Finance

Derivatives (Introduction) : Why They Are NOT The Reason For This Big Mess

December 06, 2016

The 2008 Global Financial Crisis (GFC), which saw the collapse of Lehman Brothers, almost bringing down the world’s financial system, was considered by most economists to be the worst recession in 80 years. Economic recovery remained weak years later, and like a cancerous tumour that cannot be stopped, the financial crisis slowly evolved into the Euro crisis which was soon followed by complicated political ramifications (Brexit for example), threatening the core survival of the European Union and European Central Bank.

Human beings love to find scapegoats for this big mess, and it is easy to push the blame to something we don’t understand. It is convenient (and unfair in my opinion) to blame ‘derivatives’, ‘securitisation’, ‘asset-backed products’, ‘mortgage backed products’, and other jargon known only to financial geeks for the big mess we are in today!

Before we do any finger-pointing, I think we should start by understanding:

(1) What derivatives are,

(2) Different types of derivatives, and lastly,

(3) How derivatives are used.

Yes, we need to start from the basics. And after that, you can decide for yourself whether derivatives should really be blamed for this mess we are in. Okay, let’s start.

What are derivatives?

Most people tend to shy away from derivatives because they have a misconception that derivatives are complex, high-risk instruments that ordinary folks should avoid.

But do you know that most of us, knowingly or unknowingly, have used derivatives before? Let me give you an example.

When you enter into an Option-to-Purchase contract with a seller to purchase a HDB flat, the Option-to-Purchase contract is a form of derivative.

Let me explain what a derivative is and you will understand why. A derivative is something that derives its value from something else, which is an underlying asset. Therefore, a derivative must always go hand in hand with an underlying asset.

Back to our earlier example. The Option-to-Purchase contract is a derivative, while the HDB flat is the underlying asset, and the price of the Option-to-Purchase contract derives its value from the price of the HDB flat.

In the financial markets, there are different types of derivatives, with corresponding underlying assets. The main types of underlying assets are equities, fixed income, currencies and commodities. In some places, you can have more interesting derivatives like weather derivatives. The underlying assets of these weather derivatives will be the weather – rain, temperature, snow. Yes, weather is now not just an environmental issue, but also an economic issue.

Derivatives can be traded either over-the counter (OTC) or via the exchange (exchange-traded).

(a) Exchange-traded derivatives

Exchange-traded, as the name suggests, means that the derivative is traded via an exchange (e.g. SGX, NYSE, etc.). Below are some unique characteristics of exchange-traded derivatives.

– If I buy an exchange-traded derivative, technically my counterparty is the derivatives exchange I am trading on, thus eliminating any default risk (unless the derivatives exchange collapses, which is very unlikely).

– Prices and maturity of derivatives contracts are transparent and standardized, as everyone needs to buy or sell based on what is quoted on the exchange.

– Another important feature of exchange-traded derivatives is that you need to maintain a margin (a small amount) with the exchange. Your margin will increase or decrease every day, depending on whether you make gains or losses on your derivative contracts. If your margin falls below the minimum threshold, you will need to top up your margin to the minimum amount, or else you risk your derivative positions being liquidated.

– Examples of exchange-traded derivatives include futures and options.

(Margin is a concept that you need to understand if you decide to trade in exchange-traded derivatives. There is an interesting movie ‘Margin Call’ made in 2011 on the 2007-2008 financial crisis. The purpose of a margin is to ensure companies can fulfil their obligations based on their open futures or options positions to minimize counterparty risk. So, before trading, you will need to place an initial margin, which is a small sum of money set by the exchange. Every day, your trading positions will be marked-to-market at end of day, and daily profit and loss will either add to or reduce your margin account. If your margin falls below the maintenance margin, which is the minimum amount required for margin, or some call it variation margin, your broker will issue a margin call. When that happens, you need to deposit more money to top up your margin back to the minimum maintenance margin level.)

 

(b) OTC derivatives

Trading of OTC derivatives is less formal as compared to exchange-traded derivatives

– OTC derivatives are normally privately negotiated between two parties, typically between you and the dealer (the market-maker).

– OTC derivatives are more tailor-made and flexible. Pricing is less transparent, as the dealers may not quote you the same price as they make to other customers.

– Liquidity can be an issue for OTC derivatives, if the dealers or market-makers choose to withdraw from quoting prices any time.

– Examples of OTC derivatives include forwards, swaps and options.

Some derivatives are more complicated than the rest, and I have not used all of them before in my professional life. But I will share with you the main ones more commonly used by corporates in the next section.

