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A Brief Guide to Financial Derivatives and Hedge Funds Robert M. Hayes 2005.

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1 A Brief Guide to Financial Derivatives and Hedge Funds Robert M. Hayes 2005

2 FINANCIAL DERIVATIVES §A “financial derivative” (or, briefly, a derivative) is a contractual relationship established by two (or more) parties where payment is based on or "derived" from some agreed-upon benchmark. §Since individuals can "create" a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there can be no definitive list of derivative products. §However, some common financial derivatives will be described later in this presentation, both to illustrate the concept and to highlight what are readily available. §Financial derivatives, on the one hand, have great utility. But, on the other hand, they have been the basis of serious financial losses suffered by municipal governments, well-known corporations, banks and mutual funds that had invested in these products. §They are among the principal tools of investment by “hedge funds”, so those will also be discussed.

3 §Derivatives are a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products. §When one enters into a derivative product arrangement, the medium and rate of repayment are specified in detail. For instance, repayment may be in currency, securities, or a physical commodity such as gold or silver. Similarly, the amount of repayment may be tied to movement of interest rates, stock indexes or foreign currency. §Derivative products also may contain leveraging, i.e., the use of borrowed money to pay for significant portions of the cost. § Leveraging acts to multiply (favorably or unfavorably) the impact on the total repayment obligations of the parties to the derivative instrument.

4 Why Have Financial Derivatives? §Basically, derivatives are intended to be risk-shifting devices. §Initially, they were used to reduce exposure to changes in 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 party.

5 Derivatives in a broader sense §It is worthwhile to recognize that, while financial derivates as we will discuss them are relatively recent, there is a long history of their use in well established ways. §An Insurance Policy is a derivative, in which the underlying asset is the person insured and the risks relate to age, job, health, liability, etc. §The Share Price on a stock is a derivative, in which the underlying assets are the resources of the company, its revenue, profit, interest rate, competitors. And the risks, of course, relate to all of those. §A Bank Loan is a derivative, in which the underlying asset is the collateral and the risks are the uncertainties in payment. §A Mutual Fund is a derivative, in which the underlying assets are the stocks in which the mutual fund has invested, the risks are those in managing any investment.

6 §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. §For instance, several derivative products may be created based on debt securities that represent an interest in a pool of residential home mortgages. One derivative product may provide that the purchaser receives only the interest payments made on the mortgages while another product may specify that the purchaser receives only the principal payments. These derivative products, which react differently to movements in interest rates, may have specific appeal to different investment strategies employed by investment managers.

7 §The financial markets increasingly have become subject to greater "swings" in interest rate movements than in past decades. As a result, financial derivatives have appealed to corporate treasurers who wish to take advantage of favorable interest rates in the management of corporate debt without the expense of issuing new debt securities. For example, if a corporation has issued long term debt with an interest rate of 7 percent and current interest rates are 5 percent, the corporate treasurer may choose to exchange (i.e., Swap), interest rate payments on the long term debt for a floating interest rate, without disturbing the underlying principal amount of the debt itself. (See, Description of Common Financial Derivatives ).

8 The Risks §As derivatives are intended to be risk-shifting devices, it is important to know the risks being assumed, evaluate those risks, and continuously monitor and manage those risks. Each party to a derivative contract should be able to identify all the risks that are being assumed (interest rate, currency exchange, stock index, long or short-term bond rates, etc.) before entering into a derivative contract. §Part of the process in identifying risks is to determine the monetary exposure of the parties under the terms of the derivative. A problem in doing so arises when money is not due until the specified date of performance of the parties' obligations, so the lack of an up-front commitment of cash may obscure the eventual monetary significance of the parties' obligations.

9 §There is need for constant monitoring and managing of the risks represented by the derivative. Unlike the purchase of an equity or debt security, the relationships established in the derivative instrument require constant monitoring for signs of unacceptable change. §In particular, while there may have been a degree of risk which one party was willing to assume initially, that willingness could change greatly due to intervening and unexpected events. §Each party to the derivative contract therefore needs to monitor continuously the commitments represented by the derivative product and the effect of events on those commitments. §Financial derivative instruments that have leveraging features demand closer, even to daily or hourly, monitoring and management.

10 §Derivative instruments also may have special income tax and accounting considerations. §For example, a Stripped Mortgage Backed Security (SMBS) splits the cash flows from an underlying pool of mortgages into classes, called "tranches" which represent different amounts of principal and interest. One tranche may contain only the principal on the underlying mortgages, while another may represent only interest payments. The type of SMBS purchased will determine how the income is taxed at the federal level.

11 Leveraging §Some derivative products may include leveraging features in which a significant portion of the costs are paid through borrowing. For example, if only 10% of the costs have been paid directly, any gains or losses effectively are multiplied by 10. §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. §When a derivative instrument is the result of negotiation between the parties for risk-shifting purposes, the leveraging component, if any, is likely to be unique to that instrument.

