Question;Wk 4 Assignment Questions (15% of overall course grade):1. Assume the existence of a futures market in human blood. The spot price (todays marketprice) is $200 per pint. (A curious comparison - HP #45 ink cartridges are $355 per pint.) Yourhospital is concerned about rising blood prices because competition and regulation prevents itfrom passing the cost along to patients. Explain how to use futures as a hedge against increasesin the price of human blood.2. You own stock in a NYSE exchange-listed healthcare company and have a hedge in place tolock in capital gains you have made, in case the price falls. Explain the significance of the hedgeratio to your hedging strategy. HINT: Is an option for 100 shares a perfect hedge against a longholding of 100 shares of the underlying stock?3. Calculate your pre-tax rate of return (profit divided by investment) in each of these scenarios(SHOW YOUR WORK):A: buy 1,000 shares of ABC common stock at $50 and sell at $60 one year later.B: buy 1,000 shares of ABC common stock at $50, borrowing 50% of the amountnecessary to buy it, at a 2% interest rate, sell the stock at $60 one year later, paying backthe loan at the same time.C: buy listed options at $400 for 1,000 shares of ABC, giving you the right but not theobligation to buy the shares at $50 one year later, you exercise the option one year laterwhen the stock price is $60.D: use the Long Call chart (from the CBOE material in Item #4 in this PDF) to explainwhat is going on.4. You chair the pension committee at the hospital where you work. Its a small, young hospitalwith a $40 million pension account - 50% invested in an international bond index fund, and 50%invested in a S&P 500 index fund. Your economics/financial consultant expects a rise in interestrates and constant stock prices during the next two years.A: Cite a strategy using derivatives to hedge against the predicted rise in interest rates,citing what type of derivative to use and how it works.B: Explain how covered calls (long calls) can be used to create additional income on theequity portfolio during periods when the market is flat, i.e., cyclically constant stockprices.5. As a senior member of the management team in your organization, write a well consideredand thought-out 150-word summary statement for a Use of Financial Derivatives Policy.Carefully consider material in Items 8, 9.Item 8- BRUNO IKSIL: THE LONDON WHALEFrom Wikipedia, the free encyclopediaJump to: navigation, searchBruno Michel Iksil, nicknamed the London Whale (for the size of his trades) and Voldemort (forhis supposed power on Wall Street), is a trader who worked for the London office of JPMorganChase.He is held responsible for losses up to $6.2 billion with his supervisors Javier Martin-Artajo (sued by JPMorgan), Europe CIO head Achilles Macris, Chief Investment Officer Ina Drew, and CEO Jamie Dimon.Reportedly he began working for JPMorgan in 2005 and lives in Paris, commuting to London. It isthought that Iksil, who is said to guard his privacy, is married with four children.In 2011, Iksil, also known as "Caveman" for his aggressive trades, bet approximately $1 billion that somecompanies would default and earned JPMorgan a windfall of $450 million.  He was so powerful in early2012 that his trades alone may have moved the index, according to New York magazine. After "thedisastrous $2 billion trading loss related to derivatives in the bank's chief investment office in London"became known in May 2012, he was "stripped of his trading responsibilities." Iksil is a graduate ofEcole Centrale de Paris Class of 1991.According to a U.S. Senate report, Iksil's book amounted to $157 billion by the time trading was shutdown in late March 2012. He said on March 16 2012 his portfolio became "huge" and "monstrous", andsaid the same day on a phone call with junior trader colleague Julien Grout that "There's nothing that canbe done, absolutely nothing that can be done," and that "there is no hope." Iksil's total compensation was$7.32 million in 2010 and $6.76 million in 2011.Iksil refused to be interviewed by the Senate commission.Item 9-THE WOMAN WHO TOOK THE FALL FOR JPMORGAN CHASEBy SUSAN DOMINUS, October 7, 2012, The New York Times Sunday MagazineIn February of 2011, Jamie Dimon, the chief executive officer of JPMorgan Chase, approached the podium of one ofthe ballrooms at the Ritz-Carlton Hotel in Key Biscayne, Fla., where 300 senior executives from around the worldwere attending the banks annual off-site conference. By that time, the cold fear of the financial crisis was cordonedoff in the near-distant past, replaced by a dawning recognition that the ensuing changes in business thecomparatively trifling risk limits, the dwindling bonuses, the elevated stress levels might actually be permanent.That day, Dimon took the