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 for their executives and employees. These options are granted to provide incentives to work toward driving the stock price up and can result in companies paying lower cash compensation.15 Some companies also issue warrants, which are options sold to the public that allow the holders to exercise them and buy shares directly from the companies.16
Options, forwards, futures, and swaps on bonds are widely used. The problem with creating derivatives on bonds, however, is that there are almost always many issues of bonds. A single issuer, whether it is a government or a private borrower, often has more than one bond issue outstanding. For futures contracts, with their standardization requirements, this problem is particularly challenging. What does it mean to say that a futures contract is on a German bund, a US Treasury note, or a UK gilt? The most common solution to this problem is to allow multiple issues to be delivered on a single futures contract. This feature adds some interesting twists to the pricing and trading strategies of these instruments.
Until now, we have referred to the underlying as an asset. Yet, one of the largest derivative underlyings is not an asset. It is simply an interest rate. An interest rate is not an asset. One cannot hold an interest rate or place it on a balance sheet as an asset. Although one can hold an instrument that pays an interest rate, the rate itself is not an asset. But there are derivatives in which the rate, not the instrument that pays the rate, is the underlying. In fact, we have already covered one of these derivatives: The plain vanilla interest rate swap in which Libor is the underlying.17 Instead of a swap, an interest rate derivative could be an option. For example, a call option on 90-day Libor with a strike of 5 % would pay off if at expiration Libor exceeds 5 %. If Libor is below 5 %, the option simply expires unexercised.
Interest rate derivatives are the most widely used derivatives. With that in mind, we will be careful in using the expression underlying asset and will use the more generic underlying.
A warrant is a type of option, similar to the employee stock option, written by the company on its own stock, in contrast to exchange-traded and OTC options, in which the company is not a party to the option contract. Also note that, unfortunately, the financial world uses the term
As you will see later, there are also futures in which the underlying is an interest rate (Eurodollar futures) and forwards in which the underlying is an interest rate (forward rate agreements, or FRAs).
