Documentation issues are never far from the forefront of the credit derivatives market. One of the most infamous of these is, of course, the restructuring clause. Last year, with camps in the US in favour of ditching restructuring altogether and those in Europe fiercely loyal to 'r', it seemed that a compromise was far from being achievable.

In the midst of the deadlock, a solution was developed - modified restructuring. However, despite finding success in the North American market, credit derivatives traders in Europe were not satisfied that 'mod-r' was the best fit. A mod mod-r solution was then created, but that did not find favour either.

After it became clear that mod-r and even mod mod-r were not going to save the day, International Swaps & Derivatives Association (Isda) decided that, for the short term at least, its standard credit derivative documentation should aim to please all of the people all of the time. In other words, it included four restructuring options:

• Old restructuring (old-r)
• Modified restructuring (mod-r)
• Modified modified restructuring (mod mod-r)
• No restructuring (no-r)

"It was hard not to think that the whole restructuring debate, which involved hours of intense talks and conference calls, was turning into a farce," says one credit derivatives trader. "However, Isda's new documentation does clarify where we stand on the four options and eases the burden on finding a 'one size fits all' solution, allowing the market to grow more organically. In time, I believe that the market will decide to discard restructuring."

Pricing

Until then, the credit derivatives market has to deal with a significant pricing issue. What is the value of mod-r, mod mod-r and old-r in a credit default swap contract compared to a contract that has only 'bankruptcy' and 'failure to pay' as credit events?

This question is exactly what the credit derivatives strategies team at Goldman Sachs has set out to answer. In a recent report, entitled What is the value of the restructuring credit event?, the team presents a framework that quantifies the value of various restructuring options. The group finds that, for reasonable parameter values, the model produces a mod-r premium of one to six percent of the no-r spread for a five-year, 100 basis point credit default swap.

Interestingly, this is at odds with the market's current thinking, which sees the same premium as being five to ten percent. Goldman Sachs, therefore, believes that market participants may be overpaying for the cheapest to deliver option in mod-r contracts.

However, in practice, the report's authors state that many of the model parameters are difficult to measure precisely for any given reference entity. In addition, there is the possibility that the entity will alter the value of the cheapest to deliver option at some point in the future by issuing long maturity or foreign currency debt. The authors explain that: "For this reason, we do not expect the market to begin valuing the cheapest to deliver option using models. However, we believe that our framework will encourage investors to decompose the mod-r, mod mod-r and old-r premiums versus no-r into the likelihood of restructuring relative to a 'hard' credit event and the loss following a restructuring, allowing a comparison of the implied values with investors' intuition."

Jane Douglas-Jones