——— FINANCIAL POLICY FORUM ———

Derivatives Study Center

www.financialpolicy.org                                                                                                                      1660 L Street, NW, Suite 1200

rdodd@financialpolicy.org                                                                                                                Washington, D.C.    20036

 

 

PRIMER

 

DERIVATIVE INSTRUMENTS

2000, latest update 2004

 

     A derivative is a transaction that is designed to create price exposure, and thereby transfer risk, by having its value determined – or derived – from the value of an underlying commodity, security, index, rate or event.  Unlike stocks, bonds and bank loans, derivatives generally do not involve the transfer of a title or principle, and thus can be thought of as creating pure price exposure, by linking their value to a notional amount or principle of the underlying item.[1]

 

     Forward contract.   The simplest and perhaps oldest form of a derivative is the forward contract.  It is the obligation to buy or borrow (sell or lend) a specified quantity of a specified item at a specified price or rate at a specified time in the future.  A forward contract on foreign currency might involve party A buying (and party B selling) 1,000,000 Euros for U.S. dollars at $0.8605 on December 1, 2002.  A forward rate agreement on interest rates might involve party A borrowing (party B lending) $1,000,000 for three months (91 days) at a 2.85% annual rate beginning December 1, 2002. 

 

     Consider the case of the farmer entering into a forward contract to sell corn upon harvest.  The farmer needs to plant corn in the spring, when the spot price is $3 per bushel, in order to harvest in October when the spot price is unknown.   In order to avoid the risk of a price decrease, the farmer could enter into a forward contract to sell 50,000 bushels of corn to the local grain dealer or grain elevator between October 5th and 15th, at a price of $3.15 bushel (the quality, such as No. 1 yellow corn, would also be specified).  The farmer would thus be long corn in the field and short corn in the forward market; the grain dealer would be long corn in the forward market.  The farmer would thereby hedge his price risk by shifting his long corn price exposure to the grain dealer through the forward contract.  The grain dealer could either hold the long price exposure as a speculator or hedge the risk away by entering another forward contract – this time as a seller – with either a speculator or another hedger such as a food processor that wants to hedge its price exposure to possible future price increases.

 

     Although the grain dealer is likely to have similar contracts with many of the farmers in his local market, and is likely to a have a standard template for each such forward contract, the contracts are deemed to be unique, bilaterally negotiated contracts, and their price is not reported to the market, the press, the government’s data collection agency or any government regulator.  The forward contract may be collateralized by the title to the crops.  The contract would be settled by the farmer delivering the quantity and quality of corn to the specified location on the specified date in exchange for the dealer making a payment to the account of the farmer. 

 

     This is an example of a typical commodity forward contract, but its economics are not unlike forward contracts for securities, loans or other items.  Delivery terms will likely vary according to the nature of the underlying cash or spot markets.  There may be “MAC” clauses for major adverse conditions or “acts of god” clauses that allow for the early termination or abrogation of the contract.  Similarly, forward contracts on electricity are likely to recognize the potential inability to transfer power to or from a point on the grid.

 

     The forward markets for Treasury securities in the “when-issued” market, foreign currency, and forward rate agreements are very large and liquid.   

 

     Foreign exchange forward.   A foreign exchange forward is a contract in which counterparties agree to exchange specified amounts of foreign currencies at some specified exchange rate on a specified future date.  The forward exchange rate is the price at which the counterparties will exchange currency on the future date.  The forward rate is usually negotiated so that the present value of the forward contract at the time it is traded is zero; this is referred to by describing the contract as trading at par or “at the market.”  As a result, no money need be paid at the commencement of the contract because the market value of a par contract is zero; although a contract is at the market, counterparties sometimes agree to post collateral in order to insure each other’s fulfillment of the terms of the contract.

 

     Futures.   Futures contracts are like forwards, but they are highly standardized, publicly traded and cleared through a clearing house.  The futures contracts traded on organized exchanges in the United States are so standardized that they are fungible – meaning that they are substitutable one for another.  This fungibility facilitates trading and results in greater trading volume and greater market liquidity.  Liquidity, in turn, improves the way in which all the relevant market information becomes accurately reflected in market prices.  This process of establishing efficient market prices is known as the price discovery process. 

