Lecture Notes in Economics and Mathematical Systems

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1 Lecture Notes in Economics and Mathematical Systems 494 Founding Editors: 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 Managing Editors: Prof. Dr. G. Fandel Fachbereich Wirtschaftswissenschaften Fernuniversitat Hagen Feithstr. 140lAVZ 11,58084 Hagen, Germany Prof. Dr. W. Trockel Institut fur Mathematische Wirtschaftsforschung (lmw) Universitlit Bielefeld UniversiUitsstr. 25, Bielefeld, Germany

2 Springer-Verlag Berlin Heidelberg GmbH

3 Dietmar Franzen Design ofmaster Agreements for OTe Derivatives Springer

4 Author Dr. Dietmar Franzen RofanstraBe Ilc 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 (Lecture notes in economics and mathematical systems; 494) ISBN ISBN (ebook) DOI / ISSN ISBN 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: /3142/du

5 Preface I first came across the issue of derivatives documentation when writing my diploma thesis on measuring the credit risk of OTC 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 of certain provisions in standardized contractscalled 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 surprised to obtain results that contradicted the conventional wisdom. I would strongly advise against using these results in any political debate on derivatives 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 rationale 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 of Munich, for his valuable comments and suggestions and for his support of my Ph.D. dissertation on such a seemingly odd topic. This work could not have been written without his endorsement. I would also like to thank Klaus Schmidt for his useful comments. His excellent course on contract theory has helped shape many of the ideas that can be found in this work. I would also like to acknowledge the fine work of all my teachers, academic or otherwise, throughout the years, particularly Vera Apel, Wilhelm Berghahn, Hans-Jacob Kriimmel, Reinhard Selten and Wolfgang Weimer. I am also very much indebted to all my colleagues and friends at the Seminar KMF at the University of Munich, Tanja Dresel, Sandra Fink, Christoph

6 VI Preface Fischer, Robert Hartl, Sabine Henke, Markus Kern, Christoph Kesy, Michael Pfennig, Markus Priiher, Thomas Raschel, Stephan Seidenspinner, 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 imagine how I could have finished the project without them. I would particularly like to thank Hans-Peter Burghof and Klaus Schafer, who spent much time looking over the final drafts of this work and who made many 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 University of Munich, deserves 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 Gerhild Jager, and my family for their continued support during these years. The ups and downs of this project have tested not only my endurance but theirs as well. Munich, August 2000 Dietmar Franzen

7 Contents 1. Introduction Derivatives Usage and Documentation, The Benefits of Derivatives for Non-financial Firms Irrelevance of Hedging in Perfect Capital Markets Managerial Theory of Risk Management Relevance of Hedging with Risk-neutral Agents Empirical Literature on Corporate Hedging Policies Derivative Instruments and Derivatives Markets... " ISDA Master Agreements The Design and Function of Master Agreements Netting, Early Termination, and the Mitigation of Credit Risk Limited vs Full Two-way Payment Provisions Collateralization Legal Risk, Enforceability, and Insolvency Law General Principles of Insolvency Law Enforceability of Contractual Provisions Contained in Master Agreements Recent Default Experiences Summary Incomplete Contracts and Security Design An Overview of the Literature on Incomplete Contracts Financial Theory and the Theory of Incomplete Contracts Models of Financial Contracting Using Incomplete Contracts Private Workouts and Bankruptcy Law: Theory and Empirical Evidence The Basic Framework Model Setup Default and Renegotiation A Benchmark Case: Bilateral Bargaining Without Derivatives 67

8 VIII Contents The Renegotiation Game Optimal Debt Contract and Underinvestment Comparative Statics Analysis Numerical Examples Summary The Implications of Provisions in Master Agreements The Basic Bargaining Framework with Multiple Claims The Renegotiation Game Properties of Optimal Contracts The Impact of Close-out Netting Provisions Contracts Without Close-out Netting Provisions Master Agreements with Close-out Netting Provisions Cross-product Netting Limited Two-way Payment Provisions Protecting Creditors Against Strategic Defaults Implications for Firm Vvalue Comparative Statics Analysis Collateralization of Derivatives Transactions Extending the Set of Feasible Contracts The Renegotiation Game Properties of Optimal Contracts Comparative Statics Analysis Numerical Examples Hedging Without a Close-out Netting Agreement Close-out Netting Cross-product Netting Limited Two-way Payment Provisions Collateralized Derivatives Transactions Summary Two-sided Credit Risk A Bilateral Bargaining Framework with Two-sided Credit Risk The Renegotiation Game Properties of Optimal Contracts Close-out Netting Limited Two-way Payment Provisions Numerical Examples Summary Conclusion and Outlook 157 References 161 Index 173