The Financial Times Limited

The Financial Times Limited

Financial Times (London)

May 14, 2001, Monday

The use and abuse of derivatives

by CHRISTOPHER CULP
Futures and options have been unfairly blamed for some high-profile financial disasters but this should not hinder their growing use, says Christopher Culp
In spite of their popularity, "derivatives" are regarded by many as unfathomable and dangerous financial instruments that have caused several high-profile multimillion-pound losses in the past decade. They are gaining acceptance in some circles while being derided in others. Which view is correct? Are derivatives complex, exotic back doors to leveraged gambling, or are they indispensable in reducing costs, managing risks and fine-tuning investment?
This article looks at the role of derivatives in investment management. It covers what they are, how they are traded and their uses - and abuses - in investment management.
Basic types
Most people use derivatives. If you tell a rental car company you will bring the car back with a full tank of petrol rather than taking a car with a full tank, you are evaluating a derivatives position. If you ask for part of your pay tied to performance, you are asking to be paid with derivatives. Giving customers 30 days to pay is akin to giving them a derivatives-like option of not paying at all.
Most financial instruments can be viewed as combinations of the basic types of derivatives - "forwards" and "options". As early as the 12th century, fairs in England and France provided opportunities for merchants to contract for the purchase or sale of a specified amount and quality of a commodity on a specified date at a price fixed on the day of the negotiation. A simple "forward contract" may be negotiated in March to buy 5,000 bushels of wheat in June for a fixed price, say Pounds 3/bu. If the market price is Pounds 3.05/bu. in June, the purchaser - or "long" - makes a profit of Pounds 0.05/bu., or Pounds 250. The wheat that the long has bought for the pre-contracted Pounds 15,000 now has a market value of Pounds 15,250.
Contracts can also be entered to sell, where a seller "shorts" the asset. Indeed, any forward contract has both a "long" and a "short". Forwards, like all derivatives, are bilateral contracts - unique agreements between counter-parties. For every buyer/long, there must be a seller/short.
Forwards can be used to buy and sell numerous "underlying assets", including physical commodities as well as financial assets such as foreign exchange or bonds. In addition, forward contracts may be cash-settled, where at maturity a cash flow is exchanged in lieu of an asset. The amount of the cash flows is based on the value of a reference rate or index (for example, the London interbank offered rate or the FTSE 100).
Many financial instruments can be viewed as combinations of derivatives-like forwards. A common example is a "swap", an agreement between two parties to exchange an asset or cash flow. A typical swap involves exchanging a fixed cash flow for an asset or cash flow whose value varies over time. Such a swap is equivalent to a portfolio of forward contracts that are bundled as a single instrument.
In an equity swap, for example, a company may agree to pay every six months for two years the cash equivalent of 1,000 shares of company Aristotle in return for the cash equivalent of 1,000 shares of company Plato. No stock changes hands, but the value of the contract is determined by the difference in the prices per share of the two companies on each of the swap's reset dates. The same result could be accomplished by going long on four forward contracts of 1,000 shares in company Plato stock and short four forward contracts on 1,000 shares of company Aristotle's equity, with the maturity dates of the four forwards being after six, 12, 18 and 24 months.
The second basic type of derivatives contract, an "option", gives holders the right, but not the obligation, to buy or sell an asset on or before a set date. A "call" option gives holders the right to buy and a "put" option gives the right to sell. When a call or put option is sold, the seller/writer must honour the purchaser's right to buy or sell if the purchaser "exercises" that right. Whereas forwards create unlimited liability, purchased options are limited-liability assets that act as a price insurance. In exchange for honouring such potentially unlimited liability exercises, option writers collect premiums from option purchasers.
Like forwards, options can be based on a variety of assets, reference rates, or indexes. The most common types of options are either "European" or "American". The former allows holders to buy or sell only on the option's expiration date, whereas the latter can be exercised by the buyer at any time on or before the option's expiration. Options that allow exercise on one of a few specific dates before expiration are dubbed "Bermuda options" because they lie between the two.
Like forwards, options can be combined with other products to yield new financial instruments sold as a package. A convertible bond, for example, is equivalent to a debt instrument plus an equity option or warrant. A series of call options on interest rates when maturity-matched and combined with a floating-rate loan, to take another example, is equivalent to a capped floating-rate loan.
Apart from mixing and matching forwards and options to create products, numerous contracts can be viewed as derivatives. Option-like contracts include: performance-based pay packages; the option to make part or full payment on a credit card; the option to delay a capital expenditure decision; the option to switch inputs or outputs in a production process; and so on. Indeed, corporate securities can be viewed as option contracts - debt as a short put and equity as a long call, both written on the assets of the company, with a striking price equal to the face value of that debt.
