Monday, September 29, 2008

Derivatives and Swaps

Here's how derivatives derive their value - and their risk. Say you don't buy General Electric stock, but instead buy a call on GE, an option entitling you to buy GE for a specified time at a specified price. From then on the value of your call - your derivative - is going to be determined by what happens to the price of GE stock, which in trading lingo is known as ''the underlying.'' The cost of the call, or the premium, will be relatively small and give you great leverage if the stock does well. But if the stock loafs or falls, the call could be worthless. The meat and potatoes of the derivatives business is a kind of forward contract called a swap, which we will explain by momentarily benching the dealer community. Instead, imagine two homeowners, each holding a mortgage not entirely to his satisfaction. Joe's mortgage, whose principal value is $100,000, has a fixed 8% rate. Chuck's mortgage, also $100,000, has a floating rate, tied to Treasury bills and currently costing him 8% as well. But Chuck worries that interest rates are going to go up. Joe thinks they could go down. So they ''swap'' their interest positions (that is, swap floating for fixed), agreeing to settle up between themselves every quarter, depending on what interest rates have done in the meantime. In effect, the deal sets up a series of forward contracts, each covering a quarter. Chuck must pay money to Joe if interest rates go down, and Joe must pay off if they go up. Even if Chuck emerges the loser, he has eased his mind by putting a cap of 8% on the interest rate he will have to pay.

This is a simple explanation of derivates and swaps.  Since it can be complicated regulators are adamantly insisting these days that CEOs, and their boards, do understand what is going on in the derivatives operations beneath them. The Office of the Comptroller of the Currency issued 26 pages of guidelines last October as to how national banks should manage the risks of their derivatives business and specifically mentioned more than a dozen times how responsibilities for these fall on the banks' boards.

Let’s see if anyone goes to jail.  I wouldn’t take a derivative on this one.


Gilmoure said...

Followed a link posted over at David Brin's Blogspot.

Thanks for providing a simplified explanation for what's going on. I've been following several papers, trying to figure this stuff out and feel like a dog watching a cricket match. I grok the ball but that's about it.

Mark Joseph said...

I think I'm slowly picking this nonsense up.

Question: Can you explain, as nicely as you have everything else, the relationship between these derivatives/swaps and the mess the country is now in?

Specifically, who gets what out of these default swaps? What's in it for both sides and what went wrong?

Chip Ahoy said...

Thank you for your effort.