Financial Derivatives

What is a financial derivative?

There is probably no other word in financial markets that causes more problems than "derivative". A derivative is a financial contract. It obtains its price by being linked to another financial product. Sometimes financial derivatives are called "contracts for difference".

You may know them as futures, options and swaps. What is more, in the last decade, financial derivative markets have exploded. According to the BIS, OTC derivatives outstanding at the end of 2005 amounted to $284 trillion. No surprise that if you work in operations, settlements or finance you will have seen volumes rise. Why?

Because they are liquid and offer dealers the best way of managing risk. Why the problem? For non-dealers these trades are complicated. It can be difficult to see how they work. What they are used for. And above all understand the risks involved. But it can be made a lot easier.

How do financial derivatives work?

Here is an example, it will explain why banks use swaps. A swap is a contract where one party pays another a fixed interest rate and in return receives Libor or Euribor, (floating rates). The swap is based on a nominal amount, (size) and has a maturity date, normally between 2 and 20 years.

Dealers use swaps to trade and hedge interest rate risk. If you pay fixed interest at 5.00% and rates increase to 5.10% you will gain. You could receive interest at 5.10% on a second offsetting swap. You would gain 0.10% every year. A net profit worth about $43,295 on a $10m, 5 year deal. Now we will look at two uses for swaps.

First, suppose you borrow long term money by issuing a bond. If that bond has a fixed coupon you pay a regular interest amount to the investor. But on this occasion, you want to pay a floating rate of interest. (This could match interest receipts on assets you already hold). How do you do this?

If you enter into a swap, receiving a fixed rate of interest and paying a floating rate you will achieve your objective, a floating rate cost of borrowing, (see diagram 1). Whether the cost will be Libor plus or minus a margin depends on the bond coupon.

The higher the coupon on the bond the greater will be the fixed swap rate you need to receive.

If your counterparty ends up paying you a rate in excess of the current market swap price you will have to pay something in return. Your floating rate cost of funding will be several basis points, (0.01%), above Libor or Euribor.

Second, let's suppose you hold a fixed rate bond as an investment. But you finance it on a floating rate basis. Many banks do this; it is the way their balance sheet works. Why? Because if you lend long term and borrow short term you get paid for taking liquidity risk.

You can swap the bond from fixed to floating rate and manage the interest rate mismatch. Let's see how this works.

You pay fixed interest on a matching swap and receive the floating rate. Sometimes we call this an asset swap, (see diagram 2). How do you make money from your investment? If the fixed coupon exceeds the current swap rate you receive Libor and a little margin. If you borrow at Libor the margin is profit. This profit arises because you are taking credit risk on the bond.

We could look at more examples using futures and options involving interest rates, foreign exchange prices, commodities or credit risk. The growth in these derivatives has arisen because there is a need for them. They allow dealers to hedge and trade risk efficiently and effectively.

Why the concern about financial derivatives?

There is no doubt that senior managers and regulators are concerned. There is nothing new in this. They have always questioned the use of financial derivatives. Here are three reasons why:

The effect of leverage. Leverage allows you to take large amounts of risk with small amounts of capital. Many derivatives are leveraged because they do not involve principal outlay. Large speculative positions can be established for little cost. That is until they go wrong.
The level of understanding. Often derivatives are left to the experts. That means only a handful of people really know what is happening.
High profile losses. There have been a number of high profile cases (Barings, NatWest, AIB, NAB) where things have gone badly wrong. Traders have taken advantage of weak control environments and have used derivatives to perpetrate fraud.

Does this mean financial derivatives are dangerous?

Used properly there is no reason to think that derivatives are any more risky than any other area of financial markets. But because they offer leverage and can be complex the risk control environment needs to be right. Know how also needs to be widely spread.

The record shows that it is insufficient to count the income without asking where it comes from.

Diagram 1 - Using a swap to hedge a bond issue

Bond issuer enters into swap
The issuer receives fixed interest to match the coupon payment
The swap has been used to convert a fixed rate cost of funding to a floating rate cost of funding

Diagram 2 - Using a swap to hedge an investment

The investor buys the fixed rate bond and receives the bond coupon
The investor pays fixed interest on the swap
The swap converts the fixed rate bond to a floating rate investment

First Published by Barbican Consulting Limited 2006