Derivatives. 1. Definition of Derivatives

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1 Derivatives 1. Definition of Derivatives Here is Warren Buffet s Definition: Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. 2. Here are some examples: Credit Default Swap (CDS): as we saw in the Citi case, a CDS is an agreement whereby one entity pays a fixed fee in return for a payment contingent on the default of a specific credit instrument such as a bond or loan, or a portfolio of bonds or loans. The amount paid for the fee depends on the riskiness of the instrument that is being insured. Stock Options: this is a contract in which one side pays money today for the option to purchase (a call) or sell (a put) a share of stock at a fixed price in the future. Futures and Forwards: These are contracts where one side pays the other the difference between the price of a commodity (such as oil) or a financial asset (such as a Treasury Bond) in the future minus a fixed value (called the forward or futures price) set at the outset of the contract. Interest Rate Swap: an interest rate swap is an agreement between two entities, whereby one entity pays the long-term interest rate times a notional amount minus the short-term interest rate times the notional amount. The other counterparty the entity on the other side does the reverse. 1 Let me drill down a bit more into the simplest possible interest rate swap. Suppose, to take a simple example, that we have an interest rate swap with a notional principal equal to $1 million. Counterparty A pays the fixed rate * the notional amount to counterparty B, in exchange for the short-term rate * the notional amount. The contract has a 5-year maturity, and the floating rate resets at the end of each year. 1 If you are interested in learning in detail about pricing of derivatives, take Alan Marcus class. 1

2 The swap provides the same cash flows that Counterparty A would receive if it had borrowed $1 million for 5 years at a fixed rate of interest, and invested the proceeds of that borrowing in a short term note that matures in 1 year (because the floating rate resets at the end of 1 year). We can think of the value of this contract by writing it as a little balance sheet, as follows: Counterparty A: Asset Liabilities 1 $million, $1 million, 1-Year Floating-Rate Note 5-Year Fixed Rate Note This balance sheet initially has zero value to A because the two legs of the swap have equal value ($1 million in this example). From the perspective of Counterparty B, everything is reversed. B receives the fixed rate and pays the floating rate. From balance sheet point of view: Counterparty B: Asset Liabilities $1 million in a $1 million in a 5-Year Fixed-Rate Note 1-Year Floating Rate Note Again, from B s perspective, this position has zero value initially because both legs have a value of $1 million, so the net value is zero. However, if interest rates change, then the swap has positive value for one side, and the swap thus has an equal negative value to the other. What happens to the value of the swap if interest rates increase by 1% the day after the contract is signed? The value of the swap changes from zero to something positive for A because the asset side of the swap has shorter duration than the liability side. Since B s situation is exactly reversed, that means that B s contract decreased in value by exactly the same amount. It is a transfer of wealth from B to A. 2

3 3. Key Principles about Derivatives The example from the previous section, I hope, illustrates a few key facts about derivatives: 1. The value of derivatives depends on two things: First, it depends on the PV of future cash flows. These PVs change as interest rates and other market prices fluctuate. Variation in value stemming from changes in the PV of future cash flow is what we studied last week in the section on Market Risk. Second, the value of a derivative also depends on the Credit worthiness of the Counterparty. For example, after rates rise to 1% in the example above, the swap increased in value to counterparty A based on present-value math (i.e. the market risk component). But, what would the contract be worth if B who owes these funds to A - went bankrupt and can t make the expected payments? Less So, two things matter: 1. Market Risk; 2. Counterparty Risk 2. Derivatives are always in zero net supply. In other words, for every winner in the derivatives market there is a loser. Derivatives are just side bets on what is happening to prices in the markets. Zero net supply is important because it means that there is no fixed upper limit to the scale of derivatives markets. In contrast to derivatives, regular financial assets like stocks or bonds are in positive net supply and are limited in amount based on what the issuing company has sold to investors (thus they are limited by the amount of real assets backing them). Zero net supply also means that if you add up the market value of every counterparty s positions in these markets, you get exactly ZERO! This means that, for the market as a whole, there is no market risk. But, that is NOT true for individual counterparties! 3. The value of derivatives contracts is zero to both sides when first created. The value of a derivatives contract then changes as prices change. This is illustrated above in the interest rate swap example, which starts out worth zero but then changes once interest rates change. (I am abstracting from the fact that large dealer banks will be making money on both sides from endusers.) 3