Exchange trading
Negotiating forward and option derivatives is done using fax, telephones and the internet. A typical "swap dealer" is an intermediary who enters into virtually any transaction, generally on either side (long or short) of the contract. Dealers thus transact with "end users", as well as providing customised transaction services for their customers. A bank dealer, for example, may provide services to derivatives customers, going well beyond derivatives dealing into cash management, custodial services, asset management and classical commercial banking.
That many derivatives are negotiated in a relatively opaque and highly decentralised dealer market is not surprising. This is the price for being able to customise fully the terms of a financial instrument - to know that what you get in terms of features and price may well not resemble what your competitor gets.
At the same time, not everyone values customisation, opacity and relationship management with a swap dealer. Some companies just want to get a derivatives deal done cheaply and as quickly as possible, and, provided the counter-party performs on the deal, are willing to transact with almost anyone. For such companies, "exchange-traded" derivatives provide an alternative to off-exchange forwards, swaps and options.
The most popular exchange-traded derivatives, "futures contracts", are economically equivalent to forward contracts with a few important exceptions. First, exchange-traded derivatives are standardised in many aspects, such as maturity date, settlement method, underlying asset type and quality, and delivery location. Off-exchange derivatives, by contrast, may be fully customised, provided the two parties agree on terms.
Exchange-traded derivatives are usually cleared centrally. This means a trader on a futures exchange need not worry about the credit risk of the trader on the other side of the transaction - unlike the forward or swap participant, whose contract value depends on counter-party performance. Immediately after a futures trade, the clearing house for the exchange interposes itself as counter-party to both traders. The exchange and clearing house may be the same organisation, as in the case of the Chicago Mercantile Exchange or Chicago Board of Trade, but this need not be so. Transactions on the London International Financial Futures Exchange, for example, are cleared by the London Clearing House. Indeed, the trend has been towards separate "listing" and "clearing".
An implication of standardised futures is that they can be "offset" before maturity. If company Melville agrees with company Conrad to go long on three-month gold futures but does not actually want the gold, Melville can go back into the market before final delivery and enter into an offsetting short. The company need not re-visit Conrad because the original deal has been legally transformed into an agreement of company Melville to buy gold in three months from the clearing house. Because both transactions are with the clearing house, Melville has taken itself out of the market, with only the price difference to be paid or collected.
The offset system, together with standardisation of exchange-traded derivatives, makes these derivatives markets highly liquid and deep, and hence often cheaper than their off-exchange cousins. Off-exchange derivatives, by contrast, can only be "unwound" before maturity if the original counter-party consents. This can be time-consuming and expensive.
Another distinction between futures and forwards/swaps is the use of margin, a type of performance bond that must be posted by traders to help mitigate losses incurred by the clearing house in the event of a default. If a trader is unable or unwilling to honour contractual obligations, he forfeits this performance bond. In addition, at least daily, the values of all open futures and exchange-traded options positions are marked to current market prices. Net winners may withdraw their profits, which are financed by deposits of additional margin made by losers. These daily payments and collections are called "variation margin", the effect of which is the de facto renegotiation of futures contracts each day to current market prices.
A final important distinction between off- and on-exchange derivatives is their regulation. For mainly historical reasons, exchange-traded derivatives in most countries are subject to heavier regulation. Such rules cover issues ranging from fraud and manipulation to cumbersome procedures for getting regulators' approval to list a new product. Exchanges listing derivatives can claim the benefit of "public regulation" (as opposed to the self-regulation of off-exchange markets), but only at the cost of delayed innovation and compliance.
Traders once faced a reasonably clear trade-off in considering whether to use off-exchange forwards and swaps or exchange-traded futures. If you wanted the credit risk protection of a central counter-party relying on a system of margin and daily resettlement, you went to the futures market. You perhaps also went to the futures market for transparent pricing, depth, significant liquidity and ease of unwinding or offsetting your position. But in getting these benefits, you sacrificed the ability to customise a deal.
Over the years, the distinctions between off-exchange forwards and exchange-traded futures have narrowed. Today, exchange-traded derivatives can be customised, making them more like off-exchange derivatives. And off-exchange derivatives, in turn, are often subject to collateral requirements and governed by performance guarantees that provide credit risk protection similar to that once offered only by exchanges.
