Business Law Institute                 May 2011Hedges, Swaps, Collars and Caps – A Primer on      the Wonderful World of I...
ObjectivesOverview of financial derivativesDiscussion of how derivatives can be used to manage interestrate riskDeal terms...
Financial DerivativesWhat is a derivative?A derivative is a financial arrangement that derives its value basedon the chang...
Why do companies use derivatives?   Insulate against risk (hedge)   Profit from risk (speculate)   Tax and accounting   Ar...
Hedging Derivatives allow taxpayers to manage risks, including the following:     Market fluctuations     Interest rates...
Why do companies use derivatives? Many companies use derivatives to limit exposure to movements in currency exchange rates...
Types of Derivatives    There are two broad types of derivatives:       Forward-based, and       Option based   Forward...
Types of Derivatives                          Forward-Based    Forwards                      Futures                      ...
Options One-sided protection/risk “Calls,” “Puts,” and “Collars”                                  9
Call OptionsThe writer of a call has unlimited downside risk and gain tothe extent of the premium received. The holder of ...
Put OptionsThe writer of a put has unlimited downside risk and gain to theextent of the premium received. The holder of a ...
SwapsDefinitionGenerally, a swap is an agreement between two parties to exchange(or “swap”) payments at specified interval...
Example of a Interest Rate Swap ContractFor example, a swap contract may provide that Customer is to pay,i.e. counterparty...
Interest Rate Swap withPeriodic Payment                                    7 % x $10 mm   Lender                Customer  ...
ISDA Documentation and Contract TermsFixed/Floating Swap  Payments are netted on settlement dates. Net result:  If Floatin...
ISDA Documentation and Contract TermsWhy Do a Swap? Fixed Rate not available on loan; Portability – in theory, swap exists...
ISDA Documentation and Contract TermsDocumentation  CAP. Caps (bank will pay customer if floating rates exceed a  specifie...
ISDA Documentation and Contract Terms ISDA Document: ISDA Document itself. ISDA has always been and obscure, difficult doc...
ISDA Documentation and Contract TermsDefined Terms  Great number of defined terms and concepts. A couple to watch:     Spe...
ISDA Documentation and Contract TermsOther Provisions to Watch  Other Termination Events or Events of Default.  Threshold ...
ISDA Documentation and Contract TermsCollateral Security  Its common for Banks to require same collateral that supports  t...
ISDA Documentation and Contract Terms Real Property. ISDAs often have a provision in the definition of Credit Support Docu...
ISDA Documentation and Contract TermsRepresentation:  Tax Representations  Many ISDAs will require the Customer to represe...
ISDA Documentation and Contract TermsGoverning Law  Rare to have any law but NY govern – this and the real property  issue...
ISDA Documentation and Contract TermsSet Off Provisions  Most 1992 ISDA Schedules have fairly elaborate setoff provisions ...
ISDA Documentation and Contract TermsForeign Exchange Provisions  If foreign exchange or currency option transactions are ...
ISDA Documentation and Contract TermsProposed Regulatory Changes and Dodd-Frank  Dodd-Frank Act, particularly Title VII. S...
ISDA Documentation and Contract TermsBasic Principles Applied to Swaps  SEC will regulate "security swaps" and CFTC will r...
ISDA Documentation and Contract TermsRegulation: The primary regulators of Swaps will be the SEC andCFTC;  SEC:  Security ...
ISDA Documentation and Contract Terms“Swaps Pushout”  Called the "Lincoln" rule after proponent in congress.   There will ...
ISDA Documentation and Contract TermsMandatory Clearing  All Swaps outside of specified categories must be cleared on an  ...
ISDA Documentation and Contract TermsRegistration of Swap Dealers and Major Swap Participants  Specialized – will pass ove...
ISDA Documentation and Contract TermsStatute set up regulatory framework–execution is to be by regulations  Where regulati...
ISDA Documentation and Contract Terms Not a complete change – transactions will continue to be done on ISDA agreements, as...
Derivatives and swaps               Q&A                        35
Contact InformationPeter J. Rue                                     Kevin W. KaiserBriggs and Morgan LLP                  ...
