Financial Derivatives

Definition of Financial Derivatives ❧ A financial derivative is a contract between two or more parties where payment is based on i.e., "derived" from some agreed-upon benchmark.. Repayme

Financial Derivatives

Robert M Hayes

❧ Definition of Financial Derivatives

❧ Common Financial Derivatives

❧ Why Have Derivatives?

❧ The Risks

❧ Leveraging

❧ Trading of Derivatives

❧ Derivatives on the Internet

❧ An Apologia for Derivatives

❧ The Dark Side of Derivatives

Definition of Financial Derivatives

❧ A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed-upon benchmark

❧ Since a financial derivative can be created by means of a mutual agreement, the types of derivative products are limited only by imagination and so there is no definitive list of derivative products

❧ Some common financial derivatives, however, are

described later.

❧ More generic is the concept of “hedge funds” which use financial derivatives as their most important tool for risk

Repayment of Financial Derivatives

❧ In creating a financial derivative, the means for, basis of, and rate of payment are specified

❧ Payment may be in currency, securities, a physical entity such

as gold or silver, an agricultural product such as wheat or

pork, a transitory commodity such as communication

bandwidth or energy.

❧ The amount of payment may be tied to movement of interest rates, stock indexes, or foreign currency.

❧ Financial derivatives also may involve leveraging, with

significant percentages of the money involved being borrowed Leveraging thus acts to multiply (favorably or unfavorably) impacts on total payment obligations of the parties to the

derivative instrument

Common Financial Derivatives

❧ The purchaser of an Option has rights (but not obligations)

to buy or sell the asset during a given time for a specified price (the "Strike" price) An Option to buy is known as a

"Call," and an Option to sell is called a "Put "

❧ The seller of a Call Option is obligated to sell the asset to the party that purchased the Option The seller of a Put

Option is obligated to buy the asset.

❧ In a “Covered” Option, the seller of the Option already

owns the asset In a “Naked” Option, the seller does not

own the asset

❧ Options are traded on organized exchanges and OTC

Forward Contracts

❧ In a Forward Contract, both the seller and the

purchaser are obligated to trade a security or other

asset at a specified date in the future The price paid

for the security or asset may be agreed upon at the time the contract is entered into or may be determined at

delivery

❧ Forward Contracts generally are traded OTC

quality of an asset or security at a specified date and price

standardized and traded on an exchange, and are valued

daily The daily value provides both parties with an

accounting of their financial obligations under the terms of the Future

seller in a Futures contract is the clearing corporation on the appropriate exchange

❧ Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset

Stripped Mortgage-Backed Securities

❧ Stripped Mortgage-Backed Securities, called "SMBS,"

represent interests in a pool of mortgages, called "Tranches", the cash flow of which has been separated into interest and principal components

❧ Interest only securities, called "IOs", receive the interest

portion of the mortgage payment and generally increase in value as interest rates rise and decrease in value as interest rates fall

❧ Principal only securities, called "POs", receive the principal portion of the mortgage payment and respond inversely to interest rate movement As interest rates go up, the value of the PO would tend to fall, as the PO becomes less attractive

Structured Notes

❧ Structured Notes are debt instruments where the

principal and/or the interest rate is indexed to an

unrelated indicator A bond whose interest rate is decided

by interest rates in England or the price of a barrel of

crude oil would be a Structured Note,

❧ Sometimes the two elements of a Structured Note are

inversely related, so as the index goes up, the rate of

payment (the "coupon rate") goes down This instrument

is known as an "Inverse Floater."

❧ With leveraging, Structured Notes may fluctuate to a

greater degree than the underlying index Therefore,

Structured Notes can be an extremely volatile derivative with high risk potential and a need for close monitoring

❧ Structured Notes generally are traded OTC

security or obligation Perhaps the best-known Swap occurs when two parties exchange interest payments based on an identical principal amount, called the "notional principal amount."

