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Financial Derivatives
Finance > Financial Derivatives
Table of Contents Abstract Keywords Overview Applications Issues Conclusion Terms & Concepts Bibliography Suggested Reading
derivatives instruments exemplifies how creatively markets are able to package and manage risk. There is seemingly no end to the ways that assets can be sliced and bundled to mitigate risk. Derivatives are instruments that help investors manage risk particularly where there is volatility. Tightening credit markets and fluctuating interest rates have spawned a number of credit derivatives that include credit/debt swaps and collateralized debt obligations. Likewise, the volatility of real estate markets has increased the popularity of real estate derivatives.

Overview
Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds (Davies, 2007, 2). There are three main types of financial derivatives: Futures and forwards; options, and; swaps. Derivatives are a risk management tools used by investors to mitigate risk in any market or with any underlier or underlying asset class that has risk associated with its particular market. The scope of this essay concentrates on financial derivatives and discusses some of the more common asset classes on which financial derivates are based. Some of the more common assets that financial derivatives are based upon are: Bonds, currencies and interest rates. In essence, any underlying asset that is subject to market volatility and price fluctuations is a good candidate for being the basis for a financial derivative. Financial derivatives have really only been around for about the past 30 years. Prior to creating futures trading that is tied to financial instruments; futures were exclusively tied to commodities (most of which were agricultural). In the late 1960s and early 1970s, there was already talk amongst some of the more innovative leaders and economists in the U.S. about creating a new class derivative based on underlying financial instruments. There were several watershed events that took place in the early 1970s that ushered in the era of futures trading based on financial

Abstract
Financial derivatives are risk management instruments that derive their value from an underlying asset such as interest rates, government bonds or currencies. Financial derivatives are relatively new financial instruments; having come about in the early 1970s. There were a number of factors that helped financial derivatives to gain popularity, including: The reinstitution of variable monetary rates, the rise of computer technology and the globalization of markets and economies. Financial derivatives allow investors to hedge risk when investing in asset classes that are subject to unexpected and unpredictable price fluctuations. Some derivatives gain their value from commodities that are not considered financial derivatives such as oil, natural gas or corn. Financial derivatives are increasingly tracked through broader indexes that emulate securities indexes. There are several categories of financial derivatives that are widely used in todays market; these include: Futures and forwards; options, and; swaps. Financial markets are very innovative; the rise in popularity of

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Financial Derivatives

Essay by Carolyn Sprague, MLS

Keywords
Credit Derivatives Financial Instruments Hedging Real Estate Derivatives Underliers
instruments. The Commodities Future Trading Commission One of the pivotal events that brought about the inception of financial derivatives was the establishment of the Commodities Future Trading Commission (CFTC) in 1974. Several years prior to the establishment of the CFTC, there was talk of establishing interest rate futures, but since interest rates were clearly securities, this proposal did not fall under the then current definition of a commodity. It was the CTFC Act of 1974 that redefined what a commodity was and it also granted exclusive jurisdiction by the CFTC to retain that [jurisdiction]. The Act is credited with defining futures stock indexes and interest rates (Collins, 2007). On September 11, 1975, the CTFC approved the first futures contract based on a financial instrument; it was known as the Government National Mortgage Association Certificates (Ginnie Mae). Merc & Leo Malmed Leo Malmed became head of the Chicago Mercantile Exchange (Merc) in 1969. At the time, the exchange traded futures based exclusively on meats and other agricultural products. At the time Leo Malmed became head of the Merc, the exchange was just in meats; according to Malmed, even butter and eggs werent trading. Still he didnt give up and by his own admission tried trading futures on many different commodities including: Apples, turkeys, shrimp, potatoes and oranges. All these products had one thing in common; they were all agricultural commodities and they had limited market appeal. In his own words, Malmed stated his concern; I was deathly afraid that Id be chairman of a single product exchange. Anything happened to that product, youre out of business. Mr. Malmed started asking himself if currency futures could be traded like pork bellies and beef. Malmed understood that if currency futures were possible, then it was conceivable that any financial instrument could be used to trade futures (Ryan, 2006). It was at this time that the fixed rate monetary exchange system (as had been established in the Bretton Woods Agreement of 1944) was being abandoned. Malmeds idea was to establish a way to trade foreign exchange futures

