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Derivatives in Financial Market: Portfolio Management

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Published: Tue, 27 Feb 2018

Derivative Structures in the Market and Their Place in Corporate Portfolio Management

Abstract

Derivatives are financial instruments that do not hold independent value, but where instead the value of the instrument is based on the underlying value of a given asset, which can range from financial assets such as stocks, bonds and market indexes to commodity assets such as oil, gold or wheat, to more obscure or exotic assets such as weather or other exotic assets. The four main categories of derivative include forwards, futures, options and swaps, each of which is used for a different risk control technique and each of which has its own unique structure, risk, and potential for return. Derivatives are commonly used in financial firms to balance portfolios and reduce risk by spreading it across the market, or in order to mitigate potential risk by limiting it (for example, placing a ceiling or floor on currency exchanges or purchases).

This paper explores the use of derivatives in the financial market, including their use in portfolio management. Following a thorough definition of the derivative, the paper explores the use of derivatives in portfolio management and other banking activities, and offers a substantive risk assessment that addresses the potential difficulties that the use of these instruments may pose as well as a description of the benefits of using derivatives.

The paper also explores ways in which actual financial institutions use derivatives through examination of public reports and other available information, in order to determine what current practice is in the use of these reports. The report concludes with recommendations for portfolio managers within financial institutions regarding the use of these instruments for risk management as well as the potential dangers of their use. The study is intended to provide an overview guide to this material and an analysis of existing research that can be used for further research and understanding of the subject material.

Chapter 1 Introduction to the Research Project

The use of derivatives in corporate risk management has come under scrutiny recently in the news, following reports of credit risk derivatives being used improperly by some firms and banks during the mortgage lending collapse of 2007-2008. However, while these instruments may be misused, they also hold an important role in both financial and non-financial firms in hedging risk and balancing corporate portfolios and investments. Derivatives can be used in a number of different applications. These applications include balancing risk across a number of different investors, gaining access to foreign currency or reducing currency exchange risk exposure, and reallocating loan risk across lending portfolios within or among banks.

While these instruments clearly have benefits in terms of balancing, spreading and reducing risk to the individual investor, corporation or bank, there are still considerable risks that must be considered. For example, credit risk derivatives were at fault for revenue losses because they were improperly calculated to be less risky than they actually were. Conversely, a currency option, one type of derivative that reduces the potential for risk in currency exchange rates, could end up being a poor rate if the market does not change in the expected manner. These are just a few of the risks that can be encountered within the use of derivatives in financial and non-financial firms.

This paper presents an overview of the types of derivatives available, the risk involved in using the derivative, and other important factors that must be considered in its use.

Research Aims

The main aim of this research is to explore and identify the derivative structures in the financial market and examine different corporate responses to the changes in the market and uses of these derivatives. The research also examines the impact posed by changes in the market on the corporate portfolio strategy. By first providing an overview of the different types of derivative structures available, and then analyzing corporations in order to identify how they use these structures, the research paper analyzes corporate portfolio diversification as a strategy and explores the potential for derivatives in financial markets.

Research Objectives

The main research objectives of this project include:

Definition of the structure and application of derivatives

Definition of the risk posed by application of derivatives in a competitive market

Description of the common usage and potential impact of derivatives on the financial institution

Examination of the impact of market changes in the corporate portfolio within the financial institution

Identification of the limitations and risks of derivatives as used in the corporate portfolio

Identification of appropriate risk management and portfolio management strategies

Importance of the paper

Sustained changes in the financial and competitive environment of industries, increasing globalization and increasing complexity of financial markets has led to an unprecedented period of currency and interest rate volatility worldwide. In order to counter this increase in risk, innovative foreign exchange risk and interest rate risk hedging techniques have developed at a rapid pace. Although these derivatives are intended to assist in risk management and risk minimization, particularly in terms of uncertain cash flows and currency exchange rates, their use has been uncertain, as instruments grow increasingly exotic.

This paper will provide a guide to derivatives and their use in the financial market, as well as provide a clear understanding of the risks involved in the use of derivatives and their appropriate application to risk management, as well as discussion of how the risk of the derivatives themselves may be handled. This information can be used by investment risk managers and others in order to guide policies regarding the use of these instruments and allow for an increased understanding of the underlying issues involving these instruments.

