pgp25234@iiml.ac.

in

PGP Student, 20092011

Post Lehman World Is there room for marketing derivatives

When Warren Buffett said that derivatives were timebombs and financial weapons of mass destruction, the visionary foresaw the nuclear winter we are facing today. The downfall of Lehman Brothers, 158 year old finance giant was the advent of the so called Great Recession. This global financial crisis has shaken countries, markets, and individuals, in turn causing pessimism, angst and even anger. So how did it get so bad? A lot of it can be attributed to derivatives. Its the complexity of derivatives that makes it such a dangerous instrument. In addition being a highly speculative instrument makes the outcome uncertain. It is because of this instrument that world is seeing longest recessionary period since The great depression. But now as the things are settling down, people are back to the drawing board to determine will marketing derivatives work in this postLehman world? One line of thought is to wipe out derivatives, destroying the largest mass of fictitious capital the world has ever known. Such emotions that we are witnessing today is a reminiscent of year 1969, when number of stock scandals saw loss of faith in the equity markets. At that time too, the atmosphere was of caution and despair. Everyone was predicting the end of security markets. But that situation was averted by introduction of new regulations and eventually we saw an explosion of trading volumes in just a couple of years that followed. Compare that to today. With the ills of marketing derivatives out in the open, now we need to regulate this market and increase transparency in it. Regulators need to increase the scrutiny of the contacts and it should be clear how much is traded and who is at the end of the transaction. The traders reports should specify the positions held by investors to increase the transparency of business. For the industry to progress its also important that regulators keep up with the advancements in the private sector. Inadequate knowledge can result in penalizing the market when regulators appose what they dont understand. Proper training of regulators and inspectors is essential to enhance the safety and soundness of the market. One more important factor will be the coordination amongst the regulators. There should be free flow of information, joint inspections and close consultation in forming the policies. With high level of cooperation amongst the regulators, transparency should increase and risks associated with the derivatives market should decrease. With centralized clearing and exchange trading for standardized derivative the process of regulation could be made more effective and efficient. If we could get to the point of standardized derivatives instruments that are exchange traded, it will create a hurdle for any nonstandard product a bank wants to introduce in the market. A standardised derivative instrument will have better liquidity, lower spread and superior price discovery. Regulations and standardization are the only way to build back the confidence in people. With a new open market place, these products would be safer and more accessible to a more number of investors.

Aravind Gattu, IIM Lucknow, PGP25234.

Post Lehman World Is there a room for marketing derivatives?

Post Lehman World! Has the world changed post Lehman bankruptcy? Answer is a definite yes! Now the next question is, How has it changed, what are the changes involved, how are these changes going to affect us? Financial regulations and bringing the world nations regulatory authorities under one common roof are the most discussed issues. Bailing out the companies which are too big to fail; Government reviving the economy with stimulus packages; Central bank aggressively reducing the interest rates; these are a few activities undertaken to restore world order thereby saving ourselves from witnessing what would have been the worst economic crisis of the century. But, what lead the derivatives to lose their sheen? People tend to point the fingers at these derivatives because they find it easy to play a blame game and thereby zeroin on one thing that they can attribute to the cause of the economic crisis. But, what people fail to recognize are the reasons that caused the failure of these derivatives. Going further we will see, reasons for the creation of these derivatives and the reasons for their downfall. The Risk Managers of various banks had been under tremendous pressure to sanction loans even to the subprime customers; this was because of rising pressure on the banks top management to perform at par with the shareholder expectations in an almost saturated market. This tremendous pressure has lead bankers to disburse loans to customers irrespective of their credit worthiness; this is how the banks came across a totally new customer base. No sooner the banks have started catering to the needs of this new customer base they had fallen short of funds; they started looking at innovative options for raising the money. The result of such a search is the creation of new complex financial instruments (derivatives) which had huge risk associated with them. Investors knowing or unknowingly had taken the risk of investing in these derivatives and once the risks associated with these derivatives had matured, the investors had no choice but to face the consequences. If we look back, and analyse the fault associated with these derivatives, we find that the underlying assumptions made while modelling those derivatives were wrong. The following were the assumptions made: 1. Statistical Distribution of the defaults by customers follow normal distribution curve. 2. Economic events for each individual, independently, will lead to default from him/her and in general there wont arise a case of collective defaults at one point of time. 3. Risks faced by a particular individual are totally unconnected to risks faced by another individual.

