What are financial derivatives?

This weekend my wife convinced me to see Michael Moore's movie about Capitalism. It had its good points, its bad points, and its silly points. One of the silly points was multiple purportedly smart people finding that they couldn't explain what a financial derivative was.

So I decided to see if I could come up with an easy to understand explanation. And then explain the risks and benefits in (hopefully) common sense terms.

A financial derivative is a contract that has value based on what some other thing might do.

Let me illustrate with a concrete example. A put is a binding contract saying that person A can sell person B something at a fixed price on a fixed date. There is no obligation to sell. But if A wants to sell, B has to buy at that price. No matter what the current price happens to be.

Why would someone buy or sell one of these? Well suppose I bought some stock whose price I think will fluctuate, but which I think will wind up higher. So I think I'll make money, but just in case I can buy puts at somewhat below the current stock price as insurance. If the stock goes down I can sell the stock at the pre-agreed price, and I limit my losses. Conversely the person who sells me the put doesn't think the price will go down either, which is why they are happy to sell me my insurance.

Please note this carefully. Neither the buyer nor seller here believes the put will be used. Therefore it can be purchased cheaply. (This is why it makes a good insurance policy.) Yet the put has value to the buyer and risk to the seller, and therefore money has to trade hands for the contract to be worthwhile to both.

The next thing to notice is that virtually any type of contract you can dream up can be made into a derivative. For instance if you want you can do the reverse of a put. Rather than saying that B has to buy from A at a fixed price, you can say that B has to sell to A at that price. Those actually more popular and are called calls.

Both puts and calls are called options because they give someone the option (but not obligation) to do something at some point in the future. In fact the options that are given to employees are almost always calls. (Almost, but not actually always. One job rewarded me with a contract that was carefully constructed to legally be a bond, and not a call. That was done for tax reasons.)

Now a warning about derivatives. In theory derivatives can be used to limit and manage risk. Supporters generally introduce derivatives by illustrating how all parties to them can use them to manage risks. However they can also be used to create and concentrate risk very rapidly. For instance if you sell many puts very cheaply and then the price of the stock falls, you can quickly be out an insane amount of money. This is not a hypothetical risk. Every so often a rogue trader will accidentally destroy a bank or other large financial institution by making big options trades that go sour. A good example is Barings Bank. Let me stress that this typically happens by accident, not intent. (Usually, as with that case, someone does something stupid, loses money, then keeps doubling up their bet hoping to get out of trouble. If the string of bad bets goes long enough, the company goes broke. Which makes me wonder how many mistakes are made then are successfully corrected without anyone being the wiser...)

So derivatives are contracts. People can buy and sell them. But how should you price them? Well the standard answer for puts and calls is to apply the Black-Scholes pricing model. I won't go into the math, but here is the idea. What they do is construct a portfolio that, managed very carefully, will in the end come to the same effect as a put or call. The price of this portfolio is theoretically the price of the option. Why? Well if the portfolio is less than the option, then you can buy the portfolio and sell the option, manage the portfolio, and you make a guaranteed profit. (Making some combination of trades with guaranteed profit is called arbitrage, and people on Wall St are very, very interested in finding opportunities to do this because arbitrage is free money.) Conversely if the portfolio costs more than the option you can buy the option, sell the portfolio, manage the portfolio and again make money. So in an efficient market the prices have to match.

OK, this is all well and good. Now let's move on to something more fun. Given that the complexity of derivatives are only limited by the imagination of the people writing the contract, here is no shortage of interesting possibilities. Let us focus on swaps.

A swap is just an agreement for two parties to trade things of equal, or close to equal, value at the time of the trade. There are many kinds of swaps traded today. Some are traded with insane volumes. For instance foreign exchange swaps trade money between currencies today in return for a reverse trade tomorrow. This is done to the estimated tune of $1.7 trillion (USD) per day! (The primary purpose is to transfer money at close of business from traders in New York to Tokyo, then from Tokyo to England, then back to New York. That way money can be used to make money 24 hours a day.) But let's take something different. I'll look at an example of two companies swapping mortgages.

Our scenario is that a US company is building a skyscraper in Japan. At the same time a Japanese company is building a skyscraper in the USA for approximately the same price. Neither has sufficient cash on hand to fund this, so each needs a mortgage. (This would likely be done with bonds, but let's not worry about that detail.) But rather than each taking out a mortgage in the other currency, let's say that they enter into a contract to swap the financial obligations - the US company pays the mortgage on the US building, while the Japanese company pays the mortgage on the Japanese building. That's a swap.

Well they certainly swapped something. But what is the point?

The point is that neither wants to have to worry about exchange rates. The mortgage on the Japanese building will be in yen. The mortgage on the US building will be in dollars. The US company has a reliable stream of dollars coming in in their future, but doesn't know how much to set aside to meet an obligation priced in yen. The Japanese company has the reverse situation. It is easier for each to budget and plan for an expense in their own currency, and so they'd each prefer to pay the other's mortgage.

It is important to stress that this is not just a convenience. When the companies go to the banks, the banks will recognize the exchange rate risk and that will affect the rates the companies can get. A US company can therefore get a loan in US dollars at a better interest rate than the Japanese company can. Conversely the Japanese company can get a loan in yen at a better interest rate than a US company can. So after the companies swap mortgages, each gets a better interest rate than they could otherwise get. And since both save on their interest payments, both write down immediate profits from making that swap.

