Trade credit relationship specific investment and product market power

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trade credit relationship specific investment and product market power

A method of creating and trading packaged standard credit rating derivatives on an The numeric modifiers indicate where within the particular risk category the entity . The buyer may then resell the received product at the higher market price to According to the invention, credit rating derivative investment instruments. Market power can be understood as the level of influence that a company has on determining market price, either for a specific product or. Potential suppliers must make a relationship-specific investment in order Trade Credit, Relationship-specific Investment, and Product Market.

Cash settlement provides great flexibility regarding the types of underlying assets that derivative investment instruments may be built around. Essentially any variable whose value is subject to change over time, may serve as the underlying asset for a derivative investment instrument.

While standard derivatives may be based on many different underlying assets, there currently exist no derivative investment instruments that capture changes in the credit ratings of various organizations.

A credit rating derivative investment instrument is an instrument which derives its value based on the credit rating of an entity such as a corporation, municipal government, national government, or supranational organization. The risk categories of an independent credit rating services' rating scheme are mapped to individual monetary values.

When an entity is rated by the credit rating service, the rating service assigns a risk level which identifies the perceived credit worthiness of the rated entity.

The applicable rating may change over time according to the financial health of the rated entity. As the rated entity's credit rating rises and falls, so do the values to which the various ratings are mapped. According to the invention, credit rating derivative investment instruments such as credit rating options and credit rating futures contracts may be created which are based on the mapped values associated with an entity's credit rating.

A method of creating and trading credit rating derivative investment instruments according to one aspect of the invention includes identifying a credit rating service that rates various entities and organization using a credit rating scheme that includes a plurality of risk categories. The credit rating service rates an entity's credit worthiness by associating a risk category with the entity that accurately reflects the credit rating services assessment of the rated entities credit worthiness.

The various risk categories are mapped to unique monetary values, such that if the risk category associated with a rated entity is changed, i. Next an entity which is rated by credit rating service is identified. Derivative investment instruments such as call and put options and futures contracts may be created based on the monetary values to which the rated entity's credit rating is mapped. The value of the derivative investment instrument is determined at least in part by the monetary value to which the current risk category associated with the rated entity is mapped.

According to another aspect of the invention, a system for creating and trading credit rating derivative investment instruments is provided. The system includes a credit rating derivative investment instrument definition module for defining a credit rating derivative investment instrument. A pricing data accumulation and dissemination module is provided for receiving price data which are based on executed credit rating derivative investment instrument trades.

The pricing data accumulation and dissemination module also disseminates the pricing data to investors, and data vendors. A credit rating monitoring module monitors the credit rating of the entity on which the credit rating derivative investment is based. Finally, a settlement calculation module is provided for calculating a settlement amount based at least in part on a monetary value to which the current credit rating of the entity is mapped.

Other systems, methods, features and advantages of the invention will be, or will become, apparent to one with skill in the art upon examination of the following figures and detailed description.

It is intended that all such additional systems, methods, features and advantages be included within this description, be within the scope of the invention, and be protected by the appended claims.

In the same way that traditional options and futures contracts derive their value based on changes in the market price or value of an underlying asset, the derivative investments of the present invention derive their value based on changes in an entity's credit rating. The credit rating derivatives of the present invention may encompass options and futures-type instruments and may be traded on an exchange, in either an open outcry format or electronically. According to one embodiment, the various credit rating levels of a credit rating service's rating scheme are mapped to specific monetary values.

Table 10 includes two columns. The first column 12 contains the letter ratings defining the different risk categories.

trade credit relationship specific investment and product market power

The second column 14 contains the dollar values to which the primary risk categories of column 12 are mapped. The mapping of risk categories to monetary values is substantially arbitrary. A different credit rating scheme may be employed having more or less risk categories.

For example, Moody's or Fitch's rating systems may have been employed. Or a different rating scheme altogether may be selected. A different currency may be employed as the monetary unit for column Different mapped values may be employed, with different increments there between. The only restriction regarding the selection of the mapped values is that the mapped values progress in a logical manner that corresponds with the progression of their associated risk categories.

