Financial Derivatives

This blog covers the topic of financial derivates. Also included will be an update on corporate earnings and the weekly update from Vanguard.

Corporate Earnings

My belief has been that corporate earnings will be stronger than anticipated and would be positive for investing in stocks. This week many corporations published earnings and gave guidance on future revenue and earnings. Most corporations exceeded expectations and gave a favorable view of the future stating that an economic recovery was progressing with little concern about a double dip recession. Treasury Secretary Tim Geitner also gave positive comments about economic recovery for the next 18 months. Because of these earnings reports, and an extension of jobless benefits, the stock market did perform well this week. This trend should continue through the earnings season which lasts through about the end of August.

Vanguard Weekly Recap

The speed might resemble that of rush hour traffic, but the economy is still moving. If a breakdown occurs, Federal Reserve Chairman Ben Bernanke said the Fed would take further measures. The news was mostly negative this week, but the long-term recovery still appears to be on course. Both existing-home sales and housing starts were down, mostly because of April's expiration of the federal homebuyer tax credit. The Conference Board's index of leading indicators also fell. For the week, the S&P 500 Index rose 3.5% to 1,103 (for a year-to-date total return—including price change plus dividends—of about -0.1%). The yield of the 10-year U.S. Treasury note rose 6 basis points to 3.02% (for a year-to-date decrease of 83 basis points).

Financial Derivates

A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is nearly endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying.

By contrast, we might speak of primary instruments, although the term cash instruments is more common. A cash instrument is an instrument whose value is determined directly by markets. Stocks, commodities, currencies and bonds are all cash instruments. The distinction between cash and derivative instruments is not always precise, but it is a useful informal distinction.

Referring to derivatives as assets would be a misconception, since a derivative is incapable of having value of its own. However, some more commonplace derivatives, such as swaps, futures, and options, which have a theoretical face value that can be calculated using formulas, such as Black-Scholes, are frequently traded on open markets before their expiration date as if they were assets.

Derivatives are used by investors to

1) provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative
2) speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)
3) hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
4) obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)

The recently passed financial regulation law has placed limits on the use of derivatives for banks and other financial institutions. These institutions are upset as it impacts their ability to make money as well as their ability to hedge against loss in an investment. If financial institutions are using derivatives, how can an individual investor use it?

If an investor is buying individual stocks then an option can be used to cover any loss. This is done by buying a put against the stock that gains in value as the stock declines. I am not a big believer of buying stocks options.

If an investor is buying mutual funds then an Electronically Traded Fund (ETF) can be purchased that tracks the value of future contracts. One such ETF is VXX that tracks the future value of the Volatility Indexes such as the Volatility Index of the S&P 500 (^VIX). A somewhat inverse correlation exists between the S&P 500 and the ^VIX so if one is concerned about future stock prices an individual investor can buy the VXX as a hedge. During the latest recession, while stock prices were dropping by 50% the VXX increased substantially, about 4 times higher.

The use of VXX is something that I am researching as a way to make money when the stock market is in a trading range. A portion of an investment portfolio would be used. This takes advantage of the Warren Buffet statement to be fearful when others are greedy and be greedy when others are fearful. This is how it works:
* when the stock market is acting normally and the ^VIX is low, about 20, VXX would purchased
* when fear hits the stock market and the ^VIX is high about 40, VXX would be sold
* the cycle continues as volatility rises and falls