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Kaiser Interest Rate Hedging And Swaps 2011

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Negotiating interest rate hedging and ISDA contracts

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Kaiser Interest Rate Hedging And Swaps 2011

  1. 1. Business Law Institute May 2011Hedges, Swaps, Collars and Caps – A Primer on the Wonderful World of Interest Rate Protection Devices Required by Lenders Presented by: Peter J. Rue Briggs & Morgan Kevin W. Kaiser Lindquist & Vennum 1
  2. 2. ObjectivesOverview of financial derivativesDiscussion of how derivatives can be used to manage interestrate riskDeal terms, documentation and drafting considerationsRegulatory changes 2
  3. 3. Financial DerivativesWhat is a derivative?A derivative is a financial arrangement that derives its value basedon the changes in value of some other asset (either a single asset, agroup of assets, or anything that can be valued).Examples – Stock options, forward contracts, futures contracts,swaps. 3
  4. 4. Why do companies use derivatives? Insulate against risk (hedge) Profit from risk (speculate) Tax and accounting Arbitrage opportunities Enhance yield Reduce funding costs 4
  5. 5. Hedging Derivatives allow taxpayers to manage risks, including the following:  Market fluctuations  Interest rates  Credit  Foreign currency 5
  6. 6. Why do companies use derivatives? Many companies use derivatives to limit exposure to movements in currency exchange rates, interest rates, or pricing of commodities critical to the business. A excerpt from a recently filed Form 10-K from a public company: “The company enters into contractual derivative arrangements in the ordinary course of business to manage foreign currency exposure, interest rate risks and commodity price risks. A financial risk management committee, composed of senior management, provides oversight for risk management and derivative activities.” 6
  7. 7. Types of Derivatives There are two broad types of derivatives:  Forward-based, and  Option based Forward-based derivatives contain both the right and the obligation to perform under a contract. Option-based derivatives provide the right, but not the obligation, to perform under the contract. Swap - a forward-based type of derivative 7
  8. 8. Types of Derivatives Forward-Based Forwards Futures SwapsForward Rate Agmt Index Interest Rate (FRA) Equity Equity Fx Currency Currency Commodity Commodity Commodity Option-Based Interest Rate Cap or Floor Put Option (on Equity or Debt Security) Call Option (on Equity or Debt Security) Interest Rate Option Currency Option 8
  9. 9. Options One-sided protection/risk “Calls,” “Puts,” and “Collars” 9
  10. 10. Call OptionsThe writer of a call has unlimited downside risk and gain tothe extent of the premium received. The holder of a callhas unlimited upside potential and loss limited to thepremium paid. Holder’s pay-off curve Issuer’s pay-off curve Derivative Value Underlying Price Underlying Price 10
  11. 11. Put OptionsThe writer of a put has unlimited downside risk and gain to theextent of the premium received. The holder of a put has unlimitedupside potential and loss limited to the premium paid. Holder’s pay-off curve Issuer’s pay-off curve Derivative Value Underlying Price Underlying Price 11
  12. 12. SwapsDefinitionGenerally, a swap is an agreement between two parties to exchange(or “swap”) payments at specified intervals calculated by referenceto an index upon a base dollar amount.Tax Name – Notional Principal Contract (“NPC”) 12
  13. 13. Example of a Interest Rate Swap ContractFor example, a swap contract may provide that Customer is to pay,i.e. counterparty, amounts equal to 7% of $10,000,000 and Bank is topay Customer amounts equal to the LIBOR + 2% on $10,000,000.The reason why Customer enters the swap contract is to hedgeagainst interest rate fluctuations. Assume Customer has$10,000,000 of outstanding debt where the interest rate is LIBOR +2%. By entering the swap contract, Customer is protected against arise in interest rates since Customer is effectively obligated to payonly 7%, regardless of changes in the prime lending rate. 13
  14. 14. Interest Rate Swap withPeriodic Payment 7 % x $10 mm Lender Customer Bank LIBOR + 2% LIBOR x x $10 mm $10 mm Payments are netted 14
