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Derivatives
Derivatives
are financial instruments whose value is derived from the value
of something else. The main types of derivatives are futures,
forwards, options,
and swaps.
The main
use of derivatives is to reduce risk for one party. The diverse
range of potential underlying assets and pay-off alternatives
leads to a huge range of derivatives contracts available to
be traded in the market. Derivatives can be based on different
types of assets such as commodities, equities (stocks), bonds,
interest rates, exchange rates, or indexes (such as a stock
market index, consumer price index (CPI) see inflation derivatives
or even an index of weather conditions, or other derivatives).
Their performance can determine both the amount and the timing
of the pay-offs.
Uses
Insurance
and Hedging
One use
of derivatives is as a tool to transfer risk by taking the opposite
position in the futures market against the underlying commodity.
For example, a wheat farmer and a wheat miller could enter into
a futures contracts to exchange cash for wheat in the future.
Both parties have reduced the risk of the future: the uncertainty
of the price and the availability of wheat.
Speculation
and arbitrage
Speculators
may trade with other speculators as well as with hedgers. In
most financial derivatives markets, the value of speculative
trading is far higher than the value of true hedge trading.
As well as outright speculation, derivatives traders may also
look for arbitrage opportunities between different derivatives
on identical or closely related underlying securities.
In addition to directional plays (i.e. simply betting on the
direction of the underlying security), speculators can use derivatives
to place bets on the volatility of the underlying security.
This technique is commonly used when speculating with traded
options. Speculative trading in derivatives gained a great deal
of notoriety in 1995 when Nick Leeson, a trader at Barings Bank,
made poor and unauthorized investments in index futures. Through
a combination of poor judgement on his part, lack of oversight
by management, a naive regulatory environment and unfortunate
outside events like the Kobe earthquake, Leeson incurred a $1.3
billion loss that bankrupted the centuries-old financial institution.
Types
of derivatives
Broadly
speaking there are two distinct groups of derivative contracts,
which are distinguished by the way they are traded in market:
- Over-the-counter
(OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through
an exchange or other intermediary. Products such as swaps,
forward rate agreements, and exotic options are almost always
traded in this way. The OTC derivatives market is huge. According
to the Bank for International Settlements, the total outstanding
notional amount is USD 516 trillion (as of June 2007)[1].
- Exchange-traded
derivatives (ETD) are those derivatives products that
are traded via specialized derivatives exchanges or other
exchanges. A derivatives exchange acts as an intermediary
to all related transactions, and takes Initial margin from
both sides of the trade to act as a guarantee. The world's
largest[2] derivatives exchanges (by number
of transactions) are the Korea Exchange (which lists KOSPI
Index Futures & Options), Eurex (which lists a wide range
of European products such as interest rate & index products),
and CME Group (made up of the 2007 merger of the Chicago Mercantile
Exchange and the Chicago Board of Trade). According to BIS,
the combined turnover in the world's derivatives exchanges
totalled USD 344 trillion during Q4 2005. Some types of derivative
instruments also may trade on traditional exchanges. For instance,
hybrid instruments such as convertible bonds and/or convertible
preferred may be listed on stock or bond exchanges. Also,
warrants (or "rights") may be listed on equity exchanges.
Performance Rights, Cash xPRTs(tm) and various other instruments
that essentially consist of a complex set of options bundled
into a simple package are routinely listed on equity exchanges.
Like other derivatives, these publicly traded derivatives
provide investors access to risk/reward and volatility characteristics
that, while related to an underlying commodity, nonetheless
are distinctive.
Common
Derivative contract types
There are
three major classes of derivatives:
- Futures/Forwards,
which are contracts to buy or sell an asset at a specified
future date.
- Optionals,
which are contracts that give a holder the right to buy or
sell an asset at a specified future date.
- Swappings,
where the two parties agree to exchange cash flows.
