by Joseph F. Baugher
Last revised April 24, 2010
You may have heard a lot about derivatives in the financial market in recent months. Here’s what I have learned about them.
Basically, a derivative is a risk-shifting agreement, the value of which is derived from the value of an underlying asset, sometimes just called the underlying. The underlying asset on which a derivative is based can be just about anything that has an economic value at a given time, or even anything whose value or state has an effect on the economy.. It can be some sort of financial asset such as a commodity (e. g. an equity (stock), a residential mortgage, commercial real estate, a loan, a bond, or agricultural products) or it can be an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI)), even other items such as weather conditions.
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying asset. Such an activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit that would arise if the value of the underlying asset moves in the direction they expect (either up or down!). This activity is known as speculation. Derivatives can be used to transfer risk (and the accompanying rewards) from the risk adverse to the risk seekers. Derivatives are complex instruments that are used to transfer risk among parties based on their willingness to assume additional risk, or to hedge against it. Just about every derivative bought or sold involves two parties, one of whom is hedging, with the other speculating.
Derivatives are complex bank creations that have rapidly expanded in recent years to almost completely dominate the world’s financial markets. In December of 2007, the Bank For International Settlements[i] reported that worldwide derivative trades amounted to $681 trillion dollars, ten times of the gross domestic product of all the nations in the world. Clearly, there isn’t nearly enough money in the world to cover all these derivatives. Derivatives have been the subject of severe criticism in recent months, and many financial experts blame them at least in part for the recent economic downturn. Warren Buffett once called derivatives “financial weapons of mass destruction”. However they can be useful tools when used properly. Because derivatives offer the possibility of large rewards, they can be attractive even to individual investors. However, very few people understand what derivatives are and how the work, which makes them dangerous in naïve or inexperienced hands, since they can pose unsuitably high amounts of risk for small or inexperienced investors, which is one reason why some financial planners advise against the use of these instruments. You can lose a lot of money very quickly when you deal with derivatives. If you don’t know what you are doing, don’t even think about getting involved with derivatives.
The purpose of this article is to attempt to remove some of the mystery surrounding these fascinating financial instruments. The main types of derivatives are options, forwards, futures, and swaps. In addition, there are various subtypes of products within each of the categories as described below.
The first and perhaps simplest to understand of these derivatives is the financial instrument known as the option. An option is a legally-enforceable contract between the option buyer and the option seller that gives the buyer of the option the right—but not the obligation—to buy or to sell a particular asset (known as the underlying) at an agreed-upon price on or before a certain date. The underlying asset can be just about anything—stocks, bonds, interest rates, or commodities like gold, pork bellies, wheat, or crude oil.
The price agreed upon in the option is known as the strike price, and the date after which the option contract is no longer valid is known as the expiration date. In return for granting the option, the seller of the option collects a payment (known as the premium) from the party who purchases the option. The cost of the premium is determined by numerous complex factors such as the current price of the underlying, the dollar amount of the strike price, the duration of the option, plus the expected volatility of the underlying. Buyers of options are sometimes referred to as holders, and sellers of options are sometimes known as writers. An option is considered as being a derivative, because its value is determined by the value of the underlying asset upon which it is based.
The purchaser of an option has the right to buy or sell the underlying at the strike price on or before the expiration date. This is known as exercising the option. The option holder also has the right to sell the option to another buyer during its term or to let it expire worthless. The option holder also has the right not to exercise the option should he/she so choose. However, the writers or sellers of options have the obligation to fulfill their side of the contract should the option holder wish to exercise their option. But the sellers of options can cover their backsides to a certain extent by purchasing an offsetting option contract.
There are two types of options: over-the-counter options and listed options. Over-the-counter options are those which are traded between two private parties, and the terms and conditions of such options are unrestricted and can be individually tailored to meet any business need. However, options can also be regularly bought and sold on an options exchange. An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. Such options have fixed strike prices and expiration dates. Listed options are standardized, but they come with a fairly wide variety of strike prices, expiration dates, and premium prices. Options that are purchased and sold on an exchange have standardized contracts and are settled through a clearinghouse with fulfillment of the contract being guaranteed by the credit of the exchange. In the US market, listed options can be exercised at any time between their date of purchase and the expiration date.
The possession of an option gives the holder the right to buy or sell (exercise) the underlying. However, the person agreeing to sell the underlying does not necessarily have to actually own the underlying at the time the option is written. But the person who agreed to sell the underlying will of course need to somehow acquire the underlying if the option is exercised. In the case of a security such as an index that cannot actually be delivered, the contract is settled in cash. However, most of the holders of options take their profits by trading out their options—known as closing out their positions. Option holders can sell their options to someone else in the market, and option writers can buy their positions back. According to the Chicago Board Options Exchange, only about 10 percent of options are actually exercised. 60 percent of them are traded out, and 30 percent expire worthless.
In the lingo of the stock market, an option to purchase the underlying is known as a call option, or just a call. An option to sell is known as a put option, or just a put. Purchasers of options (whether puts or calls) are said to have taken long positions, whereas sellers of options are said to have taken short positions. This nomenclature is sort of misleading, since someone who purchases an option to sell is actually doing something analogous to taking a short position in the stock market, since they will make money if the value of the underlying goes down.
Here’s an example of how an option works. Suppose that the Widget Corporation is a publicly-traded corporation that issues shares of stock. Assume that Pete owns a large number of shares of Widget stock, with over $100,000 invested in the company. However, Pete is worried that some sort of shock might occur (something like a news article about the health hazards of widgets) which would cause the Widget stock price to drop precipitously, which would wipe out a sizeable chunk of his retirement money. So Pete starts looking around for someone to take this risk off his shoulders.
Pete contacts Peggy, who writes and sells options. She works out a deal in which Pete pays her a fee for the right (but not the obligation) to sell her his Widget shares at any time during the next year at the current price of $25 per share. What makes an option strategy so attractive from Pete’s perspective is that he is not required to sell his shares to Peggy if he does not want to, but Peggy must buy Pete’s shares at the agreed-upon price if he chooses to sell them in a year’s time. The underlying entity in this sort of derivative is the price of Widget stock, since the value of the option at any time is a function of the Widget stock price at that time.
In this sort of venture, Pete is said to have hedged against the risk that the price of his stock will drop, whereas Peggy has speculated that the stock price will rise. The purchase of a put option is somewhat similar to taking a short position on a stock, since the holder of the option will profit if the value of the underlying declines appreciably before the option expires.
Suppose something bad actually occurs—for example suppose there is a massive recall of widgets because of some sort of manufacturing defect—and all the bad publicity causes the Widget stock price to tank. In such an event, Pete can exercise the put option and sell his Widget shares to Peggy at the agreed-upon price of $25 per share. This protects him from the loss of his retirement savings. Even though Peggy has to buy something that is now worth less than the price she has to pay for it, she makes out OK because she has been collecting money from the option fee that Sam paid her and she can handle the risk.
On the other hand, suppose widgets do well in the marketplace, sales rapidly increase, and the Widget stock price rises. In this event, both Pete and Peggy do well. Pete is pleased that his stock had increased in value, and he is certainly not obligated to sell his shares to Peggy and he now has absolutely no reason why he would want to. Even though Peggy doesn’t get to buy Pete’s shares, she has all this time been collecting a fee from Pete for an option that was never exercised.
Although options can be used to hedge against future risk, options can also be used purely for speculation, in which one hopes to make money whether the market goes up or down or even doesn’t change at all. When options are used in this manner, the option trader is placing a Vegas-like bet on the direction of the motion of a stock’s price. What makes an option strategy so attractive to people who can tolerate risk is the ability to use leverage—that is, the ability to use borrowed capital to increase the potential return on an investment. For example, a trader who believes that the stock price will increase with time (a bull) can do one of two things--either buy the stock outright or employ an option strategy which could be used to hedge against the possibility that they might have guessed wrong about the market.
