A derivative is
contract that is used to transfer risk. There are many different underlying risks, ranging from fluctuations
in energy prices to weather risks. Most derivatives, however, are based on financial
securities such as common stocks, bonds and foreign exchange instruments. This
chapter will explain, in broad terms, the following points:
❑ what derivatives are;
❑ how they are used;
❑ how derivatives can reduce risks such as price risk;
❑ how they can also increase risk – the aspect of
derivatives that receives most attention from the media;
❑ how some recent derivatives disasters occurred; and
❑ the ways in which some basic derivative contracts such as
forwards, options, swaps and futures work.
Derivatives have changed
the world of finance as pervasively as the Internet has changed
communication. Their growth has exploded during the last 30 years as ever more
risks have been traded in this manner. By the end of 1999, the estimated dollar
value of derivatives in force throughout the world was some US$102 trillion –
about 10 times the value of the entire
US gross domestic product.1
Insurance is the
traditional method for sharing risks. We will use the concept of insurance when
discussing derivatives because insurance is a familiar notion and most people
understand it. However, although insurance and derivatives share common
features in that they are both devices for transferring risk, there are also
distinct differences. The risks covered by insurance are generally different
from those that are dealt with by derivatives.
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We first need to
clarify the meaning of the word “risk”. “Risk” has a specialised meaning in an
insurance context: it refers to the chance that a future
event might happen with bad consequences for somebody – for example an airline might lose someone’s
baggage. This event is uncertain in that it may or may not happen. If it does
not happen, you are no worse off but if it does, there is an adverse
consequence that could involve an economic loss or something else untowards.2 The more usual meaning of
“risk” has positive as well as negative undertones. In business and investment
decisions risk involves both the prospect of gain as well as the chance of
loss. When there is a wide variation in the range of outcomes we say that a
project “carries a lot of risk”. If there is little variation in the range of
outcomes we say that it “carries very little risk”. We willingly take on risks
all the time – risk taking is a pervasive human and business activity.
Individuals and firms undertake risky ventures because of their potential
rewards even though there is the possibility of loss. Indeed, we have a basic
intuition that high expected returns are associated with high risk.
Insurance risk, then,
relates only to downside risk. Business risk, on the other hand, involves both
an upside chance of gain and a downside possibility of loss. No one likes pure
downside risk and we would like to dispose of it if we could. We can sometimes
do this by entering a contract with an insurance company whereby we pay the
premium up front and the insurance company reimburses us if a specified
event happens. The policy specifies what the payment will be under
different outcomes and is one way of eliminating downside risk.
A derivative is also a
contract where the ultimate payoff depends on future events. To that extent it
is very similar to insurance. However, derivatives are much more versatile
because they can be used to transfer a wider range of risks and are not
restricted to purely downside risks.
Contracts that serve a
useful economic purpose such as reducing or transferring important types of
risks are the ones most likely to survive and flourish. Thus, insurance
contracts that serve to transfer risks from consumers to insurance companies
are pervasive. One of the reasons why derivatives have become so popular is
that they enable risks to be traded efficiently. Different firms
face different risks and attitudes to risk vary across firms as well as
individuals. These factors increase the gains from trade. The same event may
have opposite impacts on two different firms. For example, a rise in the
price of oil will benefit an oil-producing company because it receives
more money for its product. The same price rise will hurt an airline company
because it has to pay more for fuel. However, one can envisage a contract based
on the price of oil that would make both companies better off.
The concept behind
derivatives is simple. First, the risk is sliced up into standardised pieces,
then these pieces are traded in a market so that there is a price for all to
see. Those who want to dispose of the risk sell it and those who are willing to
take on the risk buy it. The idea is that those players who are most able to
bear the risk will end up doing so at market prices. In a competitive market it
can be argued that the market price provides a fair basis for exchange.
SOME SIMPLE DERIVATIVES
With advancing technology
it is now possible to write derivatives on a broader range of underlying assets and variables. There has been remarkable innovation in the development of new
derivatives. In this section we shall look at two simple types of derivatives.
Common stocks
If you own 100 common
shares of General Electric you actually own a very tiny piece of this huge
company. Common stocks are very flexible vehicles for risk transfer. They
are, in fact, early examples of derivatives. Their basic structure illustrates
four simple yet powerful concepts that foreshadowed subsequent developments in
derivatives:
❑ Divisibility of
the claim. The division of the total-ownership
pie into identical little slices is a very simple way to distribute risk.
