WFU Law School
Law & Valuation
4.4.3 Option Applications

4.4.4 Other Derivatives

Options are derivatives in the sense that their value is derived from an underlying security. However, as the term derivative is commonly used, it refers to only instruments that are not traded on an organized exchange and whose terms are negotiated contracts between two persons called counterparties.

Forward Contracts. Derivatives were born as a method for buyers and sellers of agriculture products to manage price risks. Before the advent of derivatives, the prices of commodities, such as grain, constantly changed as the price would fall when farmers flooded the market at harvest and then spike up as shortages developed at other times in the year. To get around these problems, buyers and sellers entered into contracts for the delivery of specific quantities on specific dates. For example, before even putting seed in the ground, a farmer might contract to sell his crop at a specific price at the end of the growing season. As the price is locked in, the farmer can budget how much he can spend on labor and supplies while ensuring some margin for profit. From another perspective, a baker can contract to provide breads for customers and then lock in a price to pay for the grain and guarantee a profit. Such agreements are called forward contracts, or futures. They are similar to options, but a key difference is that such contracts obligate performance from the parties while an option holder merely has a right, not an obligation, to perform or require performance from another party.

Financial Futures. Financial futures are the largest component of all futures trading. In 1982, the Kansas City Board of Trade introduced a stock index futures contract whose value derived from the price of the Value Line Stock Index. Soon, contracts were formed using the S&P, Dow Jones index, and NYSE. Financial futures differ from their more traditional brethren in two key ways. First, no assets are delivered in conjunction with the contract. Instead, settlement in financial futures is accomplished through the payment of the cash difference between the price at which the contract was purchased and the value of the underlying asset on the trading day. A second difference is that financial futures feature a pay-as-you-lose system. Essentially, this means at the end of the day, the value of the contract is determined, and the losing party must pay the other as losses are accrued. This process is called marking to market.

Exotic Derivatives. Recently, the commodities trading industry has grown edgy due to the diminished importance of pork bellies, crude oil and other physical commodities. The response has been the development of non-traditional and sometimes exotic derivatives. For example, once-powerful Enron launched the first major bandwidth market in 2000. In these transactions, a data carrier with unused network capacity sells that capacity to a customer who might have a matching requirement. Perhaps even stranger and more speculative are futures contracts on weather. In September of 1999, the Chicago Mercantile Exchange initiated trades in this area. Previously, such contracts had been traded over the counter by utilities, insurance companies, snowmobile makers, and other companies. These contracts are very similar to over-under sports betting as two counterparties bet on whether the average temperature will be higher or lower than a set number.

Swaps. Another popular type of derivative is a swap. A swap is an agreement between two businesses to exchange commodities, payments, or other financial products to reduce the risk of volatile market conditions or to obtain a better price or rate. For example, an interest rate swap is an arrangement that requires both sides of the transaction to make payments to each other based on two different interest rates. Commonly, these require one party to pay a fixed rate of interest while the other pays a floating rate. Swaps are frequently used by banks and debt issuers to manage credit risk. Loan portfolio swaps allow two relatively non-diversified banks to diversify their loan portfolios by swapping the loan payments of a portion of the portfolio for the payments from a portion of another bank's portfolio. However, the most common credit swap is the total return swap. In this arrangement, a bank will swap the return from its loan portfolio with an insurance company which agrees to pay an adjustable rate interest payment to the bank. Thus, if the adjustable rate is 200 basis points greater than the 3-month T-bill rate, the bank is assured of this return while the insurance company takes the chance that the banks' portfolio will provide a return greater than this.

Regulation. The world of derivatives has come under intense scrutiny of late prompted by the sensational bankruptcy of Enron. The key debate is over who should regulate derivatives trading practices. At present, the Commodity Futures Trading Commission regulates futures contracts, and with the SEC, oversees options that are traded on exchanges. Derivatives traded over-the-counter or off-exchange are not monitored in the same way, and how they are monitored depends on who the counterparties are. For example, the FDIC can examine the activity of commercial banks, and the SEC can scrutinize the business of U.S. brokers. The problem in regulation, however, comes with large corporations, like Enron, who do not fit into any of the defined categories and fall through the regulatory cracks. The call for more regulation is not new, as during the 1990s, the derivative-related financial disasters of Bankers Trust New York, Orange County, CA, and Long-Term Capital Management, prompted a backlash against this unregulated area. For an example of the lack of regulation in these transactions, see The Proctor and Gamble Company v. Bankers Trust Company , 925 F.Supp.1270 (SD Ohio, 1996) (concluding the interest rate swaps entered into by the parties did not fall into the SEC's territory and were exempt from the Commodity Exchange Act).

Recently, the Genreal Accounting Standards board has urged state and local governments with derivatives holdings to improve disclosures about risks. The GASB has proposed guidance for disclosure in light of the budgetary pressures that state and local governments face and the allure of speculating in derivatives. (Comments are due May 2003). The disclosure would include the derivative's purpose, terms, fair value and specific risks -- including credit, interest rate, basis, termination, rollover and market access. See www.gasb.org The proposed guidance would supersede a technical bulletin from 1994 and would update the definition of derivatives.

The call for increased regulation of derivative dealers will meet with much opposition from powerful banks and Wall Street firms. Up to now, these groups have been successful in securing an almost complete absence of oversight of over-the-counter derivatives.

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4.4.3 Option Applications

©2003 Professor Alan R. Palmiter

This page was last updated on: August 4, 2003