derivatives explainer by the federal reserve

8/3/2019 Derivatives Explainer by the Federal Reserve

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l~ H~/ derivatives figured prom inently in a num ber of high-profilefinancial reversals involving m unicipalities, corporations, in-vestment firms, and bank s. Yet even as these instruments gained notoriet3; they remained som e-what of a my stery. The on e certainty about derivatives xvas that people wa nted to know m oreabout them.

The Federal Reserve System responded by em barking on a m ajor effort to increase publicawareness. We, at the Federal Reserve Bank of Boston, hosted a daylong educ ational forum onman aging the risks associated with investing in derivatives. Our target audience w as not the WallStreet investment professional who w orked w ith derivatives every day but, rather, the nonex pertwho wanted to know more about derivatives in order to mak e an informed decision -- either onthe job or in the realm of personal financial planning.

The en thusiastic response to ou r conference indicated that the desire for information aboutderivatives was ev en greater than we h ad anticipated. Auditors, investment planners, m unicipaltreasurers, CFOs, and even a few CE Os pack ed the Banks auditorium to hear some of the countrysforemost experts on financial derivatives discuss everything from w hat derivatives are to w hattypes of expertise and control are needed to use these instruments w isely,:

This publication is an outgrowth of that conference. Its primary p urposes are to offer someinsights into wh en and h ow derivatives can b e valuable tools for managing financial risk and tofocus on the pertinent questions to ask yourself and others before you or your com pany invests.W e hope it will help to dispel the mystique that surrounds the varied group of financial instru-ments Mmwn collectively as derivatives.

P r e s i d e n t a n d C h i e f E x e c u t iv e O f fi c e r~ , d e r a / R e s e r v e B a n k o f B o s t o n


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Troisms dollt always stand Lip tOobjective scrutin.v. "Trock driversknow where to f ind the best food,"is one that comes to mind.

Hnancial troisms arc no excep-t ion. Som e contaio m ore t roth thanothers.

The belief that derivatives areinherently risky gained broad ac-ceptancc during the mid-1990swhen nationwide news reportshighlighted the financial woes of alarge U.S. multinational corpora-tion and a Southern Californiacount$+ both of w hich suffered sig-nificant losses after investing in de-rivatives. Almost overnight,financial derivatives went from ob-scurity to notoriety. The notionthat "derivatives arc very complexand veu r isky" gained broad accep-tance, hot many who expressedthat view might have been hard-pressed to explain why .

The f iac t i s that some d er ivativesare highly complex, but others are

quite simple. Some are "exotic,"others are "plain vanilla." But moreoften than not, derivatives are ef-fective instruments for managingfinancial risk.

Anyone who has ever bought ahouse kno ws that theres a time lagbetween applying for a mortgageand closing the sale. During thatinterval, rising interest rates canadd significantly to the size of themonthly mortgage payment.

Sometimes mortgage applicantschoose to hedgc the risk of risingrates by pax+, ng the lender an up-front fee to goarantec, or "lock in,"the rate at the time of application.The borrower is betting that thelock- in fee wil l amou nt to less thanthe cumolative monthly costs thatcould rest, It if rates were to riseprior to closing.

Home mortgage rate lock-inagreements share certain attributeswith derivatives transactions. Bothallow the buyer to mitigate risk,and both enable the lender (orseller) to generate fee income in


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exchange for assuming some of therisk. But unlike derivatives, homemortgage rate lock-ins are not mak-ing headlines, nor are they trigger-ing any discernible degree of alarm.N e w P a c k a g e s fo r O l d T h i n g s

"Although derivatives seemcomplicated," says Michelle ClarkNeel.~; an econom ist a t the FederalReserve Bank of St. Louis, "theirpremise is really simple: They al-low users to pass on an unwantedrisk to another party and assume adifferent risk, or pay cash in ex-change." Neely and others broadlydefine derivatives as financial con-tracts that are linked to -- or "de-rive" -- their value from anunderlying asset, such as a stock,bond, or commodity; a referencerate, such as the interest rate onthree-month Treasury bills; or anindex, such as the S&P 500.

