DERIVATIVES DEFINED
As the derivatives market evolved, traders developed specialized terms for discussing its various products. A basic understanding of these terms is essential to a study of derivatives, so this chapter will focus on providing a few essential definitions.
A derivative product is one that derives its value from another product or other products. For example: the value of a future contract (a type of derivative) on wheat is based on the current price of wheat—it derives its value from the price of wheat. Many other factors contribute to the wheat future’s value, but it is still based on the price of today’s wheat.
There are many ways to sort or categorize derivative products. One way is to divide derivatives into two categories. The first category contains the derivatives that benefit the issuer of the derivative’s underlying product, the second is the derivatives that give the issuer no direct financial benefit. The derivatives in both of these categories derive their values from the value of the underlying product.
An example of the first type occurs when a corporation issues a bond with warrants attached. What they are issuing is a debt product (the bond) with which they are borrowing money for a period of time (the duration of the bond) and will have to pay interest over the bond’s life: they are also issuing an opportunity for the warrant holder to invest in the common stock of that company at a later time, should that investment appear appealing at that point. In other words, the warrant has a life of its own with an expiration date and the price the warrant holder will have to pay if he or she wants to take advantage of the opportunity. Both products, the bond and the warrant, are offered initially as a “unit.” With this unit the issuer has the possibility of raising funding from two sources: the borrow, which is made against the bond, and the potential investment, which is made later by the warrant holder in the issuer’s common shares, thereby benefiting from the issuance of those shares.
Options, forwards, futures, forward rate agreements, exchange-traded funds, mutual funds, unit investment trusts and other mortgage-backed securities, asset-backed securities, and covered bonds are all types of derivatives that do not benefit the issuer of the original or underlying product.
For an example of these other types of derivatives, we will use a listed option product that trades on an exchange. The buyer and seller of the option contract are anticipating changes in the underlying issue’s market value that will benefit them. The issuer of the underlying product does not receive compensation of any kind from the buying and selling of the option.
In the arena of derivative products, those benefiting the issuer include warrants, rights, units, and privately placed options. Included, although stretching the concept a bit, is the initiation of collateralized debt obligations (CDOs), which we will discuss in depth in chapter 21 to the extent that they represent packages of loans made by a financial institution and through their sale, the institution can recoup its expenditures in order to continue to make loans.
A structured product is a combination of two or more products designed in the anticipation of achieving a particular goal. The important word is “anticipation,” as the result is not guaranteed. The component parts are offered as a package. Sometimes the “package” is issued under a trust. One of the simplest examples of a structured product can be found within the option world. It is called the buy/write. The principal buys shares (100 shares is a trading lot) of a stock because the corporation that issued it pays a good-size quarterly dividend and the stock purchaser is not anticipating capital appreciation. In this particular strategy the principal wants the value of the stock to remain stagnant. Against the purchase, the principal sells an “out of the money” call on the same stock, thereby earning the option premium. As long as the stock doesn’t rise in value to the point where the owner of the option will call the stock away, the principal can earn the dividend and enhance that income with the premium received from the option.
Here’s an example:
Mr. Chuck Spear purchases a package consisting of the acquisition of 1,000 shares Marnee common stock @ $38 per share (the stock pays a dividend of $1.00 per share annually, which is paid quarterly) and the sales of ten call options (option represents 100 shares) expiring in six months with a strike price of $40 for $1 per underlying share. Putting commission and fees costs aside, the package cost $37 ($38 − $1) per share. Assuming the stock does not rise above $40 per share, the option will expire and be worthless. Mr. Spear has earned $0.50 in dividends during the six-month period and $1 from the sale of the now worthless option for a total of $1.50, versus just the dividend of $0.50 had the options not been sold. This strategy and others, including risks, are discussed later in this book.
The financial industry, like most industries, runs on credit. Some participants arrange financing for their clients, who use it to finance their own company’s operation—often by arranging private loans, underwriting their company’s securities, and advising on mergers, acquisitions, or consolidations. This financing originates with lenders, known as clients. Banks lend money received from depositors, and broker-dealers offer securities for their clients to buy (more funding). These same clients acquire and sell the securities using financing as the conduit. The use of all this financing involves interest charges. The amount of interest charged depends on the creditworthiness of the borrower.
“Broker-dealer” is a catchall term for any firm that must be registered with the Securities and Exchange Commission (SEC) to do brokerage business with the public. This general term encompasses broker-dealers whose customers are institutions, those that focus on retail customers, and those that are national, international, or multinational firms.
An investment bank may or may not be a broker-dealer; the usual operation either is or has an affiliation with one. Typically an investment bank is the intermediary between a corporation or other institution and the public markets. An investment bank can assist a young company in raising short-term funding by introducing the company to lending operations such as venture capitalists or broker-dealers that specialize in the placement of this type of financing.
As the company grows, its need for financing grows and the investment bank assists it in preparing to issue securities to the public. This process is known as underwriting an initial public offering (IPO). As the company continues to grow the investment bank will continue to assist it if it is issuing securities.
Investment banks also assist their corporate clients through the steps necessary to execute a merger or acquisition. This assistance ranges from locating prospective candidates to helping to thwart an unwanted takeover.
Of importance to this book is the role investment banks play in the derivative and structured markets. It is the clients of the investment bank that need and use these products. It is these firms that have the financial strength to support these strategies, to take the opposite side when necessary, and to facilitate the transaction through their contacts. They are basically set up to focus on a few large transactions per day.
Investment banks bring new issues to market. They underwrite the issue, meaning they buy the issue from the issuer and sell the product into the market. Once issued, the product begins secondary trading as the new buyers sell their new issue to market makers, who in turn sell them to new buyers, and the trading begins. Many of these products will be serviced by the initial issuer.