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 doesn’t matter for value of the firm (Modigliani/Miller, 1958) You don’t 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 t=0.

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-NPV’s of derivatives seen from a market point of vie can co-exist with positive NPV’s 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 America’s 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? • Don’t 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