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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