Design of master agreements for OTC derivatives (Q1587499)

Non-financial firms generally prefer privately negotiated over-the-counter (OTC) derivatives to exchange-traded contracts. In financial practice, bilateral contractual arrangements known as master agreements have become a de facto standard for the decomentation of bilateral derivatives transactions. Although the problem of designing financial contracts in general has received much attention in financial theory, the particular issue of derivatives documentation has not yet been dealt with. The organization of the present book is as follows. In Chapter 2 the nature and function of master agreements currently used in financial practice is discussed, and the various provisions that the parties can choose from is described. The main focus is on those provisions that govern the parties' rights and obligations in the event of a default and the contractual arrangements that aim to reduce the parties' exposure to default risk. At the beginning of Chapter 3, the concept of incomplete contracts and its relevance to financial theory is discussed. After reviewing various models that have been studied in this context, the author presents a heavily modified version of a two-period model due to \textit{O. Hart} and \textit{J. Moore} [Default and renegotiation: A dynamic model of debt, LSE Financial Markets Group Discussion Paper No. 57 (London, 1989)]. Chapter 4 and 5 contain the formal analysis. In particular, Chapter 4 contains an analysis of the bilateral bargaining game involving equity, debt, and derivatives claims with the underlying assumption that credit risk is one-sided. The model is then extended in Chapter 5 to allow for the possibility of two-sided credit risk. This assumption best reflects the specific nature of forward-type OTC derivatives contracts. Chapter 6 sums up the results and discusses their implications. The book by Franzen which contains interesting applications of contract theory to various issues concerning master agreements, should also be of interest to practitioners.