 

     Futures are traded on organized exchanges.  In contrast to of negotiations in the OTC market, the trading on exchange “pits” or their electronic quote matching platforms are very public and multilateral.  Trading in the pits involves the very public statement (most likely in the form of a yell or shout) of bid and offer prices known as “open outcry.”  Open outcry is not only public, but also multilateral because all market participants can hit a bid, lift an offer, or raise or lower the quote.  In this environment, all market participants can observe the bid, offer and execution prices and thereby know whether the prices they are agreeing to are the best prevailing market prices.  This knowledge is more difficult to ascertain and the information is more likely to be incompletely disseminated in a non-transparent, OTC trading environment. 

 

     Clearing houses are used to clear exchange-traded futures contracts.   Trades from the exchange floor are reported to the clearing house, and the contracts are written anew, or novated, so that the clearing house becomes the counterparty to every contract.   In this manner, the clearing house assumes the credit risk of every contract traded on the exchange.  

 

     The presence of a clearing house in the center of market trading means that every market participant has a top-ranked (AAA) credit risk as a counterparty.  Instead of having to perform a credit evaluation of every actual and potential trading partner, the futures trader has only to evaluate the creditworthiness of the clearing house, and in the case of U.S. futures exchanges, the clearing houses all carry a AAA credit rating. 

 

     Clearing houses have top-ranked credit ratings because they are very well capitalized.  This makes their ability to perform on or fulfill the terms of futures (and options) contracts all but certain.  Their capital includes the paid-in capital plus the callable capital of clearing members of the exchange.  In addition, the clearing house maintains an emergency line of credit with an array of banks.  Moreover, the clearing house collects, and updates daily and even more frequently if required, the margin accounts of all those who hold positions in exchange-traded contracts.

 

     The front line defense against contract default is the margin accounts.   Although futures contracts are highly leveraged, with the maintenance margin rates ranging from 1429:1 for the Eurodollar contract to 17.4:1 for the S&P 500 futures (as of May 2004), the level of margin is generally set so that it would have covered 95% to 98% of the largest daily price movement in the previous six months.  The exchange also reserves the right to make intra-day margin calls to protect the integrity of the futures (and options) market in the event of an exceptionally large price swing.  If a trader fails to meet margin requirements, the exchange reserves the authority to liquidate the trader’s positions.

 

     Another implication of novation is that it allows existing positions to be offset or completely liquidated by entering into contracts from the opposite side.  For example, party A has bought 10 futures contracts for natural gas in November.  This existing long position of 10 contracts can be reduced to 2 contracts – either the next minute or at any time up to the expiration in November – by selling 8 contracts.  The short selling of 8 contracts offsets all but 2 of the existing long position of 10 contracts.

 

     How do futures contracts work?  Consider the example of a farmer hedging by entering into a futures contract to sell October corn at $3 a bushel.  The standard contract size is 5,000 bushels and so the notional value of the contract can be thought of as $15,000.  The margin requirement for the position is say $750 in initial margin to open the position, and then $500 for maintenance margin.  The first day the price rises by $0.02 so that the value of the short position loses $100 (the two cents times the 5000 bushels specified in the contract).  The clearing house debits $100 from the farmer’s margin account which now totals $650.  The new amount in the account does not fall below the maintenance level, and so no further action is required.  If the loss were to reduce the level in the account to below the maintenance level, then the farmer would be required to add resources to the account (cash or Treasury securities) until it reached the higher initial margin level.  If the price moves in favor of the farmer, then the clearing house credits the farmer’s margin account and the farmer is allowed to withdraw excess funds from the margin account.  This process of adjusting the margin account to the daily changes in futures prices is known as marking the position to the market value, or “mark to market” for short.

 

     How does the farmer, who is a short-hedger, benefit from the futures contract.  Consider the result of the futures price falling to $2.80 a bushel in October.  The farmer closes out the position by buying a corn contract in the days prior to expiration (otherwise the farmer would have to deliver the corn at one of the designated locations in the contract, and this is most likely less convenient than the local elevator).  What is left of the farmer’s margin account?  In the process of marking to market the farmer’s short position, the clearing house will have added a net amount of $1,000 (5,000 bushels times the $0.20 drop in price) to the farmer’s margin account over the holding period of the futures contract.  This $1,000 in payments to the farmer should offset the effect of a 20 cent decline in the market price of 5,000 bushels of corn harvested in October.  In sum, this daily mark-to-market process will generate a cash flow as funds are added to, or drained from, the margin account.  These changes, taken in sum, will adjust the final gain or loss on  the position to the initial price for which the contract was traded.

