaften
FernuniversitatHagen
Feithstr. 140lAVZ11,58084Hagen, Germany
Prof. Dr. W.Trockel
InstitutfUrMathematischeWirtschaftsforschung (lMW)
UniversitlitBielefeld
UniversiUitsstr. 25, 33615 Bielefeld, Germany
Springer-Verlag Berlin Heidelberg GmbH
Dietmar Franzen
Design
of Master Agreements
for OTe Derivatives
Springer
Author
Dr. Dietmar Franzen
RofanstraBe Ilc
81825 Munchen, Germany
Cataloging-in-Publication data appIied for
Die Deutsche Bibliothek -CIP-Einheitsaufnahme
Franzen, Dietmar:
Design of master agreements for OTC derivatives I Dietmar Franzen. -
Berlin; Heidelberg; New York; Barcelona; Hong Kong; London;
Milan ; Paris ; Singapore; Tokyo: Springer. 2001
(Lecture notes in economics and mathematical systems; 494)
ISBN 978-3-540-67934-9 ISBN 978-3-642-56932-6 (eBook)
DOI 10.1007/978-3-642-56932-6
ISSN 0075-8442
ISBN 978-3-540-67934-9
This work is subject to copyright. AII rights are reserved, whether the whole or part
of the material is concemed, specifically the rights of translation, reprinting, re-use
of illustrations, recitation, broadcasting, reproduction on microfilms or in any other
way, and storage in data banks. Duplication of this publication or parts thereof is
permitted only under the provisions of the German Copyright Law of September 9,
1965, in its current version, and permission for use must always be obtained from
Springer-Verlag. Violations are liable for prosecution under the German Copyright
Law.
© Springer-Verlag Berlin Heidelberg 2001
Originally published by Springer-Verlag Berlin Heidelberg New York in 2001
The use of general descriptive names, registered names, trademarks, etc. in this
publication does not imply, even in the absence of a specific statement, that such
names are exempt from the relevant protective laws and regulations and therefore
free for general use.
"Gedruckt mit Unterstiitzung der Deutschen Forschungsgemeinschaft D 19"
Typesetting: Camera ready by author
SPIN: 10780173 42/3142/du 543210
Preface
I first came across the issue of derivatives documentation when writing my
diplomathesisonmeasuring thecredit riskofOTC derivatives whileI wasan
economics student at the University of Bonn. Despite the fact that security
design has been an areaofresearch in economics for many years and despite
the widespread use of derivatives documentation in financial practice, the
task of designing contracts for derivatives transactions has not been dealt
withinfinancial theory. Theonethingthataroused mycuriositywasthat two
parties with usually opposing interests, namely banking supervisors and the
bankingindustry'slobby,unanimouslyendorsethe useofcertainprovisionsin
standardizedcontractscalledmasteragreements. Dotheseprovisionsincrease
the ex ante efficiency ofcontracts for all parties involved?
Iactuallybegan my researchexpectingtofind supportfor the widely held
beliefs about the efficiency or inefficiency of certain provisions and was sur
prised to obtain results that contradicted the conventional wisdom. I would
strongly advise against using these results in any political debate on deriva
tives documentation. They wereobtained within a highlystylized model with
some restrictive assumptions. This work should rather be seen as an attempt
to formalize the discussion on derivatives documentation and to challenge
the notion that certain provisions are generally ex ante efficient. It is also
an invitation to all those advocating the use of certain provisions in master
agreements to formalize their arguments and to explain the economic ratio
nale behind these provisions.
There are many people who played a part in the making of this book.
First, I would like to thank Bernd Rudolph, my academic teacher at the
University ofMunich, for his valuable comments and suggestions and for his
support ofmy Ph.D. dissertation on such a seemingly odd topic. This work
could not have been written without his endorsement. I would also like to
thankKlausSchmidtfor hisusefulcomments. Hisexcellentcourseoncontract
theory has helped shape many ofthe ideas that can be found in this work. I
would also like to acknowledge the fine work ofall my teachers, academic or
otherwise, throughout the years, particularly Vera Apel, Wilhelm Berghahn,
Hans-Jacob Kriimmel, Reinhard Selten and Wolfgang Weimer.
Iamalsovery much indebted to all my colleaguesandfriends at the Sem
inar KMF at the UniversityofMunich, TanjaDresel, SandraFink, Christoph
VI Preface
Fischer, Robert Hartl, Sabine Henke, Markus Kern, Christoph Kesy, Michael
Pfennig, MarkusPriiher, Thomas Raschel, StephanSeidenspinner, and Peter
Zimmermann, who made the years I spent there as a research and teaching
assistant such a wonderful time. They have supported me in so many ways
that it is hard to imaginehow Icould havefinished the project without them.
