Law Discussion-Derivative Contract - Coursework Example

Law Discussion-Derivative Contract al Affiliation Introduction This thesis seeks to evaluate Schuyler Henderson’s proposal that 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 had done something. For this argument, a derivative can then be said to be a contract that has no straightforward value of or in itself, and one whose value is consequential from an underlying asset. Given its lack of direct value, a derivative is only dependent on the underlying asset, but independent of any other contract. Furthermore, the derivative involves a party that is independent of the original contract. Here, the other involved party has nothing to do with the original contract even though the price of the underlying asset is determined by the prices of assets or products in the original contract. This means that regardless of the number of the underlying assets involved in the original contract, the prices of the derived asset wholly dependent on the prices of each underlying assets. As a result, the derived contract is nothing more than a contract that binds at least two parties, and whose value is dictated by the fluctuations experienced in the underlying asset. Common forms of underlying assets include commodities, bonds, assets, currencies, interest rates, stock, and market indexes. More often than not, derivative contracts are determined by high leverage. Conversely, some of the most common forms of derivatives are swaps, forwards, futures, and options. Other forms of derivatives are based on the data regarding the weather and include rainfall amount or number of days experiencing sun in a specified region. There are many other applications of derivatives in real world situations. Explanation of How Derivative Works Risk hedging is one of the instrumental roles of derivatives.1 This does not rule out that derivatives are also used for purposes of speculation. For instance, a foreign investor buying shares of their host country are at risk while owning the stock. Consequently, derivatives are used to hedge any anticipated risks and the investor could buy currency futures as a way of locking a particular exchange rate for future selling of stock and conversion to his national currency.2 For the foreign party in a host country, derivatives promise the potential for high returns because the derivative has been developed to mitigate an outstanding number of risks. Moreover, the transactions in financial derivatives must be considered as independent, unlike treating them as a part of the integral value of the underlying transaction that they might be linked to. Compared to debt instruments, financial derivatives do not have any associated principal figure to be advanced for future repayment and no accrued figures are involved too. Besides their use of hedging, derivatives are used in risk management, speculation, and for arbitrage between markets. Over the last years, the derivative contract market has become very huge, an evolution from the use of securities as ‘insurance’ on huge financial securities. Like the insurance industry, the derivative markets expose the involved parties to the benefits and risks of gambling. The risks are even higher considering that the money at stake in the derivative contracts is too high. Again, the fact that this market accommodates insurance brokers and banks raises fears as that any catastrophic loss could cause the financial system fall. Such speculations of losses in most cases end up presenting real dangers. Why would one require derivatives? The decision to involve in derivative contracts requires readiness and willingness to undertake the highest possible rewards that can be won. The parties must view derivatives as a form of gambling that involves nothing more than inexpensively transferring risks on commodity prices not the commodities.3 The high risks undertaken by some individuals, however, require them to use derivatives on the two sides of the equation for risk reduction or assumption with the likelihood that a reward will commensurate. The commensuration of a reward arises from the fact that speculations during a derivative contract, essentially requires the parties to bet that the expected prices in coming days will substantially go up and become incomparable with that of other contractual members’.4 Derivatives operates under the conditions that any speculator involved in such contracts pretend to do something while all they do is to bet that the prices of a given asset will differ substantially from the expected prices held by other members. However, more often than not, the assumption by derivative parties is that the search for insurance deviates when it comes to the search for profit from error and the future of profits and market price. Nonetheless, companies that need to ensure that their profits are safe in the volatile market offer mitigated risks for each investor searching for investment insurance every day. Furthermore, derivatives have been linked to numerous high-profile corporate events hit the world over the past two decades. For some critics, derivatives are responsible for the new bankruptcies or collapsing of Enron, 2001, American International Group (AIG) 2008, and Baring Banks in 1995, Long-term Capital Management 1998.5 According to Chui, Warren Buffet’s view of derivative contracts was analogous to a time bomb ready to explode the