financial derivatives and trust

Investment Banking and the Ethics of RISK

Are there special obligations of trust, reliance and protection that arise in

such cases?

Multitrillion dollar global market in trading of derivatives

Potential to impact the overall credit functions of various national economies

Potential to impact investment and growth in national economies

special obligations of protection for social trust and reliance?

What are “derivatives?”

Derivatives are financial instruments whose value is derived from other

assets, entities or transactions.

What is the financial purpose of derivatives?

A means of insuring against (or hedging) some future adverse

financial event.

Comparison with other financial instruments

STOCKS:Sale of a share of equity in the assets and

profits of a firm

Seller: issues stock to raise capitalBuyer: invests in stock on the

promise of increase in value due to firm’s rate of profit

Value of Stock: based on financial health/profit

performance of firm

Risk?

Derivatives: incorporate greater risks Value/cost is based on likelihood of possible future “adverse event”

Derivatives permit the buying and selling of risk:commoditization of risk

Buyer: Risk of adverse financial events can be shared (by contract) so that the financial exposure can be lessened

Seller: Revenue from purchase of this “insurance” is the primary incentive for those who issue derivatives

Derivatives permit the buying and selling of risk:commoditization of risk

Types of “adverse events” for which derivatives provide hedges:

rising prices in energy, resources, labor, health

costs possibility of weather events (e.g.,

tornadoes, etc.) possibility of financial defaults by

borrowers

Derivatives permit the buying and selling of risk:commoditization of risk

High likelihood of some “adverse events” makes derivatives in these areas highly risky:

[1] higher the likelihood of risk higher price to buyer [2] higher revenue to derivatives seller [3] incentive: spread the risk exposure further

Secondary incentive for seller: commoditize the original risk to additional buyers

Market additional shares in original “insurance” contract to additional investors“secondary” derivative sales

1993-94: broad deregulation of investment industryfrom derivatives to trading in derivatives

Original purpose – hedging against risk -- recedes as exchange/sale of derivative contracts becomes a market in its own right

1993-94: broad deregulation of investment industryfrom derivatives to trading in derivatives

Derivative seller: takes on part of buyer’s original risk

(i.e., acquires financial exposure)Secondary derivatives trading market: permits original seller to “spread”

this exposure to other parties (i.e., those who

buy shares in

secondary sale)

Original “risk” becomes more detached as trading in the derivatives operates on its own termsOriginal risk = “reference entity” for the riskReference entity is the basis for establishing a financial value and price for the derivative contract in the first place

How much is a derivative contract worth?

Original value = degree of risk and cost of adverse event

Subsequent trading and re-trading of derivative contracts: abstraction from original value

Trading market conditions establish new value and price

Likelihood of wide price /value fluctuations

Financial “upshot” of a market for trading in derivatives

Original risk is converted into a sellable commodity

This commodity is further “commoditized”

Value of commodity (and basis of price) is less connected to the “trading” value of derivatives

Derivatives trading and profit are less predictable, more subject to risk

Financial “upshot” of a market for trading in derivatives

derivatives market as a “casino”

Credit Derivatives: the riskiest gamble of all

Derivative contracts that transfer defined credit risks in a credit product (e.g., a

loan) to the purchaser of the derivative.

“defined credit risks”adverse financial events associated with credit

[1] specific credit risks: a borrower will be unable to repay the loan (i.e., default)

[2] generic credit risks: a firm or individual will fail financially (i.e., bankruptcy)

Derivatives traders acquire “virtual” possession of the credit asset

Risks and rewards of the loan are transferred to the secondary partyNo actual ownership of the credit asset itself

Banks and lenders could enlarge their loan capacity without fear of lossCredit derivatives would protect against adverse credit events

Retail Credit industry: risk of default could be “spread” to other parties

Broader the “spread” of risk exposure the lower the likelihood of financial loss in case of adverse credit events

Derivatives trading industry: creating more complex “secondary” trading instruments = more profit

Credit risk is securitizedstructured credit investments

“Credit derivative indices:”

contracts provide “shares” in a bundle of credit risks that span many different entities (e.g., firms, individual borrowers, etc.)

traders purchase tranches that allocate a share of the risk revenue from loans is divided up among investors in each of

the tranches based on degree of risk (3% or 6% or 10%)

In case of default... Share of revenue is divided based on risk share

Credit risk is securitizedstructured credit investments

“Credit derivative indices:” In case of default... Share of revenue is divided based on risk

share tranch 1 tranch 2 tranch 3

Risks inherent in credit derivatives market

For commercial lenders (banks)

incentive to increase loan volumes without concern about credit risks

risk exposure can be “spread by derivatives hedges

Risks inherent in credit derivatives market

For investors and traders

profits from trading in securitized credit risks were disconnected from the economic conditions of the borrowers and firms whose credit initiated the process

abstraction from economic reality

Derivatives “world” Profits generated through trading in

risk

Exploits the hardships of “real world” borrowers

Detached from “real world” economic conditions

ILLUSION of risk-free profits