Derivatives explained... part two

Former City-girl Alice continues with part two of her response to a student's enquiry about derivatives

In the last issue of The Gateway, young Sophie from Cambridge asked me for a little derived wisdom... she wanted me to explain derivatives.

As a refresher, a derivative is a financial product or legal arrangement whose characteristics depend on another financial product, asset or event ("an underlying"). They are used for two purposes: hedging (ie insurance and risk mitigation) and speculation (ie for income).

They generally come in three types - futures, options and swaps:

  • A future is an agreement (ie the obligation) to buy something, for a certain price at a certain price in the future - it allows someone to lock in today's rate for a future transaction - like a farmer agreeing to sell next year's crop at today's price.
  • An option is the right, but not the obligation, to buy something, for a certain price at a certain point in the future - like someone putting down a deposit now on a cheap holiday package for next summer - you reserve the right to the cheap price if, by next summer, you still want to go; on the other hand, you can simply forfeit your deposit and stay at home if the weather turns out ok in the UK.
  • Finally a swap is an exchange of cashflows based around certain events (eg two parties agree that one will pay the other the difference between the prevailing rate of interest and an agreed rate... if the prevailing rate is above the agreed rate, A pays B... if the prevailing rate is below the agreed rate, B pays A.

I then went on to talk about equity derivatives - mostly options relating to equities - ie shares in a company.

Today, I am going to focus on credit derivatives.

People generally think that equity is a sexier form of finance than debt - that shares are more interesting than bonds - and that equity derivatives are more fun than credit derivatives.

People think debt is dull. It isn't so. Debt is hot. It is the Alice of finance.

If I was going to date a form of finance, I would be stepping out with a bond, not a stock. Stock is often referred to as 'common'. They got that right. Debt is where it is at.

Equity is so imprecise. It is simply whatever is left after all the other claims on a business are met. Before we get there, management has to cope with the day to day grind of making products, selling services and managing operations. These need financing and any sensible owner will first turn to debt to raise a form of finance that does not dilute their ownership and control.

Equally, financiers will prefer to lend debt rather than invest equity. With debt they can calculate their likely returns. With equity, they may never get paid.

The size of the equity market is tiny compared to the debt market. Most financial transactions are credit related. As a result, most derivatives are credit derivatives not equity derivatives, and like their underlying, they are far more interesting.

Credit derivatives refer to any credit or debt situation - where money is lent from one party to another. Like all derivatives, they give counter-parties the chance to mitigate risk or earn income.

All credit transactions have the following characteristics:

  • The right to repayment of the debt.
  • The right to earn interest on the debt.
  • The right to some form of security in the case of default.

Threats of risk and opportunities to earn extra income arise from each of these characteristics and this is where credit derivatives come in.

In simple transactions, all these features are bundled together in a loan agreement. Bonds take things a stage further - breaking up a large loan into bite-size chunks, as a bond is a loan broken up into bits that can be traded separately from each other.

However, in order to give lenders and borrowers increased flexibility, mitigate risk or earn extra returns, derivatives often break up these features into their component parts.

They also combine different debts, repayments, interest streams and securities together to tailor their credit characteristics or to create new securities to address specific investment needs.

Because there is almost an infinite combination of the above, the credit derivatives market is massive.

So here, I will talk about just two of the most popular credit derivatives:

  • Credit Default Swap ("CDS")
  • Asset-Backed Securities ("ABS")
  • Total Return Swaps ("TRS")

Credit Default Swaps ("CDS")

Credit-default swaps are a form insurance against the fear that goes hand on hand with any debt transaction - the risk that the borrower will not repay the debt or meet interest payments.

Having taken a lending fee when offering a loan and earning a rate of interest, a lender may want to insure themselves against the risk of credit default. They can do this with a Credit Default Swap or CDS.

The borrower in wanting to buy risk protection finds a counter-party who is willing to sell risk protection - or, to look at things in a different way - to buy risk.

The CDS will have an agreed set of rules about who pays what to who in the event of various "credit events" - a default on a scheduled repayment, a default of a payment of interest, or even, without either of these things, a worsening of the borrower's credit quality - for example, poor profits or asset dissipation.

Participants in financial markets have different priorities and different views. Some people will think the risk of companies defaulting on their debt obligations is increasing. Some people will think that the risk is over-stated.

Participants with the former view will buy CDSs. People with the latter views will sell CDS.

Neither need be linked to actual money lending or borrowing. Thus credit derivatives can be used either by lenders and borrowers themselves, or by pure speculators.

Asset-Backed Securities ("ABS")

Asset-backed securities are credit instruments where funds are raised on the back of a pool of assets of one kind or another. The assets will generally be a stream of cashflows arising from receivables owing on debts (like credit card receipts, car loans, mortgages) or from a future income stream (like football ticket sales or entertainment royalties).

They provide debt-holders with the ability recoup money lent or invested earlier than they would if they simply waited to receive the stream of cashflows in due course.

ABSs therefore provide lenders with recycled funds that can be relent to leverage a fixed capital base.

Generally, a securitisation requires the creation of a special purpose vehicle of SPV that squirrels the income that will repay the loan straight to the lender, rather than tricking back into the borrower's wider business.

In this way, the securitization might enjoy a better credit rating than the borrower would if they raised the money n the basis of their general credit worthiness.

When Arsenal Football Club wanted to finance the building of a new stadium, they turned to asset-backed securities. They issued a bond which would be repaid from the increased ticket sales that would result from larger attendances at matches. The proceeds from the ticket sales are gathered together into the SPV and can't be used for buying players.

Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations are also examples of ABSs. They are used by credit card issuers and mortgage lenders to recoup the money they lend to borrowers, so it can be relent to other borrowers, thus making two loans for the same amount of capital, and getting double the return (albeit for twice the credit risk). CDOs therefore provide 'leverage' for lenders.

It is the CDOs relating to sub-prime mortgages in the United States that blew up recently to cause the credit crunch, then the underlying assets of these shady instruments were found to be less than expected.

Total Return Swaps ("TRS")

Total Return Swaps or TRSs simply mimic the cashflow effects of owning something - an asset - without actually having to own it. This allows the buyer of the TRS to enjoy financial risk and return without having to manage operational risk or holding the asset on its balance sheet.

TRS are not strictly just a credit derivative, since they are not just linked to credit events - but to market events too.

As such, they bundle together credit and market risk in an instrument that allows two counter-parties to swap these risks in exchange for an agreed payment. One buys the risks (and rewards) - the other sells them.

A TRS creates a synthetic asset - which can be very convenient. You avoid the time and trouble and having to actually buy and operate the asset, and you keep the asset and its financing off your balance sheet. Many companies and banks operate with restrictive legislation, obligations or policies that mean it is advantageous to arrange "off balance sheet financing".

Summary

Credit derivatives are complicated and meet the needs of sophisticated players in the financial markets.

However, it is possible to keep their analysis simple. In approaching any financial situation, ask yourself three questions, all about cashflows: -

  • What magnitude are the cashflows?
  • When do they arise?
  • How certain are they?

Nothing other than cashflows matter.

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