Excerpt
Contents:
1 Introduction
2 Derivatives
2.1 Definition
2.2 Usage of derivative contracts in basic strategies
3 The common types of derivatives
3.1 Futures and forward
3.1.1 Basic characteristics and differences
3.1.2 Futures and forward pricing
3.1.3 Hedging, speculating using futures and forward
3.1.3.1 Hedging
3.1.3.2 Speculating
3.2 Swaps
3.2.1 Basic characteristics
3.2.2 Four basic types of swaps
3.2.2.1 Interest rate swaps
3.2.2.2 Currency swaps
3.2.2.3 Credit swaps
3.2.2.4 Commodity swaps
3.2.3 Swaps pricing
3.3 Options
3.3.1 Basic characteristics
3.3.2 Options strategies
3.3.2.1 Call option
3.3.2.2 Put option
3.3.3 Option valuation
3.3.3.1 Intrinsic and time value
3.3.3.2 Binomial option pricing
3.3.3.3 Black-Scholes valuation
4 Credit default swaps and the financial crisis 2007 - 2008
4.1 Credit default swaps on companies
4.2 Credit default swaps on subprime mortgage-backed securities
4.3 The financial crisis 2007-2008
4.3.1.1 The operation of securitization
4.3.1.2 Why did the financial crisis happen?
5 Conclusion
References
1 Introduction
When securities are mentioned, people commonly think of stocks and bonds as the effective investment tools. The stock market is huge, in which stocks and bonds are only a few of investment tools. There are any other countless concepts and tools which serve the same purpose of maximizing profits for investors: Among them, derivative securities, which have been indicated as the first important factor. Derivative securities - also known as derivative stock - are financial instruments, which are built on the basis of investment tools such as stocks and bonds. Their various objectives are known as risk diversification, profits protection or profits making. Derivatives help to hedge risks of price reduction, if any, not to stabilize price. In those markets, for example, stock options, option contracts are transacted. Derivatives securities are classified into four main types: forward, option, swaps and futures.
Recent years have been witnessing the development of the derivatives markets. According to the Bank for International Settlements of Basel, the OTC derivative contracts worldwide increased to $596 trillion at the end of 2007. A number of financial institutions and banks assumed derivatives to be a great financial instrument which brings many profits for their users. Warren Buffet, the legendary investor, however warned about the risks of derivatives, which threatened to endanger the financial market system. In the annual letter to shareholders in 2002, he wrote “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”1. His words were demonstrated to be true through the financial crisis in 2007-2008. Except in the case of Lehman Brothers’ bankruptcy, many big financial institutions and banks were rescued by governments or had been acquired by other enterprises. The subprime mortgage default was initially blamed for this financial crisis. However the true culprits were later identified to be credit default swaps and the credit guarantee2.
This paper work will focus on four types of derivatives and analyze their characteristics and their operation for the purpose of understanding the financial crisis in 2007-2008, the credit default swaps in the financial market will be defined. The link between credit default swaps and financial crisis will also be explored. The governments’ policies in order to take control over the derivatives in financial market will be mentioned. In the conclusion part, the advantages and disadvantages of derivatives will be discussed.
2 Derivatives
2.1 Definition
“A derivative is a term that refers to a wide variety of financial instruments or contract whose value is derived from the performance of underlying market factors, such as market securities or indices, interest rates, currency exchange rates, and commodity, credit, and equity prices”3. Most derivatives are traded in OTC markets. Derivative securities play an important role for both enterprises and investors, because enterprises use them to manage risks on their corporate activities and corporate projects. For individual investors, derivatives lighten the risks on the portfolios. They can also generate more profits in investment through arbitrage or speculation. The derivative instruments include a wide range of the contracts. In general they are divided into four main types: forward, future, swaps and option. Many financial institutions, enterprises and individual investors use derivatives as an effective tool in hedging, speculation, portfolio diversification and arbitrage.
2.2 Usage of derivatives contracts in basic strategies
The purpose of any investment in the financial market is to maximize the value of the assets. However, the rise in the value of underlying assets always associates with different risks. The greater the risk is taken, the greater the returns investors receive in the future. For reducing the risk of negative price changes in underlying assets, hedging is used. When derivatives are traded, the price risks transfer to another party. “Derivatives are also useful when the quantity of the underlying assets to be hedged is uncertain”4. If the number of the hedged underlying assets is known, option contracts are an ideal choice. Because the original value of the assets changes when prices fluctuate. The hedging activities can be found mostly in the currency, interest rate or commodity risk management.
While some investors use hedging to avoid the unexpected risks in their investment activities, speculators willingly take any kind of high risk. In finance, speculation is defined as the activities of buying, selling or short selling of financial assets such as stocks, bonds, commodity products or derivatives to make profits from the price changes in the market. The speculative activities are applied to the underlying assets when prices fluctuate. Therefore, speculation is a high risk business. Contrary to the speculation is purchasing or selling of the assets to increase income through dividend or interest rate, also known as investment. The good side of speculation is providing the amount of capital, so that the liquidity increases in the markets. Furthermore, investors may use it for arbitrage to eliminate risks. Speculation nevertheless also has negative effect. When speculation occurs, prices of goods can rises more dramatically than its real value. The traders will then enter into the situations, in which they can get more profits. This effect makes the prices continues increasing artificially and contains the potential risks as well. The financial assets are bought and sold at the same time in the different markets for generating profits and incurring no risk, called arbitrage. When the act of buying and selling concurrently happens, the portfolio is found. In arbitrage, it’s divided into three common types, i.e.: stock arbitrage, currency arbitrage and interest-rate arbitrage. By the same type of financial asset, its prices vary in different markets. Assets are bought at the cheap price and sold at higher price in another market. Through the difference of prices, investors gain more profit5.
