Risk Takers
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Risk Takers

Uses and Abuses of Financial Derivatives

John Marthinsen

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eBook - ePub

Risk Takers

Uses and Abuses of Financial Derivatives

John Marthinsen

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About This Book

Risk Takers: Uses and Abuses of Financial Derivatives goes to the heart of the arcane and largely misunderstood world of derivative finance and makes it accessible to everyone—even novice readers. Marthinsen takes us behind the scenes, into the back alleyways of corporate finance and derivative trading, to provide a bird's-eye view of the most shocking financial disasters of the past quarter century.

The book draws on real-life stories to explain how financial derivatives can be used to create or to destroy value. In an approachable, non-technical manner, Marthinsen brings these financial derivatives situations to life, fully exploring the context of each event, evaluating their outcomes, and bridging the gap between theory and practice.

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De Gruyter

Chapter 1
Primer on Derivatives

Learning to use derivatives is a bit like developing an athletic or musical skill. The key to success is understanding the fundamentals. This chapter focuses on the two most important derivative instruments, forwards and options, and explains how they are like Lego blocks in the sense that they are useful by themselves and for constructing more sophisticated structures.

What Are Derivatives?

A derivative contract is an agreement between two or more parties (also known as counterparties), whose value is based on movements in the price of an agreed-upon underling asset or factor, such as a stock, bond, currency, credit rating, or index. It is called a “derivative” because changes in its value are derived from changes in the price of a specifically defined underlying asset or factor, which is called, for short, the “underlying.”1 Every derivative contract has an underlying, whose price, at contract initiation, is called the current market price and, at maturity, the maturity market price.
Among the most popular, derivative underlyings are financial securities (e.g., equities, bills, bonds, and interest-earning deposits), commodities (e.g., agricultural products, precious metals, and energy), and currencies (e.g., euros, pounds, Swiss francs, and yen). However, there are active derivative markets in unexpected areas, as well, such as weather conditions, creditworthiness, and stock indices. They are “unexpected areas” because their underlyings cannot be delivered or would be extremely difficult to deliver at maturity. In such cases, cash settlement replaces actual delivery. Almost anything can serve as the underlying for a derivative contract. To be successful, it must be something that can be valued and is attractive enough so that many people are willing and able to buy and sell it.
Every derivative contract has a buyer and a seller, who are called counterparties. Consequently, there is a buyer counterparty and seller counterparty for every derivative contract traded. When a derivative is initiated, its master agreement establishes important terms, such as the price, quantity, quality, and date on which the contract will be settled in the future.
Derivatives have one major function, which is to transfer risks from those who are either unwilling or unable to bear them to those who are willing and able to do so. They are not sources of funds but, often, are attached to debt instruments, which are sources. Similarly, these financial instruments do not create wealth because the gains to one counterparty are matched by losses from the other; but make no mistake about the broader, beneficial role derivatives play in our real and financial markets. By improving the allocative efficiency of national and international financial systems, increasing liquidity, and improving price determination, derivative instruments create a bigger pie for everyone to share.

Who Buys and Sells Derivatives?

Derivatives are bought and sold by end users, arbitragers, and intermediaries. End users are individuals, businesses, and financial institutions, which utilize these financial instruments to hedge or speculate. Hedging neutralizes or mitigates the risks of an existing or expected position, and speculation intentionally increases these risks in order to earn profits.
Arbitragers are not interested in owning derivatives. Rather, they make small and (virtually) risk-free profits by simultaneously buying and selling them. In this way, they benefit from tiny discrepancies in the prices of financially identical (or similar) contracts offered on different markets.
Intermediaries make up the final group of participants in derivative markets. They connect buyers to sellers and are the creators of innovative derivative products. Dealers, brokers, banks, exchanges, and an army of financial wizards earn revenues from commissions, fees, and the difference between buy and sell (i.e., bid and ask) prices of derivative contracts. Market makers are intermediaries that quote customers both bid and ask rates, but as volatility increases, the spread between these buy and sell rates widens.

Where Are Derivative Contracts Bought and Sold?

