All you need to know about investing short and simple
© Leonardo Timis
CHAPTER 3
FINANCIAL INSTRUMENTS
3.1 Introduction
The term ‘instrument’ or ‘security’ in finance can be changed with the more common term ‘product.’ A financial instrument is a product that you can buy, just like you buy a product from the supermarket.
3.2 Stocks
A stock is also named ‘share’ or ‘equity.’ A stock is a small part of a company. For instance, when multiple founders start a company, they have to decide who gets how many stocks in order to understand how much a single founder owns of that company in percentage terms.
If a single founder divided her/his number of shares by the total number of shares, she/he would get the percentage of her/his ownership. For example, if a company had 100 total shares, and one founder owned 10 shares, that founder would own 10% of the company.
Owning a stock (a part of a business) means having three fundamental rights: being able to get a part of the periodic profits of the company, being able to participate in the company’s decisions, and being able to get a part of the assets of the company if it failed.
During the life of a company, new external people can get interested in the company and consequently can ask the founders to become part of it as well, becoming new stockholders. So, the stockholders are the owners of the company, and some of the stockholders can be the founders.
In this case, the founders have to ‘issue’ (which means to create) new stocks in order to exchange them for new fresh money to be used in the business. In simple terms, a new guy comes to the founders with new fresh money to fund the company, and in exchange, he takes some newly created stocks, which means a part of the company, which means a percentage of the profits, a percentage of the company’s decisions and a percentage of the company’s assets.
As you can see, stocks are an important way used by companies to raise money, but the previous stockholders sustain the cost of this way of getting funded because they get ‘diluted,’ which means they lose part of their percentage of ownership of the company.
Considering the previous example with 100 shares, if 10 new stocks were created for a new stockholder, the total shares would be now 110. The old stockholder (also founder) that was already owning 10 shares now owns 9.09%, not 10% anymore. She/he has just got diluted.
First observation. Actually, the periodic profits are not always divided among the owners entirely. Most of the time, just a little part of profits comes back to the owners; the rest is kept inside the company to be reinvested to get better profits in the next years. The part of profits that come back into the owner’s pockets is named ‘dividends.’
Second observation. Not all stocks are the same. There are common shares (the ones we have just explained without giving a name) and preferred shares. In general terms, preferred shares give up their decision-making rights (i.e., voting rights) to get more dividends.
But be careful. Each company has different types of common and preferred stocks because of different rules. For instance, some companies may be sharing stocks that, instead of giving up voting rights, they give up dividend rights to get more voting rights. So be always careful to be well informed about the rights you are buying by buying a stock. Buying stocks is like signing a contract, you want to read all the terms and conditions.
After a stock is issued, the new stockholder can decide to keep it for a long time, hoping the corporate assets and with them, the stock's value will grow, or she/he can decide to sell the stock prematurely.
We can define 'primary market' as the market between companies and new stockholders, where companies issue new fresh stocks to new stockholders (investors). In contrast, we can define 'secondary market' as the market between previous stockholders and new stockholders, where a previous stockholder sells prematurely to a new stockholder.
Thus, if you wanted to buy a share, you could buy it on the primary market directly from the company or on the secondary market from an already existing stockholder; in the second case, the company would be getting no money.
The stock prices that you see on graphs around the internet and in the news are the prices formed on the secondary market because previous and new stockholders keep exchanging their stocks among themselves on a daily basis forming daily prices - while a company issues new stocks only once in a while when it needs money.
In the financial jargon, ‘buying’ means speculating on future higher prices, and ‘shorting’ means speculating on future lower prices. But how does it really work a short on a stock or any other security?
The shorting operation is based on borrowing a security and is defined in 4 steps as follows: 1) you borrow a security (usually from a special financial institution like an investment bank), no upfront money 2) right after you sell the security on the market cashing out the market price 3) time goes on, and right before you have to return the security you buy back that same security from the market at the new market price 4) you return the security plus cash interests.
So, at the end of the operation, your profit is made by the difference between the old market price and the new market price, minus also the interests paid to the lender for the lending service. In other terms, if the old market price was higher than the new market price, which means the price fell, you would make a profit from the shorting operation.