Here’s an example of how a speculative option strategy might work. Suppose that Harry is bullish on the Widget Corporation, and expects that the price of Widget stock will rise over the next few months. Instead of buying Widget stock outright, Harry could hedge against the risk of him guessing wrong by paying a fee to Peggy for the right to buy Widget stock from her in the future at a fixed price. This is called a long call, long because Harry is purchasing the option contract and call because he is acquiring the right to buy. When the price of the underlying instrument exceeds the strike price plus the cost of the option, the option is said to be in–the-money, since the option holder will make money if they choose to exercise it. Should the Widget stock rise above the strike price, Harry could exercise the option and Peggy would be obligated to sell Widget stock to him at the agreed-upon price. Harry will make a profit on the deal if the price of Widget stock rises above the strike price, since he can buy the stock from Peggy and then immediately sell it on the market for a higher price. But if Harry has guessed wrong and the stock price goes down or does not change much, he can simply let the option expire unused, but he will be out the cost of the option. The act of purchasing a call option is similar to someone who takes a long position on a stock, since the holder of a call option will make money if the value of the underlying increases substantially in price.
Peggy, the seller of the call option, does not necessarily have to own the underlying entity at the time of the transaction, but she will indeed have to somehow obtain the underlying entity and sell it to Harry if he chooses to exercise his option. If the option writer actually owns the underlying at the time the option is sold, the contract is said to be covered. In the current market, contracts are almost never covered, and options are most frequently leveraged, relying heavily on borrowed money, which means that they allow the holder to control equity in a limited capacity for a fraction of what the shares would cost if they were directly purchased in the stock market. The extra money saved can be invested elsewhere until the option is exercised.
A trader might decide to use a long call rather than purchase the shares outright, since for the same amount of up-front money he could obtain a much larger number of options than actual shares. For example, suppose that a trader who has $1000 to invest is bullish on the stock market and expects the price of certain stocks to rise. Assume that he is particularly bullish on Widget stock, which is currently trading at $25 per share. The trader could of course simply use this money to go on the stock market and buy 40 shares of Widget stock. Alternatively, he could invest this same amount of money in a call option to buy a much larger number of shares of Widget stock. Let’s assume that the price of such an option is $2 per share, which means that for the same amount of money he could purchase a call option on 500 shares of Widget stock at a strike price of $25 per share.
Let’s assume that the trader has guessed correctly about the direction of the market, and that in 6 months time the price of Widget stock has risen to $30 per share. He then exercises his option, purchases 500 shares of Widget stock from the option seller at $25 per share for a total cost of $12,500, then immediately sells the shares on the stock market for $30 per share for a total amount of $15,000, making $2500 on the deal. Subtracting out the price of the option, the trader makes a net profit of $1500, more than doubling his money.
As a point of contrast, if the same trader had used his $1000 to purchase 40 shares of Widget stock, he would have made only $200. This means that the trader can potentially make a lot more money from the same initial investment by using an option strategy rather than purchasing the shares outright. However, there can be a considerable risk in such an option strategy. Suppose the trader guessed wrong about Widget stock, and the price drops to $20 per share by the time the option expired. The option is now worthless, and the trader has lost his entire $1000. However, if the trader had used his $1000 simply to purchase 40 shares of Widget stock when it was trading at $25 per share, he would lose only $200 when the price dropped to $20 per share.
Alternatively, a trader who expects the stock price to rise could sell someone else a put option. This strategy is known as a short put, short because the trader is selling the option, put because he is granting someone else the right to sell the stock to him at the agreed-upon strike price. Under this short put strategy, the trader will be obligated to buy the stock from the put owner at the put owner’s option. If the stock price happens to rise above the exercise price at the time of option expiration, the option owner certainly would have no reason to exercise their option, since the owner could get more money by simply selling their stock on the open market. In such a case, the trader will have made a profit in the amount of the option premium. However, the trader will assume some risk because if the stock price at option expiration is below the exercise price by more than the amount of the premium, the trader will lose money since they will be required to buy the stock at a price greater than its current worth.
An option strategy could also be used if the trader is bearish and expects the stock price to decrease over time. One thing that a trader who expects the market to fall could do is to purchase a put option, which is the right to sell the stock at a fixed price. This is known as a long put. For example, suppose Frank is bearish on the Widget Corporation, and expects its stock price to go down in the next few months. In order to take advantage of this expected decline, Frank can purchase a put option from Peggy on Widget stock which gives him the right to sell her 1000 shares of Widget stock at the current price of $25 per share within a year’s time. Frank does not actually have to own 1000 shares of Widget stock at the time he purchased the option, but he will have to somehow acquire them if he chooses to exercise the put option. If in a year’s time, Widget shares drop to $20, Frank can exercise the put option, go on the market and buy 1000 shares of Widget for $20 apiece, and then immediately sell them to Peggy for $25 per share, making $5000 on the deal. But if the Widget stock price goes higher than $25, Frank is not obliged to sell if he doesn’t want to and he can simply let the option expire unused.
In many ways the purchase of a put option is quite similar to short selling. Short selling is the practice of selling a financial instrument that the seller does not actually own at the time of the sale, with the intent of being able to purchase the financial instrument at a lower price at a later time. Typically, the short seller will borrow or rent the securities that are to be sold, and later repurchase identical securities for return to the lender. This works because the shares that are returned need not necessarily be the same pieces of paper that were borrowed. The party who buys the shares generally is unaware that they are participating in a short sale. If the security price falls, the short-seller will make a profit from having sold the borrowed securities for more than he later has to pay for them. However, if the security price rises, the short seller loses by having sold them for less than the price at which he later has to buy them.
However, short selling can be a very risky strategy. For a short seller, the potential profit is limited but the potential loss is unlimited. This is because the price of the stock cannot drop below zero, but the stock price could potentially rise to infinity. Since the stock cannot be repurchased for a price less than zero, the maximum possible gain for a short seller is the difference between the current stock price and zero. However, there is no ceiling on how much the stock price can go up, and the short seller could lose a lot of money. On the other hand, by purchasing a put option the potential loss is limited to only the price of the option, so the purchase of a put option could be a less risky strategy for someone hoping to profit from a down market.
A bearish trader who believes that the stock price will decline could also sell someone else a call option. This means that the trader will have the obligation to sell the stock to the option owner at their option. This is known as a short call. If the trader’s expectations are fulfilled and the stock price indeed decreases, the option owner certainly will not want to purchase the stock at the strike price, and the option will expire unused, which means that the trader will make a profit in the amount of the premium. But if the trader guesses wrong and the stock price increases over the exercise price by more than the amount of the premium, the owner will in all likelihood want to exercise the option, and the trader will have to sell the stock to the option owner at a price less than what it is currently worth on the market, and the trader will lose money on the deal. If the trader does not currently own the stock, they must go on the market and buy the stock at the now higher price and sell it to the option owner at the (lower) strike price. Since the potential profit is limited to only the cost of the option but the price of the stock could potentially rise to infinity, there is a considerable amount of risk in the short call strategy.
Sometimes, corporations offer their employees the option to buy shares in their corporation at a preset price within a certain amount of time. The idea behind stock options is to align corporate incentives between employees and shareholders. Employees generally do not have to pay any fees to the corporate management for the option, and it is regarded as a kind of bonus that could be cashed in if the company does well. An employee stock option is slightly different from a regular exchange-traded option because it is not generally traded on an exchange and there is no put component. If the stock price rises above the preset amount, the employee can purchase shares of the company at that price, then immediately sell them on the stock exchange to gain an instant profit. Alternatively, the employee could simply retain the stock that they bought in the hope that the price will rise still further. However, if the stock price goes down, the holder of the option is not obligated to purchase the shares at the preset price--they lose the opportunity for a bonus but they don’t feel the same amount of pain that a stockholder would if they had bought stock that went down in price.
A straddle is the purchase or sale of an equal number of puts and calls, each with the same strike price and expiration date. A straddle provides the opportunity to profit from a prediction about the future volatility of the market. Long straddles are used to attempt to profit from high volatility, i.e. situations in which the stock price is rapidly going either up or down. Short straddles represent an attempt to profit from the opposite prediction--that a stock price will not change.
Long straddles can be effective when an investor is confident that a stock price will change dramatically, but does not know which way the price will go. The owner of a long straddle will make a profit if the underlying price moves a long way from the strike price, either up or down. If the price goes up enough, he owner can exercise the call option and ignore the put option. Alternatively, if the price goes down, he can exercise the put option and ignore the call option. So the long straddle owner earns money either way—the trader is hedging his bets since he is guessing both ways simultaneously. However, if the price does not change by very much, neither option will be worth anything, and the long straddle owner will lose money, up to the total amount paid for the two options. In addition, the options market tends to price options on stocks that are expected by analysts to jump significantly (either up or down) at a somewhat higher premium, reducing the expected payoff should the stock move significantly.