4 4. Uses of Derivatives Derivatives can be used to hedge risks. In this sense they help spread risks around the financial system. Example: A bank might use a credit default swap to hedge the default risk in its loan portfolio. Example: Many financial institutions use interest rate swaps to hedge the risk associated with changes in interest rates. For example, suppose you are a savings institution with a balance sheet that is heavy in long-term, fixed rate mortgages; it s your main asset class. However, most of your liabilities are short-term deposits. Your balance sheet might look something like this: Asset Liabilities $100 Fixed Rate Mortgages $85 Short-term Deposits $15 Equity If interest rates rise, this un-hedged firm s equity will fall sharply in value (why?). The firm could hedge this interest-rate risk by initiating an interest rate swap in which they pay the fixed rate and receive floating rate. This swap contract would make money when interest rates rise (why?), offsetting the losses on the underlying set of positions. Derivatives are also a very powerful way to speculate. The reason that derivatives are so powerful is that they are highly levered positions! Look again at the interest rate swap from before. It is like a set of two positions a long position (the receive side) financed with 100% borrowed money (the pay side). That is to say, it is fully levered, to the max. We will see later how LTCM created lots economic leverage using huge positions in interest rate swaps. AIG is another good example of how a firm may use swaps to speculate. In their case, they were speculating that mortgage-backed securities would not experience defaults. AIG insured over $400 billion in mortgage-backed securities by taking the fees on a large number of credit default swaps in return for the promise to pay the other side if defaults occurred. This strategy looked good while housing prices were rising because AIG was being paid fees for the CDS that they wrote but paying nothing because defaults were nil as long as housing prices continued to rise. Again, derivatives are in zero net supply. That means they do not create any new risks. However, they do create a very efficient way to move risks around in the financial system, which made it possible for risks to be concentrated at a few firms such as AIG. Risk concentrations can cause problems. For example, because AIG believed, falsely, that they were making $$ for nothing, they effectively made a huge one-way bet on housing prices. They became very exposed to the risk of a housing collapse. The entities on the other side, however, were hedgers. They were firms such as German banks who had purchased US mortgage-backed securities and wanted to hedge the risk of a housing downturn by buying protection from AIG. But 4

5 remember that the value of this protection depends on the quality of the counterparty If the counterparty is making a large-scale one-way bet, then they may not be able to make payments on these contracts in the event of default. Stay tuned: More on AIG below 5. Counterparty Risk The fable of AIG is a good segue to the topic of counterparty risk, and how this risk depends on the structure of the market. How should entities in the derivatives markets manage their counterparty risk? Unfortunately, this market evolved as a bilateral over-the-counter (OTC) market, which means that there is no central exchange where all players in the market come together. Hence it is often hard for entities to understand the positions and/or risks of their counterparties. Standard practice for managing counterparty risk focuses on three issues: 1. What is my net exposure across all contracts to each of my counterparties, based on the value of my positions at today s prices (this is known as current exposure )? 2. How much might these net positions change in value over the near term (this is known as potential future exposure )? 3. How reputable are each of my counterparties (e.g. does the other side have a AAA rating)? Many swap contracts are protected by collateral flows. For example, in the case illustrated above, Counterparty B might send A collateral equal to the change in value of the contract at the end of the day that rates changed. This ensures that A gets paid even if B fails. Collateral might fail to fully mitigate counterparty risk, however, if prices change too quickly, as happened to LTCM (more later when we do the case). In the case of AIG, its collateral agreements were tied to its credit rating. As housing prices fell, the implied value that AIG owed to its CDS counterparties (that is, the PV of future cash flows) mounted, leading the ratings agencies (Moody s and S&P) to downgrade AIG. The ratings downgrade triggered an increase in the amount of collateral that AIG had to pay its counterparties. Since AIG did not have the collateral a massive risk management failure on their part - they would have been forced into bankruptcy. Since the Fed and Treasury were worried that AIG s failure could threaten the solvency of many other large banks who had bought protection, they opted to bailout AIG. Warren Buffett anticipated exactly this type of problem in his letter to shareholders back in 2002 (see the course website)! Be sure to read his 2002 discussion of derivatives at the website. AIG was able to amass its huge one-way bet on housing because of the decentralized nature of the OTC markets. None of its major counterparties that is, the banks that bought protection 5