10-year $10,000 home equity loan that has a fixed interest rate of 7 percent, and Party B holds a 10-year $10,000 home equity loan that has an adjustable interest rate that will

change over the "life" of the mortgage If Party A and Party

B were to exchange interest rate payments on their

otherwise identical mortgages, they would have engaged in

an interest rate Swap

❧ Interest rate swaps occur generally in three scenarios Exchanges of a fixed rate for a floating rate, a floating rate for a fixed rate, or a floating rate for a floating

rate

❧ The "Swaps market" has grown dramatically Today, Swaps involve exchanges other than interest rates, such

as mortgages, currencies, and "cross-national"

arrangements Swaps may involve cross-currency

payments (U.S Dollars vs Mexican Pesos) and

crossmarket payments, e.g., U.S short-term rates vs U.K short-term rates

Rights of Use

❧ A type of swap is represented by swapping capacity on networks using instruments called “indefeasible rights

of use”, or IRUs Companies buying an IRU might

book the price as a capital expense, which could be

spread over a number of years But the income from IRUs could be booked as immediate revenue, which would bring an immediate boost to the bottom line

❧ Technically, the practice is within the arcane rules that govern financial derivative accounting methods, but only if the swap transactions are real and entered into for a genuine business purpose.

Combined Derivative Products

❧ The range of derivative products is limited only by the human imagination Therefore, it is not unusual for

financial derivatives to be merged in various

combinations to form new derivative products

❧ For instance, a company may find it advantageous to finance operations by issuing debt, the interest rate of which is determined by some unrelated index The

company may have exchanged the liability for interest payments with another party This product combines a Structured Note with an interest rate Swap

Hedge Funds

❧ A “hedge fund” is a private partnership aimed at very wealthy investors It can use strategies to reduce risk But it may also use leverage, which increases the level

of risk and the potential rewards.

❧ Hedge funds can invest in virtually anything anywhere They can hold stocks, bonds, and government securities

in all global markets They may purchase currencies, derivatives, commodities, and tangible assets They may leverage their portfolios by borrowing money against their assets, or by borrowing stocks from investment

brokers and selling them (shorting) They may also

invest in closely held companies.

Hedge Funds

For this reason, they are available only to those fitting the Securities and Exchange Commission definition of

“accredited investors”—individuals with a net worth

exceeding $1 million or with income greater than $200,000 ($300,000 for couples) in each of the two years prior to the investment and with a reasonable expectation of

sustainability

partnerships, have higher minimum requirements The SEC reasons that these investors have financial advisers or are savvy enough to evaluate sophisticated investments for

themselves

Hedge Funds

❧ Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies Others use hedge funds as the primary means of

implementing their long-term investment strategy

Why Have Derivatives?

❧ Derivatives are risk-shifting devices Initially, they were used to reduce exposure to changes in such factors as

weather, foreign exchange rates, interest rates, or stock indexes

❧ For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to

reduce the risk that the exchange rate with the U.S

Dollar will be more unfavorable at the time the bill is due and paid Under the derivative instrument, the other

party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed By using a derivative product, the company has shifted the risk of exchange rate movement to another

Why Have Derivatives?

❧ More recently, derivatives have been used to segregate categories of investment risk that may appeal to

different investment strategies used by mutual fund

managers, corporate treasurers or pension fund

administrators These investment managers may decide that it is more beneficial to assume a specific "risk"

characteristic of a security

The Risks

❧ Since derivatives are risk-shifting devices, it is important to identify and understand the risks being assumed, evaluate them, and continuously monitor and manage them Each party to a derivative contract should be able to identify all the risks that are being assumed before entering into a

derivative contract

❧ Part of the risk identification process is a determination of the monetary exposure of the parties under the terms of the derivative instrument As money usually is not due until the specified date of performance of the parties' obligations,

lack of up-front commitment of cash may obscure the

eventual monetary significance of the parties' obligations

The Risks

❧ Investors and markets traditionally have looked to

commercial rating services for evaluation of the credit and investment risk of issuers of debt securities.