As an example of a long straddle, suppose a trader knows that the Widget Corporation is currently trading at $30 per share, but will be issuing its quarterly earnings report in a couple of days. The trader doesn’t know whether the report will be good news or bad news, so he doesn’t know which way the stock price will move after the release of the report. He bets that the earnings report will cause high volatilty, so he purchases a put option for 5000 shares of Widget stock at a strike price of $30 that expires in 3 months, and he also purchases a call option for 5000 shares of Widget stock at the same strike price and the same expiration date. Assume that the total cost of each option was $10,000, although in actual practice the premium price for the put need not necessarily be the same as that of the call. Since he is purchasing the options, the trader is said to have taken long positions in both call and put options.
Suppose that the Widget quarterly report had a whole bunch of bad news, causing the price of Widget stock to drop to $20 per share 3 months later. The trader then lets the call option expire unused and exercises the put option. He immediately goes on the market and buys 5000 shares of Widget stock at the current price of $20/share, and then immediately sells them to the option writer at the strike price of $30/share, making a profit of $50,000. Subtracting out the price of the two options, the net profit is 50,000 – 2x10,000 = $30,000.
If on the other hand the quarterly report had a lot of good news and in three months’s time the Widget stock price goes up to $40/share, the trader could let the put option expire unused and exercise the call option—he could purchase the 5000 shares of Widget stock at $30/share, and then immediately sell them on the market at $40/share, making a profit of $50,000. Subtracing out the cost of the two options, the net profit is still $30,000.
The trader of course loses out if the price of Widget stock does not change much. For example, if it stayed at $30/share, then neither option would be worth anything and they would both expire unused, and the trader would be out the cost of the two options, namely $20,000. The long straddle option is an unlimited profit, limited risk strategy. The amount of possible profit is potentially unlimited (as could happen if the price of the underlying either rose rapidly or completely tanked), but the most money that a long straddle owner could lose is the price of the two options that they purchased.
The short straddle strategy is a bit more risky. It is one in which the trader is betting that the stock price will not change very much in the near future. Suppose that the above trader thinks that the results of the Widget Corporation quarterly report will be neutral, that it will not cause the stock price to move very much either way. Instead of buying a pair of put and call options, he would sell them to someone else. For example, the broker would sell party A a put option to sell him 5000 shares of Widget stock at a price of $30/share in 3 months time, and sells party B a call option to buy 5000 shares of stock from him at $30/share at the same date. The trader is taking a short position, since he is selling the options.
If the stock price does not move at all in three months time, the short straddle trader wins--both options will be worthless to their holders and will expire unused, and the broker will gain a modest profit from the sale of both options, neither of which is exercised. However, if the stock price makes a strong move either up or down, the trader could potentially lose a lot of money. If the price rises to $40/share, the holder of the put option will certainly not want to exercise their option, but the holder of the call option certainly would, and the trader would be obliged to sell the option holder 5000 shares of stock at $30/share when they are worth $40 on the market. On the other hand, the price falls to $20/share, the holder of the call option would not want to exercise their option, but the holder of the put option would, and the trader would be obliged to buy 5000 shares of stock from the put option holder at $30/share when they are only worth $20 on the market.
Consequently large losses for the short straddle strategy can occur if the underlying stock price makes a strong move either up or down at option expiration time. The short straddle is a limited profit, unlimited risk strategy. The maximum profit that a short straddle could gain is fairly small, namely, the premium collected from two unused options, but the maximum possible loss is unlimited, particularly if the price of the underlying stock rises rapidly since there is no limit to how high the stock price can go. Therefore, the short straddle is a very risky strategy which should be used only by advanced traders due to the unlimited amount of risk associated with a very large move up or down.
One of the past disasters involving a short straddle strategy was the case of Nick Leeson, who ran up big losses for Barings Bank when he had invested in short straddles on the Nikkei 225 stock market, betting that the market would not move very much overnight.. The very next day, there was an earthquake in Kobe, which sent the Nikkei significantly lower, and Leeson lost a boatload of money. He then made large risky bets that the Nikkei would quickly recover. It didn’t, and he lost another large amount of money. Losses rapidly escalated to over $1.3 billion, causing the eventual bankruptcy of Barings.
A forward contract (sometimes just called a forward) is a customized, privately-negotiated binding agreement between two parties to buy or sell an asset (known as an underlying instrument) at a preset price at a specified point of time in the future. Unlike options, both parties in the forward contract are required to buy or sell under the terms of the contract. Entering a forward contract typically does not require the payment of a fee.
The forward price (sometimes called the delivery price) is the agreed upon price of an asset at the time of the maturity of the forward contract. The spot price is the price at which the underlying asset happens to be trading on the agreed-upon date. The party who is to purchase and receive the underlying instrument at the date called for in the contract is said to be long, the other party is said to be short.
The forward contract first appeared in the 19th century, primarily for the grain market, in which farmers could arrange to be able to sell their wheat at a set price in the future. The forward contract saved many a farmer from the loss of crops and profits and helped stabilize supply and prices in the off-season. Although they originally evolved for the agricultural commodity market, forward contracts can be written on just about any sort of asset or commodity, as well as on more abstract items such as Treasury debt, currency exchanges, or on any number of other investments. Like other derivatives, forwards can be used either to hedge risk or to speculate.
Forward contracts are privately negotiated between the two parties, they are not standardized, and they are not purchased or traded on any exchange. Given the lack of standardization in these contracts, there is very little scope for a secondary market in forwards, which means that forwards are rarely bought or sold by investors subsequently from their original issuance in the primary market. The term “forward market” is a general term used to refer to the informal market in which these contracts are arranged. Since a forward contract is privately negotiated between the two parties, it is often said to be over-the-counter (OTC). No actual cash changes hands in a forward contract until the date of the maturity of the contract. In addition, no asset of any kind changes hands until the maturity of the contract.
Also, since forward contracts are not exchange-traded, there is no mark-to-market requirement, which means that there is no requirement that the current spot price of the underlying be recorded to reflect its current market value rather than its book value. In addition, neither party is required to put up any money in any sort of margin account to account for daily losses or gains. This means that a forward contract buyer can avoid almost all initial capital outlay (though some contracts might set collateral requirements). However, a forward contract specification can be customized to include mark-to-market or daily margining requirements, or it might require that the losing party pledge collateral or add additional collateral to better secure the gaining party.
Since there is generally no margin or mark-to-market requirement for forward contracts, they can be rather risky because of the danger that one or the other of the parties might default or go bankrupt and not be able to keep their part of the bargain. This means that the two parties in a forward contract must bear each other's credit risk. The fact that forwards are not margined daily means that due to movements in the price of the underlying asset, a large difference can build up between the forward’s delivery price and the spot price, and one or the other of the parties in the contract could stand to lose a lot of money at the date the contract becomes due. This creates a credit risk, since there is a danger that the supplier will be unable to deliver the required asset when the contract becomes due or that the buyer will be unable to pay for it on the delivery date.
Here’s how a forward contract works. Suppose that Judy needs to buy a house in one year's time, but she is worried that there might be a housing bubble which would result in an uncontrolled increase in housing costs which could make a new house unaffordable for her at that time. At the same time, suppose that Barbara owns a house with a current market value of $400,000 that she needs to sell in one year's time. However, Barbara is worried that the housing bubble might burst, and that housing prices might precipitously drop in a year’s time, and her house would be worth a lot less at that time, resulting in a loss for her. Both parties could hedge against these risks by entering into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $416,000. Judy, because she is committing herself to buying the underlying, is said to have entered a long forward contract. Conversely, Barbara is selling the underlying and will have the short forward contract. Judy is said to be long because she is hoping to profit from a rise in the market—she is betting that the spot price will rise above $416,000 in a years’ time. Barbara is said to be short because she is hoping to profit in a declining market—she is betting that the spot price will be below $416,000 after a year has gone by.
If Barbara’s house rises in value in a year’s time to, say, $500,000, she will still be obliged under the contract to sell her house to Judy for $416,000. This means that Judy makes money on the deal, since she is paying only $416,000 for something that is now worth $500,000. If she wished, Judy could immediately sell the house that he just bought from Barbara on the open market, making $84,000 on the deal Barbara loses, because she is forced to sell her house for only $416,000 whereas if she hadn’t taken out the forward contract, she could have sold it for $500,000.
However, if the housing market tanks and in a year’s time Barbara’s house is worth only $300,000, Barbara will win and Judy will lose, because Judy is obliged under the contract to buy Barbara’s house for $416,000. Taking positions in a forward contract is a zero-sum game--any gains that Judy makes will equal the losses that Barbara incurs.
