2010 Vol. 3

Pansy Yang, Ph.D. (Bio)
Executive Director of the Fink Center for Finance & Investments

Derivatives were created to reduce risk, but the financial meltdown in the latter part of the recent decade has been attributed, in part, to undue risk created precisely by the use of derivatives. To avoid a repeat of the worst financial crisis since the Great Depression, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed into law in July. The goal of the Act is to "promote the financial stability of the United States by improving accountability and transparency in the financial system, to end 'too big to fail,' to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."

While some economists view the Act as insufficient and too broad to achieve its goal, critics say that in fact, more risk is being created with the new legislation. With no fewer than 243 new rules, will the additional rule-making create a safer, better financial environment for all? In this issue of the bulletin, we tackle only a small piece of the Act; the requirement that most derivative trades be routed through clearinghouses.

Craig Pirrong, Professor of Finance at the Bauer College of Business, University of Houston, provides a thorough comparative analysis of the benefits and shortcomings of trading through a clearinghouse and over the counter (OTC). He argues that the view in which a clearinghouse will absolve the risks associated with derivatives is a flawed one, and that while OTC markets are not the perfect solution, there are mechanisms that can be put in place to mitigate some of the problems they face.

Francis Longstaff, Allstate Professor of Insurance and Finance at UCLA Anderson, shares a glimpse of his recent empirical work on how counterparty credit risk affects the pricing of credit default swaps. Six key results emerge, which have important regulatory implications. In particular, the paper finds that proposals to create a central default swap exchange may not actually be as effective as might be anticipated in reducing counterparty credit risk.

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Academic Perspective

Craig Pirrong
Professor of Finance, University of Houston Bauer College of Business

The recently enacted Dodd-Frank Act includes an OTC derivatives clearing mandate as a centerpiece. Moreover, the European Commission's recently tabled proposal to regulate OTC derivatives also incorporates a clearing mandate.

OTC derivatives are widely considered to be a source of systemic risk; regulators including Treasury Secretary Timothy Geithner and CFTC head Gary Gensler argue that OTC derivatives form a dense network of interconnections between large financial intermediaries, and can serve as a channel by which contagion is spread through the financial system. Mandatory clearing through "central counterparties" ("CCPs") is often advanced as a solution to this problem. Indeed, in Washington clearing often plays the role of deus ex machina in a Greek drama, descending from the heavens to resolve all intractable dilemmas.

This view of clearing as panacea to a fundamentally flawed OTC derivatives market is wrong, and potentially dangerous. Clearing changes the topology of the network of connections between financial firms, but does not eliminate these connections. Moreover, the failure of a clearinghouse would have serious systemic consequences. Furthermore, a strong case can be made that bilateral arrangements heretofore common in OTC markets are efficient for some trades and some traders, due to informational and incentive advantages. Thus, clearing mandates pose a serious risk of failing to achieve their purported goal of reducing systemic risk, and may raise the costs of trading and managing risks through the derivatives markets by forcing the use of institutions with poorer information and incentive properties.

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Academic Perspective

Francis Longstaff
Allstate Professor of Insurance and Finance, UCLA Anderson

During the past several years, counterparty credit risk has emerged as one of the most important factors driving financial markets and contributing to the global credit crisis. Concerns about counterparty credit risk were significantly heightened in early 2008 by the collapse of Bear Stearns, but then skyrocketed later in the year when Lehman Brothers declared Chapter 11 bankruptcy and defaulted on its debt and swap obligations.1 Fears of systemic defaults were so extreme in the aftermath of the Lehman bankruptcy that Euro-denominated CDS contracts on the U.S. Treasury were quoted at spreads as high as 100 basis points.

