What is a Derivative?

1
What is a Derivative?

• In its most simple form, a derivative
• is a leveraged bet on anything that can be
  measured.
• Interest rates
• Currency exchange rates
• Commodoties prices
• Election results

2
What is a Derivative?

• DERIVATIVES are so-called because they are
  contracts that DERIVE their value from the value
  of something else in the future.
• Forward contracts entail an obligation to buy
  or pay something in the future
• Option contracts entail only a future right but
  no obligation

3
What is a Derivative?

• Example of a Forward Contract (Kieso, Weygandt
  and Warfield p. 864)
• Heartland Farms grows potatoes and sells to
  McDonalds. Harvest is 2 months away. Heartland
  agrees to sell the potatoes in 2 months at
  todays price. Both companies have hedged their
  positions although one company will benefit at
  the expense of the other if the price changes.

4
The Zero-sum Game

• Unlike stock prices, which (presumably) react to
  an underlying value, derivative contracts are a
  zero sum game.

5
Purpose of Derivatives

• The stated purpose of derivatives usage is to
  hedge against factors detrimental to
  performance. The hedge can be either direct or
  indirect factors.

6
Purpose of Derivatives

• The stated purpose of derivatives usage is to
  hedge against factors detrimental to
  performance.
• BUT THEY ARE NOT CONFINED TO THAT USAGE ALONE!

7
Purpose of Derivatives

• The stated purpose of derivatives usage is to
  hedge against factors detrimental to
  performance.
• THEY CAN ALSO BE USED AS A TOOL FOR GAINING
  ADDITIONAL INCOME

8
Derivatives and Risk

• Hyper-sophisticated, computer-generated
  derivative instruments are traded electronically
  world-wide. Institutions have used them to
  create a parallel universe of side bets and
  speculative mutations that exceed in total more
  than five times the size of the global economy.
  These statistical based programs lie beyond the
  intuition of bank and institution managers.
  However historically based, risk assessment
  models, reflecting global events and transactions
  fail to reflect selling pressures and reactions
  to a crises.

9
Derivatives and Risk

• Derivatives deals are essentially formed off the
  books, in an opaque environment with little or no
  oversight or fiduciary responsibility. In
  aggregate, nobody knows about the nature or form
  or inherent risks associated with incredible
  numbers of monumental derivative bets.

10
Derivatives RiskChase Manhattan

• According to the Controller of Currency, Chase
  carries over 8 of risk for every 1 capital.
  This amount is likely understated.
• Amount of capital required is tied to risk
  (measured by credit ratings).

11
Significant Events

• CBOE opens large scale trading in derivatives
  is made feasible
• 1983 President Reagan signs the Futures Trading
  Act
• 1986 Derivatives market exeeds 500 Billion

12
Significant Events

• 1987 Presidential Task Force on Market Mechanisms
  concludes that a one day stock market crash was
  caused by the failure of the stock market and
  derivatives markets to operate in sync.
• 1988 Derivatives market exceeds 1 Tril
• 1994 Derivatives market excees 10 Tril
• 1994 Metallgesellschaft reports 1.5 Bil loss on
  oil futures bets Orange County admits a similar
  amount lost on derivatives plays county declares
  bankruptcy

13
Significant Events

• 1995 One single rogue trader named Nick Leeson,
  loses 1.4 billion in unauthorized derivatives
  bets on the Nikkei Index following an earthquake
  and the prestigious _ year old Barings Bank is
  brought down in a single day.
• 1995 State of Wisconsins Investment Board
  discloses a 95 million loss from unauthorized
  use of derivatives
• 1997 Asian markets collapse. Derivatives based
  credit and currency swaps are cited as a cause of
  the collapse
• 1998 Federal Government authorizes a 3.5 Billion
  bailout of trades conducted by a single firm,
  long Term Capital Management in order to prevent
  a possible irreversible collapse of global
  markets.

14
Significant Events

• 2001 Enron indiscriminately and secretly
  transforms from energy company to derivatives
  player. Actions directly lead to power blackouts
  in California and to the eventual collapse of the
  firm.
• 2003 FNMA loses 1.9 billion in derivatives
  portfolio, leading to near collapse.
• 2005 Derivatives market exceeds 200 trillion

15
Trillion Dollar ClubDerivatives Contracts

• JPMorgan Chase Bank 33.118
• Bank of America 14.216
• Citigroup 12.836
• Wachovia 2.457
• Bank One 1.133
• HSBC 1.043
• Wells Fargo 1.014

16
SFAS 133

• In Summary, SFAS 133
• Requires that derivatives be reported as an asset
  or liability at fair value of the derivatives
  contract.
• Requires gains and losses from speculative
  derivatives be reported in income
• Allows gains and losses from hedge transactions
  to be reported differently

17
Speculative Trading

• Oil is trading at 68 per barrel
• A company makes a speculative trade to purchase
  an option to buy 100 barrels at 70 in one month.
  The option costs 200
• Two weeks later, the fiscal year ends with oil
  trading at 72 barrel and the option worth 450
• The company must report the option on the balance
  sheet as a 450 asset and must report the
  UNREALIZED GAIN as INCOME, not COMPREHENSIVE
  INCOME (EQUITY)

18
Fair Value Hedge

• Exxon is trading _at_ 70 per share
• A company holds 100 shares of Exxon
• The company buys options to sell 100 shares of
  Exxon for 70. The options cost 200.
• The company reports the option on the balance
  sheet and unrealized gains and losses on Exxon
  stock are netted out against the unrealized
  losses and gains on the option in INCOME (not in
  COMPREHENSIVE INCOME)

19
Cash Flow Hedge

• An airline will purchase 1000 gallons of fuel.
• The company agrees to purchase the fuel next
  month for 10 per share.
• In one month, the price of fuel is 12. The
  company takes delivery of 12000 of fuel
  (supplies inventory) for a pay out of 10,000
  cash and a 2000 unrealized gain (COMPREHENSIVE
  INCOME-EQUITY)
• When the fuel is used, the unrealized gain is
  converted to a reduction in expenses (INCOME)