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  1. 1. 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’
  2. 2. Futures contract – a bet <ul><li>A futures contract is an agreement to trade something in the future, at an agreed upon price (strike price K) . </li></ul><ul><li>LIGHT CRUDE OIL, Aug '08, $137.15 </li></ul><ul><li>futures exchanges ( CME , CBOT , NYME ) </li></ul><ul><li>corns, currencies, interest rates, stock prices, stock index, etc. </li></ul>
  3. 3. 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
  4. 4. Futures price and spot price
  5. 5. Functions of futures market <ul><li>Three groups of futures market users: </li></ul><ul><ul><li>Speculators who wish to make lots of money. </li></ul></ul><ul><ul><li>Hedgers who wish to avoid losing lots of money. </li></ul></ul><ul><ul><li>Arbitragers who wish to make easy money by ‘price-discovery’. </li></ul></ul><ul><li>Futures market provides risk-sharing, liquidity, and information. </li></ul>
  6. 6. Speculation - idea <ul><li>You believe that floods in Iowa will reduce soybean yields and hence soybean price would rise in Nov. </li></ul><ul><li>How can you profit from this scenario? </li></ul><ul><li>Bet on soybean prices to rise - long futures </li></ul><ul><li>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. </li></ul><ul><li>Why not speculate in spot market? </li></ul>
  7. 7. Speculation - example <ul><li>A speculator buys (takes a long position in) 1 Aug contract on July 1st at $942.10, pay initial margin $6,500. </li></ul><ul><li>contract size is 100 troy ounces , it has a market value of $94,210. </li></ul><ul><li>You are paying ($6,500/94,210 = 6.9%) of contract value. </li></ul><ul><li>Scenario 1: If Gold contract goes up to $960 by end of July, then: </li></ul><ul><ul><li>Profit = ($960 - $942.10)*100 = $1790 </li></ul></ul><ul><ul><li>Return = $1790/$6500 = 27.5% </li></ul></ul><ul><li>Scenario 2: If Gold contract goes down to $930.00 by end of July, then: </li></ul><ul><ul><li>Profit = ($930 - $942.10)*100 = - 1210 </li></ul></ul><ul><ul><li>Return = - 1210/6500 = -18.6% </li></ul></ul>
  8. 8. Hedging - idea <ul><li>People who would sell or buy commodities in the future c ould hedge price risk by holding positions in futures markets. </li></ul><ul><li>Why? </li></ul><ul><ul><li>spot price and futures price move together  offset </li></ul></ul><ul><ul><li>lock in selling (purchase) price in advance </li></ul></ul><ul><li>Short hedgers: e.g. farmers </li></ul><ul><li>Long hedgers: e.g. processors </li></ul>
  9. 9. Short hedge - example <ul><li>A farmer who has a n agriculture commodity to sell in the future will be hurt by a price decline in the future. </li></ul><ul><li>Hedging: profit from the futures market whenever lose from the cash market. Risk in spot market is offset by trading in futures market. </li></ul>
  10. 10. Short hedge - example <ul><li>Suppose lean hogs are now trading at $70 (per 100 pounds) in spot market. </li></ul><ul><li>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. </li></ul><ul><li>Step 1: Look at futures quote to find out Aug Lean Hogs futures contracts are trading at $70.75 in Chicago Mercantile Exchange. </li></ul><ul><li>Step 2: Call broker and place order to sell 1 Aug Lean Hogs contract and send margin money. </li></ul>
  11. 11. Short hedge example <ul><li>It is now August and the farmer is ready to sell hogs to the packer. </li></ul><ul><li>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). </li></ul><ul><li>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). </li></ul>
  12. 12. Conflicts of interest <ul><li>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. </li></ul><ul><li>Essentially a moral hazard problem. </li></ul><ul><li>Consequence of conflicts of interest is that funds are not channeled into the most productive investment opportunities. </li></ul>
  13. 13. Underwriting and research in investment banks <ul><li>Two objectives: </li></ul><ul><ul><li>research on firms to provide information for potential stock buyers </li></ul></ul><ul><ul><li>underwrite stocks to help firms’ IPO </li></ul></ul><ul><li>Conflicts of interest: </li></ul><ul><ul><li>firms want to hide bad news, investors need to know. </li></ul></ul><ul><ul><li>‘ spinning ’: investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business. </li></ul></ul>
  14. 14. Auditing and consulting in accounting firms <ul><li>Auditors may be willing to skew their judgments and opinions to win consulting business. </li></ul><ul><li>Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts (tax consultants). </li></ul><ul><li>Auditors may provide an overly favorable audit to solicit or retain audit business. </li></ul>
  15. 15. Remedies <ul><li>Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act) </li></ul><ul><ul><li>Increases supervisory oversight to monitor and prevent conflicts of interest </li></ul></ul><ul><ul><li>Establishes a Public Company Accounting Oversight Board </li></ul></ul><ul><ul><li>Increases the SEC’s budget </li></ul></ul><ul><ul><li>Makes it illegal for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an impermissible audit </li></ul></ul>
  16. 16. Remedies (cont’d) <ul><li>Sarbanes-Oxley Act of 2002 (cont’d) </li></ul><ul><ul><li>Beefs up criminal charges for white-collar crime and obstruction of official investigations </li></ul></ul><ul><ul><li>Requires the CEO and CFO to certify that financial statements and disclosures are accurate </li></ul></ul><ul><ul><li>Requires members of the audit committee to be independent </li></ul></ul>
  17. 17. Remedies (cont’d) <ul><li>Global Legal Settlement of 2002 </li></ul><ul><ul><li>Requires investment banks to cut the link between research and securities underwriting </li></ul></ul><ul><ul><li>Bans spinning </li></ul></ul><ul><ul><li>Imposes $1.4 billion in fines on accused investment banks </li></ul></ul><ul><ul><li>Requires investment banks to make their analysts’ recommendations public </li></ul></ul><ul><ul><li>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 </li></ul></ul>
  18. 18. Recap <ul><li>Futures contract </li></ul><ul><li>Position diagrams </li></ul><ul><li>Functions of futures market </li></ul><ul><li>How to hedge and speculate using futures </li></ul><ul><li>Conflicts of interest in investment banks </li></ul><ul><li>Conflicts of interest in accounting firms </li></ul>