economic system and weapons of mass destruction in the world financial system.6 As destruction weapons, derivatives parties are mostly classified as hedgers or speculators. Hedgers in that they engage in a derivative contract to protect against unknown adverse effects in the value of their assets or liabilities. The anticipation of the hedging party is that upon entering into a derivative, any fall in their assets’ value will result in compensation through price increment. In this case, the role of derivative hedgers are to just enter into contract and assume they have done something, then wait for a time when their assets will have more monetary worth compared to when they invested it. At the end of the derivative contract, the derivative contract parties only end up allocating themselves the benefits obtained from difficult risk taking decisions. Like Schuyler Henderson put it, these parties do nothing, but take some risky investment decisions. On the contrary, speculators attempt to gain from expecting deviations in market prices or rate upon entering a derivative contract. On their part, speculators are more risk averse compared to hedgers, and their entering into a derivative contract calls for the involvement of financial regulators to want close monitoring of the derivative progress. What should clearly be understood is that both speculation and hedging derivatives are two sides of the same coin.7 Speculating and hedging are however, not the only trading derivatives’ motivations. For instance, in most cases, banks offer more favourable monetary terms to firms that lessen their market risks through hedging activities compared to those without. In business, most transactions within derivative securities are based on speculations unlike hedging. Nonetheless, speculators play a crucial role in the market as they introduce liquidity that enables the market to achieve its social function of risk transfer. For instance, the credit defaults for 2007 was approximated to be in the tune of $62 trillion by comparing the market size for derivatives to the underlying asset, while $19.9 was the sum of household real estate back then8. The immediate consequence of these actions was the 2008 monetary crisis. This financial crisis was due to the fact that businesses with home mortgage investments risks did not have their risks transferred. This failure revealed that the household real estate owners had invested with counter parties who could not fulfil their monetary obligations. Consequently, the businesses with mortgage default risks had simply transformed into counter-party risks. It is for this reason that businesses that had thought they had default insurance, realized their heavily invested risks were not transferred to risky securities. In the end, the rise in mortgage defaults awakened businesses that began to realize that their investments did not involve any default insurance. This meant that the mortgage assets of the investing businesses were worth much less than had or could not have been anticipated. While the financial institutions pretended to do something such giving mortgages to investing businesses, all they did was allocated risks and benefits to themselves, while the investing businesses had to bear the risks. In this case, the financial institutions did not trade in primary commodity or asset. In order to settle their financial derivatives, the investing businesses in 2008 did nothing but settle their net payment of cash. Furthermore, cash payment acts as a logical outcome of using monetary derivatives to trade risks without any association with the ownership of the underlying item. Types of financial derivatives In business, financial derivatives exist in four different forms where each is used to reduce the risks of one party (derivative owners)on one hand, while providing a high return potential for another party (investing parties). In addition, derivatives are founded on varying types of assets such as interest rates, indices, commodities, equities, and bonds among others. The four main forms of derivatives are swaps, options, futures, and forwards. Forward In forwards, two parties agree on purchasing or selling of an identified asset at an agreed upon price. This agreement puts in mind that the real exchange will take place in a coming date, and that no outside party will be included in the agreement besides the two of them. In a forward financial derivative, the contract is non-standardized and the subjects’ chose how to engage. In order to arrive at the best choice, forward contract parties have to negotiate and arrive at the terms of use for that and future transactions. Some attributes that require prior agreement include contract size and the involved asset, and transaction venue and delivery date, and the consummation price for that deal. Upon the establishment of such an agreement, both parties share benefits or losses yet in the real sense they never did anything to control the value of the underlying asset. Benefits arise from elements such as more or less value of the underlying commodity that may be as a result of delays or lag durations, thus affecting the agree upon price. For the party with the performance obligation, a decline in price translates to acquiring the same commodity later at lower prices compared to those in the contract. Since the party with a performance obligation has no control over the price of the underlying