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Nick Cavalla
Introduction and selection© Macmillan Publishers Ltd, 1993
Contributions © the contributors 1993
All rights reserved. No reproduction, copy or transmission of
this publication may be made without written permission.
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Contents
Contributors viii
Preface xii
Nick Cavallo
1 Overview 1
Nick Cavallo
Regulatory and credit arbitrage and accounting treatment 2
Parallel growth in securities markets 4
Investor-driven debt issues 5
Deregulation 5
Quantitative investment 6
Tax efficiency 7
New products and 'financial engineering' 7
Option-based structures 9
Risk management 10
Credit risk 10
Regulation and capital adequacy 12
Market trends 14
2 Structured Equities 17
Mark A. Zurack
Introduction 17
Benefits of structured equities 18
Credit and liquidity considerations 20
The products 20
Strategies 26
3 Interest Rate Products 33
Andrew Norman
Introduction 33
Types of product and market 33
Risk and capital adequacy regulation 36
Pricing characteristics of interest rate derivatives 39
Applications of interest rate derivatives 43
Some examples 46
Bibliography 49
v
Contents
4 Foreign Exchange Products 51
Christopher C. Taylor
Introduction 51
The development of derivatives 53
Phase one: strategy-driven instruments 53
Phase two: new forms of option derivatives 58
Future developments 69
Conclusion 70
71
5 Commodity Derivatives
Louise Rowsell
71
Introduction
76
The nature of commodity price risk
85
Risk management
90
The structure and pricing of commodity derivatives
101
6 The Forward Market in Electricity
Josh Danziger
101
Introduction
102
The UK electricity industry
105
The pool
109
Pool price derivatives
116
Hedging and trading
118
Pricing
121
Spreads
122
Summary
124
The Relationship with Exchange Traded Derivatives
7
Victoria Ward
124
Introduction
Defining characteristics of exchange traded and
125
OTC derivatives
133
Implications of differences in product design
137
Trading environments and comparative liquidity
139
Administration and cost
140
Regulation, competitive attitudes and credit risk
145
Future developments
146
Bibliography
147
Investment Management Applications
8
Karen Mason
147
Introduction
148
A brief history of quantitative fund management
vi
Contents
The changing shape of index funds 149
Further developments in quantitative fund management 150
The interest in OTC derivatives 151
Some applications of OTC-based products 153
Stumbling blocks for the fund manager 168
Conclusion 169
9 Corporate Applications 170
Mike Shilling
Introduction 170
Identification of exposures 171
Currency exposures 171
Interest rate management 183
Management and controls 190
Monitoring and performance measurement 191
Conclusion 192
10 Risk Management 193
Chris Currington
Introduction 193
Risks 194
Risk control framework 201
11 Accounting and Regulation 208
Robert Rountree
Introduction and scope 208
Current accounting standards and developments 210
Accounting policy 218
Regulatory environment 230
240
Conclusion
240
Bibliography
242
12 UK Tax Treatment
Leon Cane
242
Introduction
Aspects of the UK tax system which bear on derivative
242
instruments
250
Treatment of specific instruments
255
Proposed reform
258
Appendix
258
ISDA Master Agreement
284
lSD A Schedule to the Master Agreement
291
Index
vii
Contributors
Leon Cane. After qualifying as a chartered accountant in London, Leon Cane
read law at Cambridge University and subsequently qualified at the Bar. He
is a principal in the Financial Institutions Tax Group of Touche Ross, where
his work includes advising on the UK and international tax aspects of derivative
instruments. This involves assistance in the development of new products
with financial institutions and advising on the implications of existing products
for corporate users.
Nick Cavalla. A chartered accountant and MA in mathematics from King's
College, Cambridge, Nick Cavalla is currently a management consultant with
Touche Ross, specialising in corporate and financial treasury management.
His previous employers have included: the futures broker GNI, where he was
head of research, and responsible for the interpretation and forecasting of
major financial markets, money management in futures and options, and
advice on hedge construction and the mathematical and technical aspects of
derivative instruments; and County NatWest Investment Management, where,
as an assistant director in the quantitative investments section, he managed
the fixed income and derivatives dealing operation and the product develop-
ment group.
Chris Currington is a partner in Arthur Andersen's Financial Markets Division
and is a member of the Canadian and Scottish Institute of Chartered
Accountants. Chris returned to Arthur Andersen in 1988, after spending
18 months as European Financial Controller for a major American investment
bank. He has also been seconded to an international bank and to a major
international trading and broking group. The majority of Chris' work is of an
advisory nature, including treasury and risk management studies, business
reviews and investigations. Chris has directed numerous reviews on the quality
of management, financial dealing and treasury control environments for a
number of major UK corporates and for a number of international banks
based in London. He is a regular speaker at conferences on risk and treasury
management and accounting for new financial products. Chris has also written
a number of articles on these topics.
