Mention derivatives and even the financially literate quiver with fear. Yet these instruments (increasingly standardised) are no more than creatures of contract where a few fundamentals and a lack of fear of jargon will always hold you in good stead. There has been much in the news about derivatives. The European Union is seeking to reform regulation for example on central clearing parties and in the US there are similar moves afoot.
But a few fundamentals will always hold you in good stead when looking at these instruments:
Know your counterparty:
Whether your trade is cleared centrally reducing counterparty risk or whether you are directly exposed to counterparty risk is a fundamental starting point. If you have a portfolio of these instruments then you have the added dimension of portfolio risk in relation to your counterparty exposure. It is worth spending time on this as part of your due diligence. These trades often unravel due to actions taken by a counterparty so it is important to understand who they are and what pressures they may be susceptible to.
Who owns the assets and liabilities in the contract:
Derivatives are often described as zero sum games – there is a winner and a loser – and the accounting to determine who is which depends on where the assets and liabilities in a trade sit – who owns the assets and liabilities and how they are determined and payable need to be clear.
Cash Flows:
Ignore these at your peril – delays in payments can have devastating consequences – triggering default clauses and even ruining reputations. I have written before about the consequences of illiquidity on foreign exchange hedging – these contracts are simple over the counter derivatives but an inability to meet calls on margin due to illiquidity can have serious consequences. You need to understand how the cash flows will operate – a good understanding will highlight the weak points of the trade and where your investment could potentially go wrong. The profit and loss accounting cannot be done without understanding these flows properly. These flows determine when trades become profitable and will influence the decisions that are taken on the trade – such as exercising an option, taking delivery of a future or closing out a trade
Collateral and Margining:
Derivatives are generally geared transactions. What this means is that your exposure on a contract can be a multiple of what you actually pay out and so the consequences of a trade can be much higher than the money put down to enter the trade. When there is borrowing or financing involved the party lending the money will always want some form of security or collateral. It is therefore important to understand what amount is put down as initial margin, what constitutes variation margin and what sort of haircuts (fees) are taken on each tranche of a trade. Margins are essentially a partial payment of collateral as insurance if there is a default on a contract. There will be rules as to how these are calculated and when and to whom they are paid. A good indicator as to how a counterparty views risk on a transaction is to look at the amount of margin they require the other side to put up. The greater the proportion of margin required the higher the perception of risk. It is no surprise that investment managers can be cagey about disclosing this information as it gives a good view on how the counterparty views them as a risk.
Valuation Methodologies:
It is essential that you understand these – they will determine the profit and loss on the trade and the gains that you report/account for and form the basis on which the cash flows occur. Mistakes can happen and it is important to apply the methodologies to double check what you are being told about your assets, liabilities and cash flows. Derivatives can be priced using models – referred to as synthetic prices – but you should still conduct “reality checks” on these prices both for calculation and for checking in the market that you are within acceptable parameters.
Crystallisation & Default events:
Make sure you know how the contract will crystallise or close out and what the options are to close out the transaction and how this would be done. As important is the need to understand what constitutes a default and what that implies – generally the rights over collateral will get exercised and there will be further liability/penalties to be addressed. The strength of the counterparty is relevant because a weaker counterparty may not be interested in helping you weather a temporary problem or it may be the weakness that triggers issues for you in the way the contract is serviced.
Definitions:
Make sure you understand how terms are defined – even if the references are to standard ISDA terms make sure you understand what they mean and their effects. Even professionals make assumptions on terms which can turn out to be incorrect – question jargon – people often use it without really understanding what they mean when they use it. It can be an expensive legal exercise to unravel what was meant when a transaction goes wrong.
These seven simple steps will ensure that the basics are at least understood and they will enable you to have better clarity on the derivative trades that your investment manager may be using and give you a clearer view on the risks of that investment strategy.
©Jaitly LLP