Financial Derivatives

Financial Derivatives Robert M. Hayes 2002

Overview • Definition of Financial Derivatives • Common Financial Derivatives • Why Have Derivatives? • The Risks • Leveraging • Trading of Derivatives • Derivatives on the Internet • An Apologia for Derivatives • The Dark Side of Derivatives

Definition of Financial Derivatives • A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed-upon benchmark. • Since a financial derivative can be created by means of a mutual agreement, the types of derivative products are limited only by imagination and so there is no definitive list of derivative products. • Some common financial derivatives, however, are described later. • More generic is the concept of “hedge funds” which use financial derivatives as their most important tool for risk management.

Repayment of Financial Derivatives • In creating a financial derivative, the means for, basis of, and rate of payment are specified. • Payment may be in currency, securities, a physical entity such as gold or silver, an agricultural product such as wheat or pork, a transitory commodity such as communication bandwidth or energy. • The amount of payment may be tied to movement of interest rates, stock indexes, or foreign currency. • Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed. Leveraging thus acts to multiply (favorably or unfavorably) impacts on total payment obligations of the parties to the derivative instrument.

Common Financial Derivatives • Options • Forward Contracts • Futures • Stripped Mortgage-Backed Securities • Structured Notes • Swaps • Rights of Use • Combined • Hedge Funds

Options • The purchaser of an Option has rights (but not obligations) to buy or sell the asset during a given time for a specified price (the "Strike" price). An Option to buy is known as a "Call," and an Option to sell is called a "Put. " • The seller of a Call Option is obligated to sell the asset to the party that purchased the Option. The seller of a Put Option is obligated to buy the asset. • In a “Covered” Option, the seller of the Option already owns the asset. In a “Naked” Option, the seller does not own the asset • Options are traded on organized exchanges and OTC.

Forward Contracts • In a Forward Contract, both the seller and the purchaser are obligated to trade a security or other asset at a specified date in the future. The price paid for the security or asset may be agreed upon at the time the contract is entered into or may be determined at delivery. • Forward Contracts generally are traded OTC.

Futures • A Future is a contract to buy or sell a standard quantity and quality of an asset or security at a specified date and price. • Futures are similar to Forward Contracts, but are standardized and traded on an exchange, and are valued daily. The daily value provides both parties with an accounting of their financial obligations under the terms of the Future. • Unlike Forward Contracts, the counterparty to the buyer or seller in a Futures contract is the clearing corporation on the appropriate exchange. • Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset.

Stripped Mortgage-Backed Securities • Stripped Mortgage-Backed Securities, called "SMBS," represent interests in a pool of mortgages, called "Tranches", the cash flow of which has been separated into interest and principal components. • Interest only securities, called "IOs", receive the interest portion of the mortgage payment and generally increase in value as interest rates rise and decrease in value as interest rates fall. • Principal only securities, called "POs", receive the principal portion of the mortgage payment and respond inversely to interest rate movement. As interest rates go up, the value of the PO would tend to fall, as the PO becomes less attractive compared with other investment opportunities in the marketplace.

Structured Notes • Structured Notes are debt instruments where the principal and/or the interest rate is indexed to an unrelated indicator. A bond whose interest rate is decided by interest rates in England or the price of a barrel of crude oil would be a Structured Note, • Sometimes the two elements of a Structured Note are inversely related, so as the index goes up, the rate of payment (the "coupon rate") goes down. This instrument is known as an "Inverse Floater." • With leveraging, Structured Notes may fluctuate to a greater degree than the underlying index. Therefore, Structured Notes can be an extremely volatile derivative with high risk potential and a need for close monitoring. • Structured Notes generally are traded OTC.

Swaps • A Swap is a simultaneous buying and selling of the same security or obligation. Perhaps the best-known Swap occurs when two parties exchange interest payments based on an identical principal amount, called the "notional principal amount." • Think of an interest rate Swap as follows: Party A holds a 10-year $10,000 home equity loan that has a fixed interest rate of 7 percent, and Party B holds a 10-year $10,000 home equity loan that has an adjustable interest rate that will change over the "life" of the mortgage. If Party A and Party B were to exchange interest rate payments on their otherwise identical mortgages, they would have engaged in an interest rate Swap.

