Derivatives: Futures, Options and Swaps, 

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Part I: Futures

As we mentioned in chapter 3, financial instruments and markets play an important role in the transfer of risk. How is this accomplished? Among the tools available are derivative securities that derive their value from other securities traded in financial markets. Fluctuating interest rates cause the value of these securities to fluctuate, so buying or selling derivative securities can help banks control fluctuations in the value of their assets and the costs of their liabilities. The derivatives market grew rapidly in the 1970s as increased volatility in interest rates and foreign exchange rates increased the demand for risk-management tools.
Futures Contracts
Simply put, a futures contract is a contract for a trade to take place in the future. Two counterparties enter into this contract and promise to buy/sell an asset at a specified price on a specified date.

• The asset to be traded is called the underlying.
• The date for the trade is the settlement date or maturity date
• The price to be paid/received for the asset is the futures price.
• The buyer or long position in the futures contract has the obligation to buy the underlying at the futures price on the settlement date.
• The seller or short position in the futures contract has the obligation to sell the underlying at the futures price on the settlement date.

The market for futures contracts originated in the 1800s as a way for farmers to lock in prices for agricultural commodities, like soybeans or beef. There is still a huge commodities futures market with contracts trading on exchanges in Chicago and New York. In the 1970s futures contracts began to trade where the underlying was a financial asset instead of a commodities.
The futures markets trade contracts for future trades, while immediate trades occur in the spot or cash market (at the spot price or the cash price). As the price of the underlying changes in the spot market, this affects the value of the futures contract, since the price of the underlying is already locked in. Therefore, firms concerned about price fluctuations of certain commodities or financial assets can lock in prices in the futures market and thus control that risk.

Example 1
Suppose Southwest Airlines is concerned about fluctuations in jet fuel prices. So in this case, rising jet fuel prices would be bad for Southwest, cutting into their profits. Falling jet fuel prices would be good, but the real problem here is the uncertainty created by fuel prices that fluctuate up and down. So Southwest could control this risk (known as hedging) by taking a long position on jet fuel future contracts. This makes them the buyer of jet fuel on a future date, at the futures price. Southwest has locked in a price for fuel. As the contract proceeds to the settlement date, fluctuations in the cash price of fuel affect the value of the futures contract. Suppose the futures price is $3 per gallon.

• If the price of jet fuel rises in the spot market to, say $3.20 per gallon, Southwest's long position has just gotten more valuable, since they will buy fuel for $3 per gallon. When the spot price of the underlying rises, the buyer of a futures contract gains, while the seller loses.
• If the price of jet fuel falls in the spot market to, say $2.85 per gallon, Southwest's long position has just gotten less valuable, since they must buy fuel for $3 per gallon. When the spot price of the underlying rises, the buyer of a futures contract loses, while the seller gains.

Southwest pays $3 per gallon no matter what, so they can price airline tickets accordingly. In reality, Southwest is pretty good at hedging jet fuel prices in the futures markets, which is one reason why they are one of the most profitable airlines in the industry.

In the next example, we see how interest rate risk may be hedged using financial futures. The underlying is a short-term or long-term bond. Remember: bond prices rise when interest rates fall, and bond prices fall when interest rates rise.

Example 2
Suppose A1 Savings & Loan is concerned about its interest rate risk. Most of its assets are long-term mortgages, while most of its liabilities are savings and time deposits. If short-term interest rates rise, the costs of attracting these deposits will increase. However, the income from the mortgages on the books will not increase, since most of them have a fixed rate. So for an S&L rising short-term interest rates could mean lower profits. So A1 could hedge this risk by taking a short position on a Tbill contract. Suppose the futures price of the Tbill is $98 per $100 of face value.

• If short-term interest rates rise, the spot Tbill price will fall, say to $96. A1 still gets to sell their Tbill for $98 in the futures contract. This gain in their futures position helps offset the losses from the increased interest costs on their deposits.
• If short-term interest rates fall, the spot Tbill price will rise, say to $99. A1 still has to sell their Tbill for $98 in the futures contract. This loss in their futures position offsets the gains from the decreased interest costs on their deposits.

So the gain/loss in the futures market offsets any gain/loss in the cost of A1's liabilities. Note that in order to protect themselves against rising short-term interest rates they give up potential gains from falling short-term interest rates. But the purpose here is to minimize the impact of ANY fluctuation in short-term interest rates.

In general,

• Parties concerned about rising prices for the underlying will hedge their risk as buyers of futures contracts.
• Parties concerned about falling prices for the underlying will hedge their risk as sellers of futures contracts.

