Accounting, Derivatives and Financial Engineering

I had a chat with my collegue the other day and we discussed about how useless auditors are. In my view, they just look over financial statements and get paid, period. When in the last 20 years can you name an accounting firm that actually prevented a financial fraud anyways?  So I decided to discuss here some strategies that can easily manipulate the balance sheets with the use of derivatives. Maybe I should work for the regulators instead...


Example 1: Say you are a bank and the 1000$ you lent out is now worth 600$, meaning you have lost 400$. To disguise the loss on your books, you first enter into a trade with the market dealer. He pays you 1000$ for the loan but you have to simultaneously enter into a interest rate swap with the dealer on 2000$ where you pay 5.34% pa for 10 years. The rate is 2.34% more than the market rate of 3%. (2000$*2.34%=46.80$), the extra payment over 10 years equal the 400$ loss plus interest plus the dealer’s profit. So there you go, one way to hide a loss on your books!


And to give a real example of how even government use swaps to hide their transactions, let me tell you a story of what happened in Italy in the year 1996-97. Between 1996-97, Italy had cut its budget deficit from 6.7% to 2.7% to meet the EU target. It issued a 200 Billion Yen bond and by 1996, the yen depreciated, giving Italy a large currency profit on its borrowing. Then, Italy enter into a currency swap to lock in its profit in the OTC markets. Under the swap, Italy paid a rate of dollar LIBOR minus 16.77%, given the LIBOR was at 5%, Italy was than paying a massive negative interest rate so it was actually receiving huge payments from the swap. The swap was really a loan where Italy had accepted a bad exchange rate and received cash in return. Then, they use the payment to pay down that budget deficit...Who figured huh?


Example 2: The magic of an option trade! LEPO, short for low exercise price option were options that were around 4 years in maturity with a strike price of 0.01$ that cannot be exercised until expiry. To see how they work, I'll bring in a real life example again. Lend Lease Corp, wanted to sell its 9% holding in Westpac when the stock were trading at 5.40$. So this is how a transaction goes:


With the strike of 0.01$ on the option, the buyer of the option would paid a 3.65$ premium on a stock that is trading a 5.40$. The discount of 1.75$ to the Westpac share price reflected the value of dividend forgone by these option buyers. Now, you might ask, why do that? Because the dividend were tax free due to tax credit, investors on the higher tax bracket who would prefer capital gain took up on the option. So what does this do? Simple, the tax authorities would lose out on the taxes!




Well there you go, one example of avoiding losses on the books and another of avoiding taxes with derivatives... Hey, is EY, PWC, KPMG or Deloitte hiring these days?