This is how the prices for forward contracts are typically set. Since Barbara knows that she could immediately sell her house for $400,000 and place the proceeds in an interest-earning account at the bank, she wants to be compensated for the delayed sale of her house. Suppose that the risk free annual rate of return at the bank is 4%. Then the money in the bank would grow to $416,000 in a year’s time, completely risk free. So Barbara would want at least $416,000 one year from now for the contract to be worthwhile for her--the opportunity cost will be covered.
Because the forward contract is privately executed between the two parties, both Judy and Barbara should make sure that all of the terms and the contingencies are completely clear and that there are no uncertainties or ambiguities. Both parties are exposed to the risk of the other defaulting on their obligation. Judy could go bankrupt in a year’s time and not be able to afford to buy the house, and Barbara might change her mind and decide to stay in her house. Since either party in a forward contract could default on their obligation to deliver or to take delivery of an asset, forwards can be risky.
There are some forward contracts that are strictly cash-settled and do not involve any actual exchange of physical objects. In a cash-settled forward, it is a cash flow rather than a physical asset that is bought, sold, or exchanged. These types of forwards are generally based on underlyings such as interest rates, exchange rates, or indexes rather than on assets or commodities. The cash-settled forward contract is basically a Vegas-type bet that a number will go up or down over some time and is a zero-sum game, since the gain made by one is a loss taken by the other. Instead of actually exchanging the underlying, the contract is settled with a single payment for the market value of the forward at the time of settlement. If the market value of the underlying goes up, the short party pays the long party. If it goes down, the long party pays the short party.
As an example of a cash-settled forward contract, suppose that a forward contract calls for 100,000 barrels of oil to be delivered 3 months from now at a price of $55/barrel. The short party doesn’t actually own any oil and has absolutely no intention of ever selling any oil, and the long party has no intention of ever buying any oil—they are simply speculating on the direction in which the price of oil will move in 3 months time.
At the time of settlement, the forward will have a market value given by the formula
(number of barrels)(spot price/barrel – delivery price/barrel)
Suppose that the spot price of oil 3 months from now has dropped to $45/barrel, and the value of the forward is
(100,000 barrels)($45/barrel - $55/barrel) = -$1,000,000
that is, it is negative, and the long party will have to pay the short party one million dollars. On the other hand, suppose that at settlement time, the spot price of the oil has risen to $70/barrel, and the value of the forward is
(100,000 barrels)($70/barrel - $55/barrel) = $1,500,000
which means that the short party will have to pay the long party a million and a half dollars.
Forwards are a convenient vehicle for hedging. For example, an airline can hedge against rapidly rising fuel costs by purchasing jet fuel several months forward. The hedge eliminates price exposure and it doesn’t require a large initial outlay of funds to purchase the fuel. The airline has hedged without having to take delivery of or store the fuel until it is actually needed. The airline doesn’t even have to enter the forward with the ultimate supplier of the fuel—if the forward is cash settled, the hedge can be put on with any counterparty.
Another example of a derivative is a futures contract, sometimes just called a futures. A futures contract is a binding standardized contract to buy or sell a specified financial entity at a certain date in the future at a price specified today. The way that a futures contract works is quite similar to the forward contract, with the exception that futures contracts are standardized. The terms of a futures contract—including delivery places and dates, volume, technical specifications, and trading and credit procedures—are standardized for each type of contract and are not subject to negotiation by the parties to the contracts.
Traditionally, futures contracts have been bought and sold on a futures exchange or trading floor, located in a defined physical space. However, as electronic trading of these products expands, buying and selling of these futures contracts doesn’t always occur on the floor of an exchange, but rather by people sitting in front of computer terminals. There are futures exchanges in Chicago, Kansas City, Minneapolis, and New York. Brokers, who are members of the exchange, always handle the transactions. No futures contracts are executed by the parties themselves, thereby maintaining anonymity throughout the process. For example, when someone buys pork bellies via a futures contract, they have no idea of who or what they are buying them from, and someone who sells hog bellies via a futures contract has no idea to whom they are selling them to. The futures exchange makes its money by charging a commission of approximately $50 per contract.
Like a forward contract, a futures contract is a contract between two parties to buy or sell a specified asset at a specified future date at a price agreed today (the futures price). A futures contract obligates the buyer to purchase the underlying commodity and the seller to sell it, unless the contract is sold to someone else before the settlement date, which may happen if a trader wants to take a profit or cut a loss. The settlement date is known as the delivery date, or the final settlement date. The official price of the futures contract at the end of a day’s trading session is called the settlement price. The party agreeing to buy the underlying in the future is said to be assuming a long position, with the party agreeing to sell the asset in the future is assuming a short position.
Although the futures market was originally created to handle the trading of agricultural commodities such as cattle, pork bellies, soybeans, grain, poultry, or corn, today, the futures markets have far outgrown their agricultural origins, and now include strictly financial entities such as interest rates, foreign currency exchange rates, government bonds, and stocks. The trading and hedging of financial products using futures now dwarfs the traditional commodity markets and plays a major role in the global financial system.
Buyers and sellers in the futures market primarily enter into futures contracts to hedge risks or to speculate, rather to actually exchange physical goods. The futures market is a major financial hub, providing an outlet for intense competition among buyers and seller and provides a center to manage price risks. The futures market is risky and complex by nature, and is not for the risk averse. Since people who deal in the futures market can lose a lot of money very quickly, only people who know what they are doing and can stomach the risk should get involved in the futures market.
The US futures market is regulated by the Commodity Futures Trading Commission, which is an independent agency of the US government. The market is also subject to regulation by the National Futures Association, which is a self-regulatory body that is authorized by the US Congress and subject to CFTC supervision. Brokers must register with the CFTC in order to buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business. The CFTC has the power to seek criminal prosecutions through the Department of Justice in case of illegal activity, and violations of the NFA’s code of ethics can permanently bar a company or a person from dealing on the futures exchange. If you thinking about getting into the futures market, make sure that your broker or trader is licensed by the CFTC. The CFTC and the futures exchanges impose limits on the total amounts or units in which any single individual can invest, which ensures that no one person can completely control the market price for a particular commodity.
Some futures contracts may call for the actual physical delivery of the asset, but most are settled in cash without the actual delivery of the underlying asset. By participating in the futures market, a trader is not necessarily intending to actually receive or deliver any sort of physical commodity—buyers and sellers in the future market primarily enter into futures contract either to hedge risk or to speculate on the price movement of the underlying. For example, a producer of soybeans could hedge by using futures to lock in a certain price at delivery time, whereas anyone could speculate on the future price movement of soybeans without actually buying or selling any soybeans. Buyers and sellers of futures contracts have the option of exchanging an expiring contract for a new one, which is what most participants in the futures market actually do, rather than actually selling or taking delivery of any commodity
There is some amount of risk in a futures contract—the commodity might not be available for delivery at all for some cause unspecified in the contract, or one of the parties might default or renege on the contract. However, unlike forward contracts, where each party is exposed to the credit risk of the other party, with futures the exchange assumes the credit risk if either party defaults on its obligation. The clearing house does this by interposing itself as a counterparty to every trade and provides a guarantee that the trade will be settled as originally intended. For example, when somebody buys pork bellies via a futures contract, the exchange’s clearing house actually acts as the counterparty on all contracts, and provides a mechanism for settlement. The exchanges are, in turn, backed by insurance policies, lines of credit, and the financial strength of its members.
Another major difference between futures and forwards is that when you open a futures contract, the exchange will require that you open and maintain a margin account which will pay out any losses and receive any profits. This is basically a good-faith measure, used by the clearing house to ensure that you will be able to fulfill your end of the contract. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day’s trading are deducted or credited to a person’s margin account each day. The current price of the underlying is recorded on a daily basis (known as being “marked to the market”) and the amount of money in your account changes daily as the market fluctuates in relation to your futures contract, and you would be required to cover your losses on a daily basis.