that would be based on the floating exchange rates. As Malmed pointed out, agricultural commodities were limited and had limited appeal, but with financial instruments it was anything you want (Ryan, 2006). Risk Because financial derivatives are based on assets that are inherently risky themselves (for example interest rates), financial derivatives can also be risky financial instruments. Like many financial market instruments, the higher the risk, the greater the chance for high financial rewards. Derivatives allow for investors to look at industries and sectors that face risk and use a mechanism (derivative) to price and transfer that risk. Understanding where current risks are and where future risks will be is crucial to the success of effectively using derivatives as an investment tools (Collins, 2007). Warren Buffet is famous for making the following statement about derivatives in 2002. We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal (At the risky end of finance, 2007). Financial derivatives have been described by many proponents as financial instruments that threaten the status quo; they are also credited for making opaque markets more transparent. The love/hate relationship with financial derivatives will continue in the future and new derivative products are introduced to investors. As with most change, there will be reluctance, speculation and fear regarding new derivative products. As investor confidence in derivatives rises, however, markets and investors will embrace instruments that will help them manage the risk/return paradigm. This essay discusses both sides of the risk/return spectrum of financial derivatives: Do derivatives disperse risk or boost it?

Applications
There are three main types of derivatives that fall under the broader heading of financial derivatives. These derivative types are: Futures and forwards; options, and; swaps. Forwards & Futures Forward and futures contracts are one category of financial derivatives. Forward and futures contracts are similar in that they are contracts that allow for the purchase or sale of an underlying security or asset with the actual delivery date to occur in the future. A future or forward contract allows for the buyer to lock in a price today for a transaction that will take place in the future (Forward and futures contracts, 2007).
Futures Publicly traded contracts Traded on exchanges Transactions handled by brokers Exchange assumes risk Forwards Private contract between buyer and seller Traded privately (aka: Over the Counter) Transactions handled by contract holders Parties assume risk

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Financial Derivatives

Essay by Carolyn Sprague, MLS

Over the Counter (OTC) derivatives are the fast growing financial instruments in modern capital markets. OTC derivatives are hitting the mainstream and allowing fund managers to add long and short term strategies to retail investors portfolios. OTC derivatives are both novel and complex instruments and their growing popularity is straining the operational infrastructure that supports the markets. OTC derivatives were initially traded by the brokerage arms of investment banks to structure hedge fund investments (Stillabower, 2007). Today, OTC derivatives are straining the operational platforms of firms that dont have the capacity and systems that have been built into exchanges. The risk of OTC financial derivatives has been outlined in the table, above, but that is not stopping institutional and retail investors from pursing OTC financial derivatives in droves. Theres a need to improve the processing, servicing and valuation of OTC derivative instruments as they become more widely accepted as financial instruments that mitigate risk and diversify investor portfolios (Stillabower, 2007). Options Options are defined as the right, but not the obligation, to buy or sell a specific amount of X (currency, index, debt) at a specific price during a specific period of time. Another way of stating what an options contract is, is to say that two parties have the right to engage in a future transaction of some underlying security. The buyer of the option is known as the option holder. The seller of the option is known as the writer of the option. The option holder and option writer are the two parties that must uphold the terms of the contract. The option holder has a couple of choices in exercising the option. Exercising an option can occur in the following ways: The option holder can buy a call option which gives him the right to buy a specified quantity of security at a set price at some point on or before the contract expiration date. The option holder can buy a put option that allows him to sell (the same as above). In either case, the terms of the contract must be fulfilled by the two parties that have entered into the contract (Options/option contracts, 2006). Swaps Swaps are the third common category of financial derivatives. In a swap, an agreement is made between two parties (counterparties) in which the parties involved swap cash flow streams, liabilities or debt. For purposes of illustration, we will assume that a contract involves a cash flow swap. Cash flows can be defined in various ways, but what matters most is that the two cash flows that are being swapped have equal value. The present value of the swapped assets must be equal at the time of the swap. Swaps can be used to hedge risk or to speculate in markets, but their fundamental purpose is to change the character of an asset or liability without liquidating the asset or liability. Parties use

swaps to change the nature of a cash flow stream to one that is less risky. Instead of renegotiation with the original counterparty, you enter into a swap with another party. Swaps allow investors to change existing contracts to ones that better meet their needs. When a swap occurs, the original counter party from the originating contract doesnt even need to know about the swap (Swap, n.d.). Today, credit default swaps are a derivative tool that is commonly used to transfer risk and is part of a larger class of credit derivatives. Credit derivatives are gaining popularity and finding their ways into many investment portfolios. The topic of credit derivatives is timely because of the role that they play in financing risk for commercial and residential mortgages in the United States. This essay discusses the trends in credit derivatives as related to the sub-prime credit troubles of 2007 and the emerging trend of derivatives that track real estate markets.

