Derivatives: An Overview

Derivatives (aka derivative assets, contingent claims) are securities whose value depends on an underlying asset or benchmark (sometimes simply called the underlying) — another security, commodity, or some benchmark, such as a particular interest rate or the value of a financial index at a specified time. Primitive securities are based directly on real assets or on payments from the issuer. For instance, stocks represent an ownership interest in a corporation, and bonds are valued mainly on what the issuer promises to pay. The value of a derivative security will fluctuate with the value of the underlying. With many derivatives, there is either no cash flow or a minimal payment at the time of the agreement, since derivatives are really just contracts that promise to pay a certain amount if certain conditions are satisfied, and the net value of the contract to both parties is 0 when the contract is agreed to — otherwise, there would be no agreement.

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There are more than 1,000 different derivatives on the market, with more to come. Derivatives are based on stocks, commodities, debt, currencies, and almost anything else that 2 parties can agree on, or for which an investment bank considers marketable. However, the following are the most common type of assets:

Many derivatives are illiquid investments and are difficult to value. Oftentimes, their value is derived from pricing models for accounting purposes. Derivatives can be listed on an exchange, but most are traded either privately or in the over-the-counter market, although this is beginning to change after the Credit Crisis of 2007-2009, when new laws were passed requiring the trading of derivatives on public exchanges, so that the level of risk imposed by derivatives can be better ascertained and to make prices more transparent.

Derivatives are created by investment banks or other dealers by entering into a contract with a business, dealer, or investor to provide payment depending on the future price of some asset or the future value of some benchmark. For instance, a business may have to pay floating rate on issued securities, but doesn't want to take the interest-rate risk, so it does an interest-rate swap with a bank to pay the floating rate interest on the securities in exchange for a fixed rate of interest paid by the business to the bank.

Derivatives are created by financial engineering, which is the design and creation of securities with particular characteristics that the issuer thinks can be marketed for a profit. Financial engineering frequently involves the securitization of debt, or the bundling of other securities into a hybrid security, or the unbundling of a security into different risk classes, or even different tax classes, such as separating interest or dividend income from capital gains income, which is usually taxed at a lower rate.

There are 3 types of derivatives: pass-through, option-type and forward-type. Pass-through derivatives are created by the securitization of debt instruments. A good example of a derivative is the mortgaged-backed security (MBS), first issued in 1970 by the Government National Mortgage Association (GNMA, or Ginnie Mae, as it is usually called), which is created by the securitization of a pool of mortgages. Mortgage payments are collected by the bank servicing the mortgage, and both interest and principal payments are passed-through to the buyers of the MBSs — thus, they are called pass-through securities. Other debt, such as auto loans, credit card debt, and student loans, is similarly packaged as asset-backed securities. Generally, the investor would buy this type of derivative just as she would buy a bond, and like a bond, she would receive interest payments periodically and a repayment of the principal at maturity.

The option-type derivative is also based on the price of the underlying asset, but, for a small premium, it gives the holder the right, but not the obligation, to buy or sell a specific asset for a specific price for a specific time period. The most common example is stock options, which are based on the price of a stock. A call is a stock option giving the holder the right to buy a specific stock for a specific price—the strike price—and a put gives the holder the right to sell the stock for the strike price within a specific time. Option-type derivatives usually sell for much less than the underlying asset, since the exercise of the option would still require payment for the stock or, in the case of a put, the delivery of the stock to sell.

The forward-type derivative is a contract, where there is no payment at the time of the agreement, but any future payments will depend on the value of some benchmark, such as interest rates or a financial index or the price of a commodity, on a specified date or series of dates. A common example is the FX forward contract, which is a contract to buy or sell currency at a specified exchange rate at some time in the future. Another example is futures, which are contracts to buy or sell specific commodities or other assets at a specific price on the settlement date. Forward-type derivatives are based on an agreement about a future transaction for a specified price. No cash or asset changes hands until the contract is settled. However, public exchanges that trade derivatives generally require a performance bond—sometimes referred to as margin — to ensure the performance of the contract by the parties, such as is commonly required for futures. In the over-the-counter market, the seller of a forward contract is frequently required to post collateral so that the buyer of the contract has some protection against nonperformance. In many cases, the seller will have to post more collateral if the value of the forward contracts moves against them. This is what happened to the American International Group (AIG). AIG sold credit default derivatives to cover defaults on mortgage-backed securities to banks, such as Goldman Sachs. When the securities started defaulting in large numbers, because many of them were based on subprime mortgages, AIG was forced to post additional collateral to cover the increasing risk that it would have to pay out. Since AIG did not have enough collateral to post, there was a danger that it would collapse, potentially causing many other banks to collapse in turn. To prevent this potential financial calamity, the United States had to bail out the company with $85,000,000,000 of taxpayers' money because it was "too big to fail".

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Settlement is the performance of the contract. So if a gold futures contract specifies that 100 troy ounces of gold be delivered for $1,000 per ounce on the delivery date, then the short position supplies the gold and the long position pays $100,000 for it. Settlements can also be classified as single settlements or multiple settlements. Single-settlement contracts require performance only on a specific date — the delivery date; multiple-settlement contracts are settled multiple times during the term of the contract. The most common type of a multiple-settlement contract is the swap, where a payment may be due at specified dates during the term of the swap. The maturity date is when the contract terminates.

