Professional Documents
Culture Documents
Financial Derivatives
Financial Derivatives
Robert M. Hayes
2002
Overview
Definition of Financial Derivatives
Common Financial Derivatives
Why Have Derivatives?
The Risks
Leveraging
Trading of Derivatives
Derivatives on the Internet
An Apologia for Derivatives
The Dark Side of Derivatives
Options
The purchaser of an Option has rights (but not obligations)
to buy or sell the 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. "
The seller of a Call Option is obligated to sell the asset to
the party that purchased the Option. The seller of a Put
Option is obligated to buy the asset.
In a Covered Option, the seller of the Option already
owns the asset. In a Naked Option, the seller does not
own the asset
Options are traded on organized exchanges and OTC.
Forward Contracts
In a Forward Contract, both the seller and the
purchaser are obligated to trade a security or other
asset at a specified date in the future. The price paid for
the security or asset may be agreed upon at the time the
contract is entered into or may be determined at
delivery.
Forward Contracts generally are traded OTC.
Futures
A Future is a contract 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
daily. The daily value provides both parties with an
accounting of their financial obligations under the terms of
the Future.
Unlike Forward Contracts, the counterparty to the buyer or
seller in 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.
Structured Notes
Structured Notes are debt instruments where the
principal and/or the interest rate is indexed to an
unrelated indicator. A bond whose interest rate is decided
by interest rates in England or the price of a barrel of
crude oil would be a Structured Note,
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.
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.
Swaps
Interest rate swaps occur generally in three scenarios.
Exchanges of a fixed rate for a floating rate, a floating
rate for a fixed rate, or a floating rate for a floating
rate.
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.
Rights of Use
A type of swap is represented by swapping capacity on
networks using instruments called indefeasible rights
of use, or IRUs. Companies buying an IRU might
book the price as a capital expense, which could be
spread over a number of years. But the income from
IRUs could be booked as immediate revenue, which
would bring an immediate boost to the bottom line.
Technically, the practice is within the arcane rules that
govern financial derivative accounting methods, but
only if the swap transactions are real and entered into
for a genuine business purpose.
Hedge Funds
A hedge fund is a private partnership aimed at very
wealthy investors. It can use strategies to reduce risk.
But it may also use leverage, which increases the level of
risk and the potential rewards.
Hedge funds can invest in virtually anything anywhere.
They can hold stocks, bonds, and government securities
in all global markets. They may purchase currencies,
derivatives, commodities, and tangible assets. They may
leverage their portfolios by borrowing money against
their assets, or by borrowing stocks from investment
brokers and selling them (shorting). They may also
invest in closely held companies.
Hedge Funds
Hedge funds are not registered as publicly traded securities.
For this reason, they are available only to those fitting the
Securities and Exchange Commission definition of
accredited investorsindividuals with a net worth
exceeding $1 million or with income greater than $200,000
($300,000 for couples) in each of the two years prior to the
investment and with a reasonable expectation of
sustainability.
Institutional investors, such as pension plans and limited
partnerships, have higher minimum requirements. The SEC
reasons that these investors have financial advisers or are
savvy enough to evaluate sophisticated investments for
themselves.
Hedge Funds
Some investors use hedge funds to reduce risk in their
portfolio by diversifying into uncommon or alternative
investments like commodities or foreign currencies.
Others use hedge funds as the primary means of
implementing their long-term investment strategy.
The Risks
Since derivatives are risk-shifting devices, it is important to
identify and understand the risks being assumed, evaluate
them, and continuously monitor and manage them. Each
party to a derivative contract should be able to identify all
the risks that are being assumed before entering into a
derivative contract.
Part of the risk identification process is a determination of
the monetary exposure of the parties under the terms of the
derivative instrument. As money usually is not due until the
specified date of performance of the parties' obligations,
lack of up-front commitment of cash may obscure the
eventual monetary significance of the parties' obligations.
The Risks
Investors and markets traditionally have looked to
commercial rating services for evaluation of the credit and
investment risk of issuers of debt securities.
Some firms have begun issuing ratings on a company's
securities which reflect an evaluation of the exposure to
derivative financial instruments to which it is a party.
The creditworthiness of each party to a derivative instrument
must be evaluated independently by each counterparty. In a
financial derivative, performance of the other party's
obligations is highly dependent on the strength of its balance
sheet. Therefore, a complete financial investigation of a
proposed counterparty to a derivative instrument is
imperative.
The Risks
An often overlooked, but very important aspect in the use
of derivatives is the need for constant monitoring and
managing of the risks represented by the derivative
instruments.
For instance, the degree of risk which one party was
willing to assume initially could change greatly due to
intervening and unexpected events. Each party to the
derivative contract should monitor continuously the
commitments represented by the derivative product.