Issues
Credit Derivatives Credit markets are experiencing turmoil as 2007 draws to a close and theres a heightened anxiety and an acknowledgment of risk within them. The time is ripe for credit derivatives to gain a greater foothold in financial markets. Indeed in just a few years, credit derivatives have moved from being a highly technical byway for financial markets used primarily by insiders to a mainstream path traveled by nearly every investor on Wall Street (OLeary, 2006). The freewheeling credit markets of the past few years have drawn attention to the inevitability of a credit crunch. Banks that had diversified their investments into credit derivatives in 2001-2002 weathered the worst of that market downturn much better than some other lenders (OLeary, 2006). Not surprisingly then, the market has been looking for ways to hedge against a credit downturn. Credit derivatives may be perceived as the Holy Grail for hedging credit risk. The credit derivatives market grew 109% from 2005 to 2006 - accounting for $26 trillion in outstanding derivatives. Theres no question that the inception of a number of index-related derivatives has created more widespread appeal amongst more traditional investors. Index-related derivatives offer a broader balance of products than the more traditional single name derivatives that are pegged to a specific issuer. Tying credit derivatives to indexes more closely emulates equity market risk exposure. Investors are more confident in credit derivatives if the risk is spread across wider indexes. Nearly every product with a credit exposure has a number of derivative products tied to its performance and include a spectrum from high grade corporate bonds to leveraged bank loans (OLeary, 2006). The Underlying Bond Market Credit derivatives have yielded benefits to all levels of investors. In todays market that boasts low interest rates and narrow credit spreads, it is not difficult for investors at all risk levels to make gains. As mortgage borrowers with poor credit ratings begin to default on their mortgages (aks sub prime mortgages), the true test of credit derivatives may lie in the offing. Credit derivatives

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Financial Derivatives

Essay by Carolyn Sprague, MLS

derive their value from the bond markets (remember a derivative is defined as deriving its value from an underlying asset). In this case, the underlier is a bond. Collateralized debt obligations (CDOs) are the bundling of bonds, loans and swaps; each component carries different levels of risk. Some investors, such as banks and insurers prefer to own less risky slices of the risk pie - these slices are known as tranches. The tranches that have less risk associated with them are called senior securities. Investors that own these slices of risk in the CDO will get paid first from the interest on the bonds. The middle tranches are held by junior investors and this level holds more risk because these investors wont get paid unless primary obligations have been met. If defaults happen that affect any area of the CDO, the junior trances will take the first hit. The very lowest level tranches carry the most risk and are referred to as toxic waste. Even at this high risk and potential high return investment level, returns have flowed to investors over the past few years. Low interest rates, low instances of default and plenty of liquidity may have lulled even these investors into thinking that they are safe from risk. Residential Mortgage Backed Securities & Rising Defaults Theres no question that some CDOs are linked to sub prime mortgages through the purchase of other bundled investments known as residential mortgage backed securities (RMBS). CDOs bought RMBS bundles and now with the number of sub prime borrowers defaulting, the pain is trickling through the system (At the risky end of finance, 2007). According to Moodys credit rating agency, slightly less than 50% of CDO are invested in RMBS. However, in some extreme cases, some CDOs may have as much as 90% exposure to risky mortgages and as defaults rise, many of these tranches could head toward junk bond status. Most analysts and market watchers admit that it is too early to tell what will happen because many 2006 mortgages that are at risk for default have not yet defaulted. Perhaps one of the biggest questions is just how complex some of these credit derivative structures are. The ever inventive financial sector has taken the ingredients and cooked up a bewildering alphabet soup of risk debt now know as a portfolio (At the risky end of finance, 2007). One analyst described credit derivatives with the following characteristics: Credit derivatives are currently the fastest growing, most heavily traded and most complex securities (OLeary, 2006) of all derivative instruments. Effects on the Global Credit Supply A second, and potentially just as serious, problem could be the effect of derivatives on the global supply of credit. David Roche, of Independent Strategy, argues that derivatives have created a form of liquidity outside the control of central bankers. It is pretty obvious that if one can buy a security that represents an asset for 3-5% of its value, an awful lot of liquidity has been freed

