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Excerpted and abstracted with permission of The Yale law Company and Fred B. Rothman & Company. The underlying work originally appeared in The Yale law Journal, Volume 102, Number 6, April 1993, pp. 1457-1513. Copyright |C~ 1993 by The Yale Law Journal Co., Inc., Yale Law School, 401A Yale Station, New Haven, CT 06520.

New financial products are being introduced throughout the industrialized world at an unprecedented rate. Innovation has been especially striking in the market for over-the-counter (OTC) derivatives. Moreover, the OTC derivatives market has enjoyed enormous growth in volume. On a crude, "notional amount" basis the market for selected OTC derivatives reached four trillion dollars by year-end 1991, eight times its level five years before. Such activities are concentrated in those large, money center financial institutions central to the world's financial system. The size of these markets and the prominence of the market players mean that the stakes in the derivatives game are high. Moreover, because they are novel, complex, and opaque, derivatives activities look risky.

Thus, it is not surprising that regulatory concern over OTC derivatives activity has grown along with the OTC derivatives market. Some industry leaders and regulators worry that OTC derivatives could cause the next great banking crisis.

Analysis of regulatory concerns leads to a striking puzzle and a corresponding dilemma. Many regulators -- as well as some bankers -- believe that, too often, bankers know too little about the risks of their derivatives pose to the banks themselves. This poses the puzzle: how could banks suffer from such systematic informational failures? Banks have put many of their best and brightest to work on these new financial products. How could such knowledgeable sellers, as opposed to investors or consumers, not have adequate information?

Although there is neither consensus nor conclusive evidence regarding the existence of such structural informational failure on the part of banks, there is no such disagreement regarding regulatory informational failure. Observers agree that regulators know less than the bankers and that they know too little. If the puzzle is why banks know so little, then the dilemma is how can regulators, who know even less, be effective. How can the blind guide the nearsighted?

Hu offers a partial explanation of the puzzle. The basic analytic framework begins with the premise that information is a commodity created from a production process built upon the new financial science that has emerged in the past two decades. Using this framework, banker informational failure is analyzed from several different perspectives.

From an economics standpoint, "inappropriability" and other theories drawn from the economics of industrial R & D can illuminate allocative problems associated with financial R & D. Under certain circumstances, inappropriability can contribute to aggregate informational failure even if individual banks may, in the aggregate, be spending enormous (and individually rational) amounts on developing bank-specific risk information.

From a psychological standpoint, cognitive biases might explain underproduction of information relevant to certain kinds of risks, especially legal ones. "Threshold effects," "availability effects," and "expert effects" may lead bankers to underestimate the privately optimal amount of investment in bank-specific risk information.

From the principal-agency perspective, the same theories that would normally imply excessive managerial aversion to risk-taking and underinvestment could, when applied to the OTC derivatives context, lead to excessive risk-taking and overinvestment. For example, many of the material risk exposures on certain derivatives occur years after the execution of the transaction; since employee turnover in the derivatives industry is high, the "negatives" may arise long after the rocket scientist is gone. So, an employee's short term focus may have the counter-intuitive result of the entity making too many, rather than too few, long-term investments.

Hu also sketches possible pathways to resolving the dilemma in the hope that they would serve as springboards for more extended analysis by regulators, market participants, and academics. Financial science differs from traditional science in ways that are highly relevant to the resolution of this dilemma. Because financial science violates traditional scientific norms of "openness" and "universalism," original government research probably can only play a limited role. These differences also provide fresh reasons for why information flows unevenly to regulators, and they highlight the concomitant importance of institutionalizing the transfer of financial technology from the private sector to the government.

In light of the foregoing, Hu argues for consideration of a number of incrementalist pathways, "incrementalist" in the sense that they involve gradual, reversible change. These include: (1) an institutionalized risk assessment mechanism involving centralized reporting by banks and certain other market participants about their products, exposures, and theories; (2) user fees that could provide regulators with the requisite resources and political cover needed to utilize private third party expertise; (3) encouragement of collective action through such mechanisms as trade associations; and (4) the mandatory (but confidential) disclosure to regulators of the incentive structures of derivatives personnel.