assets, then when such price lowers, this party pretends to have influenced the fall, thus gaining from the purchasing the underlying commodity at low prices and selling them at a higher one.9 Conversely, for the potential recipient, any rise in the prices of the underlying asset spells the ability to resell it a price that is higher than that in the contract. As a result, the potential recipient does pretends to own the commodity when it is worth more than the price in the contract in order to gain.10 Historically, forward contracts have been known for routine sales where the underlying commodity had to be delayed to achieve a given situation.11 Furthermore, forwards have never been associated with physical trading facilities, and no formal corporate body exists in any organized form in the market. Consequently, trading is strictly over the counter direct communication among financial institutions. However, forwards are used to understand future contracts, Future Contracts Future contracts, like forward contracts, involve two parties, a party with performance obligation or the seller, and the potential recipient or the buyer. These two parties agree to sell or buy a commodity in futures where the price is agreed upon today. However, futures are characterized by participants whose gain or loss is realized on a daily basis, unlike forwards where one has to await until the final payment or cash settlement for commodity delivery. Furthermore, future contracts are standardized and so do not need customization to meet customer specific needs. To settle any future derivative contract, parties engage the services of an established clearing house and are exchange traded, thus regulated. The clearinghouse plays the crucial role that guarantees fulfilment and eliminates any ties between the contract parties, the counter-party, and the party. In case of price falls, the party with performance obligation gains by purchasing the underlying commodity at a lower price than that in the contract. Through this contract, this party pretends to have the responsibility of lowering the price, but in the real sense has done nothing to lower such prices to favour them. On the contrary, the intended recipient gains when the underlying commodity is higher than the contract prices and though not responsible for such price rise, this party gain for doing nothing. Gains and loses extend till the due date of the contract. However, the pain and agony, and gain are borne equally by all parties. Again, counterparties in futures can exit commitment by incurring equal, but offsetting exchange position such that the position’s net is nil, and the cash flow for a profit will be the loss or gain. In this case, the counterparties only engage in a commitment and that make them take the obligation of the buyer whilst their only interest is to share in the resulting gain or loss. All in all, any parties planning to engage in futures must post a margin; agree on a minimum margin requirement to be attained the via a margin call; and use mark-to –market. Swaps Like futures and forwards, swaps are surrounded by a high likelihood of default. Swaps involve agreements to exchange the first part of a series of cash flows in the future.12 Although the underlying reference assets can vary, the underlying asset’s value will is obtained from price sources available in public. For instance, the equity swap, the received or paid amount is the difference between the price of the equity at the contract end and start. For instance, a party obtaining cash flow from an investment and that would prefer another type of investment the uses a different form of cash flow.13 In this case, contracting a swap dealer operating in over-the-counter market to be the other party in the transaction. Consequently, the firm and the contracted dealer swap cash flow streams. In this case, either of the parties is subject to gains or losses depending on the market impact on interest rates or prices. Besides using over-the-counter dealers, contracting parties can opt for an arrangement where the firm decides to combine the commodity’s price to the payments obtained from the swap contract. This form of arrangement is referred to as the commodity swap. Chance and Brooks14 reveal the other arrangements to be a swaption. Here, a firm purchases an option to get into a swap. When swaps combine swaptions and forward contracts they form special forms of options. In swaps, the most common types of contracts that combine the qualities of futures, forwards, and options are interest rate swaps. In swaps, the firms and their dealers do not involve in investing any tangible assets, but cash flows. However, in this transaction, both parties equally share in their losses depending on the impacts of different factors on the interest rates or prices.15 Take for instance, a firm that borrows money through a floating rate. Such a firm is exposed to increasing rates of interests and this poses a risk to that company. However, in order to minimize such risks, the company can decide to purchase a cap or option to pay of any rates that go beyond the threshold. In this case, the firm assumes to have invested in something through purchasing the option. However, the driving force is to share in resulting benefits, and rarely do they make losses which they also share.16 The most popular forms of swaps are fixed-float swaps where parties use the same