Derivatives Defined
Derivatives are contracts that derive their value from the value of some underlying instrument or index. They are powerful financial tools that allow individuals, corporations, institutions, and governments to manage and reduce various risks in their businesses and portfolios. In this age of modern finance, global trade, and high volatility of FX rates, interest rates, and asset prices—they are essential tools. While any tool can be used improperly, any suggestion that derivatives are only “weapons of mass destruction” or beneficial only to Wall Street insiders is both absurd and irresponsible.
For example, suppose a US investor buys some 6% 10-year IBM Eurobonds. By doing so, the US investor is taking three primary risks:
Interest rate risk— The investor is betting that euro interest rates will decline, which will cause the bond’s market value to appreciate.
Credit risk— The investor is betting that IBM’s credit quality will improve, which will cause the bond’s market value to appreciate.
Currency risk— The investor is betting that the euro will get stronger against the US dollar, which will increase the return in dollar terms.
If the investor didn’t have all three expectations, this would be the wrong investment.
As time goes on, however, one or more of the investor’s expectations may change. Suppose, for example, the investor’s outlook concerning the euro/dollar exchange rate changes. If so, the investor can:
Sell the investment and replace it— In this case, the investor can sell the IBM bond denominated in euros and replace it with an IBM bond denominated in dollars. This alternative will require transaction charges and perhaps have adverse tax consequences.
Do nothing— The investor hopes that the projected gain from the other two bets exceeds the loss on the euro. It seems a little silly to hold an investment that competes against itself.
Use a cross currency swap to hedge the FX risk— This option eliminates the one bet but allows the others to remain. If the investor’s outlook on the euro should revert back to the original, the cross currency swap can be eliminated so that the investor again has the original three bets.
Following the same logic, the investor can use:
Each of these hedges can be “put on” when the investor believes the odds are against them and “lifted” when the investor believes the odds are again with them. As a risk is hedged, it can no longer hurt the investor but also can no longer reward the investor. By buying the bond and hedging all three risks, the investor makes the bond risk free. Of course, since the bond is now risk free, it will only offer the risk-free return—minus the transaction charges for the derivatives, which may be substantial. The bottom line is that these derivatives allow an investor to manage the portfolio of risks inherent in this investment.
Going one step further, options on the derivative contracts not only allow the investor to hedge the risks, but to reverse them without selling the original investment, as depicted in Figure 1.1.
FIGURE 1.1
Hedging the Three Risks of a Eurobond
Derivatives offer their users power and flexibility. This book examines all of the major types of derivative instruments with an emphasis on how they can be used to solve practical problems.