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Investment Analysis and Portfolio Management

Investment Analysis & Portfolio Management (FIN630)
Lesson # 40
A Banker and corporate treasure perambulate past in pet shop window and spy a dog for
sale. The banker buys it for $5, then sells it to treasure for $10. A few days later, the banker
wants it back, so he bids $20. The dog keeps changing hand until the banker buys it for $1
million. Then the dog escapes from the bank and is killed by a car. The treasurer is furious:
"Couldn't you have been more careful?" he complains to the banker. "Don't you realize
how much money we were making in that dog?"
Derivative assets get their name from the fact that their value derives from some other asset.
A coupon for a free Big Mac is not inherently valuable; the paper on which it is printed is
virtually worthless. We all agree that the coupon is valuable for what it represents: the
chance to get a $ 2.50 sandwich for nothing. The coupon is a simple derivative asset.
The best- known derivative assets are futures and options are the focus of this chapter.
Many other kinds of derivative assets, such as swaps, swaptions, and inverse floaters, have
vastly different risk characteristics. Plain vanilla derivative assets are enormously useful to
corporate treasurers, mutual funds, endowments, pension funds, and financial institutions.
At the same time, they are widely misunderstood by the general public, by Congress, and by
many people in the investment business (including many who should know better). Ralph
Mercer, writing in Global Finance, states, "The adoption of generic term `derivative' (i.e.,
derived from something else') to describe a complex spectrum of financial products, was a
public relation disaster." Derivatives are not all the same; some are inherently speculative,
some are highly conservative.
The Rationale for Derivative Assets:
The first organized derivatives exchange in the United States was probably the Chicago
Board of Trade, founded in 1848. This future exchange developed in order to bring stability
in agricultural prices. The farmer's problem is easy to understand. Everyone's wheat was
harvested at essentially the same time. As it arrived at market in quantity, principles of
economics prevailed. The huge supply caused prices to decline sharply, with the decline
aggravated by farmers who sold "at any price" for fear they would not be able to sell at all.
Later, during the winter, prices rose because of consistent demand in the face of dwindling
The future market enabled farmers to eliminate or reduce their price risk, the risk of not
knowing the ultimate proceeds from the sale of their crops. It serves this same function
today. Using futures, the farmers could (if they wished) promise to deliver their crop in the
future at a known a price, thereby reducing anxiety and promoting market stability. Of equal
importance is the fact that financial managers can use derivatives to eliminate the price risk
of their stock, bond, and foreign currency portfolios or obligations.
Today's communication technology brings us virtually instantaneous information about
events such as earthquakes in Turkey, airline accidents, world trade balances, and Federal
Reserve Board interest rate activity. These events influence the value of our investments.
Experienced investors are seldom 100 percent bullish or 100 percent bearish. The constant
Investment Analysis & Portfolio Management (FIN630)
arrival of new information means the investment process is dynamic. Positions need to be
constantly reassessed and portfolios adjusted.
Current Events:
Newspapers in recent years have been full of reports on various businesses that have lost
billions "investing in derivatives." Orange county, California; Proctor and Gamble;
Metalgesellschaft; Gibson Greeting Cards are a few of firms receiving particularly
voluminous press coverage. Brokerage firms have been deluged with calls from individuals
asking if there are any "derivatives" in their account. Reminiscent of Seven Up's "no
caffeine" advertising that infuriated the soft drink industry a number of years ago and set off
the subsequent caffeine-free range, some money market mutual funds bill themselves as
"derivative free."
Difficulty in educating the user is a perennial problem in the investments business. It is hard
enough to get the typical citizen to understand that stock pays dividends, not interest and
that you can sell abound before its 30-year life is up. Puts, calls, futures, and other
derivatives is the outside the vocabulary of all but the best informed.
Bonds, in fact, provide a good example of quandary in which rational people might find
themselves immersed during a discussion of derivatives. Suppose a county treasure bond $1
million par value pf the principal portion of the stripped U.S. Treasury bond as a long-term
investment, full expecting to hold the bond for its 30-year life.
Risk of Derivative Assets:
One of the most important things a finance professional can learn about derivative asset is
that they neutral products. Futures and options are not inherently risky, dangerous,
inappropriate, or anything else. Their risk depends on what an investor does with them.
A person responsible for the management of someone else's money has a fiduciary
responsibility to act prudently. Legal experts in this area have struggled for years with the
fact that the term speculation is almost impossible to define adequately. People will agree
that church endowment funds, the YWCA, and public library should not "speculate" with
entrusted funds, but there is no consensus on what it means. Some books say that a
speculation is anything accompanied by a chance of loosing money. If this definition is
accepted, then common stock is an ineligible investment, because the stock market certainly
experiences ups and downs. Almost, everyone recognizes the necessity of equities in long-
term portfolios, so this definition is unsatisfactory.
The same definitional problem plagues the user of derivative assets. The public
overwhelmingly views futures and options as "super risky" even though few folks with this
opinion ca tell you what they are. You can explain that insurance policies, adjustable rate
mortgages, and football tickets are derivative assets, but, as the philosopher said, "To prove
the thing is not enough; you must convince someone to accept it." We will see in the
following chapters that futures and options make life much simpler for portfolio managers
and that policies precluding their use are usually ill conceived.
Listed vs. Over-the-Counter Derivatives:
Before ending this discussion, one more point needs to be made. There is a world of
difference between an exchange-traded asset and one created as a private transaction
Investment Analysis & Portfolio Management (FIN630)
between two parties. An APR Microsoft call from the Chicago Board Options Exchange, for
instance, is a listed option. As such, it has standardized characteristics, is guaranteed by the
Options Clear Corporations, is fungible and can be quickly traded if desired.
The vast majority, if not all, of the derivative horror stories deal with derivatives that are not
exchange- traded. They are called over-the-counter derivatives. A large, multinational firm
might approach several money center banks and ask each to design and price a product
carefully defined degree of protection against market risk, interest rate risk, and foreign
exchange rate risk. Each of the banks wants to provide the service, and each knows that
other institutions are bidding on the job.
One of the fascinating things about the derivatives business is that a product can be built for
the client in many different ways. One version might be sturdy (and expensive), capable of
withstanding volatility and unexpected shocks in the marketplace. Another product might be
much less expensive, but prone to explode into a million pieces if the market moves too
much in the wrong direction. Often the client lacks the sophistication to understand these
differences, and buys the product largely on the basis of the lower cost. Unexpectedly large
increases in interest rates caused this latter situation to occur with the derivative products
used by the unlucky firms of the 1990s newspapers headlines.
As investor can still get in trouble with inappropriate use of listed derivative. Outright
speculation is always dangerous, and leverage should be used judiciously. Still a well-
conceived derivatives strategy is part of good management at many businesses. Risk is a
fact of life, and derivatives are a helpful tool in dealing with it. We don't like fires, but that
should not mean we hate the fire department.