  15. 15. ISDA Documentation and Contract TermsFixed/Floating Swap Payments are netted on settlement dates. Net result: If Floating Rate rises, customer receives payment and can apply it to interest on the hedged loan, bringing effective overall rate to the Fixed Rate If Floating Rate falls, customer pays less interest on loan, but pays Bank up to the Fixed Rate 15
  16. 16. ISDA Documentation and Contract TermsWhy Do a Swap? Fixed Rate not available on loan; Portability – in theory, swap exists separately from loan and could be continued if the loan is refinanced (but many swaps require early termination if loan is repaid) "Breakage" – For fixed rate loans, breakage goes one-way (from customer to bank, if fixed rates have declined) For Swaps, as long as "Second Method" is chosen in schedule, payment may go either way. 16
  17. 17. ISDA Documentation and Contract TermsDocumentation CAP. Caps (bank will pay customer if floating rates exceed a specified level) can be transactions that are paid for (by customer) up front, and do not involve credit risk to Bank. May be a simple contract. Swaps, Collars (upper and lower limits) and other transactions require: ISDA Master Agreement, and related documents; Approval resolutions; incumbency Legal Opinion Documents for any collateral or cross-collateral required (swap exposure may be required to be covered by same collateral as the loan) 17
  18. 18. ISDA Documentation and Contract Terms ISDA Document: ISDA Document itself. ISDA has always been and obscure, difficult document (even for long-time practitioners) Basic document published in 1987, 1992 and 2002 (1992 is still most popular) Local Currency, Single Jurisdiction is the one to use for most transactions 18
  19. 19. ISDA Documentation and Contract TermsDefined Terms Great number of defined terms and concepts. A couple to watch: Specified Entities – these are written into the events of default and termination events, so that a default by a Specified Entity will be a default by the customer Threshold Amount – the threshold for cross-default; should match cross default amount in the credit agreement; Early termination – Preference should be to "Market Quotation" and "Second Method" 19
  20. 20. ISDA Documentation and Contract TermsOther Provisions to Watch Other Termination Events or Events of Default. Threshold Amounts (for cross default). Netting Provisions. 20
  21. 21. ISDA Documentation and Contract TermsCollateral Security Its common for Banks to require same collateral that supports the loan to support any swap obligations. Issues are: Personal Property. Covered by Security Agreement (either specifically or under dragnet clause) and perfected by UCC-1. Probably few issues. 21
  22. 22. ISDA Documentation and Contract Terms Real Property. ISDAs often have a provision in the definition of Credit Support Document" that states that any agreement that supports the loan supports the swap obligations. This raises the issues: If ISDA obligation is not described as a secured obligation in the Mortgage, is it secured? ISDA may be an obligation separate from the loan and interest on the loan for Minnesota mortgage registration tax (and equivalent purposes in other jurisdictions). If MRT is not paid, is ISDA effectively secured? How much extra MRT should be paid? 22
  23. 23. ISDA Documentation and Contract TermsRepresentation: Tax Representations Many ISDAs will require the Customer to represent that it is an "eligible contract participant" under the Commodities Futures Trading Commission Modernization Act of 2000 Schedule may include additional representations concerning capacity to enter swaps, and awareness of customer that Bank is not advising customer or acting as its representative. 23
  24. 24. ISDA Documentation and Contract TermsGoverning Law Rare to have any law but NY govern – this and the real property issues create issues for customers counsel requested to give legal opinion. 24
  25. 25. ISDA Documentation and Contract TermsSet Off Provisions Most 1992 ISDA Schedules have fairly elaborate setoff provisions applicable on termination of swaps. There are a variety, and are generally intended to give the non-defaulting party the right to include obligations to and from its affiliates in an overall netting of obligations. 2002 ISDA attempts to incorporate these provisions, so they will not be in the Schedule. 25
