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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. 1. The role these complex securities have played in the current economic turmoil Faculty Panel Discussion October 7, 2008 Kathie Sullivan, PhD Finance
  2. 2. <ul><li>Any security whose value depends on (is derived from) some primary security or asset. </li></ul><ul><li>As the value of the underlying asset changes, the value of the derivative security changes. </li></ul><ul><li>Derivatives are cheap, efficient ways to transfer risk from those who don't want it, to those are willing to take it. </li></ul><ul><li>They may be used to speculate, as well as to hedge. </li></ul><ul><li>Types of derivatives: options, futures and forward contracts, interest rate swaps, CMO's, warrants. </li></ul><ul><li>Underlying assets on which derivatives may be based: stocks, bonds, currencies, interest rates, and commodities. </li></ul>
  3. 3. <ul><li>Forward Contracts </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Futures Contracts </li></ul><ul><ul><li>Same as a forward contract, except traded on an organized exchange; standardized; liquid; no credit risk. </li></ul></ul><ul><li>Options </li></ul><ul><ul><li>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. </li></ul></ul>
  4. 4. <ul><li>Structured Notes </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><ul><li>Zero – Coupon Bonds </li></ul></ul></ul><ul><ul><ul><li>CMOs </li></ul></ul></ul><ul><li>Swaps </li></ul><ul><ul><li>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. </li></ul></ul>
  5. 5. <ul><li>Valuing any financial asset is always difficult. In a general sense, the value of anything is: </li></ul><ul><li>Present Value of all </li></ul><ul><li>Expected Future Cash Flows </li></ul><ul><li>This requires us to consider: </li></ul><ul><ul><li>Return desired, given degree of risk perceived </li></ul></ul><ul><ul><li>Cash flows the security is expected to produce </li></ul></ul><ul><li>Valuation is based on ASSUMPTIONS, and as I always tell my students… </li></ul><ul><ul><li>Always question your assumptions! </li></ul></ul>
  6. 6. <ul><li>First introduced by JP Morgan in 1995. </li></ul><ul><li>Current value of this market is estimated to be $45 - $60 TRILLION. </li></ul><ul><li>Sold by Bear Sterns, Lehman Brothers, AIG, Citigroup, and many other banks and financial service companies. </li></ul><ul><li>Buyer pays a premium to seller so that in case of a “negative credit event,” the seller takes on the credit risk. </li></ul><ul><li>If no credit default, seller pockets the premium and everyone is happy. </li></ul>
  7. 7. <ul><li>How happy was AIG? Consider the following data on AIG’s Financial Products Unit: </li></ul><ul><ul><li>Revenue rose to $3.26 billion in 2005 from $737 million in 1999. </li></ul></ul><ul><ul><li>Operating income … also grew, rising to 17.5% of AIG’s overall operating income in 2005, compared with 4.2% in 1999. </li></ul></ul><ul><ul><li>In 2002, operating income was 44% of revenue; in 2005, it reached 83%. </li></ul></ul><ul><ul><li>(“ Behind Insurer’s Crisis, Blind Eye to a Web of Risk” </li></ul></ul><ul><ul><li>New York Times, 9/28/2008) </li></ul></ul>
  8. 8. <ul><li>Problem… the bonds and other underlying debts referenced by these swaps started to deteriorate. </li></ul><ul><ul><li>The market started experiencing “negative credit events,” something sellers assumed would never happen. </li></ul></ul><ul><li>Even bigger problem… the sellers of these instruments didn’t set aside adequate capital to cover possible payments on these contracts. </li></ul><ul><li>“ 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.” </li></ul><ul><li>— Joseph J. Cassano, a former A.I.G. executive, August 2007 </li></ul><ul><li>(as quoted in NYT, 9/28/2008) </li></ul><ul><li>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… </li></ul>
  9. 9. <ul><li>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. </li></ul><ul><li>Markets really hate uncertainty and not knowing what’s going to happen. </li></ul><ul><ul><li>More risk  greater return demanded </li></ul></ul><ul><ul><li>Higher return demanded  lower prices paid </li></ul></ul><ul><li>Markets are rationally reacting to extreme degree of uncertainty; although perhaps over-reacting – also a common market trait. </li></ul><ul><li>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! </li></ul>