Stocks and bonds are the most familiar financial markets. In some periods of time, stocks and bonds have a negative correlation. This is why bonds are often recommended as a hedge to stocks. The traditional recommendation in financial planning is 60% stocks and 40% bonds. This is the basic diversified portfolio. However, there are more financial markets than the stock market and bond market. These are the universe of alternative assets. Alternative assets are financial assets other than stocks and bonds.
Asset-Backed Securities
Securitization is the process of producing liquid financial securities from illiquid financial assets. In other words, “securitization” is the process of turning something that is not a security into a security. This may bring to mind the term “alchemy,” which is the process of turning something like lead into gold. The securities produced by securitization are secured by the underlying assets.
Asset-backed securities (ABS) are securities that are secured (collateralized) by a pool of assets. The most familiar form of ABS is mortgage-backed securities. Mortgage-backed securities (MBS) are bonds that are issued against a pool of mortgages. The category of MBS includes residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).
The subprime mortgage crisis in 2007-2009 highlighted the risks in mortgage-backed securities.
ABS is a close cousin of the bond market. Asset-backed securities are bonds with coupon payments, maturity, yield-to-maturity, and principal repayment. They also have credit ratings. This makes them similar to corporate bonds. However, asset-backed securities are not an obligation of a corporation that is based on corporate cash flow. Asset-backed securities are based on the value and cash flow of the underlying assets. This makes them a form of secured debt.
Asset-backed securities are not based on a discretionary corporate manager. This is another difference from corporate bonds. Asset-backed securities are issued by special purpose vehicles (SPV) that hold the assets in a form of trust. The management of the SPV is a rules-based agreement that is determined at its origin. The “pooling and servicing agreement” is a binding contract that limits the ability of the servicer to manage the underlying assets. This was a point of policy concern during the subprime mortgage crisis, because securitized mortgages were very difficult to renegotiate.
Asset-backed commercial paper (ABCP) is the short-term version of asset-backed securities (ABS). ABCP trades in the money market, not the bond market.
Structured finance is a unique form of securitization. Structured finance involves securitized assets with a structuring of liabilities to produce different tranches of debt securities. Senior ABS have less credit risk than subordinate (or mezzanine) ABS. With sufficient subordination, senior ABS can be rated as AAA securities. The “magic” (alchemy) of structured finance was the ability to produce AAA securities from relatively risky underlying assets by using subordination in the capital structure. Subordination measures the amount of junior debt below senior debt. This is a credit risk buffer because the senior debt will only default if the junior debt is wiped out.
It was believed that a large degree of subordination would make senior ABS basically risk-free. The subprime mortgage crisis proved that this was not the case. Ratings agencies rated the bonds based on the principle of geographic diversification. But a national housing market collapse produced a much higher correlation in mortgage defaults. This resulted in systemic risk that caused mortgage-backed securities to experience significant financial distress.
Currencies and Commodities
Currencies and commodities are another form of alternative asset. Currencies and commodities can be traded in financial markets just like stocks and bonds. Many banks and investment funds have a “Fixed-Income, Currencies, and Commodities” (FICC) trading desk for these assets.
The commodities “super cycle” is primarily focused on energy commodities (oil and gas) and metals (copper and steel). Other agricultural commodities like lumber can also be part of this phenomenon. Global demand drives the pricing of global commodities. We are potentially going to see an upswing of the commodities super cycle in 2021 as the global economy recovers from the COVID-19 pandemic. Rising commodity prices reflect rising global demand.
Precious metals like gold are considered a safe haven against inflation and severe financial distress. Bitcoin is increasingly taking on the role of “digital gold” as a hedge against inflation.
Most commodities are priced in U.S. dollars, so the value of the dollar is a factor in the valuation of commodities. Some countries like Russia and China are attempting to challenge the role of the dollar in international markets. For instance, Russia is an oil exporter and would like to sell oil in Russian rubles (RUB). China would like the Chinese Yuan (CNY) to become a more common denomination for other assets as well.
Long and Short Positions
A long position is an investment position that benefits from an increase in prices. A short position is an investment position that benefits from a decrease in prices.
If an individual or corporation owns an asset or other cash flow, this is typically a long position. For instance, owning a stock or bond is a long position. Traditional investing, including wealth management and mutual funds, focuses on “long only” investing. One way to hedge the risk of a long only position is simply to reduce the size of the position. For instance, moving investments out of stocks and into cash is one way to hedge exposure to the stock market. However, this strategy is often at odds with the underlying business proposition.
Short selling is a form of short position in the stock market. The investor borrows the shares and sells them with the goal of buying them back at a lower price and returning them to the lender. This strategy makes money if prices decline. However, it loses money if prices increase. The GameStop (GME) “short squeeze” is a good example of short selling that did not go according to plan.
Hedge funds are investment management funds associated with alternative assets. Other types of funds, like mutual funds, invest in stocks and bonds. Hedge funds charge high management fees to seek higher returns beyond stocks and bonds. One way to place these bets is through short positions. Traditional funds are long only, but hedge funds use long and short strategies. This use of short strategies is one reason why they are called hedge funds.
Speculation is using a financial instrument to increase risk with the goal of increasing returns. Other investors use derivatives for hedging. Hedging is using a financial instrument to reduce risk with the goal of reducing the possibility of negative returns.
Speculation increases the exposure to either the long or short side of the market. Hedging reduces the exposure to either the long or short side of the market. Speculation increases the exposure by adding a long or short position that is not offset by the other side. The position is not “covered.” For example, a short position that is not hedging a long position is a “naked short.” Hedging reduces the exposure by adding a short position to an existing long position or a long position to an existing short position. This will reduce the net exposure.
