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Why Investors may be Attracted to High-risk Investments
Investors are attracted to high-risk investments with complex financial instruments such as CDOs and forward exchange contracts due to contracts backed by banks or insurers. Investors hedging CDOs know that banks issue insurance policies against the system’s implosion. Collateralized Debt Obligation (CDOs) is a security, a pool made up of various debt instruments, such as “pool of bonds” etc. Investors have the ability to hedge or leverage that risk for high returns which mean guaranteed returns.
Investors of all ages, and different stages in their investment cycle found themselves under seize with foreclosures due to the risky sub-prime mortgage crisis. Lehman Brothers formerly, one of the four big investment banks around the world found themselves in debt after the sub-prime mortgage crisis due to deregulation and irregular by historic standards of subprime mortgage market –CDOs. On the other hand, investors are interested in forward exchange contracts which is a foreign currency derivative, when hedging, it allows more flexibility in selecting dates and contract sizes; and that the cash that backs a forward contract will not be paid until the contract expiration. Therefore, countries like Japan and China are appealing to investors because they strong and rising currencies.
Risk Associated with Exchange-Traded Derivatives
Brokers must know the way interest rates and inflation affect exchange rates in order to anticipate the effect on their exchange- traded derivatives such as forward exchange contracts in order to minimize the risk to investors. Some key steps how brokers can reduce risk to investors is to educated them on how to diversify their portfolio which can mitigate or minimize exchange rate risk domestically and internationally by reducing different country currency risk. Therefore, brokers should encourage investors to invest in countries like China and Japan. China is known for being the country of choice when it comes to global foreign investment. Over 500 Fortune Global firms perform business in China. 70 of the world’s top 100 banks reside in China.
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China increased consumer spending, evolving demographics, low income and high production is an attractive platform for investors no matter the variety of industries. In the 1970s, China welcomed foreign direct investment. In 2001, China joined the World Trade Organization (WTO) and soon adopted free market principles. Statistics show that by 2020 China will become the world 2nd largest global economy replacing the United States. What does this mean and how does it help to minimize risk? When hedging, brokers can encourage investors to use forward exchange contracts in China. Since China is a very lucrative country with the majority of the world banks residing, forward exchange contracts would be an appealing derivative instrument.
An investor may take advantage of China suppliers and banks, by entering into a forward exchange contract with a China supplier of choice by selecting dates and contract sizes; and that the cash that backs a forward will not be paid until the contract expires. (Madura, 2015). Investors can use a forward contract to purchase or receive proceeds from a foreign country like China to fix the exchange rate between two currencies today for a fixed time in the future. One of main reason for engaging in forward contracts is to minimize or mitigate corporate translation, transaction and economic exposures, to hedge against loss, and to manage portfolio risk.
Challenges Related to Regulating a Complex Global Financial Firm
When money become important then people anything could happen. In addition, the financial crisis of 2008 proved that banks cannot regulate themselves without government regulatory oversight such as Dobb-Frank Wall Street Reform Act which allows FED to reduce bank size for those that become too big to fail; without this element, another global crisis could occur. The 2008 crisis, caused the stock market to crash. Transparency was “clear as mud”, no international regulations, lack of capital buffers and the inability to consistently judge the interconnections within the financial system caused the collapse of Lehman Brothers and almost triggering a financial global tsunami.
Lehman Brothers (LEH) collapse had a domino sour effect on the capital market. Confidence deteriorated for our Government including SEC, Fannie and Freddie, credit rating systems, regular banks and investment banks. On September 15, 2008, the day Wall Street titan Lehman Brothers filed for bankruptcy sent shock waves triggering a potential financial tsunami of such size and scope that it was compared to the Great Depression. To some, it will be remembered as a day that almost triggered a global financial meltdown. As one can see, there are challenges related to regulating a complex global financial firm for regulatory improvements that deals with highly complex financial instruments such as CDOs and other complex financial instruments.
Ethical Violations of the Company
Lehman Brothers formerly, one of the four big investment banks around the world found themselves in debt after the sub-prime mortgage crisis. Lenders irresponsibly were handing out risky (subprime) mortgages to borrowers with poor or severe credit scores; greedy banks bundling these subprime mortgages into securities and treating them as if they weren’t risky at all; and banks and insurers issuing insurance policies against the system’s implosion. Warren Buffett argues that highly complex financial instruments such as CDOs are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system. Some even described CDOs as the mother bubble of all bubbles.