A stock index is a graph that shows the (weighted) average price of specific stocks which represent a geographic region like a country or an economic sector. So, a stock index is a calculated average, it is not something you can buy. The purpose of an index, like the Standard & Poor’s or the Dow Jones, is to keep track of the performance of a specific geographic region or a specific economic sector.
Nevertheless, you can buy an ETF that replicates the index, ETFs will be explained later in this chapter.
3.3 Bonds
Companies also use bonds to fund their investments and operations besides stocks.
When a company asks for a single big loan from a single big lender, the terms and conditions of this loan are often customized according to the wishes of the big lender, due to the lender’s power position. On the other side, when a company asks for a single big loan from many small lenders, the terms and conditions of this loan are often standardized according to the wishes of the company, due to the company’s power position. Those little standardized pieces of the big loan borrowed from those many small lenders are named ‘bonds.’
A bond (similarly to a stock) is a small fraction of a bigger loan agreement between a company and a pool of small lenders. All bonds of the same loan agreement have the same standardized rights. But the company can deal a new loan agreement in the future, with another pool of small lenders using different terms and conditions, so, similarly to a stock, be careful to read the terms and conditions before buying a bond.
Owning a bond means having two fundamental rights: being paid back the initial lent capital plus interests and getting a part of the company's assets if it failed before the stockholders do.
Since bondholders can recover their assets before stockholders in case of failure, they are usually considered less risky. But, unlike stocks, bonds do not have decision rights.
Observation. There are senior bonds and junior bonds. In case of failure, senior bonds are paid first, then junior bonds, then stocks.
To really understand the difference between stocks and bonds, or more in general between equity and debt, it is useful to see how a balance sheet of a company is made. Stocks and bonds are little pieces forming equity and debt, equity and debt are the whole summed thing.
As you can see above, a company is made by assets ($300,000) such as machinery and plants, that were provided through cash investments by lenders ($200,000) and owners ($100,000). Formally, the assets are property of the owners, but actually in case of failure, by law, lenders are always paid back first ($200,000), and the residual goes back to owners ($100,000). So, a company is the sum of assets possessed (not owned) in part by lenders and in part by owners, where lenders have no decision-making rights about the business because only owners can run the business.
In reality, lenders can indirectly interfere in the business decisions using ‘covenants’ which are special conditions imposed before awarding a loan, in order to limit the risk exposure of the company by limiting its financial ratios, thus limiting the business decisions.
We have two types of bonds: zero-coupon bonds and coupon bonds.
Zero-coupon bonds do not pay anything between the lending act and the final repayment act. All the interests are cumulated at the end of the repayment, where capital and total interests are paid back.
While coupon-bonds pay coupons between the lending act and the repayment act - coupons are cash payments, which represent interests or interests plus a part of the capital.
We also have another particular type of bond, the ‘convertible bond’. This type of bond can be a zero-coupon bond or a coupon bond and can be converted into stocks during its life.
General observation about the financial industry. The ideas discussed in this book are the fundamental ideas that lay under the surface. But in finance, basic ideas can cross each-others creating new and more complex ideas than explained here. A zero-coupon convertible bond is an example. Again, read terms and conditions before buying.
Newly issued bonds can then be sold to other people, creating the secondary bond market, just like the secondary stock market, where exchanged prices are constantly monitored and published on graphs to be seen by everyone.
Not only do companies issue bonds to attract more debt, but governments also find small lenders an attractive source of funds. On the contrary to corporate bonds, government bonds have a greater social impact because they are usually considered the least risky type of debt because it is very rare for a government to fail, unlike companies.
As a matter of fact, financial professionals often approximate these very low-risk bonds to the ‘risk-free’ bonds, and the interest rate of these bonds is named risk-free interest rate. Any interest rate in the world is the sum of the common risk-free rate and a specific risk premium. The risk-free rate comes from the risk-free bond and the risk premium depends on the specific features of the debt instrument and the borrower's specific features.
Thus, the interest rate of a government bond is responsible for determining the total interest rate of everything in its country, also the loans we take from our around the corner bank.
