For Hewlett-Packard and all other Silicon Valley companies, innovation has been a strategic decision. Choosing Silicon Valley as a paradigm has been a deliberate choice because many financial experts today think that its pattern may one day characterize the banking industry, as smaller bou- tiques multiply. By all likelihood in the years to come the banking industry too will be characterized by start-ups and former start-ups that became giants—similar to the rise of Microsoft, Intel, and Apple in the field of information technology.
Practically everything changes over time. Organizational and structural issues are as well very important regarding the relation of the service firm to its clients, looking at services as a concept that continues to evolve over time. Additionally, an indispensable part of every design, produc- tion, and delivery process is the need for rules and feedback proce- dures focusing on quality management. Metrics and methods must be available to per- mit dependable analysis of patterns of service, on which manage- ment can base corrective action.
A thorough and critical examination is an integral part of the management infrastructure necessary for providing the stimulus for steady innovation and for the manage- ment of change. The currently pre- dominant families of financial products are shown in Figure 1.
A little-appreciated fact about derivatives is that they blur distinc- tions between instruments regulated by different authorities responsible for market discipline. Many of them are customized. They promote novelty without the need for com- plex documentation or extensive negotiation. To suc- ceed, it capitalized on a great deal of trust its people had in the future of its products and services, as well as on their own ability to deliver.
In fact, the distinguishing feature of Silicon Valley is not electronics but entrepreneurship. The same feature characterizes companies engaging in financial innovation. Entrepreneurship succeeds when managers, engineers, finan- cial experts, and other professionals are willing to invest an inordi- nate amount of time and effort in pursuing their goal while avoiding the beaten path. They must also communicate their ideas well enough to attract venture capitalists and enthusiastic collaborators.
Warren Buffett calculated that trading the stock for beans and simultaneously selling cocoa beans on the commodities market would result in a huge profit because the market had soared. Taking advantage of price discrepancies in separate markets is the best example of benefit derived from insight.
Experi- mentation helps in accelerating the learning process, building know-how on the basis of day-to-day experiences. Experimenting in new ideas, methodologies, designs, and marketing strategies is what makes the entrepreneur keen in creating new markets and products—rather than protecting the status quo. This sort of spirit sees to it that the entrepreneur does not have a unique method or technology that he or she keeps close to the chest but excels in what is known as the first-mover advantage in product or service innovation and in capturing market share.
The first-mover advantage also helps in attracting venture capital for an infusion of cash and in building investor confidence. As explained in the preceding section, trust is a crucial factor in service science. Up to a point, but only up to a point, the gearing of equity makes the firm more efficient—though the risk increases. If not properly managed, successive layers of leveraging and exposure will eventually lead the company into trouble.
To appreciate the foregoing statement, the reader should understand that one of the characteristics of new financial instru- ments is the switch from dealing with assets to dealing with lia- bilities. Traditionally, bankers have been preoccupied with the assets side of business, which has underpinned the whole process of giving loans. From an entrepreneurial viewpoint, the new world of wholesale money markets has worked to the benefit of both the banks and their clients, particularly those more sophis- ticated.
Just as a money center bank can sell certificates of deposit and securitized mortgages or corporate loans around the world, a big multinational corporation can circumvent the bank and sell promissory notes or commercial paper , paying interest rates lower than those a bank demands for a loan. Entrepreneurship has been instrumental in revamping inter- mediation, an age-old concept in banking.
Restructured intermediation may also be employed for regulatory, tax, or other reasons.
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The instruments of intermediation may be specially designed derivatives Chapter 2 that enable participants to buy or sell an underlying asset at a predetermined forward price; options that grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price; or swaps and other cus- tomized over-the-counter OTC contracts. They permit the holder to virtually simulate any financial activity by redrawing assets and liabilities, separating and recombining different types of exposures, bypassing what regulators may pro- hibit, and changing the taxation profile of a client, investor, or company.
This is an investment product with a wide variety of characteristics, and its importance has significantly increased in the early years of the twenty-first century. CHAPTER 1 Financial Innovation 17 Tailored to meet a range of investment objectives, these instruments share the characteristic that banks establish for them bid-ask prices on each trading day: If the certificate is based on a performance index, Then on expiry of the period, interim earnings on the underlying asset can generally be collected as capital gains.
As advantages of index certificates, market participants cite that they have relatively low transaction costs and comparatively good liquidity; they require a low minimum capital outlay; and they provide a basis for risk diversification. From a legal view- point, index certificates are debt securities on which no interim dividends are paid. A single repayment is made when the certifi- cate matures.
Moreover, critics say that lack of transparency also prevails in connection to their pricing. True enough, pricing is most often a challenge with financial instruments, but the more complex they are, the more opaque they become. Basically, the value of index certificates, or participation cer- tificates, is derived from their underlying. Generally the underlying is key domestic and foreign share indexes. Shipowners who know how to play with the system could use it to hedge the future value of their assets, while speculators employ the paper ship index for profits.
