CONTRACT ELEMENTS

The counterparties that enter into a bilateral or multilateral financial deal are in essence defining a contractual legal agreement with an underlying set of rules. Such rules describe the terms and conditions for exchanging cash flows during the lifetime of the contract.

In fact, the contractual rules are referring to characteristics of time, markets, and coun­terparties, and in some cases to certain behavior. These are the input elements to financial contracts that are related to the rules in a legal agreement of the financial contracts. Techni­cally, the mapping of such rules, on a contractual level, is done by using attributes. Examples of such attributes are the amount of principal capital, the set dates of interest payments, the market reference, the counterparty ID, and many more.

The main characteristics of the counterparty are the ones referring to the credit quality, e.g., default probabilities and credit ratings; and of the markets are the yields and spread curves, prices, and rates as well as the applied accounting and discounting rules. These are the credit and market financial risk factors which are somehow correlating and interacting with each other as well as affecting the behavior analysis element.

Before—and even during—the lifetime of a financial contract, all counterparties involved in the deal are expected to fulfill their contractual obligations. The degree of accuracy of this assumption is associated with counterparty credit quality. Evaluating counterparties is an ongoing process. This is usually done by determining their ratings, default probabilities and credit spreads and monitoring them closely for changes.

In some cases, counterparties agree to have certain rights for making and employing their own decisions during the lifetime of the contract. Such decisions may influence the expected exchange of cash flows. For instance, a lender may have a right to prepay part of the principal amount at any time. However, the contract usually defines a fee the borrower has to pay in the event of prepayment.

Thus, think of a simple case when constructing a simple loan, the contract must be linked to an agreed predefined market interest rate in which the cash flows will be exchanged. The contract also belongs to the lender and borrower counterparties who agreed on assumptions for market conditions that will be considered to calculate the future interest payments. The lender also assumes that the borrower will pay back the principal and interest as agreed. However, we can expect there will be a difference between the assumed and actual market conditions and counterparty credit status. Therefore the contract is directly exposed to market volatilities and counterparties.

Market conditions, counterparties and behavior drive the financial events in a contract. Technically, what happens is that attributes are “decoded” as parameters in mathematical functions following algorithms for generating the events during the lifetime of the contract. These are including all expected cash flows such as payments referring to principal, interest, premiums, dividends, expected recoveries, etc. considering all contract rules at different points in time or through the cycle iterations. It is important to note that in most cases they are correlated and therefore influence each other’s performance. For example, an increase in the market interest rate could influence the counterparty to prepay, partially or fully, the outstanding principal. If interest rates move against the counterparty’s favor, this could prompt a borrower to default in his interest and principal payment obligations.

Figure 5.1, illustrates the main elements referring to financial contracts. In Chapters 6, 7 and 8, we will discuss the main input financial elements named “Markets,” “Counterparty,” and “Behavior”. In the following paragraphs, however, we will go through the element of time and the patterns of financial events created by the contract mechanisms. As we will also see, financial events are the basis in liquidity, value and income analysis.

5.2