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Demystifying Derivatives: Understanding Financial Risks and Rewards in Wall Street Transactions

Explore the complex world of derivatives through a detailed analysis of swap agreements, pricing, and risk management strategies. Learn how businesses and governments utilize derivatives, uncovering hidden reasons and potential pitfalls. Gain insights into credit exposure, operational relationships, and valuation issues associated with these financial instruments. Navigate through the intricacies of derivative usage with clarity and practical examples.

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Demystifying Derivatives: Understanding Financial Risks and Rewards in Wall Street Transactions

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  1. An Unfinished Mission: Making Wall Street Work for Us AMERICANS FOR FINANCIAL REFORM and THE ROOSEVELT INSTITUTE Toward an Understanding of the Use of Derivatives by End Users Wallace C. Turbeville Senior Fellow, Demos

  2. Basic Swap Configuration Inception Price of 100 Barrels of Oil in June @ Cushing Party A Party B June Price of 100 Barrels of Oil in June @Cushing

  3. Swap as Hedge Payments at Close of Swap Contract $100/Barrel Party A Party B Purchase Price $120/Barrel $120/Barrel Oil Seller

  4. Credit Exposure on Swap Swap Lost on Potential Default $10,000 @ $100/Barrel Party A Party B Party A Actual June Price Potential Replacement Swap $10,100 @ $101/Barrel Party A Party X Actual June Price A has extended $1/barrel of Credit to B.

  5. COMPARISON OF SWAP AND RESERVE FUND

  6. Valuation/Risk Issues • Obscure Pricing, especially of Credit Extension • Catastrophic Margin Call Risk • Valuation of foregone Upside • Inter-relationship with Operations

  7. Operational Relationship Fuel Purchase Swap Operating Company Fuel Price @ Swap Maturity Fuel Fwd. Price @ Inception Price Fuel Supplier Fuel for Production Line Bank If the operating company shuts down the production line, it remains obligated on the swap. This would cause a loss if the price at maturity falls below the fixed payment

  8. Operational Relationship Fixed Payment: Forward Price at Inception $100 Party A Party B Floating Payment: Fuel Price @ Swap Maturity Line Shuts Down; Party A Reverses Swap Fuel Price Exposure Fixed Payment: Forward Price at Inception $90 Party C Party A Floating Payment: Fuel Price @ Swap Maturity Loss to Party A: $100 - $90, or $10.

  9. Hidden Reasons Businesses and Governments Use Swaps • Mis-perception/Obscuring of Risks and Costs • Credit Rating Agencies • Tax Consequences of Reserves • Accounting Rules regarding Credit Exposures • Safe decision for Executives • Share Value Compensation Rules • “Shadow” Debt

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