 

     Options.    An option contract gives the buyer or holder of the option (known as the long options position) the right to buy (sell) the underlying item at a specific price at a specific time period in the future.  In the case of a call option on a stock, which is the type granted as employee stock options, the holder has the right to buy the underlying stock at a specified price – known as the strike or exercise price – at a specified time in the future.  If the spot market price of the stock were to exceed the strike price during the time period in which the option could be exercised, then the holder would be able to exercise the option and buy at the lower strike price.  The value of exercising the option would be the difference between the higher market price and the lower strike price.  If the market price were to remain below the strike price during the period when the call option was exercisable, then the option would not be worth exercising and it would expire worthless.

 

     In the case of a put option, the option holder has the right to sell the underlying item at a specified price at a specified time in the future.  Imagine a situation in which a farmer has purchased a put option on the price of corn.  If the spot price of corn were to fall below the strike price during the period in which the option was exercisable, then the farmer would be able to exercise the option and sell at the higher strike price.  In the way, the put option acts as a form of price insurance that guarantees a floor or minimum price.  Like an insurance policy, the price paid for the option is called a premium.  The value of exercising this put option would be the difference between the higher strike price and the lower market price.

 

     Whereas the holder of the option has the right to exercise the option in order to buy or sell at the more favorable strike price, the writer or seller of the option (known as the short options position) has the obligation to fulfill the contract if it is exercised by the option buyer.  The writer of an option is thus exposed to potentially unlimited losses.  The write of a call option is exposed to losses from the market price rising above the strike price, and the writer of a put option is exposed to losses if the price of the underlying item were to fall below that of the exercise price.  

 

     American style option can be exercised over a specified period which is usually the life of the contract, while European style options can be exercised only on the expiration date.

 

     A call options writer can hedge by covering the short call option with the underlying item.  For example, a company granting stock options to its employees will cover its short call position in either of two ways.  The first way is to set aside some of its authorized but unissued stock whose price will offset any cost of fulfilling the short call position.  The second way is to borrow money and buy back outstanding shares in the stock market so that any increase in the price of these shares will cover the expense of fulfilling the option.  In contrast, a put option writer can hedge by obtaining a short cash or futures market position in the underlying item.  For example, a grain dealer selling a put to a farmer can hedge by selling in the futures market.

 

     The value or price paid to buy an option is known as the premium.  What determines the value of an option is the length of time before the option expires, the volatility in the price of the underlying item, the current market price and the strike price.  Although the specifics of this relationship are more precisely expressed in closed form equations such as the Black-Scholes formula or options pricing models such as the Binary or lattice models, the basic economic reasoning is the same.  The value of an option serves as an insurance policy against a rise (or fall) in the price of the underlying item, and so it follows that insurance against a highly volatile price is worth more than insurance against a very stable price.  This is akin to higher auto insurance rates for risky drivers.  The value of an option also increases with the length of time to expiration because a greater maturity means there is more time, and hence greater likelihood, for the option to be exercised at a profit.  This is akin to paying more for two years of auto insurance than for one year of auto insurance.

 

     In sum, a call gives the option buyer the right to buy at the strike price, and so the option is profitable if the price goes up.  A put gives the option holder the right to sell at the strike price, and so it is profitable if the price goes down.  Here is a useful memory device: call up – put down.  Farmers can hedge by buying puts on corn.  If the price falls the farmer is covered, and if the price rises then the farmer receives the benefit of the higher price.  The seller of an option, however, is obligated to pay if the price moves past the strike price.

 

     Interest rate options.  Interest rate options provide insurance against rate increases (caps), rate decreases (floors), and both hikes and drops (collars).  A cap option has an exercise interest rate that creates an interest rate ceiling to protect against a rate hike, while a floor option has an exercise rate that creates a minimum rate to protect against a fall in interest rates.

 

     A costless collar can be constructed by selling a put in order to pay for the cost of buying a call (or vice versa).  For example,  party A wants to protect itself from short-term interest rates – represented by LIBOR – rising above 6% by buying an option that allows it to borrow at say 6%.  In order to pay for this option, party A will write or sell an option that allows the counterparty to lend at say 4%.  This obligates party A to borrow at 4% when interest rates fall below that level.  The combined effect of the long and short options positions is that party is protected from interest rates rising above 6%, and this protection is paid for by selling protection to someone else that rates will not fall below 4%.  By selling the protection, party A gives us the benefits of borrowing at short-term interest rates below 4%.