In other words, there was the accessibility of pioneering mortgages outlooks which allowed buyers to acquire houses that they could not keep up the credits payments in stability as well as on the ability to refinance them constantly at higher prices. This made the lending rate deteriorate as the conditions were favorable. (Ariccia et al, 2008). This attributed to increased competition among lenders. The massive amount of issuance added by an inadequate number of players changed the primary nature of the relationship between credit evaluation agencies and the savings bank issuing these collaterals. (Sherlund, 2008). In a nut shell, Lehman Brothers (LEH) collapse had a domino sour effect on the businesses which violated ethics on a grand scale.
Managers such as (1) Kathleen Corbert (S & P CEO) rating agencies who stopped performing bona fide analysis. (2) Phil Gramm, who slashed the SECs budget and help to emasculate investor protection added to the dilemma. Therefore, confidence deteriorated for our Government including SEC, Fannie and Freddie, credit rating systems, regular banks and investment bank due to ethical violation of LEH.
Consequences for the Senior Management and Brokers Trading in High-risk Investments
Because of malpractice and irregular accounting practice, Sarbanes Oxley was created to let greedy and corrupt managers, investors, bankers, government know that consequences for violation of regulatory standards will have strict punishment up to include jail time. Managers like (1) Kathleen Corbert (S & P CEO) rating agencies who stopped performing bona fide analysis. (2) Phil Gramm, who slashed the SECs budget and help to emasculate investor protection added to the dilemma. (3) Bernie Madoff who set the stage for Ponzi scheme that inflicted $50 billion in losses.
Madoff pulled off the hedge fund financial fraud in history. (4) Jimmy Cayne, CEO of Bear Stearns who sold risky home loans and leveraged hedge funds that collapsed in mid-2007. (5) Angelo Mozilo, Countrywide CEO, poster child of all corrupt mortgage lenders, preyed on the elderly and (6) Daniel Dudd (Fannie Mae CEO) created accounting scandal using exotic private label securities. (7) Dick Fuld and his president of LEH , Joe Gregory irresponsibly handled risky (subprime) mortgages. All seven scenarios, should be given lengthy jail time, exposed by the media and made to pay back every dime they took. Create a scenario where you believe the use of high-risk investments would be beneficial for the investor. Provide support for your rationale.
An investor such as Apple, a US electronic manufacture who currency is USD has to pay Xiaomi a Chinese electronics manufacturer whose currency is Renminbi (China supplier), 100 Y (Renminbi) in six months. Apple wants to fix the rate of exchange between the USD and Y-Renminbi, today. It buys China currency Y in a spot foreign exchange transaction today. Apple places the Y-Renminbi on deposit for six months, before paying Xiaomi (China supplier). Interest earned on the Y-Renminbi deposit could be used to offset any borrowing cost in Y-Renminbi.
However this course of action would mean that the 100 Y-Renminbi would just stay on deposit for six months. A high risk investment may be beneficial to Apple by engaging in a forward foreign exchange contract, by allowing the Apple electronic manufacture to fix the USD-(Y) Renminbi rate today while avoiding the need to place the 100 Y on deposit for six months. High risk investment in forward exchange contracts is appealing in China due to various reasons; gain or build relationship with China lucrative banks and emerging markets including its logistic platforms.
Conclusion
Lehman Brothers (LEH) bankruptcy was caused by many variables and factors. Many factors contributed to this included the government, banks, investors, credit rating agencies, lack of international regulations dealing with high risk investment such as CDOs . LEH will always be a defective accounting practice coupled with bad ethics and flawed risk management textbook discussion. The “Financial weapons of mass destruction”, mother bubble of all bubbles or financial tsunami or even a global financial meltdown has affected everyone at some level and triggered output contractions in almost all industrialized economies in 2009. Therefore, investors may be attracted to high-risk investments such as exchange-traded derivatives, global funds, and other complex investment vehicles but educating yourself against risk can be detrimental to future retirement cash. On a good note, forward exchange contracts seem to be a better investment strategy. Investing in countries like China with lucrative banks and increased consumer spending, evolving demographics, low income and high production is an attractive platform for investors no matter the variety of industries.
