caused by a third party’s default. They do not involve borrowing the premium or the payoff.
Although these instruments are covered in more detail in the fixed-income material, we would be remiss if we failed to include them with derivatives. But we will give them only light coverage here.
As discussed earlier, derivatives take (derive) their value from the value of the underlying, as do mutual funds and exchange-traded funds (ETFs). A mutual fund or an ETF holding bonds is virtually identical to the investor holding the bonds directly. Asset-backed securities (ABSs) take this concept a step further by altering the payment streams. ABSs typically divide the payments into slices, called tranches, in which the priority of claims has been changed from equivalent to preferential. For example, in a bond mutual fund or an ETF, all investors in the fund have equal claims, and so the rate of return earned by each investor is exactly the same. If a portfolio of the same bonds were assembled into an ABS, some investors in the ABS would have claims that would supersede those of other investors. The differential nature of these claims becomes relevant when either prepayments or defaults occur.
Prepayments mostly affect only mortgages. When a portfolio of mortgages is assembled into an ABS, the resulting instrument is called a collateralized mortgage obligation (CMO). Commonly but not always, the credit risk has been reduced or eliminated, perhaps by a CDS, as discussed earlier. When homeowners pay off their mortgages early due to refinancing at lower rates, the holders of the mortgages suffer losses. They expected to receive a stream of returns that is now terminated. The funds that were previously earning a particular rate will now have to be invested to earn a lower rate. These losses are the mirror images of the gains homeowners make when they proudly proclaim that they refinanced their mortgages and substantially lowered their payments.
CMOs partition the claims against these mortgages into different tranches, which are typically called A, B, and C. Class C tranches bear the first wave of prepayments until that tranche has been completely repaid its full principal investment. At that point, the Class B tranche holders bear the next prepayments until they have been fully repaid. The Class A tranche holders then bear the next wave of prepayments.14 Thus, the risk faced by the various tranche holders is different from that of a mutual fund or ETF, which would pass the returns directly through such that investors would all receive the same rates of return. Therefore, the expected returns of CMO tranches vary and are commensurate with the prepayment risk they assume. Some CMOs are also characterized by credit risk, perhaps a substantial amount, from subprime mortgages.
When bonds or loans are assembled into ABSs, they are typically called collateralized bond obligations (CBOs) or collateralized loan obligations (CLOs). These instruments (known collectively as collateralized debt obligations, or CDOs) do not traditionally have much prepayment risk but they do have credit risk and oftentimes a great deal of it. The CDO structure allocates this risk to tranches that are called senior, mezzanine, or junior tranches (the last sometimes called equity tranches). When defaults occur, the junior tranches bear the risk first, followed by the mezzanine tranches, and then the senior tranches. The expected returns of the tranches vary according to the perceived credit risk, with the senior tranches having the highest credit quality and the junior the lowest. Thus, the senior tranches have the lowest expected returns and the junior tranches have the highest.
An asset-backed security is formally defined as follows:
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.
ABSs seem to have only an indirect and subtle resemblance to options, but they are indeed options. They promise to make a series of returns that are typically steady. These returns can be lowered if prepayments or defaults occur. Thus, they are contingent on prepayments and defaults. Take a look again at Exhibit 4, Panel B (the profit and payoff of a short put option). If all goes well, there is a fixed return. If something goes badly, the return can be lowered, and the worse the outcome, the lower the return. Thus, holders of ABSs have effectively written put options.
This completes the discussion of contingent claims. Having now covered forward commitments and contingent claims, the final category of derivative instruments is more or less just a catch-all category in case something was missed.
4.3. Hybrids
The instruments just covered encompass all the fundamental instruments that exist in the derivatives world. Yet, the derivatives world is truly much larger than implied by what has been covered here. We have not covered and will touch only lightly on the many hybrid instruments that combine derivatives, fixed-income securities, currencies, equities, and commodities. For example, options can be combined with bonds to form either callable bonds or convertible bonds. Swaps can be combined with options to form swap payments that have upper and lower limits. Options can be combined with futures to obtain options on futures. Options can be created with swaps as the underlying to form swaptions. Some of these instruments will be covered later. For now, you should just recognize that the possibilities are almost endless.
We will not address these hybrids directly, but some are covered elsewhere in the curriculum. The purpose of discussing them here is for you to realize that derivatives create possibilities not otherwise available in their absence. This point will lead to a better understanding of why derivatives exist, a topic we will get to very shortly.
EXAMPLE 5 Forward Commitments versus Contingent Claims
1. Which of the following is not a forward commitment?
A. An agreement to take out a loan at a future date at a specific rate
B. An offer of employment that must be accepted or rejected in two weeks
C. An agreement to lease a piece of machinery for one year with a series of fixed monthly payments
2. Which of the following statements is true about contingent claims?
A. Either party can default to the other.
B. The payoffs are linearly related to the performance of the underlying.
C. The most the long can lose is the amount paid for the contingent claim.
Solution to 1: B is correct. Both A and C are commitments to engage in transactions at future dates. In fact, C is like a swap because the party agrees to make a series of future payments and in return receives temporary use of an asset whose value could vary. B is a contingent claim. The party receiving the employment offer can accept it or reject it if there is a better alternative.
Solution to 2: C is correct. The maximum loss to the long is the premium. The payoffs of contingent claims are not linearly related to the underlying, and only one party, the short, can default.
4.4. Derivatives Underlyings
Before discussing the purposes and benefits of derivatives, we need to clarify some points that have been implied so far. We have alluded to certain underlying assets, this section will briefly discuss the underlyings more directly.
Equities are one of the most popular categories of underlyings on which derivatives are created. There are two types of equities on which derivatives exist: individual stocks and stock indices. Derivatives on individual stocks are primarily options. Forwards, futures, and swaps on individual stocks are not widely used. Index derivatives in the form of options, forwards, futures, and swaps are very popular. Index swaps, more often called equity swaps, are quite popular and permit investors to pay the return on one stock index and receive the return on another index or a fixed rate. They can be very useful in asset allocation strategies by allowing an equity manager to increase or reduce exposure to an equity market or sector without trading the individual securities.
In addition, options on stocks are frequently used by companies as compensation and incentives