Despite the significance of counterparty credit risk in the financial markets, however, there has been relatively little empirical research about how it affects the prices of contracts and derivatives in which counterparties may default. This is particularly true for the $57.3 trillion notional credit default swap (CDS) market in which defaultable counterparties sell credit protection (essentially insurance) to other counterparties.2 The CDS markets have been the focus of much attention recently because it was AIG's massive losses on credit default swap positions that led to the Treasury's $182.5 billion bailout of AIG. Furthermore, concerns about the extent of counterparty credit risk in the CDS market underlie recent proposals to create a central clearinghouse for CDS transactions.3

To briefly review, a CDS contract is best thought of as a simple insurance contract on the event that a specific firm or entity defaults on its debt. As an example, imagine that counterparty A buys credit protection on Amgen from counterparty B by paying a fixed spread of, say, 225 basis points per year for a term of five years. If Amgen does not default during this period of time, then B does not make any payments to A. If there is a default by Amgen, however, then B pays A the difference between the par value of the bond and the post-default value (typically determined by a simple auction mechanism) of a specific Amgen bond. In essence, the protection buyer is able to put the bond back to the protection seller in the event of a default. Thus, the CDS contract "insures" counterparty A against the loss of value associated with default by Amgen.4

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*This article is a condensed version of a joint paper with Navneet Arora (BlackRock) and Priyank Gandhi (UCLA Anderson).

1 Lehman Brothers filed for Chapter 11 bankruptcy on September 15, 2008. During the same month, American International Group (AIG), Merrill Lynch, Fannie Mae, and Freddie Mac also failed or were placed under conservatorship by the U.S. government.

2 The size of the CDS market as of June 30, 2008 comes from estimates reported by the Bank for International Settlements.

3 For example, see the speech by Federal Reserve Board Chairman Ben S. Bernanke at the Council on Foreign Relations on March 10, 2009. For an in-depth discussion of the economics of CDS clearinghouse mechanisms, see Duffie and Zhu (2009).

4 For a detailed description of the characteristics of CDS contracts, see Longstaff, Mithal, and Neis (2005).


 


Recent Events

On October 22nd and 23rd, the Fink Center hosted a select group of private equity limited partners and academics to its first annual Private Equity Summit. "The purpose of the Summit is to identify and discuss key issues facing investors and facilitate a constructive discussion between academics and practitioners," said Professor Richard Roll, co-chair of the Summit. Industry thought leaders like Fire and Police Pension Commissioners of the City of Los Angeles, Northwestern Mutual Life and the University of California Regents Endowment Fund were represented. Henry Cisneros, former Secretary of the U.S. Department of Housing and Urban Development addressed attendees as the keynote speaker, discussing the role that private equity will have in reinvigorating the global economy. As a member of President Obama's Debt Reduction Task Force, Mr. Cisneros has a unique vantage point.

"This was the first of an annual event where leading academics and institutional investors gathered to explore the future of private equity. Private equity is a misunderstood asset class and is in fact an important economic stimulant", said Jonathan Rosenthal of Saybrook Capital, co-chair of the Summit. This year, Professor Morten Sorenson of the Columbia Business School presented the results of a paper titled "Private Equity and Industry Performance", reflecting a demonstrable correlation between PE investing and improvements in industry performance, including an increase in domestic job creation. Professor Per Stromberg of the Stockholm School of Economics presented his research entitled "Borrow Cheap, Buy High," exploring the relationship of the availability of cheap debt and the use of leverage on buyouts.

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Faculty Highlights

Bhagwan ChowdhryBhagwan Chowdhry appeared on CNN October 18th, 2010 discussing his Financial Access at Birth (FAB) Campaign, which seeks to combat poverty by providing every newborn child in the world with a bank account consisting of $100. The segment can be viewed at the link below.
http://www.cnn.com/video/#/video/bestoftv/2010/10/19/nr.child.banking.cnn

 


Liu YangLiu Yang's paper "Private and Public Merger Waves", joint work with Vojislav Maksimovic and Gordon Phillips at the University of Maryland received the Best Paper in Corporate Finance Award at the 2010 Financial Management Association (FMA) Annual Meeting. The meeting was held in New York City this year. The FMA is a global leader in developing and disseminating knowledge about financial decision making. FMA's members include academicians and practitioners worldwide.

 

Mark GrinblattMark Grinblatt's paper "Do Smart Investors Outperform Dumb Investors?" along with co-authors Matti Keloharju and Juhani Linnainmaa, received the Goldman Sachs International Award for best European Finance Association (EFA) Meeting conference paper. The Best Conference Paper Prize is the highest distinction awarded for an academic paper during the Annual Meeting.

