Transcript Derivatives and Credit Default Swaps

The role these complex securities have played
in the current economic turmoil
Faculty Panel Discussion
October 7, 2008
Kathie Sullivan, PhD Finance
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Any security whose value depends on (is derived from) some
primary security or asset.
As the value of the underlying asset changes, the value of the
derivative security changes.
Derivatives are cheap, efficient ways to transfer risk from those
who don't want it, to those are willing to take it.
They may be used to speculate, as well as to hedge.
Types of derivatives: options, futures and forward contracts,
interest rate swaps, CMO's, warrants.
Underlying assets on which derivatives may be based: stocks,
bonds, currencies, interest rates, and commodities.
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Forward Contracts
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Futures Contracts
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Agreement to exchange an asset in the future at a price set
today. Buyer and seller must perform, or buy back the
contract and reverse their position. Traded OTC; nonstandardized; illiquid; subject to credit risk.
Same as a forward contract, except traded on an
organized exchange; standardized; liquid; no credit risk.
Options
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An agreement to exchange at a predetermined price,
within a set time. The option buyer (holder) has the
OPTION to exercise the option or not. Trade on organized
exchanges – liquid market, little/no credit risk.
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Structured Notes
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Investment bankers reconfigure some existing
security (a short term bond or note) and create an
entirely new security. Process of securitization.
Offers additional hedging opportunities.
• Zero – Coupon Bonds
• CMOs
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Swaps
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Contract between two parties to exchange cash flow
obligations. Not rigidly structured. No organized
exchange. Usually occurs between a company and a
money center bank or investment bank.
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Valuing any financial asset is always difficult. In a
general sense, the value of anything is:
Present Value of all
Expected Future Cash Flows
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This requires us to consider:
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Return desired, given degree of risk perceived
Cash flows the security is expected to produce
Valuation is based on ASSUMPTIONS, and as I always
tell my students…
Always question your assumptions!
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First introduced by JP Morgan in 1995.
Current value of this market is estimated to be $45
- $60 TRILLION.
Sold by Bear Sterns, Lehman Brothers, AIG,
Citigroup, and many other banks and financial
service companies.
Buyer pays a premium to seller so that in case of a
“negative credit event,” the seller takes on the
credit risk.
If no credit default, seller pockets the premium
and everyone is happy.
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How happy was AIG? Consider the following
data on AIG’s Financial Products Unit:
Revenue rose to $3.26 billion in 2005 from $737
million in 1999.
 Operating income … also grew, rising to 17.5% of
AIG’s overall operating income in 2005, compared
with 4.2% in 1999.
 In 2002, operating income was 44% of revenue; in
2005, it reached 83%.
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(“Behind Insurer’s Crisis, Blind Eye to a Web of Risk”
New York Times, 9/28/2008)
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Problem… the bonds and other underlying debts referenced by
these swaps started to deteriorate.
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The market started experiencing “negative credit events,” something
sellers assumed would never happen.
Even bigger problem… the sellers of these instruments didn’t set
aside adequate capital to cover possible payments on these
contracts.
“It is hard for us, without being flippant, to even see a scenario
within any kind of realm of reason that would see us losing one
dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007
(as quoted in NYT, 9/28/2008)
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Perhaps – if AIG, Lehman, Bear Sterns top executives hadn’t
gotten such generous paychecks and bonuses, some money would
have been available to make good on these claims…
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Markets don’t really know the extent of damage these derivatives
will do (or have done) to the banking and financial system; they
don’t understand how the bailout plan will effect these swaps and
it is trying to digest these complex factors.
Markets really hate uncertainty and not knowing what’s going to
happen.
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More risk  greater return demanded
Higher return demanded  lower prices paid
Markets are rationally reacting to extreme degree of uncertainty;
although perhaps over-reacting – also a common market trait.
But, what goes down also comes back up… just sit tight and hold
steady as the information gets digested and risk finds its proper
price!