❑ Upside
appreciation. Common stocks do well when the firm
does well, so they provide a way to share in the firm’s good fortunes.
❑ Downside
protection. Common stocks provide a way of
limiting the investor’s downside risk. Because of limited liability, the
maximum a shareholder can lose is the initial investment made to buy the share.
This protection does not exist under some other forms of ownership such as
certain types of unlimited partnership.
❑ An organised
market. Publicly traded stocks trade on an
organised market. The prevailing market prices should accurately reflect
their current value.
These four features make common stocks extremely efficient
tools for transferring risk. Financial derivatives have magnified such
features.
A forward contract is an important example of
a derivative. It is an arrangement, made today, to buy something
in the future for a fixed price. Consider the example of
buying a house. Normally there is a period between the signing of the purchase
contract and my taking possession of the property. This contract to purchase
the house is an example of a forward contract. In other words, I agree to buy the house in three
months’ time and to pay the agreed
purchase price at that time. The seller also agrees now to sell me the house in three months’ time. In the jargon of forward contracts, I have a
long position in the forward contract
or, more simply, I am . The seller is said to have a short
position in the forward contract
or, more simply, is short the forward contractA forward contract can be
written on almost any type of underlying asset. The owner of a forward contract
has the obligation to buy the underlying asset (or commodity) at a fixed
date in the future for a fixed price.
The price to be paid for
the asset is termed the delivery price or the contract price. This price is fixed
at inception and does not change over the term of the contract. In contrast,
the price of the underlying asset will change as time passes. If the price of
the asset rises a lot over the term of the contract, the asset will be worth
more than the contract price at the delivery date. In this case fortune has
favoured the person holding the long position because they can buy the asset
for less than its market value. However, if the price of the asset falls during
the life of the contract, the asset will be less than the contract price at the
delivery date. In this case fortune has favoured the person holding the short
position because they can sell the asset for more than its market value.
The parties have agreed in advance to exchange the asset for the
contract price at a fixed rate in the future. However, when the delivery
date arrives, one of the parties will show a profit on the contract and
the other will show a loss. We will explain later how the contract (delivery)
price is determined at the outset so that when the forward contract is set up,
the terms of the contract are fair to both parties.
HEDGING AND SPECULATION
Corporations use forward contracts to manage
price risk. A gold mining company, Sperrin Corp (a hypothetical company named
after a mountain range in Northern Ireland that does contain traces of gold)
faces the risk that the price of gold will fall. To protect itself against this
risk Sperrin could enter a forward contract to sell gold in one year’s time at
a fixed price of US$310 per ounce. In other words, the delivery price is
US$310.
This forward contract
protects Sperrin if gold prices drop below US$310. If the price falls to US$200
an ounce Sperrin will still be able to sell its gold at the prearranged price
of US$310. On the other hand, if gold prices rise Sperrin still has to fulfil
the terms of the contract. For example, if the price of gold jumps to US$400 an
ounce Sperrin has to sell its gold for the contracted price of US$310 per
ounce. In other words, Sperrin has given up the right to any price appreciation
above the contract price of US$310. In this situation, the other party will be
able to make money by buying gold from Sperrin under the forward contract at
US$310 and selling it on the cash (spot) market at US$400.
Who might be willing to
take the other side of the forward contract with Sperrin Gold? The forward
contract might also be attractive to a firm that makes gold jewellery, as
the risks it faces are the mirror image of those faced by Sperrin. Suppose the
Old Triangle3 jewellery firm normally buys its gold on the
cash market. If the price of gold rises, Old Triangle faces higher production
costs. If the price of gold falls the firm’s costs decline. Gold price
changes have opposing impacts on Old Triangle and Sperrin so they can both
reduce their risks at the same time by entering the forward contract. Through
the forward contract Sperrin has locked in a fixed price at which it can
sell gold in the future and Old Triangle has a contract to buy gold at a fixed
price in the future.
This practice of reducing
price risk using derivatives is known as . In our example, Sperrin is hedging its exposure
to gold price risk. Old Triangle is also hedging its price risk. Thus, the same
contract can be used as a hedging vehicle by two different parties.
