Derivative Securities
Derivatives
(Black Tuesday)
Derivative Securities
Derivative Securities
It is difficult to understand or explain why throughout history some negative investor philosophies continually repeat themselves. Far too often investors miss blatant signs that lead to major collapses in the free markets. The purpose of this report is to discuss derivative securities in detail and how they affect those investor philosophies. Even unsophisticated investors understand that the stock and commodities markets are supposed to fluctuate on a daily basis. A key in the minds of investors is to avoid overly large swings in either direction and to also take advantage of those market swings that are heading in the right direction. To solve this ageless dilemma, investment bankers and individual investors themselves have historically created new and unique systems, methods and processes that help avoid those big swings. But what happens when the new and unique systems, methods and processes actually become the problem. Over the last few decades for example, even with foolproof protection systems in place, investors have missed big swings in the wrong direction far too often. Consider Black Tuesday in the 80's, the dot com bubble bursting in the 90's, and the likes of companies such as Citigroup, Washington Mutual, AIG, the X Leman Brothers and all of the others currently suffering through a world economic crisis that has been compared to the Great Depression and mainly caused by speculation in mortgage backed securities. This report may be too late to provide some lessons learned for the current crisis, but there is always the next big bust. The aim of this work therefore is to describe futures and options and how they can be used in both investment speculative trading and hedging. The focus will also be on details of derivatives methodology such as the Black-Scholes option pricing model, puts and calls and concepts such as Delta, Gamma, and Vega as they pertain to investing.
What are the first real signs of trouble and how could a CEO of a smalltime and not so famous Irish football team be a great place to start a paper on derivative securities? The answer lies in how potentially dangerous derivatives can be when they are in the hands of the wrong trader. Nicholas 'Nick' Leeson, that CEO just mentioned, in 1995 was the lead derivatives broker for the now collapsed Barings Investment Bank. Even though he never actually received any formal professional broker training, he almost single-handedly brought down Barings through speculative derivatives trading on the Singapore International Monetary Exchange (SIMEX). "Working the floor of the Singapore International Money Exchange, Leeson quickly realizes he's completely out of his depth but can't admit it, so he hides his losses and continues to gamble until the deficit adds up to a $1 billion." (Rogue Trader) Prior to Leeson's handiwork, Barings was the oldest investment bank in England, founded in 1762, which made it older than the United States. One would have to seriously take into consideration that Napoleon, the Great Depression, WWI and II all could not bring Barings down.
Apparently, companies felt that they had nothing to learn from the Barings and Leeson experience. Speculative buying and selling by the likes of companies like AIG and Citigroup are now more famous for their holdings of toxic assets than they are for the positive aspects of their businesses. AIG for example actually has a few very successful subsidiaries. Although the underlying principles are similar to Leeson's derivatives, today's problems regarding the toxic assets are slightly different. Toxic assets, named so because of their affect on the current financial crisis, are issues that were mortgage-backed securities, collateralized debt obligations and credit default swaps. All of these have become illiquid because of the fact that their secondary markets have dried up. In other words, there used to be markets that would buy and sell these items but because the original underlying securities and loans have become worthless, the markets simply disappeared. As all of the former Leman Brother's employees are fully aware, without immediate governmental assistance, many of the other companies holding those toxic assets would have also followed in the wake of Barings.
The companies that bought toxic assets were using those tools to either hedge or speculate. Speculation means that a business or individual investor buys or sells an asset with the intent of that asset making a profit for the investor based on...
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