How to settle down a variance swap on a single name when default

[henryxf]

Could someone tell me that in real market, how to settle down a variance swap on a single name when there is a default of the stock before the maturity?　Thanks a lot!!!

 

[financeguy]

i'm curious as well...
anyone out there work in equity derivatives?

 

[JulianT]

Wouldn't that be governed by the ISDA? I'm assuming by default of the stock you mean the underlying stock goes bankrupt. My understanding is if the stock files for chapter 11, then the clause for "Nationalization, Insolvency
or Delisting" under the "Extraordinary Events" of the Share Variance Swap (SVS) General Terms and Agreements under the ISDA Master Agreement would become applicable. The transaction is then cancelled according to the SVS Cancellation and Payment. The methodology is again detailed in the SVS General Terms and Agreements. The amount payable is the PV of the Equity Amount, discounted from the cash settlement date to the payable date.

 

[financeguy]

Wouldn't that be governed by the ISDA? I'm assuming by default of the stock you mean the underlying stock goes bankrupt. My understanding is if the stock files for chapter 11, then the clause for "Nationalization, Insolvency
or Delisting" under the "Extraordinary Events" of the Share Variance Swap (SVS) General Terms and Agreements under the ISDA Master Agreement would become applicable. The transaction is then cancelled according to the SVS Cancellation and Payment. The methodology is again detailed in the SVS General Terms and Agreements. The amount payable is the PV of the Equity Amount, discounted from the cash settlement date to the payable date.

For those of us that do not have a variance swap ISDA on hand, how exactly does that payment work? How is the Equity Amount defined?

 

[JulianT]

To start, if the equity amount is positive the Variance seller is the payer.
Then the equity amount = variance amount * min(FRV, Variance Cap Amount- Variance Strike price)
The default under the ISDA is for the Variance cap amount to be 2.5* Variance Strike Price. These are set when the transaction is entered into. FRV stands for Final Realized Volatility and in the case of the cancellation of a contract, it is calculated as follows
\( FRV= 100*\sqrt{\frac{252*\sum^{t_c}_{t=1}\large(\ln(\frac{P_t}{P_{t-1}}\right)^2+ (T-t_c)v_r^2}{T}}\)
I'm using a slightly different notation than the ISDA.
\(T\) is the number of trading days (Observation Days in ISDA parlance) the swap is in effect (ie. for a 1 year swap, it would be 252)
\(t_c\) is the number of trading days that have occurred since the contract was entered into until the contract cancellation/ termination
\(v_r\) is the mid market volatility of the underlying for the remaining term of the swap at the time of cancellation. (1 year left then you would look at 1 year options)
Note that if you let \(t_c=T\) you get the FRV for a swap that is not prematurely canceled.
A a lot of ISDA documentation can be found online through clever use of google. Also the supplement on which I'm getting this info clearly defines what happens at the end of the contract and is thus much simpler calculation than would be required for the mark to market. Disclaimer: I'm not an expert in this, I just decided to read ISDA legal framework (which is riveting stuff after reading the Basel II and Basel III accords) after reading this article: Feldstein who Speared Whale Ready to Unwind Derivatives

 

[financeguy]

To start, if the equity amount is positive the Variance seller is the payer.
Then the equity amount = variance amount * min(FRV, Variance Cap Amount- Variance Strike price)
The default under the ISDA is for the Variance cap amount to be 2.5* Variance Strike Price. These are set when the transaction is entered into. FRV stands for Final Realized Volatility and in the case of the cancellation of a contract, it is calculated as follows
\( FRV= 100*\sqrt{\frac{252*\sum^{t_c}_{t=1}\large(\ln(\frac{P_t}{P_{t-1}}\right)^2+ (T-t_c)v_r^2}{T}}\)
I'm using a slightly different notation than the ISDA.
\(T\) is the number of trading days (Observation Days in ISDA parlance) the swap is in effect (ie. for a 1 year swap, it would be 252)
\(t_c\) is the number of trading days that have occurred since the contract was entered into until the contract cancellation/ termination
\(v_r\) is the mid market volatility of the underlying for the remaining term of the swap at the time of cancellation. (1 year left then you would look at 1 year options)
Note that if you let \(t_c=T\) you get the FRV for a swap that is not prematurely canceled.
A a lot of ISDA documentation can be found online through clever use of google. Also the supplement on which I'm getting this info clearly defines what happens at the end of the contract and is thus much simpler calculation than would be required for the mark to market. Disclaimer: I'm not an expert in this, I just decided to read ISDA legal framework (which is riveting stuff after reading the Basel II and Basel III accords) after reading this article: Feldstein who Speared Whale Ready to Unwind Derivatives

Yeah I mean I get how forward volatility / varswap MTM is calculated and how variance swap contracts work under normal circumstances, but if a company goes bankrupt and their stock gets delisted and/or options stop trading, then finding the mid market volatility of an asset which has stopped trading will be a bit of a challenge. Is this subject addressed?

 

[JulianT]

Sorry for the long delay. My reading of the ISDA is that the vols would be taken off instruments on the day of the cancellation. That is if the stock is desisted on day \(t_c\) then the vols would be taken of instruments on the underlying on \(t_c\). If no such vols are available, then there are two possible options (i) being the case where the options exchange announces termination of contracts, in which case the vols will be backed out from the termination prices given by the exchange. (ii) states that is there is no announcement prior to the termination, or termination amount determined by the exchange is only the intrinsic value of options the the vol is set to be 0.