Derivatives, says Boston Fedeconom ist Peter Fortune, are "newpackages of old things." One wayto look at those "pack ages" is to di-

vide them into four broad catego-ries: for\yard agreements, futures,opt ions, and swap s.F o r w a r d s , F n t n r e s ,O p t i o n s , a n d S w a p s

Fo~~va~~t Ag~e~,~e~ts: Thereare no sure things in the global m ar-ketplace. Deals that looked goodsix months ago can quickly turnsour if unforeseen economic andpolitical developments trigger fluc-tuations in exchange rates or com-modity prices.

Ov er the years, t raders have de-veloped tools to cope with theseuncertainties. One of those toolsis the forward agreem ent - - a con-t rac t that comm its one pa r ty to buyand the other to sell a given quan-tity of an asset for a fixed price ona specified future date.

For example, an Am erican com -pany might agree today to buy acertain product from a Japanesemanufacturer. The deal will bepriced in yen, and payment will bemade when the product is deliv-

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ered in six months. Both compa-nies will base their business calcu-lations on a certain dollar/yenexchange rate, but for the next sixmonths they will face the uncer-tainty that a sharp fluctuation inthe rate could make their deal lessprofitable than anticipated.

To protect themselves againstexchange ra te uncer ta int3; com pa-nies sometimes use for\v~ard agree-ments -- agreements thatguarantee a speci f ied exchange rateon a given date in the future. For-ward agreem ents are a form of de-rivative, and they are usuallyarranged through large, money-center banks. An American com-pany might, for example, go to amoney-center bank seeking to buya certain amount of yen at a speci-fied rate on a given date in the fu-ture. And a Japanese companymight be looking to sell an equiva-lent anaount of yen at a specifiedrate on the same future date.

Rather than dealing directlywith one another , both sign a sepa-

ra te agreement w ith the money-cen-ter bank, which in the parlance of de-rivatives becom es a counterpart3, toboth. The bank is acting as a brokerto the counterparties, and in returnfor accepting a p ortion of their r isk,the compan ies pay the bank/brokera fee.

This type of forward agreementi s known as an over- the-counter orOTC derivative. An OTC deriva-tive is not traded daily on an orga-nized financial exchange, and itsterms are customized to the needsof the counterparties.

Futures: Chances are that mostpeop le think of corn or pork bell ieswhen they hear the word "futures."But in the world of derivatives, theword "futures" refers instead to suchthings as foreign exchange futuresand stock index futures.

Futures contracts are forwardagreements with an important dif-ference. Wh ereas the terms o f a for-ward agreement are generallycustomized to the needs of thecounterparties and sold through


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over-the-counter (OT C) dealers, fu-tures contracts are standardizedagreements t raded on organized cx-changes.

Buying and selling of futuresagreements takes place in the t rad-ing pits of the Chicago MercantileExchange and other organized ex-changes. Traders settle their ac-counts through the exchangesclearinghouse, and the clearing-house, rather than an OTC dealer,becomes the counterparty to eachtransaction.

OHio,s: As the name implies,trading in options involves choice.Someonc who invests in an optionis purchasing the right, but oot theobligation, to buy or sell a speci-fied underlying item at an agrecd-upon pr ice , know n as the exercise ,or strike, price.There are two basic types of op-tions -- calls and puts. A call op-tion gives an investor the right tobuy the underlying item during aspecified period of time at aoagreed upon price, while a put op-

tion confers the right to sell it. Per-haps the best known un der lying as-sets are shares of co111111o11 stock.Standardized stock options aretraded daily on a number of majorexchanges.

I, te~e st Rate S~z,aps: Interestrate swaps allow tw o parties to ex-change or "swap" a series of inter-est payments without exchangingthe under lying debt . The least com-plicated interest rate swaps arecom mo nly referred to as "plain va-nilla." They usually involve oneparty exchanging a portion of itsinterest payments on a floating ratedebt for a portion of the interestpayments on another partys fixedrate debt. (For an explanation of a"plain vanilla" interest ratc sw ap, seeb o x , l F m i !/ a m d O t lw / " F / ~ / ~ o / s, p. 10.)

