Appendix B

Derivatives

Many Diversified Financials, Insurance and Banking companies use derivatives to alter the characteristics of assets, to hedge risks and to take bets. This often makes their balance sheets difficult to digest because you can’t take the numbers at face value. For example, an investment bank could disclose zero net exposure to Greek sovereign debt, but in reality, it could have $15 billion in gross exposure and $15 billion in insurance on the exposure, which collectively nets to zero. Other common tactics include altering cash flows via interest rate contracts or hedging currency risk with foreign currency swaps.

At face value, the derivatives market is the largest market in the world. As of November 2011, the estimated notional value of over $707 trillion dwarfs the combined value of the $56.5 trillion global stock market and $98.7 trillion global bond market.1 Considering the complex nature of derivatives, this may seem daunting, but the reality is $707 trillion is a useless number. Here’s why.

INTEREST RATE CONTRACTS

The vast majority of the derivatives market consists of interest rate contracts. For the most part, these contracts simply swap cash flows—fixed for variable. There is no risk to principal, and no money changes hands other than the difference between cash flows at the end of the contractual period. The large notional value simply represents the principal amount used to determine the contracted cash flows.

For example, you may want to swap the 2.50% fixed rate on a $10 million US Treasury note for a variable rate—let’s assume 2.49%. If rates didn’t move over the 10-year period, the total money changing hands would be the difference between 2.50% and 2.49% over the 10-year period (around $1,000 per year). But the notional amount of the contract would be $10 million, vastly overstating the potential impact of the contract.

In 2011, interest rate contracts had a notional value of $553 trillion, but the market value of these contracts amassed to just $14.6 trillion—only 3% of the notional value.2 Although $14 trillion is still a large number, even this is overstated since the gross credit exposures of total over-the-counter derivatives is just $3.5 trillion—gross notional takes into account bilateral netting agreements.3 This implies the interest rate swap market is valued closer to just $2 trillion.4

To varying degrees, other types of derivatives follow a similar pattern. There is the notional value, which is the value from which derivatives derive their values—hence the name. There is the market value, which is the replacement cost of the contracts. And then there is the credit exposure, which is net of legally enforceable bilateral netting agreements. Table B.1 shows the various types and values of the global derivatives market in June 2011.

Table B.1 Global Derivatives Market

Source: Bank for International Settlements, “OTC Derivatives Market Activity in the First Half of 2011” (November 16, 2011): www.bis.org/publ/otc_hy1111.htm.

CREDIT DEFAULT SWAPS

Imagine you were a bank and had a $100 million loan portfolio, which we will simply refer to as an asset. This asset contains an element of credit risk, and for some reason, you don’t want to be exposed to the credit risk (risk of default) anymore. But you can’t sell the asset—perhaps due to an illiquid market or because you’re bound by contract. Since you can’t sell, instead, you can purchase an insurance contract on the asset, protecting you from the credit risk.

With the insurance, if your asset defaults, the insurance company would indemnify you (make you whole). The cost of this insurance is an annual fee, but you’re more than happy paying the fee if you’re protected against default. This process, as a whole, is a credit default swap (CDS)—an insurance contract against a credit event.

Let’s say a year later, you decide you no longer want the credit protection, but you’re bound by the CDS agreement. Instead of attempting to sell the contract (which isn’t possible in many cases due to the unique nature of many contracts) or potentially paying a fee to back out of the deal, you enter into an offsetting agreement. Instead of buying insurance, you sell insurance on the same asset. This way, your long position offsets your short position, and your net exposure is that of your original position.

Unlike interest rate swaps, CDS do have a larger degree of credit risk associated with them since principal values are at risk, not just cash flows. In the same example, let’s say there was a credit event, your asset defaulted and the recovery value was 50%. Your counterparty to the CDS contract would be responsible for making you whole—either by taking possession of the asset and indemnifying you or by giving you the difference between the asset’s original value and the recovery value.

But what if your counterparty can’t make good on that obligation? You lose! Sure, you can take legal action against the counterparty, but if the counterparty defaulted on his obligation, it’s likely because he’s already in a bad situation. This is why it’s more important to pay attention to counterparty risk in the CDS market than in the interest rate swap market. If your counterparty in the interest rate market defaults, you are simply out a certain degree of cash flow, which can hurt. But if your CDS counterparty defaults, you could be out a large sum of principal, which can be devastating. Moreover, if you’re using the CDS to alter the risk characteristics of your asset for regulatory capital purposes, things get even trickier. (Read more on the risk weighting of assets in Chapter 2.)

OTHER

Foreign exchange-, commodity- and equity-linked contracts are much less mysterious than CDS or interest rate swaps. They are contracts allowing for hedging or betting on the direction of currencies, commodities or equities.

Notes

1. Bank for International Settlements, “Securities Statistics and Syndicated Loans” (March 2012), www.bis.org/statistics/secstats.htm (accessed March 30, 2012); World Federation of Exchanges Monthly Statistics, as of 12/31/2011, http://world-exchanges.org/statistics/monthly-reports (accessed March 30, 2012); Bank for International Settlements, “OTC Derivatives Market Activity in the First Half of 2011” (November 16, 2011), www.bis.org/publ/otc_hy1111.htm (accessed March 30, 2012).

2. Bank for International Settlements, “OTC Derivatives Market Activity in the First Half of 2011” (November 16, 2011), www.bis.org/publ/otc_hy1111.htm (accessed March 30, 2012).

3. Ibid.

4. See note 2.