Understanding Derivatives: Beyond Good and Evil

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H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally  recognized authority on financial issues and Derivatives.

Derivatives are often viewed as mysterious and dangerous instruments and they are much maligned these days.  The most famous investor, Warren Buffet, referred to derivatives in Berkshire Hathaway’s 2002 Annual Report as ‘I view derivatives as time bombs, both for the parties that deal in them and the economic system.’ Buffet continued:  ‘The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’  These are strong words from a wise man.  Since we cannot put the genie back in the bottle, we have no choice but to deal with the genie.

To get started, what are derivatives and why do investors fear and loath them so much?  What makes them toxic?  Part of the reason is that derivatives are complex instruments, hard to understand and difficult to value.  This is part of their fear factor.  They are also everywhere, sometime obvious as in traded options, most of the times hidden, as in over-the-counter CDS’s.  The size of derivative markets is huge.  Fearing or avoiding derivatives will not help us understand them.   The purpose of this essay is to make them just a little less frightening.

The term derivative is used to describe any security whose value depends on the price of another asset.   Derivatives are interesting and important in their own right as they are traded and they must be priced.  There are derivatives on individual stocks, market indices (such as S&P 100 or S&P 500), commodities (crude oil, gold, silver, corn, or wheat), interest rates and currencies.  We also have derivatives on volatility, weather and credit events.  Some trade on exchanges such as CBOE or ISE and others trade over-the-counter.  There are also different kinds of derivatives, American, European, Asian or Bermudan.   The simplest derivative is a call option, which is a right, but not an obligation to purchase an asset (could be stocks, bonds, commodities, foreign currency) during a fixed length of time (life of the call option) at a fixed price (called the exercise price).  If the underlying asset price ends up above the exercise price, the call option pays the difference in prices at maturity.  Otherwise, it pays zero.  There are also put options, which is a right but not an obligation to sell an asset during a fixed length of time at a fixed price (called the exercise price).  If the underlying asset price ends up below the exercise price, the put option pays the difference at maturity.  Otherwise, it pays zero.  A forward or a futures contract is another example of a derivative.  A forward contract obligates two parties to buy or sell an asset at a fixed price sometime in the future.  Both payment and exchange of asset take place in the future.  A swap is a forward contract involving exchange of two assets or an exchange of an asset for cash.

Often, the size of the derivatives market is much larger than the size of the underlying asset.  Daily volume of currency forwards exceeds trillion dollars.  The daily volume in S&P500 index futures exceeds the entire volume for 2,000+ securities that trade on the NYSE.  The daily volume of Treasury bond future exceeds hundred billion dollars.  Hence, the market for derivatives typically dwarfs all other markets. The notional value of CDS (credit default swaps) is estimated to be over 300 trillion dollars.  This makes them both awesome and feared.

The most basic use of derivatives is in risk management.  Take the case of a typical corn farmer, who spends money to till the land, fertilize, and plant seeds in the Spring, and then waits until Fall to find out what his income is going to be.  The farmer is at the mercy of global weather and economic conditions.  Bad weather elsewhere and smaller global supply can mean high income for the farmer.  Bumper crops can mean low income.  Farmer can get rid of this price risk in the Spring and have a pretty good estimate of his income throughout the year by pre-selling and thus fixing his selling price of his corn crop at CBOT using corn futures.  Now regardless of weather or economic conditions in the fall, farmers’ selling price is fixed.  We will have a less stressed corn farmer which is good for farming.  Kellogg Corporation which makes corn flakes can take the opposite side of the farmer and fix its buying price of corn.  Both parties are now hedged and both parties are better of using corn futures.

Most corporate securities can be viewed as options or contain embedded options.  These include stocks, bonds, convertible debt, convertible preferred securities, callable securities, and warrants.  Take common stock first.  The limited liability associated with common stocks means that they can be viewed as call options on the underlying assets of the corporation.  Suppose the corporation has $100 of debt.  If the market value of the assets exceeds $100 at the maturity of the bonds, then common stocks holders will exercise their call option, pay the bondholders $100, and buy the entire assets of the firm.  In this case, the firm is solvent.  If the market value of the assets at the maturity of bonds is less than $100, common stockholders do not have to make up the difference out of their pocket due to limited liability; they will simply walk away and leave the firm to the bondholders.  We call this bankruptcy.  Hence, common stock is simply a call option on the underlying assets of the firm with the same maturity as debt and exercise price equal to the face value of the debt.

