The role these complex securities have played in the current economic turmoil Faculty Panel Discussion October 7, 2008 Kathie Sullivan, PhD Finance

 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.

 Forward Contracts  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; non- standardized; illiquid; subject to credit risk.  Futures Contracts  Same as a forward contract, except traded on an organized exchange; standardized; liquid; no credit risk.  Options  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.

 Structured Notes  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  Swaps  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.

 Valuing any financial asset is always difficult. In a general sense, the value of anything is: Present Value of all Expected Future Cash Flows  This requires us to consider:  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!

 First introduced by JP Morgan in  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  If no credit default, seller pockets the premium and everyone is happy.

 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  Operating income … also grew, rising to 17.5% of AIG’s overall operating income in 2005, compared with 4.2% in  In 2002, operating income was 44% of revenue; in 2005, it reached 83%. (“ Behind Insurer’s Crisis, Blind Eye to a Web of Risk” New York Times, 9/28/2008)

 Problem… the bonds and other underlying debts referenced by these swaps started to deteriorate.  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)  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…

 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.  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!