The opposite of hedging is speculating. Speculation involves
taking on more risk. An investor with no exposure to the price of gold can
obtain this exposure by entering into a forward contract. Many financial
markets need risk takers or speculators to make them function efficiently
and provide liquidity. Speculation serves a useful economic purpose. It can lead
to improved risk sharing and provide a rapid and efficient way of incorporating
new information into market prices. Derivatives provide a very powerful tool
for speculating as they can increase an investor’s exposure to a given type of
risk. OPTIONS Options are classic examples of derivatives
that can be used to increase or reduce risk exposure. An
option is a contract that gives its owner the right to buy or sell some asset
for a fixed price at some future date or dates. A call option gives its owner the right to some underlying asset for
a fixed price at some future time. A put option confers the right to an asset for a fixed
price at some future date. The owner of the option
has the right – but not the obligation – to buy (or sell) the asset. In
contrast, under a forward contract one party is obliged to buy (or sell) the
asset. Options can be based on a wide range of underlying assets. The asset
could be a financial security such as a common stock or a bond. The
underlying asset need not be a financial asset: it could be a Picasso
painting or a rare bottle of Chateau Margaux.
The terms of the option
contract specify the underlying asset, the duration of the contract and the
price to be paid for the asset. In option jargon, the fixed price agreed
upon for buying the asset, is called the exercise strike price. The act of buying or selling the asset is
known as exercising the option. The simplest type of option is a “European” option, which can
only be exercised at the end of the contract period. On the other hand, an
“American” option can be exercised at any time during the contract period.
Put options provide
protection in case the price of the underlying asset falls. Sperrin Corp could
use put options on gold to lock in a floor price. For example, suppose
the current gold price is US$280 an ounce and Sperrin decides it wants to have
a guaranteed floor price of US$285 per ounce in one year’s time. The
company could buy one-year maturity put options with a strike price of US$285
an ounce. If the price of gold in one year’s time is below US$285, Sperrin has
the right to sell its gold for a fixed price of US$285 per ounce. For
example, if gold dropped to US$250 per ounce Sperrin has the right under the
put option to sell the gold for US$285 per ounce and the option is then worth
US$35 per ounce. However, if the price were to rise to US$360, Sperrin can make
more money by selling its gold at the prevailing market price and would not
exercise the option. In this case, the option would not have any value at
maturity. The put option gives Sperrin protection against a fall in the price
of gold below US$285 while still allowing the gold company to benefit
from price increases. In this respect the put option differs from the forward
contract. Under a forward contract, the firm still has price protection
on the downside but it gives up the benefits of price increases because
it has to sell the gold (at a loss) for the contract price.
We will now examine how
call options can be used by an airline to reduce the risks of high fuel costs.
Assume the current price of jet fuel is US$135 per tonne and American Airlines
is concerned about future increases in fuel prices. If American Airlines buys
one-year call options with a strike price of US$140 per tonne it has the option
to buy jet fuel at a price of US$140 per tonne. We assume the option is
“European”, which means simply that it can only be exercised at its maturity.
If the price of jet fuel in one year’s time is US$180 per tonne, the airline
can buy the fuel at US$140 per tonne or US$40 below what it costs on the cash
market. In this case American Airlines will exercise the call option, which
will then be worth US$40 per tonne. On the other hand, if the price of fuel in
one year’s time has dropped to US$100 per tonne, the airline will not exercise
its option. It makes no sense to pay US$140 for fuel when it can be bought in
the market for US$100. When American Airlines buys this option contract from a
Texan-based energy company it has to pay for the option. The price it pays for
the option is called the option premium We will discuss how this premium is
determined in Chapters 4 and 5. edgers can use option
contracts to reduce their exposure to different types of risk. In the above
examples both Sperrin and American Airlines used options to reduce their risk.
As is the case with all derivatives, options can also be used to increase risk.
Victor Niederhoffer, a legendary trader, provides a dramatic example of how put
options can be used to increase risk. Niederhoffer’s hedge fund routinely sold
put options on the Standard and Poor (S&P) Index. This index is based on a
portfolio of the common stocks of large US corporations. When the fund sold the
options it collected the option premiums. This strategy worked well as long as
the Index did not drop too sharply. However, on October 27, 1997 the S&P
fell by 7% in a single day and totally wiped out Niederhoffer’s fund.
Ironically, Victor Niederhoffer’s autobiography was titled "Education
of a Speculator" SWAPS.