And now that we have understood the source of the problem, we can very well say that the problem was not with the derivatives. But, the problem was with the 1. The loose ends in the government/central bank policies that had provided for excess liquidity and didnt bother regulating the situation later on. 2. Faulty assumption involved while modelling the financial instruments. 3. The abuse of leverage by various investment banks. Here a few investment banks have leveraged themselves to the tune of 34 times the debt equity ratio 4. Uncertainties in economic conditions lead to apprehensions among the lenders, which in turn resulted in freezing of the funding markets. e.g. the LIBOR freeze in Europe 5. The inability of economists, analysts, central banks to predict the outcome of the events in such scenarios.

I would conclude by saying, had the derivatives been prudently used and had they not been used to excessively leverage the banks balance sheets, the situation wouldnt have been uncontrollable. The need for financial derivatives still exists, in the sense that their use should and can reap benefits not only to the financial institutions but also to the end consumers. And all that is needed from our part is to be wise enough so that the capabilities of these derivatives are not misused.

Indranil Saha pgp24137@iiml.ac.in PGP student 20082010

Post Lehman World Is there a room for marketing derivatives?

Post Lehman World The Myth
Yes its a myth theres no postLehman world. In fact, there is nothing like postLehman. Companies come and companies go yes even behemoths like Lehman do, but the economy continues. I see this as the churning out process of the evolution from which the fittest survive and metamorphose into new avatars that surprise the whole world. It is almost similar to Jack Welchs Differentiation with the 207010 grid where the bottom 10 needs to make space for others. A closer review would reveal that the world economy keeps on undergoing such cycles. The 1930 US recession, the PostWar 1940s, The Oil recession of the 80s, the Gulf War, the East Asian crises of 97, the Dot com bust of 2000, 9/11 of 2001 almost every decade has had its share of downturns. They said the bonds are out, they said Internet was doomed and they are saying Derivatives have died! Lets admit we saw it coming! And we never paid attention. Its always too good to end. Although the Subprime Crisis would not classify as more than another glitch in the economic progression, it definitely has its bit of effect on the story.

The Derived Angle!

The slowdown definitely changes the way derivatives are going to be treated in the future. Synthetic financial instruments like the CDOs might find it difficult to reappear in all its complexity and exotics could be a way of the past. Investors have become more cautious about the instruments they invest in. It would be long before derivatives would be used to speculate and make money in the financial circles. But the role and the effectiveness of derivatives in risk management and hedging is undeniable. And derivatives are here to stay. The financial crisis has made valuations of a lot of companies quite attractive. Quite logically there would be a flurry of M&A activity in the market in the near future. In Q1/2009 China was the largest acquirer among the AsiaPacific nations, investing $353 million in 18 announced deals in Asia, according to AVCJ Research. Inbound M&A transactions totalled $6.9 billion through 75 announced deals in Q1/2009. Sentiment remains favourable, as evidenced by Bain Capitals recent agreement to invest in Chinese retailer Gome. Consequently, organizations would have to do business across borders and hence transact in multiple currencies. Automatically they would have to face currency risk, interest rate risk, counterparty risk and all their kin and kind. Except for natural hedging, the only way to hedge all these risks is with currency derivatives.
M&A deal scorecard 2009 - deals valued at over $1,000m

