Derivatives

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Securities that derive their value from other financial instruments that are used by the insurance company to hedge its bets on which direction the market is moving. For example, cattle futures are a simple derivative in that the cattle futures contract increases or decreases in value as future prices change for cows on the hoof. When insurance companies use derivatives, they are more likely to use them in association with currency and interest rate transactions as a means of protecting themselves against adverse moves in interest rates or foreign currency exchanges. This instrument provides a mechanism for hedging against the interest rate risks that are inherent within insurance products by pricing in that risk in advance and protecting against future negative occurrences.

Derivative instruments are used as financial management tools to enhance investment returns and to manage such risks relative to interest rates, exchange rates, and financial instrument and commodity prices. Several local and international banks, businesses, municipalities, and others have experienced significant losses with the use of derivatives. However, their use has increased as efforts to control risk in complex situations are perceived to be wise strategic decisions.

Sfas 133's Definition of a Derivative Instrument

In 1998, the Financial Accounting Standards Board (FASB) issued Statement on Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities, which is effective for companies with fiscal years beginning after June 15, 2000. SFAS 133 establishes new accounting and reporting rules for derivative instruments, including derivatives embedded in other contracts, and for hedging activities. Derivatives must now be reported at their fair values in financial statements. Gains and losses from derivative transactions must be reported currently in income, except from those transactions that qualify as effective hedges.

According to Statement on Financial Accounting Standards (SFAS) 133, a derivative instrument is defined as a financial instrument or other contract that represents rights or obligations of assets or liabilities with all three of the following characteristics:

• It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the settlement amount of the derivative. An underlying is a variable (i.e., stock price) or index (i.e., bond index) whose market movements cause the fair value market or cash flows of a derivative to change. The notional amount is the fixed amount or quantity that determines the size of the change caused by the change in the underlying; possibly a number of currency units, shares, bushels, pounds, or other units specified in the contract. A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.
• It requires no initial net investment or an initial net investment that is smaller than would be required for other types of similar instruments.
• Its terms require or permit net settlement. [SFAS 133, paragraph 6]

Users of Derivatives

The derivatives market serves the needs of several groups of users, including those parties who wish to hedge, those who wish to speculate, and arbitrageurs.

• A hedger enters the market to reduce risk. Hedging usually involves taking a position in a derivative financial instrument, which has opposite return characteristics of the item being hedged, to offset losses or gains.
• A speculator enters the derivatives market in search of profits, and is willing to accept risk. A speculator takes an open position in a derivative product (i.e. there is no offsetting cash flow exposure to offset losses on the position taken in the derivative product).
• An arbitrageur is a speculator who attempts to lock in near riskless profit from price differences by simultaneously entering into the purchase and sale of substantially identical financial instruments.

Other participants include clearinghouses or clearing corporations, brokers, commodity futures trading commission, commodity pool operators, commodity trading advisors, financial institutions and banks, futures exchange, and futures commission merchants.

Types of Derivative Instruments

Derivative instruments are classified as:

• Forward Contracts
• Futures Contracts
• Options
• Swaps

Derivatives can also be classified as either forward-based (e.g., futures, forward contracts, and swap contracts), option-based (e.g., call or put option), or combinations of the two. A forward-based contract obligates one party to buy and a counter party to sell an underlying asset, such as foreign currency or a commodity, with equal risk at a future date at an agreed-on price. Option-based contracts (e.g., call options, put options, caps and floors) provide the holder with a right, but not an obligation to buy or sell an underlying financial instrument, foreign currency, or commodity at an agreed-on price during a specified time period or at a specified date.

Forward Contracts Forward contracts are negotiated between two parties, with no formal regulation or exchange, to purchase (long position) and sell (short position) a specific quantity of a specific quantity of a commodity (i.e., corn and gold), foreign currency, or financial instrument (i.e., bonds and stock) at a specified price (delivery price), with delivery or settlement at a specified future date (maturity date). The price of the underlying asset for immediate delivery is known as the spot price.

Forward contracts may be entered into through an agreement without a cash payment, provided the forward rate is equal to the current market rate. Forward contracts are often used to hedge the entire price changed of a commodity, a foreign currency, or a financial instrument. irrespective of a price increase or decrease.

