ISDA PRESS REPORT - OCTOBER 23, 2001

ISDA PRESS REPORT - OCTOBER 23, 2001

CREDIT DERIVATIVES
* ISDA clears way for Railtrack convertible delivery - IFR

TRADING PRACTICE
* Investment banks offer derivatives services to clients -
Financial Times

WEATHER DERIVATIVES
* Every cloud...? - FOW

ISDA clears way for Railtrack convertible delivery
IFR - October 23, 2001

A UK lawyer retained by the International Swaps and Derivatives Association
last Thursday advised that convertible bonds in their normal form meet the
"not-contingent" clause of ISDA's standard credit derivatives definitions.

This cleared the way for banks to accept delivery of Railtrack's ?400m 2009
convertible under existing default swaps. Around ?75m of convertibles had
been delivered under default swap exercises by the close of trading on
Friday. Although banks and other protection sellers will now realise some
losses on acceptance of the Railtrack convertible, compared with accepting
Railtrack's straight debt, the advice from Robin Potts QC was welcomed by
the heads of credit derivatives at the major dealers.

The legal opinion in effect removes one of the last main uncertainties about
the enforceability of default swaps, and should allow increased sales of
credit derivatives to convertible bond buyers. "The market has demonstrated
its maturity," said the head of credit derivatives trading at one bank. "All
the major houses are now accepting convertibles as deliverables."

A London-based lawyer was chosen to provide the advice because the UK is the
regime with the main legal question marks about deliverability of
convertible bonds under default swap contracts, as well as the home of
Railtrack. European convertibles typically feature a trustee with the
responsibility to exercise conversion rights if a stock price moves a
certain way beyond the strike price on a convertible bond.

Banks had worried that this "widows and orphans" feature of convertible
bonds could be interpreted to mean that the holder of a bond did not have
full rights over its disposal, and that the deal would not therefore be
deliverable under standard default swap language.

The finding that convertibles are not contingent, whether they have a
trustee or not, and therefore are deliverable under default swaps, unless
specified otherwise, brought the price of the convertible bond closer to
that of the cheapest to deliver of Railtrack's straight bonds, its S150m
2028 issue.

The convertible had been trading as low as 80 early last week, while the
2028 bond had been trading around 90. By the close of trading on Friday,
however, the convertible was priced at 84, bid only, while the 2028 bond was
at 87.75/88.5.

Assuming that default swap exercises were around these levels, the total
cost to protection sellers of the Potts opinion would have been roughly ?3m,
when comparing the cost of accepting ?75m of the convertible with delivery
of the straight bond. This cost will rise slightly, as the gap between the
prices of the convertible and the straight issue is likely to narrow further
before more exercises are completed.

Bank derivatives heads generally view the short-term cost as negligible
compared with the benefit of some assurance that convertibles are
deliverable.

The advice from Potts does not carry the same weight as a court judgement,
but as the price of the convertible has appreciated, there is little chance
that an end investor in a synthetic securitisation or credit-linked note
will mount a legal challenge to try to stop a bank from accepting delivery
of the convertible.

The banks that arrange these structured trades normally have the
responsibility for handling any default swap exercises on the credits
included. ISDA will soon unveil new detailed guidance on credit derivatives
written on convertible debt, including the zerocoupon bonds that have been a
major feature of issuance this year.

Investment banks offer derivatives services to clients
Financial Times - October 23, 2001
By John Labate

JP Morgan and Deutsche Bank are the latest firms to offer new derivatives
services to their clients. The two investment banks are expected to
announce the first licensing agreements today with Longitude, a
Manhattan-based online derivatives platform that will also launch today. The
agreements give both firms exclusive licenses to offer derivatives trading
in a unique series of products.

Derivative services allow companies and other institutions to offset the
risks that are inherent in a number of their investments or commercial
activities. Traditionally, the risks that have been hedged have been limited
to things traded already, such as stocks, bonds or currencies.

Longitude was founded in 1999 and offers a service to run auction-based
hedging services for "events of economic significance that cannot be hedged
currently in the derivatives markets", according to chief executive Andrew
Lawrence.

Mr Lawrence, a former hedge fund executive, says in its initial phase, the
company will offer JP Morgan and Deutsche Bank clients derivatives and risk
management services for economic statistics. In the near term, other
derivatives services will be launched through Longitude to hedge the
weather, equity prices, mortgage payments data, central bank target rates,
and to cover other areas.

JP Morgan and Deutsche Bank did not state the amounts of their spending for
their licenses or the length of those contracts with Longitude. "This
differentiates us as a provider of cutting-edge derivatives products," said
Chris Harvey, managing director at JP Morgan. "There is no direct mechanism
in the capital markets for clients to take views or hedge exposure to
underlying economic variables."