S o l ir ( , l ~ 0 { l i l t l i i [ [ i i u i l l , yBasic derivatives are not particu-

lar ly com pl icatcd, and in the propercontext they can be effective toolsfor managing risk. So, why havethey led some users into so much


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difficulty? The answer can besunan~ed up in two words: com-p!exity and speculation.

(bmp/e.xiO: A fom~ard agreementis relativdy uncom plicated. ~vo par-ties agree to the purch ase or sale of acomm odi ty at an agreed upon pr iceon a spec ified future date.

But not all derivatives are sostraightforward. Certain "exotic"der ivat ives, wi th nam es l ike C acal l ,Caput, Contingent Premium Call,and Barrier Option, have featuresthat make them more difficult tounderstand than the "plain vanilla"varie ty . O n som e der ivat ives , smallchanges in the value of the under-lying asset, reference rate, or indexmay produce big changes in thevaluc of the derivative. Investorsmay overlook the potential for thistype of "leveraging." The trouble-some product for some investorshas been "structured notes."These are ordinal, securities withderivative features added. The se-curity sounds safe, and the inves-tor may pay insufficient attention

to how the der ivative works .As always, investors who dont

understand what they are gettingthemselves into arent in the bestposition to fully assess the risk at-tached to a particular investment.(See the box,s h e I o s , e s y o u , c h e c L " i t o u t ! " )

%!)uu~l+~tio,: A m anufactur ingcompany is hedging risk when ituses a forward agreement to limitthe impact that exchange rate fluc-tuations might have on an interna-tional trade deal. But its probablyfair to say that the same companywould be spcculating if it were toinvest heavily in a foreign currencyfom*ard agreem ent solely on the as-sumption that a certain currencywill move sharply in one directionor the other.

Not that the line between hedg-ing and speculat ing is a lw ays clear .As M ichcl le Clark Nccly of the St .Louis Fed puts it, Any instrumentthat can be used to hedge can alsobe used to speculate." There aretimes when treasurers or portfolio


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managers m ight feel as if they are un-der pressure to increase the returnon their money by investing heavilyin "exotic" derivatives -- the "noguts, no glou" approach to invest-ing. Hedging can easily becomespeculation through greed or igno-rance or carelessness.

T h e B a s ic R i s k ~Whether a derivative is "plainvanilla" or "exotic," there arepoints that investors ought to con-sider before entering into a deal:

Ma,t, ,et Risl~: Investors tend tobase their decisions on certain as-sumptions: Interest rates will go upor down, the stock market willmov e higher or lower, the dollar wil lbe s tronger or weaker .

Bankers and investment bank-ers often rely on computer modelsto predict how markets will move.The models are based on a set of"normal" assumptions . But ~vhat is"normal"? Are the assumptionsvalid? And even if the assumptionsare valid, the model might indicate

that theres a certain probability ofthings going very wrong. If thatprobability becom es a realit.~; is theinvestor prepared to deal with theconsequences?

If, for example, an unforeseeninternational crisis pushes oilprices far above the anticipatednorm, a specu lator who has sold oi loptions stands to lose a great dealof money. Thats because thespeculator who sold the optionsdoesnt actually own the oil andmust scramble to buy it at a verysteep price if the party that boughtthe options chooses to exercisethem.

In short, investors need to besure the>, understand xvhat they aregetting themselves into. Theyneed to determine how much riskthey are willing to tolerate, andthey need to think about what theywill do if things go wrong.

Liq~idio, Risl,: Investors whoplan to sel l a der ivat ive before m a-turity need to consider at least twomajor points: 1) how easy or diffi-

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cult will it bc to sell before matu-r i ty , and 2) how m uch will it cost.Are there fees or penalties for sell-ing before maturity? What if thederivative is trading at a muchlower pr ice than they paid? Indeed,what arc the chances that it couldbe trading at a !ower pricc? (Ofcourse , these are the same types ofquestions people ought to askthemselves when they invest inanything, from condominiums tocollectiblcs.)

CounterparO, Credit Risk:Counterparty credit risk is a muchgreater concern in the OT C der iva-tives market. If one of thecounterparties (buyer, seller, ordealer) defaults on an agreement--just walks away after the mar-kct takes an unfavorable turn --theres no organized mcch anism fordealing with the fallout.