Methodology overview

The methodology that will be used is that of desk research and meta analysis. This method will assemble information from a large number of sources, including primarily secondary research, and organize and analyze it in such a way as to create an understanding of the research material in the general case. This information will be able to be used for description of the operation and formulation of derivatives in a number of markets.

Data collection The main data collection technique used in this discussion will be secondary research or desk research.

This method was chosen both because of the limited time available to perform the survey and because of the amount of information already available on the subject matter. Secondary information will include primarily a literature review, which will provide background and theoretical information that can be used in order to form an overall picture of the theory and practice of using derivatives and derivative structures. Other secondary data will be used to examine the issues at hand for analysis, including materials such as company reports, journal articles and time series, and previously conducted surveys that address the subject matter.

However, it should be noted that derivatives are not ordinarily considered reportable assets, and so may leave little trace on company reports and discussions. As such, generalized information from sources such as the Bank for International Settlements will be used as much as possible rather than specific firm information.

Data analysis

Following the collection of data using the method described above, the data will be analyzed using a number of techniques. Analysis methods are intended to be both quantitative and qualitative, in accordance with the data available for analysis.

Quantitative analysis will be exploratory and descriptive, using data summaries in such methods as charts, tables, and descriptive statistics. Qualitative analysis techniques that will be used will include categorization, development and analysis of relationships, and descriptive techniques. This data analysis will be used in order to create an overall view of the data that can be used in order to explore the research questions.

Organization of the paper

The table below presents the organization of the remainder of the paper in terms of chapter numbers and contents.

Chapter Contents
Chapter 2 Literature review and context review
Chapter 3 Methodology overview
Chapter 4 Presentation of results of analysis, discussion of results and examination of risk and risk mitigation strategies for firms using derivatives
Chapter 5 Conclusions and recommendations for further study

Table 1 Organization of the paper

Summary

This chapter has presented an overview of the aims and objectives of the paper as well as the methods that will be used to explore the research objectives. It will provide a guide to the remainder of the paper. The next chapter, the Literature Review, provides insight into the structure and definition of derivatives as well as providing insight into their use in financial markets.

Chapter 2 Review of the Literature

In order to provide background and theoretical information for the discussion in the following chapters, this chapter presents an overview of the current state of affairs concerning derivatives and their use in the financial firm. This includes a description of the definition of derivative, the varying types of derivatives and what their uses and significance are, and a description of their current use in the banking context in order to examine the overall importance of derivatives in portfolio management.

This chapter will also provide an overview of the concepts of portfolio management in order to examine issues involved in the use of derivatives.

Definition of derivatives

Although there are a number of different definitions of derivatives, the basic principle of the derivative is that it is not, in and of itself, an asset or investment; instead, it is a financial instrument that is based on the value of an underlying asset or instrument (Hunt & Kennedy, 2004, p. 1). As such, it should be clear that as a derivative has no independent financial value, it should not be considered to be an investment per se; if the firm wishes to make an investment in the underlying asset, it is more appropriate to do so directly. Instead, derivatives are used to gain potential access to cash flows, risk, currency exchanges or other valuable items or to distribute risks across a number of different users, markets, or geographic areas rather than assigning all risk to a single portfolio or individual (Hunt & Kennedy, 2004, p. 3).

Derivatives may be based on the value of a wide range of underlying instruments, including stocks, bonds, indexes, exchange rates, interest rates or the prices of commodity such as wheat, oil or livestock (Hunt & Kennedy, 2004). More exotic underlying instruments include credit risks of packaged assets and even long-range weather forecasts; however, these exotic underlying instruments fall outside the scope of this discussion and will not be examined in-depth.

Underlying concepts

There are a number of underlying concepts that must be understood if the idea of the derivative is to be fully described. The first such idea is that of replication. In brief, replication is the portfolio of assets (trading strategy that will pay out an identical amount to the payout of the derivative in any potential trading circumstance (Hunt & Kennedy, 2004, p. 3). In other words, the balance of the portfolio, on which option pricing theory is based, is dependent on its ability to mirror the price of the option that it is compared against.

