What is a Derivative? In its most simple form, a derivative is a leveraged bet on anything that can be measured. Interest rates Currency exchange rates Commodoties prices Election results

What is a Derivative? DERIVATIVES are so-called because they are contracts that DERIVE their value from the value of something else in the future. Forward contracts – entail an obligation to buy or pay something in the future Option contracts – entail only a future right but no obligation

What is a Derivative? Example of a Forward Contract (Kieso, Weygandt and Warfield p. 864) Heartland Farms grows potatoes and sells to McDonalds. Harvest is 2 months away. Heartland agrees to sell the potatoes in 2 months at today’s price. Both companies have hedged their positions although one company will benefit at the expense of the other if the price changes.

The Zero-sum Game Unlike stock prices, which (presumably) react to an underlying value, derivative contracts are a zero sum game.

Purpose of Derivatives The stated purpose of derivatives usage is to “hedge” against factors detrimental to performance. The “hedge” can be either direct or indirect factors.

Purpose of Derivatives The stated purpose of derivatives usage is to “hedge” against factors detrimental to performance. BUT THEY ARE NOT CONFINED TO THAT USAGE ALONE!

Purpose of Derivatives The stated purpose of derivatives usage is to “hedge” against factors detrimental to performance. THEY CAN ALSO BE USED AS A TOOL FOR GAINING ADDITIONAL INCOME

Derivatives and Risk Hyper-sophisticated, computer-generated derivative instruments are traded electronically world-wide. Institutions have used them to create a parallel universe of side bets and speculative mutations that exceed in total more than five times the size of the global economy. These statistical based programs lie beyond the intuition of bank and institution managers. However historically based, risk assessment models, reflecting global events and transactions fail to reflect selling pressures and reactions to a crises.

Derivatives and Risk Derivatives deals are essentially formed off the books, in an opaque environment with little or no oversight or fiduciary responsibility. In aggregate, nobody knows about the nature or form or inherent risks associated with incredible numbers of monumental derivative bets.

Derivatives Risk Chase Manhattan According to the Controller of Currency, Chase carries over $8 of risk for every $1 capital. This amount is likely understated. Amount of capital required is tied to risk (measured by credit ratings).

Significant Events 1973 CBOE opens; large scale trading in derivatives is made feasible 1983 President Reagan signs the Futures Trading Act 1986 Derivatives market exeeds $500 Billion

Significant Events 1987 Presidential Task Force on Market Mechanisms concludes that a one day stock market crash was caused by the “failure of the stock market and derivatives markets to operate in sync.” 1988 Derivatives market exceeds $1 Tril 1994 Derivatives market excees $10 Tril 1994 Metallgesellschaft reports $1.5 Bil loss on oil futures bets; Orange County admits a similar amount lost on derivatives plays; county declares bankruptcy

Significant Events 1995 One single “rogue trader” named Nick Leeson, loses $1.4 billion in unauthorized derivatives bets on the Nikkei Index following an earthquake and the prestigious _ year old Barings Bank is brought down in a single day State of Wisconsin’s Investment Board discloses a $95 million loss from “unauthorized use of derivatives” 1997 Asian markets collapse. Derivatives based credit and currency swaps are cited as a cause of the collapse 1998 Federal Government authorizes a $3.5 Billion bailout of trades conducted by a single firm, long Term Capital Management in order to prevent a possible “irreversible” collapse of global markets.

Significant Events 2001 Enron indiscriminately and secretly transforms from energy company to derivatives player. Actions directly lead to power blackouts in California and to the eventual collapse of the firm FNMA loses $1.9 billion in derivatives portfolio, leading to near collapse Derivatives market exceeds $200 trillion

Trillion Dollar Club Derivatives Contracts JPMorgan Chase Bank$ Bank of America$ Citigroup$ Wachovia $2.457 Bank One $1.133 HSBC $1.043 Wells Fargo $1.014

SFAS #133 In Summary, SFAS #133 Requires that derivatives be reported as an asset or liability at fair value of the derivatives contract. Requires gains and losses from speculative derivatives be reported in income Allows gains and losses from hedge transactions to be reported differently

Speculative Trading Oil is trading at $68 per barrel A company makes a speculative trade to purchase an option to buy 100 barrels at $70 in one month. The option costs $200 Two weeks later, the fiscal year ends with oil trading at $72 barrel and the option worth $450 The company must report the option on the balance sheet as a $450 asset and must report the UNREALIZED GAIN as INCOME, not COMPREHENSIVE INCOME (EQUITY)

Fair Value Hedge Exxon is $70 per share A company holds 100 shares of Exxon The company buys options to sell 100 shares of Exxon for $70. The options cost $200. The company reports the option on the balance sheet and unrealized gains and losses on Exxon stock are netted out against the unrealized losses and gains on the option in INCOME (not in COMPREHENSIVE INCOME)

Cash Flow Hedge An airline will purchase 1000 gallons of fuel. The company agrees to purchase the fuel next month for $10 per share. In one month, the price of fuel is $12. The company takes delivery of $12000 of fuel (supplies inventory) for a pay out of $10,000 cash and a $2000 unrealized gain (COMPREHENSIVE INCOME- EQUITY) When the fuel is used, the unrealized gain is converted to a reduction in expenses (INCOME)