Note that in both of our examples, futures contracts are a zero sum game: One counterparty's gain is the other counterparty's loss. When spot prices change, there is a winner and a loser. This means there is always an incentive for one counterparty to try and back out or default on the contract no matter which way prices move.
There are two types of players in the futures markets:

• Hedgers are concerned about price fluctuations in the underlying due to their primary business (such as banks or airlines) to they are in the futures market in order to manage the risks faced in their primary business.
• Speculators are essentially sophisticated gamblers, betting on future price movements and trading futures contracts in order to make money. While hedgers trade futures contracts to manage risk, speculators take on risk when trading futures contracts. Speculators are essential for liquidity in the futures markets: Without them, there would not be enough buyers and sellers to make the markets work. Derivative securities are attractive to speculators because they have a great deal of leverage. With only a small initial outlay, speculators can take a futures position that has the same returns of buying 30 times the same amount of the underlying asset.

Financial Futures Market
Whether the underlying is a financial asset or agricultural commodity these contracts are traded on an exchange. The three largest in the United States are:
Chicago Mercantile Exchange (CME)
Chicago Board of Trade (CBT)
New York Futures Exchange (NYFE)
Futures trading and exchanges are regulated by the Commodities and Futures Trading Commission (CFTC). The CFTC monitors for fraud and price manipulation, and approves new contracts.
In order to deal with the trading of millions of buyers and sellers on all types of contracts, futures contracts are standardized with respect to the underlying, the futures price, and the settlement date. This means I cannot got to a futures exchange and try to create a customized contract for the date I want and the price I want. There is only a limited choice of dates, each date has a preset future price, and the amount of the underlying is fixed. It's like going to a restaurant. Your can only order what is on the menu, you cannot create your own meal.
For example, consider the Tbill future contracts that trade on the CME.

• The underlying is standardized to be Tbills with approximately 90 days to maturity (88-92 days is acceptable) and $1 million in face value. If you want to only trade $100,000 in Tbills, tough.
• There are four settlement dates available: the last business day of March, June, September, December. Each settlement date has its own futures price.
• As the spot price of Tbills fluctuate, the contracts may be sold and resold at prices that reflect the changing value of the Tbills.

This standardization enhances liquidity in a couple of ways. Since buyers and sellers must choose between only 4 or 5 Tbills contracts, this maximizes the number of buyers and sellers per contract so it will be easier to buy and sell. Also, buyers and sellers do not haggle over the terms of the contract--they are already set by the exchange.
A list of widely traded financial futures contracts is on table 1 (pages344-45) in your book.
In addition to enhancing the liquidity of the futures market, exchanges play a very important role in limiting default risk.
Recall that the nature of futures contracts creates an incentive to default since there is always a winner and loser as spot prices fluctuate. The futures exchange acts as a clearinghouse, so really when buyers and sellers enter into a contract, they each have a contract with the exchange, not with each other:

So buyers and sellers do not have to worry about default risk, because for each of them the other counterparty is the exchange. However, this does expose the exchange itself to a substantial amount of default risk as prices fluctuate. So the exchange takes several steps to limit its own exposure to default risk:

• Buyers or sellers of future contracts must put up an initial deposit, called a margin requirement. Sort of like the security deposit you give your landlord.
• Every trading day, futures contracts are marked to market. This means the change in the value of the contract (positive or negative) is credited or debited from the margin account. If the account falls too low (below the maintenance margin), the counterparty receives a margin call and must put up additional cash or the contract is canceled. This limits the losses of the exchange in case there is a default.

The global financial future markets are huge. On any given day the number of contracts outstanding (called the open interest) is in the millions.

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Part II: Options and Swaps

Options
Options contracts offer another alternative for hedging interest rate and stock market risk or for speculating on changing bond and stock prices. Option contracts are a bit more one-sided that futures contracts. They allow someone to protect against a bad price movement (like Southwest and rising jet fuel prices) without giving up all the benefits of a good price movement (like Southwest and falling jet fuel prices).
Options Contracts
First we need to examine how these contracts work, including the relevant terminology.
Options contracts have 2 counterparties: the buyer and the writer.

• The buyer of an option contract has the right to buy/sell the underlying at a set price (the exercise or strike price) with a certain period of time (the term to expiration).
• The writer of an option contract has the obligation to buy/sell the underlying at a set price (the exercise or strike price) with a certain period of time (the term to expiration) if the buyer exercises his/her rights.

So the buyer has rights, the writer has obligations. The buyer has the choice of not using the contract if it turns out not to be profitable. In return for getting this choice, the buyer pays the writer a premium. (So option contracts involve three different prices: the price of the underlying, the strike price, and the premium.)
American options can be exercised any time up to the expiration date.
European options can be exercised only on the expiration date.
Call options give the buyer the right to buy the underlying at the strike price (the writer has the obligation to sell).
Put options give the buyer the right to sell the underlying at the strike price (the writer has the obligation to buy).
The regulation of options is split between the Securities and Exchange Commission (SEC) and the CFTC. Regulators ensure that counterparties are able to cover their losses and again monitor for fraud and price manipulation. The most common options contracts are for share of stock in a specific company, but there are also contract
Contract Payoffs
Understanding contract payoffs is easiest in the context of an example:

