This article was first published in the fourth quarter 2016 edition of Personal Finance magazine.
When financial derivatives are covered in the mainstream media, it’s usually for negative reasons. Yet they have become so integral to the world’s now frighteningly complex financial system that we can’t wish them away. Unfortunately, the main strength of derivatives is also their biggest weakness: you can trade in an asset without actually owning the asset, removing the responsibilities of ownership.
In 2002, five years before what we now call the Great Recession, American investment guru Warren Buffett prophetically warned of the proliferation of derivatives, which he dubbed “financial weapons of mass destruction”.
One reason derivatives worried Buffett was that they amplified credit risk – the risk of a debtor not being able to pay back what he or she owes.
He said derivatives had the effect of concentrating large amounts of credit in the hands of a relatively small number of individuals and creating conditions conducive to a chain reaction, whereby a minor failure or default sparks a series of knock-on failures that can wreak havoc on a large scale.
That’s what happened in 2007/8. A relatively small number of United States homeowners defaulted on their home loans after an interest-rate rise and a drop in property prices. Because of the massive amplification of this credit, which had been sliced up and packaged into derivatives known as collateralised debt obligations, banks and insurers sustained losses out of all proportion to the actual losses on the loans, sending the world’s markets into turmoil.
Derivative instruments were behind two other spectacular banking disasters: trader Nick Leeson’s single-handed destruction of Barings Bank, Britain’s oldest merchant bank, in 1995, and French rogue trader Jerome Kerviel’s US$3.7-billion loss for Société Générale in 2008.
So when things go wrong with derivatives, they can go horribly wrong – usually when speculators take large financial bets with other people’s money. The speculators no doubt also make large profits for their financial institutions, but because of the nature of the media, perhaps the only place these success stories are reported is on the institutions’ balance sheets.
Used responsibly, derivatives can mitigate investment risk by enabling investors to make money when asset prices fall, providing market stability. So, ironically, heightened risk is contrary to the purpose for which they were originally intended.
What is a derivative?
Essentially, a derivative is an agreement, or contract, between parties to mitigate or transfer the risk of loss through a promise or guarantee.
Derivatives exist across all asset classes: equities, bonds, commodities, property and the money market, including the foreign exchange market. There are now even things such as weather derivatives, which are like insurance policies against bad weather.
You get over-the-counter (private) contracts and standardised contracts that are traded on public exchanges such as the JSE. The latter may form a secondary market – in other words, the contracts themselves are bought and sold like the underlying assets they represent.
The earliest derivatives were simple forward contracts between farmers and the buyers of their produce. Some time before the crop was harvested, the farmer and the buyer would agree on a price per unit. This would protect the farmer if the prevailing price of the commodity, such as wheat, dropped in the intervening period. It would protect the buyer if the price went up.
Similarly, in today’s markets, mining companies can protect themselves – or “hedge” – against a drop in the price of the commodity they are mining, and pension funds can protect their members by hedging against a drop in the value of their investments. This type of contract, which is governed by a future outcome, forms the basis of the most common types of derivatives: forwards, futures, contracts for difference (CFDs), options and warrants.
A forward contract locks a buyer and a seller of an asset into a price that is payable on a specified date in the future, the expiry date. You own, for example, shares currently trading at R100 each. You are not optimistic about the prospects of the company whose shares they are and expect the share price to fall. You enter into an agreement with a buyer – who, conversely, expects the share price to rise – that you will sell him or her the shares in four months’ time at, say, the price they are today, R100.
On the expiry date (also known as the settlement or delivery date):
* If the share price has dropped to R80, you will make a profit of R20 a share, and the buyer will be forced to pay R20 more than the market price; and
* If the share price has risen to R120, you will have lost out on the R20 increase. After paying you the contracted R100 a share, the buyer can immediately sell the shares on the market at a R20 profit.
For you, the seller, this is a simple way of protecting yourself against your shares losing value, which may or may not happen.
But you don’t have to own any shares at the outset. If you simply want to profit from a drop in a company’s share price, you could enter into such a contract and buy the shares and sell them to the buyer when the contract expires. Under such a scenario, on the expiry date:
* If the share price has dropped to R80, you buy the shares at R80 and sell them to the buyer for R100, making a profit of R20 a share; and
* If the share price has risen to R120, you will have to buy the shares at R120 and sell them to the buyer at R100, making a loss of R20 a share.
To remove the transaction a step further away from the assets themselves, neither party needs to hold any shares at all, but simply settle in cash on the expiry date. If the share price goes up to R120, the “seller” will owe the “buyer” R20 multiplied by the number of shares in the contract. If the share price drops to R80, the seller will profit to the same extent, at the expense of the buyer. In this way, even intangibles such as market indices can form the basis of contracts.
In such a one-to-one, over-the-counter contract, each party is vulnerable to the other party, known as the counterparty, reneging on the deal. This is known as counterparty risk.
Futures are standardised forward contracts that are traded on public exchanges, and the exchange itself provides protection against counterparty risk. Buyers commit to buying assets and sellers commit to selling assets on a certain date.