Last updated: August 11, 2009

Rank 1 2 3 4 5 6 7 8 9 10

Partners Pfizer Wyeth Merck ScheringPlough GSK Stiefel BMS Medarex Watson Arrow Group Varian Agilent Gilead CV Therapeutics J&J Cougar Lundbeck Ovation

Date

Value, US$m

Jan '09 $68,000 Mar '09 $41,000 Apr '09 $3,600 Jul '09 Jul '09 $2,400 $1,500 Jun '09 $1,750 Mar '09 $1,400 May '09 $970 Feb '09 $900

Abbott Adv. Med. Optics Mar '09 $1,300

Source: CurrentPartnering, 2009

Consumer spending in America rose by 0.2% in July compared with June and personal income was unchanged as Americans swapped their old cars for new ones in a program meant to help steer the US economy out of recession, as commented by the US Commerce Department. According to Robert Morrice, chairman and CEO, Asia, Barclays PLC, there is a financial market large enough to back up such activities. Over the past few months the international credit markets have seen record volumes and a significant compression of credit spreads. With the compression of credit spreads and strong liquidity with real money accounts, the international credit markets are a viable option. Once credit becomes available, credit risk derivatives are sure to be used to hedge against defaults. Based on a Crisil assessment of over 500 projects and extensive interactions with stakeholders across 11 key sectors in India such as power, telecom, oil, gas, cement, metals, and automobiles, aggregate industrial capital expenditure is projected to be to the tune of Rs 10.5 trillion during 200910 to 201112. It is anything but over!

A K Kishore Kumar, PGP Student, 20092011 pgp25114@iiml.ac.in

Post Lehman World Is there a room for marketing derivatives?

Derivatives have earned a bad reputation after the fall of Lehman Brothers amongst the investors. The bankruptcy of the investment bank had indeed put a brake on the economy world over changing all the indicators to red from amber. It is not only in the recent times that derivatives have drawn criticisms. In 2003 itself Warren Buffet had rightly cited them as Financial weapons of mass destruction. Bankruptcy and lawsuits related to derivatives were not new phenomena but the scale was definitely unprecedented. The greed of quick money and the sophistication and opportunities to explore complex mathematical models kept the derivatives market from falling. In process of making or rather innovating, as the investment banks would like it, confounding and compounding the existing products one critical term was lost, namely, the Accountability Factor. The investment banks selling derivatives products did not have any incentive for creating long term value for the customer and neither did the customer know of the inherent risks associated with it. This was exactly what led to packaging high risk subprime mortgages into the so called innovative products and selling them world over. The nave customers were lured to buy these promising deals at attractive prices without any knowledge of the extent of risk associated with them. And when the bubble burst they were clueless about the value of the, now renamed as, toxic products or if they could ever get back the collateral given to the investment banks. As the saying goes, Once bitten, twice shy, marketing derivatives in the aftermath of financial crisis is indeed a challenge. Customer trust levels are hitting the bottom and trying to sell derivatives seems the next most impossible thing to do. But then derivatives, with all the negative criticisms, are not without advantages. Firms can use them to mitigate risks in commodity price and interest rate fluctuations to keep their future projections & outlook clear. The investment banks may have lost credibility but financial innovations are necessary to oil the economy by keeping the cash flowing and supplying funds where it is required from where they are in excess. There is definitely a demand for derivative products. The obvious factor that can help in marketing derivatives is winning back the customers is trust. The next innovation must be to introduce the accountability factor in the derivatives and greater transparency in the risks associated. The investment banks that had been riding on the past reputation rewarding themselves handsomely must now roll up their sleeves and take the customer into confidence. Relationship banking is one such method to improve marketing of derivatives. Relationship banking emphasizes building long term relationships rather than just increasing profit margins in individual transactions. Studies indicate that the derivatives market is ideally suited for relationship banking. It is necessary to develop relationships and seek long term winwin situations instead of making short time fortunes. There should be incentives for understanding customer needs and adding value to them through derivatives products rather than just generating high quarterly earnings.

