Derivatives have taken the rap for some massive losses incurred by a number of large institutional investors in recent years. In one year alone, JP Morgan Chase reported it lost over $5.5 billion as a result of some credit default swap transactions, and both Berkshire Hathaway and German reinsurer Hannover Re attributed their sharp decline in profits to losses on derivatives. Thus, it’s not surprising that many retail investors shy away from including derivative securities in their portfolios, believing that they are too risky. And they can be. But, used wisely, derivatives can also decrease your risk exposure, so it’s a good idea to become familiar with them.
What exactly is a derivative? A derivative is simply a financial security whose value is derived from the value of some other asset, referred to as the “underlying asset.” Stock options, warrants, futures, forward contracts, and swaps are among the better known derivative securities. Basically, when you invest in a derivative, you are locking in today a price at which you can buy or sell the underlying asset in the future. This might be an individual stock or bond, a portfolio of stocks or bonds, an interest rate, a foreign currency, or a commodity, such as corn, wheat, or the oft-referenced pork bellies. This being said, each derivative security has its own defining characteristics, as explained below.
Stock options give the investor the right to buy or sell an underlying stock or portfolio of stocks at a pre-specified price, otherwise known as the strike price or exercise price of the option, but the investor is not obligated to do so. He can elect to let his option expire. There are two types of stock options. A call option is an option to buy the underlying stock, and a put option is an option to sell the underlying stock.
A warrant is also a call option, but it differs from a standard call option in a couple of ways. The seller—also referred to as the “writer”—of a standard call option is simply another investor who is obligated to sell the underlying stock to the option owner at the pre-specified price should the option owner decide to exercise his option. In contrast, the writer of a warrant is the company that has issued the stock on which the option is written. So, when a warrant holder exercises his option, the company is the entity that is delivering the stock. Warrants are often attached to a bond of the company to make the bond more attractive to investors.
Another major difference is the exercise periods of the two instruments. A standard stock option generally has 9 months from initial issue to expiration. Warrants have a longer exercise period—oftentimes 5 or more years—and the exercise price of the warrant may vary over that time period in accordance with a preset schedule.
Futures and Forward Contracts
Unlike options, both futures and forward contracts commit an investor to buy or sell the underlying asset at some future date for a pre-specified price. The investor cannot simply let the contract expire; he must actively reverse out of the contract if he doesn’t wish to maintain his position in it. A long position obligates the investor to buy the underlying asset, while a short position obligates the investor to sell the underlying asset.
Reversing out of a position is easier to accomplish with a futures contract than with a forward contract. Futures sell on exchange floors, and a clearing house facilitates the trades. In contrast, forward contracts are negotiated directly between buyer and seller—i.e., the long investor and the short investor. If an investor wants to be released from his obligation in a forward contract, he must get the investor on the other side of the contract to agree.
Swaps also involve a commitment on the part of the investors, or counterparties, to the trade. A swap is exactly what the name implies—an exchange of one thing for another. There are a number of different types of swaps, including interest rate swaps, basis rate swaps, timing swaps, and currency swaps. To illustrate, assume Company A has a debt obligation with an adjustable (floating) interest rate and is concerned that short-term rates will increase. It might arrange a swap with Company B wherein it makes fixed interest payments to Company B, and Company B takes over Company A’s floating rate payments. This is an example of an interest rate swap. As you might expect, only institutional investors are players in the swaps market. As you might expect, institutional investors are the primary players in the swaps market.