❧ Some firms have begun issuing ratings on a company's

securities which reflect an evaluation of the exposure to

derivative financial instruments to which it is a party

❧ The creditworthiness of each party to a derivative instrument must be evaluated independently by each counterparty In a financial derivative, performance of the other party's

obligations is highly dependent on the strength of its balance sheet Therefore, a complete financial investigation of a

proposed counterparty to a derivative instrument is

imperative

The Risks

❧ An often overlooked, but very important aspect in the use of derivatives is the need for constant monitoring and managing of the risks represented by the derivative instruments

❧ For instance, the degree of risk which one party was

willing to assume initially could change greatly due to intervening and unexpected events Each party to the derivative contract should monitor continuously the

commitments represented by the derivative product

❧ Financial derivative instruments that have leveraging features demand closer, even daily or hourly monitoring and management

Leveraging

❧ Some derivative products may include leveraging

features These features act to multiply the impact of some agreed-upon benchmark in the derivative

instrument Negative movement of a benchmark in a leveraged instrument can act to increase greatly a

party's total repayment obligation Remembering that each derivative instrument generally is the product of negotiation between the parties for risk-shifting

purposes, the leveraging component, if any, may be unique to that instrument

Leveraging

❧ For example, assume a party to a derivative instrument stands to be affected negatively if the prime interest

rate rises before it is obliged to perform on the

instrument This leveraged derivative may call for the party to be liable for ten times the amount represented

by the intervening rise in the prime rate Because of

this leveraging feature, a small rise in the prime interest rate dramatically would affect the obligation of the

party A significant rise in the prime interest rate, when multiplied by the leveraging feature, could be

catastrophic

Trading of Derivatives

❧ Some financial derivatives are traded on national exchanges Those in the U.S are regulated by the Commodities Futures Trading Commission.

❧ Financial derivatives on national securities exchanges are

regulated by the U.S Securities and Exchange Commission (SEC)

❧ Certain financial derivative products have been standardized and are issued by a separate clearing corporation to

sophisticated investors pursuant to an explanatory offering circular Performance of the parties under these standardized options is guaranteed by the issuing clearing corporation

Both the exchange and the clearing corporation are subject to SEC oversight

Trading of Derivatives

❧ Some derivative products are traded over-the-counter (OTC) and represent agreements that are individually negotiated between parties Anyone considering

becoming a party to an OTC derivative should

investigate first the creditworthiness of the parties

obligated under the instrument so as to have sufficient assurance that the parties are financially responsible

Mutual Funds and Public Companies

❧ Mutual funds and public companies are regulated by the SEC with respect to disclosure of material information to the

securities markets and investors purchasing securities of

those entities The SEC requires these entities to provide

disclosure to investors when offering their securities for sale

to the public and mandates filing of periodic public reports

on the condition of the company or mutual fund

❧ The SEC recently has urged mutual funds and public

companies to provide investors and the securities markets

with more detailed information about their exposure to

derivative products The SEC also has requested that mutual funds limit their investment in derivatives to those that are necessary to further the fund's stated investment objectives

Selling of Financial Derivatives

❧ Some brokerage firms are engaged in the business of

creating financial derivative instruments to be offered to retail investment clients, mutual funds, banks,

corporations and government investment officers

❧ Before investing in a financial derivative product it is vital

to do two things

● First, determine in detail how different economic

scenarios will affect the investment in the financial

derivative (including the impact of any leveraging

features)

● Second, obtain information from state or federal

agencies about the broker's record

Derivatives on the Internet

❧ In the past several years, trading of financial derivatives has become an active Internet e-commerce focus, with EnronOnline as among the most active sites Leaving

aside assessment of the reliability of e-commerce trading sites, the following are valuable sites for keeping track:

❧ For quick news bites, the best sources are maintained by some of the major financial news organizations:

● Bloomberg Online www.bloomberg.com

● Reuters.com www.reuters.com

● The Associated Press www.nytimes.com/aponline

● Bridge Financial www.bridge.com

Derivatives on the Internet

❧ One very quick and easy analysis of developments in overnight markets and identification of key issues in today's markets is Marc Chandler's commentary:

● TheStreet.com www.thestreet.com

❧ For Canadian news, there are two national newspapers,

● The National Post www.nationalpost.com and

● The Globe And Mail www.theglobeandmail.com

❧ Internationally,

● The New York Times www.nytimes.com,

● South China Morning Post www.scmp.com,

● The Washington Post www.washingtonpost.com

● The Financial Times www.ft.com/hippocampus

Derivatives on the Internet

An Apologia for Derivatives

❧ Derivatives are not new, high-tech methods.

