Module 10 Organizations and Government Learning Objectives Define derivatives and financial risk Explain how derivatives can generate risk and reward Describe the problems with regulating derivatives Explain the causes of poverty Describe the relationship between poverty and economics Explain the roles of developed and less developed governments in addressing Module 10 A Are the Risks of Derivatives Manageable poverty Background What is a derivative A derivative is a contract between two or more parties whose value is based on an agreed upon underlying financial asset index or security A contract where the value of the contract is based on some underlying financial asset index security etc an example of this is someone thinks the value of BP stock is going to go down you think it ll go up so you enter a contract together agreeing on buying and selling this stock Common underlying instruments include bonds commodities currencies interest rates market indexes and stocks Futures contracts forward contracts options swaps and warrants are common derivatives 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 o A future contract includes an agreement to buy something from someone in the future and agreeing on the quantity and price in advanced The risk from a derivative comes from when the value of the asset changes from what was agreed on in the contract How are they used Derivatives can be used as a hedge o 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 o You know what the price is now but you don t know what it will be down the line Can enter a future contract so you may make money savings or lose money pay more than the market price This can be useful because you know what your costs will be so you can more accurately set your prices and profit from that They can be used to speculate o 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 The problem is 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 I purely speculated o Now of course if the index goes up and I sell low and buy high and lose money There are some entities that are like natural hedgers The airline wants to hedge incase oil prices go up and the oil company wants to hedge in case oil prices go down A natural hedge when someone makes money when prices go up and someone makes money when the prices go down Maybe these people can enter into a contract together so they re a little bit better off when the situation becomes less favorable to them But this isn t always the case There s a real value of them being a hedge so there is also a risk to using them What s 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 Many derivatives are traded over the counter and there s no exchange that oversees this and how much risk is involved This makes it difficult to calculate the risk involved Warren Buffet Derivatives are financial weapons of mass destruction Even before the financial crisis he saw that they were dangerous Later his company did get involved in them and lost millions Why use them Legitimate hedging function they are a risk management tool Amplify leverage returns both good and bad o All about risk reward o Help make money move faster o Help make money work harder unregulated What is the exposure in derivatives What don t we know It s hard to know what the exposure is because it s highly No one knows exactly how big the derivatives market is o Estimated in 2007 1 144 quadrillion more than one thousand trillion in the derivatives market To put this in perspective 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 Remember derivatives are based on underlying assets So there could be hundreds of derivative contracts based on one underlying asset which is why the market gets so big so fast How they should be regulated If you want to speculate shouldn t you be allowed Speculators often help to make markets work Derivatives can be very complex can they be regulated effectively Sometimes it s hard to know what position you are even standing on in a contract Looking back at failures if internal supervisors could not see the risk how could an external regulator Even the people working inside the companies couldn t detect the risk Derivatives are a global product who should regulate Take aways general Define derivatives financial risk Explain how derivatives can generate risk reward They help put the money to work but they can generate more risk than they manage Describe the problems with regulating derivatives specifically but risk reward in Module 10B Alleviating Human Misery Outline World Poverty and Economics Causes of Poverty and Requisites of Economic Growth Can Governments Help World Poverty Economics Our insatiable wants o Our wants and desires spur economic activity Needs food water shelter clothing Wants entertainment communication variety brownies unlimited Our Limited Means o Resources are scarce not unlimited What s available to produce our wants and needs Usually can t be increased drastically at any given time o Labor Capital These are the two main areas of resources The labor is human efforts Capital can be any non human ingredient that goes into production like money oil etc o Technology the known means or methods to combine our resources to produce the goods and services we want GDP Gross Domestic Product Primary measure of production Measuring the capacity of the economy to produce goods and services total value of production using market prices o You can increase the GDP by increasing production or by increasing the price doesn t take into account
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