What is a derivative According to Investopedia a derivative is a contract between two or more parties whose value is based on an agreed upon underlying financial asset index or security Common underlying instruments include bonds commodities currencies interest rates market indexes and stocks This is an example of organizational level risk Important topic for finance majors Module 10A Common derivatives Futures contracts Forward contracts Options Swaps Warrants A futures contract for example is a derivative because its value is affected by the performance of the underlying contract Similarly a stock option is a derivative because its value is derived from that of the underlying stock Derivatives used as a hedge Derivatives are great for hedging and it allows you to get rid of price risk by setting a price to sell product in the future The value of the contract is unknown This does not create risk I am an airline and I will use 10 million barrels of aviation fuel this year I don t know what the price of aviation fuel will be when I need to buy it I can enter into a futures contract to purchase the fuel at a specified price at a specified time I have hedged my exposure to fuel price risk If prices go up I make money If prices go down I lose money Derivatives used to speculate Derivatives can also be used to speculate about future prices Sell it now high and buy it again later low If prices are predicted to go down I make money If prices go up I lose money This creates risk by taking on exposure that I have never had I think that the S P index is going to go down how can I make money on that I can enter a derivative transaction where I sell the index at today s prices Problem I don t actually own shares of the index to sell Well when the index goes down I can enter into a different derivative transaction to buy at the lower price So I sell high I buy low I make money without ever actually owning any shares of the index Or the index goes up and I sell low and buy high and lose money What is the risk Since many trades are unregulated there is little oversight to see how risky some of the positions that are being taken by individuals or organizations are Domino effect and systemic risk are an issue Orange County CA loses over 1B and went bankrupt Robert Citron got involved in derivatives and for years he was beating the market Eventually his streak ended They could no longer pay their municipal bonds Barings Bank goes Bankrupt because Nick Leeson hid his billions of dollars speculative transactions of losing money in Singapore Lehman Brothers were exposed to credit default swaps and subprime mortgages and were guaranteeing other financial institutions money A 3 4 move in property values and they went bankrupt Everyone saw this coming and a domino effect was created The federal government did not bailout Lehman Brothers but it did help Bank of America AIG Berkshire Hathaway Warren Buffet Derivatives are financial weapons of mass destruction he said this 6 years before he caused his company to go bankrupt Why use them Legitimate hedging function they are a risk management tool Amplify leverage returns both good and bad All about risk reward Help make money move faster Help make money work harder What don t we know What is the risk exposure in derivatives No one knows exactly how big the derivatives market is because there is over the counter trades Estimated in 2007 1 144 quadrillion more than one thousand trillion US GDP 16 8 Trillion in 2013 US Real Estate 25 Trillion Zillow Global Real Estate 180 Trillion Global Citizens Report Global Stock Bond 155 Trillion 2012 Wikipedia 212 Trillion 2010 QVM Group How should they be regulated If you want to speculate shouldn t you be allowed o Speculators often help to make markets work Very complex can they be regulated effectively regulator Derivatives are a global product who should regulate o Looking back at failures if internal supervisors could not see the risk how could an external Reading Are the Risks of Derivatives Manageable Provides an explanation of the continuing national and global use of derivatives as safe instruments in hedge funds Derivatives were estimated to be one of the largest potential disasters of business transactions in 2009 Derivatives are determined by what someone is willing to pay for a contract Derivatives are financial instruments based on other products both physical and financial Yes Yong Chen The financial derivatives are under attack as an important and ethical investment practice Derivatives can be powerful investment devices especially in hedge funds 70 of hedge funds trade derivatives He measured fund return volatility average market exposure and market exposure during market downturns Hedge funds using derivatives are not associated with heavy risk taking Little is known about their effects on fund risk and performance Derivatives derive their value from other assets and are derivatives are financial instruments that allow investors to speculate on the future price of an asset Hedge means to insure against The high risk reputation spurred from financial failures which used derivative trading No Thomas A Bass The recent market failures were due in to mismanagement of the derivative investments Gambling risks world s largest betting parlor derivatives are similar to crystal meth Widespread regulation should be instated or do not use them at all Warren Buffet the Oracle of Omaha called derivatives financial weapons of mass destruction in 2002 In 2009 Buffet lost 67 billion dollars in derivatives transactions and stripped Berkshire Hathaway of its triple A debt rating He said auditors can t audit these contracts and regulators can t regulate them No one knows how big the market is in derivatives Module 10B This module deals with societal risk Our Needs We need food water shelter and clothing Our Insatiable Wants our wants desires spur economic activity We want entertainment communication variety and brownies Our wants are unlimited Our Limited Means Our means are limited Resources labor capital and technology are scarce It is difficult to determine the right mix of production i e how much of each product World Poverty and Economics Resources available to produce to fulfill our wants needs are limited and usually cannot be increased greatly at any given time Technology is also usually subject to limited degrees of improvement Technology refers to the known means and methods available for combining resources to
View Full Document
Unlocking...