Komal Bhardwaj, PGP Student, 20092011 pgp25132@iiml.ac.in

Post Lehman World: Is there room for marketing derivatives

The reasons for the current global financial meltdown have been comprehensively established. Be it the 1998 Russian economic crisis, or the subsequent Y2K scare or dot com bust or the 9/11 tragedy, the US Federal Bank in order to preempt a downturn, cut the interest rates to encourage citizens to spend more and more. The US economy was being stimulated on steroid of easy money that doubled their household debt in the last seven years to $14 trillion. This attracted a lot of undeserving (subprime) buyers to own assets without having to pay consummately. The lenders offloaded these risks through creative yet poorly understood financial instruments to investors who thought these as a safe haven for big returns. The regulators too saw no need to slow down the juggernaut because everyone was making tons of money. Everyone wanted to be a part of the ride before it came to a screeching halt, which was symbolized by the fall of Lehman Brothers in Sept 2008. But how could so many bright people in these financial institutions get it so wrong? Simply put, it was due to faulty financial modeling and the short term interests of financial executives to earn immediate rewards. The use of overly simplistic modeling to correlate the default risk of one loan in a pool gave a false authenticity to toxic financial derivatives such as CDS (Credit Default Swaps), ABS (Asset Based Securities) and CDOs (Collateralized Debt Obligations). Financial derivates are only a technological innovation, analogous to airplanes or electricity. If used prudently, they can be immensely beneficial to the economy by measures such as hedging market risks, improving the efficiency of price signals, increasing the profitability of financial institutions, and increasing the value of firms. However, unscrupulous derivative trading can also lead to systemic risks that can trigger a systemic crisis, in which valuation of financial assets, payments, or credit allocation can be impaired severely as experienced in the current crisis. So what are the solutions to current financial malady, and what is the road ahead for financial derivatives? The real solution to the crisis is three pronged. Firstly, it must be ensured that the originator or the sponsor of a security retains a financial interest in its performance. Secondly, financial products should be regulated to spread risks wisely by imposing robust reporting requirements. Thirdly, the investors should use more prudence rather than being overly reliant on creditrating agencies. These measures may seem to stifle innovation, but that may not be such a bad thing considering that the kind of innovation that was prevalent till now mainly attempted to bypass accounting and regulating standards. If planned properly the next generation of derivatives will be covered by more robust safeguards of payment and settlement systems and strong oversight of "over the counter" derivatives. Derivates just as other technological innovations are here to stay; all that needs to be done is to create regulations that guarantee that derivatives go the way of airplanes and not the way of zeppelins.

Poonam Shami PGP1 Student, Indian Institute of Management, Lucknow Poonam.Shami@gmail.com

Post Lehman World Is there a room for marketing derivatives?

Warren buffet called derivatives Weapons of mass destruction way back in 2003. Marketing derivatives indeed proved hazardous for the financial world. However, it is essential to realize that there are different kinds of derivatives and all of them are not equally destructive. The key here is to understand which type one is dealing with before concluding whether it is destructive.

Buffets perspective may actually be just a reflection of his personal experience with derivatives positions that he held in 1998 that included 82 percent holding of Cologne Reinsurance. It seemed an excellent proposition; unfortunately Buffet had hard time finding a buyer and ultimately decided to close it down. He stated later that derivatives position is easy to enter and almost impossible to exit.

Undoubtedly, Lehmans bankruptcy and the crisis that followed raise doubts about future of marketing derivatives. The world witnessed how the instruments mutated, multiplied and morphed over the years to lead to a financial meltdown. Many analysts believe that dilution of strict controls and restrictions in the US financial market is the primary cause for the crisis. Markets have their highs and lows, and reputed financial institutions seemed to have forgotten this, in view of fast growth and greed.

