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Master Class: Derivative Products: Review

A second look at derivative contracts

A typical derivative deal comes with a long list of qualifications that are presented and shared with customers in the form of a term sheet. A term sheet is generally executed as a legally binding document with a number of clauses and warning labels, such as:

  1. Not all derivative contracts are appropriate for every investor. Some instruments are extremely complex and involve significant risks therefore investors in derivative products should only use these instruments only if they fully understand both the instrument and the overall transaction and are able to bear the risks associated with each instrument and transaction.
  2. Each derivative instrument is unique and the range of their possible uses is wide which in turn means that they could be many factors that could potentially affect their performance. Over-the-counter instruments may be highly customized to meet investor needs such as hedging, tax, credit and other needs. It is important to remember that as the complexity and customization of the instrument increases, the risks it may be exposed to, may also increase, including its tradability.
  3. Generally, derivative transactions involve risks which include (among others) the risk of adverse or unanticipated market, financial, or political developments, risk of counterparty or issuer default and other credit and enforcement risks, and risk of illiquidity and related risks. In addition, parties may be subject to operational risks in the event that appropriate internal systems and controls to monitor the various risks are not in place.
  4. It is important to understand the requirements (including investment restrictions), if any, applicable that are established by regulators or by board of directors or other governing body. The legal, tax and accounting implications of entering into any derivative transaction need to be considered.
  5. Investors should take steps to understand the assumptions underlying the instrument involved in the particular transaction.
  1. As mentioned above swap and OTC option transactions permit precise customization to accomplish particular financial and risk management objectives that might otherwise be unachievable. Customization can, because of the individualized nature of such transactions, introduce significant liquidity risk and other risk factors of a complex character. Dealers may not always be willing to make markets in these transactions or terminate early existing positions.
  1. Cash settled OTC options and swaps may present certain enforceability risks due to local gaming and bucket shop laws, although certain exemptions from such laws may be available depending upon the terms of the instrument. Options that are not automatically exercisable involve monitoring requirements and may involve communication risk.
  1. Before entering into a derivative contract, the parties to deal need to make an assessment of various factors involved in the transaction.

A template for making this assessment is given in the section below. At a minimum this includes evaluating the payoff formula, the maximum risks for the buyer and seller of the contract, the degree of complexity of the instruments and the variables that influence the value of the instrument.

Standard Template for Evaluating Derivatives

Here is a typical template that an Investment banking team would use to review a transaction or a product for risk and suitability for a client. This template is based on a slightly dated derivative product manual from Salomon Smith Barney (SSB).

FACTOR

DETAILS

High level reviewThe instrument and the risks and return (economic exposure) that the parties will be exposed to.
MotivationThe motivation behind entering the transaction from the buyer’s and seller’s perspective.
MechanicsThe mechanics of the instrument including:

  • The payoff formula applicable and
  • The nature and frequency of payments that are to be made on the trade day (i.e. the day when the contract was issued)
  • The nature and frequency of payments that are to be made on or before the expiration date.

Additional mechanics of the derivative, for example for a swaption this includes the exercise day, which is day when the buyer and sell enter into a swap contract. For a forward start call option this could include the payment date when the buyer would pay the call option price and the nature of that payment.

Key ConceptsBased on the specific instrument this will include (but is not limited to), where applicable:

  • Exercise style, e.g. American or European
  • Total/ price return, i.e. the basis on which payments are to be made
  • Notional amount, i.e. the notional used in the calculations of the payment as well as the actual payment calculation methodology
  • Resets, i.e. their nature and frequency
  • Underlying index (such as LIBOR) used in the calculation
  • Currency risk, in particular how the payments expose the party to this risk
  • Credit risk, in particular how exposure to the underlying exposes the party involved in the transaction
  • Volatility of the underlying instruments and factors that affect the value of the derivative
  • Breakeven point i.e. that is the minimum move in the underlying that is needed in the underlying that will make the payout equal the initial cost
  • Average, i.e. for certain options such as Asian options where the payout is based on an average value of prices, the periods and frequencies used in the calculation of the average will be specified
  • Path dependent, i.e. whether the value of the derivative is based on the exact path taken by the underlying
  • Barrier (for Barrier options), i.e. the nature and mechanics of the barriers
  • Rebate (for Barrier options)
  • Correlation between assets if the derivative’s payoff is based on performance of two or more underlying
Market RisksThe nature and extent of the upside and down side exposure to this risk for the buyer and the seller of the contract.
SensitivitiesThe Greeks as well as various other factors (such as currency, correlation, time, etc) that impact the value of the derivative and the payouts.
ComplexityThe complexity of the financial instrument is rated on a scale of one to five, one being the least complex and five the most complex.

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