Here you can understand the importance of central banks. These public institutions (with public, I mean that they work for the well-being of everyone living in that country) have the power to print new fresh money from nothing, in order to use it to buy government bonds to influence their price, and doing so to influence the risk-free rate, and doing so to influence the cost of your loan.
During recession periods, central banks push interest rates down to boost the economy, while during growth periods, central banks push interest rates up to keep them as a stock reserve in order to be able to push them down again during new unavoidable recession periods.
Actually, central banks have also other tools to boost the economy, like using the new freshly printed money to buy not paid back loans (i.e., ‘non-performing loans’ or ‘NPLs’) from banks and companies, freeing them from a burden and giving them the chance to get back into the business.
Both strategies, buying government bonds or buying NPLs, are commonly named ‘quantitative easing’ policies.
3.4 Mortgage-Backed-Securities
Probably you remember MBSs from the 2008 global crisis since they were blamed as the cause of the crisis.
Observation. A commercial bank is a bank specialized in giving loans to families and companies. An investment bank is a bank specialized in anything else (capital raising, mergers and acquisitions, advisory mandates, equity research, sales and trading, and asset management). A universal bank is a bank that does both commercial banking and investment banking.
Loans are not traded because they are customized debt, while bonds are traded because they are standardized debt. Your commercial bank does not trade your home mortgage with other commercial banks because it is a customized instrument. Analyzing in detail any mortgage before buying them is an expensive and time-consuming process. Thus, they just do not do it.
But something happened during the 60s. Some financial professionals had the idea of massing together many bank mortgages into a single instrument, baptized ‘mortgage-backed-security.’ As the name suggests, a mortgage-backed-security is a financial instrument that is composed (i.e., backed) by mortgages.
These financial professionals were following the golden rule ‘diversified is better’; in this case, single risks of single mortgages were spread over a portfolio of multiple mortgages. In short, when an unexpected loss happens on a single mortgage is better if this mortgage was placed in a portfolio of more mortgages than owning only that failing mortgage - ‘diversified is better’ minimizes the impact of unexpected losses of single mortgages on the entire portfolio. ‘Diversified is better’ is sensitive and works well if you did not push it to extremes like in 2008.
With mortgage-backed-securities, untradeable single mortgages became packaged tradeable because the overall risk of buying a portfolio was lower. Investment banks started creating and selling these MBSs to investors and whoever wanted to buy them. At the start, investors bought them because ‘diversified is better’ was protecting them, and they did not feel the need to analyze every single mortgage contained in the MBSs before buying it. As already mentioned, it is expensive and time-consuming.
A new big financial market was created, many other investment banks started grouping together mortgages into MBSs and started selling them on the market thanks to the ‘diversified is better’ principle. To make it feel even safer, investment banks began insuring these MBSs against default by big insurance companies in order to get a good rating on their credit safety from famous rating agencies.
So, at this point, we have three key players involved: investment banks that created the MBS, insurance companies that insured the MBS, and rating agencies that certified the MBS.
Hungry buyers of MBSs at that time were pension funds.
At the start, MBSs were safe for real. The ‘diversified is better’ worked well because commercial banks kept their safety measures before issuing new mortgages, which means they kept being choosy on mortgage borrowers. After a while, commercial banks understood that if they had loosened their safety measures on choosing borrowers, they would have faced no risk, because they were able to sell them right after to investment banks that would then have grouped these mortgages and sold the MBS on the market to investors that were still believing MBSs were safe.
This was the key point that started the crisis. Commercial banks started loosening their safety measures on lending mortgages.
Commercial banks started giving more and more loans to less and less trustworthy borrowers in order to sell them to investment banks that were willing to sell as many as possible MBSs on the markets. Of course, if you loosened the safety measures, a bunch of borrowers would start failing mortgage payments.
Some investors that first noticed this loosening policy adopted by commercial banks sold their MBSs and even started shorting them to maximize their profit. After the voice spread, everyone started selling their MBSs because the safety level perceived on MBSs fell. No one wanted them anymore. ‘Diversified is better’ does not work anymore if all these grouped mortgages were risky.
