Design of Master Agreements for OTC Derivatives (Lecture Notes in Economics and Mathematical Systems, 494)

I first came across the issue of derivatives documentation when writing my diploma thesis on measuring the credit risk ofOTC derivatives while I was an economics student at the University of Bonn. Despite the fact that security design has been an area of research 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 with in financial theory. The one thing that aroused my curiosity was that two parties with usually opposing interests, namely banking supervisors and the banking industry's lobby, unanimously endorse the use ofcertain provisions in standardized contracts called master agreements. Do these provisions increase the ex ante efficiency of contracts for all parties involved? I actually began my research expecting to find support for 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 were obtained within a highly stylized 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.

The book deals with the design of bilateral contractual arrangements for OTC (over-the-counter)-traded derivatives transactions. These arrangements govern inter alia the rights and obligations of the parties in the event of a default. The main provisions of the widely used ISDA Master Agreements as well as their relation to insolvency law are described in the text. The formal analysis focuses on the trade-off between protecting the interests of the non-defaulting party and enabling the failed counterparty to reorganize its liabilities in order to avoid inefficient liquidations. The results of the book challenge some widely held beliefs about the benefits of certain provisions commonly used in master agreements. The analysis also suggests implications for the pricing of risky derivatives transactions containing these provisions.

Front Matter....Pages I-VIII Introduction....Pages 1-5 Derivatives Usage and Documentation....Pages 7-44 Incomplete Contracts and Security Design....Pages 45-79 The Implications of Provisions in Master Agreements....Pages 81-139 Two-sided Credit Risk....Pages 141-155 Conclusion and Outlook....Pages 157-161 Back Matter....Pages 163-179