Matters are further complicatedby the fact that many derivativestrades are done orally w ith little orno accompanying documentation.Ad d all this to the fact that the

OTC market has gone largelyunregulated, and its easy to sccwhy much of the apprehensionover derivatives has centered onthe OTC variety.

Exchange-traded derivativesraise fewer collcerns overcounterparty risk, largely becausethe counterparty in each transac-tion is the exchange clearinghouserather than a single OTC trader.The poolcd capital of the clearing-house members makes its cootractguarantees stronger than those of-fered by an individual OT C de aler .

An organized exchange, notesFederal Resea~e Bank of Richm ondeconomist Robert Graboyes, also"enforces contract pertbrmance b yrequiring each buyer and seller topost a performance bond, M ~own asa margin requirement . At the end ofeach day , traders are required to rec-ognize any gains or losses on theiroutstanding com mitments , a processknown as marking the contracts tomarket ." The exchange ci thcr addsor subtracts ~l?ollev from an


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s m a r t e n o u g hf o r t h a t . "

investors account, dependingon howmuch a derivative contracts price hasmov ed dur ing the t r ading da3 :

The daily process of "marking tomarket" means that the pricing ofexchange-traded derivatives islikely to be far less arbitrary or am-biguous than the pricing of OTCderivatives. Indeed, one of the pri-mary concerns surrounding OTCderivatives is the question ofwhether or not pricing accurately

reflects current value and condi-tions. (This is also an importantconsideration when assessing li-quidity risk.)

Robert C. Pozen, general coun-sel and managing director for Fi-delity Investments, suggests thatderivatives users can cope withcounterparty credit risk by devel-oping a list of approved dealerswith whom they are xvilling to dobusiness, because the likelihood ofcredi t ri sk i s lower wi th som e deal -ers than others. Pozen also raisesthe possibilities of asking for col-lateral or asking for a third-partyinsurer to back the derivatives.But he acknowledges that insur-ance ar rangem ents can cost a greatdeal of m oney.

Interconnectio~ Risk: Intercon-nection risk, also known as "sys-temic risk," is the danger thatdifficulties experienced by anysingle player in the der ivat ives m ar-ket could trigger a chain reactionthat might ultimately affect theent i re banking and f inancial system.

As Michelle Clark Neely notes,policymakers apprehensions stemfrom the fact that so many OTCder ivat ives dealers are mo ney-cen-ter banks. Regulators andpolicymakers are concerned,writes Neel3; "that banks will betempted to take large speculatorybets on interest rates that couldimpair their capital or lead to fail-ures. [And some] worry that thefailure of one bank dealer mayhave a domino or systemic effecton the whole banking industryand, hence, taxpayers" in the formof a taxpayer-funded bailout.

" D o n t b e t t h e r a n c h ! "In April 199.5, the Federal Re-

serve Bank of Boston hosted aneducational forum for users of de-rivatives, W hat ShouM You Be AskingAbout Derivatives? E. GeraldCorrigan, former president of theFederal Reserve Bank of New Y ork,offered some valuable, plain En-glish words of advice to those in a t-tendance. When it comes to


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derivatives, they are words to live by: Dont be shy about asking ques-t ions. That may seem v e~T simple,but the fact of the matter is thatderivatives intimidate people. Dont give a second thought towhether a ques tion may or m ay notbe stupid. It doesnt matter. Press.Press your own p eople. Press yourdealer. If you cant find the answerto your question there, then talkto a regulator or lawyer. But askquestions and ask questions ag-gressively. If you dont understand how apar t icular t ransact ion is valued, andif you cannot satisfy yourself as tohow to determine that value, justdont do the transaction. Thoseextra 2 basis points wont make orbreak you r l i fe . If someone calls you on thephone an d is t rying to sel l you a 10percent piece of paper in a 7 per-cent market, tell them they havethe wrong number. Dont bet the ranch on anything.None of us is sma rt enough to do that.

V a n i l l a a n d O l l n e r F l a v o r s-- Adapttd from On Reserve, September 1995, Federal Resetwe Ba~tb of Chicago.