  26. 26. ISDA Documentation and Contract TermsForeign Exchange Provisions If foreign exchange or currency option transactions are anticipated, the form ISDA will include additional provisions, including reference to published ISDA definitions (1998 FX and Currency Option Definitions) Often, even more elaborate "netting" provisions. The intent of these is to net premiums and payments, and also "novation netting" (which means that if a transaction is entered, then afterwards a transaction with matching qualities is entered in a greater or lesser amount, the initial transaction and later transaction will be deemed terminate, except to the extent of the increase or decrease in amount). 26
  27. 27. ISDA Documentation and Contract TermsProposed Regulatory Changes and Dodd-Frank Dodd-Frank Act, particularly Title VII. Signed into law July 21, 2010 Regulations: All are in the proposal phase 27
  28. 28. ISDA Documentation and Contract TermsBasic Principles Applied to Swaps SEC will regulate "security swaps" and CFTC will regulate all others. "Swaps Pushout" (called the "Lincoln" rule) No federal assistance for any swap entity; Banks will put derivatives activities (except for certain customer swaps) in a separate, non-insured, entity; No federal bailout, no "too big to fail“ Mandatory Clearing through a Market or Swap Execution Facility Registration of Swap Dealers and Major Swap Participants. Prognosis 28
  29. 29. ISDA Documentation and Contract TermsRegulation: The primary regulators of Swaps will be the SEC andCFTC; SEC: Security Swaps – narrower definition, as swaps based on a single security, debt instrument or narrow index of securities CFTC: All "Swaps" (which excludes Security Swaps), including interest rate swaps foreign exchange forwards and swaps credit default index, equity and debt index swaps total return swaps commodity swaps options on all swaps may exclude certain swaps where physical delivery of a commodity is intended 29
  30. 30. ISDA Documentation and Contract Terms“Swaps Pushout” Called the "Lincoln" rule after proponent in congress. There will be no "Federal assistance" for any swap entity (swap dealers, non-bank Major Swap Participant). This will not apply to insured depositary institutions that limit swap activity to (i) hedging related to their own activities, and (ii) swaps that are permissible for investment by national banks, which should include customer swaps to hedge interest rates on loans. Otherwise, Banks will have to put derivative activities in a separate, non-insured entity. Premise is no federal bailout; no too big to fail 30
  31. 31. ISDA Documentation and Contract TermsMandatory Clearing All Swaps outside of specified categories must be cleared on an exchange - a Designated Contract Market ("DCM") or Swap Execution Facility. DCMs were created in 2000, but regulatory underpinning will be changed. Exception is for end-users, that (i) are not financial entities, (ii) use swaps to hedge commercial risk, and (ii) notify regulators how they generally meat financial obligations of non-cleared swaps 31
  32. 32. ISDA Documentation and Contract TermsRegistration of Swap Dealers and Major Swap Participants Specialized – will pass over for this session. Includes capital and margin requirements. This will effect markets in which Banks operate; In effect, all swaps will be "collateralized" and marked to market by a credit support annex 32
  33. 33. ISDA Documentation and Contract TermsStatute set up regulatory framework–execution is to be by regulations Where regulations stand. Massive sets of proposals published by agencies including SEC and CFTC (30 regulations, many running to several hundred pages) were published late in 2010 and early 2011. Mid-April, the comment deadline on the basic regulations published late 2010 were again extended. House Republicans, have been urging that rules be pushed back to 2012. Will not be enacted in any law Dodd Frank ran to 848 pages, published proposed rules to many thousand. Prognosis – review and comments will continue. Regulations may start to be finalized late in 2011. Effect on Lender-required swaps 33
  34. 34. ISDA Documentation and Contract Terms Not a complete change – transactions will continue to be done on ISDA agreements, as one-to-one transactions (not any sort of exchange) Markets in which Banks operate will be changed. Economic effect on the basic interest rate swap market may be subtle. 34
  35. 35. Derivatives and swaps Q&A 35
  36. 36. Contact InformationPeter J. Rue Kevin W. KaiserBriggs and Morgan LLP Lindquist & Vennum PLLPPhone: (612) 977-8638 Phone: (612) 371-2467E-mail: prue@briggs.com E-mail: kkaiser@lindquist.com The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 36

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