The price of MBSs free fell in a matter of days because Wall Street is a small place thus, information passes around quickly. Panic. Commercial banks could not sell their mortgages anymore to investment banks that were full of MBSs not sold yet and that were not able to sell anymore. None trusted MBSs anymore. Commercial banks had to keep these newly issued high-risk mortgages that were meant to be sold to investment banks, which meant no more new mortgages until they got rid of the already existing ones or they cashed the mortgage payments from the risky borrowers.
The music instantly stopped after years of excessive borrowing. No more new mortgages meant average Americans could not buy homes, the real estate prices started free falling as well. The consequent free fall of the real estate market made the crisis even worse. All the real estate mortgages became riskier because the collateral (the house) was losing its market value. As a consequence, the number of defaults on mortgages accelerated. MBSs became ‘junk’ instruments, and those big insurance companies that insured them started failing as well because of them; they had not enough money to cover all those mortgage defaults. The system was clogged.
3.5 Commodities
Commodities are not properly financial instruments, they come from the real-world economy. But they are very popular among investors at a point that some of them specialize themselves in a specific commodity and exchange only on that one on a daily basis. The most known commodities traded in financial markets are: gold, silver, platinum, copper, oil, natural gas, gasoline, electricity, live cattle, corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar.
Industry drivers determine commodities prices, each commodity price depends on the many variables that determine how its industry works. The fact that often there are so many variables to analyze about a single industry is why some investors choose only one commodity or a few of them to trade, sometimes for their entire life.
On the opposite side, other investors use commodities just to diversify their portfolio following the former ‘diversified is better’ principle because they feel it is too risky keeping only stocks or bonds, thus they also want commodities. In this case, the effort put into studying a commodity is lower because the purpose is just diversification. In this case, the idea of diversification is the following; if something bad happened to the entire stock market (for instance), there would still be bonds and commodities to sustain the overall portfolio performance.
3.6 Currencies
A currency is the way a country uses to exchange goods, services, and assets.
But what happens when there are multiple countries with multiple currencies? The people living in a country start exchanging their type of money (currency) for the type of money (currency) used in the other country in order to buy goods, services, and assets from the other country and import them to their home country.
When we exchange a currency for another, the ‘currency rate’ represents how much 1 unit of my currency is valued in foreign currency units. Attention, an exchange rate is double-faced. It can be expressed in two different ways depending on which currency is adopted as a point of view. So be sure always to choose one currency as the standard point of view and stick to it in order not to confuse yourself.
International government bonds equilibriums mainly determine a currency rate (the price of 1 currency unit in foreign currency units). Government bonds play a big role also in determining international exchange rates, besides determining the level of interest rates of everything as explained before.
Currency trades among international investors are then reported on graphs that you then see on the news.
The currency market has a big social impact on the world, because when a tourist or a company asks the bank to exchange their money to travel abroad or to import goods from abroad, the bank looks at the current exchange rates recently traded in the market - by those few big international investors.
So, the currency market impacts international tourism and international trading.
Last observation about cryptocurrencies. These new interesting forms of currencies are kept reliable by a decentralized technology named blockchain technology, which essentially means that the new money is not printed by a centralized central bank but by a decentralized network of computers (like my computer or yours) that have decided to ‘mine,’ i.e. printing new cryptocurrencies. This decentralized network of computers ensures that the currency cannot be double-spent or counterfeited, keeping it reliable to exchange goods and services. Moreover, this decentralized network of computers ensures anonymity, like traditional cash. This is why cryptocurrencies are popular among criminals. Actually, illegal online activities made cryptocurrencies popular at the start before becoming a bubble. But the real strength of cryptocurrencies is that they have no country borders. They are not meant to be the currency of a geographic area. They are worldwide currencies, a characteristic that traditional currencies miss.
On the contrary, the problem of these instruments, which is also why they should not become official currencies, is that because there is no central bank behind them, they cannot be used to manipulate inflation and interest rates to help the economy when needed.
3.7 Investment funds
An investment fund is a company. This company, instead of owning traditional machinery and plants, owns a pool of financial instruments.