currency, or different currency, float-float, where the parties use similar currencies, but different indexes, or different currencies and different indices; and fixed-fixed where currencies are used. Options Options contracts are either customized or standardized, and derivative contract parties can engage in either call options or put options.17 When in call options, the purchasing or intended customer can legally purchase a specific commodity quantity or financial asset at a given price. This price is referred to as the exercise price can be paid on or prior to an agreed upon future or expiration date. Input options, however, it is the seller who can rightfully sell a given asset quantity at a specified price, before a given date. In these contracts, the purchaser first acknowledges the right to sell or buy by first paying the premium option. However, due to the limitation on the expiration date any premium paid is lost upon the event that upon expiration, the options are not exercised. Additionally, any losses due to changes in the value of the underlying asset are incurred by the writer and this is to the benefit of the purchaser. Hypothetical Derivative as a Form of Hedge Effectiveness Assessment From the analysis of the various forms of derivative contracts, changes in the value of the underlying assets or derivative conditions subject one party at a benefit or loss that does not affect the ownership of the underlying asset.18. For instance, when a company hedges for a commodity, any fall in prices subjects it to a loss since the contract prices are higher, while the party under performance obligation gains. Conversely, any increase in prices does translate to gain for the purchasing firm and a loss for the writer of the option.19 Furthermore, derivatives contract transactions are hypothetical in nature, and participating parties simply agree to pretend that a change had occurred and therefore, pay each other in accordance with the agreement terms. However, rounding up the transactions would then mean including any related hypothetical “borrowing” that the parties will agree to utilize during their calculations. For instance, in interest rate swaps, a decline in the interest rate would translate to the firm with lower credit rating paying the difference to the swap party with high interest rates.20 Conversely, the high credit rating company would have to pay the lower credit rate company with the difference in interests. Swaps are not limited to interest rates, but also accommodate foreign currencies, securities, commodities among others. For interest rate swaps, the parties getting into the contract are exposed to a defined interest rate, while both parties undertake what is known as counterparty credit risk in case any of them decides to default in a future day coinciding with that date of the contract.21 For instance, any client entering into an interest rate swap with derivative dealers to protect against a rise in rates through a fixed rate speculates that the rates will only rise and expects no falls. For the dealer, an offsetting transaction is used to hedge the client’s risk. In order to shield self from risks of loss, the dealer carefully monitors and control risks through offsetting futures position.22 For the counter party, the net variation between the present value of payment anticipated to be received and the present value of payment expected to be made. The present value, thus becomes the value of a quantity to be received in coming days that is adjusted with regard to the time value of money. In ordinary conditions, the net present value of payments to be made in the future for each phase of the swap would be identical to the initial ones, but with time, market movements contribute to variations from the anticipated value. It is for this reason that hedging the position is engaged to ensure that despite such variations, the status of the funding remains the same. For instance, an inflation rate swap is crucial in shielding pension schemes against pension scheme’s liabilities. This is because inflation introduces negative implications on the NPV of the liability of the pension scheme, thus higher values that could require additional funding for any corporate sponsor. This means that the corporate sponsor has to identify swaps that shield them during inflation rise such that they continue paying similar fixed amounts though receiving more as variable payment. In this case, the swap value increases, while the net present value increases as well. Conversely, the corporate sponsor must shield from lowering inflation, such that they still pay the same fixed amount but receive less variable payment. Derivative Effectiveness and International Swaps and Derivative Association In order to manage the credit risks; improve transparency; and improve the operative infrastructure industry, ISDA uses a master agreement structured in such a way that it offers protection and certainty to the involved parties. According to Catherine and Barrera,23 derivatives can be characterized as counter intuitive tools and instruments of wholesale market that contradict business expectations. The two schemes used to govern this market are stock exchange and over-the-counter market. In order to govern the transactions, an institution uses stock exchanges to establish rules that control its derivatives to guarantee transparency, actors and transaction requirements