Commodity and Equity derivatives
Commodity derivatives
Commodity derivatives function much as commodity options, allowing the buyer to lock in a price for the commodity in return for a premium payment. Commodity options can also be combined with other sorts of options into multi-asset options. For example, an airline might feel that it could withstand higher fuel costs at most times, but not at a time of economic slowdown, which depresses air travel. The airline might therefore purchase a derivative that would entitle it to purchase aviation fuel at a specified price whenever a key interest rate is above 7% (at which point the economy is presumably slowing), but not at other times.
Trading in commodity derivatives is small relative to trading in interest-rate and currency derivatives. At the end of 2004, the notional value of all commodity derivatives outstanding was $1.4 trillion. Gold accounted for one-fifth of this amount; undisclosed “other commodities”, presumably mainly oil, made up almost all the rest.
Equity derivatives
Over-the-counter equity derivatives are traded in many different ways. Synthetic equity is aderivative designed to mimic the risks and rewards of an investment in shares or in an equity index. For example, an American firm wishing to speculate on European telephone-company shares could arrange a call option on a synthetic basket whose value is determined by the share prices of individual telephone companies. Synthetic equity can be used, among other purposes, to permit an investor such as a pension fund to take a position that it could not take by purchasing equities, owing to legal restrictions on its equity holdings. Step-down options on shares or equity indexes provide for the strike price to be adjusted downwards either at a specific date or if the price of the underlying falls to a predetermined level. Total return swaps are interest-rate swaps in which the non-floating-rate side is based on the total return of an equity index.
Credit derivatives
Credit derivatives are a comparatively new development, providing a way to transfer credit risk, the risk that a debtor will fail to make payments as scheduled. One type of credit derivative, a default swap, provides for the seller to pay the holder the amount of forgone payments in the event of certain credit events, such as bankruptcy, repudiation or restructuring, which cause a particular loan or bond not to be serviced on time . Another way of achieving the same end where publicly traded debt is concerned is a swap based on the difference between the price of a particular bond and an appropriate benchmark. If a given ten-year corporate bond loses substantial value relative to a group of top-rated ten-year corporate bonds, its credit standing is presumed to have been impaired in some way and the swap would cover part or all of the owner’s loss, even if the company does not default on its debts.
Structured securities
These are synthetic securities created from government bonds, mortgages and other types of assets. The “structure” refers to the fact that the original asset can be repackaged in forms whose components have very different characteristics from one another, as well as from the underlying. The value of such securities depends heavily on option characteristics. For example, the owner of an interest-only (io) security receives the interest payments, but not the principal payments, made by the issuer of the underlying security; if the issuer is able to prepay the underlying security before its maturity date, the value of the interest-only portion may collapse as no more interest payments will be received. The owner of a principal-only (po) security, however, would applaud prepayment, as it would receive the principal to which it is entitled much sooner. It is not possible to determine the notional amount of each type of derivative that is outstanding or that has been written in a given year.
Commodity derivatives function much as commodity options, allowing the buyer to lock in a price for the commodity in return for a premium payment. Commodity options can also be combined with other sorts of options into multi-asset options. For example, an airline might feel that it could withstand higher fuel costs at most times, but not at a time of economic slowdown, which depresses air travel. The airline might therefore purchase a derivative that would entitle it to purchase aviation fuel at a specified price whenever a key interest rate is above 7% (at which point the economy is presumably slowing), but not at other times.
Trading in commodity derivatives is small relative to trading in interest-rate and currency derivatives. At the end of 2004, the notional value of all commodity derivatives outstanding was $1.4 trillion. Gold accounted for one-fifth of this amount; undisclosed “other commodities”, presumably mainly oil, made up almost all the rest.
Equity derivatives
Over-the-counter equity derivatives are traded in many different ways. Synthetic equity is aderivative designed to mimic the risks and rewards of an investment in shares or in an equity index. For example, an American firm wishing to speculate on European telephone-company shares could arrange a call option on a synthetic basket whose value is determined by the share prices of individual telephone companies. Synthetic equity can be used, among other purposes, to permit an investor such as a pension fund to take a position that it could not take by purchasing equities, owing to legal restrictions on its equity holdings. Step-down options on shares or equity indexes provide for the strike price to be adjusted downwards either at a specific date or if the price of the underlying falls to a predetermined level. Total return swaps are interest-rate swaps in which the non-floating-rate side is based on the total return of an equity index.
Credit derivatives
Credit derivatives are a comparatively new development, providing a way to transfer credit risk, the risk that a debtor will fail to make payments as scheduled. One type of credit derivative, a default swap, provides for the seller to pay the holder the amount of forgone payments in the event of certain credit events, such as bankruptcy, repudiation or restructuring, which cause a particular loan or bond not to be serviced on time . Another way of achieving the same end where publicly traded debt is concerned is a swap based on the difference between the price of a particular bond and an appropriate benchmark. If a given ten-year corporate bond loses substantial value relative to a group of top-rated ten-year corporate bonds, its credit standing is presumed to have been impaired in some way and the swap would cover part or all of the owner’s loss, even if the company does not default on its debts.
Structured securities
These are synthetic securities created from government bonds, mortgages and other types of assets. The “structure” refers to the fact that the original asset can be repackaged in forms whose components have very different characteristics from one another, as well as from the underlying. The value of such securities depends heavily on option characteristics. For example, the owner of an interest-only (io) security receives the interest payments, but not the principal payments, made by the issuer of the underlying security; if the issuer is able to prepay the underlying security before its maturity date, the value of the interest-only portion may collapse as no more interest payments will be received. The owner of a principal-only (po) security, however, would applaud prepayment, as it would receive the principal to which it is entitled much sooner. It is not possible to determine the notional amount of each type of derivative that is outstanding or that has been written in a given year.
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