3.7.1 Hedge funds Vs. Mutual funds
Investment funds can be of two types: mutual funds and hedge funds.
Even though there are many different and not unique definitions around, there is a common point where any definition agrees what differentiates these two investment funds. Hedge funds have low or no law restrictions on managing money, while mutual funds have more law restrictions enforced by the public authority in order to protect investors. Hedge funds have more discretional margins than mutual funds, being allowed to use financial leverage, assume short positions, and buy derivatives in order to maximize their performance and minimize their risks. But more freedom brings more concerns. Before buying a hedge fund quota, you really want to trust the hedge fund manager.
In addition to mutual funds and hedge funds, it is important to mention the usage of life insurance companies (as opposed to non-life insurance companies) as vehicles to invest. Their worthy and important role in society grants them a better legal and tax environment.
3.8 ETFs
An investment fund is managed by highly specialized professionals (asset managers and hedge fund managers). An ETF is not.
When managers use their brain to decide what and when to buy or sell something is named ‘active investing.’ So, you with other small investors are pooling your money and give it to one of these managers in order to be invested in the financial markets (or in the real estate markets, or both), trusting them that they will decide the best for you in order to achieve great returns under minimum risks.
To sum up, when you buy a quota of an investment fund (similarly to a stock), you are buying a small fraction of a pool of financial instruments picked by a manager. You are basically delegating the decision of spreading your money on different investments to a highly specialized professional because you think this professional will achieve better returns under fewer risks than you would be able to.
Similarly to an investment fund, an ETF is a pool of financial instruments, but these instruments are picked following a rigid rule. This composition rule was agreed upon at the start. So, an ETF manager's job would be just to sell and buy to make sure the composition of the portfolio respects the composition rule. That is why this job is actually done by computers, not by humans. An ETF does not need a manager. Since the portfolio composition is adjusted by algorithms that buy and sell financial instruments to keep the composition rule respected, ETFs are considered self-picked and automatized.
What distinguishes investment funds from ETFs is the human decision-making part. When you invest in investment funds, you are trusting people’s cleverness. When you invest in ETFs, you are trusting the composition rule. An investment fund is based on human decision-making actions, while an ETF is based on rule decision-making actions. This is why investment funds are often regarded as 'active investing' vehicles, while ETFs are regarded as 'passive investing' vehicles.
Since ETFs are managed by a composition rule applied by computers, there are no salary payroll costs to be charged. Because of none or very low payroll costs, ETFs usually charge very low fees, which is the most important characteristic of ETFs and is what makes them so attractive to investors.
ETF is the acronym of Exchange-Traded Fund because there is an active market on ETFs where these instruments are bought and sold by international investors. Unlike investment funds that can be or not be traded in a public financial market, ETFs are always traded in a public financial market, so their prices are showed on graphs all over the world.
ETFs can pool by geography, which means that you can buy an ETF that pooled proportionally all the traded stocks (or bonds, or anything else) of a country or a particular geographic region. Thanks to ETFs, you can buy indexes like the Standard and Poor’s and the Dow Jones.
ETFs can also pool by sector, which means that you can buy an ETF that pooled proportionally all the traded stocks (or bonds, or anything else) of a sector.
The ways an ETF can pool are infinite, you just need creativity.
If you bought an ETF, you would do it because you thought that country or that sector is going to grow in the future.
It is interesting to see how ‘diversified is better’ applies here as well. ETFs are based on this principle. This principle became a golden rule in finance thanks to Markowitz, who demonstrated its consistency using mathematics tools based on risk-return relationship. Actually, Markowitz went well over just diversifying. He discovered how to best diversify: you should pick financial instruments in such a way that when some of them go down, other ones go up (technically named ‘negative correlation’), in this way you are avoiding losses on single instruments because compensated by returns on other instruments. Negative correlation keeps your overall return of the portfolio less uncertain. You want negatively correlated financial instruments in your portfolio, according to Markowitz.