❧ Derivatives are not purely speculative or leveraged.

❧ Derivatives are not a major part of finance.

❧ Derivatives are of value to companies of all sizes.

❧ Derivatives are tools to meet management objectives.

❧ Derivatives reduce uncertainty and foster investment.

❧ Derivatives can both reduce and enhance risk.

❧ Derivatives do not change the nature of risk.

❧ Derivatives reduce, not increase systemic risks.

❧ Derivatives do not call for further regulation.

The Dark Side of Derivatives

❧ Six examples will be used to illustrate some of the perils, especially ethical perils, in use of financial derivatives:

● Equity Funding Corporation of America (1973)

● Baring Bank (1994)

● Orange County, California (1994)

● Long Term Capital Management (1998)

● Enron (2001)

● Global Crossing (2002)

❧ Each of them represented an effort to use financial derivatives to produce inflated returns Two cases were proven to be frauds Two appear to have been innocent of fraud Two are still to be seen.

❧ Each was a major financial catastrophe, affecting not only those directly involved but the world at large.

The Steps on the Primrose Path

A B C D E F

2 wish to have stock price go up x ? x x x

3 use of stock options as incentives x x x x x

4 use of hidden borrowing x ? x x x

5 use of financial derivatives in risky gambles x x x x x x

6 consulting by auditor on use of derivatives x ? x x x x

7 use of deceptive accounting to hide risks x x ? x x

8 acquiescence of auditor in deception x ? ? ?

9 use of fraudulent entries to support deceptions x x ? ?

10 use of hidden partners x ?

11 move from individual fraud to corporate fraud x ? ?

12 connivance of auditor in fraud x ? ?

13 use of a Ponzi scheme to continue fraud x ? ?

14 profiting before the collapse x x x

Equity Funding Corporation of America

❧ The insurance funding program

❧ The first scam

❧ The next scam

❧ The really BIG scam

❧ The final scam

❧ The house of cards collapses

❧ The fallout from Equity Funding

❧ An analysis of the causes

The insurance funding program - 1

❧ Equity Funding Corporation of America was founded in 1960 Its principal line of business was selling "funding programs" that merged life insurance and mutual funds into one financial package for investors

❧ The deal was as follows: first, the customer would invest in a mutual fund; second, the customer would select a life

insurance program; third, the customer would borrow against the mutual fund shares to pay each annual insurance

premium Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value

of the mutual fund shares Any appreciation of the investment

in excess of the amount paid would be the investor's profit

The insurance funding program - 2

❧ The company had a huge sales force The thrust of the salesman's pitch to a customer was that letting the cash value sit in an insurance policy was not smart; in fact, the customer was losing money The customer was

encouraged to let his money work twice by taking part

in the above deal

❧ The development of such creative financial investments was a trademark of Equity Funding in the early years

of its existence After going public in 1964, Equity

Funding was soon recognized across the country as an innovative company in the ultraconservative life

insurance industry

The insurance funding program - 3

❧ This kind of leveraging of dollars is a concept used by

sophisticated investors to maximize their returns They use an asset they already own to borrow money in the expectation that earnings and growth will be greater than the interest costs they will incur However, it's a concept that is fraught with risks for the investor and should not be promoted by an ethical company without fully informing the investor of the risks.

❧ Even so, there was nothing illegal or even immoral about the basic concept Indeed, it was a captivating idea, except it didn't make enough money for the company or its executives So some executives—led by the president, chief financial officer and

head of insurance operations—got a little more creative with the numbers on their books.

The first scam

❧ "Reciprocal income“

Preparing to take the company public in 1964, there was concern that its earnings were too low To

correct this "problem", the owners decided that

Equity Funding was entitled to record rebates or kickbacks from the brokers through whom the

company's sales force purchased mutual fund

shares The resulting income, called "reciprocal

income" was used to boost 1964 net income for

Equity Funding So the fraud apparently began in

1964 when the commissions earned on sales of the Equity Funding program were erroneously inflated