Derivatives
Rutter Associates’ partners each have over 40 years of experience in the analysis, documentation, and use of financial derivatives[1]. Our engagements have included the calculation of thousands of close-out values of contracts terminated at the Lehman bankruptcy, close-out calculations and derivative usage rationale in one of the largest derivative losses of a non-financial entity in history, and claims validation for counterparty banks with losses (or gains) due to the default of a financial entity that suffered one of history’s largest derivative losses (if not the largest). As part of our work with state insurance and banking regulators we examine the derivative usage of Life & Annuity and Property & Casualty insurance companies and state and municipal Pensions.
Rutter Associates has an active advisory and education program for helping end-users from industry and government understand the valuation, credit risk assessment and mitigation, and optimal use of derivative contracts from plain vanilla to highly exotic in hedging, speculation, asset replication, and income generation. We discuss each of these uses briefly below.
Hedging with derivative contracts is a cost-efficient means of reducing the risk of loss due to changes in the rates, indices, prices, or credit exposures that underlie the derivative contracts. For example, a banking institution exposed to losses when interest rates rise might enter into an interest rate swap agreement (i.e., a payor swap) in which it agrees to pay a fixed rate of interest in return for receipt of a stream of floating rates; the value of this swap will increase when interest rates rise offsetting the institution’s losses on its balance sheet. A life insurer offering variable annuities might be exposed to a stock index falling as much as 10% from current levels and choose to hedge that exposure by purchasing an index put option “at the money” and writing (i.e., selling) an index put option 10% “out of the money”. While derivatives can be used to offset risks currently in portfolio, they can also be used as “anticipatory hedges” to offset the risks of future transactions up to the time that they close. All derivative hedges must be well structured and actively monitored for effectiveness and for proper accounting treatment.
Speculation with derivative contracts is a cost-effective means of assuming a risky position with the hope of profiting from changes in the rates, indices, prices, or credit exposures that underlie the derivative contracts. Speculation has an important social role in providing information to market participants and liquidity to the derivatives market. It is extremely important that individuals and institutions speculating with derivative contracts understand fully the valuation and potential payoff profiles (including market-implied probabilities of those outcomes for the more complex or “exotic” contracts) before entering the contracts. Additionally, end-users must be aware of possible regulatory restrictions on the speculative use of derivatives.
Asset Replication is the use of a derivative contract to replicate the payoff profile of an investment asset or a set of assets. These are generally temporary in nature. Examples include investment portfolios seeking to increase allocation to investment grade corporate bonds quickly that purchase a Treasury security and simultaneously sell protection in the form of a credit default swap (CDS) on the CDX.NA.IG Index that contains 125 reference obligations of major investment grade North American firms. The same replication can be achieved for an investment in an individual company by combining a purchased Treasury security with the sale of CDS protection on that company. At times the regular premium earned on the CDS exceeds the spread over Treasuries paid by the cash bond, so the replicated asset yield exceeds that of the cash asset.
Income Generation is the use of derivative contracts to sell away some return potential in an owned asset or strategy in return for current income, without an increase in risk of loss. The standard example of an income generation trade is the sale of a “covered” call option. For example, an investor might have a 5% return objective on a particular equity position in its portfolio, i.e., is willing to sell when that 5% goal is attained and forego further upside potential. In that case, the investor can generate income by selling a call option 5% “out of the money.” Should the stock price rise above that level by the time of option expiry, the shares will be called away and the investor will have earned 5%; should it not, the shares will remain with the investor. In either case, the investor keeps the premium received (i.e., the income generated) for the call option it sold.
[1] The International Monetary Fund defines financial derivatives as “financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right”. Financial derivatives enable parties to trade specific financial risks (such as interest rate risk, currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more willing, or better suited, to take or manage these risks.