Example 3
Microsoft stock option contract (100 shares)
Price (P) = $53 per share
Strike price (X) = $50
call premium (Qc) = $2.50 per share or $250 for the contract
put premium (Qp) = $1.25 per share or $125 for the contract
Suppose this option contract is about to expire. We want to ask ourselves: (1) will the options be exercised by the buyer at these prices? (2) what are the payoffs to the buyer/writer at these prices?
First, the call option. The buyer has the right to buy the stock for $50, and it is worth $53. Will the buyer exercise the right? YES! If the price of the underlying is greater than the strike price, the call option is in the money. This means it will be exercised.
The buyer's payoff is the difference between the strike price and the market value of the stock, minus what the buyer paid for the option:
($53 - $50 - $2.50)(100) = $50
The writer must sell the stock for less than it is worth, but received the call premium, so the writer payoff is:
($50 - $53 + $2.50)(100) = -$50.
Note that the buyer's and writer's payoffs sum to zero. THIS IS ALWAYS THE CASE FOR ANY OPTIONS CONTRACT.
Now the put option. The buyer has the right to SELL the stock for $50, but they can sell it elsewhere for $53. Will put buyer sell the stock. NO! If the price of the underlying is greater than the strike price, the put option isout of the money. This means it will NOT be exercised and will be allowed to expire unused.
The buyer does not exercise the option, so the buyer is just out the put premium of $125.
The writer received the put premium of $125, but does not have to do anything since the option is not used.
Note that the buyer of a put or call option cannot lose more than the option premium. The buyer's losses are limited, the writer's losses are potentially huge.

It is the price, P, and strike price, X, that determined if an option is in or out of the money. However, an in the money option does not guarantee a positive payoff. Consider the next example:

Example 4
Consider again the Microsoft stock option contract. Now suppose P = $51.
P > X. The call option is still in the money. The buyer payoff is
($51 - $50 - $2.5)(100) = - $150.
The buyer payoff is negative. Why did she exercise? Well, if she didn't, she would have lost the entire call premium of $250. So losing $150 is better than losing $250.
P and X alone determine whether an option is in the money or out of the money.

Check yourself: Go through this example again by yourself where P = $48. Check yourself here.
The table below summarizes the payoffs for the buyers and writers of put and call options:

				call option						put option
P > X				in the money buyer payoff = P - X - Qc writer payoff = X - P + Qc						out of the money buyer payoff = -Qp writer payoff = +Qp
P < X				out of the money buyer payoff = -Qc writer payoff = +Qc						in the money buyer payoff = X - P - Qp writer payoff = P - X + Qp

Option Pricing
There are several factors that affect the size of the option premium. In general

• anything that makes an option more likely to be in the money will increase the premium;
• anything that makes an option less likely to be in the money will decrease the premium.

There are several factors that affect this likelihood.

• The price of the underlying. The higher the price of the underlying, ceteris paribus, the more likely that P>X, so the call option is more likely to be in the money, the put, out of the money. So as P rises, Qc rises and Qp falls, ceteris paribus.
• The strike price. The higher the strike price of the option, ceteris paribus, the more likely that P< X, so the call option is less likely to be in the money, the put, in the money. So as X rises, Qc falls and Qp rises, ceteris paribus.
• The term to expiration. The greater the time until expiration, ceteris paribus, the larger the likely fluctuations in P. So the possibility of large gains with put or call options is there. So a longer time to expiration mean higher Qc and Qp, ceteris paribus.
• The volatility of the price of the underlying. Again, the greater the volatility of P, ceteris paribus, the larger the likely fluctuations in P. So the possibility of large gains with put or call options is there. So the greater the volatility of P, the higher both Qc and Qp, ceteris paribus.

Using Options to Manage Risk
Looking at the examples above, it is not hard to see how options may be used to manage risk. By buying an option, the buyer essentially purchases insurance that guarantee a maximum price for buying an asset (in the case of a call option). Or a minimum price for selling an asset (in the case of a put option). One such example is a married put. In this case the other of, say, Microsoft stock also buys a put option for that stock. If the stock price falls, the put options helps offset the losses.
Options Trading
Options trade on the CME, CBT, and the NYSE. The regulation of options is split between the Securities and Exchange Commission (SEC) and the CFTC. Regulators ensure that counterparties are able to cover their losses and again monitor for fraud and price manipulation. The most common options contracts are for shares of stock in a specific company, but there are also contracts for stock indices, financial futures, Tbills and Tbonds, and foreign currency.
Options contracts are also standardized with respect to the underlying, expirations dates, and strike prices. They expire the third Friday of March, June, September, December in what is known as "triple witching day."On this day financial markets are characterized by heavy volume and price volatility as stock index futures, stock index options, and stock options all expire.
Interest Rate Swaps
While the standardization of futures and options contracts make trading easy and limit exposure to default risk, the downside to standardization is that it "one size fits all." In other words, banks cannot custom tailor those contracts to match their specific risk exposure. Its like the restaurant menu, where they have chicken marsala and veal piccata, but you really want chicken piccata.
Swap contracts are custom-tailored arrangements between financial institutional. Each party of the swap contract trades one set of payments they receive for a set of payments the other party receives. Swaps can be incredibly complicated, but we will focus on a basic interest rate swap (known as the plain vanilla swap).
The interest rate swap specifies the interest rate each party will exchange (typically one interest rate is fixed and one is variable, or both are variable), the notional principal that determines the size of the payment, the time period over which payments will be swapped. The principal never gets exchanged, only the interest payments.

