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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
    contracts.

    ―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
    happen.

       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
    price!