Optionality

Credit derivative contracts often provide options to the protection purchaser with
respect to which instruments it can deliver upon a default event. For example, the
purchaser may deliver any instrument that ranks pari passu with the reference
asset. Though two instruments may rank pari passu, they may not have the same
value upon default. For example, longer maturities may trade at lower dollar prices.
Protection purchasers can thus create greater losses for protection sellers by
exploiting the value of these options, and deliver, from among all potentially
deliverable assets, the one that maximizes losses for the protection seller. Protection
sellers must carefully assess the potential that the terms of the contract could
provide uncompensated, yet valuable, options to their counterparties. This form of
legal risk results when one party to the contract and its legal counsel have greater
expertise in credit derivatives than the counterparty and its counsel. This is particularly
likely to be the case in transactions between a dealer and an end-user,
underscoring the importance of end-users transacting with reputable dealer
counterparties.
These issues highlight the critical need for participants in credit derivatives to
involve competent legal counsel in transaction formulation, structure, and terms.