If you are a buyer, you are taking what is known as a “long” position on the underlying asset, expecting its price to rise. If you are a seller, you are taking what is known as a “short” position, expecting the asset’s price to fall. It is possible to settle the contract by either delivering the underlying asset on the expiry date or settling in cash.
To encourage the buyer and seller to honour their commitments, the exchange requires a deposit from each, known as the initial margin. In addition, to prevent the accumulation of unrealised losses and the possibility of a party defaulting, buyers and sellers are required to transfer cash in and out of their margin accounts in line with movements in the share’s price.
A widely used instrument on share-trading platforms is the single stock future (SSF), which gives investors the ability to buy or sell an underlying listed share at a fixed price on a future date. In South Africa, SSFs and related instruments are traded on the JSE’s Equity Derivatives Market. Each SSF contract is for 100 shares in a particular company, and it has a predetermined expiry date. Because the SSFs themselves are traded on a secondary market, they have a value, which is related to, and moves up and down in line with, the price of the underlying share.
Investors are required to open a trading account and deposit the initial margin, which should cover the maximum loss that may occur in a single day’s trade. At the end of each trading day, the exchange determines the closing price of its contracts and revalues each investor’s position. Any gains or losses you have made on your contract are added to or subtracted from your account. This is called “marking to market” and results in the payment, or receipt, of what is called a variation margin.
You don’t have to hold an SSF until its expiry date – in fact, few investors do. You can “close out” your position at any stage after entering the contract, at which point you will be paid out the current value of the SSF less costs.
The beauty – and huge danger – of trading SSFs, instead of actual shares, is that your investment is “geared”, much like a small cog turning a large cog. You can make (or lose) a large amount of money by committing a small amount of money (the margin). A relatively small change in the share price can have a big effect on your investment, and you can lose more than your original capital (see “Gearing on an SSF contract”, below). Because you don’t actually own the shares, you don’t receive dividends (although these may be reflected in the SSF price), and you don’t have a shareholder’s voting rights.
Apart from SSFs, exchanges such as the JSE offer standardised futures in bonds, commodities such as gold, indices and currencies.
Contracts for difference
CFDs are a related, newer type of share-based derivative that became popular in the early 2000s. CFDs are mostly available over the counter by stockbrokers and platforms, but the JSE also offers an exchange traded product.
According to the JSE’s website, the underlying asset is a share, and the contract is settled in cash on expiry. It is an agreement to exchange the difference in value of a particular share in the period between the opening and closing of the contract. As with SSFs, you put down an initial margin and a variation margin is added or subtracted daily according to the mark-to-market system. Unlike with SSFs, dividends are taken into account.
CFDs, the website says, are simpler to understand and trade than SSFs and are used by both private and professional investors. But they carry the same risk that you might lose more than your capital.
On the plus side, CFDs are a way of gaining exposure to big global companies, such as Apple or Microsoft, whose share prices may be beyond your reach. For example, on its platform, Standard Bank offers about 150 CFDs on local shares and over 5 000 CFDs on international shares.
Options and warrants
Options are different from futures in one fundamental respect, reflected in their name: they give a trader the option to buy or sell an asset on a certain date for a certain price. The trader is not locked in, as he or she would be with a futures contract, and can exercise the option, or not, depending on whether the price of the asset has gone his or her way. If you don’t exercise your right to buy or sell, you can simply let the contract expire.
The counterparty in the transaction (the seller in the case of a trader who is buying, and the buyer in the case of a trader who is selling), however, is obliged to honour the contract.
There are two types of options:
* An option whereby you can sell the asset on a certain date is known as a “put” option. You take out a put option if you expect the price of the underlying asset to fall.
* An option whereby you can buy the asset on a certain date is known as a “call” option. You take out one of these if you expect the price of the underlying asset to rise.
Hey, that’s a sure-fire way to make money, you may be saying to yourself: I take out a call option on a share, and exercise my right to buy only if the price of the underlying asset goes up.
Unfortunately, to take out the option, there’s a charge. Instead of depositing a margin, as with an SSF, you pay the party offering the option what is known as a premium. This is not refunded; in fact, it’s much like an insurance premium.
Like futures, options have a day-to-day fluctuating value based on the value of the underlying asset. If the daily value is below or above the option’s contract price, known as the strike price, you are either “in” or “out of the money”, depending on whether you have a call or put option.
For example, you buy a call option with a strike price of R100 at a premium of R5. This means you have paid R5 for a contract to buy a specific share on a future date at R100 if you want to. The share price rises to R110 within the contract period and, because you are “in the money”, you decide to exercise the option. You pay R100 for a share that is worth R110, sell it and pocket the R10. You paid in R5 and got back R10, so your profit is 100 percent. (With an “American-style” option, you can exercise your option at any stage during the contract period; with a “European-style” option, you have to do it on the expiry date.)
If the share price rises to R105, you break even, because the R5 profit you make on the share you lose on the premium. If the share price goes any lower than that, you will be “out of the money”. If it goes below R100, you will naturally choose not to exercise the option and will have lost your R5 premium, or 100 percent of your investment.
