Prof. dr. Piet Duffhues

1
Prof. dr. Piet Duffhues

• Tilburg University, Finance Department

2

• The Concept
• Derivatives are financial instruments or
  contracts whose value can be derived from other
  assets (the underlying)
• In the press, scandals about derivatives
  (Barings, Long-Term Capital Management) are hot
  news, not the excellent properties

3
Origins tulip bulbs in the Netherlands and the
70s in the universities Black Scholes option
formula
4

• Main forms
• forwards
• futures
• swaps
• options
• exotics (complex derivatives) e.g. binary options
• The pricing of derivatives is on the basis of a
  replicating portfolio which has the same value

5

• Basically it is all about unconditional or
  conditional future deliveries (physical or cash)
  at an agreed price.
• Combinations of options can create a
  synthetically long or short position as in the
  other three cases.

6

• Market people
• Hedging (a.o. 73 of hedge funds / only 21 of
  mutual funds)
• Speculation
• Arbitrage
• Markets
• Public markets
• Over The Counter (OTC) Markets

7

• Derivatives markets (BIS figures)
• Important markets
• Interest rate derivatives
• Currency derivatives
• Equity derivatives
• Credit derivatives
• Growth has been enormous (see BIS) especially
• OTC
• Credit derivatives

8
All derivatives in 2006 underlying values
415.000 bln ( 40) with market values of the
derivatives 10.000 bln Further strong growth in
first quarter 2007(BIS)
9

• Why is it that people are interested in
  derivatives if it is only a replicating
  portfolio?
• low transaction costs
• high speed transactions
• spot markets become more efficient (e.g. more
  information about interest rate via the swaps
  market)

10

• 60 of non-financial firms in the US use
  derivatives
• Risk management management of total risk, not
  only systematic risk
• Tabaksblat Code of Corporate Governance (2003)
  requires stringent corporate risk management
• Enterprise Risk Management (ERM)
• Firm-Wide Risk Management the rise of the
  Corporate Risk Officer (CRO)

11
Total risk operational or real risk (asset
side) and financial risks (a.o. liabilities
side) Derivatives are just one way of risk
management
12

• Alternatives for derivatives risk management
• Vertical integration (NATURAL HEDGE)
• Diversification (NATURAL HEDGE)
• 100 equity financing ( buffer stock)
  FINANCIAL HEDGE
• All invite to less derivatives risk management
  (Confirmed by empirical work (jof, 2007))

13

• Counter Arguments
• shareholders can hedge themselves so why hedge by
  the firms? (hedging is redundant)
• capital structure doesnt matter for value of the
  firm (Modigliani/Miller, 1958)
• You dont find a motive for derivatives usage on
  the ground that these are so cheap. Actually all
  these derivatives have (in well-developed and
  perfect markets) a zero net present value at time
  t0.

14

• What then is their deepest motivation to use
  those instruments in all kinds of organizations?
• Answer to change risks in a way you prefer at a
  certain moment of time because this is a better
  outlook for the value of the organization.

So zero-NPVs of derivatives seen from a market
point of vie can co-exist with positive NPVs
seen from the point of view of an organization.
15

• Value creating properties for organizations and
  persons
• Why it works
• In finance literature several arguments are
  mentioned for organizations though there is as
  yet no clear picture of a total theory
• We distinguish two groups
• financial and real-side (operational) arguments

16

• Financial arguments (well-known in literature)
• Tax advantages (income tax is lower when there is
  a convex tax curve and risk is hedged)
• b. Reduction of convex bankruptcy costs
• c. Less underinvestment risk.
• No shortfall of NPVs of projects which must be
  cancelled because of lack of cheap funding

17

• d. More tax advantages of the increased debt
  capacity of the firm (implied by the decreased
  bankruptcy costs)
• e. A more certain environment for the people
  working in the firm (risk aversion creates lower
  labor costs and less turnover of people)
• f. A nice contribution to the insights in the
  performance skills of the management by taking
  away external non-core risk sources of risk

18

• Hedging costs are different
• Hedging non-core risks is not very costly (e.g. a
  currency risk on accounts receivable)
• Hedging core risks is very costly (e.g. sales
  currency risk of next year moral hazard
  problem))

19

• Real-side arguments (new approach)
• Recent work shows that hedging can add value if
  revenues are concave in product prices or if
  costs are convex in factor prices

20

• Conclusion (traditional and real-side approaches
  taken together)
• In general literature says that firm value is
  positively related to corporate hedging activity
  (Cassidy et al, 1990 Allayannis en Weston, 2001,
  Mackay en Moeller, 2007)

21

• Personal use of derivatives
• Financial derivatives make it possible to invest
  in a broad new category of investment products
  which better fulfill the needs of the private
  people

22

• More specifically
• Structured products that incorporate attractive
  properties of risk aversion on one side and rate
  of return on the other side
• This market has grown enormously now 1 to 3
  private investors have a structured product in
  their portfolios in the Netherlands.
• Risk opaqueness (e.g. steepeners in Greece and
  other EU countries)

23
Structured products are mostly a portfolio of a
debt instrument and derivatives and give in many
cases a certain minimum floor or guarantee
payment to the investor with an upside
potential.
24

• Positive and negative aspects of increased
  financial autarky by using derivatives
• 1. Derivatives are excellent for the organization
• creates liquidity when this is needed for the
  organization independent of the tastes of the
  public markets in future
• investments can go on undisturbed and do create
  NPV as is hoped for without lack of available
  capital
• central financial planning within organizations
  is supported by derivatives transactions because
  of the notion of capital availability in the
  future

25

• 2. Important flaws are
• corporate governance degree of independency of
  the financial markets increases
• the efficiency of the markets no open minds to
  inform outsiders
• hardly any issues of equity and debt in the
  public markets nowadays

26

• Derivatives markets and spot markets
• Or Market efficiency aspects of derivatives
• Usually and by definition spot markets are first,
  derivatives markets are following from spot
  market quotations
• But in practice the reverse is gaining ground.