are met. Normally, stock exchange derivatives look into the transparency of prices and liquidity.24 The need for liquidity is governed by the increasing salability of contracts given their standardized nature. Furthermore, prices must immediately be published such that price transparency prevails and ensure that closely relates to the market price. Conversely, OTC derivative market introduces the concept of rules to be used with transactions and market actors and involve deals sold by banks. Since the transactions re over the counter, the actors set the rules to regulate the market and the best practices. Current derivative market status ISDA’s move to regulate the derivative markets was considerably implicated and to regulate the deficiencies evidence in the 2008 financial global crises. Though not the only affected market, the derivative market was compromised and the work of regulators and actors was crucial to restore the market. Both assumed certain commitments to offer complete regulation and avoid any systemic risks in the future. Prior to the crisis, everyone in America seemed to be getting wealthier, but through greedy investment characterized by reckless lending and too much risk taking.25 The market lacked transparency. Since there was less knowledge of any bank risks of trading using derivatives, banks shunned away from trading or lending with other banks. In any market, OTC derivatives offer direct role of insurance policies covering actual risks in business. A hedging scenario also involves and investor engaging in an interest rate swaps to hedge from the exposure of variable interests through the involvement of a counterparty. During the 2008 crisis, businesses and individuals engaged in what was believed to be an OTC derivative where they took subprime mortgage lending and mortgage backed securities like collateralized debt obligations26. This led to the lack of close observation of agencies offering credit rating, failed derivative instruments that did not account for the true market price, and poor risk management. The lenders then were banks that engaged in derivative trading that with an unknown degree of risks. The CDOs were sold to pension funds, cities, individuals, foreign governments, and pension funds with full knowledge that they were risky despite high credit rating. Investors as the parties engaged in original contracts with the banks suffered the loss while people who could not afford to pay mortgages defaulted and their securities declared junks. Unlike investors, Goldman Sach made lots of money from the meltdown owing to the credit swaps with AIG insurance. Clearly, Goldman pretended not to anything about the swap and pretending that changes had occurred, AIG had to pay accordingly.27 The pretence can be attributed to the fact that swap transactions are private arrangements, and there is no clearing house to offer safeguards as a financial guarantor of the swap. Furthermore, Banks did not care to tell investors the notional amount that could be lost in a worst-case scenario. On the contrary, banks allowed credit risks to reside on investors who were willing to bear it, but did not introduce higher transparency in credit pricing. As the derivative seller, the investor is at the losing end of numerous derivative contracts and lost massively, while the insurance companies acting as counterparties had to pay for the surplus credit swap amount.28 However, should the situation have changed and hedging by investors led to profits, then investors would have gained massively. In the 2008 crisis, parties wished to realize the whole price changes occurring within the swap period. Today, derivative markets have attained significant transparency levels aimed at guaranteeing better information access aimed at avoiding adverse liquidity impact. This has been made possible through the inclusion of a comprehensive and effective clearing house, constant update of terms, and sufficient rules on information report. According to Catherine and Barrera,29 information repository is one of the tools that have been made available and accessible such that regulators can access accurate and up-to-date information needed to assess the state of transparency, mitigate systemic risks and protect against abuse of the market. System risk mitigation and reduction in derivative transactions involves ensuring that the close-out netting tool is effective.30 The netting tool generally refers to allowing positive or negative values to set-off in part or fully cancel each other. In close-outs, a series of open executor contracts are cancelled on the default of counterparty and set-off the gains and losses that result. To perform such cancellation, the first step is to cancel the unperformed contract, and finally, calculating arising losses and gains, or set off. Set-offs involves discharging the reciprocal responsibilities to the level of the minor ones. For instance, a debtor can opt to set off the cross-claim he owes with the primary or major claim he owes the creditor. Within any economic systems, Parameswaran31 reveals that settlement netting is when an advance is set off using a contract of claims that are equitable and fungible under the contract of the executor. Examples of settlement netting include foreign exchange or commodities that has due dates for delivery or payment falling on the same day. For both clear and unclear derivatives, the ISDA