The exchange also requires that when you do open your margin account, you must deposit a minimum amount of money in your account—this is known as an initial margin. This account is typically 5 to 15 percent of the contract’s value. This is somewhat different from the meaning of a margin in the stock market, where it means the use of borrowed money to purchase securities. The amount of money that must be placed in the initial margin is continually reviewed—at times of high market volatility, the initial margin requirement can be raised. When you liquidate the contract, you will be refunded the initial margin plus or minus any gains or losses
In most cases, you can buy futures with a good faith deposit or initial margin of only 10% of the value of the contract at the time of delivery. This means that forward contracts are highly leveraged instruments, which gives their owners the ability to control large dollar amounts of a commodity with a comparitavely small amount of capital. But this also means that there is a lot of risk in the futures market--the owners of futures contracts can lose a lot of money very rapidly. If the price of a futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin deposit. But if the price moves down, the same high leverage will produce large losses in comparison to the initial margin deposit.
Your account also has a maintenance margin requirement, which is the lowest amount of money an account can reach before it needs to be replensished. Maintaining an appropriate margin level affirms to the exchange that you will be able to meet the terms of the contract. If your account drops below a certain level because of a series of daily losses, your broker will make a margin call, and request that you put more money into the account to bring it back up to the initial amount. When a margin call is made, the funds usually have to be delivered into your margin account immediately, lest your brokerage get angry with you and immediately liquidate your position completely in order to make up for any losses.
The futures contract can be settled by delivering or taking delivery of the underlying commodity when the contract becomes due. However, this almost never happens in actual practice. 98% of all futures transactions are settled in cash, and the actual physical commodity involved in the underlying is not exchanged between the two parties. Often, the buyer and seller of the commodity liquidate their holdings before the contract expiration date. To do so, a buyer sells their futures contract to someone else and the seller needs to buy a futures contract from another party.
Here’s an example of how a futures contract works. Suppose that Felicia is the owner of a large chicken farm and her chickens will be ready for market six months from now. However, she is worried about the volatility of the chicken market, since there have been sporadic news reports of bird flu outbreaks in the Far East. She wants to protect herself against the price of chickens going down as a result of yet another bird flu scare. So she meets with a broker who offers her a futures contract. Let us assume that the other party in the futures contract is a poultry-processing house, which needs to buy chickens in 6 months time. Under the terms of the futures contract, Felecia agrees to sell 6000 chickens in six months time at a price of $30 per bird, whereas the poultry-processing house agrees to buy 6000 chickens at a rate of $30 per bird when they are ready for slaughter, say in 6 months time, no matter what the actual market price is at that time. Generally, Felicia is unaware of who or what the other party is, and the other party does not know anything about Felicia—the transaction is completely anonymous. Both Felicia and the poultry-processing house will open up margin accounts to handle the cash flow—the initial margin put into each account will typically be about ten percent of the worth of the contract, namely $18,000.
By entering into a futures contract, Felicia has protected herself from price changes in the open poultry market, since she has locked herself into a price of $30 per bird. She will lose out if the price per bird rises to $50 because of a mad cow scare, but she will be protected if the price falls to $10 because of news of a bird flu outbreak in Indonesia. The poultry processing house is protecting itself against a sudden and unexpected rise in the price of chickens six months from now. Felicia is said to hold the short position since she is selling the underlying and will profit if the poultry market goes down, and the poultry-processing house is said to hold the long position since they are buying the underlying and will profit if the poultry market goes up. Felicia is said to have hedged by taking out this futures contract, and has limited her worry about uncontrolled price fluctuations. The poultry processor in the futures contract has speculated that the price of chickens will rise. So in order for a futures market to work, there must be both a hedger and a speculator.
If in 6 months time the market price is above $30 per bird, the poultry-processing house will get the benefit, as they will able to buy the birds from Felicia for less than the current market price at that time. They can buy the chickens from Felicia at $30/bird and either go ahead and slaughter them for food, or they can immediately sell them on the cash market to someone else at a higher price for a financial gain. However, if the price in 6-months time drops to $25, Felicia will get the benefit because she will be able to sell her birds for more than the current market price. Under a futures contract, Felicia will not get the full benefit of a sudden rise of the price of chickens, but she is protected against an unexpected collapse of the poultry market.
The profits and losses of a futures contract depend on the daily movements of the market and are calculated on a daily basis. In the above example, Felicia and her counterparty have entered into a futures contract for 6000 chickens at a price of $30/bird. Let us assume that the very next day the price for chickens rises to $31/bird. Felicia, who holds the short position, will lose $1 per bird because the selling price just rose from the price at which she is obliged to sell her chickens. The poultry processing house holding the long position will profit by $1/bird because the price they are obliged to pay is now less that what the rest of the market is obliged to pay for the chickens. On this day, Felicia’s account is debited (6000 chickens)($1/chicken) =$6,000, and the long party’s account is credited by $6,000. Since Felicia’s margin account has now dropped to $12,000, she will probably be subject to a margin call requiring her to add more money to the account. As the market moves each day, these kinds of adjustments are made accordingly.
There is considerable risk in the futures market, both for the long party and for the short party. For the long party, the downside is the risk that the price of the commodity will rapidly drop. The poultry processing house which agreed in a futures contract to purchase chickens at a certain price at a future date is required to purchase the chickens at that price, no matter what the spot price of the chickens happens to be at the time the futures contract is due. For example, if the processing house had agreed to purchase 6,000 chickens at 30 dollars per bird, they must pony up 180,000 dollars to buy them when the contract is due, even if the price of chickens on the open market has dropped to only $3 per bird because of a bird flu scare. They would lose $162,000 on the deal.
Conversely, there is also risk for the short party. Here, the downside for the short party is the risk that the price of the chickens will rapidly rise. If the selling party has guessed wrong and the poultry price has unexpectedly risen, they can lose a lot of money. For example, if Felicia has agreed to sell 10,000 chickens for $30 per bird, and the price on the market has now risen to $60 per bird, she would have lost $300,000 on the deal, since she would have to sell her birds for only $300,000 when they are actually now worth $600,000.
Felicia and the chicken-processing house could have simply exchanged chickens to close out the contract, but this almost never happens in actual practice, and almost all futures contracts end without the actual physical delivery of the commodity. The profits and losses are kept in the margin accounts held by the two participants, and when the futures contract closes out, the party who makes a profit takes the money out of their account and the party who takes a loss will have to pay money into the account to cover the losses. A futures contract is really more like a financial position, not unlike a bet on the blackjack tables at Las Vegas. The two parties in the chicken futures contract could actually be a couple of speculators, both of whom never intend to handle chickens in any manner, rather than a chicken farmer and a poultry processing house. If the price of chickens goes up at the time of the settlement of the futures contract, the short speculator will lose money and the long speculator will make a profit. Neither party would have any need or desire to go on to the cash market to actually buy or sell the chickens after the contract expires.
On the date that either party decides to close out their futures position, the contract will be settled. If the contract was settled at $35/bird, Felicia would lose $30,000 on the futures contract and the poultry processor would have made $30,000 on the contract. But after the settlement of the futures contract, the poultry processor still needs to buy chickens, but he probably won’t actually buy Felicia’s birds, but will instead buy his poultry on the cash market for the price of $35/bird (for a total price of $210,000) because that’s the price of chickens in the cash market when he closes out the contract. However, the chicken processor’s profits from his futures contract of $30,000 will go toward his purchase, which means that he will effectively still be paying his locked-in price of only $30/bird. Felicia, after closing out her contract, can of course sell her chickens on the market at $35/bird, but because of her losses in the futures contract, she effectively receives only $30/bird.
The fact that delivery occurs at the spot price removes any incentive for either party to default on the contract when the time for delivery arrives. The spot price and the price that the exchange pays are the same, so neither buyer nor seller can gain an advantage by dealing with a source other than the exchange. It also removes any incentive for either party to actually go through with the delivery procedure. One of the major advantages of futures is that neither side is required to hold onto its position until contract expiration. Because all profits and losses associated with the transaction are already recorded in each party’s margin account (they are “marked to the market”), most futures contracts are closed out in advance. Only a very small percentage of them actually go through to delivery.
Most futures contracts are purely speculative, with absolutely no intention of ever actually exchanging any sort of commodity. Here’s how a purely speculative futures contract works. Suppose that Janet is a speculator in gold futures and is hoping and expecting that the price of gold will rise in the short term—but she certainly does not actually want to actually handle or store gold. Instead, she buys a futures contract for 1000 ounces of gold at a price of $350 per ounce. She is going long, with the expectation that the price of gold will rise by the time the contract expires in three months’ time. The exchange asks her to set up an initial margin account of $2000. Let’s say that 2 months later the price of gold increases by $2 to $352/ounce, and Janet’s margin account has increased to $4000. She will have made a 100 percent profit. She now decides to sell her futures contract to someone else to realize a profit. She never takes on the hassle and expense of actually acquiring, handling or storing any gold.