Everyone stands in the shadow of OTC derivatives activities. Large, growing, and complex, they appear menacing in the dark. Some observers who fear that neither bankers nor regulators understand the risks are tempted to halt these activities altogether. To do so would be Procrustean, unnecessary, and destructive of social wealth. An understanding of the puzzle and the dilemma should discourage regulatory adventurism. We should take comfort that the informational failures are explicable, and we should lay plays to slowly -- incrementally -- begin turning on the lights.

The Daffier Side of Derivatives

Copyright Institutional Investor, abstracted with permission. This article originally appeared in the February 1993 issue, pp. 94-98.

The spirit of innovation is running high in today's financial markets; whether that is good or not depends on which new products are under investigation. With the introduction of each new derivative seeming wackier than the next, investors are stuck trying to determine which investment is best for them. Author Ida Picker explains some of these new investment tools and offers her thoughts on their value to investors.

Pushing Volatility

This past January, the Chicago Board Options Exchange announced that it would soon introduce options based on a new index that tracks volatility. This announcement is good news for traders and investors who like to gamble on their hunches; however, this new instrument has its drawback in that it is disconcertingly abstract. Regardless, if you seek to limit volatility, the developers insist that volatility futures are more efficient than a put-call straddle.

Coping With Catastrophe

Catastrophe futures made their debut this past December. "The impetus for catastrophe futures for insurance companies arose from the squeeze on reinsurance, particularly after Hurricane Andrew. The Chicago Board of Trade devised several geographic futures and options known as national catastrophe and eastern catastrophe contracts. The intended buyers: insurers for homeowners, commercial business owners, farmers and commercial inland marine companies that need coverage for wind, hail, riot, earthquake and floods. The putative sellers: mainly speculators."

In theory, according to Bruce Thomas, Travelers Insurance Co.'s Director of Corporate Strategy and Research, catastrophe futures allow for efficient price discovery and risk transfer. Regardless, these contracts have not faired so well in the market. Some fundamental problems exist with these futures:

1) From an insurer's perspective, the insurer may be playing a speculative game if the symmetry between the risk specific to one's own portfolio is poorly correlated with the risk that ultimately exists from the underlying pool of risk on which the contract is based.

2) From an accounting perspective, regulatory bodies have not agreed to whether these futures are hedges or speculative investments. If the latter holds true, then insurers would have to put up capital, defeating the futures purpose.

3) From a seller's perspective, well, they have yet to materialize.

Auctioning Pollution

Pollution-rights swaps began trading last March on the CBOT's electronic system. "The Environmental Protection Agency has authorized the exchange to administer auctions in which companies and utilities buy and sell emission allowances for sulfur dioxide, a prime cause of acid rain." In short, companies can either "clean-up their act" or buy the right to pollute.

Barging in on Clients

The barge freight-rate index serves grain firms and barge companies reliant on the inland waterway formed by the Mississippi, Illinois and Ohio Rivers. "The index covers the cost of shipping one barge of grain anywhere on the system, with prices weighted according to the time of year." What makes this index a success is the natural market of buyers and sellers.

"Bankers Trust Co.'s brain trust has devised a strategy for hedging paper pulp prices that involves swapping fixed-rate pulp for a floating-rate pulp index published by a trade paper." What makes this derivative interesting is that it is a strategic derivative. More important than the money generated from the trades is the chance to establish business relationships and generate financial work.

Hedge of Hedges

"One of the more intriguing strategic derivatives is the net revenue hedge, a kind of hedge of hedges. It's an option that functions like a portfolio of hedges against a company's collective risk in multiple areas, such as commodities, interest rates and foreign exchange."

Richard Timbrell, Vice President of J.P. Morgan & Co. notes "that from a shareholder perspective, a 'net revenue hedge is much less costly and more efficient' than individual options, since it can be custom-designed and avoids 'overhedging.' The hitch for the client is that a custom-designed net revenue hedge will provide a lower payoff than individual option positions under certain market conditions."

Protecting Strategic Stake

"Costless collars, a technique born in the interest rate markets a decade ago, can now be used by companies wanting to hedge equity stakes in other companies. A company buys a put option from Bankers struck at or close to the money, and to pay for it sells a call struck out of the money."

