Derivatives explained... part one

Former City-girl turned careers advisor, Alice, clears up a student's confusion over derivatives

This is a big request. You might as well have asked me to explain the complex subject of love. Actually, I can explain both derivatives and love. However, the Editor of The Gateway only pays me to do the former, and I have already rejected his overtures for me to demonstrate freely, let alone explain, the latter (the answer is still 'no' by the way, Mawuli). So, let me shed a little light on derivatives for you. Actually, it's such a big subject, that I am going to dedicate both my column in this issue and the next, to answering your question in full.

It's a matter of opinion and risk management

'Derivatives' is a collective name for futures, options and other securities whose characteristics and values depend on the performance of something else. They all relate to the opinions of lenders and borrowers, of investors and speculators, of producers and customers - in the financial, commodity and other markets around the world - who act on their opinions and take up 'positions'. Positions of lending or borrowing money, or investing in shares, of producing crops, or buying oil, of betting on the outcome of a football match, and just about everything else in-between. If you have an opinion on any of these things, you can seek to profit from it by buying the commodity in question and hoping that, over time, your opinion is vindicated.

So, for example, if you think Barclays PLC shares are undervalued at the moment, buy them and see if the market proves you right. If it does, you can sell your shares at a profit. But you can equally seek to profit from your opinion by recreating this trade synthetically - by buying a derivative of Barclays shares - in this case, an equity option. Equity options (sometimes also referred to as stock options), allow you to take advantage of share price movements without necessarily physically buying or selling the shares.

And there are advantages to in doing so, versus buying the underlying shares. Equally, if you act on any of your opinions and take up a position, you have risk. Risk that your opinion might be wrong, or risk that a counter-party with whom you do business might not deliver. Or that other circumstances might intervene to harm your position.

What can you do?

Again, you can use derivatives to protect yourself. So, let's say you're a farmer who produces wheat, and your growing cycle is nine months long. You can protect yourself against falling wheat prices in the interregnum period (or period of discontinuity) by using derivatives.

Options for options

There is, in fact, a wide variety of derivatives out there to choose from:

  • Equity derivatives are contracts linked to the performance of equities (shares).
  • Credit derivatives which relate to loans, bonds and other debt instruments.
  • Commodity derivatives relate to energy (oil, natural gas and electricity), precious metals, base metals and agricultural produce.
  • Index options are linked to the performance of an index of shares like the FTSE, or S&P 500FX options relate to foreign currencies.
  • Weather futures relate to the climate (a farmer might use these to hedge against extremes in climate and, hence, bad harvests).
  • Spread bets placed on football matches are also a type of derivative.

Within each of the genres, there tends to be three categories of derivatives, and these are futures, options and swaps.

Futures

Futures are contracts to buy something for a certain price at a specified point in the future. There is no optionality and the contract has to be fulfilled. Futures are often used for hedging (i.e. downside protection).

For example, I remember a while ago I was dating a young trader who, after a good year in the markets, wanted to buy his very first Porsche. Maybe he thought this would impress me? Fat chance! Like any financier worth his salt, he shopped around for the best deal and saw that Porsches were substantially cheaper in Germany than in Britain. He stood to save a whopping £10,000 if he chose to buy the car from Stuttgart rather than Farnham.

The favourable price was actually due to two factors: firstly, the lower cost of the car because it was in its home country and, secondly, the then-favourable exchange rate between sterling and the euro. So, he ordered the car and agreed to take delivery of it in three months' time, when he would have to pay the German car dealer in euros. At that point, the pound was worth roughly two euros.

Over a cocktail one night, I whispered in his ear to be careful about FX exposure (or, to the uninitiated, Foreign Exchange exposure). It's not contagious like certain other things I was worried he might have been exposed to, but potentially a lot more expensive. What I meant was, if, in the next three months the pound depreciated substantially against the euro, his liability in sterling would increase, potentially wiping out the generous saving he stood to make on the car. If the pound really fell off a cliff during that time, he could end up paying a lot more for the car in Germany, than he would have done, had he simply had bought it from the showroom down the road.

So, following my advice, he purchased a futures contract for euros, locking in the favourable exchange rate that day. He agreed a contract with his local bank to exchange a sufficient number of pounds for the requisite amount of euros in three months' time, and thereby locked in his saving. They charged him a slight 'spread' above the price that day to compensate them for their risk and the time value of money. A small price to pay, I thought, for financial peace of mind.

From this point on, he would pay the same price for the car, no matter what happened subsequently to the rate of exchange between the pound and the euro. Anyway when he took delivery three months later, I saw that the car was a Boxster and not a 911, so sadly this young man was no more. For the men of the world, there are no future contracts in Alice available from your local bank.

Options

Options are like futures, in the sense that they allow someone to buy something for a specified price within a specified time in the future. However, the contract does not have to be fulfilled. It has optionality. It grants the option holder the "right but not the obligation" to take up their option. An option contract will have the following four main characteristics:

  • Reference to an underlying - a share, a bond, an index, a commodity, a sporting event, etc.
  • A strike price - a time period within which the option can be exercised, regardless of what its market price is at the time.
  • The price of the option itself. So a "Barclays plc October £5 option trading for 50p," means that for 50p, you can buy the right to purchase Barclays shares for £5, any time you choose, between now and October.
  • Two purposes - futures and options are used for two main things: hedging and speculation.

