Download day 6

Clarifications
• An uninformed investor is one who has no
superior information
– Uninformed is not the same as uneducated or
ignorant.
• An informed investor is one who has
information other market participants do
not.
Clarifications
• An uninformed investor may be as educated
and as sophisticated and knowledgeable and
as highly able and trained as an informed
investor. It is not superior ability, merit,
education, training, birth, social position or
any personal attribute that makes the
informed investor informed, it’s the fact that
they have superior information! :)
Clarifications
• Uninformed investors can compute betas,
they have access to all historical
information, just not to current value
relevant information that is not public.
• Market efficiency does not imply there are
no returns to information -- just that there
are none to public information. There still
are returns to private information.
Derivatives and SEC Enforcement
• Today we examine the enforcement procedures of
the SEC in the context of the use (and abuse) of
financial derivatives.
• Enforcement process has two thrusts:
– Policing of companies for failure to disclose the
extent of speculation in financial derivatives
– Policing of brokerage firms selling financial
derivatives to client firms without sufficient
information regarding risks and losses.
Understanding financial derivatives
• What are “financial instruments”?
– Cash
– Ownership interest in an entity
• shares of stock
– Contractual right to receive or deliver cash
• Receivables and payables
– Contractual right to receive or deliver another
financial instrument
Understanding financial derivatives
• What is a derivative security?
– “…a financial agreement whose value is linked
to, or derived from, the performance of an
underlying asset.”
– Changes in the value of the underlying asset
indirectly affect the value of the derivative.
– Examples: futures, forwards, swaps, and
options.
Understanding financial derivatives
• What is the purpose of derivative securities?
– They can provide a hedge to the risks
businesses face from unexpected changes in
currency exchange rates, interest rates,
commodity prices, etc.
– They can be a speculative device that is
essentially a bet that a particular rate or price
will rise or fall.
Understanding financial derivatives
• Hedging reduces exposure to risks that are
not part of the “core” business.
– An exporter wants to eliminate the risk that
changes in currency rates will reduce profit.
– A borrower wants to hedge the risk of rising
interest rates.
– A farmer wants to hedge against drops in crop
prices before she can get it to market.
Understanding financial derivatives
• Example of a Futures Contract
– Farmer plans to sell corn crop in 6 months
– Wants to protect against a drop in corn prices.
– Purchase a futures contract to sell corn 6
months from now at a set price
 Farmer is price protected against price drops
– Notional amount of contract is the value of the
corn at the agreed price Cost of the contract is
much lower than the notional amount.
Understanding financial derivatives
• Example # 2: Interest Rate Swaps
• Builder provides adjustable rate mortgages
to buyers.
– Risk: loss of income if interest rates fall
– Solution: Replace the variable payment stream
with a fixed payment stream. Swap interest
payments with a bank that likes the variability
of interest.
• Bank pays depositors based on variable rates
Understanding financial derivatives
 The builder and bank “swap” interest payments.
 Bank pays builder interest at a fixed rate and
receives variable payments from homeowners
 Result: builder protected against interest rate
fluctuations
 The notional amount of the contract is the total
amount the builder lends to the homeowners. The
cost of the contract is very small, but the potential
gain or loss is quite large because the notional
amount is large.
Understanding financial derivatives
• What is the value of a derivative security?
– Because the notional amount of derivatives can
be very high
• The cost of the initial derivative contract can be
quite small
• The notional amount can be quite large in
comparison
• This divergence makes derivatives very volatile or
risky: small changes in the risk factor can cause
large changes in dollar value of contract.
Understanding financial derivatives
• The potential gain or loss in value of the
derivative is huge.
– If the underlying asset is volatile, the derivative
is even more volatile because it is so leveraged.
– For the interest rate swap, a 1% interest rate
change can cause thousands of dollars per year
change in cash flows. A very small investment,
can produce returns (positive or negative) of
several thousand percent.
Understanding financial derivatives
• The current value is the amount received or
obligated to pay if the derivative would be
“unwound” at that moment.
• Contracts are usually extremely complex
• “value” is often calculated by one party to
the contract (most often the seller) using
sophisticated and proprietary formulas.
• There may be no open market for these things!
Understanding financial derivatives
• Derivatives can also be speculative.
– The futures and swap examples above show the
use of derivatives as a hedge to reduce risk.
– Without underlying business transaction, the
derivative increases risk exposure!
– For instance in the corn price hedge, if no corn
sale is involved, the derivative is simply a bet
that the price will fall -- what was a risk
reducer, becomes a risk seeking investment.