Sunday, September 10, 2006

Derivatives (Part one)

To most market participants, warrants provide a so-called cheap alternative to owning the underlying asset of a business. But however, it is one of the many different products that belongs to the family of Deriatives. It is important for market participants to realise the full risk of a deriatives. In fact, derivatives is 99% or more in the form of speculation or gambling.

It should be viewed as time bomb, for both the parties that deal in them and the economic system. Since derivatives covers an extraordinary wide range of financial contracts - some of which is totally so interwined and complicated that even a maths professor needs some thinking-, it is important to understand it in the most basic form. Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rate, stock prices or currency values.

The range of derivatives contracts is only limited by the imagination of man. At Enron, for eg, newsprint and broadband deriatives, due to be settled in many years in the future, were put on the books. Or say, if you want to write a contract to speculate on the number of twins to be born in Singapore in 2020. No problem - at a price, you'll easily find an obliging counterparty.

In deriatives business, it is like hell - easy to enter and almost impossible to exit. Once you write a contract - which may require a huge payment decades later - you are usually stuck with it. Though there are methods by which risk can be laid off to others. But most strategies of that kind still leave you with residual liability.

Another trait of derivatives is reported earnings are oftenly wildly overstated because today's earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors may usually be honest, reflecting on human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market (think about the contract involving twins) and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for the counterparties to use fanciful assumptions. In the twins scenario, for eg, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model may well turn into mark-to-myth.

The valuation problem is far from academic. In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for eg, companies use derivatives and trading activities to report great "earnings" - until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. Mark-to-market then turned out truly to be Mark-to-myth.

You can be assured that marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report "impressive earnings" (or both). The bonus were paid and the CEO profited from his options. Only much later did the shareholders learn that the earnings were nothing but a sham.

To know more about the pitfall of derivatives, I recommend you to read this book "Fiasco" by Frank Partnoy.

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