Example 5
A1 Savings and Loan & Ed's Finance Co. agree to a swap with
--$1 million notional principal
--annual payments over 10 years
--A1 will pay Ed's Finance 6%
--Ed's Finance will pay A1 6-mo. Tbill rate + 1%
So A1 is paying a fixed rate and Ed's Finance is paying a variable rate.
Suppose at the end of the first year the Tbill rate is 4.5%:
A1 owes Ed's Finance (.06)($1 million) = $60,000
Ed's Finance owes A1 (.045 + .01)($1 million) = $55,000, so A1 pays Ed's Finance the $5,000 difference.
Suppose at the end of year 2 the Tbill rate is 6%:
A1 owes Ed's Finance (.06)($1 million) = $60,000
Ed's Finance owes A1 (.06 + .01)($1 million) = $70,000, so Ed's Finance pays A1 the $10,000 difference.

What's the point? Well, recall that A1, as an S&L, has many rate-sensitive liabilities (deposits) but few rate-sensitive liabilities (mostly fixed-rate mortgages). By receiving the variable rate payments from Ed's Finance company, A1 gains from rising short-term interest rates in their swap position to offset losses in their traditional activities. What's in it for Ed's Finance Co.? They may have more rate-sensitive assets than liabilities, or they may simply be speculating that interest rates will fall. By using a swap, A1 can hedge its interest rate risk and tailor the assets to its exact needs.
There are two big disadvantages to swaps. First, there is substantial default risk. There is no exchange to guarantee this transaction. If Ed's Finance Co. goes bankrupt, A1 is left without any protection against rising short-term interest rates. Second, because the swaps are custom-tailored for A1 and Ed, the swap is not liquid. If A1 wanted to get of the contract during the next ten years, it might be impossible to find a buyer. Also, A1 and Ed may have difficulty finding each other in the first place.
High profile losses from derivatives trading, including the Orange County bankruptcy in 1994 and the bailout of Long-Term Capital Management in 1999 (see the link below), have caused some to be concerned about whether derivatives are safe enough assets. However, the truth is the derivative use allows many financial institutions to reduce their risks and regulator guidelines supervise and limit trading activities.

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financial derivatives crisis 2008

Fast forward to the financial meltdown of 2008 and what do we see? America again was celebrating. The economy was booming. Everyone seemed to be getting wealthier, even though the warning signs were everywhere: too much borrowing, foolish investments, greedy banks, regulators asleep at the wheel, politicians eager to promote home-ownership for those who couldn’t afford it, and distinguished analysts openly predicting this could only end badly. And then, when Lehman Bros fell, the financial system froze and world economy almost collapsed. Why?

The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.

Since then, massive efforts have been made to clean up the banks, and put in place regulations aimed at restoring trust and confidence in the financial system. But the result in terms of dealing with the basic problem, according to a terrific article by Frank Partnoy and Jesse Eisinger in The Atlantic entitled “What’s Inside America’s Banks?” is failure.

Another global financial crisis is on the way

Financial reform didn’t work. Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.

Ignoring warning signs has inevitable consequences. We ignored them before and we saw what happened. We can say this with virtual certainty: if we continue as now and ignore them again, the great white shark of a global financial meltdown will gobble up the meager economic recovery and make 2008 look like a hiccup.

We can’t say when this will happen. We can’t say which bank or which particular instrument will trigger the debacle. What we can say with virtual certainty is that if we continue as now is that it will happen. Because the scale of the trading is larger, and because the depleted government treasures are not well placed for another huge bailout, the impact will be worse than 2008.

Today’s financial scandals are mere sideshows

Thus the biggest risk we face is not the stories of repeated wrongdoing by the banks that are still making headlines, such as:

• Trading gone awry: JPMorgan’s [JPM] loss of $6 billion from trading activities of which CEO Jamie Dimon was blissfully unaware.
• Price fixing at LIBOR. “Many of the biggest banks now stand accused of manipulating the world’s most popular benchmark interest rate, the London Interbank Offered Rate (LIBOR).
• Foreclosure abuses. Just this week, big banks agreed two settlementstotaling $20.15 billion for foreclosure abuses.
• Money laundering: Accusations of illegal, clandestine bank activities are also proliferating. Large global banks have been accused by U.S. government officials of helping Mexican drug dealers launder money (HSBC), and of funneling cash to Iran (Standard Chartered).
• Tax evasion: Two Swiss banks were involved in Switzerland-based. In 2009, UBS [UBS] helped 20,000 U.S. taxpayers with assets of about $20 billion hide their identities from the IRS. Now, the oldest Swiss bank, Wegelin & Co. has been indicted on criminal charges for helping U.S. taxpayers avoid taxes on at least $1.2 billion for a nearly ten years.
• Misleading clients with worthless securities: Only after the financial crisis of 2008 did people learn that banks routinely misled clients, sold them securities known to be garbage, and even, in some cases, secretly bet against them to profit from their ignorance.

