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 Definition of Financial Derivatives ❧ A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed-upon benchmark ❧ Since a financial derivative can be created by means of a mutual agreement, the types of derivative products are limited only by imagination and so there is no definitive list of derivative products ❧ Some common financial derivatives, however, are described later ❧ More generic is the concept of “hedge funds” which use financial derivatives as their most important tool for risk management Repayment of Financial Derivatives ❧ In creating a financial derivative, the means for, basis of, and rate of payment are specified ❧ Payment may be in currency, securities, a physical entity such as gold or silver, an agricultural product such as wheat or pork, a transitory commodity such as communication bandwidth or energy ❧ The amount of payment may be tied to movement of interest rates, stock indexes, or foreign currency ❧ Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed Leveraging thus acts to multiply (favorably or unfavorably) impacts on total payment obligations of the parties to the derivative instrument Common Financial Derivatives ❧ Options ❧ Forward Contracts ❧ Futures ❧ Stripped Mortgage-Backed Securities ❧ Structured Notes ❧ Swaps ❧ Rights of Use ❧ Combined ❧ Hedge Funds 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 Stripped Mortgage-Backed Securities ❧ Stripped Mortgage-Backed Securities, called "SMBS," represent interests in a pool of mortgages, called "Tranches", the cash flow of which has been separated into interest and principal components ❧ Interest only securities, called "IOs", receive the interest portion of the mortgage payment and generally increase in value as interest rates rise and decrease in value as interest rates fall ❧ Principal only securities, called "POs", receive the principal portion of the mortgage payment and respond inversely to interest rate movement As interest rates go up, the value of the PO would tend to fall, as the PO becomes less attractive compared with other investment opportunities in the marketplace 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 Enron and E-Mail's Lasting Trail ❧ It is almost impossible to hide transactions: ● ● ● ● ● Paper records at the source Local computer system records Internet communication records Recipient records Paper records at the destination End of Enron’s Overseas Energy Program ❧ In mid-February 2002, Overseas Private Investment Corp., which backed many of Enron’s overseas energy projects, moved to stem its $1-billion Enron exposure by canceling $590 million in loans to the company, once one of its largest clients Enron had missed deadlines for OPIC requirements in financing projects in Brazil, an OPIC spokesman said OPIC's decision shifted more of the burden for the troubled projects from the U.S government to Enron's creditors, lenders and partners The Fallouts of Enron Collapse ❧ On the Workers ● ● Reduction in force by 6,000 workers Effects on their retirement accounts ❧ On the Stock Market ● ● ● Effects of “sophisticated accounting” Effects on Internet-related stocks Effects on Communications-related stocks ❧ On the Accounting Profession ● Effects of conflicts-of-interests: ❧ On the Halls of Government ● ● Effects on Energy Policy-Making Effects on Political funding Combining Auditing & Consulting Effects on the Accounting Profession Biggest Accounting Firms The accounting industry is dominated by the aptly named Big Five, followed by much smaller firms whose client lists includes mainly mid-size and small companies 2001 U.S revenue (billions) PricewaterhouseCoopers $8.1 Deloitte & Touche 6.1 Ernst & Young 4.5 Andersen 4.3 KPMG 3.2 BDO Seidman 0.4 Grant Thornton 0.4 McGladney & Pullen 0.2 Source: Public Accounting Report 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 March 15, 2002 The Los Angeles Times, page A1 U.S Indicts Enron Auditor Over Shredding Andersen faces an obstruction of justice charge after failing to reach a plea agreement with prosecutors By Edmund Sanders and Jeff Leeds, Los AngelesTimes Staff Writers WASHINGTON Federal prosecutors Thursday hit accounting firm Andersen with a criminal indictment for allegedly orchestrating the "wholesale destruction" of tons of Enron Corp documents, raising new doubts about Andersen's survival The one-count indictment is the first of what Justice Department officials hinted could be a string of criminal charges arising from the collapse of energy giant Enron, which filed for Chapter 11 bankruptcy protection Dec amid an accounting scandal Reacting swiftly to the indictment, the government today suspended Enron Corp and Andersen from entering into new federal contracts March 15, 2002, New York Times Andersen Charged With Obstruction in Enron Inquiry By Kurt Eichenwald WASHINGTON, March 14 — In the first criminal charge ever brought against a major accounting firm, Arthur Andersen has been indicted on a single count of obstruction of justice for destroying thousands of documents related to the Enron investigation, the Justice Department announced today The indictment, handed up by a grand jury last week and unsealed today, describes a concerted effort by Andersen to shred records related to Enron in four of the firm's offices, in Houston, Chicago, London and Portland, Ore It was the first criminal charge stemming from the government's investigation of Enron's collapse in December "Obstruction of justice is a grave matter, and one that this department takes very seriously," Larry D Thompson, deputy attorney general, said at the Justice Department "Arthur Andersen is charged with a crime that attacks the justice system itself by impeding investigators and regulators from getting at the truth." Global Crossing Bankruptcy ❧ January 29, 2002: “Global Crossing Ltd, which spent five years and $15 billion to build a worldwide network of high-speed Internet and telephone lines, files for bankruptcy after failing to find enough customers to make network profitable; had attracted many notable business and political figures, including Democratic National Committee chairman Terry McAuliffe, former Pres George Bush, Tisch family and former ARCO chairman and big Republican fund-raiser Lodwrick Cook.” ❧ This is the largest bankruptcy of a telecommunications company 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 cables—including links that traverse the Atlantic Ocean—linking 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 Former Employee ❧ At the center of the controversy is Joseph Perrone, the company's former executive vice president of finance and former outside auditor For 31 years he had been an auditor and partner with the Big Five accounting firm Arthur Andersen & Co ❧ By the time he joined Global Crossing in May 2000, Perrone was intimately familiar its operations, having directed Andersen's work in connection with Global's 1998 initial public offering, which raised about $400 million ❧ Though it is common for outside auditors to jump ship and go in-house at the companies they audit, Perrone's move was unusual because he was so highly placed at Andersen 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 ❧ “Chairman Gary Winnick could lose control if bankruptcy plan is accepted, but the blow would be softened by stock deals that reaped him more than $730 million ❧ Company shares traded for more than $60 as recently as March 2000 They have now fallen more than 99 percent, to 13.5 cents, in over-the-counter trading after being de-listed by the New York Stock Exchange THE END ... Definition of Financial Derivatives ❧ Common Financial Derivatives ❧ Why Have Derivatives? ❧ The Risks ❧ Leveraging ❧ Trading of Derivatives ❧ Derivatives on the Internet ❧ An Apologia for Derivatives. .. 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... of derivative products ❧ Some common financial derivatives, however, are described later ❧ More generic is the concept of “hedge funds” which use financial derivatives as their most important