>----- Original Message -----
>From: "joanna bujes" <joanna.bujes at ebay.sun.com>
>To: <lbo-talk at lists.panix.com>
>Sent: Thursday, March 14, 2002 9:24 AM
>Subject: Re: lbo-talk-digest V1 #5804
>
>
>> At 03:15 PM 03/13/2002 -0500, you wrote:
>> >Of course, were you to tell me that New York financial
>institutions'
>> >derivative books had a net notional principal that was long the
>> >dollar to the tune of $3 trillion, my mind would change.
>>
>> What does this mean please?
>>
>> Thanks,
>>
> > Joanna
> >
>
>Yeah, could the econogeniuses on the list help us out with some
>explication when you've got the time?
No doubt this is underinformed and out of date, but here's what I wrote on custom derivs in Wall Street.
Notional value is the face value of deriv contracts - principal. But what's usually at risk is an exchange of cash flows, not the notional value. So citing that amount overstates things. There's lots of netting out. Which isn't to say they're not dangerous. But I think there's a phobic fear of them because they're complex and relatively new, but they're complex and relatively new ways of doing old things. Entities with deriv problems are just sophisticated vehicles for borrowing big money to make investments that don't work out. What Brad is worried about is that Wall Street has staked its clients money in a big bet on the U.S. dollar. If they're wrong, they'll lose lots of money and we could all be in trouble.
Doug
----
bespoke derivatives
This section is for readers who want to get some idea of what really complex derivatives are about; those who don't care are advised to skip a few pages for a discussion of the point of all this inventiveness.
Players who find the off-the-rack derivatives that trade on exchanges too common can always turn to custom-tailored instruments. The lack of standardization makes them untradeable, but the possibilities are limited only by imagination and the number of willing partners. As with exchange-traded derivatives, the custom kind - also called over-the-counter (OTC) - can serve as a hedge or a bet, or even both at once.
Details of custom derivatives may be more than many readers want to know, but they do involve the full richness of financial imagination. Swaps were pioneered in the late 1970s, but the first deal to attract wide attention was a currency swap between IBM and the World Bank in 1981, and the first interest rate swap was one involving the Student Loan Marketing Association (Sallie Mae), a U.S.-government-sponsored vendor of student loans (Abken 1991).17 Unlike exchange-traded derivatives, swaps don't really involve a claim on an underlying asset; in most cases, the partners in the swap, called counterparties, swap two sets of cash flows, cash flows that are usually thrown off by positions in other securities (bond interest, stock dividends, etc.).
That sounds terribly abstract; maybe a bit more detail about so-called "plain vanilla" swaps will make it clearer. In a currency swap, the two counterparties exchange specific amounts of two different currencies, which are repaid over time according to a fixed schedule which reflects the payment of interest and amortization of principal. Essentially, the counterparties are lending each other currencies and paying back the loan over time. The interest rates charged can be either both fixed, or both floating, or one fixed and one floating.
In an interest rate swap, the counterparties exchange payments based on some underlying principal amount (called the "notional" amount). One set of payments could be at floating rates (that is, adjusted with changes in market rates) and the other fixed, or both could be at floating rates, but tied to different market rates.
This still sounds very abstract. The evolution of the currency swap from its 1970s ancestor, the parallel loan agreement, may make things clearer. Imagine that a U.S. firm would like to borrow German marks, for use by a German subsidiary, and a German firm would like to borrow dollars, for complementary reasons. Both the German and the U.S. firms could issue bonds in their domestic markets in similar amounts, swap the principal, leaving the U.S. firm paying mark-denominated interest and the German, dollar interest. In effect, each has borrowed in the other's capital markets - something they might otherwise have been unable to do because of legal restrictions or the lack of name recognition. The problem with such agreements was that if one party defaulted, the other was still on the hook for principal and interest. Currency swaps take care of this by stipulating that a default by one party means the end of the agreement; this limits risk only to the difference between the two interest streams, not the full face value of principal and interest.
