John W. Coughlan, PhD, CPA, CMA

Now let's explore who are the "players" in these derivatives dramas and let's ask whether these plays fulfill any "purpose." Who would get involved in these transactions and iset there any excuse for the existence of these markets?

PLAYERS

There are a great number of players in derivatives markets, including regulatory agencies (such as the SEC and the Commodity Futures Trading Commission, aka CFTC), the exchanges, the clearing houses, brokers, futures commission merchants... and many others. Some of these having been mentioned in prior pages, only three will be further discussed here: hedgers, speculators, and arbitrageurs.

Hedgers

The primary motive of the hedger is to reduce risk, not to make profit.

Vicki has a large portfolio of stocks and her portfolio looks a lot like the S&P500. She suspects the market bears a striking similarity to a bubble and, while not wanting to incur the substantial transaction costs and the big taxes that liquidating her portfolio might entail, she wants to protect herself somewhat from a precipitous plummet in prices. She is considering buying index puts on the S&P500. She will find that the "premiums" on this kind of insurance are quite high and that, unless she keeps renewing the puts, the insurance is very definitely short term. Nevertheless, it is clear that Vicki is trying to "hedge," or "cover" her bets. Her motive is to reduce the risk implicit in a large portfolio of stocks in a volatile, and possibly inflated, market.

Vicki is putting a floor under her portfolio. If the prices of stocks go way down, as she suspects might happen, the value of her portfolio will likewise go way down giving Vicki much pain. But the value of her S&P500 puts would likewise go way up and her settlement with the broker would partially offset her loss. The gain on the puts would assuage the pain on the loss. She does know that, lacking a perfect crystal ball, there is no way to know that the price of stocks may go way down in, say, the next six months so that the puts may expire worthless. Her puts, having a strike price about ten percent below the current level of the index, will not be particularly expensive in relation to the potential loss in value of her portfolio in the event of a crash. She figures that what she pays for the puts is essentially an insurance premium against the market tsunami she fears.

Old McDonald has planted many acres of wheat and is very nervous that when it reaches the market in September the price may be quite different, possibly much lower, than the commodities markets now predict for September wheat. If he can sell the wheat at the futures price for September wheat, he will be well satisfied. He sells, goes short, on September wheat. He is trying to reduce the risk of a substantial loss from a bad spot price in September. In return he is willing to forego the profit from a high spot price in September. Old McDonald is trying to reduce the risk relating to his prospective harvest.

Speculators

Joan, poor Joan, has a net worth of only $1 million. Many people would be satisfied with that net worth but Joan has the misfortune to travel in the company of basketball players, movie stars and political pros to whom $1 million is petty cash. Joan was gorgeous at 40 but now at 60 cracks mar the makeup and she is desperate to catch up financially with her "connections." They loved her when she was beautiful; will they still love her when she is old and poor?

She can invest her $1 million in the stock market or in carefully selected real estate but she doesn't believe the "irrational exuberance" of the 'ninetys and the "Bernanke bond bubble" is likely to be duplicated again in her remaining years. Yes, as a devotee of the "common stock theory of investment," she believes stocks will, in the long run continue to earn ten or eleven percent a year but even at 12 percent, it will take her six years to double her net worth. Even six years will stretch to ten because she has to pay taxes and living expenses out of the 12 percent and her social security receipts. So she will be 70 before she has a net worth of $2 million and her friends are already far above $2 million. She will be 80 before she's worth $4 million and at 80 it will take much more than $4 million to make a splash on Sunset Boulevard.

Joan has decided to get more bang for her buck by speculating with derivatives. She is going to buy calls on carefully selected high-tech stocks and she will research her tea leaves and take positions in the futures market. Yes, Joan, derivatives don't require a big investment in relation to the gains they can bring. Yes, with luck you can make a 100 percent return on your investment in a year. But bear in mind, Joan, that the losses can just as easily be 100 percent.

Do the derivative markets provide a service to the speculator? Perhaps. If you like poker and betting on the horses, you can get some of the same adrenaline highs from the derivative markets. And lows.

It is also possible that in some areas of the derivative markets there may be higher returns than in safer investments. It is a commonplace of finance theory that efficient markets may award a higher return to those areas of investment that have higher risk. It is possible therefore that the returns may be high in some areas of the derivatives markets. Possible.

Does the speculator provide a service to the derivative markets? Again perhaps. The speculator may add an element of liquidity that the market might not otherwise have. Given that the derivative markets may provide a social good, the speculator may be providing a service.

Since every futures sale, for example, must have a futures purchase, it may be useful for these markets to have speculators who can complete the transactions. Old MdDonald, anxious to sell September wheat, needs a buyer. If the millers and bakers don't want to buy, it may help the market if Joan is there to buy September wheat.

Arbitrageurs

The arbitrageur may be considered a special case of a speculator. Exploring the relationship between the prices and characteristics of various commodities, financial instruments and related derivatives and finding a misalignment, she attempts to exploit that misalignment by buying the underpriced instruments and selling the overpriced. Doing so she puts upward pressure on the underpriced instruments and downward pressure on the overpriced.

Suppose, for the sake of an unrealistically simple illustration, there is a convertible debenture selling on the market at $1,000 and that the stock into which it is convertible is worth $1,500. (The conversion privilege in this case is sometimes referred to as an "embedded" derivative; it is embedded inside a debenture.) Clearly there is a misalignment of prices here. If the stock is really worth $1,500 then the debentures must be worth more than $1,000 and presumably they are worth $1,500. If the debentures are really worth only $1,000 then the stock cannot be worth $1,500. Something is out of line here.