Examples
Some common
examples of these derivatives are:
| UNDERLYING |
CONTRACT TYPE |
| Exchange-traded futures |
Exchange-traded options |
OTC swap |
OTC forward |
OTC option |
| Equity Index |
DJIA Index future
NASDAQ Index future |
Option on DJIA Index future
Option on NASDAQ Index
future |
Equity swap |
Back-to-back |
n/a |
| Money market |
Eurodollar future
Euribor future |
Option on Eurodollar future
Option on Euribor future |
Interest rate swap |
Forward rate agreement |
Interest rate cap and floor
Swaption
Basis swap |
| Bonds |
Bond future |
Option on Bond future |
n/a |
Repurchase agreement |
Bond option |
| Single Stocks |
Single-stock future |
Single-share option |
Equity swap |
Repurchase agreement |
Stock option
Warrant
Turbo warrant |
| Credit |
n/a |
n/a |
Credit default swap |
n/a |
Credit default option |
Portfolio
It should
be understood that derivatives themselves are not to be considered
investments since they are not an asset class. They simply derive
their values from assets such as bonds, equities, currencies,
etc. and are used to either hedge those assets or improve the
returns on those assets.
Cash
flow
The payments
between the parties may be determined by:
- the price
of some other, independently traded asset in the future (e.g.,
a common stock);
- the level
of an independently determined index (e.g., a stock market
index or heating-degree-days);
- the occurrence
of some well-specified event (e.g., a company defaulting);
- an interest
rate;
- an exchange
rate;
- or some
other factor.
Some derivatives
are the right to buy or sell the underlying security or commodity
at some point in the future for a predetermined price. If the
price of the underlying security or commodity moves into the
right direction, the owner of the derivative makes money; otherwise,
they lose money or the derivative becomes worthless. Depending
on the terms of the contract, the potential gain or loss on
a derivative can be much higher than if they had traded the
underlying security or commodity directly.
Valuation
Market
and arbitrage-free prices
Two common
measures of value are:
- Market
price, i.e. the price at which traders are willing to buy
or sell the contract
- Arbitrage-free
price, meaning that no risk-free profits can be made by trading
in these contracts; see rational pricing
Determining
the market price
For exchange-traded
derivatives, market price is usually transparent (often published
in real time by the exchange, based on all the current bids
and offers placed on that particular contract at any one time).
Complications can arise with OTC or floor-traded contracts though,
as trading is handled manually, making it difficult to automatically
broadcast prices. In particular with OTC contracts, there is
no central exchange to collate and disseminate prices.
Determining
the arbitrage-free price
The arbitrage-free
price for a derivatives contract is complex, and there are many
different variables to consider. Arbitrage-free pricing is a
central topic of financial mathematics. The stochastic process
of the price of the underlying asset is often crucial. A key
equation for the theoretical valuation of options is the Black-Scholes
formula, which is based on the assumption that the cash flows
from a European stock option can be replicated by a continuous
buying and selling strategy using only the stock. A simplified
version of this valuation technique is the binomial options
model.
Controversy
Derivatives
are often subject to the following criticisms:
- The use
of derivatives can result in large losses due to the
use of leverage. Derivatives allow investors to earn large
returns from small movements in the underlying asset's price.
However, investors could lose large amounts if the price of
the underlying moves against them significantly.
- Derivatives
(especially swaps) expose investors to counter-party risk.
For example, suppose a person wanting a fixed interest rate
loan for his business, but finding that banks only offer variable
rates, swaps payments with another business who wants a variable
rate, synthetically creating a fixed rate for the person.
However if the second business goes bankrupt, it can't pay
its variable rate and so the first business will lose its
fixed rate and will be paying a variable rate again. If interest
rates have increased, it is possible that the first business
may be adversely affected, because it may not be prepared
to pay the higher variable rate. This chain reaction effect
worries certain economists,
who posit that since many derivative contracts are so new,
the effect could lead to a large disaster. Different types
of derivatives have different levels of risk for this effect.
For example, standardized stock options by law require the
party at risk to have a certain amount deposited with the
exchange, showing that they can pay for any losses; Banks
who help businesses swap variable for fixed rates on loans
may do credit checks on both parties. However in private agreements
between two companies, for example, there may not be benchmarks
for performing due diligence and risk analysis. This has been
a cause for concern among many economists
- Derivatives
pose unsuitably high amounts of risk for small or inexperienced
investors. Because derivatives offer the possibility of large
rewards, they offer an attraction even to individual investors.
However, speculation in derivatives often assumes a great
deal of risk, requiring commensurate experience and market
knowledge, especially for the small investor, a reason why
some financial planners advise against the use of these instruments.
Derivatives are complex instruments devised as a form of insurance,
to transfer risk among parties based on their willingness
to assume additional risk, or hedge against it.