What this index provides is the ability to page the value of assets, but as with all hedges, there is the risk of a counterparty going bust Chapter 4. Leveraged bets have great risks because nobody really knows which way the market will switch. Experts had not really foreseen this, but while everybody has been jumping on the bandwagon, very few people have been question- ing whether and when the shipping boom which started in will end.
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At the origin of the paper ship index is a brokerage firm: Clarkson Ship Brokers. Annoyed by the fact that insurance compa- nies have not been providing residual value insurance, Richard Fulford Smith, one of its brokers, developed a derivative to fill the gap. Expert insurers say that dealing with the paper ship index is a game too complex for small ship owners, but it can be rewarding to those who truly understand its risk and reward profile.
As with any instrument, the pricing affects the issuer, the buyer, and the market as a whole. Still another challenge is that of arriving at a fac- tual and documented answer to the question of how far the paper ship index is effective in laying off risk. As all derivatives, one of the counterparties will benefit and the other will lose. CHAPTER 1 Financial Innovation 19 This is tantamount to speculating, and some experts suggest that serious shipping companies should not be interested in the paper ship index. Another reason for this negative reaction is that a derivative shipping instrument cannot, and does not, have a com- mitment to high quality of services.
A crucial problem confronting the shipping insurance market is that it has not reached a level at which it incorporates an appropriate price for assumed risk. It comes therefore as no surprise that freight derivatives have interested not only invest- ment banks but also shipowners, though the majority is still cau- tious about an instrument they know little about.
Forward freight agreements FFAs are still relatively new in the market, even if experts suggest that with time they will become an inevitable part of shipping. People careful about instrument design, as well as its risk and return, say that FFAs are not traditional forward contracts see Chapter 2. Their handling needs a lot of sophistication that does not yet exist in the shipping sector, particularly among companies which are small- to medium-sized family-run organizations.
There is as well the opinion that, as it has happened with other complex instruments, most markets are not ready to embrace FFAs. Today, there is no forewarning system on credit risk, though there is an ongoing discussion that includes some of the parties involved in FFA transactions. Knowledgeable people suggest that a sound approach is to include all of the parties: shipowners, charter- ers, operators, and FFA brokers and the exchange s.
Critics, how- ever, say the idea that brokers would draw up such a forewarning system poses an inherent conflict of interest. Some experts advise that to help themselves calculate the odds, shipowners should make macroeconomic analysis and study macro- opportunities. Many forward deals like currency exchange, stock indexes, bond futures, and several other derivatives have a macrodi- mension. Moreover, momentum must be gained with profits commensurate to the risks being taken.
Risk and return sees to it that shipowners are more likely to use forward freight agree- ments when they labor to secure part of their new-building projects. Deals in the futures and forwards markets Chapter 2 stand or fall by the short- to longer-term balance between risk and reward. An analysis of the fundamental motivation for entering into a given type of transaction permits entrepreneurs and their risk managers to determine whether the transaction is suitable for the firm.
Derivatives based on uninformed speculation are the sort of trans- actions that over the past decade have been the primary sources of losses for investors and intermediaries. Being careful and analytically minded implies that one has to do his or her homework prior to commitment. Expert opinion helps, but one should not depend solely on experts. Over time I would fill the gaps. This happens for many reasons, two of the most important being that novelty tends to have many unknowns and the fact that, in spite of that, clients always demand greater sophistication and inventiveness of features—which has inherent risks.
Combining lending and trading with counterparties leads to risk correlation. This and similar practices create concentric circles of credit risk and market risk, which will eventually lead to unexpected consequences. Innovation is always welcome, but to keep on beingahead of the curve, we must know the risks we are taking beforehand, not after the fact. Precisely for this reason, it has been a deliberate choice to introduce the reader to the concepts underpinning the control of risk in Chapter 1—even prior to the definition of derivative instru- ments, which is done in Chapter 2.
Risks assumed with financial instruments are by no means limited to derivatives. They can be found all over the debt market junk bonds being an example and in the equities market. In contrast, over the same period the equity price increase of many established industrial companies was mediocre or nil, with declines at Bethlehem Steel, Boeing, Caterpillar, DuPont, Lockheed Martin, and U.
The need for steady and rigorous watch over exposure is pres- ent, without exception, with every single investment. Compared to horse-and-buggy classical bonds and equities, complex derivatives are supersonic engines. This section is not the only case in this book where emphasis is placed on risk management. Practically every chapter has some- thing to say on the control of risk. The concept of risk management can be wide. On August 29, , at the annual meeting of the Fed of Kansas, Dr.
He said the term means a combination of judgment and analytics. Also, their projections on inflation and its aftermath, including inflation caps and floors, are not the same. Yet, they are all members of the same process of service science. A similar statement is valid about risk control decisions made in connection to new and old financial instruments. But a personal trait that distinguishes great risk managers from the average lot is the ability to say No! And sometimes those filters are very irritating to people who check in with us about businesses—because we really can say no in 10 sec- onds or so to 90 percent of all of the things that come along, simply because we have these filters.
