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
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.
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.
Swaps
A Swap is a simultaneous buying and selling of the same security or obligation. Perhaps the best-known Swap occurs when two parties exchange interest payments based on an identical principal amount, called the "notional principal amount." Think of an interest rate Swap as follows: Party A holds a 10-year $10,000 home equity loan that has a fixed interest rate of 7 percent, and Party B holds a 10year $10,000 home equity loan that has an adjustable interest rate that will change over the "life" of the mortgage. If Party A and Party B were to exchange interest rate payments on their otherwise identical mortgages, they would have engaged in an interest rate Swap.
Swaps
Interest rate swaps occur generally in three scenarios. Exchanges of a fixed rate for a floating rate, a floating rate for a fixed rate, or a floating rate for a floating rate. The "Swaps market" has grown dramatically. Today, Swaps involve exchanges other than interest rates, such as mortgages, currencies, and "cross-national" arrangements. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and crossmarket payments, e.g., U.S. short-term rates vs. U.K. short-term rates.
Rights of Use
A type of swap is represented by swapping capacity on networks using instruments called indefeasible rights of use, or IRUs. Companies buying an IRU might book the price as a capital expense, which could be spread over a number of years. But the income from IRUs could be booked as immediate revenue, which would bring an immediate boost to the bottom line. 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.
Hedge Funds
A hedge fund is a private partnership aimed at very wealthy investors. It can use strategies to reduce risk. But it may also use leverage, which increases the level of risk and the potential rewards. Hedge funds can invest in virtually anything anywhere. They can hold stocks, bonds, and government securities in all global markets. They may purchase currencies, derivatives, commodities, and tangible assets. They may leverage their portfolios by borrowing money against their assets, or by borrowing stocks from investment brokers and selling them (shorting). They may also invest in closely held companies.
Hedge Funds
Hedge funds are not registered as publicly traded securities. For this reason, they are available only to those fitting the Securities and Exchange Commission definition of accredited investorsindividuals with a net worth exceeding $1 million or with income greater than $200,000 ($300,000 for couples) in each of the two years prior to the investment and with a reasonable expectation of sustainability. Institutional investors, such as pension plans and limited partnerships, have higher minimum requirements. The SEC reasons that these investors have financial advisers or are savvy enough to evaluate sophisticated investments for themselves.
Hedge Funds
Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies. Others use hedge funds as the primary means of implementing their long-term investment strategy.
The Risks
Since derivatives are risk-shifting devices, it is important to identify and understand the risks being assumed, evaluate them, and continuously monitor and manage them. Each party to a derivative contract should be able to identify all the risks that are being assumed before entering into a derivative contract. Part of the risk identification process is a determination of the monetary exposure of the parties under the terms of the derivative instrument. As money usually is not due until the specified date of performance of the parties' obligations, lack of up-front commitment of cash may obscure the eventual monetary significance of the parties' obligations.
The Risks
Investors and markets traditionally have looked to commercial rating services for evaluation of the credit and investment risk of issuers of debt securities. Some firms have begun issuing ratings on a company's securities which reflect an evaluation of the exposure to derivative financial instruments to which it is a party. The creditworthiness of each party to a derivative instrument must be evaluated independently by each counterparty. In a financial derivative, performance of the other party's obligations is highly dependent on the strength of its balance sheet. Therefore, a complete financial investigation of a proposed counterparty to a derivative instrument is imperative.
The Risks
An often overlooked, but very important aspect in the use of derivatives is the need for constant monitoring and managing of the risks represented by the derivative instruments. For instance, the degree of risk which one party was willing to assume initially could change greatly due to intervening and unexpected events. Each party to the derivative contract should monitor continuously the commitments represented by the derivative product. Financial derivative instruments that have leveraging features demand closer, even daily or hourly monitoring and management.
Leveraging
Some derivative products may include leveraging features. These features act to multiply the impact of some agreed-upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly a party's total repayment obligation. Remembering that each derivative instrument generally is the product of negotiation between the parties for risk-shifting purposes, the leveraging component, if any, may be unique to that instrument.
Leveraging
For example, assume a party to a derivative instrument stands to be affected negatively if the prime interest rate rises before it is obliged to perform on the instrument. This leveraged derivative may call for the party to be liable for ten times the amount represented by the intervening rise in the prime rate. Because of this leveraging feature, a small rise in the prime interest rate dramatically would affect the obligation of the party. A significant rise in the prime interest rate, when multiplied by the leveraging feature, could be 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 national securities exchanges are regulated by the U.S. Securities and Exchange Commission (SEC). Certain financial derivative products have been standardized and are issued by a separate clearing corporation to sophisticated investors pursuant to an explanatory offering circular. Performance of the parties under these standardized options is guaranteed by the issuing clearing corporation. Both the exchange and the clearing corporation are subject to SEC oversight.
Trading of Derivatives
Some derivative products are traded over-the-counter (OTC) and represent agreements that are individually negotiated between parties. Anyone considering becoming a party to an OTC derivative should investigate first the creditworthiness of the parties obligated under the instrument so as to have sufficient assurance that the parties are financially responsible.
(A) Equity Funding, (B) Baring Bank, (C) Orange County, (D) Long Term Capital Management, (E) Enron, (F)Global Crossing
In subsequent years, to supplement the reciprocal income so as to achieve predetermined earnings targets, the company borrowed money without recording the liability on its books, disguising it through complicated transactions with subsidiaries. The fraud expanded in 1965, when fictitious entries were made in certain receivable and income accounts. By 1967, revenues and earnings of Equity Funding had increased dramatically, and the stock price rose accordingly. Equity Funding began to take over other companies, and it became critical to maintain the price of the stock of Equity Funding so it could be used to pay for the companies being acquired.
