THE ROLE OF DERIVATIVE ASSETS

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 40

THE ROLE OF DERIVATIVE ASSETS

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?"

INTRODUCTION:

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.

BACKGROUND:

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

supply.

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

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Investment Analysis & Portfolio Management (FIN630)

arrival of new information means the investment process is dynamic. Positions need to be

constantly reassessed and portfolios adjusted.

DERIVATIVE ASSETS AND THE NEWS:

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

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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.

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