The world’s scariest story: trading in derivatives

Bad as these scandals are and vast as the money involved in them is by any normal standard, they are mere blips on the screen, compared to the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy. Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.

Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny Walsh in The Paper Boat.

“The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour.  Its size and potential influence are difficult just to comprehend, let alone assess.”

The bulk of this derivative trading is conducted by the big banks. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount.” Wells Fargo for instance says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments” and “many of its derivatives offset each other”.

However as we learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.

Banks don’t tell investors how much of the “notional amount” that they could lose in a worst-case scenario, nor are they required to. Even a savvy investor who reads the footnotes can only guess at what a bank’s potential risk exposure from the complicated interactions of derivatives might be. And when experts can’t assess risk, and large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown.

In 2008, governments had enough resources to avert total calamity. Today’s cash-strapped governments are in no position to cope with another massive bailout.

Wells Fargo: is this good bank “extremely safe”?

The article in The Atlantic clarifies what’s going on by exploring what’s going on inside what is arguably the safest and most conservative bank: Wells Fargo [WFC].

Last year, I had written an article about the case for considering Wells Fargo as a “a good bank”.

Wells does what banks are supposed to do: take deposits  and then lend the money back out. Interest margin drives half its revenues. Fees from mortgages, investment accounts and credit cards generate the other half. ‘I couldn’t care less about league tables,’ says Wells CEO Stumpf. ‘I’m more interested in kitchen tables and conference room tables.’ By operating a bank like a bank, the article says, Stumpf has at once made Wells exceedingly profitable—for 2011 the bank’s net income jumped 28% to $15.9 billion, on $81 billion in revenue—and extremely safe. The value of Wells Fargo’s shares is now the highest of any U.S. bank: $173 billion as of early December 2012.

Wells Fargo: large scale trading in derivatives

But among the startling disclosures in the article in The Atlantic from examining the footnotes in its most recent annual report are:

• The sheer volume of proprietary trading at Wells Fargo suggests that this bank is not what it seems.
• A large part of that trading is not in safe conservative things like equities or bonds but in derivatives—the things that almost blew up the economy in 2008.
• These derivatives are hidden under seemingly the benign headings.
• The scale of this trading is breath-taking.
• The benignly labeled activity “customer accommodations” has derivatives on its books with notional risk of $2 trillion. That number, assuming it is accurate, can make any particular trading loss appear minuscule.

A lower circle of financial hell: “special purpose entities” redux

Ever heard of “variable interest entities” aka VIEs? If not, you are not alone. They are phenomena that reside in what The Atlantic calls “an even lower circle of financial hell” than proprietary trading. They are basically a new label for “special-purpose entities” i.e. the infamous accounting devices that Enron employed to hide its debts. These deals were called ‘off-balance-sheet’ transactions, because they did not appear on Enron’s balance sheet.

The article likens variable interest entities to “a horror film, which the special-purpose entity has been reanimated… The problem is especially worrisome at banks: every major bank has substantial positions in VIEs.”

As of the end of 2011, Wells Fargo, the “extremely safe bank”, reported “significant continuing involvement” with variable-interest entities that had total assets of about $1.5 trillion. The ‘maximum exposure to loss’ that it reports is much smaller, but still substantial: just over $60 billion, more than 40 percent of its capital reserves. The bank says the likelihood of such a loss is ‘extremely remote.’ As The Atlantic comments: “We can hope.”

Worse: “Wells Fargo… excludes some VIEs from consideration, for many of the same reasons Enron excluded its special-purpose entities: the bank says that its continuing involvement is not significant, that its investment is temporary or small, or that it did not design or operate these deals. (Wells Fargo isn’t alone; other major banks also follow this Enron-like approach to disclosure.)… The presence of VIEs on Wells Fargo’s balance sheet ‘is a signal that there is $1.5 trillion of exposure to complete unknowns.’”

Other banks are even riskier

Thus it turns out that Wells Fargo isn’t so much an “extremely safe” bank in absolute terms but rather a bank that isn’t doing as much risky stuff as the other big banks. “One reason Wells Fargo is trusted more than other big banks is that its notional amount of derivatives is comparatively small… It’s just somewhat less involved in derivatives than other banks.” The amount of its ‘notional involvement’ in proprietary trading in derivatives amounts to “only” about half the size of the entire US economy.

