Magoosh GRE

Derivatives and Securitization – Exam Notes

| May 20, 2012 | 0 Comments

Derivatives:

  • A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments.
  • Derivatives have special legal exemptions that make them a particularly attractive legal form through which to extend credit.
  • The strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause capital markets to undervalue credit risk. This can contribute to ‘credit booms. ’

EXAMPLE:

For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

 

Explanation:

A derivative is a form of security whose price is dependent upon or derived from one or more underlying assets i.e the stocks. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the stock price. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. I.e. no matter the risk involved, there will be a guaranteed buy back price.  

 

Securitization:

  • Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to various investors.
  • Can limit investors potential to monitor risk.
  • Off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts.

EXAMPLE:

Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage’s inherent risk of default and then sell those smaller pieces to investors.

Explanation:

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

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Category: Essay & Dissertation Samples, Finance Essay Examples

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