Unlike with futures, in which your loss can be substantially more than your capital investment, with options your loss is restricted to the premium.
A warrant is a form of option not offered by an exchange, but by an issuer, such as a bank, and listed on an exchange. Warrants are generally more accessible than options, or shares themselves, to smaller investors, because the value of the contract is smaller. You can, for instance, get warrants for half or a quarter of a share. They are for short-term investing or trading and are valid over periods of about four to 18 months.
Warrants and options may have an “intrinsic” value (if the price of the underlying asset is greater than the strike price), and they have a “time” value. The further away the instrument’s expiry date is, the higher its time value, because there is more time to finish “in the money”. As you approach the expiry date, the time value approaches zero.
Swaps and related instruments
Now a brief look at the complex derivative instruments that caused such a storm in 2007.
These over-the-counter contracts are used not so much by individual traders as by banks and other large financial institutions, ostensibly to spread risk or contain it.
* A swap is basically what it says: two parties agree to “swap” financial instruments – commonly debt instruments where one has a fixed interest rate and the other a floating rate. A simple example would be if you had a floating-rate bond on your house and you “swapped” it for a bond with a fixed interest rate. You would be assured of a steady interest rate and benefit if the rate increased, whereas the counterparty would reap rewards if the rate were to drop.
* A credit default swap (CDS) is like an insurance policy against a debt going bad. As Investopedia puts it, it is designed to transfer the credit exposure of fixed-income products between two or more parties.
As a simple example, A takes a loan from B and makes regular repayments on the loan. To protect itself from a default by A, B (the buyer of the CDS) enters into a contract with C (the seller of the CDS). B pays C a premium (a single premium upfront or a regular ongoing premium) for C to take on the risk of a default on the loan. If A defaults, C pays B the remaining repayments that A should have made. If A does not default, B loses out on the premiums paid to C. Note that A may not know about the CDS contract at all.
US financial journalist Greg McFarlane, writing on derivatives for Investopedia, highlights the absurdity of these instruments. “You can’t neutralise a debtor’s dubious credit history by simply charging a few dollars more for a credit default swap. And yet the holder can list [this instrument] on its books as an asset. By 2007, the entire credit default swap market was worth US$45 trillion – twice as much as the entire US stock market.”
* Another arcane instrument of the debt crisis is the collateralised debt obligation (CDO). Originally developed for corporate debt, CDOs came to be used in the mortgage market in the US.
A CDO is a contract to pay investors in a prescribed sequence, based on the cash flow from a pool of debt instruments it owns. The CDO is sliced (collateralised) into “tranches”, which catch the cash flow from the various debt instruments, based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most “junior” tranches suffer losses first. The last to lose out in the case of default are the safest, most senior tranches.
Interest rates vary by tranche, with the investors in the safest, most senior tranches getting the lowest rates and those in the most junior tranches getting the highest rates to compensate for higher risk.
GEARING ON AN SSF CONTRACT
Gearing expresses the proportion of your outlay relative to the value of the underlying assets. Standard Bank’s online share-trading platform provides an example of how gearing works in an Anglo American single-stock future (SSF) contract.
The contract has the following reference: AGLQ Dec-16. The letters AGL indicate that the shares underlying the contract are in Anglo American Plc. The Q indicates that it’s an SSF, and Dec-16 is the date (December 31, 2016) on which the contract expires (and the shares have to be traded).
Assume the SSF price, which is tied to the share price, is R150 and a buyer believes it will rise over the short term. The buyer buys an AGLQ Dec-16 contract, which is equivalent to 100 Anglo American shares. The share-trading platform, which manages clients’ SSF positions, sets the initial margin at R2 100 a contract. The initial margin is taken from the trader’s online share-trading account and deposited in trust with the JSE.
The exposure is now one contract: a bundle of 100 Anglo shares the trader has contracted to buy on December 31, 2016 for R150. The trader is geared about seven times (the R2 100 margin is a seventh of the value of shares worth R15 000).
Assume the SSF price moves steadily upwards and reaches R170. The trader decides to close out the position by selling his contract. The initial margin is refunded, along with the difference in the value of the underlying shares, which is 100 x (R170 – R150) = R2 000. The R2 100 outlay has yielded R4 100, a return of 95 percent, about seven times the increase in the share price during the period, which was only 13 percent.
On the other hand, if the share price steadily dropped to R130 by the end of the contract period, the buyer would be obliged to buy the shares at R20 more than their market value. The difference between the buyer’s investment loss of R2 000 and the returned initial margin of R2 100 is R100. So the buyer would have lost just over 95 percent of his outlay. Note that costs have not been included in these calculations.
An advantage of trading in derivatives – instead of shares, for example – is that the trading costs are lower than when you trade in the actual assets. As an example, Standard Bank Online Trading charges the following brokerage fees on its derivative products*:
* As at September 2016.
* The writer thanks Richard Juchniewicz, the manager of retail equity derivatives at Standard Bank, for his assistance with this article.