By contrast, at the end of the third quarter of 2012, JPMorgan had$72 trillion in notional amount on its books—almost five times the size of the U.S. economy, or about the size of the entire world economy.

But even at the lower levels of trading by Wells Fargo, the numbers are so large that they put Wells Fargo’s seemingly immense capital reserves—$148 billion—as a mere drop in an ocean of potential losses.

Wells Fargo declined to answer questions from the journalists from The Atlantic. Their response to requests for clarification was to suggest re-reading the unhelpful sections of the annual report. They also declined to answer: “How much money would Wells Fargo lose from these trades under various scenarios?”

Ironically, Jamie Dimon has been proven right when he made light of the $6 billion trading loss at JPMorgan last year. Compared to the scale of these potential losses, and the financial crisis that lies ahead, a loss of $6 billion is merely a “tempest in a teacup.”

How does Wells Fargo make money?

The Atlantic also finds worrying issues in how Wells Fargo does make money. Scouring through Wells Fargo’s annual report, seemingly safe conservative categories turn out to involve proprietary trading:

• Almost $1.5 billion of the seemingly safe “interest income” comes from “trading assets”;
• Another $9.1 billion results from “securities available for sale.”
• One billion dollars of the bank’s seemingly safe “non-interest income” are “net gains from trading activities.”
• Up and down the ledger, abstruse, all-embracing categories appear: “other fees earned from related activities,” “other interest income,” and just plain “other.” The income statement’s “other” catchalls collectively amounted to $6.6 billion of Wells Fargo’s income in 2011.

Meanwhile in this world of shell games and mind-boggling numbers, big losses can go unremarked. Buried in a footnote on page 164 of Wells Fargo’s annual report is the admission of a trading loss of $377 million loss on trading derivatives related to certain CDOs,” or collateralized debt obligations went unremarked, because of bigger losses for instance at JPMorgan. “Wells Fargo’s massive CDO-derivatives loss was a multi-hundred-million-dollar tree falling silently in the financial forest. To paraphrase the late Senator Everett Dirksen, $377 million here and $377 million there, and pretty soon you’re talking about serious money.”

Specialists and hedge funds as much in the dark as the public

Public confidence in banks is now at a record low. According to Gallup, in the late 1970s, around 60 percent of Americans said they trusted big banks “a great deal” or “quite a lot.” In June 2012, less than 25 percent of respondents told Gallup they had faith in big banks.

But it’s not just public confidence. Specialists are equally bewildered. The Atlantic cites:

• Ed Trott, a former Financial Accounting Standards Board member, when asked whether he trusted bank accounting, he said, simply, “Absolutely not.”
• Several financial executives told The Atlantic that they see the large banks as “complete black boxes.”
• A chief executive of one of the nation’s largest financial institutions considers banks “uninvestable,” a Wall Street neologism for “untouchable.”
• Paul Singer, who runs the influential investment fund Elliott Associates, wrote to his partners this summer, “There is no major financial institution today whose financial statements provide a meaningful clue” about its risks.
• Arthur Levitt, the former chairman of the SEC, lamented to us in November that none of the post-2008 remedies has “significantly diminished the likelihood of financial crises.”
• A recent survey by Barclays Capital found that more than half of institutional investors did not trust how banks measure the riskiness of their assets.
• When hedge-fund managers were asked how trustworthy they find “risk weightings”—the numbers that banks use to calculate how much capital they should set aside as a safety cushion in case of a business downturn—about 60 percent of those managers answered 1 or 2 on a five-point scale, with 1 being “not trustworthy at all.” None of them gave banks a 5.
• A disturbing number of former bankers have recently declared that the banking industry is broken, including Herbert Allison, the ex-president of Merrill Lynch and former head of the Obama administration’s Troubled Asset Relief Program, Philip Purcell (ex-CEO of Morgan Stanley Dean Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO of Merrill Lynch), and John Reed (former co-CEO of Citigroup) and Sandy Weill, another ex-CEO of Citigroup. The Atlantic notes that “this newfound clarity typically follows their passage from financial titan to rich retiree.”
• Bill Ackman, one of the nation’s highest-profile and most successful investors, lost almost $400 million betting on the recovery of Citigroup [C]. Last spring, Pershing Square sold its entire stake in Citigroup, as the bank’s strategy drifted, at a loss approaching $400 million.

Wall Street doesn’t trust big banks

Wall Street already reflects its distrust of the big banks. Even after a run-up in the price of bank stocks this fall, many remain below “book value,” which means that the banks are worth less than the stated value of the assets on their books. This indicates that investors don’t believe the stated value, or don’t believe the banks will be profitable in the future—or both.

The reality is that even an ostensibly simple and “extremely safe” bank like Wells Fargo impossible to understand. Every major bank’s financial statements have some or all of these problems; many banks are much worse.