Swaps • Interest rate swaps occur generally in three scenarios. Exchanges of a fixed rate for a floating rate, a floating rate for a fixed rate, or a floating rate for a floating rate. • The "Swaps market" has grown dramatically. Today, Swaps involve exchanges other than interest rates, such as mortgages, currencies, and "cross-national" arrangements. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and crossmarket payments, e.g., U.S. short-term rates vs. U.K. short-term rates.

Rights of Use • A type of swap is represented by swapping capacity on networks using instruments called “indefeasible rights of use”, or IRUs. Companies buying an IRU might book the price as a capital expense, which could be spread over a number of years. But the income from IRUs could be booked as immediate revenue, which would bring an immediate boost to the bottom line. • Technically, the practice is within the arcane rules that govern financial derivative accounting methods, but only if the swap transactions are real and entered into for a genuine business purpose.

Combined Derivative Products • The range of derivative products is limited only by the human imagination. Therefore, it is not unusual for financial derivatives to be merged in various combinations to form new derivative products. • For instance, a company may find it advantageous to finance operations by issuing debt, the interest rate of which is determined by some unrelated index. The company may have exchanged the liability for interest payments with another party. This product combines a Structured Note with an interest rate Swap.

Hedge Funds • A “hedge fund” is a private partnership aimed at very wealthy investors. It can use strategies to reduce risk. But it may also use leverage, which increases the level of risk and the potential rewards. • Hedge funds can invest in virtually anything anywhere. They can hold stocks, bonds, and government securities in all global markets. They may purchase currencies, derivatives, commodities, and tangible assets. They may leverage their portfolios by borrowing money against their assets, or by borrowing stocks from investment brokers and selling them (shorting). They may also invest in closely held companies.

Hedge Funds • Hedge funds are not registered as publicly traded securities. For this reason, they are available only to those fitting the Securities and Exchange Commission definition of “accredited investors”—individuals with a net worth exceeding $1 million or with income greater than $200,000 ($300,000 for couples) in each of the two years prior to the investment and with a reasonable expectation of sustainability. • Institutional investors, such as pension plans and limited partnerships, have higher minimum requirements. The SEC reasons that these investors have financial advisers or are savvy enough to evaluate sophisticated investments for themselves.

Hedge Funds • Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies. Others use hedge funds as the primary means of implementing their long-term investment strategy.

Why Have Derivatives? • Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in such factors as weather, foreign exchange rates, interest rates, or stock indexes. • For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party.

Why Have Derivatives? • More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. These investment managers may decide that it is more beneficial to assume a specific "risk" characteristic of a security.

The Risks • Since derivatives are risk-shifting devices, it is important to identify and understand the risks being assumed, evaluate them, and continuously monitor and manage them. Each party to a derivative contract should be able to identify all the risks that are being assumed before entering into a derivative contract. • Part of the risk identification process is a determination of the monetary exposure of the parties under the terms of the derivative instrument. As money usually is not due until the specified date of performance of the parties' obligations, lack of up-front commitment of cash may obscure the eventual monetary significance of the parties' obligations.

The Risks • Investors and markets traditionally have looked to commercial rating services for evaluation of the credit and investment risk of issuers of debt securities. • Some firms have begun issuing ratings on a company's securities which reflect an evaluation of the exposure to derivative financial instruments to which it is a party. • The creditworthiness of each party to a derivative instrument must be evaluated independently by each counterparty. In a financial derivative, performance of the other party's obligations is highly dependent on the strength of its balance sheet. Therefore, a complete financial investigation of a proposed counterparty to a derivative instrument is imperative.

The Risks • An often overlooked, but very important aspect in the use of derivatives is the need for constant monitoring and managing of the risks represented by the derivative instruments. • For instance, the degree of risk which one party was willing to assume initially could change greatly due to intervening and unexpected events. Each party to the derivative contract should monitor continuously the commitments represented by the derivative product. • Financial derivative instruments that have leveraging features demand closer, even daily or hourly monitoring and management.

Leveraging • Some derivative products may include leveraging features. These features act to multiply the impact of some agreed-upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly a party's total repayment obligation. Remembering that each derivative instrument generally is the product of negotiation between the parties for risk-shifting purposes, the leveraging component, if any, may be unique to that instrument.