6 were fully aware of AIG s similar derivatives positions with other banks. Thus, no one had a sense for the huge market risk that AIG had taken on! An alternative market mechanism is to create a Central Counterparty (CCP), also known as a Clearinghouse, to stand as the counterparty between all players in the market. Here is how it works: two banks, say, agree to enter into a swap. As in the above example, A agrees to pay the fixed rate to B, in return for the floating rate: Flow of $$ in the Original Swap: A NP*Fixed Rate B B NP*Floating Rate A After A and B agree, the contract is restructured (novated) such that the CCP is the counterparty to both A and B. So, instead of having one contract we have two: Two Swaps, with the CCP as counterparty to both A and B: A NP*Fixed Rate CCP CCP NP*Floating Rate A CCP NP*Fixed Rate B B NP*Floating Rate CCP Notice that as long as both A and B perform on the contract (meaning neither defaults), the CCP is perfectly hedged. The CCP is just a conduit to pass along the cash flows. However, if A defaults, then the CCP would lose but B would not! B is not exposed to A; B is only exposed to to the CCP. (And A is also not exposed to B, only the CCP.) So, counterparty risk becomes much simpler: everyone needs to worry only about the CCP. This type of arrangement has three huge advantages relative to the bilateral OTC arrangement: 1. Market Risk. The clearinghouse (CCP) has no market risk. This is true because the CCP is on the opposite side of every deal, meaning that all of their deals cancel out. 2. Counterparty Risk. The amount of counterparty risk, while not zero with a CCP, is always less than it would be in a bilateral OTC market. This follows because you get more netting or offsetting of positions in a clearinghouse. (This should become clear with my example below.) 3. Market Transparency. The CCP knows the market. That is, the CCP knows the positions of every player in the market. Thus, if a bank or firm begins to become too exposed to a market risk, such as AIG in housing, this concentration will be apparent to the CCP and to regulators. Hence they can nip it in the bud! The AIG mess happened in large part due to weaknesses in the ability of regulators, counterparties and rating agencies to understand what they were doing. 6

