Conflict of interest and
Mishkin Ch 8 – A page 181-205
Plus supplementary stuff about futures market
Reference book: John Hull, ‘Futures, Options, and
Futures contract – a bet
A futures contract is an agreement to
trade something in the future, at an
agreed upon price (strike price K).
LIGHT CRUDE OIL, Aug '08, $137.15
futures exchanges (CME, CBOT, NYME)
corns, currencies, interest rates, stock
prices, stock index, etc.
profit Long position (buyer) profit
Short position (seller)
A zero-sum game
The long (buyer of futures The short (seller of futures
contract) profits if spot price contract) profits if spot price
in the future St exceeds the in the future St is below the
strike price K. strike price K.
Futures price and spot price
Functions of futures market
Three groups of futures market users:
Speculators who wish to make lots of
Hedgers who wish to avoid losing lots of
Arbitragers who wish to make easy money
Futures market provides risk-sharing, liquidity,
Speculation - idea
You believe that floods in Iowa will reduce
soybean yields and hence soybean price
would rise in Nov.
How can you profit from this scenario?
Bet on soybean prices to rise - long futures
Today: buy Nov Bean at $5.58; later: sell
Nov Bean to offset. If price goes up, you
profit. But you also bears the risk that price
may decline as well.
Why not speculate in spot market?
Speculation - example
A speculator buys (takes a long position in) 1 Aug contract on
July 1st at $942.10, pay initial margin $6,500.
contract size is 100 troy ounces , it has a market value of
You are paying ($6,500/94,210 = 6.9%) of contract value.
Scenario 1: If Gold contract goes up to $960 by end of July,
Profit = ($960 - $942.10)*100 = $1790
Return = $1790/$6500 = 27.5%
Scenario 2: If Gold contract goes down to $930.00 by end of
Profit = ($930 - $942.10)*100 = - 1210
Return = - 1210/6500 = -18.6%
Hedging - idea
People who would sell or buy commodities in
the future could hedge price risk by holding
positions in futures markets.
spot price and futures price move togetheroffset
lock in selling (purchase) price in advance
Short hedgers: e.g. farmers
Long hedgers: e.g. processors
Short hedge - example
A farmer who has an agriculture
commodity to sell in the future will be
hurt by a price decline in the future.
Hedging: profit from the futures market
whenever lose from the cash market.
Risk in spot market is offset by trading
in futures market.
Short hedge - example
Suppose lean hogs are now trading at $70 (per
100 pounds) in spot market.
A farmer is afraid that in Aug when he is ready
to sell the hog, he would not be able to sell at
this good price.
Step 1: Look at futures quote to find out Aug
Lean Hogs futures contracts are trading at
$70.75 in Chicago Mercantile Exchange.
Step 2: Call broker and place order to sell 1
Aug Lean Hogs contract and send margin
Short hedge example
It is now August and the farmer is ready to sell
hogs to the packer.
Scenario 1: Aug Lean Hogs trading at $74.00,
loss ($70.75 - $74.00 = -$3.25 per 100 lb.) in
futures market. In spot market, sell hog at a
high price of $74.00 ($4 up).
Scenario 2: Aug Lean Hogs trading at $65.25,
gain ($70.75 - $65.25 = $5.5 per 100 lb.) in
futures market. Sell hog in spot market at a low
price of $65 ($5 down).
Conflicts of interest
Conflicts of interest arise when a financial
institution (e.g. investment bank, accounting
firms, etc.) has multiple objectives and, as a
result, has conflicts between those objectives.
Essentially a moral hazard problem.
Consequence of conflicts of interest is that funds
are not channeled into the most productive
Underwriting and research in investment banks
research on firms to provide information for potential
underwrite stocks to help firms’ IPO
Conflicts of interest:
firms want to hide bad news, investors need to know.
‘spinning’: investment bank allocates hot, but
underpriced, IPOs to executives of other companies
in return for their companies’ future business.
Auditing and consulting in accounting firms
Auditors may be willing to skew their judgments
and opinions to win consulting business.
Auditors may be auditing information systems or
tax and financial plans put in place by their
nonaudit counterparts (tax consultants).
Auditors may provide an overly favorable audit
to solicit or retain audit business.
Sarbanes-Oxley Act of 2002 (Public
Accounting Return and Investor
Increases supervisory oversight to monitor and
prevent conflicts of interest
Establishesa Public Company Accounting
Increases the SEC’s budget
Makes it illegal for a registered public accounting
firm to provide any nonaudit service to a client
contemporaneously with an impermissible audit
Sarbanes-Oxley Act of 2002 (cont’d)
Beefs up criminal charges for white-collar
crime and obstruction of official investigations
Requires the CEO and CFO to certify
that financial statements and disclosures are
Requires members of the audit committee to
Global Legal Settlement of 2002
Requires investment banks to cut the link between
research and securities underwriting
Imposes $1.4 billion in fines on accused
Requires investment banks to make their analysts’
Over a 5-year period, investment banks are
required to contract with at least 3 independent
research firms that would provide research to their
Functions of futures market
How to hedge and speculate using futures
Conflicts of interest in investment banks
Conflicts of interest in accounting firms