The second important underlying idea is that of arbitrage. Hunt and Kennedy (2004, p. 3) defined arbitrage as a trading strategy that generates profit from nothing with no risk involved. Arbitrage opportunities are assumed not to exist in the trading of derivatives; although it is clear that some random arbitrage opportunities might exist, they cannot be counted upon in a trading strategy and should not be considered for the purposes of this analysis.

The underlying security is defined as the security involved in an option or other derivative transaction (Chorafas, 2008, p. 36).

In other words, the underlying security (or underlying asset) is the security or asset from which the derivative derives its value, like a commodity such as oil, gold or wheat. These underlying securities rarely actually change hands (although it may occasionally occur). As Chorafas noted, while the underlying security may be based in an asset or liability, it cannot be considered to be an asset or liability itself, but is instead intended only to hedge risks from other market areas. Chorafas demonstrated that the relationship between the underlying security and the derivative is likely to be nonlinear; that is, the price of the derivative will not depend immediately on the price of the underlying security, but will instead be offset by other factors. The figure below demonstrates this nonlinear relationship.

Figure 1 Nonlinear relationship between the value of derivatives and underlying instruments (Chorafas, 2008)

The idea of notional principle amount, or face amount, is the amount of money on which the trade is based; however, this money is never actually intended to change hands, it only provides a basis for such characteristics of the derivative as interest rate calculation or other bases for engaging in the trade (Chorafas, 2008, p. 36). This may be specified not only in currency, but also in any other relevant measurement, such as shares, kilos, gallons, bushels, or whatever the natural means of measuring the underlying asset might be. Types of derivatives There are a wide range of types of derivatives, and custom derivatives are often assembled in order to meet the requirements of the parties involved in the trade that do not easily coincide with the definition of any standard type.

However, the four major categories of derivatives include options, forwards, futures and swaps. Each of these types has a different structure and different uses within the market, and each is traded differently within the market. The description, structure and main uses of each of these types of derivatives are described in detail below.

Options An option is an instrument that gives the buyer the opportunity (but not the requirement) to purchase a given instrument at a specific time for a specific price (Chorafas, 2008, p. 39). An option may be a call option (guaranteeing the buyer the right to buy the underlying good at the set price) or a put option (guaranteeing the owner the right to sell the underlying good at the strike price) (Kolb, 2003, p. 4).

The buyer of an option may decide to exercise it (in which case they take delivery of the underlying) or to not exercise it (in which case it expires); if the buyer does exercise the option (decide to take delivery) the seller must give it to them for the agreed-upon price. The price at which the buyer may exercise the option is the strike price, while the price paid to the seller for the option is known as the premium (Chorafas, 2008, p. 40). The expiration date is the date by which the option must be exercised is the expiration date. The type of option will determine whether the option can be exercised only on that date, at any time prior to that date, or at certain specific times prior to the expiration date. American options can be exercised at any point up to the expiration date, while European options allow exercise only on the expiration date (Kolb, 2003, p. 507).

A Bermuda option has set intermediate dates between the purchase and the expiration date at which it may be exercised (Kolb, 2003). There are also a number of exotic options that provide more customized payment, delivery and exercise agreements that may rely on the price of the underlying asset; for example, a barrier option’s exercise depends on the value of the underlying asset reaching a price specified in the contract, while an Asian option depends on the average price of the underlying security (Kolb, 2003). A so-called plain vanilla option, however, depends only on the current price of the underlying and other characteristics of the option such as exercise price and time until expiration (Kolb, 2003, p. 577). Caps, floors and collars are particular characteristics of a given option, which are intended to limit exposure to upside and downside risk (Smith & Walter, 2003, p. 84).

A cap, commonly used in an interest rate swap as well as other options, fixes the upper rate of exchange, while a floor similarly fixes the lower rate of exchange; as can be envisioned, a collar fixes both the upper and lower rates of exchange in order to reduce the potential for risk. Options are extremely popular derivatives that are used in both financial and nonfinancial firms for portfolio balance.

