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Financial Derivatives Explained

What Are Financial Derivatives? ­ The History

Options

Options are arguably the simplest example of a series of instruments known as financial derivatives. Derivatives get their value by predicting the future value of another, underlying stock, bond, asset, or commodity. By their very nature, derivatives are constantly evolving products of financial engineering that can either be traded over the counter or on exchanges.

An option contract can be thought of as the right to purchase (a “call option”) or sell (a “put option”) an asset (i.e. common stock), at a specified price (“strike price”) at a certain time in the future (“expiration date”). The value of an option, as you might expect, is driven in part by the current price of the underlying asset. Each option also carries a risk component, and this component is usually measured by historical risk of the underlying asset. The two categories of options are American and European – with the only difference being the European options can be exercised before the expiration date.

In 1973, Massachusetts Institute of Technology professors Robert Merton and Myron Scholes collaborated with University of Chicago’s Fischer Black in an effort that yielded the Black-Scholes-Merton (or simply, Black-Scholes) model of options pricing. The resulting work ultimately won a Nobel Prize for it’s widespread applicability throughout the financial services and corporate world.[1] The formula itself is simply an adaptation of the heat transfer equation from physics.

Also in 1973, the Chicago Board of Options Exchange (CBOE) opened for business, making exchange-traded options in the United States a reality for the first time. This innovation, while hardly the first time options were sold, introduced a level of increasing risk and complexity to the markets that has gone largely unregulated.

By June 2014, according to the Bank of International Settlements, the notional value of the market for financial derivatives such as options reached a staggering amount just shy of three-quarters of one Quadrillion U.S. dollars.[2] Other estimates put the notional amount in excess of a Quadrillion dollars. The largest exposure by far is to financial services companies such as global retail and investment banks and hedge funds. A sample of the projected notional value of derivatives held by global banks is shown in Figure 1.

Investing in derivatives typically happens because of one of two reasons. The first reason is because a party wants to limit their exposure, or “hedge” as it is referred to in the financial world, against an unknown risk. In these instances, derivatives can be thought of as insurance to offset a firm or an individual’s exposure. The second, and somewhat more nefarious, reason is speculative in nature. These transactions are a type of betting. So-called hedge funds, for example, are a bit of a misnomer since they are only in business to trade for a profit. In practice, most derivatives are used to speculate whether a security will rise or fall in value.

A hedge fund or an investment bank’s involvement in these speculative derivatives transactions becomes many times more hazardous to both the investor and, consequently, the economy at large, when debt financing comes into play. Combined with the ability to borrow money (i.e. “leverage”), these largely unregulated derivatives have contributed to an unsettling instability of the global financial system. This leveraged investing renders derivatives many times more risky. Left unchecked, this unpredictable type of trading activity has led to market failures such as the collapse of Long-Term Capital Management hedge fund and the bankruptcy of Lehman Brothers investment bank.  To be sure, financial guru Warren Buffett has gone so far as to describe derivatives as “weapons of financial mass destruction”.

The market for option derivatives is relatively new and evolving. As such, there is talk of trading derivatives for things such as weather, the weekend box office returns for movies, and even terrorist attacks.

One of the more interesting applications is in the field of Real Options. The use of Real Options is a relatively newer practice that combines of valuation of projects and components of business strategy. Real Options are a way of making strategic decisions that substitute approximations for the market-driven data used to price more garden variety financial options in the Black-Scholes formula.

One example of a project using Real Options is Ford Field, The Detroit Lions football stadium, which was built on an abandoned warehouse. Instead of imploding the warehouse with the demolition of the aging Hudson’s building, the designers incorporated the existing footprint of the warehouse into the blueprint of the stadium.[3]

Forwards and Futures

Beyond options, derivative instruments climb the ladder of increasing complexity. Forwards and futures contracts are foreign exchange currency purchases and sales geared to limit exposure to exchange rates.

