Monday, April 14, 2008

Derivatives Overview: Uses and Abuses

Derivatives: An Overview and Thoughts

What are they, Do they work, Uses, Abuses

What are they?

Derivatives are assets whose values are derived from values of underlying assets. These underlying assets can be commodities, metals, energy resources, and financial assets such as shares, bonds, and foreign currencies. There is a huge variety of derivative products that are traded on organized exchanges or OTC markets. 

Most derivatives can be summarized in the following categories:

Forwards: A contract between two parties. One party agrees to buy a commodity or financial asset on a date in the future at a fixed price, while the other agrees to deliver that commodity or asset at the predetermined price. Both sides are obligated to complete the deal, however there is a risk one side might default on its obligations. These are not traded on exchanges because they are negotiated directly between two parties.

Futures: A contract essentially the same as a forward except the deal is struck via an organized and regulated exchange. There are three key differences between forwards and futures. 1. Futures contract is guaranteed against default. 2. They are standardized. 3. They are settled on a daily basis.

Swaps: A swap is an agreement made between two parties to exchange payments on regular future dates. Swaps are OTC products and there is a risk for default. Swaps are used to manage or hedge risk associated with volatile interest rates, currency exchange rates, commodity prices, and share prices. It can be considered a series of forward contracts. 

Options: A option gives the holder the right to buy or sell an underlying asset at a certain date at a predetermined price. A call is the right to buy. A put is the right to sell. The buyer pays a premium to the writer of the contract because the option provides flexibility as the buyer can choose whether or not to exercises it. Options are OTC and exchange products.  

Participants of derivatives are dealers, hedgers, speculators, and arbitrageurs. Dealers work for major banks and securities houses. Hedgers consists of corporations, investment institutions, banks and governments that want to reduce exposure to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices. Speculators are those such as hedge funds that want to bet on the prices of commodities and financial assets and on key market variables such as interest, indices, and exchange rates. It is usually much cheaper to speculate using derivatives than on the underlying. As a result, the risks and returns are much greater. Arbitrageurs exploit mispricing in the market to create risk-free profits. Those that are not members of a future and options exchange have to employ a broker to fill their orders. 

Trading in these markets are regulated by Commodity Futures Trading Commission (CFTC) and International Swaps and Derivatives Association (ISDA) and the National Futures Association (NFA).

Do they work?

The derivatives business has unfortunately been tied to financial disasters and scandals. They have provided some of the most devastating headlines. In 1994, Orange County lost $1.6 billion because of its involvement with derivatives known as “reverse floater” whose values moves inversely with market interest rates. The collapse of Baring Bank in 1995 was a partially the result of speculative trading on futures contracts on the Japanese stock market by Nick Leeson. Long-Term Capital Management, the infamous hedge fund, was forced into bankruptcy in 1998 because of trading losses including those on complex derivatives deals. And in 2002, John Rusnack lost Allied Irish Banks around $700 million from currency-based deals. 

The reason for these enormous losses is that derivatives are often significantly leveraged. OTC derivatives can effectively provide participants with almost unlimited leverage.  A slight change in interest rates can cause a massive change in the price of the derivative. Another reason why derivatives are so risky is they can become worthless fairly easily. An out-of-the-money option once expired is worthless. In a sense it is all or none.

However, these are spectacular events that stick out in the public’s mind. These stories tell of poor risk -control and bad management practices rather than anything that is inherent specifically to derivatives. Financial institutions have lost billions of dollars on activities as mundane as lending money to governments, trading bonds, and stocks. For example, due to poor controls and management oversight, Jerome Kerviel lost Societe Generale an estimated 4.9 billion euros from trading low risk portfolios and market indices as was discovered in early 2008. 