The monetary values to which the various credit rating risk categories are mapped have many similarities with corporate share prices commodity prices, and market indexes. However, the credit rating risk category applied to describe the entity's credit worthiness may in fact change over time depending on the rated entity's perceived ability to repay its debts.

As the credit rating risk category changes, the mapped monetary value changes with it. Thus, just like a company's share price, which moves up and down with the company's performance, or just as a market index goes up and down based on the performance of a group of stocks, or just as commodity prices move up and down based on supply and demand, so the mapped values associated with an entity's credit rating will rise and fall with chances in the entity's perceived ability to pay its debts.

And just as derivative investment instruments may be written based on corporate share prices, market indexes or commodity prices, so to may derivative investment instruments be written based on the monetary values associated with an entity's credit rating.

A credit rating call option may be created as follows. If the entity's credit rating improves before expiration of the option, for example if the entity's credit rating is upgraded to AA, the call option will be in-the-money. This situation corresponds exactly with a standard in-the-money call option based on a company's share price. When a corporate share price rises above the strike price, a call option is in-the-money.

The long investor is entitled to collect the difference between the actual share price and the strike price. When the entity's credit rating is upgraded to AA, the current credit rating is several levels above the BB strike rating.

A credit rating put option operates in much the same way, only in reverse. If the entity's credit rating is downgraded to a level below A before the expiration of the option, for example if the entity's credit rating is downgraded to CC, the credit rating put option will be in-the-money. This situation corresponds exactly with an in-the-money put option based on a company's share price.

When a corporate share price falls below the strike price, the put option is in-the-money. The short investor who sold the option must pay the difference between the current share price and the strike price to the long investor. In the case of the present credit rating put option, the strike rating is AA. When the entity's credit rating is downgraded CC, the credit rating is several levels below the A strike rating.

Next we will consider a credit rating futures contract. Again referring to the table 10 in FIG.

trade credit relationship specific investment and product market power

A long investor may anticipate that a particular entity's credit rating will be at or above a certain level at some time in the future. A short investor may hold the opposite view that the entity's credit rating will in fact be below the level anticipated by the long investor.

For example, assume that the long investor believes the entity's credit rating will be at A or above BB rating and the short investor believes it will be below that level on a specified date in the future.

According to an embodiment of the invention, step S1 is to identify a credit rating service whose rating of an entity or organization will serve as the basis of a derivative investment instrument. Step S2 is to map the various risk categories of the rating services rating scheme to specific monetary values.

Step S3 is to identify an entity which is rated by the credit rating service identified in Step S1, and whose credit rating is to serve as the basis for the credit rating derivative instruments. Step S4 is to specify a credit rating derivative instrument based on the credit rating of the entity identified in Step S3 and the monetary values to which the credit risk categories of the credit rating service's rating scheme are mapped to.

Step S5 is to create a market for the credit rating derivative instrument. Step S6 is to accept bids, offers and purchase orders for both long and short positions credit rating derivative instruments which are to be created according to the credit rating derivative investment instrument specified in step S4.

Step S7 is to execute credit rating derivative investment instrument by matching corresponding orders for long and short positions. And, finally, step S8 is to settle positions in the executed credit rating derivative investment instruments. It is intended that credit rating derivative investment instruments according to the present invention will be traded on an exchange.

Employing the method outlined in FIG. The exchange may decide to specify credit rating derivative investment instruments such as credit rating option contracts or credit rating futures contracts based on the entities credit rating, as determined by an independent credit rating service. Creating a market for the credit rating derivative investment instruments may be accomplished by listing one or more specified contracts on an exchange or trading platform.

Listing a contract includes disseminating information about the contract to potential investors and providing a mechanism whereby investors may make bids and offers and place orders for the contracts. Essentially, once a contract is defined and listed, the CBOEdirect electronic trading platform, in conjunction with other backend systems of the exchange, is responsible for all of the remaining steps of the method shown in FIG.

