Types of Derivative Contracts - Coursework Example

Per Schuyler Henderson, a derivative is a contract in which the parties only pretend to do something and allocate the risks and benefits between themselves as if they hand done something. Discuss. Name Institution Affiliation Course Date A derivative Contract Introduction A derivative is a contract that is made between two or more people whose value is based on the agreed-upon underlying financial index, asset or security1. Derivative is also a financial agreement with a value that is derived from an underlying asset. They do not have direct value in and of themselves in that their value is based on the predictable future price movements of their underlying asset. Firms that work on financial derivatives are a handful as they are seen to have a lot of risk in them. In that, in case one of the firms went bankrupt it could cause a daisy-chain effect that would cause all others to fail; hence wiping out the whole financial system. This is what happened in the failure of the Lehman Brothers that almost caused the collapse of the financial system during the credit crisis in 2007-20082. The failure of the Lehman brothers would have succeeded had it not been for the intervention of the Federal Reserve, FDIC, Treasury and some other government agencies3. Derivatives are used as instrument to hedge risk for one party of an agreement, while offering the potential for high returns for the other party. Derivatives were created to mitigate the remarkable number of risks, changes in foreign exchange rates, fluctuations in stock, commodity, bond and index process and changes in interest rates, as well as, weather events among others. Among the various derivatives that have been provided for the most commonly used is the option, which is derived from an underlying asset. Others include forwards, swaps and future4. The major goal of all derivative products is to obtain funding at a preferential rate or to take speculative advantage of a movement in a financial market for an investor. The importance of derivatives has increased over the years and have expanded rapidly since the late 1980’s because there has been an increased volatility in the world financial markets. Over time the complex structures have shown that they can manage to take advantage of the profit-making opportunities and offer protection against any risk of loss in the underlying financial markets. The main reason derivatives are used if for earning income and managing risk. In order to achieve these goals four activities have to be carried out that is speculation where a derivative product may allow an investor to imitate the results of trading on an underlying financial marking by arriving into an off-market transaction with any financial institution. This is today that a company can manage to obtain the effects of speculation on the FTSE- 100 without having to by the actual shares in the companies in the FTSE-100. Secondly, there is hedging where the derivative products can be used as a means of risk management against rate changes or market movements. Where the purchase of a derivative instrument will allow the buyer to control its exposure to standard financial operations as incongruent as its normal borrowing or its coverage to other investments. Thirdly, there is asset liability management where the growth in mixed portfolio funds have been beneficial from the capacity of derivatives when it comes to construction mixed with speculation strategies and hedging. In instances where a portfolio is weighed heavily towards an exposure to sterling the derivatives can change the exposure of another currency. Lastly, there is arbitrage where in this case the use of derivative instruments allows the market users to take advantage of the mismatches on market conditions and prices by speculation on the underlying financial products without the requirement to undergo the formalities that are required in conventional trading5. Additionally, derivative markets also contain the possibility to generate arbitrage opportunities that can be used to form part of an arbitrage strategy. There are other uses of derivatives whereby they can be used where there are objectives that have not been specifically been geared to speculative hedging or profiting6. There are often capital or regulation adequacy goals in investing in one type of derivative instrument rather than owning market obligations or instruments. Types of Derivative contracts Forwards Forwards or a forward contract indicates clearly the price at which an asset can be bought or sold at some future dates. It has been established that although a forward contract can be classified as a derivative in various markets it is very difficult to differentiate between the forward and the underlying factor. In that large trading volumes in OTC forwards can make them more imperative than spot markets. Therefore, a forward contract does not need an upfront payment. This is because the sale or purchase of an asset is set for some future data at a price that is fixed by the parties that is the forward price7. It is assumed that the forward price reflects the value of this asset on this date where the assumption has been based on a market view that characterizes a forward contract as a derivative that is very misleading. A forward contract is classified as a derivative in various cases because it can be derived through a no-arbitrage argument that relates to the forward price of an asset to its spot price8. A forward contract has the following main features; that is it is an agreement between two people to