For instance, suppose a manufacturing company in the U.S. is selling to a French company. In the interest of customer service, the U.S. firm might accept payments from the French concern in Eurodollars. The American firm might arrange a forward contract with their bank to offset their liability to changes in the exchange rate between the Euro and the U.S. dollar set for the expected date of the payment.

If the U.S. firm decides to do nothing, they are then ultimately engaged in two different lines of business. The first is their day-to-day specialty, the kind of manufacturing operations that they know intimately. The second is foreign currency trading, something that the manufacturer is likely ill-equipped to deal with. In order to simplify their matters and focus on their core business, a forward contract with their bank arranges for the company to shield itself, or hedge, against changes in the exchange rate.

Future contracts are a lot like forwards except they’re traded on an exchange and expire at pre-specified quarterly dates rather than as a private arrangement with the company and a bank. The U.S. firm may not be able to match the exact date of the expected payment in Euros. For this reason, currency futures are more likely to be considered for speculation than for hedging and are thus more popular in the investment and financial services world than in corporate finance.

But futures are not simply foreign currencies. They can represent commodities as well. It’s possible to buy futures in anything from precious metals, to crude oil, to the yield of next year’s cotton crop. In the 1983 movie “Trading Places”, Eddie Murphy’s character engages in a scheme to profit and defeat his rivals by concocting a news story about a winter storm that threatens the market for orange juice.[4]

Index Funds

 An Index Fund is a type of mutual fund that enables an investor to bet on the performance of an entire market exchange to rise or fall. Index funds are exchange-traded products built to mimic the movement of Indexes such as the Standard & Poor’s 500 (SPDRS) or NASDAQ Composite. One way to mitigate wild swings in the market or bet on long-term growth of the economy is to utilize Index Funds.

Swaps

 Swaps are among the most complex derivative instruments, and they’re usually reserved for large corporate concerns. The easiest way to think of a credit default swap is that it is insurance on the purchase of a bond. When investing in a bond, the purchaser is essentially lending the issuer money. In order to minimize their exposure to the issuer’s default in an event such as bankruptcy, the purchaser takes out a credit default swap from a third party. The third party is usually an investment bank, who guarantees the bond in turn for the payments from the purchaser.

In an interest rate swap, a party whose exposure to interest in the form of floating payments purchases insurance to make payments at a fixed rate instead (or vice-versa). Also arranged by banks, these types of transactions are typically reserved for large corporate entities trying to hedge their risk to large swings in the macro economy.[5]

Swaps can also be speculative in nature, and the dangerous of this were on full display during the Global Financial Crisis of 2008. The worst of the bad actors was American International Group (AIG), who was deeply involved in credit default swaps, to the tune of $527 Billion. The larger share of these instruments reduced the amount of cash European holders had to have on hand for their Asset Backed Securities (see below) like CDOs. The rest of these allowed AIG to double down on their bet that companies in their portfolio would not experience a “credit event”.[6]

Asset Backed Securities and the Housing Crisis

 Asset Backed Securities derive their value from other financial instruments such as loans or bonds. Loans, bonds and insurance policies are combined by financial engineers and sold back to investors through large investment banks as securities in a process known as “securitization”.

As these derivative instruments move further and further away from observable value of markets and instead trade over the counter, their component risk increases. For example, the crash attributed to the housing bubble in 2008 was due to Asset Backed Securities known as Collateralized Debt Obligations, or CDOs. AIG, for example, had invested a notional amount in excess of $61.4 Billion when it had to turn to the United States government for a bailout.[7]

CDOs are a way to repackage large swaths of home loans and resell the right to collect these debts to investors. The problem with CDOs as it played out in the housing crash is that the repackaging process is clouded with a layer of obfuscation that hid low-performing (i.e. “toxic”) assets known as subprime loans.