A first final observation. Do not confound ETFs with Robo-advisors. ETFs are baskets of financial instruments, Robo-advisors, easily accessible through a website, are non-human financial advisors that permit little savers to invest as little as $1. The saver has just to choose a level of risk she/he wishes to invest her/his dollar, and the Robo-advisor will do the rest thanks to its algorithms. Be careful to understand and trust a Robo-advisor investing strategy before investing in them.
ETFs are passive investments, Robo-advisors are active investments.
A second final observation. Do not confound ETFs with Smart Beta ETFs. Let’s take an ETF and a Smart Beta ETF that both replicate the Standard & Poor’s. The ETF replicates exactly the index, while the Smart Beta ETF adds some active investing rules. In short, ETFs are pure passive investments while Smart Beta ETFs are also passive investments but with a flavor of active investing. Smart Beta ETFs' idea is that by adding some active investing rules to a pure passive ETF, you diverge a bit from the index, and by doing so, you might be able to beat the market.
Smart Beta ETFs aspire to keep the low fee cost of a classic ETF but performing better by adding some active investing rules.
3.9 Venture capitalists
Venture capital companies or VCs work similarly to investment funds. But VCs are specialized in non-publicly traded stocks (i.e., private equity) of recently born small companies with high growth potential (i.e., start-ups).
These start-ups must have already achieved their ‘first phase’ of life, which means starting and running the business using: bootstrap resources provided by founders / family / friends / fools and resources provided by ‘angel investors’ that are usually rich retired experts of the sector.
If the start-up successfully passed its first phase, it would enter its ‘second phase’ of life. Here VCs become interested in their business and want to buy a piece of the equity, wishing to provide also consulting support by mentoring the founders. VCs generally avoid buying during the first phase because still too risky.
VCs base their existence on the ‘20/80 rule’ which basically means that VCs are conscious that 80% of the acquired start-ups will lose them money (start-ups fail often), but VCs count on that 20% of companies that will end up being profitable, hoping that their profits will more than compensate the losses provided by the previous 80%.
Actually, what really thrills VCs are ‘unicorns,’ unicorns are those one-century companies that become extremely successful, often in a short time period. VCs hope to have a future unicorn in their 20% part of portfolio, which will not only compensate for losses but will make them very rich.
The ‘third phase’ of life is getting big enough to meet the requirements needed to be traded in a public stock exchange. Unicorns usually end up here.
Last observation. Over the last few years, a new trend has been seen in the industry. More and more ‘venture capitalists’ are choosing to turn into ‘venture builders.’ A venture builder operates exactly like a venture capitalist, but instead of buying a piece of equity during the second phase, they directly buy the idea even before the first phase starts. Venture builders want to develop the idea by themselves in-house. In short words, there are no more ‘founders’ but ‘ideas creators,’ who can or can’t actually decide to join the venture with the venture builder after having sold the idea.
3.10 Derivatives
A derivative is a financial instrument that is based on something else named ‘underlying’ (the underlying is usually another financial instrument). This is why it is named derivative. Its existence derives from the existence of the underlying. Consequently, the price of a derivative derives from the underlying.
In practice and more simply, a derivative is an agreement/contract between two counterparts based on an underlying (like a stock, a bond, gold, or the weather).
Derivatives have a worthy original goal. It is how they are used (speculation) that gave them a bad reputation. Derivatives are contracts meant to protect from certain risks linked to the underlying. But most of the time, these financial instruments are exploited to speculate on the underlying.
Since derivatives are usually customized contracts among the parts involved, they are not suitable for public trading, where a graph keeps the exchanged price monitored. A market where the price is not monitored is said ‘over-the-counter,’ and it is where derivatives are said to be traded.
But in some cases, we can also find standardized derivatives, which means that there are many contracts around with the same terms and conditions. In this case, since many contracts are equal, the price involved in all these transactions refer to the same thing and thus can be monitored, forming a public market.
3.10.1 Forward
A forward is an agreement between two counterparts that agree to exchange the underlying (for instance, gold) in a specific point of the future at an agreed price (i.e., forward price).