A
swap is an agreement between two parties to exchange a periodic stream of benefits
or payments over a pre-arranged period.
The payments could be based on the market value of an underlying
asset. For example, a pension plan that owned 10,000 shares of the
Houston-based energy company Enron could enter an equity swap with an investment
bank to exchange the returns on these shares in return for a periodic fixed
payment over a two-year period. Assume the payments are exchanged every month.
Each month the pension plan pays the investment bank an amount equal to the
change in the market value of its Enron shares. In return, the plan receives
the agreed fixed dollar amount every month; after two years the swap
expires. The pension plan still owns its Enron shares. The two parties go their
separate ways. During this two-year period the bank receives the same returns
that it would have received had it owned the Enron common shares. The pension
plan receives a fixed income for two years, thus giving up its exposure to
the Enron shares for the two-year period. We now describe some of the terms associated
with swaps. The duration of the swap contract is called the of the swap. In the above
example the tenor is two years. The two parties to the contract are called the counterparties following the example, the counterparties
are the pension plan and the investment bank. The sequence of fixed
payments is called the leg of the swap and the sequence of variable
payments is called the commodity swap the payments on one leg
of the swap may be based on the market price of the commodity. Sometimes the
swap is based on the actual delivery of the underlying commodity. Cominco, the
largest zinc producer in the world, is based in British Columbia, Canada. In
December, 2000, Cominco entered an innovative swap with a large US energy
company.Under the terms of the swap Cominco agreed to deliver electricity
to the energy company at a price per megawatt hour. The energy
company paid US$86 million for the power. The duration of the swap was from
December 11, 2000, to January 31, 2001. During this period, electricity prices
were very high in the western US as a result of the California power crisis
(which we discuss in more detail in Chapter 2). Cominco generates its own power from a dam on the Pend Oreille
River. Normally, Cominco uses this power to refine zinc in its plant near
the town of Trail in southern British Columbia. In the winter of 2000, the
price of power in the Pacific North West was so high that Cominco found
it profitable to scale back its production of zinc to free up the power.
During this period, Cominco reduced its zinc production by 20,000 tonnes. To
meet its customers’ demands for zinc, Cominco purchased the zinc on the spot
market. The employees, who were no longer needed in the zinc-production
operations, were deployed on maintenance activities. The revenue from the swap
had a major impact on the company’s bottom line. According to Cominco officials,
the company has a goal of making an annual operating profit from its
Trail operations of US$100 million – the revenue generated by the swap almost
produced an entire year’s projected profit.
Interest rate swaps
Interest rate swaps are very popular financial
instruments. They have grown to such an extent that they are the most widely
traded derivatives contracts in the world. In an interest rate swap, one
counterparty pays a fixed rate of interest and the other counterparty
pays a variable, or floating, rate of interest. The payments to be
exchanged are based on a notional amount of principal.
Interest rate swaps are
useful tools for managing interest rate risk. We can illustrate this use of
interest rate swaps with an example involving a savings and loan bank. These
institutions, often known as “thrifts”, were set up in the US to provide
mortgages to residential homeowners. Most of the assets of a typical thrift
consist of long-term mortgages, which often pay fixed interest rates, and
the liabilities tend to be consumer deposits. The interest rates paid on these
deposits vary with market conditions and depend on the current level of
short-term rates. This means that the thrift’s income and outflow are not
well matched. If there is a dramatic rise in the level of rates, the thrift has
to pay out more money to its depositors. At the same time its revenue stream
remains fixed because its existing assets provide a fixed rate of
interest computed at lower rates. The thrift therefore faces a significant
exposure to interest rate risk.
The thrift’s problem can be neatly solved with an interest rate
swap. The parties exchange a stream of fixed-rate payments for a stream
of floating-rate (variable-rate) payments. The thrift agrees to pay the fixed
interest rate and receive the floating rate. The dealer agrees to pay the
floating rate and receive the fixed rate. These floating rate
payments provide a much closer match to the amounts the thrift must pay to its
depositors.
NEW CONTRACTS
New types of derivative instruments are being
introduced all the time. Weather derivatives provide a good example of a recent
innovation in this area. Many business organisations have profits that
depend on the weather and there is considerable scope for such derivatives as
hedging vehicles. For example, a brewery company’s beer sales in the summer are
strongly linked to the weather. As the temperature increases, more beer is
consumed but if it gets too hot the consumption of beer may actually decrease.