12 §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.

13 Combined Derivative Products §As has already been identified, 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 and where the company has exchanged the liability for interest payments with another party. §This product combines a derivative known as a Structured Note with another derivative known as an interest rate Swap.

14 Trading of Derivatives §Some derivative products are traded on national exchanges. Regulation of national futures exchanges is the responsibility of the U.S. Commodities Futures Trading Commission. §National securities exchanges are regulated by the U.S. Securities and Exchange Commission (SEC). §Certain financial derivative products, like options traded on a national securities exchange, 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. §Other derivative products are traded over-the-counter (OTC) and represent agreements that are individually negotiated between parties. It is especially important to be sure of the reliability of the parties involved in such cases.

15 Derivatives in Mutual Funds §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.

16 §If you own shares in a mutual fund or participate in a pension plan and want to know if either the fund or the plan has invested in financial derivatives, read the annual or quarterly reports (including notes to the financial statements) and call or write the fund manager or pension plan administrator in order to receive a complete response to your inquiry.

17 Common Financial Derivatives §There are a number of well known financial derivatives that can serve as illustrations of the kinds of instruments that are possible: l Options l Forward Contracts. l Futures l Stripped Mortgage-Backed Securities l Structured Notes l Swaps

18 Options § An Option represents the right (but not the obligation) to buy or sell a security or other 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“. §You can purchase Options (the right to buy or sell the security in question) or sell (write) Options. §If you are a seller of an option, you would become obligated to sell a security to, or buy a security from, the party that purchased the Option. §Options can be either "Covered" or "Naked“. In a Covered Option, the contract is backed by the asset underlying the Option, e.g., you could purchase a Put on 300 shares of the ABC Corp. that you now own. In a Naked Option, the contract is not backed by the security underlying the Option. Options are traded on organized exchanges and OTC.

19 Forward Contracts. §In a Forward Contract, the purchaser and its counterparty are obligated to trade a security or other asset at a specified date in the future. The price paid for the security or asset is agreed upon at the time the contract is entered into, or may be determined at delivery. Forward Contracts generally are traded OTC.

20 Futures §A Future represents the right to buy or sell a standard quantity and quality of an asset or security at a specified date and price. §Futures are similar to Forward Contracts, but are standardized and traded on an exchange, and are valued, or "Marked to Market " daily. The Marking to Market provides both parties with a daily accounting of their financial obligations under the terms of the Future. §Unlike Forward Contracts, the counterparty to 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. Parties to a Futures contract may buy or write Options on Futures.

21 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.

22 §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. Where the underlying mortgages for an IO carry variable ("floating") rates of interest, the value of the IOs tend to increase in periods of rising interest rates due to anticipated higher interest payments on the underlying mortgages. For IOs that have underlying mortgages at a fixed rate, the value of IOs also tends to increase in value during periods of rising interest rates because individual homeowners are less likely to refinance and prepay their mortgages. The value of the SMBS would therefore, tend to increase over the "life" of the mortgage instrument.

23 §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 compared with other investment opportunities in the marketplace. §Some Tranches may offer interest and principal payments in various combinations. Planned Amortization Classes "PACs, " for instance, provide stable interest and principal repayments if the rates of prepayments on the underlying mortgages stay within a specified predetermined range.

24 Pooled Mortgages §Another potential derivative in which the underlying assets are a set of mortgages might pool the mortgages based on time period. Thus, one might pool mortgages that will end within five years, another within ten years, etc. §In this way, the lender holding those mortgages can transfer the risk related to them to investors who evaluate the risk based on the time when the lent funds will be returned.

25 Structured Notes §Structured Notes are debt instruments where the principal and/or the interest rate is indexed to an unrelated indicator. §An example of a Structured Note would be a bond whose interest rate is decided by interest rates in England or the price of a barrel of crude oil. §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.

26 Swaps §A Swap is a simultaneous buying and selling of the same 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." §Think of an interest rate Swap as follows: Party A holds a 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.

27 §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. Swaps may include "Caps“, "Floors“, or Caps and Floors combined ("Collars"). §A derivative consisting of an Option to enter into an interest rate Swap, or to cancel an existing Swap in the future is called a "Swaption." You can also combine a interest rate and currency Swap (called a "Circus" Swap). §Swaps generally are traded OTC through Swap dealers, which generally consist of large financial institution, or other large brokerage houses. There is a recent trend for Swap dealers to Mark to Market the Swap to reduce the risk of counterparty default.

