negative interest rates has prompted the derivatives industry to rewrite its basic contracts. The International Swaps and Derivatives Association last week issued guidelines to its members on how to amend their swaps contracts for the possibility of negative interest rates in Japan and elsewhere. The trade group's master agreements cover most over-the-counter derivatives contracts. At issue are the terms of settlement when interest rate calculations in a swap transaction produce a negative number for one of the counterparties. The new guidelines present two approaches. Under the first approach, the company responsible for paying the amount that results in a negative rate would pay nothing. Instead, that company's counterparty would pay not only the amount it would have had to pay anyway, but also the amount of the negative interest rate. The second method sets a floor for the interest rates at zero percent. The Bank of Japan has pushed some rates below 0.5% to jump-start that country's troubled economy. But the effort has created legal confusion for participants in the derivatives markets. "It is a big issue, and the markets were anxious to get a solution and some official language," said a lawyer working on amending the legal agreements. In fact, the problems created by the complexities of the instruments involved prevented the trade group from immediately issuing guidelines for other types of derivatives like options, caps, floors, swaptions, forward rate agreements, and collar transactions. The guidelines issued last week cover only the swaps market and took more than six weeks to create, according to insiders. There is little precedent for negative interest rates, and the situation in Japan has caught the industry off guard. In recent memory, only Switzerland has had experience with negative interest rates, when it attempted to prevent inflation over a decade ago.
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