This is one of the most important and counter-intuitive points to understand about financial derivatives. Two companies entered into a contract, and both wrote down an immediate profit. Nothing is faked here. Real money is saved in their monthly bills. That saving can be calculated, and as a result the company is better off. Over time the exchange rates will likely move and as a result one probably makes money and the other eventually loses on the deal. But on day 1, both marked down a profit and the profit is real.

Now if there is one thing that gets the attention of people in finance, it is the ability to manufacture money out of thin air. That apparently happened here. It is therefore worth repeating that this example has been studied to death and generally accepted accounting rules agree that both companies get to write down immediate profits in this case.

Of course you can only set this up if the conditions are just right. These profits aren't particularly easy to find. But once you've seen a way to do it, people can set them up over and over again. And over time the financial wizards found cases where companies could write private contracts and claim an immediate profit. As with the swap described there was inevitably long-term risk associated. But who wants to turn down free profits?

Now here we have a critical danger. With many financial derivatives people enter into complex contracts which, based on some complex theory, they think entitles them to write down a profit. However the investments take time to pan out, and come with significant risks. Worse yet there is the very real possibility that people will write down profits that aren't real due to honest mistakes. And if someone honestly overvalues the value of a particular kind of contract, they will enter into that kind of contract over and over again, writing down fake profits each time. (And getting paid correspondingly large bonuses for finding such great deals!) As a result in the end even the smartest people in the world can find themselves unable to truly measure the risks a given company is taking.

If you think I am exaggerating, go read what one of the greatest investors ever has to say about financial derivatives. There is a section about derivatives that starts on page 14 of this PDF from Berkshire-Hathaway. When Warren Buffett wanted to talk about financial derivatives in 2002, the first point he made was, Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. He then goes on to explain many of the same points that I have. His common sense comments are well worth reading by anyone who wishes to make sense of the recent financial crisis.

Now let's move on to securitization. Securitization starts with a bunch of things with promised future payments that may or may not materialize. The things could be loans on houses, credit card debt, student loans, risky bonds - as long as it is a stream of future payments it is meat for the grinder. Typically each thing is a stream of relatively small payments that lasts for a long time. An issuer takes a whole bunch of these, and puts them together in a deal. A deal likely will have a long stream of big payments. Technically a deal is a very carefully set up corporation whose assets are the things that go into the deal, and whose likely future revenue is used to issue a series of bonds. Each bond is a stream of payments that ends once a particular amount of money has been delivered. The first bonds issued are very likely to be worth full face value, and the last ones are unlikely to make much money. For technical reasons the different kinds of bonds are of interest to different investors.

A financial security is any financial instrument that can be traded. The loans etc that go into a deal can't be traded in any kind of open market. The bonds that come out of the deal can. Therefore this process creates securities out of debt, hence the name securitization.

When the deal is set up right, the loans, etc that go into the deal can be purchased for less than the bonds sell for, and the issuer gets to write down an immediate profit. If the deal is correctly modeled, every purchaser gets a known amount of possible future profit with a clearly understood associated risk. Everyone wins.

Given recent bad press it is worth pointing out that securitization has been around for a while and until recently it worked out well for most of us. Whether or not we were aware of it.

Securitization is really a mechanism for diversifying risk. Before securitization took hold, mortgages would be held by the local issuing bank. This meant that if a local area's economy took a nose dive, the local banks would get seriously hurt and sometimes got wiped out. This would restrict the availability of credit for a long time following, and made eventual economic recovery much, much slower.

Since the 80s things have been very different. Banks now sell their loans on to Wall St, which turns them into securities. This means that if a local economy collapses, like Pittsburgh's when the steel industry left or Michigan's with the auto industry troubles, local banks are much less likely to collapse with it. And they can continue to offer credit, which makes it much easier to recover down the road. Therefore securitization has made local economies much more resilient than they otherwise would be.

But, as we all know, there is a fly in the ointment. In the case of sub-prime mortgages we had bad risk models. Thanks to those risk models companies could write down easy profits while not understanding the size of the risks they were taking on. And in their pursuit of profit, they repeated the mistake over and over again. As a result widespread acceptance of securitization wound up replacing the risk of fairly frequent nasty local economic collapses with the risk of relatively rare nasty global collapses. Luckily with the last one having been averted. (So far, anyways.)

So there we have it. Financial derivatives are just contracts. People enter into them for all sorts of reasons. They are traded in large volumes. They can be arbitrarily complex. They can mitigate or create risk. We have theories on how to price them. When financial derivatives are set up correctly, apparently free money is created. This money comes with associated risk. Honest mistakes about the pricing or risks can lead to disaster. Warren Buffett has written on this topic with extreme warnings about this exact issue. Securitization is a way of bundling lots of little streams of cash into nice bonds. Securitization brought us increased local financial stability, which has been to our general benefit. But systemic mistakes in securitization also brought us a real risk of global collapse.

If you understood that then you likely understand financial derivatives better than half the talking heads you see on TV. And you definitely understand them better than Michael Moore appeared to in his movie.