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Lecture16
 

Lecture16

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    Lecture16 Lecture16 Presentation Transcript

    • Lecture 16: Conflict of interest and futures market Mishkin Ch 8 – A page 181-205 Plus supplementary stuff about futures market Reference book: John Hull, ‘Futures, Options, and Other Derivatives’
    • 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.
    • Position diagrams profit profit St St The long (buyer of futures contract) profits if spot price in the future S t exceeds the strike price K. Long position (buyer) Short position (seller) K K The short (seller of futures contract) profits if spot price in the future S t is below the strike price K. A zero-sum game
    • Futures price and spot price
    • Functions of futures market
      • Three groups of futures market users:
        • Speculators who wish to make lots of money.
        • Hedgers who wish to avoid losing lots of money.
        • Arbitragers who wish to make easy money by ‘price-discovery’.
      • Futures market provides risk-sharing, liquidity, and information.
    • 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 $94,210.
      • 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, then:
        • Profit = ($960 - $942.10)*100 = $1790
        • Return = $1790/$6500 = 27.5%
      • Scenario 2: If Gold contract goes down to $930.00 by end of July, then:
        • Profit = ($930 - $942.10)*100 = - 1210
        • Return = - 1210/6500 = -18.6%
    • Hedging - idea
      • People who would sell or buy commodities in the future c ould hedge price risk by holding positions in futures markets.
      • Why?
        • spot price and futures price move together  offset
        • lock in selling (purchase) price in advance
      • Short hedgers: e.g. farmers
      • Long hedgers: e.g. processors
    • Short hedge - example
      • A farmer who has a n 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 money.
    • Short hedge example
      • It is now August and the farmer is ready to sell hogs to the packer.
      • Scenario 1: Aug Lean H og s 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 H og s trading at $65.25, gain ($70.75 - $65.25 = $5.5 per 100 lb.) in futures market . S ell 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 investment opportunities.
    • Underwriting and research in investment banks
      • Two objectives:
        • research on firms to provide information for potential stock buyers
        • 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.
    • Remedies
      • Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act)
        • Increases supervisory oversight to monitor and prevent conflicts of interest
        • Establishes a Public Company Accounting Oversight Board
        • 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
    • Remedies (cont’d)
      • 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 accurate
        • Requires members of the audit committee to be independent
    • Remedies (cont’d)
      • Global Legal Settlement of 2002
        • Requires investment banks to cut the link between research and securities underwriting
        • Bans spinning
        • Imposes $1.4 billion in fines on accused investment banks
        • Requires investment banks to make their analysts’ recommendations public
        • Over a 5-year period, investment banks are required to contract with at least 3 independent research firms that would provide research to their brokerage customers
    • Recap
      • Futures contract
      • Position diagrams
      • Functions of futures market
      • How to hedge and speculate using futures
      • Conflicts of interest in investment banks
      • Conflicts of interest in accounting firms