Ethics and integrity of management and employees Management's philosophy and operating style Lack of independence of the auditors Lack of professional skepticism of the auditors External impairments to the audit
The Auditors
The Management
The ethics and integrity of management and employees Management's philosophy and operating style
The Auditors
The independence of the auditors Professional skepticism of the auditors
Account 88888
Account 88888 was started when a phone clerk sold 20 contracts instead of purchasing them. Mr. Leeson was unable to do anything about it until the next trading day because the market rose 400 points. That next trading day, Leeson established account 88888 and created fictitious transactions to cover up the error. Over the next few months Leeson hid some 30 large errors in account 88888. He relaxed his attitude towards errors, and when an important customer brought an error to Leeson's attention, he simply put the error into account 88888 without any further investigation.
The Collapse
As the market moved, errors in account 88888 changed in value, and a $1 Billion loss was generated by open positions in account 88888. As the account grew bigger, margin calls also got bigger. London approved these large margin calls because of the large profits Leeson was posting. Baringss problems arose because of serious failure of controls and management within Barings.
Orange CountyHistory
In 1994, the Orange County investment pool had about $7.5 billion in deposits from the county government and almost 200 local public agencies (cities, school districts, and special districts). Borrowing $2 for every $1 on deposit, Citron nearly tripled the size of the investment pool to $20.6 billion. In essence, as the Wall Street Journal noted, he was "borrowing short to go long" and investing the dollars in derivativesin exotic securities whose yields were inversely related to interest rates.
Enron Bankruptcy
The Start as a Gas Pipeline Company in 1985 Deregulation Enron Finance in 1990 Enrons Overseas Energy Projects Enron Communications and Internet Structure Enron Online and Internet Brokering Enron and the Market in Broadband The Catchesone after another! The Collapse Enron and E-Mail's Lasting Trail The Fallouts
Deregulation
In the mid-1980s, oil prices fell precipitously. Buyers of natural gas switched to newly cheap alternatives such as fuel oil. Gas producers, led by Enron, lobbied vigorously for deregulation. Once-stable gas prices began to fluctuate. Then Enron began marketing futures contracts which guaranteed a price for delivery of gas sometime in the future. The government, again lobbied by Enron and others, deregulated electricity markets over the next several years, creating a similar opportunity for Enron to trade futures in electric power.
Enron Communications
January 21, 1999: Enron Communications, Inc., introduced today the Enron Intelligent Network (EIN), an application delivery platform that will enhance the companys existing fiber-optic network to create next generation applications services. The EIN brings to market a reliable, bandwidth-on-demand platform for delivering data, applications and streaming rich media to the desktop. The Enron Intelligent Network architecture is based on a unique approach to networking through distributed servers that supports the development and maintenance of distributed applications across network environments.
Enron Communications
In November 1999, Enron Communications (as a wholly owned subsidiary of Enron) joined with Inktomi Corporation in a strategic alliance in which the Inktomi Traffic Server cache platform was to be integrated into the Enron Intelligent Network. The objective was to offer high quality network performance and bandwidth capacity to support broadband content distribution and e-business services. The integration of Inktomi's caching software into the Enron Intelligent Network was to enhance the ability of Enron Communications to seamlessly and selectively push content to the desktop while handling massive volumes of high bit rate network traffic in a scalable manner.
Enron Communications
About Inktomi: Inktomi develops and markets scalable software designed for the world's largest Internet infrastructure and media companies. Inktomi's two areas of business are portal services, comprised of the search, directory and shopping engines; and network products comprised of the Traffic Server network cache and associated valueadded services. Inktomi works with leading companies including America Online, British Telecom, CNN, Excite@Home, GoTo.com, Intel, NBC's Snap!, RealNetworks, Sun Microsystems, and Yahoo!. The company has offices in North America, Europe and Asia.
EnronOnline
EnronOnline was launched Nov. 29, 1999.
EnronOnline offers customers a free, Internetbased system for conducting wholesale transactions with Enron as principal.
EnronOnline is your best tool for trading energy-related products and other commodities quickly, simply and efficiently. Our Web-based service combines real-time transaction capabilities with extensive information and customization tools that increase your knowledge of what's happening around the world-even as it happens. EnronOnline sharpens your sense of the marketplace to make you a more knowledgeable trader.
EnronOnline
No matter what commodity you want to buy or sell, you're almost certain to find a live, competitive quote on EnronOnline. We cover markets all over the world including gas, power, oil and refined products, plastics, petrochemicals, liquid petroleum gases, natural gas liquids, coal, emission allowances, bandwidth, pulp and paper, metals, weather derivatives, credit derivatives, steel and more. EnronOnline covers almost every major energy market in the world. And we're not sitting still. We're adding new markets and new products all the time. An ironic example of "Trading Markets": Credit Risk Management Tools, including Bankruptcy Swaps
EnronOnline Claims
Real-Time Pricing Fast, Free, Secure Execution Price Limit Orders Option Contracts Market News and Quotes Industry Publications Weather Insights Complete Customization Capabilities
Step 1. Sell to an affiliated partnership Step 2. Set an internal value on the sale Step 3. Sell from one partnership to another Step 4. Act as underwriter for the sale
The Collapse
Sudden announcement of losses in Oct 2001 File for bankruptcy in Dec 2001 Bankruptcy Congressional Investigations began in Dec 2001 Attempted destruction of documents
Paper records at the source Local computer system records Internet communication records Recipient records Paper records at the destination
Reduction in force by 6,000 workers Effects on their retirement accounts Effects of sophisticated accounting Effects on Internet-related stocks Effects on Communications-related stocks Effects of conflicts-of-interests: Combining Auditing & Consulting Effects on Energy Policy-Making Effects on Political funding
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
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."
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 cablesincluding links that traverse the Atlantic Oceanlinking 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 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.
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