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					The role these complex securities have played
       in the current economic turmoil

          Faculty Panel Discussion
              October 7, 2008
            Kathie Sullivan, PhD Finance
   Any security whose value depends on (is derived from) some
    primary security or asset.

   As the value of the underlying asset changes, the value of the
    derivative security changes.

   Derivatives are cheap, efficient ways to transfer risk from those
    who don't want it, to those are willing to take it.

   They may be used to speculate, as well as to hedge.

   Types of derivatives: options, futures and forward contracts,
    interest rate swaps, CMO's, warrants.

   Underlying assets on which derivatives may be based: stocks,
    bonds, currencies, interest rates, and commodities.
   Forward Contracts
       Agreement to exchange an asset in the future at a price set
        today. Buyer and seller must perform, or buy back the
        contract and reverse their position. Traded OTC; non-
        standardized; illiquid; subject to credit risk.
   Futures Contracts
       Same as a forward contract, except traded on an
        organized exchange; standardized; liquid; no credit risk.
   Options
       An agreement to exchange at a predetermined price,
        within a set time. The option buyer (holder) has the
        OPTION to exercise the option or not. Trade on organized
        exchanges – liquid market, little/no credit risk.
   Structured Notes
       Investment bankers reconfigure some existing
        security (a short term bond or note) and create an
        entirely new security. Process of securitization.
        Offers additional hedging opportunities.
        • Zero – Coupon Bonds
        • CMOs
   Swaps
       Contract between two parties to exchange cash flow
        obligations. Not rigidly structured. No organized
        exchange. Usually occurs between a company and a
        money center bank or investment bank.
   Valuing any financial asset is always difficult. In a
    general sense, the value of anything is:
                  Present Value of all
              Expected Future Cash Flows
   This requires us to consider:
       Return desired, given degree of risk perceived
       Cash flows the security is expected to produce

   Valuation is based on ASSUMPTIONS, and as I always
    tell my students…

            Always question your assumptions!
   First introduced by JP Morgan in 1995.
   Current value of this market is estimated to be $45
    - $60 TRILLION.
   Sold by Bear Sterns, Lehman Brothers, AIG,
    Citigroup, and many other banks and financial
    service companies.
   Buyer pays a premium to seller so that in case of a
    ―negative credit event,‖ the seller takes on the
    credit risk.
   If no credit default, seller pockets the premium
    and everyone is happy.
   How happy was AIG? Consider the following
    data on AIG’s Financial Products Unit:
       Revenue rose to $3.26 billion in 2005 from $737
        million in 1999.
       Operating income … also grew, rising to 17.5% of
        AIG’s overall operating income in 2005, compared
        with 4.2% in 1999.
       In 2002, operating income was 44% of revenue; in
        2005, it reached 83%.
                  (―Behind Insurer’s Crisis, Blind Eye to a Web of Risk”
                                            New York Times, 9/28/2008)
   Problem… the bonds and other underlying debts referenced by
    these swaps started to deteriorate.
       The market started experiencing ―negative credit events,‖ something
        sellers assumed would never happen.

   Even bigger problem… the sellers of these instruments didn’t set
    aside adequate capital to cover possible payments on these

    ―It is hard for us, without being flippant, to even see a scenario
    within any kind of realm of reason that would see us losing one
    dollar in any of those transactions.‖
    — Joseph J. Cassano, a former A.I.G. executive, August 2007
        (as quoted in NYT, 9/28/2008)

   Perhaps – if AIG, Lehman, Bear Sterns top executives hadn’t
    gotten such generous paychecks and bonuses, some money would
    have been available to make good on these claims…
   Markets don’t really know the extent of damage these derivatives
    will do (or have done) to the banking and financial system; they
    don’t understand how the bailout plan will effect these swaps and
    it is trying to digest these complex factors.

   Markets really hate uncertainty and not knowing what’s going to

       More risk  greater return demanded
       Higher return demanded  lower prices paid

   Markets are rationally reacting to extreme degree of uncertainty;
    although perhaps over-reacting – also a common market trait.

   But, what goes down also comes back up… just sit tight and hold
    steady as the information gets digested and risk finds its proper