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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: JG who wrote (973)	10/26/1999 11:17:00 AM
From: Henry Volquardsen	Respond to of 2794

sorry for the delay in responding, somehow I missed the fact that there were responses. For those of us that are trying to get a better handle on this issue, would you please give us some concrete examples of these increases in liquidity and risk transferences. Risk transference is easy. One of the examples I used to use when teaching was beer brewing. Most hops are grown in Germany (at least that is what I have been told -g-). A US brewer needs to buy hops in Germany. The brewer will have currency risk on these purchases. By buying the currency forward the brewer can eliminate this risk. This will transfer the risk to a currency market maker who is better able to manage the risk. By eliminating currency risk the brewer can more accurately forecast cost and use this to more aggressively price his product increasing sales. And liquidity ;) Another example is the mortgage market. Back in the 70s and early 80s the mortgage market was very difficult to manage. Term mortgages predominated the market while bank funding was predominately short term. In addition prepayment features gave the borrower the right to put the mortgage back to the lender. What this did was put mortgage lenders in a heads you win tails we lose situation. If rates rose they would have to pay higher rates for deposits while the term mortgage rates wouldn't change. This would cause a significant erosion if not outright loss of their margins. Meanwhile if rates dropped their margins would expand but they ran a high risk that borrowers would refinance and they would lose their assets entirely. A very difficult management problem. As a result mortgage lenders would require larger margins and often would just refuse to lend. Derivatives helped solve the mortgage lenders broblems. Since the pre-payment feature was essentially a written option they could use Treasury options as a partial hedge. In addition they could use fixed floating interest rate swaps to extend the maturity of their funding. They could convert their deposit base into long term rates and match the maturity of their mortgage portfolio. Along with the growth od ARMs it made mortgage lending a much more manageable business. By reducing inherent risk it attracted more money into the market thereby increasing liquidity. The increased competitive pressures also caused profit margins to contract. This provided consumers with both greater flexibility and a more competitively priced product. Henry