Financial derivative instruments that have leveraging
features demand closer, even daily or hourly monitoring
and management.
Leveraging
Some derivative products may include leveraging
features. 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. Remembering that
each derivative instrument generally is the product of
negotiation between the parties for risk-shifting
purposes, the leveraging component, if any, may be
unique to that instrument.
Leveraging
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.
Trading of Derivatives
Some financial derivatives are traded on national exchanges.
Those in the U.S. are regulated by the Commodities Futures
Trading Commission.
Financial derivatives on national securities exchanges are
regulated by the U.S. Securities and Exchange Commission
(SEC).
Certain financial derivative products 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.
Trading of Derivatives
Some derivative products are traded over-the-counter
(OTC) and represent agreements that are individually
negotiated between parties. Anyone considering
becoming a party to an OTC derivative should
investigate first the creditworthiness of the parties
obligated under the instrument so as to have sufficient
assurance that the parties are financially responsible.
deregulation
wish to have stock price go up
use of stock options as incentives
use of hidden borrowing
use of financial derivatives in risky gambles
consulting by auditor on use of derivatives
use of deceptive accounting to hide risks
acquiescence of auditor in deception
use of fraudulent entries to support deceptions
use of hidden partners
move from individual fraud to corporate fraud
connivance of auditor in fraud
use of a Ponzi scheme to continue fraud
profiting before the collapse
A B C D E
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The Auditors
The Management
The ethics and integrity of management and employees
Management's philosophy and operating style
The Auditors
The independence of the auditors
Professional skepticism of the auditors
Account 88888
Account 88888 was started when a phone clerk sold 20
contracts instead of purchasing them. Mr. Leeson was
unable to do anything about it until the next trading day
because the market rose 400 points. That next trading
day, Leeson established account 88888 and created
fictitious transactions to cover up the error.
Over the next few months Leeson hid some 30 large
errors in account 88888. He relaxed his attitude towards
errors, and when an important customer brought an
error to Leeson's attention, he simply put the error into
account 88888 without any further investigation.
The Collapse
As the market moved, errors in account 88888 changed
in value, and a $1 Billion loss was generated by open
positions in account 88888. As the account grew bigger,
margin calls also got bigger. London approved these
large margin calls because of the large profits Leeson
was posting.
Baringss problems arose because of serious failure of
controls and management within Barings.
Orange CountyHistory
In 1994, the Orange County investment pool had about
$7.5 billion in deposits from the county government
and almost 200 local public agencies (cities, school
districts, and special districts). Borrowing $2 for every
$1 on deposit, Citron nearly tripled the size of the
investment pool to $20.6 billion. In essence, as the Wall
Street Journal noted, he was "borrowing short to go
long" and investing the dollars in derivativesin exotic
securities whose yields were inversely related to interest
rates.
Enron Bankruptcy
Deregulation
In the mid-1980s, oil prices fell precipitously. Buyers of
natural gas switched to newly cheap alternatives such as
fuel oil. Gas producers, led by Enron, lobbied vigorously
for deregulation. Once-stable gas prices began to
fluctuate.
Then Enron began marketing futures contracts which
guaranteed a price for delivery of gas sometime in the
future.
The government, again lobbied by Enron and others,
deregulated electricity markets over the next several
years, creating a similar opportunity for Enron to trade
futures in electric power.
Enron Communications
January 21, 1999: Enron Communications, Inc.,
introduced today the Enron Intelligent Network (EIN), an
application delivery platform that will enhance the
companys existing fiber-optic network to create next
generation applications services. The EIN brings to market
a reliable, bandwidth-on-demand platform for delivering
data, applications and streaming rich media to the desktop.
The Enron Intelligent Network architecture is based on a
unique approach to networking through distributed servers
that supports the development and maintenance of
distributed applications across network environments.
Enron Communications
In November 1999, Enron Communications (as a wholly
owned subsidiary of Enron) joined with Inktomi
Corporation in a strategic alliance in which the Inktomi
Traffic Server cache platform was to be integrated into the
Enron Intelligent Network. The objective was to offer high
quality network performance and bandwidth capacity to
support broadband content distribution and e-business
services. The integration of Inktomi's caching software into
the Enron Intelligent Network was to enhance the ability of
Enron Communications to seamlessly and selectively push
content to the desktop while handling massive volumes of
high bit rate network traffic in a scalable manner.
Enron Communications
About Inktomi: Inktomi develops and markets
scalable software designed for the world's largest
Internet infrastructure and media companies. Inktomi's
two areas of business are portal services, comprised of
the search, directory and shopping engines; and
network products comprised of the Traffic Server
network cache and associated value-added services.