Josh Danziger is Senior Quantitative Analyst at GNI. His responsibilities
include analysis and advice on hedging techniques and trading strategies using
viii
Contributors
derivative instruments; in particular, he has specialist interests in interest rate
options and in the new area of electricity derivatives. Previously, he has
worked as a Financial Engineer in the interest rate market for a UK merchant
bank. Qualifications include an MA and a PhD from Gonville & Caius College,
Cambridge.
Karen Mason graduated from the City University Business School with a
degree in Banking and International Finance. Prior to joining BZW Investment
Management (BZWIM) she worked for six years in the quantitative team at
County NatWest Investment Management, where she headed the team
responsible for product development and, subsequently, the management of
the fixed income and derivatives team. During this time, she was involved in
the development and launch of a number of derivative-based investment
strategies, including portfolio insurance and currency dynamic hedging. She
joined the quantitative team at BZW Investment Management in 1991 where
she provides advice on derivative strategies and is involved in the management
of client portfolios.
Andrew Norman. After completing his studies in 1987, Dr Andrew Norman
spent three years at County NatWest Investment Management working on
quantitative modelling and product development projects for various new
fund management products, including asset allocation, dynamic currency
hedging and portfolio insurance. In 1990 he moved to Bankers Trust Capital
Markets where he has developed analytics for multi-factor derivative
products, covering fixed income, foreign exchange and equity markets. He
has also worked on risk management advisory assignments for financial
institutions.
Recently, he has joined a newly formed group at Bankers Trust in
Quantitative Research and Arbitrage, to apply new valuation and hedging
techniques to equity and foreign exchange markets, and provide consulting
on technical issues. Dr Norman holds degrees in mathematics and statistics
from London University and also obtained a PhD in Stochastic Control and
Finance from Imperial College. The subject of his doctoral research was an
investigation of the effect of transactions costs on the portfolio choices of a
utility-maximising agent.
Robert Rountree BA ACA is a Vice President in the Financial Division of
JP Morgan in London. Educated at Sedbergh and Lincoln College, Oxford,
Robert qualified as a chartered accountant with Touche Ross in 1985. After
qualification he spent two years in the financial services audit group of Peat
Marwick in Paris, before joining JP Morgan in 1987 to manage the financial
accounting area of the bank's London branch. Robert moved to the Swap
Financial Control group of JP Morgan Securities Limited in 1990 to supervise
IX
OTC Markets in Derivative Instruments
implementation of financial controls over the rapidly expanding swap derivative
business. and in 1991 took responsibility for managing the support of the New
York and Tokyo swap trading areas.
Louise Rowsell is an Associate Director of Mitsubishi Finance International
Pic. She joined Mitsubishi in 1990 to set up and develop the Commodity
Derivatives operation. This business enhances the related Equity and Interest
rate product range provided by the Bank. Louise first entered the commodity
markets by joining Phibro Salomon Ltd, London in 1983 where she traded
physical non-ferrous and Platinum Group metals. Since that date she has
been involved firstly in the trading of energy futures and subsequently energy
and metals swaps. In addition to trading activities, Louise also fulfils teaching
assignments on Energy and Metals Derivatives as well as being a regular
contributor to various financial publications on the subject.
Mike Shilling graduated in 1978 from Oxford University where he studied
Politics, Philosophy and Economics. After spending nine years with the British
Broadcasting Corporation he joined Record Treasury Management Ltd, part of
NP Record pic and one of the world's leading foreign exchange risk manage-
ment specialists.
He is currently an Associate Director responsible for developing and mar-
keting dynamic hedging and option-based strategies, as well as the on-going
management of Record's $4 billion portfolio of risk. Mike contributes regularly
to professional journals on such subjects as corporate risk management and
currency overlay for institutional investors.
Christopher C. Taylor. After graduating from The City University with an
honours degree in Banking and International Finance. Christopher Taylor
has gained extensive experience in the field of interest rate and currency
exposure management, working for a number of leading international banks.
This experience includes: helping to found Midland Bank's financial futures
operation; working as a member of Citibank's financial engineering unit,
providing the bespoke solutions to exposure management problems; mar-
keting swaps and options for County NatWest working within the bank's Rate
Risk Management group. Christopher Taylor has recently joined Barclays de
Zoete Wedd as Head of Treasury Sales from Midland Montagu where he was
Head of Specialist Derivatives Sales.
Victoria Ward read Modern and Medieval Languages (German and Italian)
at Selwyn College, Cambridge. In 1981 she joined Fiamass as a graduate
trainee. She moved to Messel Futures Ltd (now part of Shearson Lehman)
in 1982 to develop the futures operations, initially in the gilt market. In 1984,
she was made a Director of Messel Futures Ltd and moved from gilts to head
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