Some securities are called “derivatives” or “derivative contracts” because their value is derived from the price of an underlying asset. In Famous Frauds & Financial Failures, I often describe how hedge fund managers trade in exotic securities such as futures, options, swaps, and collateralized debt obligations.
Futures: a futures contract is a standardized, legally binding agreement to buy or sell a a specific quantity of an underlying instrument (commodity, currency, stock index, bond, cryptocurrency, etc.) at a predetermined price on a specified future date. All futures contracts are forms of derivative contracts because their value is derived from the price of the underlying asset.
A hedge fund may purchase or sell futures contracts to gain exposure to, or economically hedge against, changes in interest rates (interest rate risk), changes in the value of equity securities (equity risk), changes in commodity prices (commodity risk), or changes in foreign currencies (foreign currency exchange rate risk). Futures contracts are exchange-traded agreements between the hedge fund and a counterparty. Depending on the terms of the contract, futures contracts are settled either through physical delivery of the underlying instrument on the settlement date or by payment of a cash amount on the settlement date. Upon entering into a futures contract, the hedge fund is required to deposit an initial margin with the broker in the form of cash or securities in an amount that varies depending on a contract’s size and risk profile. The initial margin deposit must then be maintained at an established level over the life of the contract.
Pursuant to the contract, the hedge fund agrees to receive from or pay to the broker an amount of cash equal to the fluctuation in the market value of the contract (“variation margin”). When the contract is closed, the hedge fund records a realized gain (or loss) equal to the difference between the notional value of the contract at the time it was opened and the notional value at the time it was closed. The use of futures contracts involves the risk of an imperfect correlation in the movements in the price of futures contracts and interest rates, foreign currency exchange rates, or the underlying assets.
Options: Closely related to futures, though distinct from them, are options. The buyer of a call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial asset from the seller (the writer) of the option at a certain time (the expiration date) for a certain price (the strike price). The buyer of a call option expects the price of the commodity or underlying instrument to rise in the future. When the price passes the agreed strike price, the option is said to be “in the money.” A put option is the opposite contract: the buyer has the right, but not the obligation, to sell an agreed quantity of something to the seller of the option.
Swaps: Another kind of derivative is a swap, which is effectively a bet between two parties on, for example, the future path of interest rates. Such contracts are agreements between the hedge fund and a counterparty to make periodic net payments on a specified notional amount or a net payment upon termination. Swap contracts are entered into by hedge funds to manage exposure to issuers, markets, and securities.
Interest rate swap contracts are agreements in which one party pays a stream of interest payments, either fixed or floating rate, in exchange for another party’s stream of interest payments, either fixed or floating rate, on the same notional amount for a specified period of time. A pure interest rate swap allows two parties already receiving interest payments to swap them; thus, a hedge fund receiving a variable rate of interest can convert it to a fixed rate, which would protect the fund if interest rates were to decline. Interest rate swap contracts are entered into by hedge funds to gain or reduce exposure to interest rates or to manage duration, the yield curve, or interest rate risk, by economically hedging the value of the fixed rate bonds which may decrease when interest rates rise (interest rate risk). Interest rate caps and floors, which are types of interest rate swap contracts, are agreements in which one party agrees to make payments to the other party to the extent that interest rates rise above a specified rate cap or fall below a specified rate floor in return for a premium. In more complex swap contracts, the notional principal amount may decline (or amortize) over time.
Credit default swaps, which are valued based on the price of debt issued by an underlying company, offer insurance protection against a company defaulting on its bonds. (Hedge funds use them to hedge the risk in corporate bonds that they have already invested in.)
A total return swap is a bilateral derivative contract in which one party (the total return payer) transfers the total return on a reference asset (or basket of assets) to the other party (the total return receiver) in exchange for regular payments based on a designated financing rate, typically a floating interest rate. The total economic return may include coupons, interest, dividends, and the gain or loss on the asset over the life of the swap. Total return swap contracts are entered into by hedge funds to gain exposure to a security or market without owning such security or investing directly in such market, or to exchange the risk/return of one market (e.g., fixed-income) with another market (e.g., equity or commodity prices, equity risk, commodity price risk, and/or interest rate risk). To the extent the total return of the transaction exceeds or falls short of the offsetting interest rate obligation, the hedge fund will receive a payment from or make a payment to the counterparty.
