Financial Derivatives and Conflicts of Interest Chapters 13 and 14

Overview Financial Derivatives Forward Contracts Financial Futures Options Swaps Conflicts of Interest Sarbanes-Oxley Financial Derivatives Forward Contracts Financial Futures Options Swaps Conflicts of Interest Sarbanes-Oxley

Why Derivatives? Volatile interest rates, stock prices of 70s and 80s Managers want to reduce risk! Contracts related to previously issued securities, so it is like a safety net Arbitrage Chance to make money/off balance sheet profits Volatile interest rates, stock prices of 70s and 80s Managers want to reduce risk! Contracts related to previously issued securities, so it is like a safety net Arbitrage Chance to make money/off balance sheet profits

How Derivatives? Hedge Enter into a financial contract that reduces risk Taking a long position: buy an asset Taking a short position: sell an asset Hedging using derivitives: take one position while simultaneously taking the other position at a future date E.g. buy a bond now (long position) and make a contract to sell it (short position) a year from now at the expected market rate Hedge Enter into a financial contract that reduces risk Taking a long position: buy an asset Taking a short position: sell an asset Hedging using derivitives: take one position while simultaneously taking the other position at a future date E.g. buy a bond now (long position) and make a contract to sell it (short position) a year from now at the expected market rate

Forward Contracts A contract between two parties to engage in financial transaction in the future Advantage Allows hedging Flexible terms, tailor to individual needs Disadvantage Liquidity risk: hard to resell Default risk Buyer/seller may break contract if prices change dramatically Buyer/seller may not exist in the future! A contract between two parties to engage in financial transaction in the future Advantage Allows hedging Flexible terms, tailor to individual needs Disadvantage Liquidity risk: hard to resell Default risk Buyer/seller may break contract if prices change dramatically Buyer/seller may not exist in the future!

Financial Futures Contract Same as forward contract, except: Easier to find a counterparty resell Standardizes contracts Tradable everyday Not specific (e.g. Treasury bonds on delivery) Avoids cornering the market Insurance against default Buy or sell from clearinghouse Margin requirement Micro = one security Macro = whole portfolio Same as forward contract, except: Easier to find a counterparty resell Standardizes contracts Tradable everyday Not specific (e.g. Treasury bonds on delivery) Avoids cornering the market Insurance against default Buy or sell from clearinghouse Margin requirement Micro = one security Macro = whole portfolio

Arbitrage Elimination of riskless profit in futures Bond example: Face value: $50,000 Bond future price: $55,000 Market price of bonds at call time: $54,000 Therefore everyone wants to sell! No one will buy, of course, until the future is sold at market rate. Uncertainty factor: convergence to market rate Elimination of riskless profit in futures Bond example: Face value: $50,000 Bond future price: $55,000 Market price of bonds at call time: $54,000 Therefore everyone wants to sell! No one will buy, of course, until the future is sold at market rate. Uncertainty factor: convergence to market rate

Options The RIGHT to buy or sell assets deliverable in the future (without obligation) Puts a floor on losses Pay premium up front Put: owner sell at exercise price To put back on someone Same as short position but for options Call: owner buy at specific price To call back from someone Same as long position but for options The RIGHT to buy or sell assets deliverable in the future (without obligation) Puts a floor on losses Pay premium up front Put: owner sell at exercise price To put back on someone Same as short position but for options Call: owner buy at specific price To call back from someone Same as long position but for options

Example Face value: $50,000 Strike price: $55,000 Put option: Sell bonds at strike price Premium: $2000 Market (at expiration): $54,000 Make $1000, but paid premium, so actually lost $1000! If bought future instead of option, would have made $1000 Pay premium for the OPTION to sell Face value: $50,000 Strike price: $55,000 Put option: Sell bonds at strike price Premium: $2000 Market (at expiration): $54,000 Make $1000, but paid premium, so actually lost $1000! If bought future instead of option, would have made $1000 Pay premium for the OPTION to sell

Swaps Exchange set of payments between owners Payments traded generally have… Different interest rate sensitivities Different maturities Manage assets and liability (duration and gap) Example Bank pays finance company fixed 5% on 1M Finance pays bank variable T-bill valued at 1M Bank gets more variable assets, finance gets fixed Exchange set of payments between owners Payments traded generally have… Different interest rate sensitivities Different maturities Manage assets and liability (duration and gap) Example Bank pays finance company fixed 5% on 1M Finance pays bank variable T-bill valued at 1M Bank gets more variable assets, finance gets fixed

Conflicts of Interest Audit and consult at same time Credit rating and consulting at same time Universal Banking Underwrite and research at same time Sarbanes-Oxley (2002) Audit and consult at same time Credit rating and consulting at same time Universal Banking Underwrite and research at same time Sarbanes-Oxley (2002)

Auditing and Consulting Clients pressure skewing Reluctant to criticize own setup Favorable audit to retain business Clients pressure skewing Reluctant to criticize own setup Favorable audit to retain business

Credit Rating and Consulting Bias credit rating to retain business Reluctant to give low rating of their own advice Clients pressure to skew upward Bias credit rating to retain business Reluctant to give low rating of their own advice Clients pressure to skew upward

Universal Banking Investment and Commercial banking Risky, risky, risky Can hold equity position (stock) in the same companies to which they are lending! Problem increases with size of banking institutions Investment and Commercial banking Risky, risky, risky Can hold equity position (stock) in the same companies to which they are lending! Problem increases with size of banking institutions

Sarbanes-Oxley Act of 2002 No consulting services contracts while doing audit Stronger criminal charges for white collar crime and obstruction of investigations CEO/CFO must certify accuracy of financial statements Audit committee must be made up of outside directors, no management Public Accounting Oversight Board (PCAOB) supervise accounting firms Independent (third-party) Quality controlled No consulting services contracts while doing audit Stronger criminal charges for white collar crime and obstruction of investigations CEO/CFO must certify accuracy of financial statements Audit committee must be made up of outside directors, no management Public Accounting Oversight Board (PCAOB) supervise accounting firms Independent (third-party) Quality controlled