Derivative and Underlying: One Can Be Held, One Cannot

Every derivative points at something, and that something is its underlying: whatever the contract's amounts get computed from. Point a contract at an asset and the underlying is an object with an owner, a location and a delivery route. Point one at the benchmark behind an interest rate swap, and the underlying is a published percentage. Percentages have no owner, no location and no delivery route.

Every derivative points at something, so the pointing itself is never the interesting part. The far end of the point is where the interest sits. Something that can be picked up behaves one way. A number that can only be looked up behaves another way, and the gap between them runs through everything the contract has to do: how the obligation is discharged, what the agreement has to carry in order to turn the reading into money, and on how many days of the year anybody can put a value on it at all.

One agreement, invented for teaching, sits behind every rupee figure on the unholdable side of the comparison. Its notional is Rs 1,000 crore. The rate written into it is 7.20 per cent a year, and that written rate is what Chitrakoot Cements Limited owes each period, with the floating benchmark coming back the other way. Saranga Capital Limited holds the mirror of that obligation: the floating benchmark leaves, the written rate arrives. The benchmark it points at is called the floating benchmark throughout. Any named benchmark would carry a vintage, and none of the arithmetic below depends on which one it is.

One fact governs every figure below. No dated schedule sets out where the floating benchmark might land in periods still ahead. Without such a schedule, valuing the arrangement is impossible. So is quoting a rate that would make the two sides open level. So is producing any figure at all for a period after the first. The opening period has a reading and stands alone, and every period after it stands blank.

What does the word underlying actually name?

An underlying is whatever a contract's amounts get computed from, and that definition says nothing whatever about what kind of thing it is. The contract issues an instruction in three parts: take this thing, read it at this named moment, and work out from that reading what one side owes the other. Every derivative carries that instruction. The instruction does not care whether the thing being read is a lorry load of steel or a percentage sitting in a published table, and the word underlying does not care either.

A small company writes two bonus schemes in the same week. The first pays the sales head a share of the turnover the branch books that year. The second pays the finance head a share of a published price index for the industry. Both schemes are one sheet long, both use the word linked, and both pay in rupees. Anybody in that office asked whether the two are the same sort of promise says no immediately. The first points at something the branch does; the second points at a number somebody outside the building compiles and publishes. Nobody confuses those two when they are put side by side, and almost everybody confuses them once both are called linked to an underlying.

The whole difficulty sits in that one sentence. The word is doing honest work in both cases. The reader quietly imports a set of features from the case learned first, and those features do not travel. Whoever met underlyings on a commodity desk arrives with a mental picture of a warehouse. Whoever met them on a rate desk arrives with a mental picture of a table on a screen. Each picture is right for one kind and misleading for the other, and the two have to be pulled apart before either gets carried somewhere it cannot go.

What does an underlying look like when somebody can hold it?

Take the reference asset carried through this subject area, and notice how much of what is true about it is true simply because it is an object. Its spot priceWhat taking the item now rather than later costs, quoted for dealing today. is Rs 2,000.00/-. Somebody holding the reference asset from today through to the same date next year has money tied up in it for twelve months. At 6.50 per cent a year that tie-up costs Rs 130.00/-. Set that on top of the Rs 2,000.00/- it takes to buy the thing today and Rs 2,130.00/- is where a contract for the later date settles. Every step of that was worked through earlier in this subject area, and it is carried across here rather than opened up again.

Across those twelve months the reference asset returns not one paisa to whoever is holding it. The absence of any payout does a specific job. A payout would take a bite out of the Rs 130.00/-, and the Rs 2,130.00/- would come down by whatever the bite was worth. The arithmetic on this side of the comparison only reconciles if the asset throws off nothing at all. Assume a payout instead and every figure that follows comes out different.

The ordinary facts about the object matter more here than the arithmetic. Set the arithmetic aside and look at the object itself. Somebody has titleWhoever the law would recognise as the owner of a thing has title to it, and that recognition is what lets them sell it or hand it across. to it. There is a person or an institution the law would recognise as its owner, and that recognition is not decorative: it is what makes the next three facts possible. The asset sits somewhere: a warehouse, a vault, or the books of a bank that offers custodyKeeping somebody else's asset safe for them and maintaining the record of whose it is.. The asset can be handed across from one holder to another, and after the handover the first holder no longer has it. And holding it between two dates costs real money that somebody actually pays. The financing costWhat carrying a purchase across a stretch of time costs, since money parked in the item is money doing nothing else. of 6.50 per cent a year measures exactly that.

Title, a location, transferability and a real cost of carry are what let a contract on this asset be settled by handing the asset over, should the two sides want it settled that way. Worth saying slowly: deliveryHanding the actual item over, so that whoever receives it now has the thing and whoever gave it up no longer does. feels like a feature of the contract and it is not. Delivery is a feature of the underlying, borrowed by the contract. A contract cannot offer to deliver something that has no owner, no location and no route from one pair of hands to another. Where those exist, delivery is available as a choice; where they do not, it is not available at all, and no amount of drafting will make it so.