A speculator could also make money in a declining market by using a futures strategy. Suppose that Gayle is a gold speculator who is going short, and that she hopes to make a profit from declining gold price levels. She could sell a contract today at the current higher price and then buy it back after the price has declined. By selling high now, the contract can be repurchased in the future at a lower price, generating a profit for Gayle. Suppose she owns a futures contract for 1000 ounces of gold at a price of $350/ounce, with an initial margin deposit of $3000, and she sells the contract that is now worth $350,000. Assume that in three months time the price of gold has dropped to $250/ounce. She now decides that it is time to cash in on her profits. She buys back the futures contract that is now worth only $250,000. By going short, Gayle has made a profit of $100,000. But if she guessed wrong, her strategy could have resulted in a big loss.
Another common strategy used by futures traders is a spread. Spreads involve taking advantage on the price difference between two different contracts of the same commodity. The trader simultaneously buys (longs) and sells (shorts) futures contracts for two related commodities or securities. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short futures contracts. For speculators, spread-trading offers reduced risk compared to the trading outright futures, because long and short futures that comprise a spread are usually correlated and they tend to hedge one another. For this reason, exchanges have less strict margin requirements for futures spreads than they do for ordinary futures.
An intracommodity spread is one for which both futures has the same underlier (say cattle futures) but with different maturities. An intercommodity spread is one in which the two futures have different underliers, but have the same maturities.
A spread is long on one future and is short on another. Suppose that this is the month of May and you have an intracommodity spread, with two futures contracts for corn, one a long contract due in September at $6.50/bushel and a short contract due in November at $5.50/bushel. Assume that as your opening position you have agreed to buy 1000 bushels on the September contract and to sell 1000 bushels on the November contract. The spread is now $1.00, the difference between the two contracts. Suppose that in June the September contract goes up to $6.90 while the November contract goes up to $5.60. The spread is now $1.30. You could immediately close both contracts and make $0.30 per bushel. You made a net gain of $40 from buying and then selling the September contracts, while you have taken a net loss of $10 from selling and then buying the November contracts. This means you have made a net profit of $300.
The swap is a different sort of derivative. A swap is a contract between two parties to exchange two streams of cash flows on or before a specified future date. These cash flow streams can be defined in almost any manner—they can be based on the underlying value of things like currencies, exchange rates, bonds, interest rates, commodities, stocks, or other assets. With a swap, you can change the character of an asset without having to liquidate the asset or renegotiate the terms of the asset. A swap can be used to hedge against certain risks such as interest rate fluctuation, or can be used to speculate on changes in the expected direction of underlying prices. Swaps are usually traded over-the-counter and are tailor-made for the counterparties, but some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange.
Here’s an example of how a swap works.
Suppose that Felicia has been a successful chicken farmer, so successful that she now wants to open up her own chicken processing plant. She needs to obtain financing for this project, but the lender, Lenny, rejects her request for a loan because she has too many variable-rate loans outstanding. Lenny is worried that if interest rates rise, Felicia won’t be able to pay her debts. Lenny tells Felicia that he will only lend to her if she can convert her loans to a fixed rate. Unfortunately, her other lenders won’t do this because they are also expecting that interest rates will rise, and are hoping that they will.
Unable to convert her variable-rate loan to a fixed rate, Felicia starts considering other options. Felicia meets with Craig, who owns a chain of restaurants. Craig has a fixed-rate loan about the same size as Felicia’s and Craig wants to convert his loan to a variable-rate loan because he is of the opinion that interest rates will decline in the near future. However, Craig’s lenders won’t change the terms of his loan because they think that interest rates will go up instead.
Craig wants to convert his fixed rate loan into a variable rate loan, and Felicia wants to convert her variable-rate loan into a fixed rate loan. But neither of their lenders will let them do this. To get around this problem, Craig and Felicia decide to swap loans. They work out a deal under which Felicia’s payments will go toward Craig’s loan, and Craig’s payments will go toward Felicia’s loan. Neither Craig’s nor Felicia’s lenders have to even know that the swap has taken place. Although the names on the loans haven’t changed, and there is no exchange of principal amounts, their swap contract allows them both to get the type of loan they want. This can be a risky strategy, since if one of them defaults or goes bankrupt, the other will be snapped back to their old loan, which may require a payment for which they are unprepared.
This deal between Felicia and Craig is known as an interest rate swap. It is sometimes called a “plain vanilla” interest rate swap, since the two cash flows are being paid in the same currency. In cutting the swap deal, Felicia is said to be hedging against future interest rate rises, and Craig is said to be speculating that interest rates will go down in the future. If interest rates decline, Craig wins and Felicia loses, because Craig is now paying the lower variable rate interest rate and Felicia is still paying on a fixed rate loan. But if interest rates go up, Felicia wins because she is still paying the fixed interest rate and Judy loses, since Craig is now paying a higher interest rate on a variable-rate loan.
Interest rate swaps are very popular and highly liquid instruments. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. Interest rate swaps are also used speculatively by hedge funds or other investors who expect and hope to profit by a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would simply purchase cash bonds, whose value increased as rates fell. Today, investors with a similar expection could enter into a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Unlike standardized futures contracts, swaps are not exchange-traded. They are customized contracts that are traded in the over-the-counter market between private parties. In most cases, firms and financial institutions dominate the swaps market, with very few individuals actually participating. Since the swaps are over-the-counter, there is some risk of a counterparty defaulting on the swap. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap.
Another popular type of swap is the currency swap, which deals with the different cash flows that take place in different currencies, such as US dollars and Euros. By entering into a swap, the US party could convert a loan involving US dollars into one involving Euros. A currency swap is a foreign exchange agreement between two parties to exchange certain aspects (either the principal or interest payments or both) of a loan in one currency for equivalent aspects of a loan of equal value in another currency. Currency swaps are over-the-counter derivatives and are somewhat similar to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal as well as the interest. Currency swap maturities can be negotiated for at least 10 years. They can be used to lock in the current exchange rate, to hedge against the risk of exchange rate fluctuations or to speculate on the expected direction of a change in exchange rates.
An example might be a US-based company that needs to borrow money in Euros to expand its operations in Italy and at the same time an Italian-based company that needs to borrow the same amount of money in US dollars to get into the US market. Each company is worried that fluctuations in the exchange rate between the two currencies might result in them having to pay back their loans in more expensive currency. Suppose that the current exchange rate is 1 dollar = 0.7425 Euros. If the exchange rate in a year’s time shifts to 1 dollar = 0.85 Euros, the American-based company will be paying back its loan in cheaper dollars, which means that they will have to come up with fewer dollars to pay back the same loan. On the other hand, the Italian-based company will now have to come up with more Euros to pay back the same loan. If the companies have already borrowed the money, they could agree to swap cash flows only, so that each company’s finance cost is in that company’s domestic currencies. Currency swaps were originally created to get around government-imposed exchange restrictions.
A total return swap is one in which the two parties agree to swap periodic payment over the specified life of the agreement. One party makes payments based on the total return from a specified reference asset, whereas the other makes fixed or floating payments.
An inflation derivative (sometimes known as an inflation-indexed derivative) is a financial device that is used by individuals to protect themselves against potentially large levels of inflation. It is used to transfer inflation risk from one counterparty to another. The most common type of inflation derivative is a swap in which a counterparty’s cash flows are linked to a price index and the other counterparty is linked to a conventional fixed or floating cash flow. In most cases the Consumer Price Index is used to measure the differences in annual inflation.
An inflation protected security has a rate of return that is adjusted for inflation, and guarantees a real rate of return, which protects investors from inflation. Examples are Treasure Inflation-Protected Securities, provided by the government, but private sector companies also provide these securities. However, many investors prefer to get their inflation protection from derivatives because unlike inflation-indexed bonds, a significant amount of capital is not required and it is more flexible. But inflation derivatives require the buyer to provide a small premium to the swap provider.
A credit derivative is a privately-held bilateral contract between two parties whose value derives from the credit risk on some sort of financial asset or entity. It is a bilateral contract between a buyer and seller under which the seller sells protection against the credit risk of the entity. It can be used to manage exposure to credit risk. They are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of the participants. Regular derivatives, such as forward contracts and options, can be used as credit derivatives, depending on the amount of credit risk in an investor’s other positions.
