DERIVATIVES

Here is a basic definition of the new "thing on the block" by Ian MacKinnon of Vanguard's Fixed Income Group. A derivative is a "synthetic security created from a plain vanilla long term bond that also has a variety of options attached to it that can add a higher degree of volatility that would otherwise not be present in the underlying bond. A derivative security, for example, could have two, three, four or five times the price volatility of a conventional bond. They can provide massive gains- or massive losses if the manager selects incorrectly. Other derivatives have the principal stability of a money market obligation- representing every bit a s much safety and quality as the underlying security. Vanguard buys ONLY these short term instruments. " that last comment is important. Everything else being equal, I'd much prefer a low risk scenario within the fund I am actually using. Sure, it's nice to be surprised by a huge gain if a manager picked some high volatility instrument correctly, but I don't like the risk of the huge downfall as well. You might remember that previous comments from other experts is that few managers really understand the risk of these or how they might be properly utilized.

(WSJ) They are not securities in themselves but financial arrangements. Their values are derived from changes in underlying variable such as stock indexes, interest rates, currency and commodity prices, etc. One of the most commonly known to the layman is the CD whose rate is tied to the S&P index. One recently advertised CD said that it would only pay interest IF the S&P rose. Derivatives usually trade OTC- over the counter- by telephone and include:

Forwards- an OTC obligation obliging the buyer and seller to trade at a set price on a future date a fixed amount of a particular commodity , currency or other financial instrument. Forwards are price fixing contracts because they saddle the buyer both the same returns as owning the underlying asset. Normally no money changes hands until the delivery date; then the contract is usually settled in cash.

Futures: an exchange traded forward contract. They are highly standardized and the exchange acts as a counterparty to both buyer and seller guaranteeing payment in cash in case one defaults. In return , buyer and seller are required to put up collateral or margin equal to a certain percentage of the contracts underlying value which is marked to the market each day. However tremendous leverage is available since the margin is extremely small.

Swaps: A forward type contract in which two parties agree to exchange streams of payments over time according to a predetermined rule. In an interest rate swap, one party agrees to pay a fixed interest in return for receiving a floating interest from another party. Equity index swap may involve swapping the returns for two different stock market indexes or swapping the return of a stock market index for a floating rate interest.

INTEREST ONLY (IO) DERIVATIVES: These securities are stripped from mortgages and allow the holder to receive interest only payments on the underlying securities. It's probably a good bet if rates are constant or rising. But when rates fall- as they have been recently- homeowners refinance. That means the strips have dropped in value- and sometimes evaporated. Portfolios have lost 50% in value recently. While bad for individual investors since few understand them properly, it is bewildering to note that professional investors have lost their shirts as well. Several portfolios for schools districts in OHIO lost over $10 million. As the chairman of an association for investment policy community noted, "treasurers would know an IO from a bankers acceptance".

MORTGAGE BACKED SECURITIES: (Investment Advisor) There is about $1.2 trillion in mortgage backed securities in the market and somewhere between 1/3 and 1/2 are made up of derivatives. These mortgage backed securities can be divided into tow main groups. The first includes CMO's (Collateralized Mortgage Obligations) and REMIC's (Real Estate Mortgage Investment Conduit) The second category includes derivatives of stripped mortgage backed securities often referred to as IO/PO's (interest only/principal only). Here are some definitions you never want to bother with.

Principal Only Strips- A zero coupon mortgage baked security is referred to as a PO. All such securities are created by stripping the coupon interest from the underlying mortgage to create the PO and the associated interest only IO security. PO's can represent the principal from an entire pool of mortgages, or they can be tranches within a CMO.

PO's are sold at a deep discount to face value. Because there is no coupon, the financial performance of the PO is extremely sensitive to prepayment rates. Higher prepayments leads to a more rapid return of principal and higher return. Interest only strips (IO's)- the security representing the coupon payments from an underlying pool of mortgages is referred to as an IO. IO's can represent the interest from an entire pool of mortgages or they can be tranches within a CMO. In their pure form, IO's are sold at a deep discount to their notional principal amount. The notional amount is the principal balance used as a reference to calculate the amount of interest due. IO performance is highly sensitive to prepayments rates, but IO's increase in value when prepayments rates decline. This feature gives IO's some of the characteristics of hedging instruments with negative duration.