The counterpart that is buying the underlying is said to have a ‘long’ position while the counterpart that is selling the underlying is said to have a ‘short’ position. Long because if the market price went up before the exchange, it would profit the long counterpart, who is obtaining an underlying that is priced more on the market. Short because if the market price went down before the exchange, it would profit the short counterpart, who is giving away an underlying at a greater price (forward price) than the price offered by the market at that moment.
To put it simpler, a forward contract is used to lock a price on the underlying. A very common forward is a forward on commodities, used by entrepreneurs to lock current commodity prices because they want no surprises when they have to sell/buy commodities for their business, and the usual counterpart of the entrepreneur is a financial professional that is speculating on the price of that commodity.
3.10.2 Future
A future is the same thing as a forward, but it is standardized. This means that there is a market where the short counterpart or the long counterpart can transfer her/his position at a public market price.
3.10.3 Option
If forwards and futures were obligations to exchange an underlying in a specific point of the future, options are the same thing, but they also give to one of the two counterparts the power of withdrawing the exchange. Forwards and futures are obligations. Options are faculties.
When the long counterpart is granted the withdrawal faculty, the option contract is named ‘call’ option.
When the short counterpart is granted the withdrawal faculty, the option contract is named ‘put’ option.
Call options on stocks are popular incentives for company managers. In these contracts, the long counterpart is the manager, and the short counterpart is the company the manager is working for. If the manager managed the company well, its stock market price would rise, and her/his call option will become more valuable. Attention, while the stock market price rises, the contract's forward price is fixed (actually called 'strike price' if it was an option). The manager will be able to purchase the stock at the strike price as cost, while the stock's actual market price will be higher, a bargain for the manager.
Options, like futures, are usually standardized contracts, thus they are exchanged in public markets.
3.10.4 Warrant
A warrant is a particular type of option on stocks. A warrant is an option on newly issued stocks by the company, while an option on stocks refers to already existing stocks. Like options, we have call warrants and put warrants.
In the previous example of a call option as an incentive for a manager: if the underlying stock was directly issued by the company, which means it is new, the call option would be called call warrant. If the underlying stock was old, which means the company has repurchased it from a previous owner to give it to the manager, the call option would keep the name.
Finance language technicalities, but nothing hard conceptually.
3.10.5 Swap
A swap, like any derivative, is a contract between two counterparts. In this case, the agreement is to exchange a series of cash amounts over some time. Commercial banks use swaps to adjust their offered loans, and usually, the counterparts of these contracts are again financial speculators like investment banks. Let’s see two types of swap contracts to understand what ‘exchanging a series of cash amounts’ means.
When a commercial bank lends you a loan at a fixed interest rate, it might decide to convert this fixed interest rate into a variable interest rate by stipulating an ‘interest rate swap contract’ with an investment bank. So, when you give to the commercial bank your monthly fixed payment, the commercial bank will forward your fixed payment to the investment bank in exchange for a variable payment, which is linked to the current interest rate that changes every day. Commercial banks often decide to do so because they do not want to be locked into a fixed-rate loan, risking a loss if current interest rates went up after the loan was given. Interest rate swaps are the reason why you are able to purchase fixed-rate loans.
When a commercial bank decides to lend a loan abroad because that country has higher interest rates, the loan will be repaid in foreign currency. But the commercial bank wants to convert foreign currency repayments into home country currency repayments. In order to do so, the commercial bank decides to subscribe to a ‘currency swap contract’ with an investment bank. So, when the foreigner gives the commercial bank its monthly payment in foreign currency, the commercial bank will forward the payment to the investment bank in exchange for a home country currency payment, calculated on a fixed initially agreed currency rate. Commercial banks often decide to do so because they want to avoid losses caused by currency rate fluctuations. Currency swaps allow commercial banks to operate abroad.
Swaps are usually customized contracts, thus, they are not exchanged in public markets but are exchanged privately in over-the-counter markets.
3.10.6 CDS
Credit default swaps (CDSs) are very interesting derivatives because their price can predict defaults of countries - defaults on their government bonds.
Forget the previous swaps, they have nothing to do with CDS, the underlying of a CDS is a bond.
