Other derivatives

Learning outcomes

After studying this text the learner should / should be able to:

1. Comprehend the existence of derivatives that are not classified under the traditional derivatives (forwards, futures, swaps and options)

2. Describe the derivative product: products of securitization

3. Elucidate the derivative product: credit derivatives

4. Explain the derivative product: weather derivatives.

Introduction

The mainstream derivatives were discussed above. As stated before, derivatives are instruments that cannot exist without their underlying instruments and their value depends on the value of these underling instruments; and the traditional underling instruments are share prices, share indices, interest rates, commodity prices, exchange rates, etc.

Over the past decades, and in some cases over the past few years, other derivatives have been developed that are based on the prices of other underlying variables. For example, the following derivatives are available in international markets):

• Securitization.

• Credit derivatives.

• Weather derivatives.

• Insurance derivatives.

• Electricity derivatives.

Insurance derivatives have payoffs that are dependent of the amount of insurance claims of a specified type made during the period of the contract. Electricity derivatives have payoffs that are dependent on the spot price of electricity. Here we briefly discuss the other three mentioned.

Securitisation

The products of securitisation may also be seen as "derivatives" because they and their prices are derived from debt or other securities that are placed in a legal vehicle such as a company or a trust. Some analysts will insist that these products are not derivatives. However, the jury is still out in this respect.

Securitisation amounts to the pooling of certain non-marketable assets that have a regular cash flow in a legal vehicle created for this purpose (called a special purpose vehicle or SPV) and the issuing by the SPV of marketable securities to finance the pool of assets. The regular cash flow generated by the assets in the SPV is used to service the interest payable on the securities issued by the SPV.

There are many assets (representing debt) that may be securitised, and the list includes the following:

• Residential mortgages.

• Commercial mortgages.

• Debtors books.

• Credit card receivables.

• Motor vehicle leases.

• Certain securities with a high yield.

• Equipment leases.

• Department store card debit balances (examples: Edgars card and Stuttafords card).

For the banks, securitisation amounts to the taking of assets off balance sheet and freeing up capital. For companies, securitisation presents an alternative to the traditional forms of finance. An example of the latter is the securitisation of company's debtors' book.

example of bank securitisation of mortgages

Figure 1: example of bank securitisation of mortgages

A typical securitisation (of mortgages) may be illustrated as in Figure 1. In this example, the bank decides to securities part of its mortgage book, in order to free up the capital allocated to this asset. It places R5 billion of mortgages into a SPV, and the SPV issues R5 billion of mortgage-backed securities (MBS) at a floating rate benchmarked to the 3-month JIBAR to finance these assets. A portfolio manager manages the SPV, and trustees appointed in terms of the scheme monitor the process on behalf of the investors (in this case assumed to be pension funds) in the MBS.

It should be noted that the details of the above securitisation have been ignored, in the interests of understanding the basic principles of the transaction. In real life, the scheme is extremely lawyer-friendly, and the MBS issued are rated AAA by the rating agency/agencies in order to attract investors. This is achieved by the credit-enhancement process, by which is meant that the SPV is properly "capitalised". The latter in turn is achieved by the SPV issuing 3 streams of MBS in the following manner (this is an example)68:

• AAA rated MBS: 90% of the total (i.e. R4 500 billion).

• BBB rated MBS (called mezzanine debt): 7% of the total (i.e. R350 million).

• Unrated MBS (called subordinated debt): 3% of the total (i.e. R150 million).

The AAA rated paper, as noted, is sold to the market, while the BBB paper is usually purchased by one of the sponsors at an excellent rate of interest.69 The management company usually holds the unrated paper in portfolio, and a mixture of equity / shares and debt finances this company.

The variable rate of interest paid on the underlying assets (and the cost of the credit enhancement) determines the rate payable on the three streams of paper created by the SPV.

 
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