Basic derivative instruments such as futures and optionsare often referred to as "plain v anilla," althou gh this term ismost often applied to an instrument called a swap. M ore ex-otic "flavors" include instruments such as "repos" and som ethat have m ore bizarre names l ike "frogs" or "swaptions."W hile more com plex, these instruments are similar to otherderivatives in that they are a contract based on another asset.Lets examine a sw ap. As the nam e implies, this instru-men t swaps on e thing for another. Usually, i ts an interestrate swap. For exam ple, an organization with debt, payable ata fixed rate of interest, will sxvap its interest paym ents for afloating rate paymen t. Heres an exam ple of how the systemworks.CDB Corporation has borrowed $1 million at a floating rate,currently 7 percent. CD B is concerne d that rates will rise.

CD B w ould l ike to make f ixed interest payments of 8 per-cent.NQ , Inc. has borrowe d $1 million at a fixed rate of 8 per-cent and h as invested the funds at a v ariable rate. It is con-cerned that, if rates fall, the investment might not beprofitable. It is willing to make C D Bs interest payments at afloating rate over five years, if C D B w ill pay the 8 percentfixed rate on NQs loan for the same period of time. The twoparties agree to sw ap interest rates.CD B w ill still make floating-rate interest payme nts to itsbank, but will receive from NQ floating-rate interest pay-men ts exactly the sam e as what it is paying. Similarly, NQwill still mak e the 8 perc ent fixed-rate interest paymen ts toits bank, but will receive from C D B interest paym ents pre-


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cisely equivalent to the payments it is making. Thenet effect of th is in terest ra te exchange is that CD Bends up making fixed-rate interest payments, inaccordance w ith i ts wishes , and NQ end s up mak-ing floating-rate interest payments, in accordancewith its preferences. Both companies will continueto make the appropriate principal repayments tothei r respect ive banks in accordance wi th thei r loanagreements.

W hy d id C D B and NQ use sw aps? O ne answ eris the expectat ions of the two com panies , each t ry-ing to avoid .a certain risk. The companies havedifferent opinions of which way interest rates are

headed and different needs. Based on those opin-ions and needs, the companies are trying to man-age their risk.

Interest rate swaps provide users with a way ofhedging the effects of changing interest rates. CDBis reducing the risk of borrowing funds at a floatingrate at a time when it expects rates will rise. NQ isgaining protection against falling interest rates. Thelender of funds for each company is not affectedbecause it receives the correct principal and inter-est payments. Such transactions, multiplied manytimes over, help foster a more liquid and competi-tive marketplace.


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A B r i e f D e r i v a t i v e s L e x i c o n-- Adapted.firm an artk/e that origina//y appeared h~ Financial Industry Studies, August 1994,

Federa/ Reserve Bank o f Da//as.

Cap:

Collar:

Dealer:

Derivative:

End-User:

Floor:

Forward:

Future:

Not iona l Amount :Option:

Swap:Swapt ion:

Underly ing Reference:

An option-like contract ~hat protects the holder against a rise in interest rates or a change insome other underlying reference beyon d a cer tain level .The sim ultaneous purchase of a cap and sale of a f loor with the object ive of m aintaining inter-est rates, or som e other und erlying reference, within a def ined range.A counterparty who enters into a [derivatives transaction] in order to earn tees or tradingprofits, serving custome rs as an intermediary.A con tract whose vah, e depe nds on (or derives from) the value of an tmd erlying asset, typi-call5 a security, comm odits; reference rate, or index.A counterparty who engages in a [derivatives t ransaction] to manag e i ts interest rate or cur-rency exposure.kaa option-like contract that protects the holder against a decline in interest rates or someother underlying reference beyond a certain level .A contract obligating one counterpart5 to buy and the other to sell a specific asset for a fixedprice at a future date.A for\yard contract traded on an exchange.The pr incipal amo unt upon w hich interest and other paym ents in a transaction are based.A c ontract giving the ho lder the r ight , but not the ob ligation, to buy (or sel l) a specif ic quan-tity of an asset for a fixed price during a specified period.An agreem ent by two parties to exchange a series of cash flows in the future.An option giving the holder the r ight to enter (or cancel) a swap transaction.The asset , reference rate , or index whose p r ice movem ent helps determine the value of t imderivative.


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derivatives explainer by the federal reserve

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