sell or buy assets at an agreed future point in time. Secondly, the buying and selling in this type of contract are determined in present time. Thirdly, the delivery or the transfer of the assets is made for a future date that is agreed by the parties upon the making of the contract. Additionally, any terms of the contract can be negotiated meaning that they are not standardized between the parties to the forward contract. The transactions that are made in the forward contract are not transparent. In addition, the different that is found between the forward price and the spot is the forward contract or premium. Lastly, in case the price of stock is increased in future the buyer will gain while the seller will lose. Futures Futures are "Rights under a contract for the sale of a commodity or property of any other description under which delivery is to be made at a future date and at a price agreed upon when the contract is made9." However, various exemptions have been made on the definition. For instance, contracts that are made for purposes of investment are regulated where those that are made for commercial purposes are exempted. There are various indicators that a contract is made for investment purposes and they include that the contract is expressed in such a way that it is to be traded on an exchange or a market. Secondly, the performance of the contract is ensured by a clearing house or an investment exchange. There must be arrangements for payments or some provision of margin10. The indicators of a contract for commercial purposes include that either or the parties is a maker of the commodity or other property or they use them in their business. Secondly, the seller intends to deliver or delivers the property or the buyer intends or takes delivery of the commodity. However, the absence of either indicator of a contract creates an indication that the contract was made for investment purposes. Futures contracts same as forward contracts specify the data at which the delivery of an asset will be made in the future as the name suggests. However, unlike forward contracts futures contract have a requirement that the seller or buyer should have a post margin. Secondly, there is a minimum margin requirement that are achieved through a margin call11. Lastly, future contracts use the process of mark-to-market. It has been established that the three requirements are not unique in the future contracts and for that the right way to under is by looking and identifying a specific future contract. The major features that are found in the futures contract. They include that the contracts have a standardized contract that is made in terms of expiration date, terms of quantity and settlement procedures among others. Secondly, the transition in this form of contracts is held to be fully transparent. Thirdly, futures contract are traded in organized exchange and is marked to market daily. Lastly, the physical delivery of the underlying assets is virtually never received or taken. Swaps This is an agreement to exchange a specific sequence of cash flows over time in the future in different or same currencies. This form of derivative is used in hedging diverse interest rate exposures. Swaps are highly liquid instrument and very popular in companies. There are different types of swaps and they include fixed float that uses the same currency, fixed-float different currency and float-float where there is same currency and different index. There is also float-float where there is same currency and Fixed-fixed in instances where there is different currency12. The most common form of Swaps is the interest rate sway which is an agreement between parties to make payments periodically to another party in the same currency. The major aim of the transaction in commercial transactions is to make changes in the cost funding and an existing debt or to obtain funding at a preferential rate of interest. Swaps was defined in the case of Hazell v. Hammersmith & Fulham L.B.C13 by Woolf LJ as “An interest rate swap is an agreement between two parties by which each agrees to pay the other on a specified date or dates an amount calculated by reference to the interest which would have accrued over a given period on the same notional principal sum assuming different rates of interest are payable in each case. For example, one rate may be fixed at 10% and the other rate may be equivalent to the six-month London Inter-Bank Offered Rate (LIBOR). If the LIBOR rate over the period of the swap is higher than the 10% then the party agreeing to receive “interest” in accordance with LIBOR will receive more than the party entitled to receive the 10%. Normally neither party will in fact pay the sums which it has agreed to pay over the period of the swap but instead will make a settlement on a “net payment basis” under which the party owing the greater amount on any day simply pays the difference between the two amounts due to the other.” Options This is a financial instrument that allows the holder to purchase or sale the indicated number of shares at a price that has already been determined or what is referred to as exercise price that is within or on a certain future date. Therefore, it is a contract between two investors that is the option buyer and call writer. Two types of stock option are provided and they include first the call option which gives the purchaser the right to buy the given stock at the strike price. Therefore, the call option is only brought in when the buyer is optimistic when it comes to the underlying security. The formula for calculating call option is as