An Unfinished Mission: Making Wall Street Work for Us AMERICANS FOR FINANCIAL REFORM and THE ROOSEVELT INSTITUTE Toward an Understanding of the Use of.

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An Unfinished Mission: Making Wall Street Work for Us AMERICANS FOR FINANCIAL REFORM and THE ROOSEVELT INSTITUTE Toward an Understanding of the Use of Derivatives by End Users Wallace C. Turbeville Senior Fellow, Demos

Party A Party B June Price of 100 Barrels of Oil in Inception Price of 100 Barrels of Oil in Cushing Basic Swap Configuration

Party A Party B Oil Seller Oil Seller Purchase Price Purchase Price $120/Barrel $100/Barrel Swap as Hedge Payments at Close of Swap Contract

Party A Party B $100/Barrel Actual June Price Swap Lost on Potential Default Party A Party X Potential Replacement Swap $101/Barrel Actual June Price Credit Exposure on Swap A has extended $1/barrel of Credit to B.

COMPARISON OF SWAP AND RESERVE FUND Reserve vs. Adverse Price Move Swap Synthetically Fixing Today’s Forward Price Initial CostCost of Capital to Fund Reserve Charge for Potential Credit Exposure and Fee to Bank Ongoing Potential CostCost of Capital on Amounts Applied to Losses from Adverse Price Move Cost of Funds for Required Margin Collateral RiskInadequate Sizing of Reserve Counterparty Non- Performance, Cash Liquidity, Operational Inflexibility Upside From Advantageous Price Move RetainedLost

Valuation/Risk Issues Obscure Pricing, especially of Credit Extension Catastrophic Margin Call Risk Valuation of foregone Upside Inter-relationship with Operations

Operational Relationship Operating Company Fuel Supplier Bank Fuel for Production Line Fuel Price Fuel Purchase Fuel Swap Maturity Swap Fwd. Inception If the operating company shuts down the production line, it remains obligated on the swap. This would cause a loss if the price at maturity falls below the fixed payment

Operational Relationship Party AParty B Fixed Payment: Forward Price at Inception $100 Floating Payment: Fuel Swap Maturity Fuel Price Exposure Line Shuts Down; Party A Reverses Swap Party AParty C Fixed Payment: Forward Price at Inception $90 Floating Payment: Fuel Swap Maturity Loss to Party A: $100 - $90, or $10.

Hidden Reasons Businesses and Governments Use Swaps Mis-perception/Obscuring of Risks and Costs Credit Rating Agencies Tax Consequences of Reserves Accounting Rules regarding Credit Exposures Safe decision for Executives Share Value Compensation Rules “Shadow” Debt

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