What are derivative securities
The Size of the Market
The market for derivative securities has become very large in recent years. Worldwide in the 1990's these securities provided "insurance" on an estimated $16 trillion of financial securities. In 2007, according to the International Swaps and Derivatives Association the notional value of all financial swaps was $587 trillion worldwide. The gross domestic product of the entire world in 2008 was only about $60 trillion.
The economic function of swaps and derivatives is to transfer risk from those who have it but who do not want to bear it to those who are willing to bear it for a fee. In this respect the derivatives market is much the same as the insurance industry. For example, a put option is insurance against the price of a stock falling. And, like the insurance industry, both the insuree and insurer are better off as a result of the transaction. However, one usually does not refer to this insurance function as insuring; it is called hedging.
Most of the transactions in these derivative securities is for speculation rather than for hedging. Nevertheless the speculators serve a purpose. They provide the liquidity for the market to fulfill its social function of transferring risk. For an example of the size of the market for derivatives compared to the underlying asset consider that the notional value of the credit default swaps in 2007 was $62.2 trillion. The total value of household real estate at that time was only $19.9 trillion.
A major part of the financial crisis of 2008 came as a result of businesses with risk involving their investment in home mortgages finding that that had not really transfered risk. This happened because they dealt with counter parties who could not possibly fulfill the financial obligations they had incurred. Thus the businesses with a risk of mortgagee defaults had merely transformed that risk into counter-party risk. However because the businesses thought they had transfered the risk they more heavily invested in the risky securities. Thus when mortgage defaults began to escalate the businesses found that in fact did not really have default insurance which meant their mortgage assets were worth far less than they had thought.
The derivative market, like the insurance industry, does involve gambling. The sizes of the bets in the financial markets however are vastly greater than in the gambling industry. Salomon Brothers had in the recent past derivative contracts for more than $600 billion in securities. The leader in derivative securities has been Chemical Bank which has contracts for $2.5 trillion in securities.
The sizes of the involvement of banks and stock brokerage firms in derivative securities raises fears that there could be a catastrophic loss that would bring about a collapse of the financial system. There had been cases which demonstrate the real dangers of such speculation. A German corporation, Metallgesellschaft, had an American subsidiary, MG Corp. which had been playing the derivative market. MG reported losses in 1993 of $500 million and its total losses could go to $800 million.
On the other hand, some participants in the derivatives markets are reporting huge profits. Chemical Bank reported profits of $236 million for the first nine months of 1993 and J.P. Morgan reported gains of $512 million.
The derivatives market involves more than just put and call options. There are also contracts involving swapping fixed interest rate payment streams for adjustable or floating interest rate payment streams. A company may have borrowed money under an adjustable interest rate security such as a mortgage and is now fearful that the interest rate is going to rise. It wants to protect itself against rises in the interest rates without going through the refinancing of the mortagage. The company or individual liable for an adjustable rate looks for someone who will pay the adjustable interest payments in return for receipt of fixed rate payments. This is called a swap. The origin of swaps can be identified
as a deal made between IBM and the World Bank. For more on swaps and their history see Swaps.
Other Derivative Securities
There are many other contracts that businesses may find of interest. A cap is a contract that protects against rises in the interest rate beyond some limit. Likewise some businesses may want protection against a price drop beyond some level. This type of contract is called a floor. A swaption (option on a swap) gives the holder the right to enter into or the right to cancel out of a swap. Similarly there are captions and floortions (options on caps and options on floors).
Forward Contracts and Futures
Swaps, caps, and floors are recent innovations in the derivatives markets. The derivatives market traditionally included forward contracts in addition to options (puts, calls, warrants). A forward contract involved a commitment to trade a specified item at a specified price at a future date. For example, if an American company will have need of 1 million British pounds six months from now they may avoid exposure to exchange rate risk by entering into a forward contract for the pounds now. The forward contract takes whatever form the two parties agree to. There is also a market for standardized forward contracts, which is called the futures market. The standardization makes possible a wider market with greater liquidity and efficiency. Often the futures markets eliminate the ties between specific parties, the party and the counter-party, and the risk that the other might not fulfill the contract. In the futures market everyone deals with the clearinghouse who guarantees fulfillment.
In the options market there has developed some terminology that is somewhat intimidating to the uninitiated. A call option is the right to buy a share of a stock, the underlying security, at a specified price, called the exercise price or the strike price. A put option is the right to sell a share of a stock at a specified price, the exercise price or the strike price.There is a limited time for the exercise of the call option. An American option can be exercised at any time up to and including the expiration date. A European option can only be exercised on the expiration date. The value of a call option at any time depends upon:
- 1. the current market price of the underlying security
- 2. the exercise price
- 3. the interest rate
- 4. time remaining until expiration
- 5. the volatility of the price of the underlying security.
When any of these change the value of the option will change.
The options terminology that is most obscure is the use of Greek letters to refer to the response of the option value to changes in the variables which affect it.
- Δ Delta = the change in the price of the option per unit change in the price of the underlying; i.e. the increase in option value if the current market price of the stock goes up by one dollar. Delta is important in creating a perfectly hedged portfolio. The rate of change of the delta of an option is called its gamma.
- ρ Rho = the rate of change in the price of an option in response to a unit change in the interest rate.
- θ Theta = the rate of change in the price of an option with respect to time; i.e. the change as the time until expiration decreases by one unit.
- Vega (this is not a Greek letter) = the rate of change in the price of an option for a unit change in volatility.
- Credit Default Swaps .
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