The price of real estate was inflated in most markets. Along with the shared notion that housing prices would always rise, the inflated real estate prices led to foreclosures and a market-wide shift toward situations where the value of the outstanding loan exceeded the fair market value of the house itself – the loans were “underwater”. A widespread number of loans went into default. Homeowners chose to walk away rather than throw worse money after bad money, and as a result, the derivative CDOs value came crashing down. Without underlying assets to back up their value, the toxic-backed CDOs were rendered relatively worthless.[8]

In his testimony before Congress after his tenure in 2008, when asked how his free market approach had failed the economy in housing crisis, Greenspan referred to a “flaw” in his model largely attributed to refer to the belief and practice in limited regulation in the financial markets.[9] This vague allusion to a systemic risk to the financial system is disconcerting. It suggests that for all the risk analysis that goes on in the financial services industry related to speculative derivatives trading, there are market forces at work that are largely out of even the influence of the Chairman of the Federal Reserve.

Other Significant Market Failures Due to Derivatives Trading

The fall of hedge fund Long Term Capital Management in 1998 and subsequent bailout under the policy “Too Big To Fail”[10] is one example where leveraged speculation on a grand scale went horribly awry. The Greenwich, Connecticut hedge fund had borrowed and run up trading deficits that far exceeded their holdings in assets. Most of these holdings were derivatives, and as their exposure to derivatives continued to mount, the firm did more and more betting, ultimately leading Federal Reserve to broker a deal where major players in the nation’s banking industry each took hits to unwind the hedge fund’s various positions.[11]

The crash of Lehman Brothers Investment Bank in 2008 was similarly caused by overexposure to derivatives speculation. In that instance, the investment bank was not bailed out under the “Too Big to Fail” policy, but instead allowed to collapse before selling off its assets. In contrast, just a few months earlier, investment bank Bear Stearns had received consideration under “Too Big To Fail” before it was ultimately sold to JP Morgan Chase. In the end, Lehman was broken into pieces and sold off to several different global banking concerns for pennies on the dollar.[12] The Great Recession was at its peak.

The Emergency Economic Stabilization Act of 2008 (EESA) enacted at the end of George W. Bush’s Presidency sought to use government funds to bail out overleveraged financial institutions that had bet on derivatives as well as large corporate entities such as General Motors that had lost significant market value due to the financial industry’s inability to monitor itself. The EESA stood in stark contrast to the notion of free markets, and ultimately gave impetus to legislation known as Dodd-Frank.

In 2009, The American Recovery and Reinvestment Act (ARRA) took place under the Obama Administration. This was a second phase of government relief that, combined with the EESA, would come to be known as the Troubled Asset Relief Program, or TARP. No small part of these emergency actions in late 2008 and early 2009 meant to relieve banks of their toxic mortgage-backed CDOs and would also be regulated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, often referred to simply as Dodd-Frank.

The bailouts were much maligned at the time they were enacted. Even to its proponents, the TARP Acts were considered a necessary evil. There was a great deal of concern that the American taxpayer was on the hook for the moral hazards of Wall Street. While $700 Billion was authorized under TARP, the lifetime cost is estimated to be about $37.5 Billion according the Department of the Treasury.[13]

Dodd-Frank Act

In response to the Global Financial Crisis of 2008-2009, the United States Congress moved to enact legislation that would lead to stricter regulation of the financial industry. It did so against the lobbying of the conservative members of the House of Representatives and Senate, who continued to court the financial services industry even after the Global Financial Crisis demonstrated that these banks’ risk management practices were fundamentally flawed. More progressive members of both legislative bodies, led by Representative Barney Frank (D) of the House Financial Services Committee and Senate Banking Chairman Chris Dodd (D), joined forces to enact sweeping legislation to ensure that the derivative-driven shocks that led to the Global Financial Crisis would not be repeated.