Filtering is a key word in finance. This is not a matter of always being negative but rather of using intelligence and good business sense. That is a cornerstone to every risk management action; sticking to it filters out a lot of things. And we can assess that very fast. Successful investors appreciate that in finance, as it is in science in everyday life, a chain of events can reach a point of crisis that magnifies small changes. As a popular verse has it, For want of a nail, the shoe was lost; For want of a shoe, the horse was lost; For want of a horse, the rider was lost; For want of a rider, the battle was lost; For want of a battle, the kingdom was lost!
Seen under this perspective, risk management is a metalevel higher-up level in a hierarchy of quality control missions and functions that guide the hand of professionals in regard to current and future exposure. Noise is any unwanted or irrelevant input that alters the message. In risk control, this noise may well be a psy- chological factor that alters the behavior of the trader, loans officer, investment advisor, or other professional.
In service science, filtering works in conjunction with the statistical decision system that is shown in Figure 1. The scope of quantitative and qualitative analysis is to sort incoming informa- tion elements into groups with the criterion being their deviation from specifications, limits, or tolerances. In a similar way, incoming data streams can be analyzed to give answers to a potentially wide variety of problems involving compliance to, or alternatively lack of observance of, tolerances.
CHAPTER 1 Financial Innovation 27 The principles of communications theory enable the controller to assume the proper perspective in evaluating the performance of the system under his or her supervision—and its produce. At a metalevel, risk management may decide not to suppress errant impulses in the production process trading, investments, loans, or activities but to exploit them in order to unearth hidden trends. Or to exert tighter control, which requires continuously gauging not only trading and investment positions but also personal characteristics and attitudes.
This should be made in a way that keeps business activities within established tolerances, but without creating a bureaucratic culture or killing individual initiative. For instance, in the seventeenth and eighteenth centuries forward con- tracts in commodities, particularly rice, were traded in Japan.
Role of Derivatives in Causing the Global Financial Crisis
It is therefore not surprising that the large majority of early deriva- tives trades involved commodities rather than financial instru- ments. True enough, the first currency swaps appeared in the s, but they were used mainly for circumventing British capital con- trols rather than for trading for profits. Financial derivatives, as we know them today, really started in the s—with profits and losses written off-balance sheet OBS. There were commitments to extend credit; standby letters of credit; finan- cial guarantees written sold ; options written; interest rate caps and floors; interest rate swaps; forward contracts; futures contracts; obligations on receivables sold; obligations under foreign currency exchange contracts; interest rate foreign currency swaps; obliga- tions to repurchase securities sold; outstanding commitments to purchase or sell at predetermined prices; and obligations arising from financial instruments sold short.
Since then, however, the world of derivatives has undergone dramatic changes. Other events, too, have had an impact, as we will see in this chapter. Easily the most outstanding positive development of the s and beyond has been the increased emphasis bankers and investors place on risk management. Both regulators and the better-governed firms have focused on ways and means for control of actual and potential exposure, with new legislation and regulation being instrumental in achieving this result.
Additionally, the booming trade in derivatives has seen to it that these instruments are no longer minor off-balance-sheet receiv- ables and payables. They are integral parts of mainstream balance sheet BS activities, not only of banks and other financial institu- tions but also of a long list of other firms, including hedge funds, pension funds, and insurance entities, as well as manufacturing and service companies. A real-life event helps in explaining this statement. You should only con- trol the balance sheet. You have also to appreciate the positions your company has off-balance sheet.
As Figure 2. Theo- retically at least, fair value is market value. Practically, the two are not always equal because, among other reasons, market value is subject to panics and other extreme events. Their changing nature and rapidly growing usage saw to it that existing distinctions among the many types of contracts had become blurred.
For their part, regulatory authorities have called for the mod- ernization of accounting and disclosure standards in order to address new financial products and new risk management tech- niques. They have as well cited serious deficiencies in disclosures, particularly connected to market risk exposure—an issue that the Basel Committee on Banking Supervision BCBS regulated through the Market Risk Amendment to the capital adequacy stan- dards for credit risk of , known as Basel I Chapter 6.
It is not, therefore, sur- prising that both the FASB in the United States and the International Accounting Standards Board IASB in other countries, including the member states of the European Union, have established extensive dis- closure requirements concerning derivatives and other financial instruments. The definition also specifies that a derivative instrument typically requires no initial investment, or one that is smaller than would be needed for a clas- sical contract with similar response to changes in market factors. Also part of the IASB definition is the fact that the derivatives con- tract is settled at a future date.
As the reader should appreciate that this IASB twenty-first- century definition of derivatives is neither quite different nor quite the same as the definition of derivatives by the FASB. This is regrettable because it leaves open to multinational companies the possibility to game the system.
Accounting rules see to it that interest rate swaps, futures, forward rate agreements, and other interest rate instru- ments must be accounted for and revalued on an item-by-item basis. Typical currency products are futures, forwards, swaps, options, and options on futures. Interest rates, currencies, and equi- ties are traded in spot positions and forwards and as options.
Currencies and equities are often traded as spot positions. CHAPTER 2 Derivatives 35 exchange forward transactions, forward legs of foreign exchange swaps, and other currency instruments involving an exchange of one currency for another at a future date must be included in the foreign currency position.