Derivative contracts can be traded either over-the-counter (OTC) or on exchanges. Over the counter trades are mainly for non-standardized contracts and are executed via networks of dealers and traders, all communicating via phone and internet, while exchange-traded derivatives are bought and sold at distinct locations or on computer websites. Exchange-traded derivatives may be bought and sold by open outcry,2 such as on the floor of the London Metal Exchange, or they can be executed electronically, on computer websites, such as the Intercontinental Exchange or Eurex Exchange. The face value (also called the notional value) of OTC-traded derivative contracts is considerably larger than the notional value of exchange-traded contracts.3 Risk Notepad 1.1: OTC-Traded versus Exchange-Traded Derivatives, which is at the end of this chapter, provides a more detailed explanation of the similarities and differences between OTC-traded derivatives and exchange-traded derivatives.

Two Major Types of Derivatives

There are two types of derivative contracts: forwards and options. Readers with some exposure to derivatives might be asking themselves: “Hey, what happened to futures and swaps?” Futures and swaps are just modified versions of forward contracts. In short, if you understand forwards, then you will understand the other two. In this chapter, we concentrate on forward and option contracts—with futures and swaps being subcategories of forward contracts.

Forward Contracts

A forward contract is an OTC agreement to buy or sell the underlying, at a price agreed on today but with delivery on a specific day in the future or during a specified period in the future. Over the counter means dealer networks, linked by webs of telephone, telex, fax, and high-speed internet connections, which execute these trades. Their contract terms (e.g., underlying, size, and delivery date) are negotiable and can be tailor-made to customers’ needs. Because they are customized to individual customers, forward contracts, usually, are not tradable. Most are written with the intention of holding the positions until maturity, and cash settlement is common.

Futures Contracts

A futures contract is almost the same as a forward contact except it is traded on an exchange using brokers, and the contract terms (e.g., underlying, size, and delivery dates) are standardized. Most have active markets in only short-term maturities (i.e., less than one year). Due to their identical terms, futures contracts are tradable. Unless the futures contract is offset beforehand, the buyer and seller are obliged to transact the deal at maturity.

Swap Contracts

A swap is a series of forward contracts that mature sequentially between contract initiation and maturity. To reduce risks, payments are usually netted. For example, consider a five-year, $100 million interest rate swap agreement that requires ABC Inc. to pay XYZ PLC a fixed, semiannual interest rate of 6 percent. In return, XYZ PLC is required to pay a floating rate to ABC Inc. Suppose the counterparties initiate the contract on January 1 and the first payment is due on July 1. If the floating interest rate applicable to the first six months is 4 percent, then ABC Inc. would pay XYZ PLC $1 million ([i.e. [6%–4%] × 0.5 year × $100 million = $1 million) on July 1. If the floating rate is 8 percent, then XYZ PLC would pay ABC Inc. $1 million. Unless this contract is offset beforehand, the buyer and seller are obliged to transact the swap deal at each interim date and at final maturity date.

Option Contracts

An option gives a buyer the right, but not the obligation, to buy or sell the underlying at a price agreed upon now but with delivery on or before a specified expiration date in the future. There are two types of options, calls and puts. A call option gives the buyer the right, but not the obligation, to purchase the underlying at a price agreed upon now but for future delivery. A put option gives the buyer the right, but not the obligation, to sell the underlying at a price agreed upon now but for future delivery. Only buyers have the option. Sellers must transact these deals if buyers decide to exercise the rights they have purchased to buy or sell.

Forward Contracts

A forward contact allows counterparties to purchase or sell the underlying at a price agreed upon now but for settlement on a specified date in the future or during a specified period in the future. Buyers make no immediate payments to sellers when forward contracts are initiated. Payment takes place at maturity. Forward contracts often require delivery of the underlying at maturity, but some stipulate cash settlement. Because promises to pay in the future are not the same as cash in hand, these transactions carry default risks. As a result, derivative market participants must accept the creditworthiness of their counterparties.
Forward contracts are usually for relatively short periods (e.g., one year or less). One of the major benefits of OTC-traded contracts is their terms can be tailored to meet the needs of customers. At the same time, the benefits that come from customization can vanish quickly if counterparties wish to reverse their positions before maturity because the secondary market for most OTC-traded contracts is not liquid. To get out of a forward deal, there are two choices: transact a second contract with another dealer, which is equal and offsetting, or approach the original counterparty and negotiate an exit payment or receipt.

Long Forward in Action

An example: You manage a chain of U.S. retail stores and purchase dinnerware worth £100,000 from the British manufacturer, Josiah Wedgwood & Sons Ltd. To provide time to sell your new inventory of dinnerware, Wedgwood gives you one...

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