Understanding Derivatives

A derivative is, simply, a financial instrument the value of which is ‘derived’ from another financial instrument. A derivative is a contract for the exchange of cash or delivery flows between two parties, each of which is considered equal to the other at the start of the agreement. The derivatives contract is a notional transaction used as an instrument of hedging and risk reduction.

Types of Financial Derivatives
Derivatives in the present context are financial products that derive their value from the value of other financial assets. Financial options and future are the common examples, interest and currency swaps are also coming up.

All three: options, futures and swaps are contracts. Being contracts, they were not traditionally traded on exchanges, although in recent times an exception is made for some standardized options and futures contracts and options and futures exchanges now operate in some countries. This is not in the case of swaps, which are still largely bought and sold Over the Counter.

1. Options: A call option gives the buyer or owner of it the right, but does not impose on it a duty to buy from the seller or writer of the option the underlying asset (bonds or shares) at the agreed striking price during the time of the option (assuming that the option is an American type which can be exercised at any time, which is now the more common type everywhere). A put option gives the option holder the right to sell this asset to the writer of the option at an agreed price (the striking price) during the time of the option. By writing a call or put, the writer exposes himself to the option being exercised against him at the agreed price and gets paid a price or premium for his risk.

2. Futures: The futures contract is an agreement to buy or sell an asset at an agreed future time for a fixed price, often the present market price (or relevant index). By entering into a futures contract, both parties acquire rights and obligations in the nature of an ordinary sales contract. The difference is that the delivery of the goods and payment will be delayed until a future date.

This is in fact also the case with financial options. The financial futures and options are fairly brief (three months, six months or nine months) but could be longer. Under the US Bankruptcy Code it must be in excess of 2 years.

3. Forwards: The difference between futures and forward contracts is that futures are traded on an exchange (as opposed to a forward which is an Over the Counter derivative).

4. Swaps: Swaps are the other traditional examples of derivatives. The term ‘swap’ by itself does not denote a particular legal structure except some kind of an exchange. It is common to find an exchange of accruing cash flows, normally resulting from different interest rates (fixed or floating) structures. The result is an interest rate swap. They could also be in different currencies (currency swap).

Foreign exchange swap or a Forex swap or a FX swap: Forex swap is an exchange of identical amounts of one currency for another at a certain rate and for a certain time in the future. It thus helps to eliminate the risks involved with fluctuating foreign exchange rates.

Asset Swaps: Asset swap is an exchange of tangible assets for intangible assets or vice versa and would help to change the character of the assets held by an entity depending on his requirements. As an example, a company may sell equity and receive the value in cash thus increasing liquidity.

5. Swaptions: Swaptions are similar to options; however instead of exercising an option to acquire or dispose of an asset, the option would be exercised in relation to a swap. A swaption may also be cash settled and in this case the seller would have to pay a sum equal to the market value of the swap on the exercise date.

6. Caps, Floors and Collars: The above are the main type of derivatives contracts from which related products are derived. A variation in an interest rate swap is an interest rate cap. A cap is a transaction under which one party agrees to pay a floating rate to the other if the rate exceeds a specified level. Just as there are caps, there are also floors and collars. A floor, in contrast with a cap is a transaction under which one party agrees to pay a floating rate to the other if the rate is less than a specified level, so that it is protected against the risk of the rate falling below this level. A collar involves both the sale of a cap and the purchase of a floor. Under such a contract, one party agrees to pay a floating rate to the other if the rate is less than another lower level.

Credit Default Swaps
In a CDS, in exchange for a one-off or annual premium, the protection seller will make a payment to the protection buyer upon the occurrence of a previously defined credit event like the down-grading, default or insolvency of a debtor, failure to pay or restructuring. The ISDA swap mater agreement can be used to define the events of default. The protection may take the form of compensation or the transfer of the reference asset to the protection seller at face value.

In the original form of these transactions, when the protection is triggered, the seller of protection pays money to the buyer of protection and the buyer of protection delivers a complying obligation such as a bond, i.e. there is a swap of money and paper when there is a credit default and this is the process of physical settlement. These days, credit default swaps are usually settled by the auction process rather than actually having a physical swap.

The debtor in respect of which the bond is being bought (the issuer or the case of bonds and the borrower in the case of loans) is called the reference entity. The reference entity is not a party to the credit default swap or involved in any way.

A credit derivative is a financial product the value of which is determined by the creditworthiness of a third party that takes over a credit risk. These credit derivatives have become particularly popular with banks allowing them to reduce credit risk and to use their capital more efficiently. Party autonomy is supreme since it is a nothing but a private contract. There is, however, technically no sale proper even though terms like ‘protection buyer’ and ‘protection seller’ are now commonly used and the buyer pays a price for this facility. The most current types are “credit default swaps”, “total return swaps”, “credit spread options” and “credit linked notes.”

Conclusion
Derivatives are important instruments for parties (particularly banks) to protect against their market or position risk exposure in a relatively cheap and easy manner. Market or position risk is the risk associated with uncertain market movements and is becoming more and more important in the context of the modern financially troubled times. This is the essence of hedging. In these cases, there will be added credit risk and settlement risk, as the hedge assumes that the other party will perform on the future date. Credit or counterparty risk is the risk of non-performance by the other party of their terms of the contract. It can be said that market risk is exchanged for credit risk.

By choosing an alternative cash flow under a swap, an uncertain floating rate cash flow may be exchanged for a fixed rate cash flow. In this way, risk on either the asset or liability side of a balance sheet may be reduced through swaps, but it could also be increased by going from fixed to floating. Again, it increases credit risk.

The  author can be reached at: mini.anshuman@legalserviceindia.com