Derivatives are valuable because they provide efficient ways to manage and transfer risk. A  business owner who is exposed to changes in market prices can enter into an appropriate derivative contract and the risk can be assumed by a trader or speculator who is prepared to live with uncertainty in return for the prospect of achieving an attractive return. A large financial institution can withstand more risk than a small corporate and thus may choose to engage in derivative products for a reasonable compensation. Nobel Laureate Kenneth Arrow predicted this would increase economic prosperity since people would be more prepared to engage in risk-taking activities. It could also serve to improve the quality of our prediction of future events. Derivatives may not reach Kenneth Arrow’s ideal “complete market” but they do provide a global network for intelligent assessment, management, and distribution of risk on a large scale.



Derivatives can be combined in many ways to create new risk management solutions. A 1999 survey found the most common uses for derivatives are risk-management/hedging, obtaining funding, and investments. Derivatives can create instruments that depend on a wide range of variables including currency exchange prices, stock market indices, default rates on corporate debt, commodity prices, or even the occurrence of natural disasters. Some structured products are aimed at more cautious investors. Others actually increase the level of risk. Structured securities whose returns are linked to the level of default on a portfolio of loans or bonds are especially interesting in light of current events. Since these derivative products are based on the level of default, when the level of default is revealed to be highly uncertain or inaccurately estimated, the derivatives can be severely affected. As with the case of the securitization of U.S. mortgages and bank loans, revelations of higher default rates can cause billions of dollars of losses. 

Derivatives have become increasingly complex and more dangerous. Investment bankers have become more creative about the type of assets that are securitized and have sold almost anything that generates future cash flows which can be forecasted with a reasonable degree of accuracy. Derivative bonds issued have been backed by royalties, future collections of unpaid taxes, and even future ticket sales at art galleries.


I think the major problem has not been securitization, derivatives, or even the trading of derivatives, but rather the credit rating agencies’ inability to give accurate ratings which has caused such great losses in the financial sectors. Credit rating agencies almost have a conflict of interest as they derive their business from the corporations they rate. For example, Moody’s Investors Service had rated 94% of the $190 billion in mortgage-related and other structured-finance CDOs issued in 2007 and increased profits by nearly fivefold in the past six years. A recent article by Aaron Lucchetti on WSJ (April 2008) describes how Standard & Poor’s, Fitch Ratings, and Moody’s are under fire for putting top ratings on securities that collapsed in value and are now being investigated by Congress and SEC. Another problem may be the lack of regulation because modern credit derivatives (which are derived from creditworthiness) such CDOs have come into existence relatively recently. Due to high levels of speculation in the early 1990s, financial institutions created controls such as middle office and risk management units. Similarly, it seems better regulations and controls are needed for credit derivatives to ensure stability and safety.

Furthermore, there is a lack of transparency in the investment banking world. The repeal of the Glass-Steagall Act in 1999 may have caused in more risk, greed, and speculation in the banking world. The lack of understanding by many of the investors and maybe even some the sellers also contributed to the financial turmoil we are facing. Lastly, I believe the inability of financial institutions and investors to use discretion on the appropriate amount of leverage has caused severe problems and risks for themselves and global markets. 

Some critics have even accused investment banks of purposely creating derivatives with clouded, ambiguous values to deceive and confuse buyers. One writes, “In this manner the Wall Street firms could sell packages that were overpriced. Way overpriced. Obscenely overpriced.” Some argue derivatives can be easily abused as they can be overly complexed and made with the intent to deceive investors, while bankers make off with huge profits. As we have recently found out, what seems like a great way to diversify is actually not such a sound decision because the system can be easily gamed, knowledge of borrowers may be quite limited, and incentives to police loans are not present.

However, others argue “if we measure losses per unit transacted, then the banking industry is hundreds of times more risky than the derivatives industry. An analogy may be made here about the risks of planes versus cars.” Despite the abuses, the only thing that truly matters is that derivatives are here to stay because they provide an invaluable means to businesses, investors, and governments.

For in-depth information, I suggest reading “Risk Takers: Uses and Abuses of Financial Derivatives” by John Marthinsen which was published in March 2008.

For PDF with footnotes, visit the article on Scribd.

No comments: