“Weapons of Mass Destruction”

April 20th , 2011FIRMA Annual Conference

Atlanta, GA

W. A. (Trey) Ruch, IIIExecutive Managing DirectorSterne Agee Grouptruch@sterneagee.com

DerivativesDerivatives::

“Derivatives are something like electricity, dangerous if mishandled, but bearing the potential to do good.”

Arthur Leavitt-1995Former Chairman-SEC

De-riv-a-tive (n)- A right or obligation based upon an underlying asset whereby one party agrees to sell a good and one party agrees to buy it at a specific price on a specific date .

The investor does not usually own the underlying asset but the terms for the price, risk, and structure are based on the asset.

The investor in a derivative is usually making a bet on the direction of an underlying asset ‘s price movement via an agreement w/ another party.

The perceived risk of the underlying asset usually influences the risk perception of the derivative.

Hedging-Insuring the Value of an Asset Against a Downturn

Speculating-Betting on Price Movement

Option (owner)-Right to Buy/Sell at a Specified Price.

Option (seller)-Obligation to Buy/Sell at Specified Price.

Futures Contract-Obligation to Buy/Sell an Underlying Asset at a Specified Price as of a Future Date.

Swap-Exchange of Asset Variables for Different Investments.

Exchange Traded-• Regulated Market• Transparent• Liquid• Such as “Listed” Options

Over-the-Counter (OTC)-• Unregulated• Counterparty Risk• Illiquid• The “Swap” Market

Benefits• Complete Protection Below Put Strike Price• Unlimited Price Appreciation• Retain Voting Rights, Dividends, & “Indicias”

Considerations• Cost of up-front premium• Tax Straddle Rules Impact Holding Period

Benefits• Complete Price Protection Below Put Strike• Price Appreciation up to Call Strike• “Cashless”- Sale of Call Finances the Put• Retains Voting Rights, Dividends, and

“Indicias”

Considerations• Investor Forgoes price appreciation above

call strike• Tax Straddle Rules Impact Holding Period

Healthy Hens Farm

Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market with all the sporadic reports of bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with an investor who enters into a futures contract with her.

The investor agrees to pay $30 per bird when the birds are ready for slaughter, say, in six months time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as he or she will be able to buy the birds for less than market cost and sell them onto the market at a higher price for a gain.

If the price goes below $30, then Gail will be receiving the benefit because she will be able to sell her birds for more than the current market price, or what she would have gotten for the birds in the open market.

Interest Rate Swaps

Currency Swaps

Asset Swaps

Total Return Swaps

Credit Default Swaps

Interest Rate Swap• Acme agrees to pay Zenith a fixed rate of

interest, on a notional amount, on specific dates, for a specific period of time

• Zenith agrees to Pay Acme a floating rate on the same amount subject to the same terms

ZenithAcme, Inc.Thinks Rates are going up

Zenith, Inc.Thinks Rates are going down

LIBOR + 1%

Fixed Rate-6%

OTC Customized Terms Counterparty Risks Motivations

• Meet Commercial Needs• Comparative Advantage

Exiting a Swap• Buyout• Offsetting Transaction• Selling the Swap• Swaption

Private Bond Insurance for Credit Risk Buyer Wants Default Protection on

Issue• Short Bond Exposure• Long Cash Exposure

Seller Wants Premium Income• Long Bond Exposure• Short Cash Exposure

OTC Trade Limited After Market Liquidity

Reference Entity

Protection Buyer

Protection Seller

Credit Risk Transfer

CDS PremiumPremium: X bp per year

Between trade initiation and default or maturity, protection buyer makes regular payments to protection seller The spread is calculated on the notional amount of protection Typically paid quarterly Payments terminate at maturity or following credit event

Protection Buyer

Protection Seller

Protection Buyer

Protection Seller

Bond or Loan

100 $

100 – Recovery Rate

Cash settlement with an option for physical delivery has become the market standard

Did Derivatives Cause the 2008 Recession?