 

     Exotic options.   Exotic options are no longer new, but the rapid growth in these more complicated instruments makes them noteworthy.   Here are some of the established types of exotic options.

 

     One class of more complicated options – known as barrier options – contain knock-in or knock-out provisions.  A knock-in option requires that the underlying price or interest rate rise above, or fall below, a critical threshold before the option is exercisable.  For example, a knock-in call option might require that the spot price first fall below a specified threshold before the option is exercisable, while a put option might require the spot price first rise above a specified threshold in order for the option to be exercisable.  A knock-out option contains a provision that prevents the option from being exercisable if the underlying price rises above, or falls below, a specified threshold.  By reducing the exposure of the option writer, these barrier provisions are designed to lower the option premium in order to reduce the cost of purchasing the option.

 

     Another class of exotic options is called path-dependent options.  Also known as “Asian options,” these are structured so that the option holder receives the best price, or alternatively the average price, during the exercise period.  This look-back provision means that the options buyer will get the highest exercise price on a call, the lowest on a put, and thus is not faced with the dilemma of when to exercise the option and lock-in the benefit.  A similar look-back structure grants the option owner the average price over the period in which the option could have been exercised.  This provision also eliminates the decision of when to best exercise the option.

 

     Swaps.  Swap contracts, in comparison to forwards, futures and options, are one of the more recent innovations in derivatives contract design.  The first currency swap contract, between the World Bank and IBM, dates to August of 1981.[2]

 

     The basic idea in a swap contract is that the counterparties agree to swap two different types of payments.  Each payment is calculated by applying some interest rate, index, exchange rate, or the price of some underlying commodity or asset to a notional principal.  The principal is considered notional because the swap generally does not require the transfer or exchange of principal (except for foreign exchange and some foreign currency swaps).  Payments are scheduled at regular intervals throughout the tenor or lifetime of the swap.  When the payments are to be made in the same currency, then only the net amount of the payments are made.

 

     For example, a “vanilla” interest rate swap is structured so that one series of payments is based on a fixed interest rate and the other series is based on a floating or variable interest rate.  A foreign exchange swap is structured so that the opening payment involves buying the foreign currency at a specified exchange rate, and the closing payment involves selling the currency at a specified exchange rate.  Thus it is akin to a spot transaction combined with a forward contract.  A foreign currency swap is structured so that one series of payments is based on one currency’s interest rate and the other series of payments is based on another currency’s interest rate.  An equity swap has one series of payments based on a long (or short) position in a stock or stock index, and the other series based on an interest rate or a different equity position.  

 

     Interest rate swaps are financial instruments used to create future price exposure in interest rates in order to allow hedging and speculation in interest rates.  Payments in an interest rate swap contract are designed to match interest rate payments on bonds and loans.  For instance, take the situation faced by a corporation that has borrowed through a variable interest rate loan or a floating rate note.[3]  That corporation is exposed to the risk that short-term interest rates will rise during the life of the loan or note.  In order to hedge against this exposure, the corporation can enter into an interest rate swap of the same maturity so that the floating rate payments are swapped for fixed rate payments.

 

     A foreign exchange swaps differs from an interest rate swap because the principal is exchanged (due to the fact that the payments, which must be in currency, amount to the “principal” in the transaction).  A typical foreign exchange swap begins with a start leg that is indistinguishable from a spot transaction in which one currency is exchanged for another at the present spot rate.  The second, or close leg, is a forward transaction at the present forward foreign exchange rate.  Thus a foreign exchange swap is essentially the combination of a spot and forward foreign exchange transaction.

 

     Swaps contracts are traded in over-the-counter (OTC) derivatives markets, and in the United States they are not subject, i.e. are excluded from, to the Commodity Exchange Act.  

 

     Foreign exchange swap.  A foreign exchange swap is simply the combination of a spot and forward transaction (or possibly two forwards). The start leg of the swap usually consists of a spot foreign exchange transaction at the current spot exchange rate, and the close leg consists of a second foreign exchange transaction at the contracted forward rate. For example, a local investor enters a foreign exchange swap of pesos against dollars in which it buys $100,000 today at an exchange rate of $0.050 per peso (thus paying 2,000,000 pesos), and contracts to sell $100,000 dollars (i.e. buy pesos) at $0.0475 in 180 days.  The local investor first receives $100,000 in the start leg, and then upon the swap expiration date pays $100,000 in exchange for receiving 2,105,263 pesos in the closing leg. This 10.8% annual rate of return in pesos is due to the depreciation of the peso against the dollar (or appreciation of the dollar against the peso) and reflects the fact that the peso rate of return from investing in the local currency is higher than the U.S. dollar rate of return.