In finance, risks are inevitable. With putting their money into one type of shares or bonds, investors face up to high potential yield or loss of their entire investment. In “Modern Portfolio Theory”, Markowitz proved, risks can be reduced through diversification in various types of investment assets, which are called portfolio. Additionally, it helps investors gain more profits through optimization of investment plan. The portfolio diversification does not completely eliminate risks, but it can reduce them. Portfolio diversification is divided into two types: vertical and horizontal diversification. Nowadays, the phrase “portfolio diversification” becomes familiar in financial market. For reducing risks in portfolio, investors should invest in various securities, an ideal portfolio should contain not only stocks with high profits but also bonds with low profits and thus be relatively safe.
3 The common types of derivatives
3.1 Futures and forward
3.1.1 Basic characteristics and difference
Futures and forwards contracts are an agreement between two counterparties to purchase or sell the underlying assets at a predetermined price at a future date. In futures and forward contracts, there are two common terms, i.e. long and short position. Adopting the long position, the buyer agrees to buy the goods in the future and has to pay seller at the delivery price, which is agreed upon today. In return, the seller who is obligated to deliver goods for the delivery price assumes “a short position”.
Forward is a private commitment between two parties and traded in OTC market. The terms and conditions are specified by the parties. That’s why forward is known as a customized contract. Because the agreement is directly negotiated by the buyer and the seller, a clearing house doesn’t exist. The underlying asset can only be purchased or sold at the day of the maturity. “These contracts are unregulated and private because the parties don't want much of the government interference in it. But it doesn't mean that there is something illegal in the contract. The contracts are private because the parties don't want to disclose much about the customized contracts”6.
In contrast, futures are a standardized contract and traded on future exchange. It is marking to market and its transaction works through the clearing house. A margin account must be created and a fixed amount of money maintained in it. Margins are divided into two types: initial and maintenance margin. At the beginning of futures, investors oblige to put a fixed value of securities in account, called initial margin. Compared to initial margin, the maintenance margin is defined as the minimum level, which assures the value of securities, is not allowed to fall below. If the value falls lower than the minimum level, investors have to make an additional payment in order to bring the account to the original value of the initial margin.
Table 1: The major difference between forward and futures contract
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Source: www.thefinanceconcept.com/2011/03/difference-between-forward-contracts.html
3.1.2 Futures and forward pricing
Futures and forward contracts are effective derivative tools to manage risks. However, the ability to profit in those contracts is limited because of the focus on risk management. For forward contracts the profits or losses are calculated at maturity. In futures the profits or losses are calculated daily under the condition of price fluctuation. The risks, in which one party is unable to make payment, will be excluded. In futures contracts the buyer purchases the assets at the future price, he makes profits if the prices increase. The seller of futures is obligated to sell the asset at the price defined in contracts - he profits through the price reduction if any. The price in the future is estimated from spot price and future price. In principle at the determined price in contract, the trader can’t have profits through arbitrage.
Supposed, that the asset is worth S0 with interest rate r, the future price in contract is FT. The net value asset at the beginning refers to F0. Within the contract period, you have profit D. At the settlement date, the asset values St. The cash flow, which the buyer gets, is then
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Because of no arbitrage, the cash flow at maturity is equal to the cash flow at the start of the contract. It means (1.1) = 0.
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If the term is T, the future price is
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3.1.3 Hedging, speculating using futures and forward
3.1.3.1 Hedging
By trading the underlying assets in financial market, each party always faces the risks of price changes. The future prices may be higher or lower than the price in present, therefore forward contracts are used to eliminate those risks. The underlying assets which are used for hedging are mostly commodity, currency or interest rate. For hedging, a common type of forward is established which is called forward rate agreement (FRA). FRA is an OTC contract between two parties, in which the payment rates are constructed on interest rates or exchange rates. The payment date happens in the future, whereas the rates are determined with the maturity and estimated value. The specific characteristic in this contract is, the payment being made upon the estimated value of the underlying asset in contrary to swaps, in which the FRA payment is done at maturity7. Even if investors use stock portfolio to hedge risks, the possibility of the fall in the market may occur and thus may have impact on the value of stocks. In order to protect against the bad effects of downturn in the market on stocks, many investors use the stock portfolio together with stock index futures.
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1 http://www.berkshirehathaway.com/letters/2002pdf.pdf
2 Buckley A., “International Finance - A practical perspective”, Pearson Education, England, 2012
3 http://en.wikipedia.org/wiki/Derivative_%28finance%29
4 Levy H., Post T., “Futures, options and other derivatives” in Investment, Financial Times Prentice Hall, Pearson Education, England, 2005, pp. 623-676
5 Altendorf, Schlüter, Skorpel, Stein and Weber, “Das Bank- und Börsen-ABC”, Bundesverband deutscher Banken, Berlin, 2009
6 http://www.thefinanceconcept.com/2011/03/difference-between-forward-contracts.html
7 http://www.investopedia.com/terms/f/fra.asp