Derivatives disclosed as guarantees are issued in the ordinary course of business, generally in the form of written put options and credit default swaps CDSs. An investment bank manages its expo- sure to these derivatives by engaging in various hedging strategies Chapter 4. For some contracts, like written interest rate caps or foreign exchange options, the maximum payout is not easy to com- pute as interest rates or exchange rates could theoretically rise with- out limit.
Repurchase agreements repos are a popular derivative at which regulators look with great care.
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Securities lending indemni- fications are arrangements in which the bank agrees to indemnify securities lending customers against losses accrued in the event that security borrowers do not return securities subject to the lending agreement and the collateral held is insufficient to cover the market value of the securities borrowed. The IFRS accounting rules require that a repurchase agreement is recorded as a collateralized inward deposit on the liabilities side of the balance sheet. By contrast, the asset given as collateral remains on the assets side of the balance sheet.
A reverse repurchase agreement reverse repo must be recorded as a collateralized out- ward loan on the assets side of the balance sheet for the amount of the loan. This money is never actually to be paid or received. It may be a number of shares, currency units, kilos, bushels, or other metrics underpinning the derivatives con- tract. The obligations of counterparties are established on the basis of this notional principal amount—a concept that applies to a wide range of instruments. The same is true with the term underlying in a derivatives transaction. This may be a specified commodity price, share price, interest rate, cur- rency exchange rate, index of prices, or something else.
It may also be a variable applied to the notional principal amount to determine the cash flows or other exchange of assets required by the deriva- tives contract. In a general sense, the security involved in an option or other derivatives transaction is the underlying security. More on options in Chapters 7 to Notice that while the underlying may be the price of an asset or liability, in itself it is not an asset or liability. Interest rates are the underlying of interest rate swaps; currencies are the underlying of currency swaps; gold is the underlying of gold futures.
The making of a derivative instrument whose value is based on an underlying has been a stroke of genius and a major step for- ward in financial engineering. In a way not unlike that of the phys- ical sciences, innovation sometimes works through giant steps, but more often it works through steps that are smaller and that borrow on something already known. An example from the military is the original development of the tank, which eventually became a for- midable weapon. A very important concept in physics, engineering, and finance is that once a new product, be it a tank, a derivative, or something else, gets underway, it establishes its own market environment and operating conditions, which may have very little to do with those of its original components.
To explain this concept, Figure 2. As the Figure 2. Understanding nonlinearities is fundamental in appreciating the price functioning of products in derivatives markets, including risk, return, structure, cash flows, and obligations, as well as condi- tions at contract termination. Typically, the nonlinearities that char- acterize derivative financial instruments see to it that these require a much more rigorous review and evaluation than classical finan- cial products. The return mechanisms of a given instrument have to be properly analyzed in terms of their origin and sustenance.
Theoretically, profit elements may be derived from upfront fees, or upside potential of, say, an index. Practically, however, fees may be subject to discounts and upside profits are never guaran- teed as they are dependent on the direction the market takes. If the bank is unable to understand and control exposure emanating from its own derivatives book, then it will eventually register major losses.
The reader should appreciate that this concept of nonlineari- ties, largely introduced with derivatives, is new in finance, and it is still far from being properly understood in all quarters. This has a precedence in the natural sciences. The concept of linearities in underlying relationships is loved by many people because it makes it relatively easy to analyze risk.
But neither Mother Nature nor complex financial instruments work that way. This move from stability to chaos and then again to stability sees to it that even some very simple systems could produce aston- ishingly rich patterns of behavior; all that is required is nonlineari- ties. Eventually, the sequence would become so complex that events would seem to come at random.
If a given product carries unusually high or complex risk parameters, Then the profit structure should reflect these characteristics, on a factual and documented basis, which is not easy. In spite of difficulty and even adversity, the right pricing of a derivatives instrument is fundamental to the provision of a certain assurance that the issuer will be in charge of its exposure. Risks associated to projected profit payoffs must be well understood before the product is offered to the customer or launched in the market.
It is highly unadvisable to guesstimate the return. An option is an agreement between a buyer and a seller that, when exercised, gives the former the right, but not the obligation, to require the option writer seller to perform cer- tain specified obligations. The price a buyer pays to a seller for an option is its premium, meant to compensate the seller for his or her willingness to grant the option.
The price at which the option can be exercised is the strike price. The last day on which an option can be exercised, or off- set, is the expiration date. An option is exercised at the sole discretion of the buyer who will tend to act only when it is in his interest to do so. The put option holder can make a profit if prices decline, while limiting his loss to the money paid as premium if the asset increases in value.
Futures and forwards are different types of instruments, as they may require the holder to buy or sell an underlying asset at some time in the future. Unlike an option, the holder cannot simply let the contract lapse. Futures are current commitments that can be exercised, as their name implies, in the future.
They are traded in exchanges and have a market, except of course in the case of panic. Futures take the form of contracts in which the quantity of the underlying and expiration date are standardized. Forwards are not traded on exchanges; they are over-the- counter OTC instruments, essentially bilateral agreements that have no active market. While superficially they might seem similar to options, inas- much as they entail the obligation to deliver or take delivery on a specified expiration date of a defined quantity of an underlying— and do so at a price agreed on the contract date—forwards and futures can involve major risks because of the leverage they make possible.