follows: Vc= Max. (Vs- E, 0) Where, Vc = value of call option, Max = Maximum 0 = Zero, Vs = Value of stock, E = Exercise price or strike price Secondly, there is the put option where in case a person is buying a put option they get the right to sell the underlying stock at the strike price. The put option is brought in in instances where the buyer has bearish opinions about the underlying security. The put option value can be calculated using the following equation Vp= Max (E - Vs,0) Where, Vp = value of Put option, Max = Maximum, 0 = Zero, Vs = Value of stock, E = Exercise price or stike price. Significance of derivatives contracts Derivatives matters because the more risk an individual undertakes the more reward to stand to gain. Therefore, derivatives can be used on either side of the equation in that they can either assume risk or reduce risk with the possibility of a commensurate reward. This is the reason derivatives have achieved such notoriety lately because speculators who enter into a derivative contract are in essence betting that the future consideration of the asset they are about to buy will in some way be substantially different from the expected price that is held by the other party to the contract. This is to say that derivatives operate under the assumption that the individual seeking insurance has gone wrong in regards to the future market consideration where they see profit from the error. Some people are of the view that derivatives are bad; however, contrary to such opinions derivatives are not bad and they have been established to be necessary for many companies because they ensure that there are profits in the volatile markets. Additionally, they also provide some mitigated risk for investors that conduct their business everyday, as well as those looking for investment insurance. According to Schuyler Henderson14 credit derivatives market has been established to be the fastest growing compared to all the over-the- counter (OTC) derivatives markets. Conversely, they present the greatest operational and legal risks. It has been held that credit derivatives are the most successful among the many derivatives technology that have been introduced following the development of currency swaps that occurred in the late 1970s. In addition, the emergence of global OTC interest rate derivatives that were introduced into the market in the 1980’s. The OTC derivatives have been held to be global in that the major financial institutions which make up the core of the market operate an integrated and global basis through units around the world. The market is also global because the dealers operating outside the dealer’s jurisdiction deals with the end user form the deal jurisdiction, as well as, many other jurisdictions15. Thus, in order for the derivatives markets to work on a global basis and also provide for the transparency, liquidity and speed of execution and most importantly the free flow of capital it is imperative that there should be enough flexibility in the enforcement, taxation and regulation for dealer jurisdiction. This will allow the derivative markets to rum effectively and efficiently a financial institution and global book that are based in or operating outside the dealer jurisdiction16. The expansion of the OTC credit derivatives have been immense since their inception in the mid-1990s where they got to $1.925 trillion at the end of 2002 and $ 17.1 trillion by the end of 2005 by the time it was mid-year in 2006 the increase was astonishing as it was at $26 trillion. Henderson indicated that the most common credit derivative is the Credit Default Swap (CDS), which is an individually negotiated agreement that is made between two parties where one party that is the protection seller agrees to bear the credit risk of the proposed reference entity. The other party that is the protection makes payment through a periodic method agreed by the parties to the seller in return For the performance of the seller in case of a credit event. The International Swaps and Derivatives Association, Inc. have master agreements that are used by the buyer and seller in relation to passing of risks. The guideline embodied in the published document establishing the confirmation that should be followed to the latter to ensure neither party is in breach of their agreement. Regulation of Derivative contracts The United Kingdom system in relation to derivatives is self-regulatory where the Financial Services Act of 1986 provides that for a multi –tiered system of regulation. The Department of Trade and Industry have delegated most of their specified regulatory powers to a private sector that is the Designated Agency as provided for under section 114(1)17 which provides “where it is satisfied that the rules and the regulation of the body afford investors and inadequate level of protection some powers may be delegated to ensure adequate protection” the Securities and Investments Board. The SIB further authorizes numerous Self-Regulatory Organizations that make and enforce rules that relate to their respective members and the activities in the financial services industry. The Self-Regulatory Organizations that are recognized by the Securities and Investments Board include Investment Management Regulatory Organization, Securities and Futures Authority, The Financial Intermediaries, Managers and Brokers Regulatory Association and Life Assurance and Unit Trust Regulatory Organization18. It is clear that any individual who carries on an investment business in the United Kingdom must be authorized unless in instances where they are exempted. For