slides

1. Investment Banking and the
Ethics of RISK
Are there special obligations of trust,
reliance and protection that arise in
such cases?

2. Multitrillion dollar global market
in trading of derivatives
Potential to impact the overall
credit functions of various
national economies
Potential to impact investment
and growth in national
economies
special obligations of protection
for social trust and reliance?

3. What are “derivatives?”
Derivatives are financial instruments
whose value is derived from other
assets, entities or transactions.

4. What is the financial purpose of
derivatives?
A means of insuring against (or
hedging) some future adverse
financial event.

5. Comparison with other
financial instruments
STOCKS:
Sale of a share of equity in the assets
and profits of a firm
Seller: issues stock to raise capital
Buyer: invests in stock on the promise
of increase in value due to firm’s rate
of profit
Value of Stock:
based on financial health/profit
performance of firm
Risk?

6. Derivatives: incorporate greater risks
Value/cost is based on likelihood of possible future
“adverse event”

7. Derivatives permit the buying and selling of risk:
commoditization of risk
Buyer: Risk of adverse financial events can be shared
(by contract) so that the financial exposure can be
lessened
Seller: Revenue from purchase of this “insurance” is the
primary incentive for those who issue derivatives

8. Derivatives permit the buying and selling of risk:
commoditization of risk
Types of “adverse events” for which derivatives provide
hedges:
rising prices in energy, resources, labor, health
costs
possibility of weather events (e.g., tornadoes, etc.)
possibility of financial defaults by borrowers

9. Derivatives permit the buying and selling of risk:
commoditization of risk
High likelihood of some “adverse events” makes
derivatives in these areas highly risky:
[1] higher the likelihood of risk  higher price to
buyer
[2] higher revenue to derivatives seller
[3] incentive: spread the risk exposure further

10. Secondary incentive for seller: commoditize the original
risk to additional buyers
Market additional shares in original “insurance” contract to
additional investors
“secondary” derivative sales

11. 1993-94: broad deregulation of investment industry
from derivatives to trading in derivatives
Original purpose – hedging against risk -- recedes as
exchange/sale of derivative contracts becomes a market
in its own right

12. 1993-94: broad deregulation of investment industry
from derivatives to trading in derivatives
Derivative seller: takes on part of buyer’s original risk
(i.e., acquires financial exposure)
Secondary derivatives trading market:
permits original seller to “spread” this exposure
to other parties (i.e., those who buy shares in
secondary sale)

13. Original “risk” becomes more detached as trading in the
derivatives operates on its own terms
Original risk = “reference entity” for the risk
Reference entity is the basis for establishing a financial value and price
for the derivative contract in the first place

14. How much is a derivative
contract worth?
Original value = degree of risk
and cost of adverse event
Subsequent trading and
re-trading of derivative
contracts:
abstraction from original
value
Trading market conditions
establish new value and price
Likelihood of wide price /value
fluctuations

15. Financial “upshot” of a market for
trading in derivatives
Original risk is converted into a sellable commodity
This commodity is further “commoditized”
Value of commodity (and basis of price) is less
connected to the “trading” value of derivatives
Derivatives trading and profit are less predictable, more
subject to risk

16. Financial “upshot” of a market for
trading in derivatives
derivatives market as a “casino”

17. Credit Derivatives: the riskiest
gamble of all
Derivative contracts that transfer
defined credit risks in a credit product
(e.g., a loan) to the purchaser of the
derivative.

18. “defined credit risks”
adverse financial events associated with credit
[1] specific credit risks:
a borrower will be unable to repay the loan
(i.e., default)
[2] generic credit risks:
a firm or individual will fail financially
(i.e., bankruptcy)

19. Derivatives traders acquire “virtual” possession of the
credit asset
Risks and rewards of the loan are transferred to the secondary
party
No actual ownership of the credit asset itself

20. Banks and lenders could enlarge their loan capacity without fear
of loss
Credit derivatives would protect against adverse credit events
Retail Credit industry: risk of default could be “spread”
to other parties

21. Broader the “spread” of risk exposure the lower the likelihood
of financial loss in case of adverse credit events
Derivatives trading industry: creating more complex
“secondary” trading instruments = more profit

22. Credit risk is securitized
structured credit investments
“Credit derivative indices:”
contracts provide “shares” in a bundle of credit risks that span
many different entities (e.g., firms, individual borrowers, etc.)
traders purchase tranches that allocate a share of the risk
revenue from loans is divided up among investors in each of the
tranches based on degree of risk (3% or 6% or 10%)
In case of default... Share of revenue is divided based on risk
share

23. Credit risk is securitized
structured credit investments
“Credit derivative indices:”
In case of default... Share of revenue is divided based on risk
share
tranch 1 tranch 2 tranch 3

24. Risks inherent in credit derivatives market
For commercial lenders (banks)
incentive to increase loan volumes without
concern about credit risks
risk exposure can be “spread
by derivatives hedges

25. Risks inherent in credit derivatives market
For investors and traders
profits from trading in securitized credit risks were
disconnected from the economic conditions of the
borrowers and firms whose credit initiated the
process
abstraction from economic reality

26. Derivatives “world”
Profits generated through trading in
risk
Exploits the hardships of “real world”
borrowers
Detached from “real world” economic
conditions
ILLUSION of risk-free profits