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Overview of Derivatives
Moving from the world of insurance into the world of finance, another important set of aleatory contracts are the derivative contracts ("derivatives" in common shorthand). Although derivatives come in a myriad of variations, they all share one important feature—the contract derives its value by reference to an underlying value. As we will see, that underlying reference value can be something as simple as a stock price or interest rate, or something as complicated as a portfolio of mortgages, a stock index, or even the temperature in a particular city.
Some of the more common kinds of derivatives include:
Forwards and Futures: Forward contracts and futures contracts are related types of derivatives in which one party agrees to sell a set amount of an asset for a fixed price at a designated point in the future. The most significant difference between forwards and futures is that futures are standardized contracts while forwards are non-standard and can be tailored to the specific needs of the parties; thus, futures are generally “exchange traded” while forwards are sold “over the counter”. A classic example of this type of derivative are commodity futures which are used to trade a wide variety of commodities such as agricultural products (e.g., grain, pork bellies, coffee, and sugar), metals, and oil. The current price is reported using both the price and the date; “September Corn is at $4.04” means that a contract for standard-grade corn to be delivered in September carries a price of $4.04 per bushel. The plot of the classic comedy movie Trading Places starring Eddie Murphy and Dan Aykroyd revolved around an attempt to corner the market on frozen orange juice futures.
Options: Options contracts give one party (the buyer) the right, but not the obligation, to buy or sell an asset (typically shares of stock) at a set price on or before a specific future date in exchange for an up-front premium paid to the seller. An option to buy is referred to as a “call option”, while an option to sell is referred to as a “put option”. If the buyer exercises his option, the seller is obligated to sell or buy the asset at the agreed price, even if the market price is substantially higher or lower. If the buyer does not exercise his option, the contract expires. In either case, the seller keeps the premium.
Swaps: Swaps are contracts in which the parties exchange the cash flows of two financial instruments. Common versions of swaps include interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. Swaps permit parties to gain the benefits of the underlying alternative financial instrument without incurring the potential legal, tax, and other downsides of an actual transfer of ownership.
For example, one common swap—the interest rate swap—permits two parties who each have loans with different interest rates to swap or exchange the interest payments on the loans. For example, assume two companies have issued corporate bonds, one party at a fixed rate, the other party at a floating rate (e.g., a rate tied to LIBOR or U.S. treasury rates). The party whose bonds have a floating interest rate might want to be able to lock in a fixed rate on the assumption that rates will rise. The counterparty might like to move to a floating interest rate loan, on the assumption rates would fall. By using a swap, the parties gain the benefit of a different interest rate without needing to redeem and reissue their bonds, a process that would be both expensive and difficult. Also, note that individuals holding these companies’ bonds could also enter into an interest rate swap, although their expectations would be the opposite of the expectations of the underlying companies—i.e., a bondholder with a fixed rate bond would swap with a floating rate bondholder expecting interest rates to rise, not fall.
Interest Rate Caps, Floors, and Collars: Closely related to interest rate swaps are interest rate caps, floors, and collars. These derivatives are contracts in which the buyer pays a commission in exchange for a guarantee of payment if interest rates rise or fall below a predetermined point. These derivatives are commonly used as a form of insurance on bonds or other debts which have a floating interest rate. These derivatives are also useful for companies which have a business model highly sensitive to changes in interest rates, even if the interest rate derivative is not purchased to hedge a particular debt instrument.
Asset Backed Securities and Collateralized Debt Obligations: Asset backed securities (ABS) and collateralized debt obligations (CDO) are derivatives which are created by pooling underlying assets, typically various loan and debt obligations, then paying the loan proceeds (interest and principal) to the contract holders as they become due. ABS/CDO can be created from a wide range of underlying debt obligations, including mortgages, student loans, credit card debt, and auto loans. A CDO differs from a vanilla ABS in that the debt proceeds are divided into slices ("tranches") which prioritize the order of repayment. This process allows the earlier tranches to be given higher credit ratings as they are much less likely to suffer a loss in the event of unexpected default rates in the portfolio of loans underlying the CDO. The 2008 recession was precipitated in large part by a real estate bubble market created in part by the packaging of subprime residential mortgages into mortgage-backed securities (MBS) and real estate CDOs which then experienced unexpectedly high default rates (partially due to shoddy or fraudulent mortgage underwriting practices).
Credit Default Swaps: Another derivative, credit default swaps (CDS), also played a key role in precipitating the 2008 recession and stock market crash. Although nominally a swap contract, CDS function as insurance against default on a debt obligation (e.g., bond or ABS). For example, a CDS buyer might hold a large number of corporate bonds issued by one company, or a block of similar ABS (say a portfolio of RMBS), thereby exposing the buyer to risk if the issuing company or the underlying industry sector suffer adverse financial results. For a fee or commission, the CDS seller agrees to pay off the underlying debt instrument in the event of a default or other negative credit event. In 2008, insurance giant AIG became insolvent as the result of collateral calls on billions of dollars of CDS it issued in connection with RMBS, as those RMBS became financially impaired in the wake of the real estate market bubble collapse. With many institutional investors exposed to financial risk if AIG collapsed, the federal government stepped in with an $85 billion bailout.