The arbitrageur might buy the debentures, immediately exercise the conversion privilege, receive the stock and immediately sell the stock. The arbitrageur pays out $1,000 for the debentures and receives $1,500 from the sale of the stock and is ahead $500 from the series of transactions. Note that she is not going to stop with the purchase of one debenture and the sale of the related stock. She is going to keep buying the debentures, exercising, receiving and selling until the prices get back in line. Note that her continuing purchase of the debentures will have the effect of pushing up the price of the debentures and her continuing sale of the common will depress the price of the common. Eventually there will come a time when the alignment of prices is such that she cannot continue to profit from this course of action.

Does her course of action require a very large investment? Not particularly. Note that if she moves quickly her money is tied up only a short period of time between the settlement on the debentures and the receipt of the proceeds from the sale of the stock. If she can buy the debentures and sell the stock simultaneously it is possible she can manage to simply offset the $1,000 and the $1,500 on settlement day and walk away with her $500 gain.

Is risk involved? Perhaps. If she cannot sell the stock at the same time as she buys the debentures, it is possible the stock price will decline between the time when she buys the debentures and when she sells the stock. Nevertheless, a nimble arbitrageur would not consider this a particularly risky situation.

Arbitrageurs are always on the lookout for what is called "academic" or "textbook" arbitrage. Academic arbitrage involves situations in which there is a zero outlay on day 1 and a positive gain on day 2 and where there is no risk involved. You will sometimes find discussions of misalignments between the price of a put and call and of the underlying stock such that, at the "risk-free" interest rate an arbitrageur can make a certain profit in a short period with a zero investment. These discussions turn up in finance textbooks and that is why this arbitrage is called "academic."

There are thousands of investors, mutual funds, and hedge funds tracking the relationships between various securities and watching for arbitrage opportunities. If they discover an arbitrage opportunity they will usually exploit it promptly and, in exploiting it, will usually correct the misalignment that lead to the opportunity. Don't spend too much time looking for a convertible debenture selling at substantially less than the stock into which it is convertible. Such a misalignment is too obvious and too easy to spot. More subtle relations are likely to exist at various times but as soon as a misalignment is discovered and somebody writes an article about it, the misalignment tends to disappear.

While it was said above that the arbitrageur may be considered a special case of the speculator, that statement is open to challenge as the motives of the two tend to differ. The speculator seeks a high return and tends to be willing to accept considerable risk. While the arbitrageur also seeks a substantial return, she seeks to do so by exploiting opportunities with little or no risk.

While there isn't any risk in arbitrage that truly meets the definition of "textbook" (in fact the absence of risk is the essence of the definition), when one strays from the "textbook" to the "real world" of arbitrage, risk can indeed be present. The near collapse of Long Term Capital Management (LTCM) in the Summer of 1998 illustrates the point. Many of the backers of LTCM were distinguished economists well versed in academic arbitrage and one of the purposes of LTCM was to exploit arbitrage opportunities in a variety of financial markets. Unfortunately arbitrage opportunities that are completely risk free are difficult to find and LTCM apparently engaged in operations that had some risk. LTCM promptly proved that it is possible to lose money while exploiting arbitrage opportunities that are "almost" risk free. The losses of LTCM created a near panic on Wall Street and resulted in intervention and assistance from some of the major players in the world of finance.

Does the arbitrageur perform an important function for financial markets? Probably. If we think that markets should be efficient, if we think that the price of puts and calls and of the underlying stocks should be closely related, if we think that it shouldn't be possible to make a more-or-less certain profit by buying the convertible debentures and exercising, if we think logic and reason should prevail with regard to spot prices and futures prices, then certainly the arbitrageur plays an important role in the world of finance.

CHECK YOUR COMPREHENSION

Which of the following dabble in derivatives?






PURPOSES

From the above discussion of the activities of hedgers, speculators and arbitrageurs, some of the purposes and social role of the derivative markets have either been stated or inferred. Let's review those purposes and then state another purpose that may not be quite so apparent.

Yes, derivative markets may provide a source of excitement and entertainment for the speculators and other participants. It is difficult to consider this role a great social "good," however, since one can derive as much "high" with usually less expense from the rides at an amusement park.

By providing a means to reduce risk, the derivatives markets unquestionably provide an important service to the hedgers and to society as a whole. Derivatives make it possible for the hedgers to operate and for society to profit from the goods and services that might not otherwise be produced and performed. Old McDonald might not grow the wheat if he couldn't sell September red.

Price Discovery

There is another service that derivative markets provide. They may give clues about future interest rates, commodity prices, etc. that would not otherwise be available.

This price discovery role is particularly apparent in the futures markets. There many well-informed players are placing bets on what those future prices will be and the consensus of their opinions tends to be reflected in futures prices. What farmers and bakers think will be the price of wheat several months in the future can be gleaned from the price at which futures contracts for those later months may be entered into today. The home builder, thinking that interest rates several months from now are critical to his decision whether to develop a new subdivision, can get some indication of what Fed watchers, economists and mutual funds think those rates will be by looking at the interest rates in interest rate futures contracts now trading. While these markets don't reveal future spot prices with any certainty, they at least give a clue about what well-informed market participants think those future prices will be.

Unlike some of the other services provided by derivatives, this price discovery service doesn't require any investment greater than the price of buying the current Wall Street Journal.

CHECK YOUR COMPREHENSION

Which of the following services may be provided by derivatives:






Well done! If you've read all the previous sections, you may now be ready to take the quiz and get your CPE Slip

Information about our CMA Review program can be found here.