A creditor who is concerned that one of its customers might not be able to repay a loan can protect themselves against such a loss by transferring the credit risk to another party while keeping the loan on its books. Let us suppose that George is a financier who has given out a whole bunch of loans at favorable interest rates, but is worried that some of the businesses that he has loaned money to might fail and default on their loans.
Suppose that Karen now approaches George asking for money to start up a new film production company. Karen has a lot of collateral to back up the loan. Furthermore, the loan would be at a higher interest rate because of the highly volatile nature of the movie industry. But George doesn’t have very much capital available because he had already loaned it out at significantly lower rates. George would like to loan money to Karen, because he would get a significantly higher interest rate. However, he does not have the cash on hand to lend Karen anything.
A possible solution is for George to protect himself against loss by transferring the credit risk on these lower-interest loans to another party while still keeping the loans on his books. George will pay this other party a fee for assuming this risk. This is known as a credit derivative. George then sells the credit derivative to a speculator at a discount to the actual loan value. George has in effect “sold” his low-interest loans to the speculator and has gotten a lot of cash back, enough money so that he can now lend out this money at a higher rate. Although George will not see the full return on his original low-interest loans, he gets his capital back and he is now free to lend it to Karen at a higher interest rate to get her movie production operation going. George has accepted more modest returns on his loans in exchange for less risk of default and more liquidity.
The speculator will make money on the deal, provided that none of George’s loans goes into default. However, the speculator assumes some risk, since he/she will lose money if any of George’s loans goes into default. By selling the credit derivative to the speculator, George will get less money than he would have gotten from his original loans, but he no longer has to worry about the risk of any of these loans defaulting. In addition, George now has an influx of fresh cash, which he can lend out at a higher interest rate.
The speculator can cover the risk of some of George’s loans defaulting by buying a credit derivative themselves from some other company to cover any potential losses. In turn, this company could protect itself against loss by buying yet another credit derivative from some other concern, and so on and so on.
A credit default swap (CDS) is a type of credit derivative contract between two counterparties. The underlying in this type of derivative is some sort of credit risk on just about any sort of debt—it can cover things like municipal bonds, emerging market bonds, mortgage-backed securities, loans, or even corporate debt. The buyer of the CDS makes periodic payments to the seller of the CDS, and in return receives a payoff if the underlying financial instrument (known as the reference entity) undergoes some sort of credit event. The relevant credit events that are specified in the transaction can be any number of different things—possible examples are a failure to pay in relation to a covered obligation, a default, a restructuring, a bankruptcy, a default on an obligation or that obligation being accelerated, or even a downgrading of the reference entity owner’s credit rating. The buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product.
By the use of a credit default swap, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. What is being “swapped” in a credit default swap is the risk of default inherent in debt obligations, not the debt itself. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon the occurrence of a credit event (such as a default or a bankruptcy) affecting the obligations of the reference entity specified in the transaction. If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle and the seller of the swap will be required to pay for the buyer’s losses.
Here’s how it works. Suppose that Joan has invested heavily in corporate bonds issued by the Widget Corporation, and has a lot of money tied up in them. She has been duly receiving regular payments from the company to cover the principal and to pay the interest. She has been generally satisfied with the money she has been receiving from Widget. However, she has recently heard rumors on the street that the Widget Corporation is in some sort of serious trouble and she is worried that the company could default on its bonds, leaving her with worthless paper. So she goes to Reliable Investment Company to see if she can arrange some sort of hedge against this possibility. They offer her a credit default swap—in exchange for a monthly fee, Reliable Investment Company will agree to guarantee the credit worthiness of the Widget Corporation to her. If the Widget Corporation actually does default on its bonds, The Reliable Investment Company will pay Joan the full value of the bonds that she holds. Some of the money she had been receiving regularly from Widget will now have to go to the Reliable Investment Company, but Joan will now be able to sleep better at night, free from the worry that Widget could default and leave her with worthless bonds.
The credit default swap contract is not actually tied to the bond or debt per se, but instead references it, so the underlying is actually the credit risk on the reference entity rather than the reference entity itself. A credit default swap differs from a credit derivative or an interest rate swap is that neither the bonds themselves nor the interest payments on the bonds are swapped. The buyer of a credit default swap retains their bonds and continues to collect the interest on his or her bonds—the only thing that is exchanged is the risk of the credit default buyer defaulting on his or her loan or perhaps undergoing some other sort of “credit event” as specified in the contract. In such an event, the seller of the credit default swap must immediately pay off the loan. In exchange for assuming this risk, the seller of the credit default swap receives periodic payments from the buyer.
Note that the protection buyer does not necessarily have to actually own the debt of the reference entity, and does not even have to suffer any sort of loss if the specified credit event actually takes place! So you can buy credit protection on a bond even if you don’t actually own the bond. It is almost as if you could buy fire insurance on a house that you don’t own. So credit default swaps can be used for purely speculative purposes—a Vegas-type bet that the reference entity will be able to meet its debt obligations, or even a bet that the reference entity will ultimately default. A credit default swap can be used to hedge against the risk of a company going bankrupt, or it can be used to speculate against the solvency of a company in a gamble to make money in case it fails.
The credit default swap was originally created as a hedge against credit loss, but quite soon there were far more credit default swaps that were taken out for purely speculative purposes than there were that were used for insurance. For example, there are currently about $5 trillion worth of bonds issued in the world, but the total amount of money that people had bet on these bonds via credit default swaps was $60 trillion.
Sometimes, banks and hedge fund managers bet both ways—they buy CDS protection on one hand and then sell CDS protection on the same reference entity to someone else at the same time. Here’s how this sort of deal works. Suppose that a hedge fund has a hunch that Risky Company is going to go down and default on its bonds, currently worth one billion dollars. The hedge fund manager goes out and buys a CDS on Risky Company’s bonds from insurance company ABC, say for $20 million per year. If Risky Company does indeed fail, insurance company ABC will have to pony up one billion dollars to the hedge fund. Over the next few months it appears more likely that Risky Company is actually going to fail—its profits have gone down and there are a lot more negative stories appearing about it in the press. The hedge fund can take advantage of this decline by selling a CDS to someone else, say to Secure Investment Consultants. The hedge fund can charge more for this CDS, say $40 million per year, since the risk of default is now perceived to be higher. The hedge fund is now paying $20 million but is taking in $40 million, and it is making a net profit of $20 million per year. Of course, they won’t get a profit of a billion dollars if Risky Company defaults on its bonds, but the fund’s position is completely hedged, since if Risky Company defaults the hedge fund will owe Secure Investment Consultants $1 billion, but the hedge fund will collect $1 billion from ABC insurance company. So the trades balance out, but in the meantime the hedge fund has been taking in $20 million a year. This procedure is sometimes called “netting”, since ABC insurance company and Secure Investment Consultants can themselves take out counterbalancing positions by buying or selling CDSs to other entities. An expanding web of these counterbalancing CDSs can rapidly expand throughout the economy.
Most credit default swap contracts are not actually held until expiration, but are regularly traded over the counter. The value of a CDS contract will fluctuate regularly, based on the increasing or decreasing probability that a reference entity will have a credit event. If a lot of people think that there is an increased probability that a corporation will default on its debt, the contract will be worth more for the buyer of the contract and worth less to the seller. The seller of the CDS will compensate for this increased risk by charging the new buyer a higher rate. The opposite occurs if the probability of a default appears to have decreased. An investor can exit a credit default swap contract by selling it to another party, by offsetting the contract by entering another contract on the other side with another party, or by offsetting the terms with the original counterparty. CDS’s became very popular as credit risks exploded during the last seven years in the United States. Banks argued that with CDS they could spread risk around the globe. Most credit default swaps are in the 10-20 million dollar range, with maturities between 1 and 10 years.
One of the problems with credit default swaps is that the market for them is over-the-counter and is unregulated. There is no central reporting mechanism to determine the value of credit default swaps, or even a mechanism to determine how many of them are actually out there at any one time. Contracts get traded so often that it is difficult to know where one actually stands at the end of each transaction. The credit default swap market is very opaque—at any one time it is not clear who actually has CDSs and where they got them from. It might happen that the seller of a CDS might not have enough money on hand to honor the contract if there is a default, and a lot of contracts are very heavily leveraged with borrowed money. There is a danger that a widespread downturn in the market could cause massive, cascading defaults.