example, the Bank of England, acknowledged investment exchanges and clearing houses, Lloyds, in that certain money market institutions and nominated representatives have been exempted. The authorization to carry out such businesses is obtained directly from the Securities and Investment Board. Authorization can also be obtained by membership in a Self- Regulatory Organization, as well as, by certification by a recognized professional body like the Institute of Chartered Accountants or The Law society. Insurance companies are automatically authorized. In the case of derivatives they are regulated as investments for instance, if it is an option then future or contract for differences or in some cases it falls within one of the other provided categories of investment regardless of whether it is on OTC or on-exchange. In 2008, there was a credit market freeze where for many economist the crisis was unforeseeable and inexplicable. However, for the lawyers who were working in financial regulation, especially the ones who understood about derivatives regulation had a clear understanding of what was happening19. This is because the roots of the catastrophe were as a result of the change in law and not the markets. There when an attempt is made to deregulate financial derivatives it causes the banking system to collapse. Therefore, the European commission has taken upon itself to ensure that the financial derivatives are regulated. There was an international consensus that was formed to help in tightening the global financial regulation generally, but mostly on derivatives. The major obstacle that was experiences on implementing the same was the absence of a clear system of global financial regulation. Although they play an integral role in the economy of the country they are associated with various risks. The crisis are not sufficiently moderated in the over-the-counter areas of the market, and especially in regard to the credit default swaps. Therefore, since the beginning of the financial crisis in the United Kingdom the European Commission have been working on various measures to address the risks associated with derivatives. First, there were regulatory proposals that were adopted by the commission for example, on 30th October 2014 the commission adopted four correspondence decisions for the regulatory administrations for their central counterparties that is Hong Kong, Australia, Singapore and Japan. On 13th March 2014 there was the adaptation of a delegated directive on the practical rules and regulating to impose penalties on persons who were found with trade repositories. Among the reports that were adopted were in accordance to Article 85 (2).20 The report was on the assessment of the progress and efforts that were made by the CCPs in the development of technical resolutions for the transfer by PSAs of non-cash guarantee as variation verge and the need for the new measures to ease such solution. The commission demanded for a baseline study to help in the assessment of the current situation21. Additionally, on 22nd March 2013 the European commission approved a report to the European parliament and council in relation to the international management of central banks and public entities that manage public debt with concerns to OTC derivatives transactions. Besides the adoption of the various legislations and re [ports the commission also did consultations on the derivatives and market infrastructures to establish ways in which the countries would continue using derivatives and at the same time be profitable to the economy. Additionally, they made consultations on enhancing the resilience of the over the counter derivative markets. Legal issues that have arisen in relation to financial derivatives. Various legal issues have emerged in the United Kingdom courts in relation to financial derivatives in instances where the debtors have tried to avoid the jurisdiction of the court quoting various grounds. The first issue that has been addressed by the courts is on the issue of jurisdiction and the ultra vires doctrine. The ISDA contracts provide that for the use of the United Kingdom law even in matters of the competence of the courts. The Plaintiff in the procedures or the debtors have in many instances tried their best to avoid the issue by questioning the jurisdiction of the U.K courts. In relation to the ultra vires doctrine it was held that a local authority even though it may engage itself in regular borrowing it cannot validly enter into swap agreement, even in cases where they have been mentioned as debt management because it would allow itself to extract from government supervision. This was held by the seminal House of Lords in the decision of Hammersmith & Fulham. Art 22(2) provides that: “The following courts shall have exclusive jurisdiction, regardless of domicile: …. 