In addition, new insurance products called "Alternative Risk Transfer" resemble off-exchange derivatives. The formerly separate worlds of exchanges and off-exchange bilateral contracts have begun to merge into a single global capital market, but how can investment managers use this integrated capital market?
Investment
Given the "derivatives-related" losses in the mid-1990s at Barings, Procter & Gamble, Metallgesellschaft and Long-Term Capital Management, should use of derivatives by investment managers be cause for worry? The answer depends, of course, on how they are used. In the case of Barings, rogue trader Nick Leeson used them to run a fraudulent off-the-books operation. Had he stuck to futures, Barings would still be around. Similarly, Procter & Gamble used derivatives to bet on interest rates. When the bet turned out wrong, the company lost out. But derivatives did not cause the loss; swaps were just used to place the bet.
In fact, asset managers who avoid derivatives are likely to be subject to greater criticism than by using them. Take the example of a pension plan that chooses to hold 60 per cent stocks and 40 per cent bonds for a year. If the market rallies in the first two quarters, the fund will find itself over-invested based on its original holdings. The firm can sell stocks, but this can be expensive. Alternatively, the firm can short stock index futures or equity index swaps, so reducing exposure to equities "synthetically" - but at much lower cost than if the stocks themselves had to be sold. Such "synthetic asset allocation" is especially prudent if the market is expected to reverse, which would necessitate a second rebalancing.
Derivatives can also be used to fine-tune investments. Many institutional investors cannot short stocks and cannot use unlimited-liability instruments such as equity swaps. By using option contracts such as "rainbow" or "spread" options, however, an investment manager can bet on the relative performance of several stocks or stock baskets for a price while locking in a maximum loss of the option premium paid. A spread option on the Nasdaq return relative to the FTSE 100, for example, invests on the performance of Nasdaq stocks against UK blue chips, but because it is an option, the manager cannot lose more than the premium paid for the position.
Consider a mutual fund with 30 per cent of its assets allocated in equities listed in markets outside its home country and currency. If the fund considers its managers' expertise to be stock selection, the fund may prefer not to avoid the exchange rate risk that international equities can create. Derivatives provide an easy solution in which the fund buys foreign stocks, "hedges" the exchange rate risk using forwards or futures and options, and ends up with an investment whose performance is a function of the equity price moves of foreign stocks as if they were denominated in the home currency of the fund.
To take a more recent example, what if a pension plan or mutual fund wants to diversify into a new asset class altogether - such as catastrophic insurance or bank debt used to fund mergers and acquisitions? Indeed, the performance of such "asset classes" as investments can be attractive on a return-to-risk basis, especially when they are part of a bigger, globally diversified portfolio. Without derivatives, it is difficult for funds to access these asset classes. But with the use of innovative credit derivatives such as total return swaps, investing in bank debt becomes possible. Derivatives-like ART products offered by the insurance industry have also helped promote new asset classes, particularly in catastrophic insurance.
Derivatives and risk
Derivatives can be abused, but so can other instruments. Risk management ensures that the risks taken are those to which investors want to be, and think they are, exposed. If derivatives are used by a hedge fund to exploit potential misevaluations arising from corporate actions and the fund loses money, this is not a risk management failure, provided investors knew about the investment. But if those same derivatives lost investors money because they were structured or managed improperly, risk management would have helped avoid the loss.
Asset managers should avoid risk management strategies that are biased against derivatives. Derivatives can replicate cash flows on many traditional financial instruments and, in turn, instruments such as stocks and bonds are themselves types of derivatives. So a risk policy specific to financial instruments is unlikely to be of much help. It is best to focus on a policy in which risk itself is controlled, regardless of whether risk is created by using derivatives or simply by, say, using reverse repurchase agreements and repurchase agreements to lever up a classical securities portfolio.
Derivatives can reduce costs of asset allocation rebalancing with limited liability instruments and avoid risks by hedging. Responsible use of derivatives is a reason to cheer, not shrink in horror.
Dr Christopher L. Culp is an adjunct associate professor of finance at the University of Chicago Graduate School of Business and managing director of CP Risk Management LLC in Chicago.
Further reading
* Culp, C.L. (2001) The Risk Management Process: Business Strategy and Tactics, New York: John Wiley.
* Hull, J.C. (2000) Options, Futures, and Other Derivatives, Upper Saddle River, NJ: Prentice-Hall.
* Jarrow, R. and Turnbull, S. (1999) Derivative Securities, New York: South-Western
Publishing.
* Smithson, C.W. (1998) Managing Financial Risk, New York: McGraw-Hill.