Forwards A forward, or more properly a forward contract or option, is structured in much the same way as an option; however, rather than the exercise of the instrument being optional at the expiration date, exercise is mandatory at that time (Kolb, 2003). A basic definition of a forward was given by Kolb, who remarked, A forward contract… always involves a contract initiated at one time; performance in accordance with the terms of the contract occurs at a subsequent time.

Furthermore, the type of forward contracting to be considered here always involves an exchange of one asset for another. The price at which the exchange is set at the time of the initial contracting. Actual payment and delivery of the good occurs later (Kolb, 2003, p. 2). Forward contracts are commonly used in currency exchange operations and other transactions in which the individuals involved wish to reduce uncertainty; for example, in a currency exchange forward, the seller ensures the present value of the trade, as does the buyer. Although the currency exchange rates may fluctuate over the time between the contract and the expiration date, the risk for each party will be reduced because they will be able to protect themselves from changes in the currency exchange (Kolb, 2003).

As such, forwards are commonly used for securing access to foreign currency or other underlying assets that an individual will need in the future at a risk-controlled price. In effect, the use of forwards removes uncertainty from the future business climate, therefore reducing risk. Forwards may also be used in order to create a position in the weaker currency when performing interest rate hedging (Smith & Walter, 2003, p. 43). In effect, the investor attempts to determine when a weak currency is going to undergo a currency collapse (such as the 1997-1998 Asian market collapse, which began with a weakened currency in Thailand), and then purchases interest rate forwards in this currency, then waits for the interest rate in the country to drop as monetary policy shifts to propping up the currency rather than attempting to slow growth.

However, this strategy is not without risk because there is always the potential that the currency may not depreciate or, if it does, that the requisite interest rate drop will not occur, or will not be sufficient to make the investment worthwhile.

Futures Futures are an even more specialized form of the option. Futures contracts, which always trade on organized exchanges rather than in over the counter transactions, are a type of forward contract with highly standardized and specified contract terms… futures contracts are highly standardized with a specified quantity of a good, and with a specified delivery date and delivery mechanism (Kolb, 2003, p. 3).

According to Kolb, performance on a futures contract is also guaranteed with by a clearing house, or a financial institution that guarantees the integrity of the market, and are protected by margin, or security payments posted by traders as a good-faith indication of willingness to trade (Kolb, 2003, p. 3). Futures, unlike other forms of derivatives, trade in a regulated market and as such may not be as complex to handle as other forms of derivatives such as forwards. Futures are most commonly used for trade in commodities, and are often used by nonfinancial institutions rather than financial institutions.

Swaps

Unlike the other forms of derivatives, a swap is not just a specialized form of option, but is instead a different type of instrument. A swap is an over-the-counter instrument involving the exchange of one stream of payment liability for another (Smith & Walter, 2003, p. 75). According to Smith and Walter, this derivative has only developed since the 1980s, with an increasing use of derivatives by non-financial corporations in order to reduce risk and reduce cost of listing on stock and bond markets. Swaps, as contingent values, are also not listed on financial reports, which allow firms to manoeuvre their full investment in a given position if desired (Smith & Walter, 2003, p. 76).

Common swaps include interest rate swaps and currency exchange swaps. Currency swaps allow firms to exchange their exposure to currency risk (for example, by limiting the amount paid in interest from one position to another) by exchanging currency rates from one to the other. Historical currency swap rates demonstrate the overall growth in currency swaps. The table below demonstrates the growth in currency rate swaps over the top ten traded currencies in 2000. As can be seen, the Euro almost immediately became prominent, with rapidly increasing amounts of currency swaps overtaking the currency as it was instituted. The use of currency swaps is extremely common in financial and non-financial firms that require protection from currency risk. For example, those with operations in multiple countries (Smith & Walter, 2003).