On the other hand, the yield on many crops may be adversely affected by a long,
hot summer thereby reducing farmers’ incomes.
If the winter is
abnormally cold, a company that sells snowmobiles will experience increased
sales. For example, Bombardier, a Quebec-based company that manufactures and
sells snowmobiles, has sales that are highly related to the amount of snowfall
in its sales areas. Bombardier has exposure to a specific type of weather
risk and it was able to hedge this risk by buying a weather derivative, based
on the amount of snowfall. Bombardier bought a snow derivative that meant it
could offer cash back to customers if snowfall was less than half the norm. In
a weather derivative we need to specify precisely the method by which the
payment is to be computed: if the contract is to be based on the temperature
level or the average temperature level, then the location needs to specified.
For example, the traded weather options on the Chicago Mercantile Exchange use
the temperature readings at O’Hare Airport as a basis for their Chicago
contract.
Power providers and energy utilities have considerable exposure to
the vagaries of the weather. If the summer is very hot consumers will turn up
the air conditioning and if the winters are very cold there will be a surge in
heating demand. These companies can reduce their risk exposure using weather
derivatives. For example, consider Hank Hill, a propane distributor. Hank
lives in Arlen, Texas and he is concerned that in a very mild winter propane
sales will be low, reducing his profit. Suppose that under normal winter
conditions his sales are one million gallons but if the winter is very mild he
will only sell half this amount, reducing his profit. Hank can protect
himself against this risk by buying a weather derivative from Koch Industries.
The payoff on this derivative will be based on the actual average winter
temperature for Hank’s sales region. Panel 1 describes an interesting weather
derivative that is designed to protect the revenues of a chain of London pubs
from adverse weather conditions.
MARKETS
In the next chapter we will discuss the
reasons for the significant growth of derivatives that has taken place in
recent years. Much of the initial growth was in the development of
exchange-traded instruments, which are standardised contracts that are traded
on organised markets such as the Chicago Board Options Exchange (CBOE) or the
London International Financial Futures Exchange (LIFFE). The exchanges provide
a secondary market for derivatives and current information on market prices.
There are a number of safeguards to maintain orderly markets and, in
particular, to guard against the risk of default. For example, there are limits
on the position any one firm can take. If an investor is losing money on
a short position, the exchange will monitor the situation and require
additional funds from time to time, known as “margin funds”. These include the
posting of margins and position limits. The exchange knows the positions of all
the participants and can step in if necessary to take corrective action. Kroszner
PANEL 1 ENRON WEATHER DEAL FOR UK WINE BAR CHAIN
LONDON, 6 June – Corney & Barrow (C&B),
which owns a chain of wine bars in the City of London, has closed a weather
derivatives deal with US energy giant Enron – the first such undertaking
by a non-energy company in the UK. The deal was brokered by Speedwell Weather,
a division of the UK-based bond software company Speedwell Associates.
Sarah Heward, managing
director of C&B Wine Bars, told RiskNews that the deal helps to protect her
company against volatility in business caused by spikes and falls in
temperature. “This deal protects a total of £15,000 in gross profit, so
it is not a huge contract. But it does show that weather derivatives can be
used by small companies”, says Heward. She was introduced to the idea of
hedging her business’s volatility with weather derivatives by her own
customers. “Many of our customers are market makers – including Speedwell – and
we were talking about the volatility in C&B’s business. They suggested that
weather derivatives might help”, she says. Heward acknowledges that for some
executives of small companies, convincing their board of the need to use
weather derivatives will be difficult. She says it was not a tough pitch
for her, as her board members all work in the City of London.
Steven Docherty, chief
executive of Speedwell Weather, says that the market responded surprisingly
well to the offer of the C&B deal. Once Speedwell had taken some time to
research and define C&B’s particular problem, the deal itself was
closed a couple of days after it was offered, he says. He believes that those
involved in the weather derivatives market will view non-energy contracts as a
good way of hedging against putting too many eggs in the energy basket.
However, he points out that these deals will still need to be aggressively
priced.
While Docherty told
RiskNews that the weather market has developed more slowly than was expected,
he still describes himself as “insanely optimistic”. He believes that banks and
funds are becoming more interested in weather products and that this will
bring a capital markets approach – resulting in aggressive pricing and efficient
marketing of weather products, as well as additional liquidity.
