COVID-19: Derivatives Close-Outs in a Crisis
Challenges to the Valuation of Derivatives Upon Early Termination
The first half of 2020 has witnessed the detrimental impact of the COVID-19 pandemic on the global economy. Financial markets declined at rates reminiscent of the 1987 and 2008 financial crises. The path back to normalcy remains uncertain given the health crisis that continues to devastate communities worldwide.
The COVID-19 outbreak has led to an unprecedented slow-down in the global economy as entire economies are shut down due to governments’ confinement measures. Most governments have responded to this crisis with monetary policies, fiscal stimulus packages and regulatory relief in reaction to the market stress.
Some markets have closed, triggered circuit breakers, imposed temporary trading suspensions and temporary bans on short selling. Despite these various measures, the economic consequences of the pandemic have impacted virtually all asset classes and, de facto, also impacted derivatives.
This paper seeks to highlight the various valuation challenges that users of derivatives might face as a result of COVID-19. More specifically, this article discusses the operational and valuation challenges upon early termination of OTC derivative contracts under ISDA.
Introduction to Derivatives
Derivative instruments are financial agreements that derive their value from the value of an underlying reference variable. This could be the price of hard or soft commodities, a stock or basket of stocks, stock indices, a currency or basket of currencies, a bond or credit spread, an inflation or interest index, the price of real estate, the weather, etc.
Derivatives can be used to hedge or transform and therefore transfer risk (i.e. the uncertainty associated with a variable). As some markets offer a finite number of assets available to trade (e.g. the stock or bond markets, commodities) derivatives can be a convenient substitute where investments cannot be acquired directly. Some investors therefore use derivatives as substitutes to invest or speculate.