2w FinEcon 2024fall v2

Summary

This script discusses the vast difference between the $800 trillion OTC market volume and the $100 trillion exchange-traded volume, highlighting the 2008 financial crisis's impact on OTC derivatives. It recounts the bankruptcy of Lehman Brothers, emphasizing the need for risk management and regulations like global margin and CCP. The script also explains forward contracts, their pricing, and potential outcomes, using examples to illustrate gains or losses in currency exchange.

Takeaways

• 📈 The script discusses the significant difference in trading volumes between the OTC (Over-The-Counter) market and the Exchange Market, highlighting a volume of around 650 trillion dollars in OTC compared to less than 100 trillion in the Exchange Market.
• 🏦 The script mentions the bankruptcy of Lehman Brothers in 2008 during the Global Financial Crisis, which was a pivotal event that negatively impacted many countries, including the USA and various Asian nations.
• 📉 Lehman Brothers' involvement in the OTC derivatives market and their inability to secure short-term funding led to their financial difficulties and eventual bankruptcy, underscoring the risks associated with high-risk financial instruments.
• 🔄 The script explains that Lehman Brothers had outstanding OTC derivative transactions with about 800,000 different counterparties, which made unwinding these transactions challenging and contributed to their collapse.
• 🌐 Post-Lehman Brothers' bankruptcy, Nomura Holdings acquired Lehman's operations in Europe and Asia, integrating English-speaking staff from India and Europe with the existing employees.
• 💼 The script emphasizes the importance of risk management in financial institutions, especially in the context of derivatives trading, to prevent systemic risk and financial crises.
• 📋 New regulations were introduced after the Global Financial Crisis to manage risks in the OTC market, including the use of Global Margin and Central Counterparty (CCP) mechanisms to reduce credit risk.
• 💼 The script defines Global Margin as the requirement for financial institutions to exchange collateral based on the Market-to-Market (MTM) value and threshold, which has become mandatory post-crisis.
• 🔄 CCP is described as a system where standardized OTC derivatives are cleared through a central entity, reducing credit risk between counterparties by acting as an intermediary.
• 📊 The script provides examples of forward contracts, explaining how they work, and discusses the potential outcomes for a corporation entering into such a contract, including gains or losses depending on market movements.

Q & A

What is the difference between OTC and exchange traded volumes mentioned in the script?

The script highlights a significant gap between OTC (Over-The-Counter) market volume, which is around 650 trillion dollars, and exchange traded volume, which is less than 100 trillion dollars.

Why is there a big gap between OTC and exchange traded volumes?

The large gap is typical due to the nature of OTC markets, which are decentralized and involve direct transactions between two parties without going through a centralized exchange.

What happened to Lehman Brothers during the 2008 financial crisis?

Lehman Brothers filed for bankruptcy on September 15, 2008, due to its high-risk participation in the OTC derivatives market and its inability to roll over short-term funding.

Why did Lehman Brothers go bankrupt?

Lehman Brothers went bankrupt because it was unable to secure sufficient funding to sustain its large derivatives portfolio during the global financial crisis, leading to a liquidity crunch.

What was the impact of Lehman Brothers' bankruptcy on the global economy?

Lehman Brothers' bankruptcy had a significant negative impact on the global economy, causing systemic risk and leading to losses for other financial institutions and impacting economies worldwide.

What is the role of a Central Counterparty (CCP) in the OTC market?

A Central Counterparty (CCP) in the OTC market acts as an intermediary to reduce credit risk between counterparties by requiring them to post collateral, ensuring that potential credit risks are mitigated.

What are the new regulations introduced after the global financial crisis to manage OTC market risks?

New regulations post-crisis include the requirement for Global Margin (initial and variation margin) and the use of Central Counterparties (CCPs) to manage and reduce systemic risks in the OTC market.

How does the Global Margin requirement work in the context of OTC derivatives?

Global Margin requires financial institutions to exchange collateral based on the marked-to-market (MTM) value of their derivatives positions and a set threshold, making the trading of these instruments more secure.

What is the difference between a forward contract and a future contract?

Both forward and future contracts are agreements to buy or sell an asset at a specified price on a future date. The main difference is that forward contracts are customized and traded OTC, while futures are standardized and traded on exchanges.

Why do swap dealers quote both bid and ask prices for currencies?

Swap dealers quote bid and ask prices to reflect the lowest price they are willing to buy a currency (bid) and the highest price they are willing to sell it (ask), allowing them to profit from the spread.

What are the possible outcomes for a company that enters into a forward contract to sell a currency?

The possible outcomes depend on the future exchange rate compared to the forward contract rate. The company may make a gain if the future rate is lower than the forward rate, or a loss if the future rate is higher.