Derivatives: Villain or Scapegoat? Expert seeks broader understanding of maligned and misunderstood financial instruments
It takes just a farmer and a miller to illustrate the origin and usefulness of derivatives. In the spring, the miller agrees to buy the farmer’s fall harvest. The agreement, called a forward contract, specifies an underlying asset—the wheat—a price per bushel, a quantity and a future delivery date. Both parties have reduced their exposure to the uncertain price of fall wheat—the miller by locking in the cost of raw materials and the farmer by locking in the selling price of his crop. No money changes hands in the spring—only on the delivery date, when the miller pays the agreed-upon price and the farmer delivers the agreed-upon quantity.
RIGHT: Bob Whaley, Valere Blair Potter Professor of Management in Finance; Co-Director of the Financial Markets Research Center
While today’s derivative markets feature a dizzying array of variations on that theme, and while the role of such contracts in the recent worldwide financial panic is widely debated, the basics remain the same. A derivative, whether a stock future or a credit default swap, is a financial instrument whose value is derived from the value of something else. There are two main types:
1. Futures/forwards, in which parties contract to buy or sell an asset—an individual stock, a group of stocks or bonds, a foreign currency—for a given price on a specified date, as in the example of the farmer and the miller;
2. Options, in which a party buys the right, but not the obligation, to buy (a call) or sell (a put) such an asset for a given price on a specified date from a party obligated to carry out the transaction if the option is exercised.
A wealth of other financial instruments, including swaps, caps, collars and floors, are variations or portfolios of the two basic types. Derivatives help manage risk—avoiding it by hedging a bet on the future price of a commodity like wheat or a financial asset like a bond, or acquiring it to try to profit from speculation.
The rapid recent expansion in the number and worth of derivatives contracts has helped spur both supporters and critics. Some critics view the more esoteric derivatives as little more than houses of cards. It’s a view that is antithetical to the beliefs of Valere Blair Potter Professor of Management in Finance Bob Whaley, an expert on and defender of derivatives, as well as a lightning rod, since he invented one of the most visible symbols of derivatives—the Volatility Index (VIX), or Fear Index (see accompanying story).
Although the recent market crash has made derivatives a renewed target (and made the Fear Index a staple of TV commentators), Whaley is adamant in maintaining that much of the fear stems from misunderstanding. With the proper approach, he continues, the most complex issues are straightforward. He cites as an example collateralized debt obligations, securities constructed from fixed-income assets like mortgages. Many analysts regard them as a key villain in the recent credit crunch.
“A CDO is no more a derivative than is IBM,” says Whaley. “With a CDO, you bundle assets (mortgages, etc.) and then split the pool up into tranches from the most senior securities to the least senior and sell each tranche individually. What is IBM? It is a collection of assets (plant and equipment, etc.) that is then portioned into tranches or slices, from the most senior (the senior bonds of the firm) to the least senior (the common stock) and each tranche is sold separately. What’s the difference? If it’s a lousy company, it will go bankrupt, hurting the shareholders first. If they’re lousy mortgages, the first to go is the riskiest tranche. A tranche within a CDO is no more (or less) a derivative than a common stock or a corporate bond.”
And it is lousy mortgages, he maintains, that have given a bad name to the derivatives layered atop them, not the nature or design of the derivatives themselves.
"Fundamentally where this all started," he says, "was when banks decided they were going to give mortgages to people with no income, no job, no assets—nothing. Derivatives do nothing to change the risk or the quality of the underlying asset. What’s the idiom? You can’t make a silk purse from a sow’s ear.”
The bundling process added nothing self-correcting to the process.
"Salespeople were getting paid by the number of mortgages they originated," he says. "In the old days, bankers exercised great care in determining credit-worthiness and expected long-run loan performance. That all went out the window. The risk of subprime loans doesn't disappear if you package them as CDOs. The fundamental problem is in extending the credit beforehand. The derivatives worked fine."
Whaley has expressed concern that a lack of understanding of derivatives exists both in financial institutions and in the government supposed to regulate them.
"People think if they're using the word derivatives they are using an 11-letter four-letter word," he adds. "I get upset when the term derivatives is used by different people in different ways. I was amused not long ago when congressmen were bad-mouthing credit default swaps and then in the next sentence wanted to guarantee loan credit to banks. They are the same thing! The problem becomes the remedy!”
At bottom, Whaley maintains, derivatives are doing what they have always been designed to do, which is to promote safety and stability, a point he illustrates with an extension of the farmer-miller analogy.
“When the farmer seeds his land in the spring,” he says, “he does not know the price per bushel he will receive at fall harvest. The forward contract he sells in the spring can lock in the fall sales price. In other words, in a world without derivatives, the farmer is placing a bet on whether the sales price in the fall will cover the costs of operation. If the price of wheat happens to be high, the farmer will turn a profit. On the other hand, if there is a glut of wheat and the sales price is low, he loses. By using the derivatives market, the farmer can reduce his price risk. The passion with which some commentators vilify derivatives says to me, at least, they lack a basic understanding of what these markets do.”
