Derivatives Weapons of Mass Destruction April 20 th

Derivatives: “Weapons of Mass Destruction” April 20 th , 2011 FIRMA Annual Conference Atlanta, GA W. A. (Trey) Ruch, III Executive Managing Director Sterne Agee Group truch@sterneagee. com

Quote for the Day “Derivatives are something like electricity, dangerous if mishandled, but bearing the potential to do good. ” Arthur Leavitt-1995 Former Chairman-SEC

Derivative Defined De-riv-a-tive (n)- A right or obligation based upon an underlying asset whereby one party agrees to sell a good and one party agrees to buy it at a specific price on a specific date. The investor does not usually own the underlying asset but the terms for the price, risk, and structure are based on the asset. The investor in a derivative is usually making a bet on the direction of an underlying asset ‘s price movement via an agreement w/ another party. The perceived risk of the underlying asset usually influences the risk perception of the derivative.

How Derivatives are Used: Hedging-Insuring the Value of an Asset Against a Downturn Speculating-Betting on Price Movement

Types of Derivatives Option (owner)-Right to Buy/Sell at a Specified Price. Option (seller)-Obligation to Buy/Sell at Specified Price. Futures Contract-Obligation to Buy/Sell an Underlying Asset at a Specified Price as of a Future Date. Swap-Exchange of Asset Variables for Different Investments.

Trading Exchange Traded • Regulated Market • Transparent • Liquid • Such as “Listed” Options Over-the-Counter • Unregulated • Counterparty Risk • Illiquid • The “Swap” Market (OTC)-

Hedging: Protective Put Benefits • Complete Protection Below Put Strike Price • Unlimited Price Appreciation • Retain Voting Rights, Dividends, & “Indicias” Considerations • Cost of up-front premium • Tax Straddle Rules Impact Holding Period

Purchase of Put Option

Hedging: Cashless Collar Benefits • Complete Price Protection Below Put Strike • Price Appreciation up to Call Strike • “Cashless”- Sale of Call Finances the Put • Retains Voting Rights, Dividends, and “Indicias” Considerations • Investor Forgoes price appreciation above call strike • Tax Straddle Rules Impact Holding Period

Cashless Collar

Futures in Everday Use: Healthy Hens Farm Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market with all the sporadic reports of bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with an investor who enters into a futures contract with her. The investor agrees to pay $30 per bird when the birds are ready for slaughter, say, in six months time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as he or she will be able to buy the birds for less than market cost and sell them onto the market at a higher price for a gain. If the price goes below $30, then Gail will be receiving the benefit because she will be able to sell her birds for more than the current market price, or what she would have gotten for the birds in the open market.

Types of Swaps: Interest Rate Swaps Currency Asset Total Swaps Return Swaps Credit Default Swaps

The “Plain Vanilla” Swap: Interest Rate Swap • Acme agrees to pay Zenith a fixed rate of interest, on a notional amount, on specific dates, for a specific period of time • Zenith agrees to Pay Acme a floating rate on the same amount subject to the same terms Zenith Acme, Inc. Fixed Rate-6% Thinks Rates are going up LIBOR + 1% Zenith, Inc. Thinks Rates are going down

Swap Details: OTC Customized Terms Counterparty Risks Motivations • Meet Commercial Needs • Comparative Advantage Exiting a Swap • Buyout • Offsetting Transaction • Selling the Swap • Swaption

Credit Default Swap: WMD? Private Bond Insurance for Credit Risk Buyer Wants Default Protection on Issue • Short Bond Exposure • Long Cash Exposure Seller Wants Premium Income • Long Bond Exposure • Short Cash Exposure OTC Trade Limited After Market Liquidity

CDS Contract (No Credit Event): Reference Entity Credit Risk Transfer CDS Premium: X bp per year Protection Buyer Protection Seller § Between trade initiation and default or maturity, protection buyer makes regular payments to protection seller § The spread is calculated on the notional amount of protection § Typically paid quarterly § Payments terminate at maturity or following credit event

CDS Payment Mechanics (After Credit Event): Bond or Loan Protection Buyer 100 $ 100 – Recovery Rate Protection Seller Cash settlement with an option for physical delivery has become the market standard

The Big Question: Did Derivatives Cause the 2008 Recession?