In an interest rate swap, one counterparty pays the other a fixed rate of interest based on some variable rate of interest. The latter changes as market interest rates change. Traders often look at the swap as a portfolio of forward con- tracts, one for a cash payment date and each written at the same forward price. For instance, a swap can be used to offset the risk of an uncovered position, seeing to it that there is a future cash flow that would move in the opposite direction to that of a hedged position.
At least theoretically, swapping cash streams from assets enables companies and investors to turn one type of asset or liabil- ity into a different one, as well as to execute a number of other bilat- eral transactions. This statement is also valid for many other instruments. Swaps are also made with commodities. Like the interest rate swaps, a commodity swap is a financial contract between two parties that effectively fixes the price of an asset for a period of time. The parties typically agree to the length of the swap, settlement period s within the swap, quantity of the commodity swapped per settle- ment period, and fixed price of the commodity.
A market currently in the upside is that of credit risk swaps. A credit risk swap is a plain-vanilla version of credit derivatives3 whereby the protection buyer pays the protection seller a fixed recur- ring amount in exchange for a payment contingent upon a future credit event; for instance, bankruptcy. In exchange for this premium: If that event takes place, Then the protection seller must pay the agreed compensation to the protection buyer.
Depending on the amount involved in the credit swap, this helps to cover part or all of credit loss pursuant to default. By trans- ferring credit risk from protection buyer to protection writer, credit default swaps have opened up new opportunities for trading and other business transactions. These instruments, which as counter- party agreements involve their own credit risk, help in price dis- covery.
Options on caps, floors, and swaps give the purchaser the right, but not the obligation, to buy or sell the underlying instruments. Swaptions are basically options on other derivatives, also known as compound options. Current and future challenges with derivative financial instru- ments are not so much associated to products that have become commodities but to the so-called exotics. The latter are innovative and complex instruments, very difficult to price the right way, and involve too many unknowns whose aftereffects are revolutionizing the banking industry.
Exotic derivatives are products of rocket scientists Chapter 1 who see to it that the name and nature of these derivatives steadily change. Therefore, for supervisors, bankers, and investors, a better way than naming the instrument itself is to classify a derivatives trans- action as exotic by the fact that its price and underlying are linked by a nonlinear function. As we saw in the preceding section, this function may exhibit chaotic characteristics. Breaking such barriers usually results in steep changes in the payoff function, which are most difficult to foretell.
Good management practice requires that prior to making bets on exotic derivatives, it is necessary to develop not only good understanding but also reliable price monitoring and measurement techniques. Without them, one should never invest in the multitude of exotics offered in the market. A similar policy should be followed with synthetic and structured derivative instru- ments as discussed in the following sections.
In conclusion, short of adequate preparation, proper staffing, and full understanding of risk and return, the most likely outcome will be a torrent of red ink. As exotics are becoming the instrument of choice in financial engineering, losses suffered by many corporate treasurers, pension fund managers, bankers, and investors have been recently hitting the headlines. If the reader wishes to retain a valuable message from this section, it would be that he or she needs to really appreciate that custom-made and exotic derivatives are bringing with them a host of new learning requirements and associated expo- sures.
Without the ability to make these instruments reveal their risks, and to do so before commitment, exotics can be deadly because the doors of risk and return are adjacent and indistinguishable. This, however, is not the majority opinion. According to the international financial reporting standards IFRS , a synthetic instrument is a financial product designed, acquired, and held to emulate the characteristics 4 Economist, London, June 4, Such is the case of a floating-rate long-term debt combined with an interest rate swap. Because the synthetic short sale seeks to take advantage of price disparities between call and put options, it tends to be more prof- itable when call premiums are greater than comparable put premi- ums.
The holder of a synthetic short future will profit if gold prices decrease and incur losses if gold prices increase.
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A synthetic put seeks to capitalize on disparities between call and put premiums. Basically, synthetic products are covered options and certifi- cates characterized by identical or similar profit and loss structures when compared with traditional financial instruments, such as equities or bonds synthetic options are discussed in Chapter 9, and synthetic futures in Chapter Basket certificates in equities are based on a specific number of selected stocks.
A covered option involves the purchase of an underlying asset, such as equity, bond, currency, or other commodity, and the writing of a call option on that same asset. The writer is paid a premium, which limits his or her loss in the event of a fall in the market value of the underlying.
Role of Derivatives in Causing the Global Financial Crisis
The concept underpinning synthetic covered options is that of duplicating traditional covered options, which can be achieved by both purchase of the underlying asset and writing of the call option. Moreover, synthetic covered options do not contain a hedge against losses in market value of the underlying. A hedge might be emulated by writing a call option or by calculating the return from the sale of a call option into the product price. The option premium, however, tends to limit possible losses in the market value of the underlying. This pre- sents a sense of diversification over a range of risk factors.