2. in proceedings which have as their object the validity of the constitution, the nullity or the dissolution of companies or other legal persons or associations of natural or legal persons, or of the validity of the decisions of their organs, the courts of the Member State in which the company, legal person or association has its seat. In order to determine that seat, the court shall apply its rules of private international law.” The major risk that is faced by lawyers who have a reference to all derivatives is when one party to the transaction refused to pay. In such instances the enforceability of financial derivatives in case of the insolvency of one party or the other becomes the standard for defining the nature of a financial derivative product22. The risks that are included in using the derivatives include payment risk, systematic risk, market risk, netting risk, re-investment risk, equity risk, commodity risk, operations, audit and technology audit and personal risk among others. A question can be asked as to whether the or not the range of derivative transactions contracted between same parties may be comprise of one composite agreement or a number of separate contracts. Under the ISDA master agreement it is required that the interest rate swaps, forwards and options as well as all other derivatives that are entered into between two individuals should be considered as one contract even though there is no reason of supposing that that is the case. However, although the transactions are said to be one netting the payments is said to easier although there is a finding that there is no link between the payments that may allow the obliged party to refuse to make their payments. According to the case of Kleinwort Benson v Birmingham C.C23 the House of Lords held that the transactions should be different because they are entirely separate transactions although obligations under the same transactions are somehow connected. Further, it was held that the transactions should be considered separate from one another because even where a hedging contract is entered into as a part of a composite transaction it is supposed to constitute an entirely set of set of legal relations that arise from the transaction, which is hedging. In the case of Guss Mahon & Co Ltd v. Kensington & Chelsea R.L.B.C24 it was held that alternatively where an interest rate swap comprises of various payment obligations the discharge of such payments does not make the interest rate swap should not be treated any differently even in case where there are other obligations which remain outstanding. This suggests that all of the payments that are owed under a single interest rate swap comprises of one executory contract that is not compete until all the obligations in the contract have been satisfied. Various defenses have been brought in relation to the avoidance of the interest rate swaps such as equitable and restitutionary claim. The decision in the case of Westdetsche landesbank v. Islington25 (1994), pursued the House of Lords. They held that compound interest is only available in circumstances where the plaintiffs have an equitable proprietary interest of the asset in respect of which compound interest is claimed. There is no proprietary that results in trust in favor of the bank due to the availability resulting trust is restricted the two distinct categories. They further held that there was no proprietary constructive trust because it did not cause any impact on the conscience of the authority given that it had no knowledge of the invalidity of the contract at the consideration was to be paid. This was further held in the case of Sinclair V Brougham26. Disclosure There is a need to provide a risk disclosure especially for private customers. In that the private customers have the right to receive a general risk disclosure statement and specific warning when it comes to trading in derivatives and warrants and non-readily attainable investments. There are some other warning requirements where the firm may propose to treat a person unlike a private person. In that a firm must give a customer to whom it proposes to treat as a non- private customer a clear written warning of the regulatory protections that the customer will lose in the transaction27. In other circumstances the firm must send a notice to an individual to whom it proposes to trust as a marker counter party, because they do not have the benefit of the customer protect ions unless where both firms are trading members of the same or one investment exchange. There is a general obligation on risk disclosure where the application only applies in instances where a firm recommends a transaction to or they act as a discretionary manager for the private customer. Conversely, the firm, has to take the reasonable steps to allow the private customer to have an understanding of the nature of the risks they are about to take. This means that there is an ongoing obligation that affects every transaction. In the determination of what reasonable steps should be taken the firm must take into account the clients current understanding, as well as, the previous course of the transaction or dealing. Additionally, the Firm may also need to provide more warnings or explanation for the derivatives, warrants and non-readily realizable investments. The firm must provide specific write warnings recommending a transaction to the executing or arranging a transaction or acting as the discretionary manager of the private customer. A signed copy of the warning notice must be obtained by the firm “in circumstances where the firm is satisfied that the customer has had a proper opportunity to consider its terms”, as well as before making recommendations and arranging or making execution on the transaction. The Derivative risk warning notice describes the various types of derivatives that an individual requires to take up and also explains the risks associated to such derivatives. The Warning notice further outlines options where it distinguishes between writing and buying options, futures and contracts for differences. Additionally, it contains materials in relation to foreign markets, collateral, and suspension of trading, insolvency, commissions, contingent liability transactions and clear house protections among others28. It is not mandatory but the firm may include the descriptions of the