In all the commotion over derivatives, it has become difficult to tell exactly what the term meanS. At times it seems like the definition is any investment where someone recently lost money.
According to the Oxford English Dictionary, as a noun derivative means "a thing of derived character, a thing flowing, proceeding or originating from another." The word arises out of the Latin derivare, "to lead or draw off(water or liquid), to divert, derive (words)" and from the French "de + rivus (brook, stream of water)."
The connection to water is interesting, given the use of the term waterfall to describe the allocation of cash flow in complex financial structures.
The concept of derivatives stems back at least to the Bible. In Genesis, God began creation by separating light from darkness. Without too much hyperbole, to limit derivatives is to limit creation. Virtually all financial assets are derivatives of some sort.
A Few Examples
Stocks are a claim on a corporation, they are derived as the residual claim of the owners after satisfying creditors. The credit quality of Treasury bonds is derived from the guaranty of the US Government.
While real estate may be a fundamental or "primitive" asset, as opposed to a derived asset, mortgages are clearly derivatives of real estate.
Nevertheless, saying that virtually all financial instruments are derivatives of some sort, does not eliminate the risk to the financial markets from new instruments that are misunderstood or misused.
Clarification of the definition of derivatives may lead to better understanding of their risks.
In our nomenclature, there are two. basic types of derivatives: those created by dividing the cash flows or ownership of an underlying asset and those created by reference to another asset or instrument.
The first type provides segmentation of risk, with the sum of the pieces equaling the underlying instrument.
Understanding the Distinction
The second provides for risk transfer, and represents a zerosum game, with gainers always equaling losers. There is no requirement that either party possess the underlying instrument.
The first type we call structured products, the second we call indexed contracts.
To understand the distinction between the two, consider an exchange-traded call option on IBM. The call option is a contract between the buyer and the seller, (with an intermediary providing credit enhancement), where neither the buyer nor seller need own or control any shares of IBM.
It is a side transaction (at least until exercise) that has no direct effect on the underlying asset.
On the other hand, suppose shares of IBM were placed in a trust, and two securities were created, one which would own the IBM shares if their price fell. These derivative securities would be structured products.
Their value arises directly from the value of the underlying shares. The combined value of the securities would be about equal to the value of the underlying IBM shares.
Demand Steers Value
Whether the combined value exceeds or falls short of the value of the underlying shares will depend on investor demand for the structured products, and will reflect how well those products fit investor needs, coupled with liquidity, and transaction cost consideration.
This simple example reveals another important distinction between structured products and indexed contracts. Structured products look primarily to the underlying asset for their performance or credit quality.
Indexed contracts rely primarily on counter-party guaranties to assure performance. Of course there are many structured products that have counter-party guarantees and indexed contracts that are collateralized.
With our definitions on hand, we can now distinguish between types of derivatives. Treasury strips, Mortgage-Backed Securities, Collateralized Mortgage Obligations in all of their permutations, PACs, TACs; floaters, inverse floaters, IOs, swaptions, caps, and floors are all indexed contracts.
Looking at Leverage
Defining derivatives gives us a better understanding of their creation, but still does not give us a better understanding of their risk characteristics. Derivatives are not necessarily more or less risky than the underlying asset. The risk of derivatives is related to the degree of leverage.
As with the word derivatives, leverage also means different things to different people.
Here we will define leverage to mean the volatility of the value of the derivative relative to the underlying asset.
If you buy stock on margin, then you have leveraged your risk. If you borrow half the cost of the stock then you have doubled the risk of your investment. Similarly, the call options-on IBM represent leverage, because for a few hundred dollars, the owner of the option has the risk of tens of thousands of dollars of IBM shares.
Another way to look at leverage is to look at the amount of exposure to the underlying instrument based on the nominal contract size. For example, a $100,000 bond futures contract, provides roughly the same price risk as a $100,000 investment in the long bond.
Weighing Risk Exposure
While the amount of money put up for margin is small, implying substantial leverage of the cash position, the position represents one-to-one leverage based on the contract's face amount.
To evaluate derivatives (or any financial instrument) it is important to assess the risk exposure of the instrument. Derivatives are scary to many, not because they pose new risks, but because traditional measures of risk such as face value, numbers of shares, dollars invested, and maturity provide little indication of the risk.
Derivatives can only be understood by directly examining their risk characteristics. To understand the risk of derivatives, it is necessary to analyze the relationship of the derivative to the underlying instruments and how the structure of the derivative leverages (or de-leverage) the risks of the underlying security.
For derivatives in the debt markets, there are several major sources of risk. These include duration (a measure of interest rate sensitivity), convexity (a measure of the change in duration), credit, spread, volatility, and currency, as well as assetspecific risks. For MBS, the largest asset-specific risk is the uncertainty of prepayments,
2 Controversial Derivatives
Recently, I worked with the National Association of Insurance Commissioners in the development of the Flow Uncertainty index, or FLUX. This measure quantifies the degree of uncertainty of CMO cash flows due to changing prepayment rates.
This type of analysis of risk Can be applied to even the most complex derivatives. For example, two of the more interesting and controversial derivatives are the Inverse IO and the Indexed Amortizing (IAS).
The Inverse IO is a CMO tranche that pays the investor a fixed coupon less a multiple of Libor on a notional amount of principal based on the principal outstanding of another CMO tranche. As Libor rises the coupon on the inverse IO declines.
It has no principal payments and the coupon can not fall below zero. If prepayment rates increase the investor receives the coupon on a smaller principal balance.
Although the cash flows of the bond are linked both prepayment rates and interest rates, IOs are still structured transactions because their value is derived from the cash flow of the underlying mortgage-backed securities.
IASs are dollar interest-rate swap contracts where one party receives a fixed coupon and pays LIBOR based on a notional balance. The notional balance declines over time. The rate of decline of the notional balance of the swap is tied to an interest rate levels. When interest rates fall, the notional balance of the swap declines more rapidly, reducing cash flow.
This is an indexed contract balance of the value of the contract because the value of the contract arises from the promise of the counter-party to pay, not from cash flows of any underlying instrument.
While the structures of instruments are very different, they have similar characteristics. Both instruments decrease in value as interest rates rise (positive duration), both have increasing durations as rates rise (negative convexity); and lose more when rates rise than they gain as rates fall.
Derivatives are a major component of the financial markets. Through the processes of risk segmentation and risk transfer,
derivatives allow investors and issuers to manage and control risk. While better definitions will lead to more coherent discussions about derivatives, managers, regulators and legislators must focus more on the risks of financial strategies than their form.
Mr. Davidson is the founder of Andrew Davidson & Co., a New York consulting firm.