(1999) suggests that the control of credit
risk is an important achievement of organised exchanges.
The other main market for derivatives is the so-called
over-the-counter (OTC) market, which now accounts for about 85% of all
derivatives. This market does not have a fixed geographical location,
rather, it is formed by the world’s major financial institutions. OTC
derivatives are extremely flexible instruments and they have been the
vehicles for much of the financial innovation in the last two decades.
OTC contracts tend to be much longer dated than exchange-traded options: in
some cases they last for as long as 30 to 40 years. One of the most critical
differences between exchange-traded derivatives and OTC derivatives is that the
former are guaranteed by the exchange whereas OTC derivatives are only
guaranteed by the issuer. Thus, the investor is subject to credit (default)
risk. The longer the term, the higher is the risk that one of the parties will
default. Firms and countries that seem strong today may be in default in the
future. Steve Ross has noted that the largest stock markets in the world 100
years ago were in Russia, Austria and the UK.9
DERIVATIVES AND DISASTERS
Inordinate risk taking, however, can have
harmful results. Indeed, the term “speculator” has acquired unsavoury
associations because of past excesses. In their role as speculative
instruments, derivatives have been associated with some of the most famous financial
failures in recent years.
For example, in 1995 the
venerable British bank, Barings, collapsed with a loss of US$1.4 billion. The
scapegoat for this loss was Nick Leeson, the bank’s 28 year-old head trader. A
characteristic of derivatives is that the price paid to enter the contract is
often small in relation to the size of the risk. We call this property leverage because a lever gives us
the ability to magnify our efforts. Leeson used derivatives to take very highly
leveraged positions, betting on the direction of the Japanese stock market. He
guessed wrongly and brought down the bank. However, the bank’s internal control
system proved to be ineffective and Leeson’s activities were not supervised.
Most of Leeson’s pay was in performance bonuses: if he made a large trading profit
his bonus would be huge. Leeson therefore had a very strong incentive to take
risks.
One of the criticisms of the Barings case was that Nick Leeson was
not an expert in the derivatives area. In contrast , Long Term Capital Management
(LTCM), which collapsed in 1998, was advised by some of the brightest minds in
the business. LTCM was a very prominent hedge fund that invested the funds of
very rich clients and provides a spectacular example of extreme speculation.
Note that the word “hedge” in this context does not mean that these funds
actually hedge. LTCM tottered on the brink of collapse in 1998 in the aftermath
of the Russian debt crisis because it had taken on massive and very risky
positions in several markets. Edward Chancellor observes that LTCM “used
derivatives wantonly to build up the largest and most levered position in the
history of speculation”.4 Paul Krugman describes the role of
leverage in the fund’s near collapse:5
Rarely in the course of human events have so
few people lost so much money so quickly. There is no mystery about how
Greenwich-based Long-Term Capital Management managed to make billions of
dollars disappear.
Essentially, the hedge
fund took huge bets with borrowed money – although its capital base was only a
couple of billion dollars, we now know that it had placed wagers directly or
indirectly on the prices of more than a trillion dollars’ worth of assets. When
it turned out to have bet in the wrong direction, poof! – all the investors’
money, and probably quite a lot more besides, was gone.
Funds such as LTCM
historically operated with very few restrictions and little disclosure. The
justification for this state of affairs was that people who invested in
hedge funds were presumed to be sophisticated investors who needed less
protection. The most frightening aspect of the LTCM affair was the threat its
demise posed to the entire financial industry which was already under
pressure from the Russian debt crisis. LTCM was such a major player that it had
very significant positions with many large institutions. If it fell into
disarray, the domino effect could topple the entire financial system.
LTCM was rescued by an infusion of US$3.6 billion from a consortium of some of
the world’s largest investment banks, which had significant exposure to
LTCM. The rescue was mounted after it was realised that LTCM would have to
default if the banks stood idly by. Disasters such as Barings and LTCM provided
a compelling incentive for banks and other financial institutions with
large derivatives positions to improve the way in which they managed these
positions. This trend was reinforced by regulation at both the domestic level
and the international level. Trade associations, motivated by enlightened
self-interest, also developed codes of best practice for the derivatives
business.
