In case you were wondering . . . Part 3 - Derivatives

A derivative is a security deriving its value from the price volatility of another security or asset. Derivatives offer four services: income generation, insurance, liquidity, and investment hedge. These contracts obligate performance of a future act and are leverage. If there is a market and adequate volatility, any security, asset or their value elements can underlay a derivative. Standard products are listed on public exchanges and the custom “over the counter” (OTC) traded privately. Pricing models are complex, involving time, interest rates and volatility.

Income Generation: Assume you own 100K shares of Ajax Co. You sell a call option on each share. The holder obtains the right to purchase the shares at a price specific (strike price) by a date certain (expiration date). You are betting the market price at expiration will be at or under the strike price. If it is, you keep the stock and the call premium. Now, if the converse if true - the market price is “in the money”, you can buy back the call, keeping the stock but reducing the call premium; or let the stock go and the return will be enhanced by the call.

Insurance: You need the current value of the stock as security for a loan in 31 days. You buy put options obligating the seller to purchase the shares at a protective strike price in 30 days. If the market price is “at or in the money” (at or below the strike price) at expiration, you are insured against the loss of value. If the market price is “out of the money” (above the strike price) there is no exercise but you are protected.

Liquidity: You want to liquidate the stock but optimize the effect of market price volatility. This requires an OTC product involving a combination of puts and calls.

Investment Hedge: The interest rate swap is a hedge for interest bearing securities. The holder of a fixed rate bond bets interest rates will decline over time. The holder of a variable rate bond bets the contrary. The parties hedge by swapping the interest payments.

The above is Derivatives 101. The actual can be incredibly complex; saddle the writer with unlimited risk; monopolize huge investment capital; and may not be understood by the participants. Given the opportunity for profits, drifting from hedge to speculation is a temptation. You may never have a direct investment in a derivative but you are affected - they are ubiquitous. Managed well, derivatives protect investments and optimize profits. Managed poorly, disproportionate losses can result.

Example: An investment bank makes a big play in higher risk mortgages. They are hedged with interest rate swaps. It is assumed the higher interest rates and purchase discounts hedge creditor risk. The underlying collateral is thought risk free. The mortgage blocks and swaps are marketable securities; can be burdened with multiple derivatives; and are sources of liquidity and collateral. Another bank agrees to write OTC derivatives on the portfolio. The margin requirements seem moderate due to the underlying collateral. Real estate being a growth market, the bank “doubles down” with the cash released by liquidity derivatives. Technical default occurs when the bank cannot meet a margin call triggered by diminished market value of the real estate; higher risk mortgages and associated derivatives. A pyramid of investments, built from the original purchase of mortgages, is in jeopardy.

Next issue: Internal Controls – Lies, Damn Lies and Simple Incompetence