The next time you're in a conversation about investing, mention “swaps and other derivatives” and see what happens. You could get some strong reactions from otherwise levelheaded people, many of whom probably know very little about these instruments.
Derivatives have been cited as a major cause of the 2008 financial crisis and have been described as “weapons of mass destruction” and “time bombs” by some famous investors. So it's understandable to think of derivatives as the Ebola virus of financial instruments, not to be touched without head-to-toe protective gear.
But is “toxic” really a fair way to describe them?
Reality check: Derivatives are simply tools used every day by thousands of companies, banks and investors to achieve various objectives. When used wisely, they are extremely helpful, and sometimes you can't get the job done without them.
But they can also be quite dangerous, financially speaking.
In a way, using derivatives is like lighting a fire: necessary if you want a nicely grilled steak, but without the right controls, you can burn down the house.
In this article, we take a quick tour of the world of derivatives. We try to demystify them, explain how they can be useful, and show how you could get burned if you're not careful.
What Are Swaps?
We begin with swaps. As the name suggests, a swap is an agreement between two parties to exchange something, in this case, money. Payments are exchanged periodically — often quarterly, but not necessarily — for some number of years.
The most common type is an interest rate swap, in which the two parties exchange interest payments. In one type, one party makes payments based on a floating rate of interest that moves up or down each period. This is similar to the interest rate mechanism on an adjustable rate mortgage. The other party makes payments at a fixed rate of interest.
There are many reasons this can be helpful to both parties. For example, a business can lock in its interest costs even though its bank loan has a variable interest rate.
Interest rate swaps can get more complicated, but this is the most common type of swap. It is so straightforward it is called a “plain vanilla” swap.
With currency swaps, payments are exchanged in two different currencies. Typically, these are used by companies that make or receive payments in a foreign currency and want to lock in an exchange rate in advance.
There are other ways to manage foreign exchange risk. A currency swap is just one approach. Individual investors who want to trade currencies wouldn't use currency swaps.
The Danger of Credit Default Swaps
Credit default swaps (CDSs) are the ones most often blamed for contributing to the financial crisis. With CDSs, one party makes periodic payments for protection in the event that a specific company or government defaults on its debt or that a pool of loans exceeds a certain level of defaults. It's like paying homeowner's or car insurance premiums. If your house or car is damaged, you receive a payoff from your insurance company. In CDS Land, the insurance company is called the “protection seller.”
What's so dangerous about CDSs?
If bad things happen in the economy, a lot of loans could default (think home mortgages in Florida and Las Vegas in 2008). If a protection seller had made a lot of deals with CDS holders, they may not have enough money to make good on its agreements.
Those who paid the periodic “insurance” premiums on those CDSs had been counting on the payouts to cover their own losses in a bad economy, but now the money isn't there. Domino effect time.
The problem here is known as “counterparty risk.” This is the risk that the other party in the deal can't pay when they're supposed to. After the financial crisis, many new procedures and rules were created to reduce counterparty risk in the global financial system.
Right about now you may be thinking, “What does this have to do with me? I'm not going to use these things.” Perhaps not directly. But if you invest in stocks, there's a good chance a company whose stock you own uses interest rate and/or currency swaps, and maybe even CDSs.
Some mutual funds use all kinds of swaps to achieve various investment objectives. If you read a mutual fund's annual report, you may see them listed. A key thing to remember is swaps can be used for protection but also to make speculative bets. “Protection” for one party can be “speculation” for another.
What Are Futures?
Next on our tour are futures. With futures contracts, you lock in a price today for something you are now obligated to buy or sell some months in the future, unless you “close out” your position by selling what you originally bought, or buying what you originally sold.
Futures have been used for hundreds of years by farmers to secure a price for their crops long before the actual harvest. Buying or selling futures contracts is one of the easiest and sometimes the only way for investors to place a pure bet on the prices of about 50 commodities, such as crude oil, gold, coffee, livestock and soybeans.
Imagine you expect oil prices to increase and want to profit from that. You can't buy and store barrels of oil in your garage, but you can buy crude oil futures contracts. The same applies to gold and other metals, as well as agricultural products When storage is a big problem, we use futures.
You can also take a position that a commodity's price will fall by selling (shorting) futures contracts.
Futures also exist for Treasury securities and the Fed Funds Rate. This is a way of hedging or speculating on the direction of interest rates.
The risks of futures contracts are minimized by the fact that they trade on an exchange. Buyers and sellers have to “settle up” with the exchange every day, based on whether their futures contracts gained or lost value that day. A problem arises if you forget to sell your contracts before the “expiration date.” Then you do have to find a place to store those barrels of oil or bushels of soybeans that will be delivered to you.
Once in a while, someone tries to manipulate commodity prices by buying or selling huge numbers of futures contracts. For fun, you can read about the famous case of the ultra-wealthy Hunt brothers trying to corner the silver market.
What Are Options?
Finally, we turn to options. As explained in our Options Primer, options give you the right but not the obligation to buy or sell something. This usually involves a stock or a stock market index like the S&P 500. But you can also buy and sell options on Treasury bonds, currencies and commodities. The option sets the price today that you will pay (or receive) in the future.
Using options requires far less money up front than purchasing the underlying stock. You can use options in ways that limit your potential loss (buying calls or puts). But you can be exposed to big or even unlimited losses (selling puts or “naked” calls).
All of these derivatives, especially options, involve the concept of leverage. Without going into the details, using derivatives is like borrowing money to buy something using very little of your own money. If the value of the thing goes up, your return can be very large. If it goes down, you could be wiped out.
All derivatives can be used to reduce risk or to speculate. It just depends on how you use them. As with fire, derivatives can generate some nice heat for your portfolio. But be careful not to burn down the house.