Swap contracts are privately negotiated in the over-the-counter (OTC) market and may be entered into as a bilateral contract (“OTC swap contracts”) or centrally cleared ("centrally cleared swap contracts"). Swap contracts are marked-to-market and changes in value are recorded as unrealized appreciation (depreciation).
When an OTC swap contract is terminated, the hedge fund will record a realized gain (or loss) equal to the difference between the proceeds from (or cost of) the closing transaction and the hedge fund's basis in the contract, if any. Generally, the basis of the contracts is the premium received or paid.
In a centrally cleared swap contract, immediately following execution of the swap contract, the swap contract is novated to a central counterparty (the "CCP") and the hedge fund then deals with the CCP through a broker. Upon entering into a centrally cleared swap contract, the hedge fund may be required to deposit an initial margin with the broker in the form of cash or securities in an amount that varies depending on the size and risk profile of the particular swap contract. When the centrally cleared swap contract is terminated, a realized gain (or loss) is recorded by the hedge fund.
Mortgage-backed security (MBS): An MBS is a bond that is secured (backed) by a pool of residential or commercial mortgages. Here is how it works:
- Thousands of individual home loans (or commercial property loans) are bundled together into a big pool.
- The pool is placed into a trust.
- The trust issues securities (bonds) that are sold to investors.
- Homeowners make their monthly mortgage payments and those payments (principal plus interest, minus fees) are “passed through” to the MBS investors.
Collateralized debt obligation (CDO): A CDO is a structured bond backed by a diversified pool of debt instruments (i.e., it is not limited to mortgages). It can include subprime MBS tranches, corporate loans, corporate bonds, or even other CDOs. Here is how it works:
- A portfolio of 100–300 debt assets (often the riskier tranches of subprime MBS, leveraged loans, etc.) is assembled.
- The portfolio is placed in a special-purpose vehicle (SPV).
- The SPV issues multiple tranches of securities ranked by seniority:
- Senior tranches (AAA-rated) are paid first and offer a very low yield.
- Mezzanine tranches (A to BB) are paid next.
- Equity tranches (unrated) are paid last. They offer a very high yield but suffer first loss.
- Cash flows from the underlying assets “waterfall” down the capital structure.
Contracts for differences (CFDs): A CFD is an agreement between two parties providing for cash payments to be made, by way of settlement of the contract, based on the movement in the value of an underlying security and payments of any dividends on that security, rather than by the physical delivery of the underlying stock. Hedge funds enter into CFDs to gain exposure to, or hedge against changes in, the value of equities and as a substitute for an actual investment in an underlying common stock. Changes in the value of the underlying security, which in turn change the value of the CFD, are recorded by the hedge fund as unrealized appreciation or (depreciation). When the CFD is closed, the hedge fund records a realized gain or (loss) equal to the difference between the value of the contract at the time it was opened and the value at the time it was closed. The use of CFDs involves the risk that the counterparty to the contract does not perform its obligations under the agreement.
Forward Foreign Currency Exchange Contracts: Hedge funds enter into forward foreign currency exchange contracts as an economic hedge against specific transactions or investments and/or share classes to gain or reduce exposure to foreign currencies (foreign currency exchange rate risk). A forward foreign currency exchange contract is an agreement between two parties to buy and sell currency at a set exchange rate on a specified date. When used by a hedge fund, these contracts may help to manage the overall exposure to the currencies (foreign currency exchange rate risk), in which the hedge fund’s investments and/or share classes are denominated, and in some cases, may be used to obtain exposure to a particular market. The contracts are traded OTC and not on an organized exchange.
Master Netting Arrangements (MNAs): In order to better define contractual rights and to secure rights that will help the hedge fund mitigate its counterparty risk, the hedge fund may enter into an MNA, like the International Swaps and Derivatives Association, Inc. Master Agreement (“ISDA Master Agreement”), or a similar agreement with its derivative contract counterparties. An ISDA Master Agreement is a bilateral agreement between the hedge fund and a counterparty that governs certain OTC derivatives and typically contains, among other things, collateral posting terms and netting provisions in the event of a default and/or termination event. Under an ISDA Master Agreement, the hedge fund may, under certain circumstances, offset with the counterparty certain derivative financial instruments’ payables and/or receivables with collateral held and/or posted to create one single net payment.