27

• The availability of credit derivatives may
  contribute to a more relaxed attitude of lenders
  to grant credits to clients and thus influence
  the whole economy (more specially a favorable
  business cycle)
• Credit derivatives have allowed banks to reduce
  concentration risk on loans.

28

• How?
• By transferring these risks to well-diversified
  investors
• different investment horizons
• different risk attitudes
• no regional limitations all over the world
• Generally Financial markets have as a result
  become more resilient but some (a.o. Trichet from
  ECB) think that the opacity of the credit
  derivatives market could create instability in
  the financial system.

29

• It is a general tendency that spot markets have
  decreasing significance relative to derivatives
  markets.
• Or stated differently Derivatives markets have
  increasing power.
• Is this a threat for the financial system? (see
  Jacques Sijben too)

30

• Corporate financing decisions and risk management
  decisions
• Financing is basically to be done in markets
  where the firm can exploit its rating quality to
  get the best price at that moment.
• The amount of required equity for the firm is
  dependent on the risk of default of the new
  project (volatility or firm-wide VAR measure) and
  the target probability of default (Stulz en
  Nocco, 2006, blz. 13 and figure 1 on page 31)
  the lower the target probability of default the
  higher the required equity component in the
  capital structure.

31

• Derivatives - financial weapons of mass
  destruction?
• Well-known statement of one of Americas greatest
  investors Warren Buffett
• Statement after a surprising discover of an
  unknown position in a takeover transaction
• Problem what is precisely a hedge?
• Case Metallgesellschaft AG (Germany)

32

• Example Metallgesellschaft AG (Germany)
• hidden long positions in oil futures
• later on defended as hedges to hedge the oil
  price risk of future deliveries to retail clients
  on the basis of long term delivery contracts
• strategy to roll over the contracts again and
  again
• in practice two major flaws

33

• 1. High cash transfers to be made to the futures
  exchange because of losing money after oil price
  decreases.
• Liquidity of the firm became under discussion
  banks were not prepared to make the margin calls
  to the exchange.
• 2. Retail clients will not be able to fulfill
  their (buy) obligations from Metallgesellschat AG
  in a declining market, so the sale contracts of
  Metallgesellschaft AG were not hard enough to
  justify the long position in futures (which are
  unconditional as you know!)

34

• Conclusion the futures hedges were not hedges
  but economically, essentially speculative
  positions!
• Much discussion in the finance literature about
  this disaster.
• Metallgesellschaft was saved from bankruptcy by
  an equity issue meaning that shareholders took
  the losses from the hedge!

35

• Conclusion
• Derivatives weapons of mass destruction?
• Quite probably if you have no derivatives
  license (Metallgesellschaft survival case and
  Procter Gamble big losses case)
• Quite a burden in that sense!
• But apart from that and essentially a great
  blessing

36
Derivatives are efficient, mostly innovative but
complex financial instruments of mass financial
flexibility which help (at an agreed
price) parties in the financial landscape to
continually adapt their positions with the goal
to create more tactical and strategic value in
their respective organizations taking the
exposure which is wanted then. These
organizations and their goals are and should be
central. Otherwise it is merely speculating
activity.
37

• I started with the observation that public
  information in daily papers is rather one-sided
  about derivatives
• Some people who made an incorrect decision in
  their youth to study a field which is different
  from the Economics and Finance field have
  difficulty in accepting this new world but there
  is always an option to get better educated in
  this new world these people can add value to
  themselves and the (daily) papers they write for
  the big public by exercising that option!

38

• References
• Tett, Gillian, (2007), No turning back the
  revolution, Financial Times, May 28.p.12.
• Stulz, Rene M., en Brian W.Nocco, (2006),
  Enterprise Risk Management Theory and Practice,
  SSRN working paper nr 921402
• Chen, Yong, (2006), Derivatives Use and Risk
  Taking Evidence from the Hedge Fund Industry,
  Working paper, 12 December.

39

• Multi choice question for the audience
• An experience in personal risk management a
  retail investor is advised by his bank to do a
  smart transaction in the mutual funds (equity)
  market
• Text of the MC

40

• THEME INVESTING IN REAL ESTATE MUTUAL FUNDS
• Your bank calls you on a bright morning to
  propose an investment in real estate.
• In your portfolio there is already an investment
  in real estate. It dates from no longer than
  three months ago, was bought at 100 at the bank
  and is already now valued on the Stock Exchange
  at 1111,1.
• The bank advises you to sell this existing
  investment quickly and buy immediately a new one
  at 100 which is just now issued by the same
  bank. You can take a nice profit on your
  existing investment and go for a next round in a
  new completely comparable investment at 100
  starting price again.

41

• Is this a smart offer by the bank?
• Dont believe this advice. The bank is only
  interested in making more business.
• The price of the existing investment will perhaps
  increase till 125 so why sell the existing?
• The bank officer makes a mistake in that both
  investments will increase or decrease at the same
  time, so the new one may decrease till e.g. 90
  as the existing investment might decrease. They
  have the same risk, so will show the same price
  direction.

42

• Which answer (a,b,c,d) do you prefer and on what
  ground?
• Further comments further developments since the
  phone call
• Thank you