CBOE direct accepts bids and offers from investors or brokers Step S6and executes marketable orders by matching buyers to sellers Step S7.

And settles the contracts Step S8. The system includes components operated by an exchange, as well as components operated by others who access the exchange to execute trades.

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The components shown within the dashed lines are those operated by the exchange. Components outside the dashed lines are operated by others, but nonetheless are necessary for the operation of a functioning Exchange. The exchange components of the trading system include an electronic trading platforma member interfacea matching engineand backend systems Backend systems not operated by the exchange but which are integral to processing trades and settling contracts are the Clearing Corporation's systemsand Member Firms' backend systems Market Makers may access the trading platform directly through personal input devices which communicate with the member interface Market makers may quote prices for digital futures contracts.

Non-member Customershowever, must access the Exchange through a Member Firm. Customer orders are routed through Member Firm routing systems The Member Firms' routing systems forward the orders to the Exchange via the member interface The member interface manages all communications between the Member Firm routing systems and Market Makers' personal input devices ; determines whether orders may be processed by the trading platform; and determines the appropriate matching engine for processing the orders.

Although only a single matching engine is shown in FIG. Different exchange traded products may be allocated to different matching engines for efficient execution of trades. When the member interface receives an order from a Member Firm routing systemthe member interface determines the proper matching engine for processing the order and forwards the order to the appropriate matching engine.

Non-marketable orders are placed in an electronic order book. Once orders are executed, the matching engine sends details of the executed transactions to the exchange backend systemsto the Clearing Corporation systemsand to the Member Firms' backend systems The matching engine also updates the order book to reflect changes in the market based on the executed transactions.

Orders that previously were not marketable may become marketable due to changes in the market. If so, the matching engine executes these orders as well. The exchange backend systems perform a number of different functions.

Trade credit and product market power during a financial crisis - Dimensions

For example, contract definition and listing data originate with the exchange backend systems Pricing information for credit rating derivative investment instruments is disseminated from the exchange backend systems to market data vendors Customersmarket makersand others may access the market data regarding derivative investment instruments via, for example, proprietary networks, on-line services, and the like.

The exchange backend systems also monitor the credit ratings of the entities on which the derivative investment instruments are based. At settlement, the backend systems determine the appropriate settlement amounts and supply final settlement data to the Clearing Corporation.

The Clearing Corporation acts as the exchange's bank and performs a final mark-to-market on Member Firm margin accounts based on the positions taken by the Member Firms' customers. These data are also forwarded to the Member Firms' systems so that they may update their customer accounts as well.

trade credit relationship specific investment and product market power

A credit rating derivative investment instrument definition model definition module stores all relevant data concerning the credit rating derivative investment instrument, to be traded on the trading platformincluding the contract symbol, the identity of the rated entity, the rating service, mapping of the credit risk categories to the monetary values, strike prices futures prices and the like.

A pricing data accumulation and dissemination module receives contract information from the credit rating derivative investment instrument definition module and transaction data from the matching engine The pricing data accumulation and dissemination module provides the market data regarding open bids and offers and recent transactions to the market data vendors The pricing data accumulation and dissemination module also forwards transaction data to the Clearing Corporation so that the Clearing Corporation may mark-to-market the accounts of Member Firms at the close of each trading day, taking into account current market prices for the credit rating derivative investment instruments.

Finally, a settlement calculation module receives input from the credit rating service when a credit rating derivative investment instrument is settled, the settlement date the settlement calculation module calculates the settlement amount based on the rated entity's present rating and the monetary value to which it is mapped. The settlement calculation module forwards the settlement amount to the Clearing Corporation which performs a final mark-to-market on the Member Firms' accounts to settle the credit rating derivative investment instrument.

According to another aspect of the present invention, chooser options may be created based on credit rating options. A chooser option is an option wherein the purchaser of the option buys a call or a put option at some time in the future.