And here's an example of an interest rate swap (Abken 1991). Say a bank issues a one-month certificate of deposit, and then invests the proceeds in a two-year note whose interest payments are tied to the London Interbank Offered Rate (LIBOR, the rate banks charge each other in the London-based Euromarkets). The CD will mature well before the note, and the rate the bank might have to pay the CD holder may not move in lockstep with LIBOR. Should the two interest rates march to their own drummers, the bank could find itself losing money on the two-sided transaction. To protect itself, the bank could visit its swap dealer, and work out a LIBOR-CD swap. The bank would pay the dealer the LIBOR interest rate on the underlying principal, and the dealer would pay some CD-linked index rate (minus a fee, of course). The swap dealer could either be acting on its own account, hoping to make money on the fee and maybe some clever trading, or it could be acting on behalf of a customer with complementary needs. The principal amount never changes hands, however, only the interest payments do. That's why the underlying principal is referred to as the "notional" amount.
An old-fashioned banker might also argue that funding a two-year investment by a series of 24 monthly loans is a dumb thing to do, and the swap is a fancy way of getting around that; why not issue a two-year CD to fund a two-year investment? But interest rates on two-year CDs may not be very favorable, and it may be that the bank will come out ahead with the swap. If all goes well, of course.
These are only the simplest examples; intensely more complex deals can be arranged. Swaps can be combined with options in order to limit swings in floating rate payments. Say two parties enter an interest rate swap that begins with neither having to exchange money; both the fixed and floating rate are the same, at 8%, say. But a month later, when it's time to adjust the rates on the floating half of the deal, market rates have risen to 10%. That means the payer of the floating rate would have to hand over to the counterparty 2% of the underlying notional principal. Should rates rise dramatically, the deal could get very expensive. Prudence might lead the payer of the unpredictable rate to buy a "cap" - an option that limits the maximum floating rate to a fixed level, say 9% in our example. The seller of the cap, however, has to pay any amount above 9%.
Further complications are immediately possible: the cap seller will no doubt want to hedge somehow, and the floating-rate payer might want to offset the cost of buying the cap by selling a "floor," the mirror image of the cap. By selling a floor, the floating-rate payer limits any gains from a fall in market interest rates. A cap and floor together create an interest rate "collar" - the establishment of upper and lower bounds on a floating rate. The final word in the exotic vocabulary is "swaption," an option to enter into a swap, for those who are shy about making commitments. After all this maneuvering, it looks suspiciously like a Rube Goldberg version of a fixed interest rate, but participants are adamant that all the complexity is worth it - with the bankers who sell the instruments the most adamant of all.
OTC derivatives began their stunning takeoff in the middle 1980s, paralleling the rise in trading of their exchange-traded cousins. But where much of the rise in exchange-traded instruments was simply a matter of Europe and Japan catching up with U.S. financial futures markets, OTC growth was mainly the proliferation of new instruments worldwide. In 1986, notional principal in interest rate swaps was $400 billion, with another $100 billion in currency swaps outstanding; at the end of 1990, the figures were $2.3 trillion and $578 billion, respectively, to which had been added another $561 billion in caps, floors, collars, and swaptions; in 1997, notional principal on interest rate swaps totaled $22.1 trillion, and currency swaps, $1.5 trillion (Bank for International Settlements 1998).
The biggest users of currency swaps once were nonfinancial corporations - the multinationals that dominate world trade, who borrow and do business in scores of currencies around the world. But financial institutions have been steadily increasing their use, with 40% of notional principal outstanding, a bit ahead of nonfinancial firms, with governments a distant third. Financial institutions dominate the market for interest rate swaps; after all, interest-bearing paper is the basic commodity they deal in. Corporations accounted for just 23% and governments, 6%. The U.S. share of swap markets is surprisingly small - less than a third of interest rate swaps and quarter of the currency kind - and the dollar's share has been shrinking steadily, from 79% of interest rate swaps in 1987 to 30% in 1996, with the yen and the European currencies rising dramatically. No doubt European and Asian economic integration is at work here, though the merger of Continental countries into the euro will change everything.
Moves are already underway to trade standardized swaps on exchanges, or develop clearinghouses for OTC swaps, but it's not clear that this will work; needs may be too personal, and counterparties may not want to expose themselves to the scrutiny of taking public positions.
the point of it all
Having inspected the machinery, the question arises - what's the point? [...]