7 Example I have created a simple example in which to compare counterparty risks in these two market arrangements. (See the end of the notes for the tables.) In my simple world, the derivatives markets have three counterparties: Goldman Sachs (GS), Citigroup and JPMorgan (JPM). Each bank has 8 derivatives contracts in total, or 4 with each of the other two banks. For example, JPM has two interest rate contracts, one F/X contract and one CDS with GS; and they also have 3 CDS contracts and one interest rate contract with Citi. In the bilateral OTC set-up, JPM has to manage its counterparty risk separately with respect to each of these two counterparties. In my example, JPM has a net exposure of +$5 million with GS and $-9 with Citi. Notice that if you add up all of the net exposures, you get zero. However, what matters to each bank is its own net exposure, counterparty by counterparty. In my example, JPM is exposed to the risk that GS might fail ($5 million in exposure); GS is exposed to the risk that Citi might fail ($18 million in exposure); and Citi is exposed to the risk that JPM might fail ($9). They ALL face counterparty risk. Now let s see what happens with a central counterparty (CCP). The CCP puts itself between all three banks, so the number of total positions doubles. But, the beauty of this mechanism is that each bank is ONLY exposed to the CCP; moreover, each bank s exposure to the CCP is always less than (or equal to) the amount of exposure in the bilateral market. In my example, JPM and Citi both have zero exposure to the CCP, since the total value of all of their positions is negative; and GS s exposure drops from $18 million to just $13 million. The second major advantage is that the CCP itself is safe because it can never have any market risk! Thus, the AIG problem in which a major counterparty has exposed itself to a lot of risk, cannot happen. The CCP does have some risk, because it is exposed to the failure of any of the three banks. However, this risk is much lower than the systemic risk in the bilateral OTC case. There is one final problem: how does the CCP manage ITS counterparty risk? The CCP has no market risk, but it is exposed to the failure of any of the players in the market. It can protect itself using the same tools that banks now use in the OTC markets: that is, monitor its exposure to each player in the market and have collateral requirements whereby each counterparty must maintain a margin account with the CCP large enough to cover its current exposure plus potential future exposure. In addition, the CCP itself needs to have capital to cover the risk that one of the members fails and the collateral is insufficient to cover all of its losses. 7

8 Counterparty Risk in a Bilateral OTC Market JPM Derivatives Positions GS Derivatives Citi Derivatives Positions Counterparty Swap Type Notional Market Value Counterparty Swap Type Notional Market Value Counterparty Swap Type Notional Market Value GS Interest Rate JPM Interest Rate GS Interest Rate GS Interest Rate JPM Interest Rate GS Interest Rate GS F/X JPM F/X GS F/X GS CDS JPM CDS GS CDS NET EXPOSURE 5 NET EXPOSURE 5 NET EXPOSURE 18 Counterparty Risk 5 Counterparty Risk 0 Counterparty Risk 0 Citi CDS Citi Interest Rate JPM CDS Citi CDS Citi Interest Rate JPM CDS Citi CDS Citi F/X JPM CDS Citi Interest Rate Citi CDS JPM Interest Rate NET EXPOSURE 9 NET EXPOSURE 18 NET EXPOSURE 9 Counterparty Risk 0 Counterparty Risk 18 Counterparty Risk 9

9 Counterparty Risk in a Market with a Central Clearinghouse JPM Derivatives Positions GS Derivatives Citi Derivatives Positions Counterparty Swap Type Notional Market Value Counterparty Swap Type Notional Market Value Counterparty Swap Type Notional Market Value CCP Interest Rate CCP Interest Rate CCP Interest Rate CCP Interest Rate CCP Interest Rate CCP Interest Rate CCP F/X CCP F/X CCP F/X CCP CDS CCP CDS CCP CDS CCP CDS CCP Interest Rate CCP CDS CCP CDS CCP Interest Rate CCP CDS CCP CDS CCP F/X CCP CDS CCP Interest Rate CCP CDS CCP Interest Rate EXPOSURE 4 EXPOSURE 13 EXPOSURE 9 Counterparty Risk 0 Counterparty Risk 13 Counterparty Risk 0

10 CCP Derivatives Positions Counterparty Swap Type Notional Market Value JPM Interest Rate JPM Interest Rate JPM F/X JPM CDS JPM CDS JPM CDS JPM CDS JPM Interest Rate NET EXPOSURE 4 Counterparty Risk 4 GS Interest Rate GS Interest Rate GS F/X GS CDS GS Interest Rate GS Interest Rate GS F/X GS CDS NET EXPOSURE 13 Counterparty Risk 0 Citi Interest Rate Citi Interest Rate Citi F/X Citi CDS Citi CDS Citi CDS Citi CDS Citi Interest Rate NET EXPOSURE 9 Counterparty Risk 9 Total Exposure 0 Clearinghouse ALWAYS has zero total exposure, which means that the clearinghouse has zero market risk!