September 26, 2008

Derivatives 101

In the wake of the collapse of WaMu et al. many people are worried and probably just as confused as our politicians as to what caused all this financial turmoil. A lot of the blame has been directed towards “Derivatives” and its improper use. I’d like share a few thoughts on these illusive financial instruments.

What are “Derivatives”?

Here’s a definition from Wikipedia:
Derivatives are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps. The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.

Here’s a definition from Warren Buffet:
Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Here’s a view from someone who deals in them for a living:
When I first traded “Derivatives” in London in the early 90’s, the financial services industry commonly referred to them as “Contracts for Differences” (CFD’s) which sort of hints at the true nature of these financial contracts. Basically, they are (private) contracts between two parties to take a “bet” on an outcome in the future price of an underlying asset while the future price “difference” and only the price difference is settled in cash. Since the parties typically don’t own the underlying asset, nor wish to purchase the underlying asset, these derivative contracts for “differences” are usually highly leveraged and that’s exactly where the danger lies in using them. Far from its originally intended purpose, they are by no means only used to reduce risk, but just as often, they are used for speculative purposes.

Once the conceptual framework on how to price some of these contracts was in place, these legal bets could be made on anything the only limit being the imagination of those who wrote the contracts i.e. the PhD’s in Mathematics & Physics a.k.a. “Quants” who came up with the models for pricing them. While some of these derivatives have been extremely complex and often conceptually questionable (e.g. weather futures), enter the new millennium and you can see derivatives contracts in our daily lives. In fact, you may even have some friends who have entered into a derivative transaction.

Yes you guessed it…
If you bought a house with 5% or less down payment, you’re essentially a holder of a derivative contract – why? Because that’s about the same leverage you have when you trade futures, forwards or options: your standard financial derivative contracts. In fact, someone who bought a house “zero” down is essentially taking on a much higher risk than the riskiest or most highly leveraged futures contracts. Typically the lowest margin requirements for futures are 1% and “trading a mortgage” with “zero” down is riskier than that.

Now, those official voices (industry executives, regulators, politicians etc.) who claim that a mortgage meltdown and the resulting credit crisis could never have been predicted should look at the fundamental basics of derivative contracts and apply them to the housing market, then it’s not all that difficult to predict forthcoming problems.

Buying any asset on a highly leveraged basis is risky!
In fact, those of you who trade stocks more frequently know that you can only buy stocks in a margin account with 50% minimum initial margin requirement. Translate that to the property market: anyone who buys a house “zero down” is taking on 50 times more risk than the average stock investor trading stocks on margin. Of course, there are fundamental and conceptual differences between asset classes; and real estate, being one of the most stable and anti-inflationary forms of investments, has generally produced above average returns over a longer investment horizon. However, from a risk stand point, one should agree that a 100% leveraged purchase of any asset is an extremely risky endeavor and not for the average Joe. High leverage makes for great returns when you’re on the right side of a trade. But, it can wipe out a portfolio in a short time if leverage is taken to extremes and markets are going against you, the effects of which can currently be seen in the mortgage and credit crisis.

Now if you’re not yet completely confused or bored at this point, I would highly recommend reviewing Warren Buffet’s Annual Letter to Shareholders from 2002. He decicated an entire section to derivatives; it’s a great primer on derivatives and what he thinks of them and it shows his incredible foresight of the dangers ahead.

If you like a copy of the entire letter, please email me at: info@fxistrategies.com

Have a great week-end!

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