The provisions of the ISDA Master Agreement typically permit a single net payment in the event of default, including the bankruptcy or insolvency of the counterparty. However, bankruptcy or insolvency laws of a particular jurisdiction may impose restrictions on or prohibitions against the right of offset in bankruptcy, insolvency, or other events. In addition, certain ISDA Master Agreements allow counterparties to OTC derivatives to terminate derivative contracts prior to maturity in the event the hedge fund’s net assets decline by a stated percentage or the hedge fund fails to meet the terms of its ISDA Master Agreement(s), which would cause the hedge fund to accelerate payment of any net liability owed to the counterparty. To the extent that amounts due to the hedge fund from its counterparties are not fully collateralized, contractually or otherwise, the hedge fund bears the risk of loss from counterparty non-performance. The hedge fund should attempt to mitigate counterparty risk by only entering into agreements with counterparties that it believes have the financial resources to honor their obligations and by monitoring the financial stability of those counterparties.
Collateral Requirements: For derivatives traded under an ISDA Master Agreement, the collateral requirements are typically calculated by netting the mark-to-market amount for each transaction under such agreement and comparing that amount to the value of any collateral currently pledged by the hedge fund and the counterparty. A party to an ISDA Master Agreement may also require additional collateral from the other party to that agreement should the other party fail to secure a certain credit rating on certain of its debt obligations.
Generally, the amount of collateral due from or to a counterparty is subject to a certain minimum transfer amount threshold before a transfer is required, which is determined at the close of business on a trading day. Any additional required collateral may be delivered to/pledged by the hedge fund on the next business day. Pursuant to the terms of an MNA, the hedge fund and the counterparties may not be permitted to sell, re-pledge, or use cash and non-cash collateral it receives. The hedge fund generally agrees not to use non-cash collateral that it receives; however, it may, absent default or certain other circumstances defined in the underlying ISDA Master Agreement, be permitted to use cash collateral received. In such cases, interest may be paid pursuant to the collateral arrangement with the counterparty. To the extent that amounts due to the hedge fund from its counterparties are not fully collateralized, contractually or otherwise, the hedge fund bears the risk of loss from counterparty non-performance. Likewise, to the extent that the hedge fund has delivered collateral to a counterparty and stands ready to perform under the terms of its agreement with such counterparty, it bears the risk of loss from that counterparty in the amount of the value of the collateral in the event the counterparty fails to return such collateral. Based on the terms of agreements, collateral may not be required for all derivative contracts.
Hidden Risks: As described in several of the stories in Famous Frauds & Financial Failures, derivative contracts, especially Swaps and CFD transactions involve, to varying degrees, elements of interest rate, credit, and market risk in excess of the amounts that might be recognized in the hedge fund’s financial statements. Such risks involve the possibility that there will be no liquid market for these agreements, that the counterparty to the agreements may default on its obligation to perform or disagree as to the meaning of the contractual terms in the agreements, and that there may be unfavorable changes in interest rates and/or market values associated with these transactions.
For example, when Lehman Brothers filed for bankruptcy on September 15, 2008, it was a major counterparty in the OTC derivatives market, with over 900,000 outstanding contracts globally, representing about 5% of the worldwide derivatives volume at the time. Hedge funds which had Lehman as a counterparty to derivative contracts such as swaps, options, CFDs, and credit default swaps faced significant challenges due to the sudden default. Many hedge funds rushed to terminate and novate (transfer) contracts to new counterparties, leading to confusion and market turmoil as they raced to unwind positions and cover exposures. This was exacerbated by uncertainty over Lehman's exposures, contributing to short-term liquidity squeezes in related markets. Some funds hesitated to terminate their transactions if the contracts were "in the money" (i.e., favorable to Lehman at that point in time), fearing assignment to another party by the bankruptcy court or changes in mark-to-market values that could expose them to further losses. Hedge funds had to reconcile the valuation of terminated derivatives with the liquidators of Lehman, often leading to disputes over mark-to-market calculations, especially in illiquid markets which significantly delayed the settlement of derivative contracts with the firm. Lehman later sued some counterparties (e.g., J.P. Morgan Chase) for allegedly inflating claims and improper setoffs, highlighting the reciprocal risks in these bilateral contracts.
Hedge funds that used Lehman as their prime broker found that securities and cash held by Lehman became trapped in bankruptcy proceedings, preventing trading and redemptions. This doubled the failure rate of Lehman-connected funds compared to peers with other brokers, as those funds could not liquidate positions or meet collateral/margin demands.