Regulation hasn’t worked

In the wake of the recent financial crisis, the government has moved to give new powers to the regulators who oversee the markets. But the net result of the effort to regulate the big banks is almost as stupefying as the amounts of money involved. Draft Basel III regulations total 616 pages. Quarterly reporting to the Fed required a spreadsheet with 2,271 columns. 2010’s Dodd-Frank law was 848 pages and required regulators to create so many new rules (not fully defined by the legislation itself) that it could amount to 30,000 pages of legal minutiae when fully codified. What human mind can possibly comprehend all this?

Complex accounting rules have thus made the problem worse. Clever bankers, aided by their lawyers and accountants, find ways around the intentions of the regulations while remaining within the letter of the law. Because these rules have grown ever more detailed and lawyerly—while still failing to cover every possible circumstance—they have had the perverse effect of allowing banks to avoid giving investors the information needed to gauge the value and risk of a bank’s portfolio.

What to do: more clarity and actual sanctions

Some experts propose that the banking system needs more capital. Others call for a return to Glass-Steagall or a full-scale breakup of the big banks. These reforms could help, but none squarely addresses the problem of opacity, or the mischief that opacity enables.

The Atlantic suggests that a starting point is “to rebuild the twin pillars of regulation that Congress built in 1933 and 1934, in the aftermath of the 1929 crash. First, there must be a straightforward standard of disclosure for Wells Fargo and its banking brethren to follow: describe risks in commonsense terms that an investor can understand. Second, there must be a real risk of punishment for bank executives who mislead investors, or otherwise perpetrate fraud and abuse.”

The Atlantic argues that these two pillars don’t require massively complicated regulation. The straightforward disclosure regime that prevailed for decades starting in the 1930s didn’t require extensive legal rules. Nor did vigorous prosecution of financial crime.

However it does require political will-power. The decision not to prosecute UBS for criminal tax fraud in 2009, when a smaller bank was so prosecuted, sends a clear signal that the large banks are not only too big to fail and too complex to manage. They are also too big to punish.

The Atlantic suggests a grand bargain: “simpler rules and streamlined regulation if they subject themselves to real enforcement.”

A paradigm shift in banking

Rules and penalties can only take us so far. Nothing significant is likely to change until the dynamic of the financial sector changes. The SEC and the courts can pursue the banks with court cases and penalties, but they will always be confronted with time-wasting legal defenses, as well as time lags between the invention of new ways to fleece customers and the discovery and proof of those methods.

The financial sector is in effect an extreme example of the shareholder value theory run amok. Pursuit of profit not only undermines the banks themselves and ultimately the global economy as a whole.

Regulation and enforcement will only work if it is accompanied by a paradigm shift in the banking sector that changes the context in which banks operate and the way they are run, so that banks shift their goal from making money to adding value to stakeholders, particularly customers. This would require action from the legislature, the SEC, the stock market and the business schools, as well as of course the banks themselves.

Ultimately, change is for the banks’ own good. Without it, investors will continue to worry about which bank will be the next Lehman Brothers, while the rest of us can only brace ourselves for the next inevitable financial cataclysm.

marketing strategy of bmw company in india

The case discusses the marketing strategies adopted by Germany-based automobile manufacturer BMW in India. BMW India was founded in the year 2006, and the first car was launched in 2007. The company maintained an aggressive stance and launched several vehicles at different price points.

BMW was positioned as an aspirational brand for young entrepreneurs and executives and adopted innovative strategies to reach the segment. It also developed exclusive dealerships, which were used as touch points to interact with the customers.


Within three years, BMW went on to become the top luxury car manufacturer in India, surpassing Mercedes-Benz, which had been present in the country for more than a decade. The cases lists the strategies adopted by BMW on its journey to reach this position and also discusses the challenges it is likely to face from existing and new competitors like Mercedes Benz and Audi.

  "India is a key market to BMW. There is hardly any other market in the world that is being discussed so frequently at BMW Group Board meetings. Yes, it is not the size of the market or the operation. India is relatively a small market. Last year we sold 6000 cars here. It is a small operation. But look at the speed at which the Indian market is growing. It became the second fastest growing market after China, last year. For BMW, the India operation is the fastest growing. And all these factors mean that India definitely deserves our attention."

