Derivatives. Pirie Wendy L.

executives and employees. These options are granted to provide incentives to work toward driving the stock price up and can result in companies paying lower cash compensation.15 Some companies also issue warrants, which are options sold to the public that allow the holders to exercise them and buy shares directly from the companies.16

4.4.2 Fixed-Income Instruments and Interest Rates

      Options, forwards, futures, and swaps on bonds are widely used. The problem with creating derivatives on bonds, however, is that there are almost always many issues of bonds. A single issuer, whether it is a government or a private borrower, often has more than one bond issue outstanding. For futures contracts, with their standardization requirements, this problem is particularly challenging. What does it mean to say that a futures contract is on a German bund, a US Treasury note, or a UK gilt? The most common solution to this problem is to allow multiple issues to be delivered on a single futures contract. This feature adds some interesting twists to the pricing and trading strategies of these instruments.

      Until now, we have referred to the underlying as an asset. Yet, one of the largest derivative underlyings is not an asset. It is simply an interest rate. An interest rate is not an asset. One cannot hold an interest rate or place it on a balance sheet as an asset. Although one can hold an instrument that pays an interest rate, the rate itself is not an asset. But there are derivatives in which the rate, not the instrument that pays the rate, is the underlying. In fact, we have already covered one of these derivatives: The plain vanilla interest rate swap in which Libor is the underlying.17 Instead of a swap, an interest rate derivative could be an option. For example, a call option on 90-day Libor with a strike of 5 % would pay off if at expiration Libor exceeds 5 %. If Libor is below 5 %, the option simply expires unexercised.

      Interest rate derivatives are the most widely used derivatives. With that in mind, we will be careful in using the expression underlying asset and will use the more generic underlying.

4.4.3 Currencies

      Currency risk is a major factor in global financial markets, and the currency derivatives market is extremely large. Options, forwards, futures, and swaps are widely used. Currency derivatives can be complex, sometimes combining elements of other underlyings. For example, a currency swap involves two parties making a series of interest rate payments to each other in different currencies. Because interest rates and currencies are both subject to change, a currency swap has two sources of risk. Although this instrument may sound extremely complicated, it merely reflects the fact that companies operating across borders are subject to both interest rate risk and currency risk and currency swaps are commonly used to manage those risks.

4.4.4 Commodities

      Commodities are resources, such as food, oil, and metals, that humans use to sustain life and support economic activity. Because of the economic principle of comparative advantage, countries often specialize in the production of certain resources. Thus, the commodities market is extremely large and subject to an almost unimaginable array of risks. One need only observe how the price of oil moves up as tension builds in the Middle East or how the price of orange juice rises on a forecast of cold weather in Florida.

      Commodity derivatives are widely used to speculate in and manage the risk associated with commodity price movements. The primary commodity derivatives are futures, but forwards, swaps, and options are also used. The reason that futures are in the lead in the world of commodities is simply history. The first futures markets were futures on commodities. The first futures exchange, the Chicago Board of Trade, was created in 1848, and until the creation of currency futures in 1972, there were no futures on any underlying except commodities.

      There has been a tendency to think of the commodities world as somewhat separate from the financial world. Commodity traders and financial traders were quite different groups. Since the creation of financial futures, however, commodity and financial traders have become relatively homogeneous. Moreover, commodities are increasingly viewed as an important asset class that should be included in investment strategies because of their ability to help diversify portfolios.

4.4.5 Credit

      As we previously discussed, credit is another underlying and quite obviously not an asset. Credit default swaps (CDSs) and collateralized debt obligations (CDOs) were discussed extensively in an earlier section. These instruments have clearly established that credit is a distinct underlying that has widespread interest from a trading and risk management perspective. In addition, to the credit of a single entity, credit derivatives are created on multiple entities. CDOs themselves are credit derivatives on portfolios of credit risks. In recent years, indices of CDOs have been created, and instruments based on the payoffs of these CDO indices are widely traded.

4.4.6 Other

      This category is included here to capture some of the really unusual underlyings. One in particular is weather. Although weather is hardly an asset, it is certainly a major force in how some entities perform. For example, a ski resort needs snow, farmers need an adequate but not excessive amount of rain, and public utilities experience strains on their capacity during temperature extremes. Derivatives exist in which the payoffs are measured as snowfall, rainfall, and temperature. Although these derivatives have not been widely used – because of some complexities in pricing, among other things – they continue to exist and may still have a future. In addition, there are derivatives on electricity, which is also not an asset. It cannot be held in the traditional sense because it is created and consumed almost instantaneously. Another unusual type of derivative is based on disasters in the form of insurance claims.

      Financial institutions will continue to create derivatives on all types of risks and exposures. Most of these derivatives will fail because of little trading interest, but a few will succeed. If that speaks badly of derivatives, it must be remembered that most small businesses fail, most creative ideas fail, and most people who try to become professional entertainers or athletes fail. It is the sign of a healthy and competitive system that only the very best survive.

      The Size of the Derivatives Market

      In case anyone thinks that the derivatives market is not large enough to justify studying, we should consider how big the market is. Unfortunately, gauging the size of the derivatives market is not a simple task. OTC derivatives contracts are private transactions. No reporting agency gathers data, and market size is not measured in traditional volume-based metrics, such as shares traded in the stock market. Complicating things further is the fact that derivatives underlyings include equities, fixed-income securities, interest rates, currencies, commodities, and a variety of other underlyings. All these underlyings have their own units of measurement. Hence, measuring how “big” the underlying derivatives markets are is like trying to measure how much fruit consumers purchase; the proverbial mixing of apples, oranges, bananas, and all other fruits.

      The exchange-listed derivatives market reports its size in terms of volume, meaning the number of contracts traded. Exchange-listed volume, however, is an inconsistent number. For example, US Treasury bond futures contracts trade in units covering $100,000 face value. Eurodollar futures contracts trade in units covering $1,000,000 face value. Crude oil trades in 1,000-barrel (42 gallons each) units. Yet, one traded contract of each gets equal weighting in volume totals.

      The March–April issue of the magazine Futures Industry (available to subscribers) reports the annual volume of the entire global futures and options industry. For 2011, that volume was more than 25 billion contracts.

      OTC volume is even more difficult to measure. There is no count of the number of contracts that trade. In fact, volume is an almost meaningless concept in OTC markets because any notion of volume requires a standardized size. If a customer goes to a swaps dealer and enters into a swap to hedge a $50 million loan, there is no measure of how much volume that transaction generated. The $50 million swap’s notional principal, however, does provide a measure to some extent. Forwards, swaps, and OTC options all have notional principals, so they can be measured in that manner. Another measure of the size of the derivatives market is the market value of these contracts. As noted, forwards and swaps start with zero market value, but their market value changes as market conditions change. Options do not start with zero market value and almost always have a positive market value until

15

Unfortunately, the industry has created some confusion with the terminology of these instruments. They are often referred to as stock options, and yet ordinary publicly traded options not granted to employees are sometimes referred to as stock options. The latter are also sometimes called equity options, whereas employee-granted options are almost never referred to as equity options. If the terms executive stock options and employee stock options were always used, there would be no problem. You should be aware of and careful about this confusion.

16

A warrant is a type of option, similar to the employee stock option, written by the company on its own stock, in contrast to exchange-traded and OTC options, in which the company is not a party to the option contract. Also note that, unfortunately, the financial world uses the term warrant to refer to a number of other option-like instruments. Like a lot of words that have multiple meanings, one must understand the context to avoid confusion.

17

As you will see later, there are also futures in which the underlying is an interest rate (Eurodollar futures) and forwards in which the underlying is an interest rate (forward rate agreements, or FRAs).