Internacional Financing, Getafe, May 27th 2013
Name:
NIU:
TEXT (from W. Buffet)
I view derivatives as time bombs, both for the parties that deal in them and the economic
system. Basically these instruments call for money to change hands at some future date, with
the amount to be determined by one or more reference items, such as interest rates, stock
prices, or currency values. Unless derivatives contracts are collateralized or guaranteed, their
ultimate value also depends on the creditworthiness of the counter-parties to them. But
before a contract is settled, the counter-parties record profits and losses – often huge in
amount – in their current earnings statements without so much as a penny changing hands.
Reported earnings on derivatives are often wildly overstated.
The errors usually reflect the human tendency to take an optimistic view of one’s
commitments. But the parties to derivatives also have enormous incentives to cheat in
accounting for them. As a general rule, contracts involving multiple reference items and
distant settlement dates increase the opportunities for counter-parties to use fanciful
assumptions. The two parties to the contract might well use differing models allowing both to
show substantial profits for many years. In extreme cases, mark-to-model degenerates into
what I would call mark-to-myth.
Questions about the text (5/10):
- Main problems of derivatives according to Buffet. Do you agree with him?
- Why both part of a trade in derivative might show profits? what optimism and myth have
to do with derivatives?
EXERCISE (5/10):
Verify if there is a possible trianguar arbitrage:
-Selling GBPUSD
- Buying AUDCAD