Financial Instruments

 
 
 
 
 
 
 
 
 
 

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«Financial Instruments» 
 
 

 

      Contents 

 

       Introduction

     Financial Instrument can be defined as a real or virtual document representing a legal agreement involving some sort of monetary value.

     Financial instruments can be categorised by form depending on whether they are cash instruments or derivative instruments.

• Cash instruments are financial i whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.
• Derivative instruments are financial instruments which derive their value from some other financial instrument or variable.

     Alternatively financial instruments can be categorised by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category.

     Combining the above methods for categorisation, the main instruments can be organized into a matrix as follows (table 1).

Table 1

 

        

1. Derivatives’ market

     One of the most well known specialists in field of derivatives John C. Hull defines financial derivatives in the following way:¹

     “Financial Derivatives are instruments that allow financial risks to be traded directly because each derivative is linked to a specific instrument or indicator (e.g. a stock market index) or commodity.”

     The derivative is a contract, which gives one party a claim on an underlying asset (e.g. a bond, commodity, currency, equity) or cash value of the asset, at some fixed date in the future. The other party is bound by the contract to meet the corresponding liability. A derivative is said to be a contingent instrument because its value will depend on the future performance of the underlying asset. The traded derivatives that are sold in well-established markets give both parties more flexibility than the exchange of the underlying asset or commodity.

     The history of derivatives is quite colorful and surprisingly a lot longer than most people think.  To start we need to go back to the Bible. In Genesis Chapter 29, believed to be about the year 1700 B.C., Jacob purchased an option costing him seven years of labor that granted him the right to marry Laban's daughter Rachel. The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward contracting in 1637.

     In recent years, the development of the financial markets has been largely driven and directed by derivative financial instruments. Derivative financial instruments have drawn attention to the realistic, business-oriented valuation of cash flows arising from products both with and without option characteristics. This knowledge was then used to throw new light on the valuation of primary financial instruments, which had previously not been questioned. It has become clearer that the controlling and valuation of derivative instruments cannot be separated from the controlling and valuation of primary instruments. It has thus become common practice to combine derivative and primary  financial instruments, which are subject to the same categories of market risk  into where they are subject to common treatment. As derivative instruments were the starting point for such considerations, it is appropriate to refer to the locomotive function of derivatives.

     The key types of derivatives are futures, forwards, forward rate agreements, options and swaps.

     Table 2 summarizes the different types of derivatives, and shows how they are related to each other.

     The exchange-traded instruments grew from $1.31 trillion in 1988 to $17.3 trillion in 2005. The main organised exchanges are the London International Financial and Futures and Options Exchange (LIFFE), the Chicago Board Options Exchange and the Chicago Mercantile Exchange.

      Table 2    Summary of Derivatives

1. Futures

      A future is a standardised contract traded on an exchange and is delivered at some future, specified date. The contract can involve commodities or financial instruments, such as currencies. Unlike forwards (see below), the contract for futures is homogeneous, it specifies quantity and quality, time and place of delivery, and method of payment. The credit risk is much lower than that associated with a forward or swap because the contract is marked to market on a daily basis, and both parties must post margins as collateral for settlement of any changes in value. An exchange clearing house is involved. The homogeneous and anonymous nature of futures means relatively small players (for example, retail customers) have access to them in an active and liquid market.

2. Forwards

      A forward is an agreement to buy (or sell) an asset (for example, currencies, equities, bonds and commodities such as wheat and oil) at a future date for a price determined at the time on the agreement. For example, an agreement may involve one side buying an equity forward, that is, purchasing the equity at a specified date in the future, for a price agreed at the time the forward contract is entered into. Forwards are not standardised, and are traded over the counter. If the forward agreement involves interest rates, the seller has the opportunity to hedge against a future fall in interest rates, whereas the buyer gets protection from a future rise in rates. Currency forwards allow both agents to hedge against the risk of future fluctuations in currencies, depending on whether they are buying or selling.

