Academic journal article Global Journal of Business Research

Do You Know Where Your Derivatives Are?

Academic journal article Global Journal of Business Research

Do You Know Where Your Derivatives Are?

Article excerpt

ABSTRACT

This paper is designed to assist individuals and organizations in understanding the role and risks of derivatives in two specific areas - debt management and investing. The various risks associated with derivatives are discussed in this article. Similar to collateralized debt obligations (CDOs) and CDOs squared, derivatives also have the potential to be the next financial engineering bubble to burst. The SEC is concerned that investors do not understand the risks with more complex ETFs and abbreviated disclosures. Institutions, including Harvard University, have already lost millions on interest rate swaps. Individuals and organizations should take the time to educate themselves as to the serious potential risks involved with these instruments.

JEL: G01, CR11, G15, G24

KEYWORDS: Derivatives, Exchange-traded Funds, Leveraged, Futures Contracts, Counterparty Risk, Tracking Errors, Lack of Transparency, Swaps, Counter Party Risk

INTRODUCTION

The 2,315-page Dodd-Frank Wall Street Reform and Consumer Protection Act has been hailed as the solution for preventing future financial meltdowns such as those currently experienced in this economy. Investors should not be lulled into complacency though. This legislation creates a division within the Federal Reserve designed to protect consumers. However, while its goal is to increase the transparency of complex financial products including the oversight of swaps and other derivatives, it is certainly not a substitute for individual and organizational prudence and due diligence. Furthermore, many of the changes in this bill are not expected to be fully enacted until 2015. Boards of directors, management, CPA firms, elected officials and even financial advisors should view this legislation as a tool to eventually help protect their respective organizations and not insurance against future problems.

Derivatives have the potential for huge losses due to their complexity and lack of transparency. Investors and their financial advisors who invest in financial products such as mutual or exchange traded funds (ETFs) that utilize derivatives should view the Dodd-Frank Act only as eventually providing them with better tools to protect themselves and their clients but not insurance against future problems. Warren Buffet is noted for stating that individuals should invest only in what they understand. Hence, it is imperative that individuals and organizations understand the role of derivatives in debt management and investing. Otherwise, they may be in for some startling surprises. Harvard University learned this lesson the hard way in 2009 when they paid $497.6 million to investment banks in order to terminate an interest rate swap on $1. 1 billion of debt resulting in nearly a 50 percent penalty. They also agreed to pay another $425 million over the next 30 to 40 years to offset $764 million more in swaps. The literature is typically broken down into three areas with regard to derivatives. There are numerous articles discussing Harvard's loss from swap agreements, various Securities and Exchange Documents pertaining to their increasing concern with regard to the transparency of derivative products and the potential resulting risks to investors, and the third group of articles pertains to losses or potential losses from inverse and leveraged ETFs.

This article examines and discusses both sides (debt and investment) of the derivatives issue and strives to educate potential investors. The role and risks of derivatives in debt management will be discussed below followed by the role and risks of derivatives in investments. The concerns of this author is that we have a serious potential to see a domino meltdown pertaining to interest rate swaps, and that the risks involved with leveraged and inverse ETFs are still not understood by all financial advisors even given various articles that have been written on this subject in recent months. The notional value of derivative swaps are currently disclosed in the prospectus. …

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