Beyond Brady Bonds

For the less adventurous, options on Brady bonds are available for Argentina, Mexico and Brazil. However, if you want to "take a walk on the wild side", the J.P. Morgan Emerging Markets Bond Index "tracks the market for dollar denominated floating and fixed-rate sovereign restructured bonds of several countries and several sorts: Brazil Exits and Brazil New Money; Mexico Aztecs, Mexico discounts and Mexico Pars; Nigeria Pars; Venezuela DCBs (debt-conversion bonds); Philippine New Money Bonds and more. The bank says the index, embodying the 'most- liquid' of the Brady bonds, returned 53 percent over the nineteen month period ending 31." It is important to note, however, that big returns also mean big risks.

Health Insurance Derivatives: The Newest Application of Modern Financial Risk Management

Abstracted with permission from Business Economics. This article originally appeared in the April 1993 issue, pp. 36-40.

Today's business and financial markets, are experiencing tremendous change and growth, especially in the area of derivatives. The volume of exchange-traded financial derivatives doubled between the period of 1985-1990 and that growth continues today. Coupled with America's concern over health care costs, "a natural market exists for still another significant derivative product to manage the risk of changes in health care costs." Authors James Hayes, Joseph Cole and David Meiselman discuss the derivatives revolution, highlights the development of health insurance futures, and provides a hypothetical hedging example for a health insurer.

Derivatives Overview

The derivatives market has experienced dramatic growth primarily because it is a better and less expensive means of managing risk and designing useful, innovative products. The growth of the derivatives market can be viewed in three phases. In phase one, as the number and use of derivative instruments and markets increased, the options market was developing simultaneously. In phase two, market players began to understand and learn how to manage and control risk. Phase three, the new phase, marks the movement of cash through the clearing system, not the delivery of the underlying product. The result of the derivatives revolution is that risk is allocated more efficiently, "with resulting overall wealth and income gains that more than compensate for added transactions costs."

Health Insurance Futures Contacts

"The Chicago Board of Trade (CBOT) began trading catastrophic insurance futures and options contracts on December 11, 1992. It also plans to list homeowners and health insurance futures and options contracts in the first half of 1993. The introduction of trading on insurance futures and options at the CBOT offers insurers, reinsurers, and, in the case of health insurance, health care providers and hospital managers, low-cost hedging alternatives. Additionally, these new instruments provide opportunities for the development of new products."

How Health Insurance Futures Work

"The main purpose of hedging with the proposed health insurance futures is the management of the risk in changes in claims cost arising from unexpected volatility in the trend of these costs." The futures price is affected by claims--if claims go unexpectedly up, the futures price rises and vice versa. Given this relationship, insurers are natural buyers and providers of health care are natural sellers. It is important to note that insurance futures do not provide insurance coverage, thus it is not an alternative form of insurance. The CBOT health insurance futures contract differs in many ways from insurance policy coverage. In summary, "the health insurance futures contract--a standardized contract, traded on an organized and regulated market with superior creditworthiness--will permit insurers and reinsurers to hedge the systematic risk component of their insurance liabilities as related to the underlying index of health insurance policies."

Will health insurance futures contracts be successful? To answer this question, the authors outline six necessary conditions for a successful futures contract: price variability, competitive determination of prices, homogeneity, viable cash market, insufficient hedging alternatives, and contract design. Given today's environment, the most important conditions for the successful introduction of the health insurance futures contract is price variability and insufficient hedging alternatives.

"The objective of the contract design of the CBOT health insurance futures contract is to create an index that reflects value for the industry. The underlying index of health insurance losses for the futures contract will be based on a large sample of reported incurred losses for a pool of health insurance policies. The pool will be balanced in terms of group size, demographics, and cost area." The CBOT plans to form two pools of acceptable small group health insurance pools per year with four contracts per pool.

"The health insurance futures index may be calculated by standardizing the paid claims in the pool by dividing the claims by the pool premium. The resulting loss ratio for the industry pool is then multiplied by the contract size." Hayes, Cole and Meiselman perform a hypothetical hedging example for a health insurer, providing a better understanding of the contracts workings.
COPYRIGHT 1993 Financial Management Association
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Financial Management Collection
Author:Hu, Henry T.C.; Lunt, Melissa
Publication:Financial Management
Date:Sep 22, 1993
Previous Article:Corporate finance.
Next Article:Institutions.

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