Settlement can be satisfied by physical delivery or by cash settlement. Physical delivery is the actual delivery and possession of the underlying commodity or other asset. A future contract to sell and buy corn, for instance, involves the actual delivery of the corn by the seller of the future, and the actual possession of the corn by the buyer of the contract. Most derivatives are cash-settled, which only involves exchanging cash, usually for the difference between the contract price and the value of the underlying on the settlement date. Some derivatives are cash settled either because delivery would be inconvenient or entail significant secondary expenses, such as derivatives based on a stock index, or because the underlying cannot be physically delivered, such as interest rate derivatives, where the amount of cash is determined by the contracted rate and a specified reference interest rate, such as LIBOR, on the settlement date.

Derivatives are used for hedging, speculation, and to remove assets from balance sheets. Hedging is using a derivative to protect a position. For instance, a business manufactures a widget to sell in a foreign country, but will not receive payment until some time in the future. To be able to price its widgets so that it can make a profit, it must know in advance what it will receive in its own currency when the widgets are sold. Before the delivery of the widgets to the foreign country, the business can enter into a forward contract with a bank or a speculator to exchange currency at a guaranteed rate, thus, hedging any risk that the currency exchange rate will lessen the amount of money received for its widgets.

Speculation is the buying and selling of derivatives for a profit. Many future contracts call for physical delivery of a commodity; however, most speculators buy future contracts without having any intention of delivering or taking delivery of the commodity. They close out their position before the settlement date, taking a profit or loss by offsetting the contract by reversing their previous transaction. Thus, if a speculator buys a contract to buy butter, she will close out her position by selling the contract.

Derivatives can also be used to remove assets from the balance sheets of companies, which provides liquidity for the companies and reduces risk by transferring it to the holders of the derivatives. The reason why mortgaged-backed securities were created was so that banks could remove mortgages from their balance sheets, giving them more cash to issue more mortgages, and reduce their own risk by transferring it to the holders of the MBSs. Unfortunately, this transfer of risk also precipitated the credit crisis that began in 2007. Because the banks, as loan originators, earned money from application fees and processing case but did not have to worry about credit default risk, they became less concerned about the creditworthiness of the loan applicants, many of whom did not even have to supply proof of income. Hence, it was inevitable that many of them would default.

Swap Contracts

A swap contract is an agreement to exchange future cash flows. The most common type of swap agreement is the interest rate swap, where 2 parties agree to exchange cash flows, depending on the fluctuation of interest rates. The most common types of swap exchanges a fixed rate of interest for a floating rate, or an interest rate in one currency may be exchanged for an interest rate in another currency. Generally, swap agreements have many complex details, so most parties to a swap agreement rely on master agreements that are published by the International Swaps and Derivatives Association (ISDA).

Problems with Derivatives

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There are numerous problems with derivatives. Derivatives are usually complex and tailored to a particular party, so they are difficult both to value and to assess the risk. Because derivatives are based on other financial assets, any problems with the underlying assets will percolate to the derivatives.

For instance, problems have recently surfaced from derivatives that derived their value from MBSs that had subprime mortgages. Many of these subprime mortgages started defaulting, and many more were expected as adjustable-rate mortgages adjusted to higher rates. As a result, the credit rating agencies downgraded the debt, and the derivatives based on them, such as structured investment vehicles (SIVs) and collateralized debt obligations (CDOs). This has hurt many funds that hold these derivatives as means to earn greater returns.

The problem with subprime mortgages has arisen because of the ability to transfer risk to holders of derivatives. The banks granting the mortgages were not as careful in selecting loan applicants as they would have been if they had to hold the loans in their own portfolio.

The other main problem with derivatives is the substantial leverage involved, since most of the time, little or no money is exchanged until settlement. This can lead to large losses for people, companies, funds, and even governmental agencies that took what would ultimately be the wrong side of the transaction.

Another problem that is becoming more apparent is that some banks, such as Goldman Sachs Group, who issued derivatives to their clients, often took the other side of the transaction—in essence, betting against their own clients who followed their advice. For instance, according to this NY Times article, Goldman E-Mail Message Lays Bare Trading Conflicts, Goldman and other firms were bundling mortgages into CDOs to sell to investors while investing in other securities, such as credit default swaps, that would increase in value as those issued CDOs decreased in value. Furthermore, the article also said that Goldman pressured rating agencies to assign these CDOs investment-grade credit ratings, no doubt by threatening to take their business elsewhere.

The 2008-2009 Credit Crisis amply demonstrates the damage that the lack of transparency and the conflicts of interests by the issuers of derivatives can have on the economy. While derivatives have some value as a hedge, their greatest value seems to be in profiting from uninformed investors who use derivatives not to hedge real risks but to speculate for profit.

Because there is no centralized exchange for derivatives, it is difficult for investors to price derivatives. The banks that issue derivatives benefit not only from superior knowledge about the derivatives—since they created them—but also from the hefty fees they charge for their creation.

Indeed, even though it is now apparent that derivatives can cause severe economic damage, banks—many of which were bailed out by taxpayers' money—are using their money to lobby Congress furiously to head off any restrictions on their business. Why are they lobbying Congress in spite of the economic damage derivatives created? Because the banks were earning tremendous profits. But derivatives is a zero-sum game. If banks are earning tremendous profits, then somebody must be suffering tremendous losses! Hopefully, that's not you!