What does an underlying look like when it is only a reading?

The underlying of the arrangement between Chitrakoot Cements and Saranga Capital is a benchmark reading: a percentage compiled and put out by somebody who is neither of the two parties, standing at 6.00 per cent a year for the opening period. A reading deserves the same weight as the asset above. A reading is not a slightly odd asset; a reading is a different kind of object, and the cleanest way to see that is to work down the same four ordinary facts and watch every one of them fail.

Nobody has title to it. There is no person and no institution the law would recognise as owning 6.00 per cent a year, and the compiler who published it does not own it either; publishing a measurement is not the same as owning a thing. The reading is not anywhere. A measurement occupies no space, so asking where the reading is kept is not a hard question with an obscure answer. The question has no answer at all. Handing something over requires the giver to stop having it, and nobody stops having a percentage, so the reading cannot be handed across. And holding it between two dates costs nothing. Nothing is being held, so nothing ties up any money.

A percentage is a measurement, and a measurement is not a holding. Readings are enormously consequential: this one moves Rs 60.00 crore in a single period. Consequence is not the same as substance. The reading does its work entirely by being read, and everything the arrangement does with it afterwards is arithmetic performed by two parties on a number that belongs to neither of them.

What can be done with one that cannot be done with the other?

Write out what each kind of underlying permits and the asymmetry stops being an argument and becomes a list. With the reference asset: buy it, hold it, hand it over, pledgePutting something held behind a borrowing, on terms that let the lender take it should the borrowing not be repaid. it, lend it, insure it. Six things, and the list could run longer without straining. With the benchmark reading: read it. One thing, and the list cannot be extended by anybody, however clever the drafting.

The one item list is not a trick of presentation, and running those six actions past an unfamiliar underlying is the sharpest reading skill in the subject. Faced with an unfamiliar contract, on an underlying that resists immediate classification, the six run down: could somebody buy this thing, hold it, hand it over, put it behind a borrowing, lend it out, insure it against loss? The answers settle most of what matters about how the contract is obliged to work, before a single clause has been read. Six yeses and the contract can be built either way, on money or on the thing itself. Six noes and the contract has exactly one route open to it, and everything unfamiliar in the drafting is there to build that route.

What follows for the contract when nothing can be delivered?

Everything unusual about how an interest rate swap settles follows from one fact about its underlying, and follows in a fixed order. Start at the top. There is no object to hand, so nothing can be handed across. Money is the only thing left that can move between two parties, so the obligation has to be discharged in money. A percentage on its own converts into no amount whatever, so something in the agreement has to say how much money a percentage corresponds to. And that something is the notional.

The notional of Rs 1,000 crore is a scale factor and it is never a holding. Nobody has title to it. Nobody lends it, borrows it, delivers it or keeps it anywhere. The notional answers a single arithmetic question. How many rupees does one percentage point come to inside this agreement? Here, Rs 10.00 crore a point. Every rupee figure the arrangement produces is that answer multiplied by however many points the two rates happen to be apart.

What do the two kinds look like set beside each other with figures?

Two contracts, one on each kind of underlying, and the same questions put to both. On the holdable side, a spot price of Rs 2,000.00/-, twelve months of tie-up at 6.50 per cent a year, no payout arriving from the asset in the meantime, and Rs 2,130.00/- as the settlement for a contract dated a year out.

On the unholdable side, the arrangement between Chitrakoot Cements and its counterparty. Apply 7.20 per cent to a notional of Rs 1,000 crore and the fixed side works out at Rs 72.00 crore for the period. Run the same notional against a reading of 6.00 per cent a year and the floating side comes to Rs 60.00 crore. Take the smaller from the larger. Rs 12.00 crore remains, and Chitrakoot Cements hands it across. Twelve parts in every thousand is what that difference amounts to once the notional is set beside it, or 1.2 per cent. A single date carries both obligations, and rupees measure both. Only that pairing lets one difference stand in for two separate payments.

The last row is the only one where both columns read the same, and it is the row worth stopping at. Both contracts leave whoever holds them depending on a named party on the other side, and neither underlying does that to anybody. The rows above it are a list of differences. The last row is not.

What do the two kinds have in common, so that one word still covers both?

One word can honestly cover two objects this different because four things hold on both sides. In both cases the contract is a separate object from the thing it points at, and confusing the two is the root of most of the trouble in the subject. In both cases the contract can be entered into without anybody touching the underlying at all: no asset changes hands to strike a forward, and no reading changes hands to strike a swap. In both cases the amounts follow the underlying and the underlying does not follow the amounts, so a contract cannot argue its way to a better outcome. And in both cases the contract carries a counterparty while the underlying carries none.