Region certificates are derived from a number of indexes or companies from a given region, usually involving developing countries. Basket certificates are derived from a selection of companies active in a certain industry sector. An investment in index, region, or basket certificates funda- mentally involves the same level of potential loss as a direct invest- ment in the corresponding assets themselves.
Their relative advan- tage is diversification within a given specified range; but risk is not eliminated. Moreover, certificates also carry credit risk associated to the issuer. Also available in the market are compound financial instru- ments, a frequently encountered form being that of a debt product with an embedded conversion option.
An example of a compound financial instrument is a bond that is convertible into ordinary shares of the issuer. These should be characterized by practically the same terms, albeit without a con- version option. Embedded derivatives are an interesting issue inasmuch as some contracts that themselves are not financial instruments may have financial instruments embed- ded in them. This is the case of a contract to purchase a commodity at a fixed price for delivery at a future date. Contracts of this type have embedded in them a derivative that is indexed to the price of the commodity, which is essentially a derivative feature within a contract that is not a financial deriva- tive.
International Accounting Standard 39 IAS 39 of the IFRS requires that under certain conditions an embedded derivative is separated from its host contract and treated as a derivative instrument. As it is to be expected, both the U. For instance, the IFRS specifies that each of the individual derivative instruments that together constitute a synthetic financial product represents a con- tractual right or obligation with its own terms and conditions.
Therefore, when one financial product in a synthetic instrument is an asset and another is a liability, these two do not offset each other. Many are custom-designed bonds, some of which over the years have presented a number of problems to their buyers and holders. This is particularly true for those investors who are not so versatile in modern complex instruments and their further-out impact.
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Typically, instead of receiving a fixed coupon or principal, a person or company holding a structured note will receive an amount adjusted according to a fairly sophisticated formula. These derivative instruments target changes in currency rates. They are disguised to look like bonds, by structuring them as if they were debt instruments, mak- ing it feasible for investors who are not permitted to play in curren- cies to place bets on the direction of exchange rates. For instance, instead of just repaying principal, a PERLS may multiply such principal by the change in the value of the dollar against the euro; or twice the change in the value of the dollar against the Swiss franc or the British pound.
The fact that this repayment is linked to the foreign exchange rate of different currencies sees to it that the investor might be receiving a lot more than an interest rate on the principal alone—but also a lot less, all the way to capital attrition. Even capital protection notes involve capital attrition since, in cer- tain cases, no interest is paid over their, say, five-year life cycle.
Structured note trading is a concept that has been subject to several interpretations, depending on the time frame within which the product has been brought to the market. Many traders tend to distinguish between three different generations of structured notes. At currently prevailing rates, this means that the superfloater has a small coupon at the beginning that improves only if the LIBOR rises. Theoretically, a coupon that is below current market levels until the LIBOR goes higher is much harder to sell than a big coupon that gets bigger every time rates drop. Still, bear plays find customers.
Second-generation structured notes are different types of exotic options; or, more precisely, they are yet more exotic than superfloaters, which are exotic enough in themselves. There exist serious risks embedded in these instruments, as such risks have never been fully appreciated. For instance, if the range width is set to basis points, the investor has to determine at the start of the period the high and low limits within that range, which is far from being a straight job. Surprisingly enough, there are investors who like this because sometimes they are given an option to change their mind; and they also figure their risk period is really only one quarter.
In this, they are badly mistaken. Such notes usually appeal to a different class than fixed-income investors. For instance, third-generation notes are sometimes purchased by fund managers who are in the fixed-income market but want to diversify their exposure. In spite of the fact that the increasing sophistication and lack of transparency of structured financial instruments sees to it that they are too often misunderstood, and they are highly risky, a horde of equity-linked and commodity-linked notes are being structured and sold to investors.
An irony associated to this structured product is that when buying it, the average investor has no clear idea that he or she bets against a set of forward yield curves, which tend to slope upward but may be flat or trend downward see Chapter The pros say that flexibly structured options can be useful to sophisticated investors seeking to manage particular portfolio and trading risks.
Strategy is a master plan against an opponent, and financial strategy is no exception to this rule. As such, it is intended to posi- tion a company or an investor against the market. As another example, because of cost differences between cash and futures markets, an asset allocation program might be more cost-effective by using derivatives, pro- vided that exposure is kept under lock and key. The rich array of even the most basic derivative financial instruments briefly reviewed in Chapter 2 helps in documenting that the derivatives business is not merely a middleman operation.
With the exception of exchange-traded products that are standard- ized, rarely will traders resell exactly what they bought. Freedoms taken in product redesign is one of the reasons why derivatives have been revolutionizing corporate finance and banking. The introduction of new variables in product design has changed the rules of the game. In the late s and early s, as the derivatives market took off, experiments with new financial instruments became the sign of distinction of top-tier banks. Though the sophistication of financial experiments has not reached that of similar activities in engineering and physics, analysis and experimentation—therefore creativity—has opened up new per- spectives in service science.
For instance, the financial institution may provide an oil- exploration outfit with a floor on the price of oil by selling it as a commodity put. As this example suggests, the key to using derivatives in a suc- cessful way is to match an appropriate financial strategy to a par- ticular objective, within a given time horizon. In part because of simulation and in part because of new insight provided through mathematical analysis, rocket scientists realize that a lot of creative design can be done with financial instruments.
