What We Learned from H-E-D-G-E. Introduction to Business Transactions November 27, 2007.

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Presentation transcript:

What We Learned from H-E-D-G-E

Introduction to Business Transactions November 27, 2007

University of Tennessee College of Law Professor Robert M. Lloyd

Merle Hazard Merle Haggard Moral Hazard

Leaving your insured car in a bad neighborhood Executive stock options Hedge fund managers’ compensation The “Greenspan put”

Derivative A security whose value depends on another financial instrument Mortgage-backed bonds Options

Put – a contract giving the right to sell a security at a set price Call – a contract giving a right to buy a security at a set price

Swap “I’ll pay yours if you’ll pay mine.” Different currencies Fixed rate for floating rate

Hedge An investment made for the specific purpose of reducing the risk on another investment. Examples –Buying Exxon and shorting British Petroleum –Farmer selling corn futures

Hedge Fund Private investment partnership Individual partners must have net worth of $1 MM or income of $200 K Can invest in variety of vehicles Name comes from fact can hedge Managers typically receive a generous percentage of the profits.

Margin Call Buying stocks with borrowed money is “buying on margin” Federal regulations limit the amount of leverage you can have When the price of your stock drops so much you are overlevered, you get a “margin call” If you don’t put up more cash, they sell your stock

Leveraged 10 to one Can mean ratio of debt to equity is 10:1 Or can mean ratio of assets to equity is 10:1

CDO “Collateralized Debt Obligation” A mortgage-backed (or similar) security in which there are several “tranches” offering different levels of risk and reward.

Moody’s get the ratings wrong Moody’s (and other similar organizations) rated the risk of CDO tranches They screwed up—big time

Goldman Sachs The most successful investment bank Former head Robert Rubin was Treasury Secretary under Clinton I Former head Hank Paulson is present SecTreas Only major bank not to suffer big losses on sub-prime