The Case for Derivatives

My recent post, in which I shared my experiences as a derivatives salesman, elicited very strong reactions both on this blog and on Seeking Alpha. Many of the comments equate derivatives with scandal, fraud and loss, which is an unfortunate by-product of their mis-application, lack of transparency and disclosure. The fact is, derivatives are powerful and valuable tools that, when used properly, can expand the value for all parties involved: the hedger, the speculator and the investor. And with standardized hedging instruments, a centralized clearinghouse for managing counterparty risk, accounting rules that support detailed disclosures and transparency and Boards of Directors that monitor their prudent use, derivatives will regain their rightful place in the capital markets – as a powerful tool for good.

Consider the hedger. It might be a corporation that has very cyclical cash flows, like a manufacturer of construction equipment. The manufacturer’s cash flows will often rise and fall with GDP, giving it an asset duration that is short. As a result, the company would want a liability duration that is also short. But these companies often want long-term liquidity for investing in new plants, re-tooling of product lines and other capital-intensive activities, indicating that they’d want to issue long-term debt. But most companies that issue long-term debt can only do so by paying fixed rates, resulting in a liability duration that is long, much longer than its asset duration. The company, in this case, can secure long-term liquidity by issuing the long-term fixed rate bond, but can match liability duration with asset duration by swapping this bond back to floating. Assets and liabilities are matched, yet the manufacturer’s long-term capital plans are secure. The fixed-to-floating swap is a key piece of the puzzle. This is a prudent hedger in action.

Consider the speculator. It could be a derivatives trading desk on Wall Street. It could be a hedge fund. They take the other side of the hedger’s transaction, where they will receive fixed and pay floating, taking on a long duration exposure. They might do this because of a view on swap spreads, Fed policy, yield curve shape or any number of other variables. They could even hedge out part of the exposure and leave the rest open to express a view. Regardless, they provide liquidity to the hedger and make it possible for the manufacturer to see their total utility increase. To the hedger it no longer matters whether rates go up or down, because their asset and liability cash flows are highly correlated and, therefore, hedged. The speculator, meanwhile, sees their total utility increase as they are able to express a view using derivatives that they couldn’t otherwise establish in the cash markets. Speculators, like short sellers, play a necessary role in the capital formation and allocation process.

Finally, consider the investor. They can sometimes use derivatives to establish positions in stocks more efficiently than they could in the cash markets, e.g., buying deep in-the-money calls instead of the the stock outright to secure upside participation with less cash required. They can also use derivatives to trade around positions and increase return while preserving the original investment thesis, e.g., selling out-of-the-money calls to collect income in flattish environments, or out-of-the-money puts to establish long positions at depressed price levels. Derivatives can also be used to generate cash against a long-term position, such as what Warren Buffett did by selling extremely long-dated put options against his cash portfolio.

And let me add a few words about credit derivatives. They are valuable tools for both managing risk and speculating on credits. Consider the bank, the hedger, that underwrites a loan to a corporation, and even after syndication still has a significant hold position in the credit. It may want to offload most if not all of this residual risk, and the most efficient way for doing so is often the credit derivatives market. By purchasing default protection on the name, it can effectively immunize the exposure posed by the cash loan. Conversely, the speculator can express a view on credit spreads and default probabilities by taking the other side of this trade, again providing liquidity to the hedger where no cash market alternative exists. The investor can use credit derivatives to hedge both its debt and equity exposures, buying downside protection that often costs far less than equity options (while bearing a measure of correlation risk). The lion’s share of the problems we’ve seen in the credit derivatives arena are due to inappropriate mortgage-related transactions: an indictment of the entire industry is illogical, unfair and inconsistent with prudent use of the tools.

The point I made earlier still holds: pushing most of the OTC derivatives market to a central clearinghouse, together with common sense accounting rules and appropriate corporate governance will facilitate the safe and prudent use of derivatives. When used and monitored properly derivatives are financial assets, just like any other. Being scared and adopting a reactionary stance towards their use will only hurt the liquidity, efficiency and safety of the financial markets. It is so easy in times of crisis to throw the baby out with the bath water: this is one baby you want to be sure to wrap in a towel and keep safe.

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