Doubting future of marketing derivatives does not make much sense if appropriate norms and restrictions are in place. SEBI allows mutual funds to invest in the derivatives market, and it has done so with right kind of restrictions in place. It has allows mutual funds to have not more than 50 percent of its portfolio positions in the derivatives market. The total exposure of mutual funds in derivatives market in July 2009 end was approximately INR 1360 Crores.

There are several advantages of derivatives trading. Most of the managers invest in derivatives market for minimizing risk and for doing away with fluctuations in prices. This is the primary reason of investment for most managers. This phenomenon is visible in the bear phase since in the bull phase managers are less likely to hedge risks extensively. The worst of bear phase, between January 2008 and March 2009, saw a sharp rise of exposure in derivatives. The exposure grew from 1.77 percent of equity assets in January 2008 to 5.86 percent in March 2009.

Thus investors decision on whether to invest in derivatives market is a sensitive process which will determine success of marketing derivatives postLehman era. Multiple options will still be available and multiple chances of errors of judgment would still be there. However the world of derivatives market can only be remolded through more sophisticated instruments with better restrictions in place. Investor of future will be more aware of risks involved and would seek thorough information to comprehend the underlying risks. That is, research will find a more important position, which will perhaps be the best indicator of a more mature market of derivatives.

Rohit Agarwal, PGP student, 20082010, IIM Lucknow pgp24221@iiml.ac.in

Rohit Agarwal

POST LEHMAN WORLD IS THERE A ROOM FOR MARKETING DERIVATIVES

In 2003, legendary investor Warren E. Buffett called derivatives "weapons of mass destruction".He predicted that the complex financial instruments would survive only "until some event makes their toxicity clear." Was the bankruptcy of Lehman Brothers the disaster he was imagining? Lehman Brothers filed for Chapter 11 bankruptcy protection on 15th September 2008, about a year ago. Since then, the world has become a different place to do business in. Derivatives are used for three purposes hedging, arbitraging and speculating. Hedging means protect ones loss, for example, a wheat farmer buys a put option on wheat to protect oneself against a decrease in wheat prices. Arbitraging means taking advantage of irregularities in market price, for example, a contract is trading at different prices across different exchanges. Speculating means taking directional view on the future. If we look at all the three uses of derivatives, hedging is used to restrict losses, arbitraging is used to make riskless profits and speculating is used to make risky bets. Of these, hedging will continue as long as people or institutions want to minimize losses, and arbitraging as long as people want to make profits out of inefficient markets. It is only speculation that is affected by the investors confidence in the economy. Over the rest of the article, Ill discuss the recent trends in the confidence of the investor. One more thing to note is that derivatives are twoparty contracts with a finite expiry date. As such, any loss occurring to one party is essentially equal to the profit earned by the other party. Hence, derivatives does not create wealth, it merely transfers wealth from one party to the other. The winning party is one that had more information, or could make a better prediction about the future, or someone who simply got lucky. Post Lehman, the business world was filled with uncertainty. It is not everyday that a 158year old employing more than 25,000 people fail. No one knew if this was the worst or there was more to come. Things have definitely changed a lot over the past twelve months. The Emergency Economic Stabilization Act of 2008 allowed the US government to pump in USD 700 billion into the troubled economy. This was followed by coordinated response around the globe. As a result, commodity prices have started shooting up, reflecting an increase in demand. Indian economy recently reported its first increase in quarterly growth rate of GDP since 2007. The stock markets across the world are now much above their 52week low with the Indian markets at around their 52week high. All these indicators point in the direction that the worst is over and the investor has much more confidence in the economy than what one had at the time of Lehman Brothers. Now, an investor realizes that the impact of Lehman has faded and the new economy is here to stay. Enthused with all the confidence, the market for derivatives is bound to increase.

Siddhartha Choudhury, PGP Student, 20092011 Pgp25328@iiml.ac.in

Post Lehman World Is there a room for marketing derivatives?