IOette- An IO tranche in a CMO.

Floating rate REMIC- a REMIC tranche that pays an adjustable rate of interest that moves in the opposite direction in a representative interest rate index.

Super Floater- A floating rate REMIC tranche whose rate is based on a formualaic relationship at a representative interest rate index. The coupon on a straight floating rate tranche moves up and down on a one to one basis with the index; the coupon on a leveraged or super floating rate tranche will increase or decrease by more than one basis point for each basis point increase or decrease in the index.

Tranche- A class of bonds in a REMIC offering which shares the same characteristics. Tranche is French word for slice.

Z- tranche- Often the last tranche in a REMIC, the Z tranche receives no cash payments for an extended times until the previous tranches are retired. While other tranches are outstanding, the Z-tranche receives credit for the periodic interest payments that increase in face value but are not paid out. When other tranches are retired, the Z-tranche begins to receive cash payments that include both principal and continuing interest.

DERIVATIVES: Here are some more definitions on certain CMO's- collateralized mortgage obligations with supposed advantages and disadvantages. (Fitch Investor's Services)

PAC- Planned Amortization Class: PAC's are the most frequently issued tranches- maybe as high as 40%. Average lives are about two to ten years.

Advantage- cash flow stability, stable total return, price stability

Disadvantages- Lower Yield

Floaters- these are bonds with interest payments tied to an index, typically LIBOR. Payments may be reset monthly or quarterly, depending on the tranche's structure

Advantage- Stable total return, price stability

Disadvantage-Lack cash flow stability as interest rates fluctuate.

Inverse Floaters- These are structured to offset floating rate tranches. Interest payments of IF's vary inversely with an index, typically LIBOR. Because IF''s are more leveraged than other tranches, they have high price volatility as interest rates move.

Advantage- Interest rate play for sophisticated investor

Disadvantage- Moderate interest rate changes can cause large changes in price and totally return

Interest Only- these tranches only receive the interest portion of the cash flow. Since IO tranches have little or no principal, prepayments wipe out future cash flows. As prepayments accelerate in declining interest rate environments, investors could lose a portion of their initial investment. Conversely, investors benefit when rising rates extend interest payments beyond the targeted a maturity.

Advantage- typically a good hedge in rising interest rate environments

Disadvantage- potential loss of original investment, volatile total returns

Principal Only- these tranches receive only the principal component of the cash flow; they receive no interest. PO's have more price volatility than IO's. PO's are sold at a large discount from face value. Price volatility increases when rates rise because the bulk of cash flows, normally received near maturity, are pushed further out as prepayments slow. PO's perform best when interest rates fall.

Advantage- Typically a good hedge in declining interest rate environments

Disadvantage- total return fluctuates in rising interest rate environments, longer maturities create greater price volatility in rising interest rates environments.

Z bonds- Accretion bonds- in general they do not pay interest. Interest accretes, being added to principal and is compounded through the accretion period which can extend beyond 20 years. Thereafter, interest payments begin and continue through maturity. Z bonds have characteristics similar to zero coupon bonds. Average life, total return, and cash flows are subject to wide swings as interest rates rise and fall.

Advantage- if held to maturity, total return is higher, interest compounds

Disadvantage- high cash flow volatility, total return and price become volatile as interest rates change

In summary, you better understand these cold if you invest with individual issues. Even with mutual funds, you should at least recognize the volatility of such instruments.