Currency Notional Amount Traded Per Year (Historical Figures)
  1998 1999 2000
Australian dollar 206 365 387
Canadian dollar 594 647 623
Danish Kroner 28 37 40
Euro 4,667 5,981
Hong Kong dollar 89 321 450
Japanese yen 5,319 4,236 4,254
New Zealand dollar 10 6 3
Norwegian Kroner 48 127 103
Pound Sterling 2,512 2,242 2,391
Swiss franc 419 459 456

Table 2 Historical trades in currency swaps, 1998-1999 (Smith & Walter, 2003)

Interest rate swaps allow for firms to exchange interest rates on funds, often in exchange for future value of a payment stream. As noted by Smith and Walter, these instruments are advantageous because they allow for the transfer of potential immediate interest risk, as well as offering individuals access to funds at lower interest rates. In addition to an immediate swap, a pair of traders may engage in what is called a forward swap, in which payments at some time in the future are fixed rather than immediately exchanging hands (Smith & Walter, 2003, p. 83).

These derivatives are not commonly used in the financial world, but may take place for example in order to fix interest rates through the duration of a long-term building project or perform similar interest rate fixation.

Credit derivatives Of particular current concern is the credit derivative, which protect the lender against loan default in much the same way as a loan guarantee. According to Smith and Walter (85), the major types of credit derivatives include total return swaps (in which the potential returns from a risky underlying loan instrument are exchanged for a lower, but less risky, guaranteed return); credit default swaps (in which an upfront fee is exchanged for coverage in the case of a default on the underlying loan instrument); and the credit linked note (in which the buyer makes a series of payments to the seller, which are returned if there are no credit difficulties during the lifetime of the loan) (Smith & Walter, 2003, p. 86).

Banks have commonly used these derivatives in the recent past in order to limit their exposure to consumer debt; however, as the recent subprime mortgage crisis in the United States has shown, reckless use of credit derivatives may not be appropriate. Many hedge funds (estimated by Douglas to be a tenth of the total market) specialize in credit derivatives, following a number of different strategies for engaging in credit derivatives trading and arbitrage. The authors noted that of the participants in the credit derivative markets, the majority of funds that specialized in credit derivatives worked in emerging debt markets and convertible arbitrage opportunities, rather than in less risk, but less rewarding, areas such as distressed debt and high yield debt (Douglas, 2007).

The risks of credit derivative instruments will be explored more fully in Chapter 3, Data and Analysis.

Derivative trading Derivatives are traded in one of two ways. Over the counter derivatives (OTC derivatives) are derivatives that are traded directly between private parties, rather than being traded through an exchange (Smith & Walter, 2003). Some of the most commonly traded derivative structures that are traded over the counter include swaps (which are usually custom-packaged in order to meet the needs of both parties involved in the trade) and exotic options and other custom-packaged derivative products (Smith & Walter, 2003). These instruments are best traded over the counter because of their custom nature; the OTC sale format allows for customization of the package in order to meet the needs of the purchaser in terms of portfolio balance and risk adjustment (Chorafas, 2008, p. 58).

However, this flexibility comes with a cost in risk undertaking, as there is no open market value of the instrument in order to ensure that the buyer does not overpay (Chorafas, 2008, p. 59). Although precise figures on the trade of OTC derivative instruments are difficult to obtain due to the private and non-reported nature of the trades, evidence points to a very large market for these instruments. According to the Bank for International Settlements, the estimated international trade in OTC derivatives as of December 2007 was approximately 596,004 billion US dollars (Bank for International Settlements, 2007).

The second form of derivative trading is exchange-traded derivative trading, in which derivatives are listed on exchange for buyers and sellers in much the same fashion as stock or bond markets (Chorafas, 2008).

The potential for overpricing that exists in OTC derivatives is not present in exchange-traded derivatives, because the existence of the open market results in the establishment of a fair market value for the derivative (Chorafas, 2008, p. 60). However, many types of derivatives are traded in derivative exchanges; most commonly, interest rate swaps and commodity forwards and futures are available on derivative exchanges (Chorafas, 2008, p. 75). While customization of derivative packages is not possible, for some purposes the use of a traded derivative is entirely sufficient to meet the needs of the portfolio management problem, and should be considered as lower cost than creating a customized over the counter derivative sale.

According to the Bank for International Settlements, the exchange trading activity in derivatives during the 2nd quarter of 2008 (March to June) totalled 600,465 billion US dollars, which represented a total trade volume of 2,397 million contracts in total (Bank for International Settlements, 2008).

Portfolio management The main use of derivativ


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