ISDA PRESS REPORT - SEPTEMBER 24, 2001
 
CREDIT DERIVATIVES
Heavy default swap flow Invensys fears - IFR
 
DOCUMENTATION
Alternative Investment Group Blasts ISDA - Derivatives Week
 
RISK MANAGEMENT
Basle relaxes operational risk rules - IFR
 
WEATHER DERIVATIVES
Rainfall Derivatives - IFR
 
Heavy default swap flow Invensys fears
IFR - September 22, 2001
 
Credit default swap quotes drove out last week on heavy trading volume. A rush to buy protection was met with sellers taking profits on existing short positions, or offsetting CDO exposure, and as many as 100 trades a day were seen, though deal size was often US$5m, rather than the standard US$10m.
 
The widening in quotes for airlines continued to draw attention, and most trades referencing airlines required payment of an upfront premium of as much as 20% of the notional total of the trade.
 
The most pressing threat of default may be in a company, which is not directly affected by the terrorist attacks, however. A possible breach on a loan covenant test next week by UK engineering company Invensys could prompt a debt restructuring and the first substantial exercise of default swaps seen in Europe, traders said.
 
Invensys shares collapsed last week on concerns about its debt burden and the price of its default swaps shot up. There were five-year trades seen at 425bp and 475bp, before bids jumped to 700bp, then 900bp. An offer of 1,400bp was available last Thursday, before being pulled on Friday.
 
lnvensys five-year default swaps were trading at l2Obp as recently as early August, and around the 6Obp mark earlier in the year. Traders say that swaps with a notional volume of over US$1bn are outstanding on Invensys, and with the price of its secondary debt already around 70, and set to fall further, there could be substantial pay-outs if a debt restructuring triggers default swap exercises.
 
The overall default swap market was functioning well last week, with market-makers posting two-way prices, albeit at wide bid/offer spreads. The missed lease payment by Continental Airlines has yet to trigger any swap exercise, though fears remain that a major airline will default, and traders are worried that US airline managers may find filing for Chapter 11 bankruptcy and a shelter from their debts an attractive option.
 
This has led to demands for upfront premium payments on any new US airline default swap trades. Dealers have been asking for US$2m payment on a US$10m trade, to ensure that some money has been gathered in the event that a default is only weeks away. The trades then feature a reduced premium of 200bp or so for a mid-term deal, paid on the usual basis of an annual fee paid quarterly.
 
A rare example of a straightforward US airline default swap last week was a five-year deal in American Airlines at 750bp. British Airways dealt at least as high as 350bp in the five-year.
 
Hotel sector quotes were hit hard, with Hilton trading at least as high as 450bp in the five-year, and prices rose in every sector. GMAC traded at l6Obp in the five-year and Ford at least as high as 165bp, while DaimlerChrysler quotes rose above 175bp.
 
Telecoms company default swaps, which have been among the worst performing this year, bucked last week's trend by holding down relative to other sectors.  Dealers think telecoms companies may benefit from increased demand if business travel is cut.
 
 
Alternative Investment Group Blasts ISDA
Derivatives Week - September 24, 2001
 
The Managed Funds Association, an alternative investment trade group with 700 members, has slammed the International Swaps and Derivatives Association for ignoring a series of letters and e-mails in which it outlined to the derivatives industry body concerns over proposed changes to the 1992 ISDA master agreement. The MFA is worried that changes to the documentation will heavily favor sellside firms. 
 
In several letters and e-mails, the most recent dated April 2, MFA President John Gaine told ISDA that three of the eight proposed amendments to the master agreement "disproportionately favor dealers to the detriment of end users and may have the unintended consequence of increasing, as opposed to decreasing, systemic risk." ISDA, said Gaine, did not respond. 
 
Robert Pickel, ISDA executive director in New York, conceded that ISDA never directly responded to the MFA's letters, but asserts the association addressed the MFA's concerns at an August meeting in Washington. "We've tried to address everyone's concerns," said Pickel, adding that those MFA concerns that were not addressed now would likely be revisited in the next 12 months, when ISDA considers revamping the entire master agreement. 
 