Dodd-Frank may signal the end of the practice of “Too Big To Fail”, as it has provisions to break up banks and insurance companies whose exposure to derivatives and other risky assets pose a systemic risk to the financial system. Dodd-Frank prevents the use of public funds to bolster private institutions in most instances, instead calling for the “orderly liquidation” of those firm’s assets in ways dissimilar to traditional bankruptcy protection. Instead of allowing a workout or a bailout, Dodd-Frank calls for the dissolution of firms whose risk management practices fall short of Federal regulators’ “stress tests”.

Dodd-Frank created several new Federal agencies to deal with speculation in the derivatives markets, increasing capital requirements and providing contingencies to call for breaking apart banks whose risk profile exceed minimum standards. The Dodd-Frank Act includes the Lincoln Provision, or “Swaps Pushout Rule”, which prohibits federal funds from future bailouts for companies engaged in speculative swaps, but still allows FDIC-guaranteed entities to use swaps for hedging.[14]

International Banking and Hedge Fund Concerns

Despite the assurances that Dodd-Frank is meant to offer, the International Banking Community still stands significant risk of additional derivatives-driven financial crises. In addition, the largely unregulated U.S. hedge fund industry makes liberal use of derivatives trading on margin.

While foreign governments and groups such as the European Union have their own regulations for managing derivative transactions, the notion that any one of several immense financial entities could default on their trading obligations leaves rise to significant counterparty risk. This risk represents a potential ripple effect on the global economy. The failure of any number of global banks due to their bets on derivatives trading could trigger a meltdown of the global economy in ways the newfound domestic regulations would be unable to prevent. The policy of “Too Big to Fail” may be more aspirational than realistic when markets fickle tendencies swirl their influence over the global economy.

Perhaps more dangerous than the investment banking industry is the number of hedge funds operating in the United States with relative impunity. Thus far, the Federal Reserve and other regulatory bodies have been animate about keeping hedge funds largely unregulated. With the fall of Long Term Capital Management as precedent, hedge funds have proven to be a significant risk to the financial system, and the failure of any one of several large funds could lead to shockwaves throughout the global economy. Due to these loose reporting requirements, it is difficult to estimate the systemic risk these hedge funds present to the economy. Roughly 11,000 hedge funds are operating in the U.S. with value of $2.6 Trillion.[15] If the relative size of this market is not concerning, the lack of regulation in the hedge fund industry should be.

[1] The Pricing of Options and Corporate Liabilities, Journal of Political Economy 1973.

[2] Bank of International Settlements report June 2014: Over the counter (OTC)=$691 Trillion, Exchange-traded = $73.5 Trillion for a total of $764.5 Trillion.

[3] “First Degree of Freedom: Going for Three – Options in Theory and Practice”, www.ambidextrouseconomics.com, 2012.

[4] “Trading Places”, Paramount Pictures, 1983

[5] “Principles of Corporate Finance” Richard Brealey and Stewart Myers, 2013

[6] “The AIG Bailout”, Washington and Lee Law Review. William J. Sjostrom, Jr. November 1, 2009

[7] Ibid

[8] “The Big Short”, Michael Lewis, 2011

[9] “Greenberg Concedes ‘Flaw’ in His Market Ideology” Bloomberg News, October 23, 2008.

[10] “Too Big To Fail” refers to the philosophy that a large bank’s failure could lead to the collapse of the entire financial services industry, and these institutions were thus subject to assistance from the government and/or the investment community at large.

[11] “When Genius Failed: The Rise and Fall of Long Term Capital Management”, Roger Lowenstein, 2001.

[12] “The Bankruptcy of Lehman Brothers: Causes of Failure & Recommendations Moving Forward”, Amirsalah Azadinamin, March 14, 2013.

[13] www.treasury.gov

[14] “Swap Talk: Why Are People Fighting Over Dodd-Frank and Derivatives?”, Wall Street Journal, Victoria McGraine, December 10, 2014.

[15] “Hedge Fund Industry Snapshot: $2.6 Trillion in 11,000 funds”. Lawrence Delevingne  CNBC, August 31, 2014.

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