Different Types of Derivatives

The four main types of derivatives are forwards, futures, options and swaps.  There are many more complex (or exotic) instruments like cliquets, binaries, mountain range, rainbow options, which are probably unheard of for most ordinary folks like us. Personally, I think that if you are working in the corporate treasury profession, understanding these four main types of commonly-traded ‘vanilla’ derivatives will be more than sufficient to meet your company’s objectives of trading in derivatives!

Let me introduce these derivatives one by one.

(a) Forwards

Forwards are customized contracts to buy or sell assets at a specified price on a future date.  They are traded OTC, which means that they are privately negotiated between two parties. You can further sub-divide ‘forwards’ into various sub-categories like currency forwards, commodities forwards, etc.

– For example, you can enter into a forward contract to purchase a fixed amount of commoditiesg. gold, at a certain agreed price 3 months from now. 3 months later, you are obliged to pay the agreed price to the seller, and the seller is obliged to give you the gold, as per the terms in the forward contract.

– You can also enter into forward contract with a FX dealer to purchase currencies at a specified future date. At the specified future date, you and the dealer will be obliged to trade the specified currencies at the agreed FX rate (forward rate).

Non-deliverable Forwards

Another common type of forwards is the non-deliverable forwards, or NDFs. The difference between NDFs and other forward contracts is the manner in which NDFs are settled. Typically for forward contracts, the sellers is obliged to transfer the underlying assets to the buyers, and the buyer is obliged to pay the seller the amount of the underlying assets, based on the agreed price, or forward rate. However for NDFs, they are settled in cash on a net basis (difference between forward rate and spot rate at maturity), and the underlying assets do not exchange hands between the buyer and seller.

Take for example, I enter into a NDF to purchase 100 million IDR at forward USDIDR rate of 14000 in 3 months. Upon maturity 3 months later, the spot USDIDR rate is 13500. Instead of exchanging USD for IDR, I will just receive the difference between the spot rate and forward rate in cash from my counterparty.

Based on NDF, amount of USD I was supposed to pay for 100M IDR = 100M / 14000 = 7,143 USD

Based on spot rate, amount of USD I was supposed to pay for 100M IDR = 100M / 13500 = 7,408 USD

Amount of cash in USD I am supposed to receive for settlement of NDF = 7,143 – 7,408 = 265 USD

NDFs are usually done offshore (Read this if you do not understand the difference between onshore and offshore currencies), which makes it difficult for enforcement or supervision by central banks. But we are starting to see more central banks like Bank Negara Malaysia reinforcing offshore trading rules. My view is that perhaps in the near future, we will probably see tighter regulations on the NDF markets.

(b) Futures

Futures work the same way as forwards, except that they are exchange-traded derivatives. Like forward contracts, they are financial contracts to buy or sell assets at a specified future date and price, so I won’t repeat the mechanics of a futures contract.

However, as futures are exchange-traded derivatives, the contracts are standardized, and trading in futures require you to put a margin (see section above for explanation of initial margin, maintenance margin and margin call) before trading is allowed. The margin typically is 5% to 15% of the contract’s value. There are virtually every type of futures contracts, ranging from commodities and currencies to stock indices and even weather futures.

(c) Options

Options, as the name suggests, are contracts that give you the option to buy or sell an underlying asset at a specified price (exercise price or strike price) at a specified later date. A call option is an option to buy, whereas a put option is an option to sell.

Unlike forwards which create an obligation to buy or sell at a later date, longing (or buying) options give you the right, but not the obligation to buy or sell the underlying asset at a later date. For example, you purchase a call option to buy a share at $4 per share 3 months from now. 3 months later, if the share rises to $4.50, you will want to exercise your right to buy the share at $4 per share, instead of the market price of $4.50 per share (exercising the option). In doing so, you will profit $0.50 per share (minus the initial cost of option) when you exercise your option. However, if the share price is $3.50 three months from now, you will not want to exercise your option, and your loss will be the cost of the option you paid (or option premium) when you enter into the option contract.

Another difference between forwards and options is that there is no upfront cost for a forward contract, meaning no payment is required to enter into a forward, whereas there is a cost required to purchase an option. The cost of the option is called the option premium or how much the option is worth to the buyer and seller. The option premium depends on several factors – the underlying asset’s price, the useful life of the option (when the option matures), the option’s strike price in comparison to the underlying asset’s price (whether it is in the money, at the money or out of the money) and the volatility of the underlying asset’s price (the greater the volatility, the greater the option premium).