Leveraging • For example, assume a party to a derivative instrument stands to be affected negatively if the prime interest rate rises before it is obliged to perform on the instrument. This leveraged derivative may call for the party to be liable for ten times the amount represented by the intervening rise in the prime rate. Because of this leveraging feature, a small rise in the prime interest rate dramatically would affect the obligation of the party. A significant rise in the prime interest rate, when multiplied by the leveraging feature, could be catastrophic.

Trading of Derivatives • Some financial derivatives are traded on national exchanges. Those in the U.S. are regulated by the Commodities Futures Trading Commission. • Financial derivatives on national securities exchanges are regulated by the U.S. Securities and Exchange Commission (SEC). • Certain financial derivative products have been standardized and are issued by a separate clearing corporation to sophisticated investors pursuant to an explanatory offering circular. Performance of the parties under these standardized options is guaranteed by the issuing clearing corporation. Both the exchange and the clearing corporation are subject to SEC oversight.

Trading of Derivatives • Some derivative products are traded over-the-counter (OTC) and represent agreements that are individually negotiated between parties. Anyone considering becoming a party to an OTC derivative should investigate first the creditworthiness of the parties obligated under the instrument so as to have sufficient assurance that the parties are financially responsible.

Mutual Funds and Public Companies • Mutual funds and public companies are regulated by the SEC with respect to disclosure of material information to the securities markets and investors purchasing securities of those entities. The SEC requires these entities to provide disclosure to investors when offering their securities for sale to the public and mandates filing of periodic public reports on the condition of the company or mutual fund. • The SEC recently has urged mutual funds and public companies to provide investors and the securities markets with more detailed information about their exposure to derivative products. The SEC also has requested that mutual funds limit their investment in derivatives to those that are necessary to further the fund's stated investment objectives.

Selling of Financial Derivatives • Some brokerage firms are engaged in the business of creating financial derivative instruments to be offered to retail investment clients, mutual funds, banks, corporations and government investment officers. • Before investing in a financial derivative product it is vital to do two things. • First, determine in detail how different economic scenarios will affect the investment in the financial derivative (including the impact of any leveraging features). • Second, obtain information from state or federal agencies about the broker's record.

Derivatives on the Internet • In the past several years, trading of financial derivatives has become an active Internet e-commerce focus, with EnronOnline as among the most active sites. Leaving aside assessment of the reliability of e-commerce trading sites, the following are valuable sites for keeping track: • For quick news bites, the best sources are maintained by some of the major financial news organizations: • Bloomberg Online www.bloomberg.com • Reuters.com www.reuters.com • The Associated Press www.nytimes.com/aponline • Bridge Financial www.bridge.com

Derivatives on the Internet • One very quick and easy analysis of developments in overnight markets and identification of key issues in today's markets is Marc Chandler's commentary: • TheStreet.com www.thestreet.com. • For Canadian news, there are two national newspapers, • The National Post www.nationalpost.com and • The Globe And Mail www.theglobeandmail.com. • Internationally, • The New York Times www.nytimes.com, • South China Morning Post www.scmp.com, • The Washington Post www.washingtonpost.com • The Financial Times www.ft.com/hippocampus

Derivatives on the Internet • Risk measurement methodology can be found at • J.P. Morgan's www.riskmetrics.com. • Credit Suisse First Boston CreditRisk+ site www.csfp.co.uk/csfpfod/html/csfp_10.htm • The Global Association of Risk Professionals www.garp.com • The Treasury Management Association (USA) www.tma-net.org • The Treasury Management Association of Canada www.tmac.ca • CIBC Wood Gundys School of Financial Products

An Apologia for Derivatives • Derivatives are not new, high-tech methods. • Derivatives are not purely speculative or leveraged. • Derivatives are not a major part of finance. • Derivatives are of value to companies of all sizes. • Derivatives are tools to meet management objectives. • Derivatives reduce uncertainty and foster investment. • Derivatives can both reduce and enhance risk. • Derivatives do not change the nature of risk. • Derivatives reduce, not increase systemic risks. • Derivatives do not call for further regulation.

