What We Learned from H-E-D-G-E. Introduction to Business Transactions November 27, 2007.
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Transcript of What We Learned from H-E-D-G-E. Introduction to Business Transactions November 27, 2007.
What We Learned from
H-E-D-G-E
Introduction to
Business Transactions
November 27, 2007
University of TennesseeCollege of Law
Professor Robert M. Lloyd
Merle Hazard
• Merle Haggard
• Moral Hazard
Moral Hazard
• Leaving your insured car in a bad neighborhood
• Executive stock options
• Hedge fund managers’ compensation
• The “Greenspan put”
Derivative
A security whose value depends on another financial instrument
Mortgage-backed bonds
Options
Options
Put – a contract giving the right to sell a security at a set price
Call – a contract giving a right to buy a security at a set price
Swap
“I’ll pay yours if you’ll pay mine.”
Different currencies
Fixed rate for floating rate
Hedge
• An investment made for the specific purpose of reducing the risk on another investment.
• Examples– Buying Exxon and shorting British Petroleum– Farmer selling corn futures
Hedge Fund
• Private investment partnership
• Individual partners must have net worth of $1 MM or income of $200 K
• Can invest in variety of vehicles
• Name comes from fact can hedge
• Managers typically receive a generous percentage of the profits.
Margin Call
• Buying stocks with borrowed money is “buying on margin”
• Federal regulations limit the amount of leverage you can have
• When the price of your stock drops so much you are overlevered, you get a “margin call”
• If you don’t put up more cash, they sell your stock
Leveraged 10 to one
• Can mean ratio of debt to equity is 10:1
• Or can mean ratio of assets to equity is 10:1
CDO
• “Collateralized Debt Obligation”
• A mortgage-backed (or similar) security in which there are several “tranches” offering different levels of risk and reward.
Moody’s get the ratings wrong
• Moody’s (and other similar organizations) rated the risk of CDO tranches
• They screwed up—big time
Goldman Sachs
• The most successful investment bank
• Former head Robert Rubin was Treasury Secretary under Clinton I
• Former head Hank Paulson is present SecTreas
• Only major bank not to suffer big losses on sub-prime