The EFA was created in 1974 and is a professional society for academics and practitioners with an interest in financial management, financial theory and its application. EFA serves as a focal point of communication for its members residing in Europe and abroad. This year's meeting was held in Frankfurt, Germany.

 

 Mark Grinblatt was elected to the executive committee of the National Bureau of Economic Research (NBER), where he also serves on the Board of Directors. The NBER is the nation's leading nonprofit economic research organization. Founded in 1920, the NBER is a private, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works.

 

 

Hanno Lustig "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle" is a paper by Matthias Fleckenstein, Francis Longstaff, and Hanno Lustig that has recently received quite a bit of press. The paper shows that the price of a Treasury bond and an inflation-swapped Treasury Inflation-Protected Security (TIPS) issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS Treasury mispricing has exceeded $56 billion, representing nearly eight percent of the total amount of TIPS outstanding. The authors write "To the best of our knowledge, the relative mispricing of Tips and Treasury bonds represents the largest arbitrage ever documented in the financial economics literature." Their results pose a major puzzle to classical asset pricing theory. In addition, they raise the issue of why the Treasury issues TIPS, since in so doing it both gives up a valuable fiscal hedging option and leaves large amounts of money on the table. The paper has been mentioned in the Financial Times as well as the NY Times, amongst other news outlets.



The Distinguished Eagle Scout Award is a distinguished service award of the Boy Scouts of America. It is awarded to an Eagle Scout for distinguished service in his profession and to his community for a period of at least twenty-five years after attaining the level of Eagle Scout. Tim's family were also awarded with the Council's Heritage Award for their commitment to the community and Boy Scouts of America. Tim was honored at a dinner at the Beverly Wilshire on November 11th in which all the proceeds will go to support the nearly 20,000 young men and women in the youth programs of the Western LA County Council, Boy Scouts of America.


 


Kelly Leong
Kelly Leong first became interested in pursuing a PhD in finance when she wrote her undergraduate honors thesis. The paper sparked her interest to gain a deeper understanding of the financial models that led to the 2008 credit crisis. She then wished to enter a top finance PhD program to hone her research skills in order to conduct thorough, cuttingedge research. She is excited to join such an innovative group of intellectuals at Anderson and is interested in pursuing research in asset pricing, international finance, and derivative valuation.

Rama Malladi
Before joining the Ph.D. program at UCLA Anderson, Rama Malladi was a managing partner of Kubera Investments LLC. During the last 18 years of his career spanning the US, UK and India, he led groups focusing on financial analytics, infrastructure investments advisory, technology solutions and interim management services.

Kyle Matoba
Kyle Matoba has joined the doctoral program in finance to further develop his interest in the theoretical modeling and empirical analysis of investment and trading strategies. He has recently become interested in using ideas from machine learning theory to examine portfolio selection and has varied other interests in path dependent options, algorithmic trading, hedge funds, and computation.

Xuhua Zhou
Xuhua Zhou joined the doctoral program in finance in 2010 to learn the necessary methodology to conduct proper empirical research in finance. His interests span liquidity-driven market inefficiencies to fundamental equity research.

Read more about our new doctoral students >>


 


The Fink Center at UCLA Anderson is proud to announce a new Investment Banking Fellows program. The program is designed to encourage fellows in pursuing a career in investment banking. In addition to their formal recognition as fellows, the selected students will be matched with alumni mentors in the field. These mentors may be drawn from either the U.S. or international investment banking centers. Fellows will receive guidance in interview preparation. They will also have facilitated access to distinguished investment banking professionals who are friends of the Fink Center.

Fellows are expected to participate in the standard investment banking recruiting process through the Career Center, in addition to attending special meetings organized by the program. The final choice of internship is left in each fellow's hands, though the program expects that fellows will choose an internship in investment banking. Applications are encouraged from those with experience in the industry and also from those who are considering entering investment banking for the first time.


 


The Fink Center for Finance & Investments
UCLA Anderson School of Management
110 Westwood Plaza, Los Angeles, CA 90095