• Asian or look back, or average rate or average price, options use
a different benchmark than the price of the underlying asset on
expiry to determine if they are in- or out-of-the-money, for exam-
ple the average price of the underlying over the last month.
•‘Barrier options’ is a general term for a family of options, which
are either cancelled or activated if the underlying price reaches a
predetermined level. They are also known as knock-out, knock-in
or trigger options.
• Caps and floors are a series of ‘rollover’ rates agreed whereby the
difference in rates is paid, if applicable at the time of the rollover.
• Collars operate like ordinary options but have limits on the level
at which the customer can deal at a better market rate than the
underlying, in exchange for a lower premium.
We also have Puttable and Callable swaps which allow the fixed rate
receiver and fixed rate payer respectively to terminate the swap early.
They are traded as European, American and Bermudan styles of exer-
cise right.
Settlement of OTC products
The settlement of OTC derivatives is determined by the terms of the
product as agreed by the two counterparties. There are, however,
relatively standard settlement characteristics for particular products
as we have already seen.
Settlement events are triggered by such things as:
• Effective date, reset date and payment date for swaps.
• Settlement date and calculation period for FRAs.
• Premium convention, exercise date and trigger events for options.
• Maturity of all products.
We also know that most products settle at the end of a period or on
maturity with the exception of FRAs and IRGs where the settlement
takes place by a discounted present value.
Key to the settlement of OTC products is the terms of the transaction.
Unlike exchange-traded derivatives where the terms are stipulated
by the exchange contract specification, each OTC trade is effectively
a new set of terms, even though the product may be the same, i.e. a
swap or an option.
The OTC derivatives have documentation that helps to ensure that
the terms of the derivative trade are agreed.
104 Clearing and settlement of derivatives
In the past this was a major obstacle to the use of OTC derivatives,
as each trade had a separate agreement. This had to be vetted by
the legal department, and consequently delays and disputes caused
considerable problems.
The International Swaps and Derivatives Association (ISDA) have
greatly helped to resolve the problems by developing standard docu-
ments for use by counterparties in OTC derivatives. The BBA also
developed standard documentation for FRAs.
The standard documentation, known as a Master Agreement, can
be supplemented with schedules, annexes and appendices that allow
specific issues to be covered.
The ISDA master documents cover provisions for numerous aspects
that are relevant and may need enforcing during the term of the
agreement. These include:
• Contract currency
• Multi-branch facilities
• Payment provisions
• Default procedures
• Termination events
• Warranties, covenants and representations
• Tax indemnities
• Notices
• Assignment
• Legal jurisdiction
• Waiver of immunities.
Also produced is what is known as a confirmation.
This is provided as a detail of the trade terms rather than the
general terms under which business is being transacted between the
two counterparties.
The confirm, therefore, lists key details for the operations team
as well as enabling the trade details to be reconciled. Confirmations
should be issued by the operations team as quickly as possible so
that the trade details can be reconciled. Equally, receipt of a con-
firmation from the counterparty, or a signed copy of a confirmation,
sent to the counterparty should be chased as the confirm cannot be
legally enforced unless both parties have acknowledged the details
are the same or agreed.
Typically two banks participating in a trade will send each other
confirms whilst a bank and a client trade will result in a confirmation
from the bank to the client, which the client will sign and return.
OTC products 105
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