Futures Contracts Futures are standardized contracts traded on a regulated exchange to make or take delivery of a specified quantity of a commodity, a foreign currency, or a financial instrument at a specified price, with delivery or settlement at a specified future date. Futures contracts involve U.S. Treasury bonds, agricultural commodities, stock indices, interest-earning assets, and foreign currency.

A futures contract is entered into through an organized exchange, using banks and brokers. These organized exchanges have clearinghouses, which may be financial institutions or part of the futures exchange. They interpose themselves between the buyer and the seller, guarantee obligations, and make futures liquid with low credit risk. Although no payment is made upon entering into a futures contract, since the underlying (i.e. interest rate, share price, or commodity price) is at-the-market, subsequent value changes require daily mark-to-marking by cash settlement (i.e. disbursed gains and daily collected losses). Similarly, margin requirements involve deposits from both parties to ensure any financial liabilities.

Futures contracts are used to hedge the entire price change of a commodity, a foreign currency, or a financial instrument since the contract value and underlying price change symmetrically.

Options Options are rights to buy or sell. For example, the purchaser of an option has the right, but not the obligation, to buy or sell a specified quantity of a particular commodity, a foreign currency, or a financial instrument, at a specified price, during a specified period of time (American option) or on a specified date (European option). An option may be settled by taking delivery of the underlying or by cash settlement, with risk limited to the premium.

The two main types of option contracts are call options and put options, while some others include stock (or equity) options, foreign currency options, options on futures, caps, floors, collars, and swaptions.

• American call options provide the holder with the right to acquire an underlying product (e.g., stock) at an exercise or strike price, throughout the option term. The holder pays a premium for the right to benefit from the appreciation in the underlying.
• American put options provide the holder with the right to sell the underlying product (e.g., stock) at a certain exercise or strike price, throughout the option term. The holder gains as the market price of the underlying (stock price) falls below the exercise price.
• An interest rate cap is an option that allows a cap purchaser to limit exposure to increasing interest rates on its variable-rate debt instruments.
• An interest rate floor is an option that allows a floor purchaser to limit exposure to decreasing interest rates on its variable-rate investments.

Generally, option contracts are used to hedge a one-directional movement in the underlying commodity, foreign currency, or financial instrument.

Swaps A swap is a flexible, private, forward-based contract or agreement, generally between two counter parties to exchange streams of cash flows based on an agreed-on (or notional) principal amount over a specified period of time in the future.

Swaps are usually entered into at-the-money (i.e. with minimal initial cash payments because fair value is zero), through brokers or dealers who take an up-front cash payment or who ad just the rate to bear default risk. The two most prevalent swaps are interest rate swaps and foreign currency swaps, while others include equity swaps, commodity swaps, and swaptions.

• Swaptions are options on swaps that provide the holder with the right to enter into a swap at a specified future date at specified terms (stand-alone option in a swap) or to extend or terminate the life of an existing swap (embedded option on a swap).

Swap contracts are used to hedge entire price changes (symmetrically) related to an identified hedged risk, such as interest rate or foreign currency risk, since both counter parties gain or lose equally.

Risk Characteristics of Derivatives

The main types of risk characteristics associated with derivatives are:

• Basis Risk This is the spot (cash) price of the underlying asset being hedged, less the price of the derivative contract used to hedge the asset.
• Credit Risk Credit risk or default risk evolves from the possibility that one of the parties to a derivative contract will not satisfy its financial obligations under the derivative contract.
• Market Risk This is the potential financial loss due to adverse changes in the fair value of a derivative. Market risk encompasses legal risk, control risk, and accounting risk.

Bibliography

Hull, John. (1998). Introduction to Futures and Options Markets, 3rd ed. Upper Saddle River, NJ: Prentice Hall.

Kolb, Robert. (1995). Futures, Options and Swaps, 2nd ed. London: Blackwell.

Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivatives Instruments and Hedging Activities. (1998). Norwalk, CT: Financial Accounting Standards Board (FASB).

[Article by: PATRICK CASABONA]