Chooser options are advantageous in situations in which investors believe that the price of the underlying asset is for a significant move, but the redirection of the move is in doubt. This strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products.

Banks also undertake risk through proprietary tradingperformed by a special set of traders who do not interface with clients and through "principal risk"—risk undertaken by a trader after he buys or sells a product to a client and does not hedge his total exposure.

Banks seek to maximize profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and trading has created jobs for physicscomputer sciencemathematics and engineering Ph. Research[ edit ] The securities research division reviews companies and writes reports about their prospects, often with "buy", "hold" or "sell" ratings.

Investment banks typically have sell-side analysts which cover various industries. Their sponsored funds or proprietary trading offices will also have buy-side research. While the research division may or may not generate revenue based on policies at different banksits resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients.

Research also covers credit research, fixed income research, macroeconomic research, and quantitative analysis, all of which are used internally and externally to advise clients but do not directly affect revenue. All research groups, nonetheless, provide a key service in terms of advisory and strategy.

trade credit relationship specific investment and product market power

There is a potential conflict of interest between the investment bank and its analysis, in that published analysis can impact the performance of a security in the secondary markets or an initial public offering or influence the relationship between the banker and its corporate clients, thereby affecting the bank's profitability. Credit risk focuses around capital markets activities, such as syndicated loansbond issuance, restructuringand leveraged finance.

Market risk conducts review of sales and trading activities utilizing the VaR model and provide hedge-fund solutions to portfolio managers. Other risk groups include country risk, operational risk, and counterparty risks which may or may not exist on a bank to bank basis. Credit risk solutions are key part of capital market transactions, involving debt structuring, exit financing, loan amendment, project financeleveraged buy-outs, and sometimes portfolio hedging.

Front office market risk activities provide service to investors via derivative solutions, portfolio management, portfolio consulting, and risk advisory. Well-known risk groups in JPMorgan Chase, Morgan Stanley, Goldman Sachs and Barclays engage in revenue-generating activities involving debt structuring, restructuring, syndicated loans, and securitization for clients such as corporates, governments, and hedge funds.

Trade Credit, Relationship-specific Investment, and Product Market Power

Morgan's Blythe Masters during the s. The Loan Risk Solutions group [12] within Barclays' investment banking division and Risk Management and Financing group [13] housed in Goldman Sach's securities division are client-driven franchises.

However, risk management groups such as operational risk, internal risk control, and legal risk are restrained to internal business functions including firm balance-sheet risk analysis and assigning trading cap that are independent of client needs, even though these groups may be responsible for deal approval that directly affects capital market activities.

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Risk management is a broad area, and like research, its roles can be client-facing or internal. Middle office[ edit ] This area of the bank includes treasury management, internal controls, and internal corporate strategy. Corporate treasury is responsible for an investment bank's funding, capital structure management, and liquidity risk monitoring. Internal control tracks and analyzes the capital flows of the firm, the finance division is the principal adviser to senior management on essential areas such as controlling the firm's global risk exposure and the profitability and structure of the firm's various businesses via dedicated trading desk product control teams.

In the United States and United Kingdom, a comptroller or financial controller is a senior position, often reporting to the chief financial officer. Internal corporate strategy tackling firm management and profit strategy, unlike corporate strategy groups that advise clients, is non-revenue regenerating yet a key functional role within investment banks. This list is not a comprehensive summary of all middle-office functions within an investment bank, as specific desks within front and back offices may participate in internal functions.

Many banks have outsourced operations. It is, however, a critical part of the bank. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading.

Some trades are initiated by complex algorithms for hedging purposes. Firms are responsible for compliance with local and foreign government regulations and internal regulations.

Other businesses[ edit ] Global transaction banking is the division which provides cash management, custody services, lending, and securities brokerage services to institutions. Prime brokerage with hedge funds has been an especially profitable business, as well as risky, as seen in the bank run with Bear Stearns in Investment management is the professional management of various securities stocksbondsetc.