Swaps

A swap is another type of derivative and it is exactly what it sounds like - a swap of one position for another. A typical swap would be an interest rate swap and it is used by lenders and borrowers in debt transactions.

Suppose that you are buying a house for £500,000 and you take out a variable interest rate mortgage with your local building society. Let's say the prevailing interest rate is 6% - 50 bps or basis points (a unit of measure used to describe the percentage change in the value or rate of a financial instrument) over the Bank of England base rate. You are going to end up paying £30,000 per annum in interest - not an insignificant amount (unless you are on my rather robust salary, of course).

If the Bank of England, fearing inflation, raises its interest rates to 9.5%, the interest rate you will pay on your mortgage will rise to 10% - the equivalent of £50,000 per annum - and £20,000 more than you budgeted. Now you are in big trouble. Is there anything you could have done to protect yourself? Yes. You could have bought an interest rate swap.

To do this, you would have needed to have found a counter-party who had opposing views or different financial priorities to you - perhaps they might be a lender of debt who feared falling interest rates as much as you were worried they'd rise. You would have then agreed to swap 'positions' at, say, 6%.

Then, for every 100th of a per cent that the building society's interest rate went above 6% (you would have agreed the precise underlying and a notional principle - probably the amount of your mortgage: £500,000), you would have received the equivalent amount of money from your counter-party. Thus, if interest rates were to rise to 8%, you would receive £10,000 - which you would have used to pay the extra interest you will owe on your mortgage. So net versus net - you will come out level.

As long as interest rates stay as they are - at 6% - neither you nor your swap counter-party will pay each other anything. But, for as long as interest rates stay below 6%, you will owe your counter-party money. So if they fall to 4%, you will have to pay them £15,000. However, your position is actually covered, because you will make the same saving on your mortgage. In effect, you have hedged away your interest rate exposure. Quite a smart move for the risk-averse investor. Building societies actually use swaps to synthetically create fixed rate and capped rate mortgages for their customers.

More on hedging

Now, let's look at hedging in the equity markets, using options rather than swaps. Let's say you have bought 1000 shares in Hot Air Ltd for £5, hoping that they might go up in value. Your purchase has cost you £5000. If Hot Air shares rise to £6, that's a 20% rise and you will have made a profit of £1000. But what if they tumble to £4? That's a fall of 20% and a loss of £1000. Can you protect your position?

Potentially, yes you could, but it would depend on the cost of 'insurance' in the options market. There might be someone out there who is as sure as you that Hot Air shares are going to rise, and thinks that the chance of a fall is quite remote. In such circumstances they might be willing to write a 'put' option for you. A put option is the right (though not the obligation) to sell a security at a specified price within a certain period of time.

If you buy a put option, you buy the right to sell a security. In this case, you might agree with the option writer to buy a certain number of put options at £4.75 for 25p per share. So, if the share price of Hot Air falls to £4, you will lose a total of £1 on each share. But you will then be able to buy back shares in the market for £4, and sell them under the terms of your put options for £4.75, making back 75p on each share. If you bought a sufficient number of options, you will be able to buy back enough shares to cover your downside loss on your original shares, as well as covering the price of the options themselves, too.

The option agreement described above is called a 'mirrored put' because the put option is mirrored by your underlying shareholding, and it is a classic use of derivatives.

Speculation

Now, let's look at speculation, with the same example. If Hot Air shares do indeed go up to £6 - which would be a rise of 20% - is it possible for you to make a larger return on your £5000 capital than £1000, also being 20%? Yes, it is, with the clever use of options.

Rather than buying the underlying shares for £5, you could buy 'call' options. Call options are the right to buy a certain security for a certain price at a certain point in time. If you can find someone who takes a contrary view to you, and is convinced that Hot Air shares are going to fall, they might be willing to sell you call options for a low price.

Let's say you find such a person and they sell you £5.25 options for 25p each. With £5000 you can buy 20,000 options. If Hot Air shares rise to £6, you will exercise your options and buy 20,000 shares at £5.25 from your counter-party, and sell them in the market for £6, making 75p per share - or 20,000 x 75p = £15,000 in total. You will have paid £5000 for the options in the first place, so you will be left with a profit of £10,000, or a tidy 200% return of on your original investment!

Writing options

So far we have only discussed what would happen if you took out an option and exercised it. In this case, the extent of your exposure it limited to the price of the option (i.e. it is limited). But what about writing options? This is a different ball game altogether. Now enter the world of unlimited exposure.

In the previous Hot Air example, what if you were the person who wrote the call option on Hot Air stock and then they suddenly shot to £100 a share? Your exposure would depend on whether or not your 'call' was covered (i.e. whether you owned the underlying Hot Air shares). If you did, you can deliver up the stock, and you will simply have missed out on a potential gain of £95.

However, if you did not own the underlying shares and your call option was 'naked' (i.e. you had no risk-reducing position) then you are in big trouble. You will now have to buy the shares in the market for £100 and sell them to the option holder for £5 - a £95 loss. It's highly likely that you're bankrupt. And that is a good place to end for this week. Be sure to read the next week's issue of The Gateway for my second informative instalment on derivatives.

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