Friday, April 4, 2008

What Does the $13 Trillion Notional Value Derivative Contracts of Bear Really Mean?

I have previously written about counterparty risk and how the financial system is intertwined. Well Bear Stearns was one of these larger twine turners. The approximate notional value of their underlying derivatives was about $13 trillion. This does not mean that they were on the hook for $13 trillion but rather this $13 trillion represents the value of the underlying assets behind the derivatives had the derivatives been converted into that underlying asset. If this doesn't make sense then I will provide an example. Since most people understand stock options I will use that as an example. Before I begin I want to reference the Wall Street Journal for the $13 trillion. Around the week of March 17th they ran an article explaining the meaning of the $13 trillion notional value of Bear's derivative book. It helped me understand what notional value means. When large numbers get thrown around (and trillions of dollars are fairly large numbers) then people may not understand the actual risk behind these derivative contracts.

I will use the example of a call stock option. I am going to assume that the reader understands how a call option works. If not, then I may write an article explaining stock options, but that will be for another day. I will use IBM. I will also use the IBM 110 call with one week left to expiration. I will assume IBM is trading for 100 per share and there is about 1 week left before the contract expires and that the price of the call option is going to be very inexpensive. It may be 'Bid' 0.03 'Asking' 0.05. Let's say I wanted to be very daring and thought that the stock could jump over 110 by week's end or prior to expiration. Assume I am willing to risk $50,000 (note this is a bad bet as it is extremely unlikely that IBM moves 10 points higher in 1 week's time and that I am likely to lose $50,000). So I buy 10,000 contracts for 0.05 per contract. (Lets assume that there is no commission) then I have a position that gives me tremendous leverage. With a $50,000 position I now control 10,000 contracts or 1 million shares. With IBM trading for $100 per share the notional value of this position would be 1 million shares x $100 per share or $100 million dollars. Am I liable for $100 million? No. Is the entity (or counterparty) on the other side of the trade liable for the $100 million? Very unlikely, but they are liable for a portion of the contract if it went into 'the money'. For instance, if IBM went to 120 before the week's end my counterparty would have to pay me $10 million. Back to my side of the trade and what I receive. Essentially I now have exposure to the stock that if it were to clear that level of 110 that would give me leverage and exposure as if I owned 1 million shares. Notional value of a derivative assumes the full price of the underlying asset instead of just a portion of it. This is sort of what the $13 trillion of notional value that Bear was exposed to means.

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Another way to look at the notional value of the swaps market is that it represents the amount that the swap is insuring. On one side of the transaction a payment stream is often assumed. Therefor the notional value is not something that is paid out but rather just what is insured. I give credit for this further clarification to the CFA program curriculum. In recent days after reading the CFA derivatives book in preparation for the CFA exam I have a better understanding of notional value.

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