Interesting Facts about India

           

• India never invaded any country in her last 100000 years of history.
• When many cultures were only nomadic forest dwellers over 5000 years ago, Indians established Harappan culture in Sindhu Valley (Indus Valley Civilization)
• The name 'India' is derived from the River Indus, the valleys around which were the home of the early settlers. The Aryan worshippers referred to the river Indus as the Sindhu.
• The Persian invaders converted it into Hindu. The name 'Hindustan' combines Sindhu and Hindu and thus refers to the land of the Hindus.
• Chess was invented in India.
• Algebra, Trigonometry and Calculus are studies, which originated in India.
• The 'Place Value System' and the 'Decimal System' were developed in India in 100 B.C.
• The World's First Granite Temple is the Brihadeswara Temple at Tanjavur, Tamil Nadu. The shikhara of the temple is made from a single 80-tonne piece of granite. This magnificent temple was built in just five years, (between 1004 AD and 1009 AD) during the reign of Rajaraja Chola.
• India is the largest democracy in the world, the 7^th largest Country in the world, and one of the most ancient civilizations.
• The game of Snakes & Ladders was created by the 13th century poet saint Gyandev. It was originally called 'Mokshapat'. The ladders in the game represented virtues and the snakes indicated vices. The game was played with cowrie shells and dices. In time, the game underwent several modifications, but its meaning remained the same, i.e. good deeds take people to heaven and evil to a cycle of re-births.
• The world's highest cricket ground is in Chail, Himachal Pradesh. Built in 1893 after leveling a hilltop, this cricket pitch is 2444 meters above sea level.
• India has the largest number of Post Offices in the world.
• The largest employer in India is the Indian Railways, employing over a million people.
• The world's first university was established in Takshila in 700 BC. More than 10,500 students from all over the world studied more than 60 subjects. The University of Nalanda built in the 4th century was one of the greatest achievements of ancient India in the field of education.
• Ayurveda is the earliest school of medicine known to mankind. The Father of Medicine, Charaka, consolidated Ayurveda 2500 years ago.
• India was one of the richest countries till the time of British rule in the early 17th Century. Christopher Columbus, attracted by India's wealth, had come looking for a sea route to India when he discovered America by mistake.
• The Art of Navigation & Navigating was born in the river Sindh over 6000 years ago. The very word Navigation is derived from the Sanskrit word 'NAVGATIH'. The word navy is also derived from the Sanskrit word 'Nou'.
• Bhaskaracharya rightly calculated the time taken by the earth to orbit the Sun hundreds of years before the astronomer Smart. According to his calculation, the time taken by the Earth to orbit the Sun was 365.258756484 days.
• The value of "pi" was first calculated by the Indian Mathematician Budhayana, and he explained the concept of what is known as the Pythagorean Theorem. He discovered this in the 6th century, long before the European mathematicians.
• Algebra, Trigonometry and Calculus also originated in India.Quadratic Equations were used by Sridharacharya in the 11th century. The largest numbers the Greeks and the Romans used were 106 whereas Hindus used numbers as big as 10*53 (i.e. 10 to the power of 53) with specific names as early as 5000 B.C.during the Vedic period.Even today, the largest used number is Terra: 10*12(10 to the power of 12).
• Until 1896, India was the only source of diamonds in the world
  (Source: Gemological Institute of America).
• The Baily Bridge is the highest bridge in the world. It is located in the Ladakh valley between the Dras and Suru rivers in the Himalayan mountains. It was built by the Indian Army in August 1982.
• Sushruta is regarded as the Father of Surgery. Over2600 years ago Sushrata & his team conducted complicated surgeries like cataract, artificial limbs, cesareans, fractures, urinary stones, plastic surgery and brain surgeries.
• Usage of anaesthesia was well known in ancient Indian medicine. Detailed knowledge of anatomy, embryology, digestion, metabolism,physiology, etiology, genetics and immunity is also found in many ancient Indian texts.
• India exports software to 90 countries.
• The four religions born in India - Hinduism, Buddhism, Jainism, and Sikhism, are followed by 25% of the world's population.
• Jainism and Buddhism were founded in India in 600 B.C. and 500 B.C. respectively.
• Islam is India's and the world's second largest religion.
• There are 300,000 active mosques in India, more than in any other country, including the Muslim world.
• The oldest European church and synagogue in India are in the city of Cochin. They were built in 1503 and 1568 respectively.
• Jews and Christians have lived continuously in India since 200 B.C. and 52 A.D. respectively
• The largest religious building in the world is Angkor Wat, a Hindu Temple in Cambodia built at the end of the 11th century.
• The Vishnu Temple in the city of Tirupathi built in the 10th century, is the world's largest religious pilgrimage destination. Larger than either Rome or Mecca, an average of 30,000 visitors donate $6 million (US) to the temple everyday.
• Sikhism originated in the Holy city of Amritsar in Punjab. Famous for housing the Golden Temple, the city was founded in 1577.
• Varanasi, also known as Benaras, was called "the Ancient City" when Lord Buddha visited it in 500 B.C., and is the oldest, continuously inhabited city in the world today.
• India provides safety for more than 300,000 refugees originally from Sri Lanka, Tibet, Bhutan, Afghanistan and Bangladesh, who escaped to flee religious and political persecution.
• His Holiness, the Dalai Lama, the exiled spiritual leader of Tibetan Buddhists, runs his government in exile from Dharmashala in northern India.
• Martial Arts were first created in India, and later spread to Asia by Buddhist missionaries.
• Yoga has its origins in India and has existed for over 5,000 years.