However, the MFA disputes this interpretation. "[ISDA is] drafting this from the dealers side. They weren't looking to sit down with us and work things out," complained Pat McCarty, MFA general counsel in Washington. He continued, "[ISDA] don't even have the decency to send us a written response. We've gone to the trouble of writing a letter to them and they've thumbed their nose at us. I wonder if they even really care about customers." 
 
ISDA, which began a review of the master agreement last year, was expected to begin the protocol process this week, but as of last Thursday was leaning toward pushing it back a few weeks in the wake of the terrorist attacks in the U.S. The protocol process will entail ISDA working with dealers and end users to incorporate amendments into its trade agreements. 
 
Not every end user shares the MFA's sense of injustice. William Miller, independent risk oversight officer for the End Users of Derivatives Council of the Association of Financial Professionals, which organized the August meeting in Washington, said he is "very encouraged" by the attention ISDA paid to end user concerns at the August meeting. He added that ISDA is beginning to realize that in the future it needs to consider end users before it begins drafting changes. 
 
 
Basle relaxes operational risk rules
IFR - September 22, 2001
 
The more flexible stance on operational risk included in the Basle Committee on Banking Supervision's soon-to-be released discussion paper on Basle II's operational risk charge is set to go down well with banks. In the paper, the overall capital charge is lower, and the advanced approach has been opened up to allow banks to use an internal loss-distribution approach or scorecard analysis for operational risk.
 
"It is not as prescriptive about inputs [for operational risk], It's more like market risk," said an official at the Bank for International Settlements, noting that certain criteria will have to be met. "It will be up to national supervisors to judge [banks' internal methodologies]," he said. The paper will be released before the end of the week.
 
Rather than settle on a benchmark figure for the industry, the Committee's paper will offer a temporary benchmark for illustrative purposes. The temporary benchmark will be based on an analysis
 
of economic capital data from the quantitative impact study conducted earlier this year. A proposal for the level of the floor will be included in the discussion paper, the official said, declining to elaborate.
 
The BIS announced in June that the proposed capital accord's 20% operational risk charge would be reduced after many banks submitted comment letters stating that their internal capital models for operational risk are far lower than 20%. The Basle proposal's operational risk charge resulted from an industry poll undertaken last year. Many banks participating in the survey used a broad definition of operational risk and as such overstated the amount of capital allocated to the risk.
 
 
Rainfall Derivatives
Derivatives Week - September 24, 2001
 
Despite the high exposure of businesses to rainfall risk most weather derivatives that have been traded have been based on a temperature indices. Nevertheless many end users, such as farmers or hydroelectric generators, are sensitive to rainfall magnitude and frequency. The consequences of too much or not enough rain are spread widely and, directly or indirectly, we all suffer from abnormal rainfall magnitudes. 
 
A typical difficulty with risk analysis based on rainfall is that the magnitude and the frequency of rainfall strongly depend on the site where it is measured whereas the temperature is a more ambient measure. By way of example, if at Heathrow the temperature is 20?C then you can assume that the temperature in central London is near 20?C. However, even if it rains heavily in Heathrow you cannot assume that it will rain simultaneously in central London. There is a high positive probably it does, but it is not 100%. 
 
Until now rainfall process studies have been limited to either cumulative rain over a given period, mainly monthly and yearly, or on the rainfall process over a small time period, such as every five or six minutes. The first topic is quite limited and lacks interest for weather derivatives purposes. The second one is very detailed but irrelevant for market transactions. Instead of statistically analysing the rain, it may be preferable to simulate it. 
 
Only Heathrow data are used from now on. 
 
 
Frequency 
The first step in building a stochastic rainfall process is to understand with which probability rainfall occurs. Figure 1 presents the historical frequency rainfall at Heathrow. 
 
The frequency curve is not symmetric and a sinusoidal function might be inadequate to fit it. A smoothing process can be used to correct erratic values (smooth line). Subsequent results are strongly dependent on these probabilities; thus the extraction must be done cautiously. 
 