At the same time, the most brilliant among them have also found out that a torrent of innovation may be dangerous with- out a concomitant development of rigorous risk management methods. Suppose a bank sells a call option on a security and that secu- rity shoots up in price. The buyer wins, but the bank might also win if it has hedged out the price risk. Not just with derivatives, but in every walk of life, a sound policy requires looking for asymmetries well before making a deci- sion. Nowhere is this advice more important than in pricing.
Many unknowns are associated with the strategic use of derivatives, and nothing short of a thorough analysis and experimentation can provide a measure of assurance regarding end results. Experts suggest that, in the years to come, the trend to customization will gain momentum as the investor popu- lation increases and its focus shifts from acquiring a stock of goods to that of maintaining its financial well-being.
An opinion frequently heard in the course of the research that led to this book is that the shift toward the personalization of financial instruments, as contrasted to the sale of products off the racks, has not yet been properly appreciated by most bankers. Yet this switch has many surprises in store, not only for the financial community, but also for governments, industry at large, and the general public. Effective supervision poses great technical demands on the regulators them- selves, and many central bankers are simply not up to it. Philosophically, we may compare their importance to that of the paper money introduced in France in the s, which lost its worth with the Mississippi Bubble and bankruptcy of the Royal Bank.
Or we can look at customization as a generic development that is here to stay. Regarding this second option, a good example at the corporate level is provided by Cisco Systems. All companies conducting business on a global basis and hav- ing investments in several countries are exposed to adverse move- ments in foreign currency exchange rates. To protect themselves, they enter into foreign exchange forward contracts, which help to minimize the short-term impact of foreign currency fluctuations on payables, receivables, and investments.
This is a sound way of looking at risk and return with expo- sure control as the main target. Here is an example: According to GAAP, as well as the IFRS, management intent is an important element in the classification of derivative products as marked-to-market for financial reporting purposes, or carried at the original contractual price. The former is the case of instruments intended for trading; the latter of those held to maturity. One of the issues discussed in meetings on customization of derivative financial products has been the impact of regulation.
Opinions were divided. Some bankers welcomed regulation as long as it does not stifle competition and innovation more on this in the following section. In the opinion of other bankers, however, regu- latory controls and restrictions carry with them the danger of swamping economic growth, and if regulators overdo their pru- dential supervision, they might strangle risk taking. In the course of these same research meetings, there has been a convergence of opinions regarding the fact that in the last 40 years, no other financial product has puzzled regulators as much as the explo- sion of futures, options, and swaps in currencies, equities, interest rates, and commodities.
Additionally, this has increased the risk appetite of market players. One of its many plays was tax optimization. The liquidation of a position in a portfolio position contracted over the counter is usually a rather complex affair. Sometimes the investor is liquidat- ing the position in distress as in a fire sale, while in other cases a still liquid big player buys out the whole portfolio or a big chunk of it. In contrast to OTC deals, in the exchanges, fair value estimates are done through bid and ask.
However, if and when they are, they will be established by dealers in these instruments with personal con- siderations in mind. Consequently, it may be difficult to estimate what a fair price is. In turn, opaque pricing leads to difficulties in estimating expo- sure. This is an equally important constraint because typically OTC derivatives involve greater risk than investing in standardized on- exchange derivative instruments. On the other hand, as we have seen in the preceding section, major advantages of OTC transac- tions are their flexibility and customization.
The fact that there is no exchange market on which to close out an open position is a risk factor. Yet, in spite of that, the number of types and volume of derivatives traded over the counter has increased con- siderably in the past few years. Prior to the introduction of credit derivatives, currency prod- ucts dominated OTC, while interest rate instruments were by far the most traded in exchanges.
Tables 3. They have also introduced a great amount of credit risk, over and above the market risk of past deals, with the subordinated tranches of CDOs being very sensitive to changes in creditworthiness. As Figure 3. In practically all types of over-the-counter transactions, coun- terparty risk is highly important since there is no exchange to effect delivery versus payment DVP. In case of financial turbulence, this highly concentrated intermediary function can turn into a highly unsettling factor.
While concentration on a small group of financial institutions with plenty of capital and significant expertise probably tends to reduce the likelihood of a disruption in financial markets, in case some other reason creates a market disruption, it increases the poten- tial for systemic risk. They also point out that though risks faced by banks in their interbank positions are dif- ferent for assets and liabilities, in the general case shocks can be quickly transmitted within the banking system through the inter- bank market.
CHAPTER 3 Strategic Use of Derivatives 63 This likelihood is making mandatory the regular monitoring of interbank linkages, as well as of business relations between banks and hedge funds. At the same time, simply mapping of prevailing interbank relationships is not sufficient to measure contagion risk in the whole interbank market. Ready access to a large pool of interbank lenders reduces the risk of a loss of liquidity for financially sound institutions in the case of the withdrawal of any specific creditor bank.
