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the change in the implied spread of the Colgate debt yield over
an index of the yield on U.S. Treasury securities. If Colgate's
credit improved, the spread would narrow; if Colgate's credit
deteriorated, the spread would widen. The Quality Component was
the change in the value of the Colgate debt attributable to this
change in the spread. The Partnership Agreement provided for the
following Quality Component allocations: (a) For the first 50
basis point decline in value, 84.7 percent of the decline was
allocated to Southampton, 15 percent to Kannex, as were
subsequent increases within this 50 basis point range; (b) all
declines beyond 50 basis points were allocated 99.7 percent to
Southampton, and all other increases were allocated 99.7 percent
to Southampton. MLCS's share of all changes was 0.3 percent.
The substantial risk shifting potential of the Yield
Component option, which was of substantial value to Colgate's
liability management scheme, proved relatively unproblematic for
ABN because of the bank's ability to hedge interest rate risks
outside the partnership through routine techniques employed by
financial intermediaries in the derivative markets. Indeed, in
its design of this option mechanism, Merrill's Swap Group took
for granted ABN's ability to make accommodations in this manner.
The Quality Component provision was a bone of contention for
the same reason that the Yield Component provision was not. A
credit derivative that could be used by the bank to hedge the
share of spread risk allocated to it under this provision was not
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