Longitude's founders designed the system to simulate auction systems where
prices were set without the need to match buyers and sellers in the market.
The system is similar to betting that occurs at horse tracks, where the
prices are based on all "bets". Once the hedged event occurs, the many
separate claims are paid from the hedges placed in the system.

Every cloud...?
FOW - October 2001

It would have been tempting, in 1997, to believe that the art of financial
risk management had reached a zenith. That was the year innovative energy
companies demonstrated that derivatives could be used to hedge the financial
impact of one of the most powerful and unpredictable variables confronting
business managers - Mother Nature.

According to the US Department of Commerce, at least $1 trillion of the US
economy is sensitive to the vagaries of the weather, including vast portions
of the energy, manufacturing, retailing, tourism and agriculture industries.
Yet it was only with the development of weather derivatives that companies
gained the ability to protect their financial results from significant but
non-catastrophic weather events such as excessive heat, precipitation or
wind risks that few traditional insurance policies could efficiently cover.
Today, it is clear that the trading of the world's first weather derivative
- a temperature collar executed between Koch Industries and Enron - marked
the dawn of a new era in risk management, not the crowning of an old one. It
signaled the creation of a trading market fundamentally more efficient than
insurance, which, after all, requires insurers to retain their clients' risk
and to charge a risk premium for providing that service. A trading market,
by contrast, matches principals on either side of a risk, eliminating the
need for a risk premium. The result is a less costly, more efficient means
of risk transfer.

Not surprisingly, companies whose financial results are sensitive to the
weather have been flocking to this new market. The cumulative notional value
of all weather derivatives executed since 1997 exceeds $7.5 billion.
Meanwhile, leading-edge traders are continuing to develop a seemingly
endless stream of new products that give companies the opportunity to hedge
all sorts of risks once considered unmanageable, from advertising costs to
river flows.

However, it is obvious that this new market still confronts numerous
challenges. Whole industries need to be educated in the use and value of
derivatives. Governments in the US and abroad must be shown that
market-oriented solutions to risk management can be more effective, and more
efficient for consumers, than regulatory solutions. (Some US regulators
still allow utilities to recoup the cost of bad weather from their
ratepayers through inefficient weather normalisation clauses, for example.)
In some regions of the world and some market niches, data for indices that
underlie these new products must become more rigorously standardised and
more widely available.

Despite these challenges, the opportunities are nearly limitless. The past
half-decade has shown that nearly any high-volume product, service or
business variable that can be measured can be commoditised, and that
anything that can be commoditised can be traded.

Enron began proving this idea in 1989, when deregulation of the natural gas
industry was forcing companies to change the way they contracted for gas in
the wholesale market. That year, Enron executed the world's first
natural-gas swap to meet the needs of a customer that wanted to lock in a
fixed price for its gas purchases. To make the deal work, Enron agreed to
absorb the cost, or benefit, of monthly spot gas purchases tied to a
published index.

Five years after creating what would become the precursor to today's
wholesale gas trading business, Enron began migrating its gas trading
expertise into other markets, beginning with electrical power. In 1997, it
completed the world's first weather trade. Two years later, the company's
newly formed Enron Broadband Services unit debuted its Enron Intelligent
Network, an Internet application delivery platform, that later led to
Enron's first bandwidth trade. That year also marked the launch of
EnronOnline. There, companies can buy and sell a vast array of physical
commodities and related derivatives contracts in markets as diverse as
natural gas; power; emission allowances; bandwidth; weather derivatives;
NGLs, petrochemicals and plastics; coal; crude oil; pulp and paper; credit
derivatives; shipping; steel and metals.

However, the idea of hedging risk with derivatives is not a new one. As
early as the 12th century, vendors at European trade fairs were signing
contracts for future delivery of goods. Futures contracts were part of tulip
mania in Holland in the early 1600s. In that same century, the Japanese
created a futures market in rice at Dojima, near Osaka, to protect sellers
from bad weather or warfare. In 17868, the Chicago Board of Trade began
trading wheat, pork belly and copper futures. Today, the range of
commodities and risks that can be traded are limited only by imagination and
determination.

The weather market
A closer look at the development of the weather market illustrates the
opportunity. According to a survey conducted by PricewaterhouseCoopers and
the Weather Risk Management Association, the number of weather contracts
executed in the 12 months ended April 14, 2001 rose by 1150/0, to 2,759,
from the comparable year-earlier period. While the total notional value of
weather derivatives traded during that time declined 17%, to $2.5 billion,
the downturn appears to have been a consequence of happenstance - in this
case, mild temperatures during the winters of 1997, 1998 and 1999 in North
America, where more than 95% of all contracts were executed. Those temperate
winters, the survey managers theorise, likely caused buyers of
temperature-related weather derivatives to demand less protection against
the possibility of an unusually cold winter in 2000.