Derivatives are financial instruments that derive their value from an underlying security. That underlying security could be a bond, a stock or an index. In fact theoretically anything whose value can go up or down can be an underline. Derivatives allow people to hedge their positions, to manage their risks, to speculate price movements and above all are essential tools in the price discovery process. And yet they have been variously branded as weapons of mass destruction and upper class slot machines. These complex financial instruments, many based on mortgages, are also blamed for fuelling the current financial meltdown. Therefore in the post Lehman world as we become wiser and more prudent it is but natural to question the future of derivatives. Wouldnt the financial world be better off without such tools that probably belong more in casinos than in financial institutions? Such deduction is however fallacious. It is like the owner punishing the horse for losing the derby, whereas the jockey, who made the horse run all over the place goes scot free. The owner here is the regulator and the jockey the various manipulative, irresponsible and bonus hungry financial topshots. Its time that we tighten the reins of the horse, not kill the beast itself. Before gestating on the structure and form of derivatives in the near future let us look at the various dimensions within derivatives that might need a change. Almost all criticism towards derivatives has been heaped on the OTC overthecounter market. This market has remained unregulated and solely dependent on the integrity of the counterparties involved. While such a free market has encouraged financial innovation it has also led to increased opacity. Most investors ended up being a party to these derivatives without fully understanding the inherent risks. Most did not know the underline and had no idea of the value of the contracts. Such an environment will change for sure. In fact recent developments have shown that regulators are moving towards establishing the rule of law in the OTC markets. The case for independent and effective regulation is unquestionable. With increased regulation comes standardization. Out of favor, at least in the near term, would be the highly exotic products as they would struggle to meet the regulatory guidelines on one hand and diverse needs of the clients on the other. Also undergoing a major change would be the quantitative models used so far for assessing risks. This interplay, to be panned out within the coming months, between the regulators, quantitative experts and financial institutions could very well decide the market structure of derivatives of the future. Derivatives have their very important place in the financial system and will continue to do so. Investors and institutions will continue to hold assets in their books and therefore will need derivatives to spread their risk. Of course with regulations the systemic risk within derivatives would be controlled. Thereafter the markets should continue to get on with the job.

Sushovon Nayak,

pgp25159@iiml.ac.in, PGP 20092011

Post Lehman world: Is there room for marketing derivatives

When a group of businessmen formed the CBOT(Chicago board of trade)in 1848, never would they have imagined that their brainchild ,the financial derivatives would have become the raison detre for pension funds ,hedge funds and investment banks all over the world .So much so that their innovative products would drive the aforementioned institutions to an endless run for money . Someone had rightly said that There is enough for everyones need but not enough for everyones greed. First ,let us understand what basically are financial derivatives .Financial derivative is basically financial instrument whose value depends on something elsea share of stock, an interest rate, a foreign currency, or a barrel of oil, for example. One kind of derivative might be a contract that allows you to buy oil at a given price six months from now. But we do not know ,what will be the price of the oil six months from now . The deregulation of the financial sector, initiated by Mr. Alan Greenspan ,revered advocate of unbridled free market capitalism and a one time reputed fed reserve head ,culminated into the watershed event of the collapse of Lehman brothers on Sep 15,2008 .While Bear Sterns ,AIG ,Goldman Sachs were given a lifeline by the Government ,Lehman had to bear the brunt of the Treasury Secretarys indiscretion .