We have seen that derivatives have two contradictory powers. On
the one hand they are remarkably efficient tools for reducing risk. At
the same time derivatives have an awesome capacity to increase risk through
leverage. This dual nature of derivatives can be viewed in terms of two conflicting
emotions that can be used to describe attitudes to risk: fear and greed. The
common tendency to reduce risk stems from fear of loss. The motivation to take
on large amounts of risk and reap high profits is based on greed.
Derivatives provide an efficient way to construct a strategy that is
consistent with either of these attitudes.
DEFAULT RISK
Default risk has been a factor since the first
contracts were arranged and various procedures have been used to deal with it.
One is to try to set up the contract so that it provides incentives that
discourage default or nonperformance. The life of the Russian author
Dostoevsky provides an interesting example of a contract with draconian
penalties for nonperformance. The contract involved an agreement to produce a
new book within a given time. Dostoevsky was deeply in debt because of his
gambling activities and he was under pressure from his creditors, so, he
entered a deal with an unscrupulous publisher named Stellovsky. Under this deal
Dostoevsky sold the copyright to all his published books for 3,000 roubles. The
deal also stipulated that Dostoevsky would deliver a new novel by November 1,
1866. If he failed to deliver on time, then Stellovsky would also gain the
rights to all of Dostoevsky’s future books. This created a severe penalty if
the book was not produced on time. Dostoevsky with help from a secretary, Anna
Snitkin, whom he later married, managed to write the book in under a month and finished
it by October 31, 1866. By a twist of irony the new book was called The Gambler.
Futures contracts provide a further example of
how the design of a derivative contract can help reduce exposure to default
risk. These are exchange-traded instruments. The owner of a futures contract
has the obligation to buy some underlying asset. In this respect futures
contracts are similar to forward contracts but there are important differences
between them concerning the realisation of gains and losses. For example, if an
investor is long a forward to buy some asset and the price of the underlying
asset rises steadily over the contract period, the gain will not be realised
until the end of the contract term. In contrast, if the investor owns (is long)
a futures contract and the price of the underlying goes steadily up, the gains
would be realised on a daily basis and they are posted to the investor’s
account. By the same token, if a trader sells (is short) a futures contract and
the price rises every day, then the loss will have to be settled up each day
and the trader loses money every day. The exchange clearing house ensures that
losses and gains are settled up on a daily basis. If the prices move
dramatically during the day then the settling up can be more frequent. The
exchange broker will ask his client to deposit more money (margin) as soon as a
position exceeds a given loss. This periodic settling up means that no side of
the transaction is allowed to build up a large loss position. If the client is
unable to meet the margin call the position may be liquidated to prevent
additional losses. The design of futures contracts provides a very sturdy
mechanism for reducing default risk.
CONCLUSION
This chapter demonstrated how widely
derivatives are used as tools for transferring risk. It described some basic
derivative contracts such as forwards, options, swaps and futures, and gave
examples of how these contracts are used to reduce different types of risk. It
emphasised that derivatives can be used to increase leverage and take on more
risk, while pointing out the dangers of unbridled risk taking. There are also
important differences between exchange-traded derivatives and OTC derivatives.
The next chapter will analyse the reasons for the tremendous growth of
derivatives.
1 These figures refer
to the notional amounts. Figures are from the Bank for International
Settlements (BIS) press release, 18May 2000 ref 14/2000E. The data relate to
December, 1999.
2 Sometimes the term “risk” is used to describe
the occurrence that triggers the bad consequences. This usage of “risk” to
mean “peril” is common in insurance. For example, an insurance policy may be
described as offering protection against named “risks”.
3 The firm, invented by the authors, gets
its name from a song by Brendan Behan: “And the old triangle/Went jingle jangle/Along
the banks of the Royal Canal.”
4 See Chancellor (1999).
5 Paul Krugman, “What Really Happened to
Long-Term Capital Management”, Slate,
URL:http”//slate.msn.com/dismal/98-10-01/dismal.asp (1 October 1998).
6 The terms “European” and “American” are
misleading in this respect. They have nothing to do with geography. The names
are apparently due to Samuelson, who coined the term European to describe the
simpler type of option and the term American to describe the more complicated
type of option. Samuelson picked these names because of some Europeans he met
during his research on options.
7 See Niederhoffer (1998).
8 At the time of writing the name of the energy
company was not public.
9 Reference for this point Steve Ross
survivorship bias.