IwouldparticularlyliketothankHans-PeterBurghofand KlausSchafer,who
spentmuchtimelookingoverthefinal draftsofthisworkandwhomademany
helpful suggestions for improvements. I also owe a lot to Janet Dodsworth
and Norman Jones who helped improve the linguistic aspects of this work.
Lutz Johanning, a dear friend and colleague at the UniversityofMunich, de
serves a special acknowledgment. His comments on the final drafts and also
the many discussions we had over the years contributed much to the ideas
and analyses presented here.
Finally, I would like to thank all other personal friends, particularly Ger
hild Jager,and my family for their continuedsupportduringthese years. The
ups and downs ofthis project have tested not only my endurance but theirs
as well.
Munich, August 2000 Dietmar Franzen
Contents
1. Introduction.............................................. 1
2. Derivatives Usage and Documentation ,........... 7
2.1 The Benefits ofDerivatives for Non-financial Firms. ........ 7
2.1.1 Irrelevance ofHedging in Perfect Capital Markets. ... 7
2.1.2 Managerial Theory of Risk Management 8
2.1.3 Relevance ofHedging with Risk-neutral Agents 10
2.1.4 Empirical Literature on Corporate Hedging Policies .. 12
2.1.5 Derivative Instruments and Derivatives Markets .... " 15
2.2 ISDA Master Agreements. ............................... 17
2.2.1 The Design and Function ofMaster Agreements. ..... 17
2.2.2 Netting, Early Termination, and the Mitigation of
Credit Risk. ..................................... 19
2.2.3 Limited vs Full Two-way Payment Provisions. ....... 23
2.2.4 Collateralization................................. 24
2.3 Legal Risk, Enforceability, and Insolvency Law ............. 28
2.3.1 General Principles ofInsolvency Law 29
2.3.2 Enforceability ofContractual Provisions Contained in
Master Agreements ............................... 36
2.3.3 Recent Default Experiences. ....................... 41
2.4 Summary.............................................. 43
3. Incomplete Contracts and Security Design. ............... 45
3.1 An Overview ofthe Literature on Incomplete Contracts. .... 45
3.1.1 Financial Theory and the Theory ofIncomplete Con-
tracts. .......................................... 45
3.1.2 Models of Financial Contracting Using Incomplete
Contracts 48
3.1.3 Private Workouts and Bankruptcy Law: Theory and
Empirical Evidence. .............................. 54
3.2 The Basic Framework. .................................. 59
3.2.1 Model Setup. .................................... 59
3.2.2 Default and Renegotiation. ........................ 62
3.3 A Benchmark Case: Bilateral Bargaining Without Derivatives 67
VIII Contents
3.3.1 The Renegotiation Game 67
3.3.2 Optimal Debt Contract and Underinvestment ........ 69
3.3.3 Comparative Statics Analysis ...................... 74
3.4 Numerical Examples. ................................... 75
3.5 Summary.............................................. 78
4. The Implications ofProvisions in Master Agreements. ... 81
4.1 The Basic Bargaining Framework with Multiple Claims 81
4.1.1 The Renegotiation Game 81
4.1.2 Properties ofOptimal Contracts. ................... 83
4.2 The Impact ofClose-out Netting Provisions. ............... 86
4.2.1 Contracts Without Close-out Netting Provisions. ..... 86
4.2.2 Master Agreements with Close-out Netting Provisions. 93
4.2.3 Cross-product Netting 102
4.3 Limited Two-way Payment Provisions 107
4.3.1 Protecting Creditors Against Strategic Defaults ...... 107
4.3.2 Implications for Firm Vvalue 110
4.3.3 Comparative Statics Analysis 116
4.4 Collateralization ofDerivatives Transactions 118
4.4.1 Extending the Set ofFeasible Contracts 118
4.4.2 The Renegotiation Game 119
4.4.3 Properties of Optimal Contracts 122
4.4.4 Comparative Statics Analysis 128
4.5 Numerical Examples 129
4.5.1 Hedging Without a Close-out Netting Agreement 129
4.5.2 Close-out Netting 131
4.5.3 Cross-product Netting 132
4.5.4 Limited Two-way Payment Provisions 133
4.5.5 Collateralized Derivatives Transactions 135
4.6 Summary 138
5. Two-sided Credit Risk 141
5.1 A Bilateral Bargaining Framework with Two-sided Credit Risk141
5.1.1 The Renegotiation Game 141
5.1.2 Properties of Optimal Contracts 144
5.2 Close-out Netting 147
5.3 Limited Two-way Payment Provisions 150
5.4 Numerical Examples 154
5.5 Summary 155
6. Conclusion and Outlook 157
References 161
Index 173
1. Introduction
Recent surveys of derivatives usage in non-financial firms underline the fact
that derivatives playa prominent role in financial risk management.l Non
financial firms generally prefer privately negotiated over-the-counter (OTC)
derivatives to exchange-traded contracts.2 OTC derivatives allow the parties
to tailor the terms ofthe contracts to suit their desired risk profiles. Amajor
disadvantageofOTC products overexchange-traded products is that parties
areexposed to default risk,3 that is, the risk that the respectivecounterparty
will default on its obligations. Some large-scale corporate financial crises in
the 1990sthat were triggered by arguably questionable derivatives strategies
have highlighted the importance ofmanaging the credit risk ofderivatives.4
This raises at least two important questions: first, which tools can be used
to mitigate the credit risk ofOTC derivatives; second, how the credit risk of
derivatives or even entire portfolios can be priced in order that the holders
are adequately compensated for the risks they bear. Clearly, the two prob
lems are interrelated, because any contractual agreement between parties
which reduces credit risk will influence the default risk premium reflecting
the parties' relative credit quality.