 

     Foreign exchange forwards and swaps are used by both foreign and domestic investors to hedge foreign exchange risk. Foreign investors from advanced capital markets who purchase securities denominated in local currencies use foreign exchange forwards and swaps to hedge their long local currency exposure.  Similarly, foreign direct investments in physical real estate, plant or equipment are exposed to the risk of local currency depreciation.  Local developing country investors who borrowed in major currencies in order to invest in local currency assets are also exposed to foreign exchange risk, and they too use foreign exchange forwards and swaps – as well as futures and options where available – to manage their risks.

 

     Of course foreign exchange forwards and swaps were also used for speculation in these local currencies.  Derivatives enabled speculators to leverage their capital in order to take larger positions in the value of local currencies.  It means that developing country central banks must watch the exchange rate in two markets, the spot and forward, in order to maintain their fixed exchange rates.

 

     Forwards and foreign exchange swaps are not always highly collateralized (measured as a percentage of the principal).  Collateral is less likely to be used for trading between the major market dealers, and collateral is lower for less volatile financial instruments such as currency.[4] This enables foreign exchange derivatives users to obtain greater amounts of currency exposure relative to capital, and therefore it can leave foreign exchange derivatives counterparties exposed to greater credit risk. The largest source of credit losses in the derivatives markets in recent years were due to defaults on foreign currency forwards in East Asia and Russia (Swaps Monitor, 1999).

 

     Structured notes.  Structured notes contain features of both conventional credit securities and derivatives.  The term “note” usually refers to a public or private credit instrument like a bond, and may have a maturity that ranges between two and ten years.  The term “structured” refers to attached derivative or other contingent payment schedule.  Structured notes are part of a broader class of financial instruments called “hybrid instruments” which contain features of both securities and derivatives.  Examples of hybrid instruments include familiar  instruments such as callable bonds, convertible bonds and convertible preferred stock.  In the 1990s, putable bonds and loans were used to lend to developing countries. 

 

     The put option allowed the lender to demand immediate repayment of the loan in the event of a financial crisis or other “credit event” in the developing country.  Their role in contributing to the financial crises in developing countries during that decade has made them controversial.  The IMF estimated in 1999, using available public databases, that there were $32 billion in debts putable through the end of 2000 for all emerging countries. Of the total $23 billion of this is from East Asian issuers, and $8 billion was from Brazil.[5]  Of this $23 billion, $10.6 billion was in the form of bonds issued from East Asian countries.

 

     One well known structured note is called a PERL — principal exchange rate linked note. These instruments are rated as investment grade and denominated in U.S. dollars, but their payments were linked to a long position in the value of a foreign currency.  The compensation or premium for holding this exchange rate exposure was a higher than normal yield in comparison to a similarly rated dollar denominated notes.  If the foreign currency exchange rate remained fixed, or did not decline too far in value, then the higher yield would be realized.  A devaluation or a substantial depreciation, however, could cause the return of the note to fall below the norm and in the event of a major depreciation the structured note might realize a negative return.

 

 

 


[1])  The exceptions to this are foreign exchange forwards and foreign exchange swaps which usually involve the exchange of principal.  Non-deliverable foreign exchange forwards are consistent with this distinction.

[2])  The design of the swap is thought to have originated from the practice of hedging cross-currency interest rates by making back-to-back loans.  Smithson, Charles W., Clifford W. Smith, Jr., and D. Sykes Wilford. 1995. Managing Financial Risk – A Guide to Derivative Products, Financial Engineering, and Value Maximization.  Irwin Publishing, New York.

[3])  A floating rate note (FRN) is a two to ten year debt instruments whose interest payments are set each period by a designated short-term interest rate such as LIBOR or the U.S. Treasury bill rate.

[4] )  Volatility is less in comparison to local currency securities whose risk is the product of both the foreign exchange risk and the security price risk. 

[5])  IMF. 1999. Involving the Private Sector in Forestalling and Resolving Financial Crises.  Policy Development and Review Department.   Washington, D.C.  Note that the disaggregated figures in the tables do not add to $23 billion due to rounding and the exclusion of non-crisis countries such as Vietnam.