      The only difference between a future and a forward is that the future is a standardised instrument traded on an exchange, but a forward is customised and traded over the counter. To be traded on an exchange, the market has to be liquid, with a large volume. For example, it will be relatively easy to sell or buy dollars, sterling, euros or yen for three or six months on a futures market. However, if an agent wants to purchase dinars forward, then a customised contract may be drawn up between two parties (there is unlikely to be a ready market in dinars), which means the transaction takes place on the forward market. Or, if a dollar sale or purchase is outside one of the standardised periods, it will be necessary to arrange the transaction on the forward market.

      Banks can earn income from forwards and futures by taking positions. The only way they can generate fee income is if the bank charges a client for taking a position on behalf of a client.

3. Options

      At the date of maturity, if an agent has purchased yen three months forward (or a future), he must buy the yen, unless they have traded the contract or closed the position. With options, the agent pays for more flexibility because he is not obliged to exercise it. The price of the option gives the agent this additional flexibility. The first type of option traded on an exchange (in 1973 in Chicago) was a call option. The holder of a European call option has the right, but not the obligation, to buy an asset at an agreed (strike) price, on some specified date in the future. If the option is not exercised, the buyer loses no more than the premium he pays plus any brokerage or commission fees. The holder of a call option will exercise the option if the price of the asset rises and exceeds the strike price on the date specified. Suppose an investor buys a call option (e.g. stock in IBM) for $100 two months later. The underlying asset is equity, namely, one share in IBM stock. The agreed price of $100 is the strike price. If IBM stock is more than $100 on the specified day it expires, the agent will exercise the option to buy at $100, making a profit of, for example, $10.00 if the share price is $110.

      Options can be bundled together to create option-based contracts such as caps, floors or collars. Suppose a borrower issues a long-term floating rate note, and wants partial protection from a rise in interest rates. For a premium, the borrower could purchase a Cap, which limits the interest to be repaid to some pre-specified rate. A Floor means the lender can hedge against a fall in the loan rate below some pre-specified rate. Collars, where the buyer of a cap simultaneously sells a floor (or vice versa), mean the parties can reduce the premium or initial outlay.

      Currency Options are like forward contracts except that as options, they can be used to hedge against currency fluctuations during the bidding stage of a contract. Purchasers of options see them as insurance against adverse interest or exchange rate movements, especially if they are bidding for a foreign contract or a contract during a period of volatile interest rates.

4. Swaps

      Swaps are contracts to exchange a cash flow related to the debt obligation of two counterparties. The main instruments are interest rate, currency, commodity and equity swaps. Like forwards, swaps are bilateral agreements, designed to achieve specified risk management objectives. Negotiated privately between two parties, they are invariably OTC and expose both parties to credit risk. The swap market has grown rapidly since the late 1980s, for a number of reasons. Major financial reforms in the developed countries together with financial innovation, has increased the demand for swaps by borrowers, investors and traders.

      The basis for an interest rate swap is an underlying principal of a loan and deposit between two counterparties, whereby one party agrees to pay the other agreed sums — "interest payments". These sums are computed as though they were interest on the principal amount of the loan or deposit in a specified currency during the life of a contract.

      Many banks are attracted to interest rate swaps because they tend to borrow short and lend long. Many deposits are paid a variable rate of interest: many loans are at fixed interest. This exposes banks to the risk of loss if there is a rise in short-term interest rates. A bank can hedge against this risk with an interest rate swap. The bank agrees a contract with a counterparty, to pass fixed interest payments over a certain period in return for a stream of variable interest receipts.

      A currency swap is a contract between two parties to exchange both the principal amounts and interest rate payments on their respective debt obligations in different currencies. There is an initial exchange of principal of the two different currencies, interest payments are exchanged over the life of the contract, and the principal amounts are repaid either at maturity or according to a predetermined amortisation schedule.

      The need for currency swaps arises because one party may need to have its debt in a certain currency but it is costly to issue that debt in the currency. For example, a US firm setting up a subsidiary in Germany can issue US bonds but not eurobonds because it is not well known outside the United States. A German company may want to issue dollar debt, but cannot do so for similar reasons. Each firm issues bonds in the home currency, then swaps the currency and the payments. Unlike an interest rate swap, the principal is exchanged, which creates additional risks. These are credit risk (risk of default on the debt) and settlement or Herstatt risk if there is a difference in time zones.

