Derivative Securities Term Paper

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Derivative Securities


(Black Tuesday)

Derivative Securities

Derivative Securities

It is difficult to understand or explain why throughout history some negative investor philosophies continually repeat themselves. Far too often investors miss blatant signs that lead to major collapses in the free markets. The purpose of this report is to discuss derivative securities in detail and how they affect those investor philosophies. Even unsophisticated investors understand that the stock and commodities markets are supposed to fluctuate on a daily basis. A key in the minds of investors is to avoid overly large swings in either direction and to also take advantage of those market swings that are heading in the right direction. To solve this ageless dilemma, investment bankers and individual investors themselves have historically created new and unique systems, methods and processes that help avoid those big swings. But what happens when the new and unique systems, methods and processes actually become the problem. Over the last few decades for example, even with foolproof protection systems in place, investors have missed big swings in the wrong direction far too often. Consider Black Tuesday in the 80's, the dot com bubble bursting in the 90's, and the likes of companies such as Citigroup, Washington Mutual, AIG, the X Leman Brothers and all of the others currently suffering through a world economic crisis that has been compared to the Great Depression and mainly caused by speculation in mortgage backed securities. This report may be too late to provide some lessons learned for the current crisis, but there is always the next big bust. The aim of this work therefore is to describe futures and options and how they can be used in both investment speculative trading and hedging. The focus will also be on details of derivatives methodology such as the Black-Scholes option pricing model, puts and calls and concepts such as Delta, Gamma, and Vega as they pertain to investing.

What are the first real signs of trouble and how could a CEO of a smalltime and not so famous Irish football team be a great place to start a paper on derivative securities? The answer lies in how potentially dangerous derivatives can be when they are in the hands of the wrong trader. Nicholas 'Nick' Leeson, that CEO just mentioned, in 1995 was the lead derivatives broker for the now collapsed Barings Investment Bank. Even though he never actually received any formal professional broker training, he almost single-handedly brought down Barings through speculative derivatives trading on the Singapore International Monetary Exchange (SIMEX). "Working the floor of the Singapore International Money Exchange, Leeson quickly realizes he's completely out of his depth but can't admit it, so he hides his losses and continues to gamble until the deficit adds up to a $1 billion." (Rogue Trader) Prior to Leeson's handiwork, Barings was the oldest investment bank in England, founded in 1762, which made it older than the United States. One would have to seriously take into consideration that Napoleon, the Great Depression, WWI and II all could not bring Barings down.

Apparently, companies felt that they had nothing to learn from the Barings and Leeson experience. Speculative buying and selling by the likes of companies like AIG and Citigroup are now more famous for their holdings of toxic assets than they are for the positive aspects of their businesses. AIG for example actually has a few very successful subsidiaries. Although the underlying principles are similar to Leeson's derivatives, today's problems regarding the toxic assets are slightly different. Toxic assets, named so because of their affect on the current financial crisis, are issues that were mortgage-backed securities, collateralized debt obligations and credit default swaps. All of these have become illiquid because of the fact that their secondary markets have dried up. In other words, there used to be markets that would buy and sell these items but because the original underlying securities and loans have become worthless, the markets simply disappeared. As all of the former Leman Brother's employees are fully aware, without immediate governmental assistance, many of the other companies holding those toxic assets would have also followed in the wake of Barings.

The companies that bought toxic assets were using those tools to either hedge or speculate. Speculation means that a business or individual investor buys or sells an asset with the intent of that asset making a profit for the investor based on anticipated price movements. Technically, speculation is consider to be nothing more than gambling even though speculators contend that they only make buying and selling decisions based on clearly defined risk assessments. The key is supposedly that speculation differs from traditional investing only because of the associated risk factors involved. Hedging, on the other hand, is nothing more than making an investment decision that aims to reduce risk related to another investment in regard to price movements. The underlying philosophy of hedging is for a company or individual investor to take an offsetting position in some other related security. Take for example Southwest Airlines. "Using some simple and some complex investment strategies, Southwest has for a decade locked in the prices it pays for large amounts of jet fuel months and even years ahead of time. Its success at that has protected it from run-ups in crude oil prices and dramatically cut its fuel expenses. Since 1998, it has saved $3.5 billion over what it would have spent if it had paid the industry's average price for jet fuel. That's equal to about 83% of the company's profits over the last 91/2 years." (Reed)

One way to either hedge or speculate is to utilize futures. Futures are contracts with very high leverage as compared to the regular stocks. A futures contract basically entitles a buyer to buy an asset or a seller to sell an asset at an agreed upon future date and price. The asset could be a physical commodity or it could be a financial instrument of some type. A futures contract should always specify all of the inherent details like the quality or the quantity of any core assets. Thanks to the concepts made famous by Henry Ford, these contracts have also been standardized in order to facilitate seamless trading on futures exchanges. It is important to note that most futures are actually settled in the form of a cash exchange; however, some situations entail the physical delivery of whatever asset was specified. Consider a futures contract for a ton of rice or a hundred barrels of oil that specifies actual delivery. Some investor would therefore actually receive a ton of rice or those oil barrels on the specified date whether he has room for a ton of rice or the equivalent of a 100 barrels or not.

A second way to hedge and speculate is to utilize options. Options are similar to futures in the sense that they are also contracts. They allow one person or company, called option writers, to sell derivatives which are contracts to buy or sell financial assets to another party considered to be option holders. An options contract represents a right (not mandatory) to the buyer to either buy or sell a listed security or any other listed financial asset at a price the option specifies -- it also would designate the specific date that the option would expire. Options have their own unique terminology: 'buy' would be a 'call', sell would be a 'put', the 'agreed upon price' would be called the 'strike price' and the 'expiration date' would be called the 'excise date.'

Options have many possible uses. One particularly hazardous use for options is speculation while at the same time the practice of hedging is a method that is meant for reducing risk. A more critical aspect of option's speculative trading is that buyers and sellers actually need opposite things to happen in regard to the price of the underlying security. What is meant by that is that option writers require underlying share market prices to move according to their plan. Option writers selling call options do this because of a belief that the underlying asset price will fall relative to the option's strike price. This scenario could create a profit but the purchaser of the option expects the underlying stock price to rise in order for him to buy the underlying stock which he purchases then for the lower price option offer. These goals could be seen as complete opposites.

Some very important aspects of investing can be understood if concepts like Delta, Gamma, and Vega are understood. Consider the example of the Delta in use provided by Investapedia:

1. "For example, with respect to call options, a delta of 0.7 means that for every $1 the underlying stock increases, the call option will increase by $0.70.

2. Put option deltas, on the other hand, will be negative, because as the underlying security increases, the value of the option will decrease. So a put option with a delta of -0.7 will decrease by $0.70 for…[continue]

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