Inktomi works with leading companies including
America Online, British Telecom, CNN, Excite@Home,
GoTo.com, Intel, NBC's Snap!, RealNetworks, Sun
Microsystems, and Yahoo!. The company has offices in
North America, Europe and Asia.
EnronOnline
EnronOnline was launched Nov. 29, 1999.
EnronOnline offers customers a free, Internetbased system for conducting wholesale transactions
with Enron as principal.
EnronOnline is your best tool for trading energy-related
products and other commodities quickly, simply and
efficiently. Our Web-based service combines real-time
transaction capabilities with extensive information and
customization tools that increase your knowledge of what's
happening around the world-even as it happens.
EnronOnline sharpens your sense of the marketplace to
make you a more knowledgeable trader.
EnronOnline
No matter what commodity you want to buy or sell,
you're almost certain to find a live, competitive quote
on EnronOnline. We cover markets all over the world
including gas, power, oil and refined products, plastics,
petrochemicals, liquid petroleum gases, natural gas
liquids, coal, emission allowances, bandwidth, pulp and
paper, metals, weather derivatives, credit derivatives,
steel and more. EnronOnline covers almost every major
energy market in the world. And we're not sitting still.
We're adding new markets and new products all the
time.
An ironic example of "Trading Markets":
Credit
Risk Management Tools, including Bankruptcy Swaps
EnronOnline Claims
Real-Time Pricing
Fast, Free, Secure Execution
Price Limit Orders
Option Contracts
Market News and Quotes
Industry Publications
Weather Insights
Complete Customization Capabilities
The Collapse
Sudden announcement of losses in Oct 2001
File for bankruptcy in Dec 2001
Bankruptcy
Congressional Investigations began in Dec 2001
Attempted destruction of documents
Effects of conflicts-of-interests:
U.S.
Partners
2,784
2,283
1,934
1,620
1,471
306
272
493
Total
U.S. Staff
43,134
28,992
22.526
27,788
17,577
2,054
2,962
2,530
2001 global
revenue
(billions)
$19.8
12.4
9.9
9.3
11.7
2.2
1.7
1.6
Global
Crossing
Bankruptcy
January 29, 2002: Global Crossing Ltd, which spent
The History
Global Crossing was formed in 1999 from a merger of a
Bermuda-based fiber-optic cable company with a local
U.S. telecom company.
In the ensuing years, it developed a 100,000-mile global
network of fiber-optic cablesincluding links that
traverse the Atlantic Oceanlinking more than 200
cities in 27 countries in the Americas, Asia and Europe.
It was regarded as one of the most promising of the new
generation of telecom companies that sprang up in the
late 1990s, and had secured a stock market value of
$75bn.
The History
While it incurred more than $12bn debts, its assets are
believed to be worth nearly $24bn, almost twice as much as its
debts.
About mid-2000, things began to turn sour for the telecom
industry. Optimistic network operators had completed huge
infrastructures just as a nationwide economic slowdown
curtailed corporate spending for such services. That left not
only Global Crossing but other network companies with
insufficient revenue to pay the massive debt they had
accumulated to build their costly networks.
In fact, Global Crossing has never reported annual profit
since its creation, and by the first quarter of 2001, cash was
running short.
Accounting Practices
Global Crossing then entered into swaps with other
networks, using indefeasible rights of use, or IRUs.
Global Crossing would buy an IRU and book the price
as a capital expense, which could be spread over a
number of years. But the income from IRUs was
booked as current revenue.
Technically, the practice is within the arcane rules that
govern financial derivative accounting methods, but
only if the swap transactions are real and entered into
for a genuine business purpose.
Allegations disputed
But there was the possibility that these transactions were not
for legitimate business purposes and indeed were potentially
fraudulent.
Such concerns are a direct result of the revelations about
misleading accounting methods used by the failed energy
trader Enron.
Global Crossing has said it will launch an independent probe of
its accounts (by a company other than Anderson). "Recent
happenings in the industry have brought a lot of attention to
accounting," a spokesman said (but without mentioning
Enron).
Global Crossing has said it will look into allegations of
impropriety by a former employee.
The Incentives
To lure Perrone from Andersen, Global Crossing offered
him a $2.5-million signing bonus on top of a base salary of
$400,000 and a target annual bonus of $400,000, according
to SEC filings. Perrone also received 500,000 Global
Crossing stock options, along with shares in its sister
company, Asia Global Crossing Ltd., which were to vest
over a three-year period. Perrone also is chief accounting
officer at Asia Global Crossing.
This all piqued the interest of SEC officials, who questioned
whether Perrone's hiring "impaired" Andersen's
independence. Ultimately, the SEC was satisfied that
Andersen "met the requirements for independence."
The
Incentives
THE END