Derivatives Derivative Security Is a Term Paper

Excerpt from Term Paper :

These strategies can also be used to reduce the risk of a drop in the stock price without regard to tax issues. In deciding whether to employ these strategies, it is necessary to consider the cost of the option and any related transaction costs.

A swap is an agreement in which counterparties (generally two) agree to exchange future cash flows arising from financial instruments. For example, in the case of a generic fixed-to-floating interest rate swap, company a agrees to pay company B. periodic fixed interest payments on some "notional" principal amount (say $100 million) in exchange for variable rate payments on that notional. The floating "leg" is typically periodically reset based on some reference rate such as LIBOR. Usually, one leg involves quantities that are known in advance (e.g. The "fixed leg" in an interest rate swap) the other involves quantities that are uncertain or variable (e.g. The "floating leg" of an interest rate swap). This is literally true. No one can know with absolute certainty what the 6-month U.S. dollar LIBOR rate will be in 12 months time or 18 months time. However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time. The floating leg must therefore be "reset" against an agreed reference rate, which will become known at some point before the payment or settlement takes place. For instance the parties might agree to pay 50 basis points (.5%) over the LIBOR measured on the 1st trading day of every 3rd month. The payment schedule is often, but not always, timed to coincide with the resets.

The first swaps were commonly used as a way to hedge exposure to market risk for a low fee. For instance, if a trader decides to short sell a stock, there is considerable "market risk" if the stock price rises. In order to hedge that risk, the trader could enter a swap agreement for the same stock, paying a small fee to "hold" it while not actually having to pay for the stock itself. In this case if the stock price does rise, they simply end the swap and use the stock to pay off the short. In effect, they are buying insurance against their position. Known as total return swaps, in these contracts all cash flows, dividend payments for instance, are paid or received by the holder as if they owned the stock directly. However, for accounting purposes they are off-balance sheet and do not appear as an asset (they do not legally own the stock in question).

The advantages of interest rate swaps include: a floating-to-fixed swap increases the certainty of an issuer's future obligations; swapping from fixed-to-floating rate may save the issuer money if interest rates decline; swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions; and interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for several reasons:

to obtain lower cost funding; to hedge interest rate exposure; to obtain higher yielding investment assets; to create types of investment asset not otherwise obtainable; to implement overall asset or liability management strategies; to take speculative positions in relation to future movements in interest rates.

For example, in order to hedge interest rate exposure, a financial institution providing fixed rate mortgages has exposure in a period of falling interest rates if homeowners choose to pre-pay their mortgages and refinance at a lower rate. It protects against this risk by entering into an "index-amortizing rate swap" with, for example, a regional bank. Under the terms of this swap the regional bank will receive fixed rate payments of 100 basis points to as much as 150 basis points above the fixed rate payable under a straightforward interest rate swap. In exchange, the bank accepts that the notional principal amount of the swap will amortize as rates fall and that the faster rates fall, the faster the notional principal will be amortized. A less aggressive version of the same structure is the "indexed principal swap." Here the notional principal amount continually amortizes in line with a mortgage pre-payment index such as PSA, but the amortization rate increases when interest rates fall and the rate decreases when interest rates rise.

The use of derivatives is not universally approved. Warren Buffett has acknowledged that he accumulated his wealth without the use of derivatives and has referred to them as "financial weapons of mass destruction." There have been several instances where companies have abused the use of derivatives. In 1995, Nick Leeson, a trader at Barings Bank, made unwise and unauthorized investments in index futures. Through a combination of poor judgment on his part, lack of oversight by management, a weak regulatory environment and unfortunate outside events, Leeson incurred a $1.3 billion loss that bankrupted that financial institution. In December 2001, Enron was forced to declare bankruptcy when it was discovered that its CFO, Andy Fastow, had created a number of special purpose entities (SPE) and used hedges improperly to remove liabiliites from the Enron balance sheet. In January 2002, John Rusnak was found to have lost hundreds of millions of dollars for Allied Irish Bank. He had started losing large amounts of money in 1997 by making bad trades on the foreign exchange market. On February 8, 2002, Rusnak's trading accounts reportedly showed a deficit of $691.2 million. However, when used properly, with appropriate oversight, derivatives can provide great benefit to businesses.

Bibliography

McMillan, Lawrence G., 1986, Options as a Strategic Investment: A Comprehensive Analysis of Listed Option Strategies, 2nd edn, New York Institute of Finance, New York.

Smith, Courtney, 1987, Option Strategies: Profit-Making Techniques for Stock, Stock Index, and Commodity Options, John Wiley & Sons, New York.

Coates, C. Robert, 1978, Investment Strategy,…

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