Derivatives
Derivatives are financial securities whose value is derived from an underlying asset. Derivatives can be used for many different purposes. Some investors use them for speculation and others hedging. Typically the “cash market” refers to the underlying asset. Derivatives are a form of synthetic financial asset, because they have no inherent value. Their value comes from the benefits to their users in either off-loading or on-loading risk. Another benefit of being a derived value is that many derivatives allow the user to apply leverage. A greater shift in exposure can be generated in the derivatives market than the cash market because the user is not required to buy or sell the actual asset.
There are many types of derivatives. Two examples in the credit markets are the interest rate swap and credit default swap. An interest rate swap is a contract that swaps one set of interest rate payments for another set of interest rate payments. This is commonly used in banking to “swap fixed for floating” as a way to manage the risk of rising interest payments. A credit default swap (CDS) is a contract based on an underlying debt security that makes a payout in the event the debt security goes into default. CDS contracts were famously used by Michael Burry, as depicted in the movie “The Big Short.” Mr. Burry purchased CDS against subprime mortgage-backed securities as a bet that these bonds would default. When the bonds default, a payment is made by the seller of the CDS contract to the buyer of the CDS contract. Some bondholders buy CDS contracts as a way to hedge credit risk. The U.S. insurance company AIG infamously failed in the financial crisis due to the selling of CDS contracts on mortgage-backed securities as a form of insurance.
Options
Options are a common example of a derivative. Options include call options and put options.
Options are a financial contract. Companies do not issue options in the way that they issue stocks and bonds. The seller of the option contract is said to “write” the contract and is paid the option premium, which is a dollar amount per share. For example, you can think of the writer of a put option as selling an insurance contract and being paid an insurance premium. The buyer of the put contract is paying the option premium in exchange for protection from a downward move in the price of the underlying asset. These are the buyers and sellers of option contracts.
A call option provides the owner the option to purchase the underlying financial asset at a specified strike price. A call option is “in the money” if the price of the financial asset is above the strike price and “out of the money” if it is below the strike price. Buying a call option is a long position whose value increases with an increase in the price of the underlying asset.
A put option provides the owner the option to sell the underlying financial asset at a specified strike price. A put option is “in the money” if the price of the financial asset is below the strike price and “out of the money” if it is above the strike price. Buying a put option is a short position whose value increases with a decrease in the price of the underlying asset.
The option payoff has a “kink” at the strike price.
The Chicago Board Options Exchange (Cboe) is a Chicago-based exchange for trading options. Cboe operates four U.S.-listed cash equity options markets. The Cboe Volatility Index (commonly referred to as the “VIX”) is an up-to-the-minute market estimate of expected volatility that is calculated using S&P500 Index (SPX) option bid/ask quotes. The VIX uses the prices (valuation) of S&P500 options for the next 30 days as a measure of investors’ outlook for stock market volatility (implied volatility) over the next 30 days.
The VIX increases with higher expected volatility and decreases with lesser expected volatility. This is why the VIX is sometimes referred to as a “fear gauge” for the U.S. stock market. There is generally a negative correlation between between the level and volatility of the stock market. When the S&P500 goes up, volatility tends to go down, and conversely, when the S&P500 falls, volatility tends to go up. This is why some investors use volatility instruments to hedge their equity portfolios.
The VIX is an index that cannot be bought and sold directly. One way to trade the VIX is to use futures contracts on the VIX.
The iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) is an exchange-traded note whose value rises when the VIX rises. An exchange-traded note (ETN) is an unsecured debt security that tracks an underlying index and trades on an exchange.
The ProShares Short VIX Short-Term Futures ETF (SVXY) is an inverse ETF whose value rises when the VIX falls.
Futures
Futures are a less well-known form of derivative. Futures are the market-based version of a forward contract. A forward contract is an agreement between two parties to exchange an asset as a specified date in the future at a specified price. It is an obligation to exchange the asset, not an option. A forward contract is a bi-lateral agreement that is unique to the needs and preferences of the two parties involved. It is a “tailored” contract. A futures contract is a standardized version of a forward contract that trades as a liquid security on a financial exchanges.
You may have heard of stock market futures. The financial news often refers to stock futures being up or down during periods when the stock market is not open. There are often references to stock futures early in the morning prior to the stock market open.
Buying a futures contract is a long position. It benefits from an increase in the price of the underlying asset. Selling a futures contract is a short position. It benefits from a decrease in the price of the underlying asset.
Unlike the option payoff, the futures payoff is linear. It does not have a “kink” because there is no strike price.
Futures contracts can be used for speculation or hedging, just like other forms of derivatives. Speculators use futures as a “naked” long or short position to bet on price movements in particular underlying assets. Hedgers already have some form of risk that they would like to offset. For instance, a bond investor can use interest rate futures to hedge the interest rate risk in their bond portfolio. A corporation with sales in a foreign currency can use currency futures to hedge their exchange rate risk.
Chicago is a global hub for the futures market. The Chicago Mercantile Exchange (CME) has a large share of volume in a wide range of futures contracts. Some futures contracts are agricultural (corn, wheat, soybeans) and others are financial (stocks, rates, currencies). CME offers futures contracts in a wide range of markets. The CME owns the Chicago Board of Trade (CBOT) where the futures are exchanged. The Board of Trade was once a vibrant trading floor referred to as the “pits,” but most of the futures trading has moved onto CME’s electronic trading platform called Globex.
The history of Chicago as a transportation hub in the Midwest of the U.S. resulted in it becoming a hub for agricultural futures. In modern times, this has led to Chicago being a global hub for financial futures as well. Much of the Chicago trading community is focused on the derivates market, especially options and futures. This history of financial innovation is why many argue that Chicago should continue to play a role in the future of financial innovation.