While temperature-related weather contracts remain, for the moment, the most
popular type of weather derivative, there are signs that the market is
broadening. While temperature-linked contracts accounted for 98.30/0 of all
contracts traded during the first three and-a-half years of the market's
development, for example, contracts linked to other measures accounted for
7.2% of all contracts written during the six months ended April 14, 2001.
We can expect this broadening of the market to continue as new products give
companies the power to more precisely hedge their risks. Prime examples
introduced recently include power demand swaps and cross-commodity options.

Demand swaps are designed to overcome one of the biggest pitfalls of weather
derivatives: they can protect companies against swings in demand -either for
the products they sell or the raw materials they consume - only to the
extent that demand is impacted by the weather. Demand swaps, by contrast,
protect companies from fluctuations in demand regardless of the cause,
making them a more flexible and in some cases more accurate hedging tool.

Power demand swaps allow companies that buy and sell electricity to lock-in
their demand or consumption exposure within a specified power pool in the
US. Suppose, for example, that a power aggregator serving customers in the
PJM (Pennsylvania-New Jersey-Maryland) pool routinely buys its power in the
forward market. When demand exceeds the norm, the aggregator is forced to
purchase additional power in the open market, generally at inflated prices.
With demand swaps, the aggregator can receive payments from Enron when
weekly demand within its pool exceeds the average. In exchange, it would
agree to make payments to Enron when weekly demand is below average. When it
is required to make payouts, it can offset their cost in part by selling
some of its excess power back into the market. For utilities uncomfortable
with the open-ended cost of a swap, Enron also offers power demand options
that limit costs to the premium paid for the option.

Cross-commodity options protect companies against both price and volume
volatility simultaneously. Unlike a traditional weather derivative, which
pays out a specified amount of cash per unit of weather, these new contracts
pay out based on the difference between the market price of an underlying
commodity, such as energy, and a contracted strike price for that commodity.
The payout is still triggered, however, by a weather variable.

Here's a real-life example. In July, a Midwestern utility began searching
for protection against the adverse financial impact of a warmer than normal
winter. Per its custom, the utility wished to purchase its gas for the
upcoming winter in advance, via the futures market, and to lock in a
sufficient quantity to cover the coldest possible winter. The downside of
this strategy is that if the winter proves unseasonable mild, the utility
would be left with a long gas position in a soft market. Not only would the
utility sell less gas to its customers than anticipated, it would probably
have to sell gas back into the spot market at deflated prices.

Under the terms of a cross-commodity contract the utility entered into with
Enron, it will receive compensation if the number of heating degree days
(the cumulative number of degrees below 650F) from November through March is
below a predetermined strike. The amount of compensation is dependent upon
the market price of gas at the beginning of each month covered by the
contract. Enron, through what are effectively put options settled in cash,
will pay the utility the difference between the market price of gas that
month and a strike price equal to what the utility paid in the futures
market.

Growing global
While most weather derivatives have been traded in the US, they have already
begun to migrate overseas into Oslo, Tokyo, Sydney and London. Other
important players are entering the market, too. They include, most notably,
large financial institutions - Goldman Sachs in the US, Deutsche Bank and
Dresdner Bank in Germany, and Credit Lyonnais in France. The importance of
their participation in this new market rests to a large degree on the
relationships they have with their clients - relationships founded in part
on trust. Because of that trust, companies already doing business with these
banks may be more receptive to entering what is, for most of them, a novel
marketplace. In addition, these banks can offer their clients incentives to
use weather derivatives in the form of reduced lending rates - a reward
reflecting the fact that users of weather derivatives generally enjoy
smoother, more predictable financial results than their competitors who do
not use them.

A final factor driving the growth of the weather derivatives market is the
increasing pressure companies are getting from lenders and investors to make
use of these instruments. Now that companies can control the financial
impact of adverse weather conditions, they are finding it increasingly hard
to justify any failure to do so.

**End of ISDA Press Report for October 23, 2001**

THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S
BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS
REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION),
AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.

Scott Marra
Administrator for Policy and Media Relations
International Swaps and Derivatives Association
600 Fifth Avenue
Rockefeller Center - 27th floor
New York, NY 10020
Phone: (212) 332-2578
Fax: (212) 332-1212
Email: smarra@isda.org