In financial practice, bilateral contractual arrangements known as mas
ter agreements have become a de facto standard for the documentation of
bilateral derivatives transactions. Some type of master agreement, in most
casesoneofthe master agreements published by the International Swapsand
Derivatives Association (ISDA), is now invariably used by derivatives dealers
and end-users to document the legal terms ofall derivatives transactions be
tween two parties under a single agreement.5 Master agreements have been
1 See Bodnar et al. (1998, 1996, 1995), Bodnar &Gebhardt (1998), Gebhardt &
RuB (1999), Phillips (1995), Berkman & Bradbury (1996), and Berkman et al.
(1997).
2 See for instance Bodnar &Gebhardt (1998).
3 In this work, the terms credit risk, default risk, and counterparty risk will be
used synonymously.
4 The strategies that led to the Orange County bankruptcy in 1994 and the cri
sis at Metallgesellschaft in 1993 have been the subject of controversial debates
amongeconomists. SeeJorion (1997), Miller& Ross (1997),Culp& Miller(1995),
Jayaraman &Shrikhande (1997), and Spremann &Herbeck (1997).
5 See Bank for International Settlements (1999) and Global Derivatives Study
Group (1994).
D. Franzen, Design of Master Agreements for OTC Derivatives
© Springer-Verlag Berlin Heidelberg 2001
2 1. Introduction
developed to help mitigate counterparty risk in aTe derivatives transac
tions and to avoid the inefficiency of having to negotiate the legal terms of
contracts on a transaction-by-transaction basis. They contain several provi
sions intended to reduce credit exposure ifone ofthe parties defaults on its
obligations. Since the validity of these provisions has rarely been tested in
court, there are doubts about the enforceability of some of these provisions
in at least some jurisdictions. The issue ofenforceability has received much
attention in the literature on derivatives documentation. However, this is a
predominantly legal debate.
The questions of whether the provisions used in master agreements are
efficacious and whether they are desirable from an economic point of view
have been largely ignored, despite the widespread use ofthese agreements in
financial practice. Instead, banking supervisors and derivatives dealers have
universally endorsed the use ofnetting and other provisions that reduce the
aggregate credit exposure of derivatives transactions. A reduction in credit
exposure benefits the non-defaulting party in the event of a default and is
therefore believed to contribute to the stability of the financial system as a
whole.6 However, no formal proof of this argument has yet been provided.
This work aims to evaluate provisions in master agreements from the point
ofview ofan end-user, such as a non-financial firm, which will in most cases
be the lower-rated counterparty. The provisions affect the parties' actions
in the event ofa default, that is, after the contracts have been entered into,
which will in turn affect the parties' choiceofinitialcontracts. Thedifferences
between the ex post and ex ante implications of these provisions will turn
out to be important.
An incomplete contracts approach modeled on Hart & Moore (1989) is
used to examine the implications of derivatives documentation in a formal
setting. Forward contracts are introduced into the Hart-Moore model to en
able a non-financial firm to hedge its exposure to currency risk (or other
market price risks). Hedging increases ex post efficiency in this setting be
cause it increases the firm's cash flow in states whereexchange rates are low.
This lowers the probabilityofliquidation and thus reduces bankruptcy costs.
But hedging will also increase ex ante inefficiency, that is, the level ofunder
investment, because the aggregatedefault risk premium is raised by the fact
that debts, as well as derivatives contracts, are subject to default risk.
The incompleteness of contracts allows for strategic defaults and for the
renegotiation ofcontracts following a default. Therefore, a default of one of
the parties does not imply that this party is bankrupt and that its assets
have to be liquidated. Liquidation, which is assumed to be suboptimal, can
be avoided if the parties agree to a reorganization ofclaims. The amount of
cash available to the defaulting party is crucial to the successofthe reorgani
zation process. Since the provisions specified in the initial master agreement
6 See for instance Global Derivatives Study Group (1993a), Basel Committee on
Banking Supervision (1995), and Hendricks (1994).