      The market for credit swaps began to grow quickly in the early 1990s. There are two main types: a credit default swap and a total return swap, discussed below. Both are examples of credit derivatives. Credit derivatives are OTC contracts, the value of which is derived from the "price" of some credit instrument, for example, the loan rate on a loan. Credit derivatives allow the bank or investor to unbundle or separate an instrument's credit risk from its market risk. This is in contrast to the more traditional credit risk management techniques, which manage credit risk through the use of security, diversification, setting the appropriate risk premium, marking to market, netting, and so on. By separating the credit risk from the market risk, it is possible to sell the credit risk on, or redistribute it among a broad class of institutions. Credit derivatives are used to protect against credit events, which can include:

• A borrower going bankrupt;
• A default on the payments associated with a particular asset.

      An equity swap is an agreement to exchange two payments. Party A agrees to swap a specified interest rate (fixed or floating) for another payment, which depends on the performance (total return, including capital gains and the dividend) of an equity index. An equity basis swap is an agreement to exchange payments based on the returns of two different indices.

      A cross-currency interest rate swap is a swap of fixed rate cash flows in one currency to floating rate cash flows in another currency. The contract is written as an exchange of net cash flows which exclude principal payments. A basis interest rate swap is a swap between two floating rate indices, in the same currency. Coupon swaps entail a swap of fixed to floating rate in a given currency.

      Like forwards and options, hedging is one reason why a bank's customers use swaps. In a currency, interest rate or credit swap market, a customer can restructure and therefore hedge existing exposures generated from normal business. In some cases, a swap is attractive because it does not affect the customer's credit line in the same way as a bank loan. Currency swaps are often motivated by the objective to obtain low cost financing. In general, swaps can be a way of reducing borrowing costs for governments and firms with good credit ratings.

5. Hybrid derivatives

      These are hybrids of the financial instruments discussed above. Variable coupon facilities, including floating rate notes, note issuance facilities and swaptions, fall into this category. A swaption is an option on a swap: the holder has the right, but not the obligation, to enter into a swap contract, at some specified future date. Variable coupon securities are bonds where the coupon is revalued on specified dates. At each of these dates, the coupon rate is adjusted to reflect the current market rates. As long as the repricing reflects the current interest rate level, this type of security will be less volatile than one with a fixed rate coupon. The floating rate notes (FRNs) have an intermediate term, whereas other instruments in this category will have different maturities. All the periodic payments are linked to an interest rate index, such as Libor. A FRN will have the coupon (therefore the interest rate payments) adjusted regularly, with the rates set using Libor as a benchmark. Note issuance facilities are a type of financial guarantee made by the bank on behalf of the client, and have features similar to other financial guarantees such as letters of credit, credit lines and revolving loan commitments. 
 
 
 
 

      Conclusion

      The direction in which the derivative instruments engine is pulling business organization can be clearly seen: all efforts are being made to reach a corporate-wide management and controlling of counter party and market risks arising from all financial instruments.

      It is important to be clear on the different uses of financial instruments by the banking sector. Commercial banks can advise their clients as to the most suitable instrument for hedging against a particular type of risk, and buy or sell the instrument on their clients' behalf. This may help the bank to build on relationships and open up cross-selling opportunities. Additionally, banks employ these instruments to hedge out their own positions, with a view to improving the quality of their risk management.

      Banks also use derivatives for speculative purposes and/or proprietary trading, when trading on the banks' own account, with the objective of improving profitability. It is the speculative use of derivatives by banks which regulators have expressed concern about, because of the potential threat posed to the financial system.

      Non-financial corporations are attracted to derivatives because they improve the management of their financial risks. For example, a corporation can use derivatives to hedge against interest rate or currency risks. The cost of corporate borrowing can often be reduced by using interest rate swaps (swapping floating rate obligations for fixed rate). Banks are paid large sums by these firms to, for example, advise on and arrange a swap. However, some corporations, whether they know it or not, end up using derivatives to engage in speculative activity in the financial markets. There have been many instances where corporate clients have used these derivative products for what turned out to be speculative purposes.