Derivatives: More Than Financial Risk Insurance
Because derivatives are aleatory contracts, they necessarily contain an element of risk (or chance, if you prefer). Thus, like insurance and reinsurance, derivatives are an excellent tool for financial risk and volatility management. In a sense, derivatives can be understood as a form of financial insurance. Investors can hedge the risk of a falling stock market through options. Futures allow producers of raw materials to hedge against falling market prices, while manufacturers can hedge the risk of rising raw material costs. Many businesses and investors can be adversely affected by fluctuations in interest rates; derivatives can offer protection against these fluctuations tailored to the purchaser's specific need. As with insurance, there is always a premium, commission, or fee associated with the derivative contract, but the purchaser deems that cost acceptable in exchange for reduction in financial risk and volatility.
Derivatives, however, go beyond acting as financial insurance in two respects. First, derivatives such as CDO and ABS also provide the benefit of transforming a relatively illiquid asset—e.g., a bundle of mortgages or credit card accounts—into a security which can offer a less risky stream of income payments than the individual underlying loans. In essence, the process of securitization spreads the risk of any one individual loan defaulting across the full pool of loans aggregated for the CDO or ABS. So, CDO and ABS offer banks and other debt writers a way to market their debt-based assets, while investors have a method of participating in the debt market via less risky and more liquid securities.
Derivatives also go beyond the financial insurance function by creating ways to monetize non-financial risks. A classic example are so-called weather derivatives, which base payment on how much temperatures or precipitation levels fall above or below certain points over a set period of time. So, a business adversely affected by unusually hot or cold weather, or by unusually high or low precipitation levels, can purchase protection against this type of risk, and receive a monetary payoff if extreme weather conditions occur. And, unlike insurance, the weather derivative pays off without any need for the purchaser to quantify any weather-related losses.
Taking matters yet another step, reinsurers have entered the weather derivative market with insurance-linked securities (ILS), which essentially are derivatives based off an underlying reinsurance pool. For example, a reinsurer with a large block of property insurance policies on the books in an area at high risk for hurricanes, tornadoes, or earthquakes might issue catastrophe bonds (or "cat bonds") in which outside investors pay a premium in exchange for a payment of money if a defined catastrophic weather event does not occur, or based on the value of an index of natural catastrophe events.
Fantasy Sports League Or Sports Derivative Investment Fund?
Which brings us to fantasy sports. Fantasy sports started out as an effort by hardcore baseball fans to essentially play general manager and put together a better team than their opponents—usually friends or work colleagues—in a friendly league. Because these fantasy teams obviously do not exist in real life, they cannot play actual games. Instead, the players on each fantasy team roster are awarded points tied to the performance of the players in real life games.
Over the past two decades, participation in fantasy sports has exploded. Much of this growth is tied to the rise of online sites which take care of much of the tedious record keeping and scoring functions, leaving players free to focus on evaluating players to draft or trade. More recently, fantasy sports have experienced another boom with the advent of daily fantasy sports (DFS) sites in which contests run not for a full season, but for only a day.
Although DFS is legal in most states—and legislative efforts are underway to clarify the legality of DFS in the other handful of states—there has been a growing debate as to whether DFS has gone too far and approaches being a form of gambling. Although whether DFS is "gambling" requires something of a value judgment, there is little question DFS is an aleatory contract, and more specifically, a type of derivative—a sports derivative, if you will.
DFS contests clearly involve an element of risk or chance—specifically, the uncertain nature of any player's performance on a given day. There is a fee associated with the contests. The financial results of DFS contests derive from the performance of all of the players drafted in their underlying real life games, much like derivatives can be tied to the performance of outside stock or commodity prices, securities indexes, interest rates, or even weather events. And, much like weather derivatives, DFS contests act as sports derivatives by awarding financial payoffs based on a non-financial performance.
The DFS industry assiduously eschews any connection to gambling, instead marketing DFS as a "skill game". Top DFS players tout their analytical chops in winning hundreds of thousands of dollars a year, enough to even lure some to quit their Wall Street trading jobs for a regular DFS grind. Yet, there is a fairly strong public sentiment that DFS at least borders on being gambling. In New Jersey's ongoing legal battle to legalize traditional sports gambling, the state has asserted that DFS is akin to sports betting. And as prominent sports bettor Haralobos Voulgaris tweeted, "Newsflash to the NBA—DFS is actually gambling."
The question then becomes: Why is the legal system—and for that matter, the general public—comfortable that stock options, commodity futures, and even weather derivatives are not gambling, but concerned that a DFS contest—a de facto sports derivative—might be gambling? As we will see, the answer to that question is complicated.
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Additional articles in this series (links will be added as each section is posted):
Part I—Meet the Aleatory Contracts
Part II—Insurance: Gambling on Catastrophe
Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker
Part V—Hedgers and the Law
Part VI—Speculators and the Law
Part VII—Risk Creation v. Risk Management