Post the aftermath ,as far as the OTC (Over The Counter)derivatives are concerned , hedge funds realized the need to assess counterparty risk when trading them .They wondered if a mammoth entity such as Lehman could fail , so could the socalled safe counter parties .In India ,CRISIL became one of its own kind by proposing to rate listed securities unlike the IPOs and debt instruments earlier so as to satisfy the investor of the fundamentals of the company and in a way exploit the fear buried within him. But the question which now arises is that should derivatives be shunned altogether ? The fact is that there is more to it than what meets the eye .In a world of uncertain times when exchange rates and interest rates are highly unpredictable ,derivatives serve as effective instruments for hedging losses for the discreet and also innovative instruments to reap profits through arbitrage between the cash market ,OIS (Overnight Index Swaps) and the interest rate futures market for the adventurous traders .India has even proceeded to introduce interest rate futures in the NSE and BSE ,which shows the almost indispensable nature of the derivatives in the present scenario. In the word s of Warren Buffet that derivatives were economic weapons of mass destruction, might have been prescient as far as the housing mortgage market is concerned but then every asset has its own liabilities ,the final outcome depends on the way we use it.

Vaibhav Gupta, PGP 20092011, pgp25056@iiml.ac.in

Post Lehman World Is there a room for marketing derivatives?

Vaibhav Gupta People ask me why I dont prefer fiction and mostly indulge in nonfiction reading material. I just give them a brief run up of the events in financial markets of last two years. They get hooked more than they can to Godfather series. The building of irrational exuberance (thanks for the term Greenspan, but no thanks for letting it build up) in stock markets and spending many times the earnings is the base of this engaging, thrilling story. Everything was fine in this town of DERIVcity. New financial products were blooming everywhere and were in great demand. Praises of Bear Sterns, AIG, Lehman et al could be heard from anyone anytime. Loans were disbursed to people who had a history of not paying back on time. Everyone was riding on the wave of increasing house prices and using that inflated value of house to take more loans. But as with all other stories, this story of DERIVcity also has some monsters. The monster of inflation raised his head due to bottomless demand. Interest rates were raised to curb it which in turn raised another monster called loan defaults. With the interlinking of mortgages and investments by pension funds courtesy packaging and repackaging of mortgages, suddenly the whole financial system was on the brink of collapse and one the biggest casualties was Lehman. Trust, from which the word credit is derived, evaporated in thin air and so did credit which was the life giving breath of our DERIVcity. Do we have any future of DERIVcity? Well, humans tend to forget their past and move on. This is good as well as bad. We dont lose heart to setbacks and use them as stepping stone which has been the foundation of great human races. But if we do not learn from our mistakes, we will eventually destroy ourselves. History shows that people never learn from history and thats why history repeats itself. Now either we can cry for some time and let this crisis go waste or we can step up and take care that such things are not repeated and while doing this ensure the financial innovation and freedom is not curbed. We will definitely be using derivatives; to hedge interest rate risks, currency risks and obviously to speculate. In this speculation people who lost money will definitely conjure up more money to get back in the game. It is the people who were never in the derivatives market earlier and were busy in securing two square meals for the day have to suffer again. Needless to say financial regulations have to step up. With all the talks of Goldman conspiracy going on, it is there to see how government reacts in long term to such requirements of the market.

So our DERIVcity will not only rise like a phoenix but survive too with the monsters of inflations and defaults tied with the chains of regulations. And wasnt this story better than any fiction

Vasant Kumar,

PGP25109@iiml.ac.in, PGP20092011

Post Lehman World Is there a room for marketing derivatives?

