Many of the recent, highly publicized losses suffered by compames in the derivatives market have been blamed on "exotic derivatives," giving the impression that these instruments are somehow more volatile and more risky than plain-vanilla products.
Industry experts protest that it is just not so. Exotic derivatives are no more risky than ordinary interest rate swaps, they say: What they are is more complex.
What distinguishes exotic transactions from the so-called plain-vanilla deals is that exotic derivatives are created for a specific customer to deal with a specific risk or set of risks -- sort of like customtailored suits. Plainvanilla derivatives are more like offthe-rack clothing: They are designed to be used by a wide variety of market participants.
One type of exotic, the index amortizing swap [see dictionary of terms below], has proved suited to regional banks and thrifts, which use them as a hedge on the risks of savings accounts. Accreting principal swaps are said to be tailor-made for banks with rising capital requirements.
The exotics "are tailored for the client, not the market. Many times they are less risky than other derivatives," said Frederick Chapey, senior vice-president of global derivatives at Chase Manhattan Corp.
While it is estimated that exotic derivatives make up only about 2% of the derivatives market. their use can be very profitable for banks and investors. The exotics have the potential to earn 10 times what a plain vanilla deal of similar characteristics would earn.
Mr. Chapey said that the term "exotic" often is erroneously applied to derivatives transactions that are not the least bit out of the ordinary.
Some consider any new, untested instruments exotic, while others consider only highly-complex instruments exotic. Still others label an instrument exotic if it is not fully understood.
"I don't like the word," said one industry observer. "It brings to mind a stripper. Some people call them exotic if they lose money with them. There seems to be as lot of that lately."
"It is important to distinguish leveraged transactions from exotic transactions," Mr. Chapey said. "Exotic transactions are those that violate one of the more known parameters of standard deals. Non-traditional is a good term to use to describe them."
The names of the products also have created confusion.
Many times banks will do a deal for a client, and give the instrument a fancy name as a way of distinguishing the product from other similar derivatives.
As a result, some products are known by as many as 12 different names.
"Procter & Gamble had their big loss on what are called rate differential swaps," a source said. "They are also known as differential swaps, Cops, yield differential swaps, cross-index basis swaps and interest rate index swaps."
Because them are so many different names for the same instruments, many people have the impression that there are a plethora of new derivatives being introduced every day.
"There is a great deal less new out there than people would have you think," said a source. "A lot of what you see is just packaging."
The following annotated dictionary of exotic derivatives is intended to allay some of that confusion:
Accreting Principal Swap
Unlike a traditional swap, where the notional principal amount is fixed for the life of the instrument and an amortizing swap, where the-notional principal declines as a mortgage is repaid, an accreting swap features a growing notional principal amount. Often used by banks with increasing capital requirements, they are also called "accumulation swaps," "drawdown swaps,". "staged drawdown swaps," and "step up swaps."
An option on a basket of currencies. They are cheaper than standard options on specific currencies because the contract expirations vary -- some will be "in the money" and some will be "out of the money." They can be used to hedge multi-currency exposures.
A warrant that pays off only if the rate at which two currencies are exchanged stays within a certain range through the life of the warrant.
Blended Interest Rate Swap
A combination of two or more interest rate swaps, whose payments are calculated on a weighted average of rates. The advantage of these instruments is that their payments often are less than those of the individual swaps.
Covered option securities are short-term notes with a high coupon and an embedded put, giving the issuer the fight to pay intexest and prinicipal in a foreign currency at a rate fixed at the issuance of the note. The advantage of these instruments is that their payout rate is known from the beginning of the deal.
FX Range Floating Rate Note
A "range structure" derivative. usually with a one year maturity, whose payoff depends on how long the value of the underlying asset -- like an interest rate or foreign exchange rate -- remains within a predetermined range. The note pays off for every day a foreign exchange rate is within the range. It pays nothing for each day the rate is outside the range.
Known as a "powered option," this is the one that gave Gibson Greetings trouble. It acts like an option and is sometimes used to hedge an option on the opposite side of the transaction. However, one of the problems is that when you square Libor (London Interbank Offered Rate), its value can go up faster than its base rate. but will drop more slowly.
Also known as differential swaps, allow an investor to take advantage of global interest rate differentials without exposure to changes in currency rates by paying a floating interest rate on one currency and receiving a floating rate of another. Payments usually are denominated in a single currency,
A collar or risk reversal structure in which the short option expires and the long option pays off at a maximum value when the underlying structure trades through an outstrike price,
A semifixed swap that allows an investor to pay a lower fixed rate but if floating rates rise above a certain level, the borrow* er's payments will jump above the fixed rate.
Dual Currency Leveraged Floating Rate Note
Used when an investor thinks interest rates in one country will fall, while those in another will rise.
Interest-only mortgage derivative whose coupons fall as interest rates rise.
Index Amortizing Swap
One example of an exotic transaction that is widely used. They have wide applications for the mortgage market. Banks sometimes use them to hedge the risk of their savings accounts. It is essentially an interest rate swap whose notional principal amount declines at short-term money rates such as Libor or the yield on constant maturity Treasuries. They were popular with thrifts and regional banks because they were easily marketable as a substitute for mortgage-backed securities.
The term applies to a range of instruments, such as floating rate notes, swaps or options, whose payoff is boosted by the fact that its underlying asset can never leave a predetermined price range. If it does, the note become worthless.
An option in one currency or interest rate that pays out in another. They can be used when it is thought a foreign index will do well, but that the country's currency will weaken.
Kitchen Sink Bonds
What is known as a "by-product bond," they are created by bundling together the leftovers of other mortgage transactions. They are composed of many different underlying pools of mortgages and a variety of different expected cash flows.