CDS contracts have been compared with insurance. In many ways a CDS contract is sort of like an insurance policy because the buyer pays a premium and in return receives a sum of money if a specified credit event occurs. However, there are a number of important differences between CDS and insurance. For one, banks and insurance companies are regulated by the government, whereas the credit default swap market is not. In addition, the buyer of a CDS need not necessarily own the underlying security or other form of credit exposure, and the buyer does not even have to suffer a loss if a default actually occurs. In contrast, in order to buy an insurance policy the party must actually own or have control of the thing being insured, and must suffer an actual loss if the event insured against actually occurs. Insurance companies must demonstrate to regulators and inspectors that they have enough money on hand to cover potential claims, but a seller of a CDS is not required to maintain any reserves and there is no guarantee that the money will be there to pay off the buyer in the event of a default. Insurance carriers manage risk primarily by the use of statistics and the Law Of Large Numbers (meaning that they sell a lot of policies in the hope that the probability that they will have to pay off on any one of them is fairly small) whereas the dealers in CDS manage risk primarily by hedging with other dealers. For traditional insurance, the things which trigger a payoff are statistically uncorrelated—if I get into a car crash, it doesn’t increase the probability that you will have one. This is not necessarily true for bonds—once a few bonds start defaulting, it is more likely that other bonds will default as well. Just one default can create a domino effect, in which other bonds are driven into default. Investors lose confidence in the market, interest rates rapidly rise, institutions become reluctant to lend money to anyone, and borrowers find that they can’t get new capital.
The credit default swap financial tool was originally devised back in the mid 1990s by a team made up of JPMorgan bankers as a means to mitigate risk when they loaned money to other people. The problem was that when they made these loans, federal law required that the bankers had to maintain a huge amount of capital in reserve just in case any of these loans went bad. The credit default swap was devised as a means for banks or lenders to get around this capital reserve requirement, providing a sort of insurance scheme by which the bankers could be protected if any of these loans defaulted. This would make it possible to free up all that capital held in reserve by the bank to cover possible defaults. The bank would then be able to remove the risk from its books and free up the reserves so that they could lend the money to someone else.
Historically, bond issuers had very rarely if ever gone bankrupt, and banks and hedge funds figured that they could make a lot of money by selling CDSs on these bonds, collecting the premiums, and almost never have to pay out anything. CDSs soon became a way to make a lot more money a lot more quickly than was possible through more traditional investment methods. Rather than purchasing bonds outright, which requires money up front and offers only a relatively low rate of return, investors could instead sell CDSs on these bonds. The selling of a CDS requires no up-front money, the seller can simply keep the premiums as they keep rolling in, and all the seller has to do is promise to pay if something bad happens. Since it was thought the risk of default was negligibly small, profit is limited only by how many CDSs one can sell.
The credit default swap idea was quick to catch on. This new tool now made it possible for banks to get their credit risk off their books and to transfer it over to nonfinancial institutions such as insurance companies and pension funds. Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after well-publicized corporate failures like those of Enron and WorldCom, it became clear there was a big need for protection against similar sorts of company implosions, and credit default swaps proved to be a valuable tool to protect against such disasters. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
CDS are traded over the counter and are unregulated, and the Federal Reserve from the time of Alan Greenspan onward has insisted that regulators keep their hands off. The prevailing opinion was that the use of credit default swaps helped banks and other financial institutions to manage risks better by spreading risk to a more diverse range of investors. In fact, credit default swaps were credited with helping to cushion the impact of the dot-com bust, the Sept. 11, 2001 terrorist attacks, and the collapse of Enron, WorldCom and other companies.
The housing boom came along shortly thereafter. The Federal Reserve started cutting interest rates and Americans started buying homes in record numbers. Mortgage loans became easier and easier to obtain, and banks and financial institutions started giving out mortgages to just about anyone who applied, no matter what their credit rating or their ability to repay happened to be. Noting the long-term trend of rising housing prices, lots of people were encouraged to enter into subprime and adjustable rate mortgages in the expectation that they would be able fairly quickly to refinance on more favorable terms. A subprime mortgage is a type of loan granted to people with poor credit histories who would not be able to qualify for a conventional mortgage—generally, the interest rates are higher and often the interest rate that is charged is adjustable, with a relatively low initial fixed rate (sometimes known as a “teaser”) that converts after a couple of years to a floating rate which is generally much higher. Housing prices kept going up and up, and people started buying expensive houses that were way beyond their means, since they could be assured that their houses would continue to increase in value so that they could sell them at an even greater price at a later time should it become necessary to do so. A full-blown housing “bubble” was soon underway.
Mortgage-backed securities now became the hot new investment. These are securities that are secured by a mortgage or a collection of mortgages. In order to create a mortgage-backed security, mortgage loans were purchased from banks and mortgage companies and were pooled together, and bundled into bonds that were issued by the Federal National Mortgage Association (Fannie Mae), by the Government National Mortgage Association (Ginnie Mae), by the Federal Home Loan Mortgage Corporation (Freddie Mac), as well as by private institutions such as brokerage firms, banks, hedge funds, pension funds, and even homebuilders. Mortgage-backed securities soon became a way for smaller banks to issue home loans to customers without having to worry about whether these customers were actually able to pay off these loans. Foreign investors started speculating in the US housing market by buying up these mortgage-based securities. So if you had a mortgage on your house issued initially by your local bank, it might now be actually owned by someone else, perhaps even bundled into a bond sold and resold many times over, perhaps now even owned by a Chinese company.
For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. The danger of an actual default on a mortgage-backed security was perceived to be so small, so that these credit default swaps were seen to be such a great deal that everyone decided to jump in, which led to massive growth in the CDS market. Soon, insurance companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps.
And then the housing bubble burst. As the economy began to turn down and people started to lose their jobs, they could not keep up the mortgage payments on their overpriced houses, and they went into bankruptcy. Refinancing became more difficult, and defaults and foreclosures began to increase as the easy initial mortgage terms expired and adjustable rate mortgages got reset higher. The prices of houses started to collapse—homeowners soon found that they owed more money on their houses than they were currently worth on the market (such mortgages were said to be underwater), encouraging them simply to walk away from their mortgages. Credit rapidly tightened, and new mortgages became more and more difficult to obtain, and the market started to be glutted with houses that could not be sold, driving housing prices still lower. Many mortgage-backed securities now became nearly worthless, and these supposedly low-risk securities started defaulting at a high rate. The banks and hedge funds selling these supposedly low-risk CDSs now started having to pay out a lot of money.
AIG was a big loser in this collapse. AIG is the largest commercial and industrial insurer in the nation. They had sold a lot of CDSs on these mortgage-backed securities, without hedging by offsetting the risk by buying very many offsetting CDSs. AIG had been selling CDSs as if they were simply an extension of their traditional insurance business. They soon found out they were not. There is no correlation between traditional insurance events; if your neighbor gets into an automobile accident, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one bond defaults, it starts a chain reaction that increases the risk of others also going bust. Investors get skittish even when one bond issuer defaults, worrying that the issues plaguing one big player will affect another. So investors start to bail, the markets freak out and lenders pull back credit. When these mortgage-backed securities started defaulting in large numbers, AIG was faced with having to make good on billions of dollars worth of credit default swaps that were out there, and people started to worry if AIG had enough money on hand to cover these losses. The problem was exacerbated by the fact that so many institutions were tethered to one another through these swap deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. Soon it became clear that AIG wasn't going to be able to cover its losses, and AIG stock tanked. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire market, contributing to the panic. AIG was deemed too big to fail and had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had sold to investment banks, insurance companies and scores of other entities. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the credit default swap market that JPMorgan unleashed 14 years ago.
Since credit default swaps are privately-negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. The system of nesting of credit default swaps, in which every trade is matched by a counterbalancing trade, introduces a chain of interlocking connections that can be vulnerable to even the smallest failure. If just one party in the chain is unable to honor their contracts, then losses rapidly multiply. If one party has a problem, the very soon everybody else has a problem. The failure of some small bank in Ohio could cause other banks to fail, and pretty soon the entire banking system is threatened with collapse. Banks become fearful of dealing with one another because they don’t know that sorts of deals they have made, and they become reluctant to lend out any more money.
Given the CDSs' role in this mess, it's likely that the federal government will have to start regulating them. Maybe there should be some sort of central clearinghouse for credit default swaps, or an exchange could be established where they could be publicly traded like futures. Perhaps there needs to be a requirement that sellers of credit default swaps need to demonstrate that they have enough reserves on hand to meet their obligations should a default take place.
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