Derivatives also provide a means of speculating in markets where direct trading in the asset is impossible, prohibited or simply too costly, states Whaley.
“If, through careful research and analysis, you have determined that the price of crude oil is too high and will fall over the next month, how can you profit? Without derivatives markets, you can’t. As an individual, you do not have the financial or physical means of short selling crude oil. You can, however, sell crude oil futures on the NYMEX. Since the futures price moves like the price of crude, selling crude oil futures is like short selling crude. If the price falls, you are able to profit from your research, and the market is better off, since prices now incorporate more information about individual expectations.”
The modern futures market—futures are a type of standardized forward contract traded on an open exchange—was established in 1848 with the formation of the Chicago Board of Trade, the first of many such exchanges. Futures contracts could from then on change hands many times before expiration and investors could get in and out with no desire to take possession of the underlying asset.
The derivatives markets' Cambrian explosion came late in the 20th century, which remolded the financial world as surely and profoundly as it revolutionized art, transportation and weaponry. The dramatic increase in possibilities inherent in derivatives was fed by a handful of events. The first came in 1971, when currencies, which had been tied to an international gold standard, were allowed to "float." That made them market-driven commodities, and money itself became subject to futures contracts—the first time derivatives were written on something other than a physical commodity. Five years later, the cost of money—interest rates—became part of the futures market. Futures on interest paid on dollars overseas—Eurodollars—were next, and the fact that they were paid off with cash settlements rather than physical delivery broke a new barrier and further expanded the range of possible products.
Stock indexes, which reflected the overall worth of the market, followed, with trading in futures on the S&P 500 beginning in 1982. Investors could now trade a well-diversified stock portfolio without owning a single share. Futures, which had been focused on agricultural products for so long, had entered a new era. With the democratization of much financial information and the increased accessibility of trading platforms—by 1992, investors could trade electronically—as well as globalization, which took interest in new financial packages around the world, the market expanded exponentially.
Part of the expansion was driven by the simple desire of the exchanges for more business. The Chicago Board of Trade, for instance, began listing stock options in 1973, a move helped by the development of a mathematical formula for pricing derivatives based on the value of the underlying asset. The Chicago Board Options Exchange began reporting real-time levels of its Volatility Index—Whaley’s Fear Index—with one eye on new business. Futures contracts on VIX were launched in May 2004, and option contracts on VIX in February 2006.
Deregulation of the banking industry in the 1980s allowed it to create derivatives to sell to corporations and other financial institutions, setting the stage for another huge expansion.
The dizzying array of futures—The Wall Street Journal lists tens of thousands, which represent fewer than 10 percent of all such contracts worldwide, an aggregate whose notional value is estimated by some to exceed a quadrillion dollars—suggest an unwieldy and labyrinthine complexity, but Whaley stresses the logic and simplicity behind even the most complex of derivatives.
“Valuing ‘complex’ derivatives is not difficult,” he says. “They can all be reconstructed as portfolios of forwards and options. A plain vanilla interest rate swap, for example, is simply a strip of forward contracts. To price a swap, you simply add up the prices of the individual forward contracts. You simply have to have the patience to read and understand the terms of the contract. And if you don’t understand it, stay away from it.”
Calls for reform and correction of the overall derivatives market, Whaley maintains, must be measured—something they have not uniformly been.
"We went through this same thing back in October of 1987," he says. "Suggested remedies were draconian. They were going to abolish the financial futures markets. That wasn't the problem. The main problem was antiquated trading systems for individual stocks."
Of the proposals on the table for dealing with the current situation, Whaley is strongly in favor of the use of clearinghouses to settle over-the-counter derivatives trades.
"In exchange-traded markets, a clearinghouse stands between the buyer and the seller guaranteeing the performance of the contract,” he says, “and through daily reporting by the clearinghouse, we know exactly how deep and liquid the market is. In the OTC markets, on the other hand, you are left to your own devices to ensure your counterparty will honor the terms of the trade and have little or no market transparency.”
A welcome endorsement for Whaley’s position came from Leo Melamed, Chairman Emeritus of the CME Group and the founder of financial futures, in his role as keynote speaker at the Conference on Financial Innovation, which brought together at Owen financial experts, including two Nobel laureates, from around the world.
“How did exchange-traded futures perform during these unprecedented turbulent conditions?” Melamed asked. “The answer is clear: flawlessly. No defaults, no failures, no federal bailouts. The futures market model is a poster child for the free market and innovation: price transparency, liquidity, central counterparty clearing, twice daily mark-to-market, zero debt system, and regulatory oversight.”
It is by no means commonly accepted wisdom, but Bob Whaley is working to try to make it so.
Send comments and questions to bob.whaley@owen.vanderbilt.edu
Reported by Rob Simbeck
Published 2/09 in OWENintelligence
© 2009 Vanderbilt Owen Graduate School of Management
