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Financial derivatives (aka derivative assets, contingent claims) are securities whose value depends on another security 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 depends on the value of its underlying financial asset or the current value of a benchmark, such as an index or current interest rates.
The value of derivatives is sometimes called the notional value, because derivatives are generally 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.
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.
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.
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.
There are 2 types of derivatives: option-type and forward-type. The option-type derivative is based on the price of the underlying asset, and 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 always sell for much less than the underlying asset—otherwise, what value would the option have?
The forward-type derivative is based on the value of some benchmark, such as interest rates or a financial index or the price of a commodity. 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. Sometimes, however, a performance bond—sometimes referred to as margin—will be required to ensure the performance of the contract by the parties, such as is commonly required for futures.
Settlement is the performance of the contract and terminates the existence of the derivative. 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, depending on the underlying value 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.
There are numerous problems with derivatives. Derivatives are usually complex, and 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 are defaulting, and many more are expected as adjustable-rate mortgages adjust to higher rates. As a result, the credit rating agencies have 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.
There are many who believe that derivatives are potentially dangerous because it is impossible to foresee all of the ramifications of derivatives, and that it can lead to great turmoil in the markets and the economy. Nonetheless, it seems certain that derivatives are here to stay, since they do offer real benefits, and the profit potential is enormous.
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