types of investment that is covered under the notice provided that it does not lower the effect of the risk warnings. Further the warnings may be include in a two way customer agreement where the customer must sign the warning notice separately indicating that he or she has read and understood the stated warnings. Risk Management A firm that is involved with financial derivatives should ensure that they maintain the records disclosing business and financial information assisting the firm’s management to quantify, identify, control and manage any risks exposures that the firm may find itself in the course of conducting business. By so doing it helps in making informed and timely decisions; hence allowing them to monitor the performance of all the aspects of the organization’s business based on an up-to date basis. In addition, maintaining the records helps in monitoring the quality of the firm’s assets, as well as, safeguarding the firm’s assets including the belongings that belong to other people and the firm is responsible. Furthermore, the firms should ensure that their accounting and other records details limits the exposure to trading positions. This is because the information in the records must be capable of being summarized so that in case of actual exposures they can be measured and regularly and readily regulated against the limits. In case a firm is acting for the customers’ investments the manager must give the valuation in relation to any derivatives or where there is derivative related cash balances in the customer’s account at least every month. In cases where the firm is not acting as the investment manager they only have the obligation to provide a valuation for specific derivatives, which are contingent accountability investments. Under r 5-35 (5A) it is provided that “ Valuation is not required of’; off-exchange transactions entered with or for a non-private customer written call option which are covered by the customer having underlying requirements.” The valuation reports must also indicate the changes in value as well as the aggregate of each of cash, commission attributable and management fees to the transactions in relation to options, futures and related cash balances29. Additionally, the reports for futures must indicate profit or loss on unrealized profits and closed positions or loss on o [pen positions. In the case of valuation for options it must provide information in relation to market, trade and exercise prices in cases of open options. Because of the risk associated with derivatives it is important that the firm protects the clients’ money. In that a firm must put aside the client’s money by depositing it in a client bank account using an approved bank. Client Money is held to be any money that the firm’s holds in respect to the investments agreement made by the client and for the client and which is not due or payable to the firm using their own account30. The firm have a responsibility of obtaining the banks acknowledgement indicating that the fund in the account are held by the organization as a trustee for the client31. That the bank has no right to set-off against the money and they have no discretion to exercise that right. Lastly, that any interest payable and accrued in that account will be credited to the same account. The clients’ accounts may be put together in one account and the segregation requirement applies to all the on and off-exchange transactions for experts, private customers, ordinary business investors and other authorized persons. However, specific types of clients may waive the segregation requirement. When the seller is making an investment when it comes to a reference entity like buying one of the firms bond; the buyer protection in this case is obtaining protection in relation to the exposure that it may have when it come to the reference entity. Such as in instances where parties obtain a loan by guaranteeing it. When the seller is exposed under the CDS it is different than in instances where it has a held a body of the reference entity making the buyers protection under a CDS differ conceptually than in instances of an indemnity or guarantee in relation to a loan. The operational risks that are posed in credit derivatives are high creating a lot of differences. However, it is not accurate to state that buying a bond is for better that selling protection under the CDS it is only different32. Some people may make conclusions that selling the protection under the CDS is the fastest and efficient move of making a debt instrument and feel that they are leveraged. However, the main different between a bond investments and a CDS is the agreed default, which is either met or not creating either a full performance or no performance. Therefore, there is a need to understand the difference between debt instruments and derivatives to know, which investment methods should be taken, as well as, avoiding taking risks that could be inherently avoided. Conclusion It has been established that at some point derivatives can help in making the economy function adequately because of the risks it reduces they also introduces some other systematic risks. For that reason, people need to be careful on where they are placing their investments. The laws and rules governing derivatives is more concerned about the client and protecting their investments. Therefore, even though any person who wants to take up derivatives should be careful because of the risk associated with them in relation to the financing the law adequately protects the client. 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