On the other hand, cross-border interbank credit risk implies an increase in cross-border creditor exposure. Moreover, from a strategic viewpoint, counterparty risk and market liquidity risk are closely interlinked, with the latter particu- larly associated with the simultaneous unwinding of similar trad- ing positions because of so-called crowded trades. In turn, this might exacerbate tensions that could spill over to other markets, with rise in risk premiums and market liquidity tensions in the credit markets as well as a significant change in risk appetite.
This creates the threat that, unde- tected, a small mistake can create unexpected headwinds. Its notion relates to the willingness of investors, speculators, and other market participants to take more and more risks when volatility is low and creditworthiness high without necessarily calculating what will happen if there is a major reverse.
Risk appetite can be measured through the exposure assumed by people and companies, as well as by the financial market as a whole. The innovative ability of new financial instruments promotes risk appetite. For instance, labor unions can buy an unemployment derivative that allows them to bet on the outcome of a strike or the effects of inflation on wages. By doing so, they commit funds without the hindsight that comes by knowing how to analyze in advance risk and return. It needs no explaining that as the types of instruments expand, so does the market. If people with risk appetite can buy disability insurance to protect themselves in case illness prevents them from working, why should one be unable to buy a livelihood derivative that compensates its holder if his or her chosen career does not flourish?
Sounds impossible? It is not so. Who would have thoughts 20 years ago about derivatives that permit the investor to sell and buy credit risk? Since the mids, as the preceding section has briefly explained, credit derivatives enable the bank to sell the credit risk in its loans portfolio and allow a buyer to diversify the exposure embedded in his or her securities holdings by mixing credit risk and market risk. A growing risk appetite sees to it that some institutional investors like that mix. Indeed, many analysts consider credit deriv- atives as default mitigating instruments whose time has come.
Figure 3. By contrast, some economists look at risk aversion as a relatively time-invariable degree of caution toward uncertainty, at least among certain investors. These econo- mists add that the reason for lack of complementarity lies in the fact that Risk aversion reflects the underlying attitude to all types of financial exposure rather than only describing risk reception within a specific financial market environment. In the opinion of some experts, prudential regulation and supervision see to it that risk appetite and risk aversion are not a zero sum game.
Therefore, even if risk aversion is the more general market sentiment, central bankers are concerned by spikes in risk appetite that could create systemic risk. However, this increased integration also involves unknowns and requires effectively addressing financial disturbances and their systemic implications. For this purpose, simulation exer- cises on factors affecting financial crisis can provide regulators with a fruitful insight.
The message delivered in this testimony is that few people really appreciate the tricks of the trade connected to derivatives. Similarly, derivatives can be used as a way to hide invest- ment losses, even big ones. What about staying at the safe side by forecasting future events in the financial markets?
Mutual funds, pension funds, hedge funds, and insurance companies, among other entities, enter into it because their perfor- mance is measured relative to their peer group, not by an absolute yardstick of earnings. It may sound clever to dismiss bonds without covenants as a cyclical phenomenon, but they are in fact a sign of a profound moral rot at the heart of the system for which both buyers and sellers of these certificates of confiscation are treating capital with disdain. While the credit markets gutted any and all protections for lenders, the equity markets worked just as hard to remove them for stockholders.
ETFs are an incredibly noxious invention that lure investors with the promise of low costs, ease of execution and virtually any type of equity exposure they desire while relieving them of any responsibility to possess a micro-byte of knowledge about what they own. As a result, ETFs and their promoters created the least educated, most complacent and most arrogant generation of investors in history. Add to ETFs the tens or hundreds of billions of dollars of stocks owned by central banks, sovereign wealth funds, and other non-economic buyers as well as nearly a billion dollars a year in corporate buybacks financed with cheap borrowing and markets no longer provide genuine price discovery or reliable signals about corporate performance.
None of these factors existed before the financial crisis, certainly not to the degree they do today. Much of this money is levitating the price of a relatively small group of stocks affectionately known except by short sellers as the FAANGs. Unfortunately, these companies are not changing the world in the way that people think they are.
Even electric cars, which are supposed to save the earth, create their own environmental problems electricity production causes pollution and we are going to have to dispose of those batteries somewhere and are sadly led by a profoundly flawed prophet in Elon Musk. FAANG evangelists never mention that the rise of the FAANGs coincided with an explosion in suicides and drug overdoses in America, but maybe someone should look into whether this mere coincidence or a consequence of the increasing isolation and narcissism fed by new technology.
America is not as strong economically as current economic data suggests. Growth has definitely improved from the Obama years, but it is based on rising debt levels and unsustainable wealth inequality. We are heading straight into another financial crisis resulting from too much debt and too much speculation. Americans congratulate themselves about their ability to innovate, but a disproportionate amount of this innovation is related to unproductive activities like consumerism and gossip.
We need policies that promote substantive economic growth rather than financial engineering social media-driven navel-gazing. The sugar high from the tax bill peaked in the second and third quarters. This is troubling. Companies like Facebook and Google own mindshare over empty minds. We need to fill these minds with useful ideas and promote the ability for those minds to express themselves rather than shut them down over antediluvian ideas about political correctness.
And this brings us to where we are today.