Taking the options perspective can help us view and value corporate securities better.  Similarly, corporate bonds can be viewed as risk-free bonds minus a put option.  Convertible debt can be viewed as straight debt plus a bondholders’ option to convert.  Callable debt can be viewed as straight debt minus a call option given by the bondholders to the firm.  Warrants can be viewed as long term call options.

Managerial compensation contracts can also be viewed as options.  For instance, bonuses and incentive compensation can be viewed as options.  Incentive compensation is nothing but a call option on the stock price, to encourage managers to work hard, take risks, and attempt to increase the stock price.   Otherwise, if the managers simply received a flat wage regardless of effort or success, they will few incentives to either work hard or to take risks.  Incentive compensation helps align managers’ incentives with those of the shareholders.

We can think of everyday investment decisions of corporations as having option-like characteristics.  To value corporate investment decisions, we need to value options.  If a corporation discovers a new process or creates a new product or service, it simply has an option to develop this.  It does not have an obligation to do so.  Recognizing this insight, we can think of all corporate investment decisions as containing option to delay, option to expand, option to switch inputs or outputs, option to proceed to next stage, and option to abandon a project.   Similarly, test marketing, strategic partnerships, product testing can be viewed as real options.   Understanding derivatives will help managers make better investment decisions.

In addition, most corporations, large and small engage in explicit risk management programs.  Corporate and individual risk management programs involve the use of derivatives.   Using derivatives, corporations can control their exposure to commodity price risk, interest rates and exchange rates.  Suppose an airline worries about fuel price increases.  By having a right to fix the buying price of jet fuel (call option of jet fuel), the airline can control its exposure to jet fuel price.  If jet fuel price does increase a lot, the airline will still get to purchase jet fuel at a fixed price, and thereby not go bankrupt.   Risk management can create value for corporations because, 1)it can save taxes, 2) it can reduce bankruptcy costs, 3) it can reduce the need for cash reserves and external financing, 4)it can increase corporate debt capacity, 5) it can lead to better managerial incentives and therefore better business decisions.   Through risk management, a corporation can identify talented versus lucky managers.  Similarly, through risk management, corporations can tell the difference between unlucky and untalented managers.  This allows corporations to reward talented managers better and dismiss untalented managers.

Another use of derivatives is arbitrage, which is simply buying and selling essentially the same asset at the same time (in different markets) to profit from price differentials.  Buy where the price is low and sell where the price is high.  The resulting profit is risk-free, and ensures that prices efficiently reflect all underlying fundamental information.  Similar, mere speculation also increase liquidity and allows hedgers to get rid of their risks without affecting prices unduly.  Banning one side of the speculative market such as what German Chancellor Merkel has recently done is certainly not going to be helpful.  We need both supply and demand to complete the markets.  Fear does not help improve outcomes.

Properly used, derivatives are versatile risk-management tools.  Mis-used, they can create devastating losses.  Like any other tool, their power to change the cash flow profiles does not make them either good or evil.  Properly understood and properly used, we should have nothing to fear.

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H. Nejat Seyhun is Professor of Finance and Jerome B. and Eilene M. York Professor of Business Administration at the Ross School of Business, University of Michigan, where he has twice served as the chairman of the finance department.  He holds a Ph.D. in finance (1984) from University of Rochester, Rochester NY. Professor Seyhun is an internationally recognized authority on financial issues and Derivatives. His research has been quoted frequently in the financial press including the Wall Street Journal, New York Times, Washington Post, Newsweek, Business Week, Bloomberg Business News, and Los Angeles Times.   Among his past consulting clients are Citigroup, Towneley Capital, Tweedy, Browne, and Vanguard.

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