DERIVATIVES: (Fed Board of Atlanta 1997) A derivative is a contract like an option, futures, interest rate swap, etc. where one party contracts to pay another $x if a certain occurrence happens. They can get pretty esoteric and costly if one picks the wrong side of the transaction. Secondly, even if you are on the right side and do win BIG, it doesn't mean that the contra party will actually "pay up". However, many derivatives are controlled by the Chicago Mercantile Exchange and they have lots of buyers and sellers which tend to limit any major loss in case one side is incapable of paying. The FED Board was asking "what happens if there was a severe meltdown in the market- could the Chicago Mercantile Exchange survive the blitz?" They see problems primarily since the new options- interest rate and currency rate swaps- have only been in existence a few years but have sustained very high growth. They ended with a cautionary note but indicated that banks could be stuck in the middle. After the real estate debacle of the 80's, the last thing we need is a bunch of bank managers screwing up another type of investment. It simply means we need to stay vigilant whenever a fund uses a lot of derivatives.

Derivatives: (NY Times 2002) Unlike markets for stocks, bonds and commodities, where the assets traded and the details of those trades are easy to understand, the derivatives market is hardly transparent. The terms specified in a derivative contract can take up scores of pages of text, and trading is not always public.

In their simplest definition, derivatives are contracts that promise payments from one investor, or "counterparty," to another, depending on future events. Those events can be as ephemeral as changes in the prices of securities or commodities from which the contracts are derived — hence the name — or as concrete as weather changes (which Enron turned into a booming business).

The contracts' payments are usually calculated in relation to the value of some underlying asset, like a bond or a shipment of oil.

Now even before we go further with the Times article, I know some are having problems in understanding some of the above. Here's the point. Remember Long Term Capital from a few years ago? It was doing the same thing with 2 Nobel Laureates and 27 PhD's in defining "ever" element that could go on with their system thereby providing an essentially no lose scenario. It melted primarily because human beings do not have to act rationally at all times. Maybe it's 60% or 80% or whatever given XZY conditions. But you cannot pattern them to 100%. Hence the default of LTC required an effective bailout of the U.S. banking system to the tune of $3.5 billion.

In June, according to the Bank for International Settlements, the over- the-counter market for derivatives consisted of contracts based on $100 trillion in underlying assets — about twice the value of all the goods and services produced by the entire world in a year, and a 38 percent increase in size since 1998.

Michael R. Darby, a finance professor at the University of California at Los Angeles, puts it this way: "Do the products have the ability to offset risk through a true hedge? Yes. Do they have a potential for accounting abuses or trading abuses? Yes."

Those bells and whistles also hurt the financial system by reducing the transparency of a company's activities for outsiders. Yet even a company's own directors might not understand its derivatives portfolio. "Boards shouldn't allow transactions they don't understand. "That doesn't mean people don't do it."

True. But even if you have an MBA, I doubt that many director's really have a true understanding of what is going on the inherent underlying risk. Yes, they can work properly. But there are unregulated and subject to abuse.

"Outside the financial sector companies' use of derivatives is mostly unregulated and is believed to have increased sharply in the last few years. " 

Ethical conduct therefore occupies the central role in stemming systemic risk in derivatives markets. "In most cases, the accidents and negative fallout that have surrounded some derivatives episodes have been due to a lack of risk controls in the firms that have precipitated the events."

Derivatives: Lots more derivatives- the size of the credit derivatives market doubled in 2006 for the third consecutive calendar year. The International Swaps & Derivatives Association (ISDA) year-end market survey showed that the national principal outstanding volume of privately negotiated credit default swaps (CDS) rose 102 percent, to $34.5 trillion, from $17.1 trillion a year earlier.

The year-over-year growth rate was virtually unchanged from the 102 percent of 2005. But ISDA noted a more pronounced slowdown in the sequential growth that it measures on a semiannual basis. The $34.5 trillion was 33 percent higher than the $26 trillion of June 30, 2006, but the latter figure had grown 52 percent from the end of 2005. Then again, the 2005 pattern was similar to 2006, with second-half sequential growth of 38 percent comparing with 48 percent in the first half.

In any event, credit default swaps remain by far the fastest-growing derivative asset class tracked by ISDA, whose numbers aggregating single-name CDS, baskets and portfolios of credits and index trades are closely followed as a barometer not only of business growth, but also of the need to strengthen operational procedures to handle the volume.