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Derivatives

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Derivatives …

Derivatives

Historical - Presentation from 2007, slides mention Lehman - which obviously doesn't exist for reasons we all know - the subject explores in depth - Derivatives.

Published in: Economy & Finance, Business

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  • 1. The role these complex securities have played in the current economic turmoil Faculty Panel Discussion October 7, 2008 Kathie Sullivan, PhD Finance
  • 2.
    • 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.
  • 3.
    • 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.
  • 4.
    • 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.
  • 5.
    • 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!
  • 6.
    • 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.
  • 7.
    • 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)
  • 8.
    • 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…
  • 9.
    • 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!