- Derivatives
typically have a large notional value. As such, there
is the danger that their use could result in losses that the
investor would be unable to compensate for. The possibility
that this could lead to a chain reaction ensuing in an economic
crisis, has been pointed out by legendary investor Warren
Buffett in Berkshire Hathaway's annual report. Buffet stated
that he regarded them as 'financial weapons of mass destruction'.
The problem with derivatives is that they control an increasingly
larger notional amount of assets and this may lead to distortions
in the real capital and equities markets. Investors begin
to look at the derivatives markets to make a decision to buy
or sell securities and so what was originally meant to be
a market to transfer risk now becomes a leading indicator.
Many economists[citation needed] are worried
that derivatives may cause an economic crisis at some point
in the future.
- Derivatives
massively leverage the debt in an economy, making it
ever more difficult for the underlying real economy to service
its debt obligations and curtailing real economic activity,
which can cause a recession or even depression. In the view
of Marriner S. Eccles, U.S. Federal Reserve Chairman from
November, 1934 to February, 1948, too high a level of debt
was one of the primary causes of the 1920s-30s Great Depression.
Nevertheless,
the use of derivatives has its benefits:
- Derivatives
facilitate the buying and selling of risk, and thus
have a positive impact on the economic system. Although someone
loses money while someone else gains money with a derivative,
under normal circumstances, trading in derivatives should
not adversely affect the economic system because it is not
zero sum in utility.
- Former
Federal Reserve Board chairman Alan Greenspan commented in
2003 that he believed that the use of derivatives has softened
the impact of the economic downturn at the beginning of
the 21st century.
Definitions
- Bilateral
Netting: A legally enforceable arrangement between a bank
and a counter-party that creates a single legal obligation
covering all included individual contracts. This means that
a bank’s obligation, in the event of the default or insolvency
of one of the parties, would be the net sum of all positive
and negative fair values of contracts included in the bilateral
netting arrangement.
- Credit
derivative: A contract that transfers credit risk from a protection
buyer to a credit protection seller. Credit derivative products
can take many forms, such as credit default options, credit
limited notes and total return swaps.
- Derivative:
A financial contract whose value is derived from the performance
of assets, interest rates, currency exchange rates, or indexes.
Derivative transactions include a wide assortment of financial
contracts including structured debt obligations and deposits,
swaps, futures, options, caps, floors, collars, forwards and
various combinations thereof.
- Exchange-traded
derivative contracts: Standardized derivative contracts (e.g.
futures contracts and options) that are transacted on an organized
futures exchange.
- Gross
negative fair value: The sum of the fair values of contracts
where the bank owes money to its counter-parties, without
taking into account netting. This represents the maximum losses
the bank™ counter-parties would incur if the bank defaults
and there is no netting of contracts, and no bank collateral
was held by the counter-parties.
- Gross
positive fair value: The sum total of the fair values of contracts
where the bank is owed money by its counter-parties, without
taking into account netting. This represents the maximum losses
a bank could incur if all its counter-parties default and
there is no netting of contracts, and the bank holds no counter-party
collateral.
- High-risk
mortgage securities: Securities where the price or expected
average life is highly sensitive to interest rate changes,
as determined by the FFIEC policy statement on high-risk mortgage
securities.
- Notional
amount: The nominal or face amount that is used to calculate
payments made on swaps and other risk management products.
This amount generally does not change hands and is thus referred
to as notional.
- Over-the-counter
(OTC) derivative contracts : Privately negotiated
derivative contracts that are transacted off organized futures
exchanges.
- Structured
notes: Non-mortgage-backed debt securities, whose cash flow
characteristics depend on one or more indices and/or have
embedded forwards or options.
- Total
risk-based capital: The sum of tier 1 plus tier 2 capital.
Tier 1 capital consists of common shareholders equity, perpetual
preferred shareholders equity with non-cumulative dividends,
retained e arnings, and minority interests in the equity accounts
of consolidated subsidiaries. Tier 2 capital consists of subordinated
debt, intermediate-term preferred stock, cumulative and long-term
preferred stock, and a portion of a bank™s allowance for loan
and lease losses.
Footnotes
- BIS
survey: The Bank for International Settlements (BIS),
in their semi-annual OTC derivatives market activity report
from November 2007 that, at the end of June 2007, the total
notional amounts outstanding of OTC derivatives was $516 trillion
with a gross market value of $11 trillion. See also OTC
derivatives markets activity in the second half of 2004.)
- Futures
and Options Week: According to figures published in F&O
Week 10 October 2005. See also FOW Website.
External
links
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