opportunity, according to a bank employee in attendance, to try to inspire his team, torouse them from the industrywide sense of malaise. Yes, there were challenges, Dimon said, but it was the job ofleadership to be strong. They should be prudent, but step up be bold. He looked out into the audience, where InaDrew, the 54-year-old chief investment officer, was sitting at one of the tables. Ina, he said, singling her out, isbold. Jamie Dimon, chairman of JPMorgan Chase, after testifying before the Senate Banking Committee on June 13in Washington. Perhaps by now when bankers hear that kind of public praise, they simultaneously hear a distantclanging, a dim alarm that provokes an undercurrent of anxiety. It seems inevitable that an acknowledgment of suchstar power will eventually lead to a fall, a big one, and one year and three months later, Drew succumbed.Her team had been bold, so bold that along with Dimon, she had become the public face attached to a $6billion mistake, a trading loss so startling in size that it dominated the business press, put Dimon on thedefensive and cost Drew her job. Over and over again, online and on television, in stories about the loss, thesame corporate headshot appeared: a woman wearing a hot pink boucl jacket, showing a smile so faint it wasalmost frank in its discomfort. Drew never craved public recognition, which is one reason, up until the trading error,almost no one outside of Wall Street had heard of her. Her longstanding anonymity is astonishing only in retrospect:All told, she invested nearly $350 billion for JPMorgan Chase.Drew had her hand on a major economic lever and was one of the key figures whose judgment Dimon reliedon in keeping the bank steady through the financial crisis. Drew was part of the team that helped establishhim as a model of restraint at a time when other bankers offered only tongue-tied defenses of their recklessbehavior. Now she was responsible for the traders who had made Dimon look as fallible as everyone else, andat the very moment when he was trying, once again, to assure government regulators that banks couldmanage themselves, that bankers could risk-proof their balance sheets.The $6 billion blunder has turned out to be no more than a minor ding on JPMorgan Chases mighty balancesheet. The companys stock has rebounded strongly, and the financial world has moved on to otherobsessions. But for Ina Drew, this is a scorching moment of failure from which it could be hard to recover. In30 years in the banking industry, she ascended to a level of power and wealth that few women have known.Her rise tells an unlikely story of what it takes to succeed as an interloper in the Wall Street boys club. Herfall is a murkier tale about how executives are coping with the growing public scrutiny and skepticism aboutwhat exactly banks are doing with all our money. Five years ago, would anyone have cared about a largetrading loss incurred by a strong, well-capitalized bank? When the business press, including this paper, firststarted digging into the debacle, it seemed possible that Dimon himself could go down. He didnt, of course,but the conversation reflects how precarious power in banking has become.James Lee, who eventually became one of the biggest dealmakers on Wall Street, started out at Chemical Bank inNew York sitting next to Ina Drew. He remembers talking to a client on the phone one day, trying to answer somequestions about a deal the bank was proposing. So I told the client what I thought, and Im answering andanswering, and I say, So what do you think? Lee says. But there was no response. Lee looked at the phone andthen looked around. Drew, a foot away, was in the middle of a different phone conversation, but her eyes were onhim, and she was shaking her head back and forth no, thats not right and waving her hand to show she hadsomething in it: the phone jack. She heard part of what I was saying, which was obviously incorrect, Lee says.She literally pulled the plug on me.It was 1983, and Drew, just 26, had been in the business for only three years, but she proved herself quickly and wasalready running a small group of traders. A graduate of Johns Hopkins with a masters degree in internationalrelations from Columbia University, Drew had hoped for a job in corporate lending, the clubby, relationship-basedbusiness that was the track to the prestigious commercial-banking group. But corporate lending did not open itsdoors to a young woman from New Jersey with no M.B.A. After 23interviews, Drew landed a decidedly less glamorous job, on the trading floor of the Bank of Tokyo Trust.Thrown in with no training, she cried every day, she used to tell junior people at JPMorgan Chase. But then one day,it clicked: Not only did she get it, she was good at it.In 1981, she moved to Chemical