The Dark Side of Derivatives • Six examples will be used to illustrate some of the perils, especially ethical perils, in use of financial derivatives: • Equity Funding Corporation of America (1973) • Baring Bank (1994) • Orange County, California (1994) • Long Term Capital Management (1998) • Enron (2001) • Global Crossing (2002) • Each of them represented an effort to use financial derivatives to produce inflated returns. Two cases were proven to be frauds. Two appear to have been innocent of fraud. Two are still to be seen. • Each was a major financial catastrophe, affecting not only those directly involved but the world at large.

The Steps on the Primrose Path

Equity Funding Corporation of America • The insurance funding program • The first scam • The next scam • The really BIG scam • The final scam • The house of cards collapses • The fallout from Equity Funding • An analysis of the causes • The Lessons Learned

The insurance funding program - 1 • Equity Funding Corporation of America was founded in 1960. Its principal line of business was selling "funding programs" that merged life insurance and mutual funds into one financial package for investors. • The deal was as follows: first, the customer would invest in a mutual fund; second, the customer would select a life insurance program; third, the customer would borrow against the mutual fund shares to pay each annual insurance premium. Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value of the mutual fund shares. Any appreciation of the investment in excess of the amount paid would be the investor's profit.

The insurance funding program - 2 • The company had a huge sales force. The thrust of the salesman's pitch to a customer was that letting the cash value sit in an insurance policy was not smart; in fact, the customer was losing money. The customer was encouraged to let his money work twice by taking part in the above deal. • The development of such creative financial investments was a trademark of Equity Funding in the early years of its existence. After going public in 1964, Equity Funding was soon recognized across the country as an innovative company in the ultraconservative life insurance industry.

The insurance funding program - 3 • This kind of leveraging of dollars is a concept used by sophisticated investors to maximize their returns. They use an asset they already own to borrow money in the expectation that earnings and growth will be greater than the interest costs they will incur. However, it's a concept that is fraught with risks for the investor and should not be promoted by an ethical company without fully informing the investor of the risks. • Even so, there was nothing illegal or even immoral about the basic concept. Indeed, it was a captivating idea, except it didn't make enough money for the company or its executives. So some executives—led by the president, chief financial officer and head of insurance operations—got a little more creative with the numbers on their books.

The first scam • "Reciprocal income“ Preparing to take the company public in 1964, there was concern that its earnings were too low. To correct this "problem", the owners decided that Equity Funding was entitled to record rebates or kickbacks from the brokers through whom the company's sales force purchased mutual fund shares. The resulting income, called "reciprocal income" was used to boost 1964 net income for Equity Funding. So the fraud apparently began in 1964 when the commissions earned on sales of the Equity Funding program were erroneously inflated.

The next scam • Borrowing without showing liability • In subsequent years, to supplement the reciprocal income so as to achieve predetermined earnings targets, the company borrowed money without recording the liability on its books, disguising it through complicated transactions with subsidiaries. The fraud expanded in 1965, when fictitious entries were made in certain receivable and income accounts. • By 1967, revenues and earnings of Equity Funding had increased dramatically, and the stock price rose accordingly. Equity Funding began to take over other companies, and it became critical to maintain the price of the stock of Equity Funding so it could be used to pay for the companies being acquired.

The Really BIG Scam • Reinsurance • Fictitious policies • Forging files

The Final Scam • Killing off the policy holders

The computer makes it possible • Although there were a number of other aspects to the fraud, the computer was used because the task of creating the bogus policies was too big to be handled manually. Instead, a program was written to generate policies which were coded by the now famous, or rather, infamous, code "99". When the fraud was discovered in 1973, about 70% of all of the company's insurance policies were fake.

The failure of the auditors

The house of cards collapses

The fallout from Equity Funding • Accounting and auditing practices • Insider trading • The aftermath of Equity Funding

An analysis of the causes • The Management • Ethics and integrity of management and employees • Management's philosophy and operating style • The Auditors • Lack of independence of the auditors • Lack of professional skepticism of the auditors • External impairments to the audit

The Management • The ethics and integrity of management and employees • Management's philosophy and operating style

The Auditors • The independence of the auditors • Professional skepticism of the auditors

Financial Derivatives