It is difficult to explain pricing of options theoretically (This is a domain reserved for the true math geeks). But as a professional working in finance and treasury, just know for a start that there are two basic ways to price an optionBinomial and Black Scholes. The formula is quite complicated, and you probably don’t have to use it in your professional working life in finance or treasury since your companies probably have Bloomberg and Reuters which can do the job for you. Don’t fret however if you do not have such luxuries in your company, as there are many free awesome online calculators that can perform option pricing equally well (I recommend using this one).

(d) Swaps

Swaps are another big group of derivatives that are traded OTC between private parties. Investopedia defines a swap as ‘an agreement between two parties to exchange sequences of cash flows for a set period of time.’ Like forwards, there is no cost required to pay upfront, when you enter into the swap contract (remember for options, you need to pay the option premium upon inception).

The two most common types of swaps are interest rate swaps and currency swaps.

Interest rate swap

A ‘plain-vanilla’ interest rate swap involves exchanging a floating rate of interest payments for fixed rate of interest payments. Let me give a short example of how one might decide to use an interest rate swap.

For example, I currently have a loan payment with interest payments of LIBOR + 0.5%, but I prefer a fixed interest rate, as I do not want to be exposed to the risk of LIBOR fluctuations. So, I enter into a swap contract with another counterparty to exchange my LIBOR payments (floating) for fixed rate interest payments.

 

Currency swap

A currency swap involves exchanging both principal and interest payments in different currencies with another counterparty. Let’s see another example of how a currency swap works.

For example, my company is a USD company and I have a loan denominated in Euros. So I have regular interest payments and a final principal payment that I need to make in Euros. But let’s say I prefer to pay in USD, as I do not want to be exposed to currency risk. So, I enter into a swap contract with another counterparty to exchange the principal and interest payments in Euro for principal and interest payments in USD.

 

Like the example of NDFs explained above, both parties to the swap contract can settle at net, i.e. they compare the difference between the two payments at the prevailing rates and settle only the difference with each other.

How Derivatives are Used

To conclude our short introduction to derivatives, I will briefly discuss how derivatives can be used, and why the market for derivatives is growing. Derivatives are used for two main purposes – speculation and hedging.

Speculation

By speculation, I mean that you have a view on the underlying assets’ price, and you hope to profit by entering into the derivatives contract. Derivatives are excellent for speculation, because they allow us to leverage and earn huge profits with a small amount of capital. Of course, this is highly risky and I won’t recommend it, because you can potentially lose more than your initial starting capital. Nevertheless, let’s see a short illustration of how derivatives can help you leverage your profits.

For example, if I am 100% sure that the stock price will rise in the next 3 months, I can enter into a 3 months stock futures, which only require minimal amount of margin as capital, or purchase stock options, paying only the option premium upfront. Contrast this with using your limited capital to purchase a small amount of the underlying stock and earning a limited profit when the stock price increases.

[Please note that I do not recommend using derivatives for speculation, because I believe nobody can ever be 100% sure of the future!]

Hedging

For those working in treasury and finance in large corporates, you probably will be exposed to currency and interest rate risks. Hedging the risk means ‘to reduce the risk by taking an offsetting position’.

How can we use derivatives to hedge my currency or interest rate risks?

For example, if my company is a USD company, and hold mainly USD in our bank accounts. However, my company needs to make regular THB payments to our suppliers in Thailand. My company will therefore be subject to USDTHB market fluctuations. As a good and responsible finance professional, I will want to hedge the THB risk by entering into currency derivatives like a forward contract to buy a fixed amount of THB to lock in the FX rates from day 1.

Sounds simple.

But in reality, hedging is an art, and before you do any hedging, you need to have good understanding of your company’s operations, good visibility of your company’s cash flows and risk exposures and make sure that you have the capabilities of monitoring your outstanding positions on a regular basis, which is a challenge in itself, depending on the complexities of your company’s business. Investing in a good system (like a treasury management system), or creating forecast models using Excel are different ways companies handle this issue, and I will gladly discuss with you on how to do it, if you are interested.

Conclusion

I hope with this short introduction, you have a better understanding of derivatives. I will be honest with you that what I have covered is just the basics, and we have just barely touched the surface. There is much more advanced stuff like accounting for derivatives, derivative pricing and different combinations of derivatives – options on futures, swaptions, and other exotics, which I can try to explain in simple human language (sorry, it can get quite technical for more advanced topics) if you aspire to be a true finance geek.

about author

Lee is currently pursuing a Master’s degree in Finance at INSEAD. Prior to his Master’s, he has worked for about five years in the treasury and accounting space. He graduated from SMU with a double degree in Accountancy and Finance, and is also a Chartered Accountant (Singapore). Other than building Excel spreadsheets and poring through annual reports, he spends his time reading and watching sci-fi movies.