Bank, then considered a step up barely. They used to call it comicalbank, Tom Block, who was in charge of government relations there, recalls. Nothing about the bank at the timewould have suggested that over the next 30 years it would merge and acquire its way to become the megabankknown as JPMorgan Chase. By the mid-1980s, Drew was working directly under an economist named Petros K.Sabatacakis, the head of Chemical Banks global treasury department. Among the departments tasks wasmanaging interest-rate risk, ensuring that the bank did not find itself locked into paying out more in intereston the money it borrowed bonds and deposits than it was receiving in interest-rate payments from itsloans. In the mid-1980s, to hedge against falling interest rates, the group poured money into $3 billion worthof government-backed mortgage securities that grew more valuable when their call on interest rates provedright. Still, the group was considered a sleepy backwater until Sabatacakis turned their attention a few yearslater to bankings other major risk: credit default. The bank was most vulnerable to its lenders defaulting in arecession, in a recession, the Federal Reserve generally lowers interest rates to increase borrowing andspending. Sabatacakis determined they should continue to buy those securities whose value would rise in arecessionary environment.It was a traders mentality, says Glenn Havlicek, a trader who worked underDrew for 22 years. It may seem elemental, but at the time, the idea of mixing a trading solution and a creditcrisis solution itwas in its awkward infancy.In the 1970s, trading bonds was a fairly straightforward business, and anyone with enough hustlecould get on a trading floor, but by the 1980s, because of technology and globalization, bonds became morecomplex, and as the money got bigger, the competition got fiercer. Banks competed to develop investmentproducts that would give them an edge and traders started relying on complex algorithms to beat the market.By the early 2000s, tech-savvy investors had come to dominate Wall Street, helped by theoreticalbreakthroughs in the applications of mathematics to financial markets, Scott Patterson wrote in TheQuants, a book about the bankers who wield those tools. These days, banks compete for the top physics andapplied math Ph.D.s from around the world.Drew did not have a business degree, much less the skills of a quant, and yet, as banking evolved and her bank keptmerging with other banks, Drew survived. When you merge, you get to see the other sides business, and hersalways looked better, said Don Layton, the chief executive of Freddie Mac, who oversaw Drew when Chemicalmerged with Manufacturers Hanover in 1991.Drew made it through yet another merger, in 2000, when Chase merged with JPMorgan. Everymerger is painful, entailing massive layoffs, factionalism and blatant power grabs. But the mutualdisregard in this merger was especially high. JPMorgan had a sterling pedigree, and its bankersperceived themselves as innovators of gourmet financial products like structured derivatives. Theyexperienced the merger as a comedown, as if they were Dean & Deluca and they had just been bought by Stopand Shop. They made little effort to conceal their disdain. Drews deals essentially turned on one keyquestion she seemed to answer correctly more often than most (or at least when it mattered most): Wouldinterest rates go up or down? That insight seemed valuable but hardly cutting edge to her new colleagues.She was like the idiot savant of Im long or Im short, says one former JPMorgan employee, summingup how some of his colleaguesperceived her success.Soon after the banks merged, Drew and her team sat in a conference room with their counterpartsfrom JPMorgan, a group that included a banker named Patrik Edsparr, and talked about theirrespective backgrounds. Drews team had all graduated from well-regarded schools, but unlikeEdsparrs group, they did not have Ph.D.s in applied math, they werent M.I.T. graduates orphysicists from Caltech. They werent quants. You could just feel in the room that there was thissense emanating from Patrick and his team that we were going to be lunch, Havlicek says. Edsparressentially told Drew that her way of investing based on bottom-up economic analysis of markets, asopposed to abstract mathematical models was on its way out. Both stayed after the merger. Drewcontinued to run the treasury department, managing its safer trades, while Edsparr was put in charge of theproprietary-trading desk, where the bank traded its own funds for profit. Until Edsparr left in 2008, thetension between them was obvious. When Edsparr disagreed with one of Drews opinions in a meeting withseveral other high-level executives, Drew shot back, I dont care what you think. (Edsparr declined