ECN3606 Uses and Abuses of Financial Derivatives: An Economist's View
4 Advanced Liberal Arts Credits
The significant use of derivative instruments began in the 1970s and, since then, has grown at a thunderous rate. Derivatives are used by individuals, businesses, financial institutions, central banks, and governments throughout the world. This course explains financial derivatives from microeconomic and macroeconomic perspectives.
Microeconomic Perspective
The wise use of derivative instruments requires the identification, measurement, evaluation, management, and monitoring of major risks. Some risks are willingly held, but many of are not, and derivative instruments provides a way to transfer these risks to others. Uses and Abuses of Financial Derivatives: An Economist’s View explains how companies have used derivative contracts to mitigate risks. It also describes how these instruments can be used for speculative, often destructive, purposes, which have little or nothing to do with a well-conceived strategy. In some cases, actions that were intended to hedge positions ended up being speculative, due (usually) to unpriced risks and a lack of understanding.
In the spirit of “Never waste a good crisis,” this course explains the steps and missteps of companies connected to some of the most spectacular derivative disasters, such as Amaranth Advisors LLC, American International Group (AIG), JPMorgan Chase (“London Whale”), Metallgesellschaft AG, Orange County, and Proctor & Gamble Inc. In doing so, the course addresses important questions, such as: What risks did these companies fail to identify or incorrectly price? Could these losses have been prevented?
The chances are high that students in this class will be offered employee stock options sometime in their professional careers, so this course explains how to put stock option offers into the broader perspective of different forms of compensation and their risks. We will find that employers (especially those in start-up companies) often look at ESOs quite differently from employees.
Macroeconomic Perspective
Derivative products have been used by central banks to influence exchange rates and by governments to hedge international borrowing and lending costs. This course explains how central banks hedge themselves and the positive and negative impacts these transactions can have on international capital flows, domestic credit markets, and foreign exchange markets.
Uses and Abuses of Financial Derivatives: An Economist’s View also connects you to an ongoing debate about whether financial derivatives can have significant negative effects on national and world economies. On one side are those who believe derivatives are zero-sum games, with the losses of some offset by the gains of others. On the other side are those who believe that derivative instruments can negatively influence nations’ monetary and fiscal policies and expectations, thereby precipitating national and international economic and financial crises. This course discusses both sides of this debate, with particular focus the currency crises of Mexico (1994), Thailand (1997 – 1998), Russia (1998), and Argentina (2001).
Engaging in a forward contract means agreeing to pay or receive payment in the future at a price agreed upon today, but how can one know if a forward price is “fair.” To address this question, we discuss four “parity conditions,” which are at the heart of many macroeconomic discussions – particularly those dealing with derivatives.
Prerequisites: ECN2000 or ECN2002