document plays a very crucial role especially through standardization.32 However, there is a need to effectively prevent the risks associated with counterparty particularly of both cleared and uncleared products. Either way, the participants must bear the costs involved in risk management posed by each product. Conclusion This chapter offers a summary of the derivative markets, participants, and products. The paper evaluates the concept that in derivative contracts, the participants only pretend to have done something and to the extent of sharing the risks and benefits between them yet they have done nothing. From the perspective of derivative contracts, this is true for because all the participants do is to get into agreements of transaction and either benefit or lose depending on the variations in prices or interest rates. The most common forms of derivatives engaged in are options, futures, forwards, and swaps. With options, one party has the right to buy something at an approved price at some point in future. However, the right of this party does not involve obliging the buyer to purchase the underlying commodity prior to the expiry date. In addition, futures are contracts that are exchange-traded and their delivery is dependent on a point price agreed to prior to the delivery date. Here the buyer has to make margin payment representing the transaction value. Swaps involve exchanging a series of future cash flows for an alternative. Here, the only different thing is the underlying reference otherwise the price is publicly accessible. In order to count gains or losses, derivative participants pretend that some change has occurred and compensate each other based on their terms. In addition, the paper has revealed that the derivative market constitute of two parts that are derivatives traded over-the-counter, and derivatives traded in the exchange. For the exchanged traded derivatives, special rules are used to govern the while actors govern OTCs. Consequently, OTC products are surrounded by issues such as clearing systems risk management, transparency, and netting raise much concerned. The derivative market is international and standardization is crucial for efficient market research and practices. The advantages of international standards are elevating the chances of meanings for acceptance in courts; automatic coverage of deals without the need for new contracts, and offering cross-product netting such that defaults by counterparty, prompts netting to occur throughout the transactions that involve those parties. All in all, despite their huge responsibility in the 2008 global financial crisis, derivatives, when properly handled assist in system resilience improvement while introducing financial benefits for the participants. Furthermore, effective management of derivative trading causes a reduction in the risks linked to such trades while allowing participants to leap the sufficient benefits. The greatest challenge now is to establish structures that accommodate rules and regulations that reduce the risks while promoting transparency through improved quality and quantity of derivative market statistics. Bibliography Bush S, Derivatives and development : a political economy of global finance, farming, and poverty( Palgrave Macmillan 2012) Catherine L, Arias B, “Introductory Aspects On Financial Derivatives Market: ISDA Master Agreement Dealing With Legal Risk?” Universidad Externad(2012) Chance D, Roberts B, Introduction to Derivatives and Risk Management(Cengage Learning 2012). Choudhry M, Fixed Income Securities and Derivatives Handbook: Analysis and Valuation. ( John Willey & Sons 2010) Chui M, “Derivatives, Markets, Products, and Participants: An Overview.” IFC Bulletin( 2011) 1-21. Epstein B, Eva J Wiley IFRS 2010: interpretation and application of international financial reporting standard(John Willey 2010) Hera R “Forget About Housing, The The Real Cause Of The Crisis Was OTC Derivatives.” Business Insider (11 May 2010) International Swaps and Derivatives Association, Inc, Non-Cleared OTC Derivatives: Their Importance to the Global Economy(International Swaps and Derivatives Association, Inc 2013) Jarrow R, S Turnbull, Derivatives Securities (South-Western College Publishing 1999) Johnson M, Derivatives: A Managers Guide To The Worlds Most Powerful Financial Instruments (McGraw Hill 1999) Lartey R “What Part Did Derivative Instruments Play in the Financial Crisis of 2007-2008?” Social Science Research Network (2012). Loader D, Clearing and settlement of derivatives (Elsevier 2005) McLaughlin R, Over-the-counter Derivative Products: A Guide to Business and Legal Risk Management and Documentatio. (McGraw Hill Publishers 1999). Parameswaran S, Fundamentals of financial instruments : an introduction to stocks, bonds, foreign exchange, and derivatives (John Wiley & Sons 2011). Ramirez, Juan. Accounting for derivative: advanced hedging under IFRS(Wiley 2013) Staff Paper, “Effectiveness testing – Use of the hypothetical derivative.” IASB Meeting. (IAS 2010). 1-12. Steve D “Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable.” Forbes (1 August 2013). Stulz, R, “Financial Derivatives: Lessons from the Subprime Crisis.” The Milken Institute Review (March 2009). Trombley M, Accounting for derivatives and hedging (McGraw-Hill 2003) Watkins T, Options, Forward Contracts, Swaps, and Other Derivative Securities (San Jose State University 2010) Read More