tocomment.)Some of that confidence may have come from her faith in her longstanding team, many of whom had been with herfrom the Chemical days. They managed risk by buying and selling mostly safe assets like U.S. Treasury bondsand high-quality mortgages, their value would generally rise with falling interest rates and vice versa. But in2006, she and Dimon together decided that her group should branch into more complex products to hedge theexpanding, ever-more-complex holdings of the bank. To help build international range for her group and todiversify her positions in the market, Drew hired a team that would trade foreign bonds and corporate bondsand would have the quantitative skills to trade more complex and riskier credit derivatives.To lead the effort, Drew hired Achilles Macris, who had worked at the bank Dresdner KleinwortWasserstein. Originally from Greece, he was a charming but volatile figure with a reputation for brilliance.He in turn hired Javier Martin-Artajo, an opinionated trader from Spain, and Bruno Iksil, a quiet, bookishman from France, both known to have strong quantitative backgrounds. The year 2008 was a time most bankerswould like to forget, for Drew, it was one of the highlights of her career. Starting in late 2007, her group piledmoney into secure, long-term government-backed bonds, close to $200 billion worth. Those soared in value asit became clear that interest rates would have to drop and every other product on the market looked like abad bet. After the financial collapse, the group reviewed some collateralized loan obligations, financialproducts that were deemed toxic, and bought the safest aspects of those products. Those purchases werevastly riskier than Treasuries some argued too risky for an operation intended to hedge risk but thespending spree of the chief investment office ultimately reaped billions in profit for the bank. Going into thecrisis, the C.I.O. positioned us well for the turmoil ahead, Dimon says. But it also served a larger purpose,stabilizing the market when few others had the ability to do so. They took risk with thosecollateralized loan obligations, Mark Williams, who teaches finance at Boston University, says.They provided an important service.Back in 2007, the bank asked the London office to execute a credit derivative hedge that wouldprotect the bank in the event of a major crisis. (Some credit derivatives are, essentially, a bet on an outcome,like a corporation or government defaulting on their financial obligations.) The hedge not only protected thebank but also made money in 2008 when the markets collapsed.Following the crisis, the team in London, including Iksil, continued to expand the position. (A credit tradersposition can be thought of as a collection of bets on outcomes.) Iksils position was eventually so large that hebecame known as the London Whale before his identity was confirmed. At some point in December of lastyear, a former executive from the group says, Drew checked in with Macris and Martin-Artajo about theposition while the two men were in New York. They answered, but the executive, who understood the trade,remembers thinking that they did not give as full an answer as they could have. I think they glossed overdetails to the point where Ina knew the product, the size they were trading, but she did not know what thetrue P.& L. profit and loss impact could possibly be in a stressful scenario, he said. She was askingthe right questions, he said, but did not seem to be picking up on what was not being said. Why didnt he sayanything? The usual reasons: less than total certainty, resistance to jumping rank, faith in Iksils judgment.Plus, he liked the guy.In any case, there were several layers of people at the bank whose job it was to evaluate risk. Being the riskmanager at a bank, of course, is like being the chaperon at the dance: your authority is more than matched bythe desire of others to subvert it. The trader in the world of Wall Street is a lot more important than theperson with a whip and a chair attempting to keep the traders from blowing up, says Brad Hintz, an analystat Sanford C. Bernstein. To try to mitigate that very human dynamic, banks also rely on a variety ofstatistical models, including those known as value at risk models, which theoretically provide bankers witha certain degree of probability about how much they could stand to lose on any given day under adversecircumstances. Those V.A.R. models did little to help bankers when the unforeseeable happened in 2008,which is why they are generally viewed with some skepticism these days. Sometimes the models miss keyinformation, sometimes the people who use them miss what the models are telling them and sometimestraders manage to work around them.
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