It is time for action for most of the regulators. The European Commission is taking steps to clean up the Credit Default Swaps (CDS) after it failed to get a commitment from the $58 tn credit derivatives industry. It is expected that the European Commission will introduce new rules forcing banks and other usurers of credit derivatives to use a central clearing house to minimize the risk. The collapse of Lehman Brothers Holding Inc., in September 2008, is one the reasons for such an action.

For Over-the-Counter (OTC) derivatives it is a hard slog ahead, dealers are asked to increase infrastructure on OTC derivatives. There is a lot of cancellation and reconciliation of CDS trades. According to Bank of International Settlement (BIS), in 2008, TriOptima has cancelled CDS transactions worth $17.8 tn in terms of notional principal, which is almost 50% of the market.

Financial Service Authority of Great Britain has advised the holders of Contracts for Difference (CFD) to disclose their positions, if they exceed the 3% threshold set by the Act and this includes the active hedgers also.

This kind of regulatory scrutiny will continue for sometime and the level of scrutiny will be relatively higher than the 1990s. Today the derivatives market has $454.5 tn in outstanding notional. The growth of derivative industry can be traced back to 1983. The industry grew from a small niche market to a more elaborate, and quite a major business by the end of 1990. It is expected that such strict regulation will bring in more maturity to the system, and will definitely improve operations-related issues.

This issue includes five papers. The first paper, "Pricing Forward Start Options in Models Based on (Time-Changed) Lévy Processes", studies the pricing of forward start models using Lévy processes. It considers the Variance Gamma (VG) model and the Normal Inverse Gaussian (NIG) model subordinated by a Gamma-Ornstein-Uhlenbeck process and respectively by a Cox-Ingersoll-Ross process. The paper also checks the analytical results obtained by applying the Monte Carlo methods.

The second paper, "Airline Hedging Using Derivatives", analyzes airline hedging in a very practical and simple manner. The key issues that this paper uses to formulate the appropriate derivative hedging strategies for airlines industry are operating costs, currency fluctuations and oil prices. Empirical study proves that there is a need to hedge the airlines' financial positions.

The third paper, "Revisiting the Valuation of Inflation Indexed Bonds and Derivatives", presents a tractable model in closed form for pricing inflation indexed bonds, swaps and options. Closed-form solutions are provided in both discrete and continuous time settings. In keeping with empirical evidence, the model predicts that deflation is unlikely. Various model variants have been presented in this paper, some of which guarantee a strictly non-negative nominal interest rate or allow for jumps in the inflation rate.

The fourth paper, "Valuation of Swaps and Options on Constant Maturity CDS Spreads", studies the pricing of options whose payoffs are contingent on Constant Maturity Credit Default Swap (CMCDS) spreads. It extends the convexity adjustment method for Constant Maturity Swap (CMS) in interest rates by modeling the swap rate and CDS spread either as a single factor (a sum of the two) or as two factors separately. Under lognormality assumptions, the model produces analytic solutions for convexity adjustments as well as for the valuation of CMCDS derivatives such as CDS swaptions, caps and floors, and digital options.

The fifth paper, "Alternative Assets: A Comparison Between Commodities and Traditional Asset Classes", examines the relationship between the portfolio returns with the presence of commodities and traditional asset classes like stocks, bonds, money market and real estate. This paper, tries to set the role and functions of commodity derivative markets and contracts with reference to both the available literature and actual instruments. In this context, the paper also looks at the Italian market.

-- Sharon K Jose,
Consulting Editor