The Rainfall Persistence 
The probability that it rains depends on the day of the year. But does it also depend on the past? Without doubt in the case of Heathrow, it appears that when the weather is dry, the following day is more likely to be dry than rainy, and vice versa. So the probability that it rains is conditional on the past. But the probability that it rains depends on the time of year. As a consequence, it is more likely to rain two consecutive days during wintertime than in summertime and the reverse in summertime. Therefore a natural autocorrelation is created which interferes with a possible true autocorrelation. 
 
The model of the persistence of rain is set hereafter. 
 
We note Xt the event "it rains at day t". Xt is Bernoulli distributed: 
 

 
 
Where 1 is for the event "it rains". 
 
We know the historical mean of Xt from our first studies. However, this is insufficient to model the time series Xt. As a matter of fact, assuming the independence of Xt we have E[Xt | Xt-1, Xt-2, Xt-3] = E[Xt] = pt which is different from EH[Xt] (the operator EH is for the historical mean). Therefore the probability pt has a time dependent expectation and is conditional to Xt-1, Xt-2, Xt-3,... 
 
A recurrence is produced to estimate the order of this lag dependence. The probability pt is assumed to be given by: pt = Prob(Xt = 1 | Xt-1, Xt-2 Xt-3 Xt-k), with k IN*. 
 
The aim is to extract the minimum value of k that produces the best fit of the distribution of the length of period of rain. Considering a 365 day year, we assume that E[pt] = E[pt+365] which means that the climate does not vary over years. We first estimate conditional probabilities with k=1, then simulate the process and compare the simulated distribution of the length of the period to the smoothed historical one. Then the method is reproduced with higher values of k until no more information on the probability pt is added. 
 
Assuming independence between successive rainy days we have simulated the rainfall below using the historical probability for 38 years (the same length of period from which the graph below has been calculated). Supposing k=1 a good fit is already obtained: 
 
 
 
The Magnitude Process 
 
Once the length of the rainy period is known the intensity of the rainfall must be evaluated for each day. The previous study didn't reveal a dependence on the length of the rainy period. But studies show that there is a dependence on the length of the period. 
 
Since the average conditional to the previous day is different, the distribution is certainly different. Only four events can be enumerated for a rainy day t under the assumption k=1: Rt-1 / Rt / Rt+1 or NRt-1 / Rt / Rt+1 or Rt-1 / Rt / NRt+1 or NRt-1 / Rt / NRt+1 with Rt the event it rains at day t and NRt the event no rain at day t. Four distributions for each day of the year should be estimated. In order to reduce estimation bias errors a 30-day period bracketing the day for which the distributions are worked out is considered. 
 
The main characteristics are summarised in this table: 
 

 
 
The four distributions are very different from each other. The average (resp. maximum) between the event Rt-1 / Rt / Rt+1and NRt-1 / Rt / NRt+1 is approximately divided by 2.5 (resp. 3.5). One can conclude that the distribution of the magnitude of rainfalls depends on the immediate past and future. 
 
Doing the same for each day of the year, all the required information to run the simulations properly is eventually obtained. First, all the rainy days are simulated and then the magnitude of rain is randomly generated using the correct distribution between the four possible ones for each day. 
 
Conclusion 
Rainfall magnitude is extremely dependent upon the location where it is measured. This risk can be as high as 100% in a single month for close locations, approximately 20 miles. Because the probability that it rains is non-constant during a whole year, this phenomenon creates a natural autocorrelation in the process. This pitfall has to be avoided and the rainfall process can be decompounded into two steps. The first stage is the frequency process and the second stage is the magnitude given the frequency. In order to know the distribution of the rainfall magnitude, it is just as important to know if it rained the previous day as if it will rain the next day. 
 
**End of ISDA Press Report for September 24, 2001**
 
THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY.  THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.
 
 
 
 
Scott Marra 
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ISDA 
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