28 Hedge Funds §Like mutual funds, hedge funds collect pools of money from investors. However, they differ in the respect that: l Hedge funds are not required to register with the SEC. l Hedge funds are not required to maintain any particular degree of diversification or liquidity. l Hedge fund investors must qualify as “financially sophisticated” investors. §Hedge fund managers have considerable freedom to follow various investment strategies, or styles. §The objective is to obtain above-average returns using aggressive, high-risk strategies unavailable to mutual funds and other traditional money managers §Hedge fund fees: l General management fee of 1-2% of fund assets l Performance fee of 20-40% of profits

29 Hedge Funds Strategies §Investing strategies include, but are not limited, to: l Short selling l Leverage l Arbitrage l Derivatives

30 Alan Greenspan, on Hedge Funds 1 §“Of course, much of the unease about credit risk transfer outside the banking system reflects the growing role that hedge funds play in those markets and in the financial system generally. Although comprehensive data on the size of the hedge fund sector do not exist, total assets under management are estimated to be around $1 trillion. Inflows to hedge funds have been especially heavy since 2001, as investors have sought alternatives to long-only investment strategies in the wake of the bursting of the equity bubble. By some estimates, the size of the hedge fund sector doubled between 2001 and 2004. A substantial portion of the inflows to hedge funds in recent years reportedly has come from pension funds, endowments, and other institutional investors rather than from wealthy individuals.

31 Alan Greenspan, on Hedge Funds 2 §“Hedge funds have become increasingly valuable in our financial markets. They actively pursue arbitrage opportunities across markets and in the process often reduce or eliminate mispricing of financial assets. Their willingness to take short positions can act as an antidote to the sometimes-excessive enthusiasm of long-only investors. Perhaps most important, they often provide valuable liquidity to financial markets, both in normal market conditions and especially during periods of stress. They can ordinarily perform these functions more effectively than other types of financial intermediaries because their investors often have a greater appetite for risk and because they are largely free from regulatory constraints on investment strategies.”

32 Why Are Hedge Funds Interesting? §Due to their unregulated nature, hedge funds can take on huge positions, affect market dynamics and cause financial collapses: l LTCM in the 1997 Asian crisis and the 1998 Russian debt crisis ($3.6 billion bailout plan to rescue the fund) l Soros in the 1992 ERM crisis (funded a $10 billion short position in sterling, using collateral and margins) §Understanding the role of hedge funds in the global financial markets might help prevent future crises

33 Greenspan’s Big Blunders 1 §By the end of September 1998 Greenspan was caught with blood on his hands when one of the 4,000 hedge funds, mediocre Long Term Capital Management (LTCM) was about to go bankrupt in running short 13 million ounces of gold, having misjudged its price resistance at $294 as against the anticipated bearer price of $270. In carrying a debt load 100 times as great as its net assets, Greenspan rushed to its aid by twisting the arm of 16 large banks in providing $3.5 billion rescue package. It is easy to work out that the Fed, in order to depress the gold price at $300 less 10% equals $270, corresponding to 5% times the Fed's gold holding of 261 million ounces equals 13 million ounces, times $270 totals $3.5 billion, represented the Fed's bearer transaction with LTCM in line with the policy statement made by Greenspan on 30 July 1998.

34 Greenspan’s Big Blunders 2 §It demonstrates that the Fed had no scruples to engage itself in such large bearer transaction with the undercapitalised LTCM, an outright risky deal which should not have been entertained by a Central Bank at all. A most deceptive leasing transaction, unworthy in the books of any banker, certainly a Central Bank looked upon to protect the reserves of the nation. In the process the Union Bank of Switzerland lost $700 million, and fired its President, Cabiollovetta. §It is pretty obvious that the Fed, in having arranged such a lifeboat for the LTCM, guarantees must have been given to the 16 large banks and other hedge funds engaged in gold-bearer sales to make good the large R3.5 billion assistance by providing more large bearer gold lease contracts to depress the price further, and compensate those 16 banks whilst facilitating other hedge funds in their bearer gold transactions.

35 Types of Hedge Funds l Macro funds l Global funds l Long only funds l Market-neutral funds l Sectoral hedge funds l Dedicated short sales funds l Event-driven funds l Funds of funds §Special situation funds §Pure equity funds §Convertible arbitrage funds §Commodity trading advisor funds §Private equity funds §Risk arbitrage funds §Emerging market funds §Restructured or defaulted security funds


37 Hedging Examples §A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract. §An investor owns 1,000 Microsoft shares currently worth $73 per share. A two-month put for 100 shares with a strike price of $65 costs $2.50. The investor decides to hedge by buying 10 contracts.

38 Speculation Example §An investor with $4,000 to invest feels that Cisco’s stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 25 is $1 §What are the alternative strategies?

39 Arbitrage Example §A stock price is quoted as £100 in London and $172 in New York §The current exchange rate is 1.7500 §What is the arbitrage opportunity?

40 The End

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