Derivatives Law Outline

DERIVATIVES SUMME AUTUMN 2016
 
WHAT ARE DERIVATIVES?
Derivative=Agreement between Buyer and Seller that guarantees a price or performance for something
K relationship that can relate to anything. Mostly to price at which asset can be bought/sold in the future
Underlier: The asset from which D derives its price. Can be anything. IR, currency, oil price, stock price, price of OJ, wheat (Chicago exchange), emissions, weather
Ex: Golf cart operator: If summer too hot/rainy, get paid if temps fall outside specified band
Emissions, e.g. company involved in chemicals knows it will overshoot EU goals for emissions. Will want to buy offsetting credits in D with less environmental impact
Some products more liquid, others more esoteric (e.g. golf weather Ds)
 
4 building blocks
1) Forwards
2) Futures
3) Swaps
4) Options
(Also mixes and matches, e.g. “swaptions”)
 
All 4 BBs have underliers; IRs by far the most common (=rate at which money is bought/sold)
IR swaps nearly 80% of Ds market. Boring and uninteresting!
Vanilla Ds=IR swaps. Simple exchange of payment flows: fixed for floating
Currency/FX second most common. 10-12%
Credit/equity Ds. Synthetically owning shares=sans tangible ownership, derive benefit of stock price movement
Commodities=why Ds created in 1st place. Corn, OJ, jet fuel crude, gold/metals. Small market share
 
1) Forward 1 of most commonly traded instruments. K, party will buy something at specified price at specified future date. 2 parties to the K=bilateral. (Could be other entities to K, e.g. subsidiary doing trade and parent guaranteeing payments)
Ex: Buy new car and want particular type of stereo system installed before taking ownership
Pay deposit (=collateral); in 2 weeks car dealer will have it ready for 50k
K specifies agreement to buy specific car/date/price
In intervening weeks, car value rises to 60k
FW locks in price at 50 even though car worth 60 in market
Value could also decrease. Buyer still has obligation to buy at future date
=Price guarantee
Typical FW user=AAPL. Different manufacturers producing widgets in different countries for products
Ex: AAPL wants to pay no more than 50 yuan for component. Locking in price of widget needed for phone and taking delivery at future time. Creates budget stability
Buys commodities & pays laborers in local currency
With FWs, AAPL manages IR/currency/commodity price risks (typical FW D markets)
Ex: stock price. Halliburton trading at 30, think it will be at 50 (long position)
Enter into FW agreement to buy set number of shares at advance price
Settlement=pay or get difference b/w trading & fixed price
Bank will hedge risk. If selling FW where CP bets on up, bank hedges risk by entering into opposite trade
Obligation≠option. Must pay regardless of whether you won or lost bet
Settlement: 2 ways of settling K
1) Cash. Often settlement method in capital markets
2) Physical delivery. Ex: Like type of coal out of southern IL basin
Make K for physical delivery of certain tonnage/quality of coal at future date
Bilateral trade standard. Other people swept in usually guarantee payment/delivery. Could also be early warning flag of something going wrong in biz structure
Important K clause: delivery guarantee at parent level if sub goes under
Direct trading relationship=know who your counterparty is, its financial situation, etc.
 
2) Future same thing as forward but trade executed on an exchange
Can replicate most goals from bilateral trade on exchange, but can’t customize relationship
E.g. Can’t insert key person provision in Schedule or create rare trade type
FU=standardized K, standard pricing, collateral, duration. Settling up every single day
Compare FW, not settling up trade value at end of every day regardless of fluctuations
…with FU, trade settled up at the end of every day
Analogy: If you go to a bar, you can either settle you tab or drink on open tab
FW=you don’t have to pay your tab, can drink on credit because you know your bartender=CP
FU=pay your bar tab every night in full because you don’t know the bartender=CP
Policy: Shove OTC toward FU model. De-risking exposure that can grow in long-term Ks
 
3) Swap=agreement between parties to exchange future cash flows
Bank for International Settlements (BIS): out of $493 trillion industry, $384 T IR swaps
i) IR swaps=1 payment stream to CP based on floating rate (varies); other stream fixed
If I have F/F IR Swap, have to have something to make calculation on
Ex: Hypo amount, $50 mn for loan to build power plant in CH.
$50 mn not what is at risk but benchmark calculated F/F off of
If have fixed rate of 5 percent, $50 mn=notional
Only IR payments changing hands between the parties, not underlying amount
Could have different terms. Ex: loan for $50 mn might have 10 yr repayment period
Ex: I have fixed rate but 3 yrs in to trade, might think IRs will float
Need to find long-term floating IR willing to swap
Different benchmarks for floating IRs=LIBOR/Prime/Fed funder. Most of market today=LIBOR
Done by currency, rate assessed every morning by a panel of banks. LIBOR resets every day
LIBOR=rate big int’l banks can charge for unsecured lending
Set for Dollar, Pound, Euro, Yen, and Swiss Franc
Also different durations, e.g. Yen at overnight/monthly/yearly rate.
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LIBOR scandal: Barclays made morning rate submissions look like bank was healthier than it was
Same strike zone as larger, more robust banks
Banks incentivized to game system for balance sheet implications in terms of profitability
ICE=Intercontinental Exchange. Succeeded