As the financial markets have started to revive and the real economy too has started showing some mixed signs of recovery, the question that is on everyones mind these days is how will derivatives be positioned in the new post crisis financial markets. Derivatives as a financial instrument will have to be seen separately from the economic crisis that engulfed the world post Lehman. Although it is very tough to do so considering how all the blame for failure of financial markets has been heaped on the derivatives. A wide range of exotic derivatives, including MBS (Mortgage backed securities), CDO (Collateralized Debt Obligations), CDS (Credit Default Swaps) and the kind are believed to be instrumental in the collapse of Lehman in particular and financial markets in general which plunged many developed economies into recession and led to a global slowdown. The derivatives in and of themselves cannot be held responsible for the failure of entire financial markets. The major reasons of the failure were pursuit of excess profits, recklessness, ignoring basics of banking, lack of regulation, continuation of low interest rates for long, increased leverage and heightened risk taking. Lehman, for example, was leveraged around 30 times on the day of its failure and was funding its long term liabilities with short term funds from the market. This kind of mismatch in balance sheet was a sure shot recipe for disaster which the Federal Reserve allowed to happen for too long. The improper rating of the derivative instruments with the rating agencies having a conflict of interest in properly rating the derivatives which led to people wanting low risk exposure being exposed to higher risk instruments was another reason why the liquidity dried up suddenly when things started going wrong. The faith that the US housing markets were in and everlasting boom also contributed to people taking reckless risks. Derivatives offer benefits such as risk management and efficiency in trading etc. to its users. Financial derivatives should be considered for inclusion in any organizations riskcontrol arsenal. Also derivatives, when used properly, pass on the risks involved to a group of people who want to take on additional risk for the increased future returns. Thus they are essential for the financial markets as well as rest of the economy to function properly by passing on the risks from one group to another group, which is more suitable and willing to bear the risk, which is necessary for increasing liquidity in the financial markets. The only caveat is that the risks should be made clear if the markets are to avoid another disaster of the same proportions as the one we are going through now. The financial markets still need derivatives to spread out the risks and bring more risk seeking capital in market for the projects that need them but we need better control over how they are used. Whether that control is self exercised control or regulated control is a question that the markets will have to decide soon.

Vasant Kumar

Vinay Vaswani, PGP20092011, pgp25164@iiml.ac.in

Post Lehman-World Is there room for marketing derivatives?

____________________________________________________________________________________________________

Vinay P Vaswani
3 letters brought down the world. The same 3 letters which led to a number of bankers becoming superrich yuppies, came back to bite the hand of its creators and inturn, bite off huge chunks of the balance sheets in which these now broke and unemployed bankers worked. Call the 3 letters what you like CDS, MBS, CDO these portents which for a decade transformed how money was transacted now face another grim 3 letters RIP or do they? Financial weapons of mass destruction The catastrophic effects created by repackaging securities are well lamented. The vicious circle of pushing loans to anothers balance sheet (bringing in SPVs into the equation) triggered a recession. The Morgan mafia sitting in a posh Times Square office would never have dreamt their easywayout would bring down some of the most established banks. As the venerable Mr Buffett puts it, derivatives are financial weapons of mass destruction, and so right was he. Dont punish the tool However, it would be unfair to blame the credit crisis on one sole instrument. I prefer licking my wounds by lambasting the greedy but ingenious Wall Street slickers who misused derivatives to offload risks from their balance sheets. Dont blame the derivative for that. As Mr Buffett proceeded to caveat his comment but derivatives arent evil.; a security which derives its value from an underlying instrument/ contract is a remarkably handy apparatus. What once started off as a way for farmers who knew their yield but were unable to predict the future grain market prices and created a via media for that, a derivative is an instrument with huge financial potential, even today. The Nobel Prize for transforming our investment exchanges (ironically both positively and negatively) goes to the derivative. The benefits of an alternate trading platform cannot be overemphasized. Besides, derivatives are not just restricted to the credit ones. Imagine a world without interestrate swaps, futures or options. We would be stepping back a few decades in financial time if we castigated this happy little helper. Final settlement To balance the account, derivatives are useful and not bad. The lack of regulatory oversight and creative thinking led them to be misused. But the damage is done. The sheen associated with a derivative has been tarnished. Stakeholders now look at the Dword with disdain. And yes, only a fool would massively market a derivative product in these gloomy times.

But, derivatives are not dead, nor will they die out. They are just too useful to be locked up. Moreover, we human beings have very poor memories. The same tools used to defraud companies or create bubbles find their way in newer and costlier financial scams or crises. The return of the derivative in all its splendor is not far off probably 45 years. Till then, the attention will be shifted to another scapegoat which will grow into a bubble I smell a rat in the global emission trading instruments doing the rounds.