A CDS is essentially an insurance policy on a bond. As usual in derivatives, two counterparts meet and make an agreement, the first counterpart is a bond 'owner' and the second counterpart is an 'insurer.' The owner is afraid to lose money on her/his bond bought time ago, thus decides to cover it by signing an insurance policy with the insurer (a CDS). After the signature, the owner pays a periodic premium to the insurer as the insurance service's cost, while the insurer is obliged to repay back the owner of her/his losses in case the bond defaults.
The interesting part is the fact that you can ask for a CDS cover even if you were not an owner. If you thought a bond is going to default, you could look for an insurer available to issue a CDS, and you are all set. You do not need to own the bond. Here you understand why CDSs became highly speculative instruments. Investors buy a CDS to profit from the default, not to cover themselves from the default. The profit comes from the default repayment from the insurer.
Because CDSs can be made in such a freeway without actually owning the bond, many of them have been created, they became standardized and became traded in their public financial market. Therefore, a CDS has a market price. More precisely, the owner counterpart can transfer her/his position for a market price.
If many people started thinking a government bond will default, they would flood the market willing to buy a CDS (an owner counterpart position) on that bond to profit from the default. Doing so, they are raising the market price of the CDS.
When a CDS price rises, it means that the majority of investors on the market are thinking that the government will fail, and sometimes it happens.
But when a CDS price rises, those that are the real owners of the underlying bond start getting afraid of the default and start selling their bonds. Consequently, the price of the bond falls, which means the interest rate rises (it's mathematics). In brief, when the CDS price rises, the interest rate tends to rise as a consequence. This makes for the government issuing new bonds more expensive because they will have to issue them at a higher interest rate caused by the CDS, augmenting the probability of default. CDS expectations can lead to real government defaults (i.e., self-fulfilling expectations).
3.10.7 Weather derivatives
The underlying of a weather derivative is a parameter linked to the weather (temperature degrees, millimeters of rain, humidity percentage, etc.). This derivative is created to protect from peaks in the parameter.
As usual, we have two counterparts, the ‘insured’ counterpart (usually a business owner that wants to protect herself/himself from adverse weather conditions that provide her/him losses) and the ‘insurer’ counterpart.
They both agree that if the parameter went too far from the average, the insurer would pay back the insured. For instance, if the weather temperature went too far from the average temperature, it might ruin a farmer’s crops. The farmer would be losing money if he had not a weather derivative that insured her/him. Usually, the business owner gets paid X Dollars per each unit the parameter goes over a threshold.
Like other derivatives, the insured counterpart and the insurer counterpart can sell their position in the agreement to other people. Someone might want to buy an insured counterpart position to speculate on weather peaks, while someone might want to buy an insurer counterpart position to cash in the periodic premiums paid by the insured counterpart.
3.10.8 Cat bonds
Cat bonds, as the name suggests, are bonds. They are debt.
Insurance companies use to issue these bonds to protect themselves from a specific catastrophic event that would make them pay out enormous amounts of cash to their insured customers. The underlying is the catastrophic event.
These derivatives work in this way: the insurance company issues the cat bond to collect money to store it away, then the insurance company starts paying periodic interests on the debt to the bondholder, then if the catastrophic event happened before the bond life period ends, the insurance company could keep the stored money, and nothing else is due to the bondholder.
But, if the catastrophic event did not happen before the bond life period ends, the insurance company would have to give back to the bondholder the money stored away at the start plus interest, just like a normal bond.
These bonds have higher interest rates than usual corporate bonds because the catastrophic event risk is added to the other typical risks of a regular bond. That is why bond investors like these bonds, they pay more interest for an unlikely catastrophic event.
A catastrophic event is also named ‘low probability - high loss’ event. Insurance companies do not like these types of events because they can make them fail; this is why cat bonds come in hand. On the contrary, insurance companies like insuring ‘high probability - low loss’ events (like car accidents) because they are more predictable. With high probability low loss events is easier to make predictions, and therefore is easier to make reliable profits.
Like other derivatives, the insurance company and the bondholder can sell their position in the derivative agreement to other people. Someone might want to buy the insurance company position to speculate on catastrophic events, while someone might want to buy the bondholder position to cash in the periodic interests paid by the insurance company.
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