Holding an asset leaves the holder depending on nobody, and holding a contract leaves the holder depending on the other side, whichever kind of underlying the contract points at. A warehouse of the reference asset is worth what it is worth without anybody having to perform. A forward on that same asset is worth what it is worth only if the party on the far side does what the agreement says on the day. The gap opens the moment a contract is written, and nothing about the underlying being holdable narrows it. Readers who have absorbed the difference between the two kinds tend to file the counterparty under the reading side, as though a percentage were somehow riskier company than a warehouse. The contract brings the counterparty, not the reading.

Which way does the dependence run, and where does that blur?

The ordinary case runs one way and one way only: the reading is taken, and the contract follows it. Somebody outside the two parties compiles a figure, publishes it, and the agreement then does arithmetic on whatever was published. Nothing the two parties do to each other alters the figure. One way dependence is the arrangement described throughout, and for most purposes it is the only direction worth carrying.

There is a structural possibility that complicates it, and it is worth stating carefully because it is easy to overstate. Where contracts pointing at a single reading grow numerous enough, the activity going on around those contracts can itself become part of what the reading gets compiled from. If that happens, the arrow starts pointing both ways: the reading shapes the contracts, and the contracts feed back into the reading. Whether the arrow has ever turned that way for a particular benchmark is a question about how that benchmark is compiled. The compilation method settles it, and the compilation method is published.

Checking the direction for one particular reading takes three concrete facts rather than an opinion: how the reading is compiled, out of what inputs, and by whom it is put out. The administrator of the reading publishes all three. A reader who goes and finds them will know more about the direction of the arrow than any general statement on the subject could say.

What is missing even about the benchmark reading itself?

A gap worth naming sits inside the benchmark reading itself. The reading exists for one period only. The reading stood at 6.00 per cent a year, that produced Rs 60.00 crore on the floating side, and after that the record falls silent. Anybody wanting to know where the benchmark goes next would need a published series with dates attached to each entry. The blank in the right hand column of the figure above is that silence, drawn.

The absence matters because of what it says about underlyings in general. An underlying somebody can hold has a price that can be gone and looked at today, and an underlying that is a published reading has a value only on the days somebody put one out. A reference asset does not need a compiler to be worth something; it needs a willing buyer, and willing buyers turn up on ordinary days without anybody scheduling them. A reading needs a compiler, and compilers work to a publication scheduleThe dates a compiler works to when it puts a figure out, which decide the days on which that figure exists at all.. On a day off that schedule, no reading exists at all, and no amount of wanting one will produce it.

The difference has a practical edge worth carrying away. A price is obtainable, so an analyst asked what a contract on an asset is worth on a random Tuesday can answer in principle. Asked the same of a contract on a reading, the honest answer begins with a question in return: was a reading put out for that Tuesday? Sometimes the answer is no, and the contract does not become unknowable because anybody has been careless. The contract is unknowable because the schedule behind its underlying did not reach that day.

Where does this distinction earn its keep?

A household sits with a sanction letter for a home loan. The rate on it is written as a published reading plus a margin, and the reading is not the bank's number: somebody outside compiles it and puts it out. Every month the household watches that reading and feels the instalment move with it, and the natural instinct is to treat the reading as the thing to be managed. Knowing what kind of underlying that reading is settles what the household can actually do about it. The answer is nothing, and the whole question moves to what can be done about the loan. The reading cannot be bought when it looks low, cannot be sold when it looks high, and cannot be locked away. The loan can be prepaid, part prepaid, refinanced or restructured, and the tenure can be changed. Every available lever sits on the contract; not one of them sits on the underlying.

A credit officer opens a file on a mid sized manufacturer and finds a line reading swap, Rs 1,000 crore. The instinct that costs money is to read the figure as something the borrower has taken on and must repay. The instinct that earns its keep is to ask which of the six actions the underlying would permit. None. The underlying is a percentage, and once that is established the Rs 1,000 crore stops being a debt and becomes a converter sitting in a formula. Rs 12.00 crore of net difference moves each period, not Rs 1,000 crore of anything. An officer who never draws that distinction will either refuse a sound file or misprice a weak one, and both errors trace back to reading a scale factor as a holding.

What does this distinction not license?

The two kinds of underlying differ in kind and not by degree, and nothing shades from one into the other somewhere in the middle. A holdable underlying answers all six of the questions and a reading answers none of them; no case sits between the two with three answers.

Telling one kind of underlying from the other buys a way of reading a contract, and the purchase ends there. The distinction settles what a contract has to do. The distinction settles nothing about whether anybody should be inside one. Deciding that would run through what somebody already holds and already owes, what their own month looks like when a reading shifts, how long they would be carrying the arrangement, and where they stand if the other side stops answering the telephone. Not one of those four is a fact about the underlying, and none of them follows from telling one kind of underlying from the other.

The durable part is small: a test that runs in about eight seconds on any contract. Ask what its underlying is. Ask whether somebody could buy that thing, hold it, hand it across, pledge it, lend it or insure it. Count the yeses. Everything about how the contract must settle, what it has to carry in order to work, and how often anybody can say what it is worth, follows from that count.