Question

1. Explain what is a fixed income derivative instrument? Your explanations should include numerous examples of such instruments and a brief description of how they are valued, and under what context they are used.                               
2. Discuss ways of measuring the different types of risks associated with such complex financial instruments. Provide examples to illustrate points                     
3. Fixed income derivatives were instrumental in the financial crisis of 2008. Other than outright banning, what can be done to these instruments to ensure that they are not as dangerous in the future. Illustrate with suitable examples.

Answer 1

Derivative

A derivative is nothing but a product whose value is derived from an underlying product such as a stock, index, commodity, bond etc. A derivative is essentially in the form of vanilla structures such as 1) Futures 2) Forward 3) Options. Apart from these there are other exotic categories of derivatives such as Swaps, CMBS, CDS etc

Fixed Income Derivative

A fixed income derivative in essence is a derivative whose value is derived from fixed income security such as a Bond or Bond Index. Mainly, there are two type of fixed income derivatives:-

A) 'Interest-rate derivative' is a product whose value is derived basis the direction of 'interest rates'

B) The second type which is 'Credit Derivative', which is based on credit risk, or the probability of a bond issuer defaulting on an obligation

Examples:-

Interest Rate Swaps

An interest rate swap is a fixed-income derivative in which counter-parties exchange different cash flows. For example - one party ops for cash blow based on fixed rate while the other party opts for ash flow on floating interest rate, both cash flow being being applied to a notional/principal amount. The floating rate are generally tied to index or a rate on sovereign debt or else, the rate governed by central bank of a country. As an example, ABC has purchased $100 in 5% notes, but expects interest rates to rise. XYZ expects lower interest rates. ABC agrees to pay a fixed 5% to XYZ who in turn agrees to pay the current rate (such as LIBOR) on the $100 note

Bond Futures Contract

A bond futures contract is an agreement to buy or sell a bond in the future at a price agreed upon now. These are standard instruments traded on futures exchanges. The price of the futures contract is theoretically determined by the anticipated future price of the underlying bond

Collateralized Debt Obligations

Collateralized debt obligations, or CDOs is a derivative of real-estate mortgages. A CDO places many mortgages in a single pool and creates bonds that investors buy and sell in the secondary market.

Credit Default Swaps (CDS)

Credit default swaps (CDS) are credit derivatives that protect a buyer against the occurrence of a credit event, such as rating downgrade, bankruptcy, restructuring etc, on an underlying bond position. The buyer pays a timely premium to the seller of such instrument which insures that credit risk of the buyer is kind of hedged

Risks of fixed income derivatives

1) One of the key risk of such products is significant movement in the underlying price of asset class which governs the price of derivative

2) Secondly, these derivatives become very volatile due to contagion effect i.e. change in both derivative's price and underlying assets' price spilling over each other

3) Events such as trade wars, rating downgrades, sector specific crisis lead to adverse movement of such derivative products which leads to defaults at the end of derivative sellers who then don't intend to square off their obligations

What can be done to mitigate risks associated with these instruments

1) There should be stronger regulations which govern the very structure of these derivative products. Furthermore, efficient categorization of risk grades of underlying instruments would be appropriate to demystify the risks involved

2) As its well knows, that 2008 crisis was mainly driven through defaults on sub prime loans taken by mortgage holders which in turn led to crash of derivative instruments such as CMBS which was a derivative those loans. Therefore, a formal control mechanism should be in place which should send triggers or early warning signals of such loan defaults in future

3) in 2008, hedge funds used these type of derivatives (CMBS) as collateral to borrow money. That created higher returns in a bull market but magnified the impact of any downturn. ​The Securities and Exchange Commission did not regulate hedge funds, hence, the effect was much larger and shook the financial markets. This again calls for a stronger regulatory policy to govern such instruments

4) Lastly, regulations should have been/should be in place to ensure that retail investors not be allowed to invest in such exotic instruments. Even if allowed, the thresholds amounts should be set at higher levels to avoid mass participation