up, he says. Derivatives have led to many more assets and liabilities being created. By reducing the cost of buying assets, you increase the demand(At the risky end of finance, 2007, 31). The Real Estate Market Financial derivatives are a way for investors to manage risk, and for the past decade or so the U.S. real estate market has been seemingly risk free. Neal Elkin, president of Real Estate Analytics LLC, makes the following point, In a market thats going up 10% a year, nobodys thinking about hedging their portfolio, but we really are at a tipping point where the hedging of assets starts to make sense (Hudgins, 2007). Commercial real estate remains a strong investment option for many but the credit crisis and softening market of summer/fall of 2007 have spooked some investors about future prospects of real estate values. As the growth rate currently experienced may not be attainable in coming years, some are considering putting hedges in place in the form of derivatives (Credit crunch in U.S. good news for derivatives, 2007). CME Housing Futures & Options In the spring of 2006, the Merc announced the launch of the S&P CME Housing Futures and Options. This derivative enables investors to invest in the futures market for nationwide home prices or in 10 major U.S. cities, including: New York, Los Angeles and Chicago. Yale Economist Rober Shiller points out that this development is long overdue. Of the 3 major asset classes, the bond, the stock and the housing markets, only the housing market, with $20 trillion in assets cannot be speculated on easily. How can it be that we have no way of trading it [housing]? (Christie, 2006). In the U.S., derivatives have yet to catch on, sources say, largely because the real estate industry here has been accustomed to thinking in terms of assets that are concrete, not derived. Its still a relatively new concept in the U.S. real estate industry, a new way to manage risk, said Kiva Patten, a director at Merrill Lynch who specializes in real estate derivatives. Like any new concept, its taking time for traditional players to get up to speed, but were beginning to see that now. Moreover, in recent years, real estate investors have perceived no need for the kind of sophisticated risk management that derivatives offer because, on the whole, commercial real estate values have been going up, sources say (Credit crunch in U.S. good news for derivatives, 2007, 2). The Index of Real Estate Market Performance Derivatives are tracked using an index of real estate market performance. The derivative gains or loses value in tandem with the ups and downs of the index. The idea that investors will be able to invest in a market such as real estate without having

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Financial Derivatives

Essay by Carolyn Sprague, MLS

to acquire and hold a hard asset is a very radical concept for many investors. In the U.S., investment in real estate markets has always been thought of in terms of acquisition of tangible assets, so real estate derivatives will take some getting used to. Investors can participate in the investment of property by going to the futures market without actually having to go through all the legal hurdles of actually buying the hard asset. Trading in real estate derivatives makes it easier to get in, its easier to get out (Hudgins, 2007). Both Standard & Poors and Moodys investor services have introduced commercial property indices in 2007. Several of the indices have been developed collaboratively between real estate analytics and research firms and the major investor services firms. The indices include the following historical data: Construction records, real estate sales transactions, property values and appraisals (Hudgins, 2007). The Merc began hosting futures trading based on S&P/GRA indices in October 2007. The concept of a derivative to manage and trade real estate futures wont be an overnight hit, but as the credit crunch worsens, risk increases, and property values fall, derivatives are going to become more and more attractive. Real Estate transactions amounted to $330 billion in 2006 leaving the potential for 10s of billions of dollars in domestic derivatives trading. Those most familiar with derivatives point out that the biggest obstacle to the wholesale adoption of derivatives in most markets is the lack of familiarity of investors with the necessary tools (Hudgins, 2007). Risk Management & Reduction Derivatives will appeal to large institutional investors for the most part as a risk management and reduction tool. Mortgage bankers for example, could hedge against falling real estate markets that would increase exposure to delinquencies and foreclosures (Christie, 2006, 7). Ordinary investors could also buy futures in housing prices and profit if prices continue to increase. Economist David Stiff believes that the individual homeowner will be able to buy home equity insurance to protect against the loss of falling home prices. If homeowners can purchase insurance against the risk of fire or theft, then why not protection against losses from home price decreases? Many unfamiliar with derivatives ask if trading housing price futures might make the markets volatile. According to Stiff, Real Estate is already volatile and risky-like the stock market. The risk is increasing daily-theres an erroneous assumption that the real estate market only goes up. [Stiff continues:] We need hedging on both sides (Christie, 2006).

understand. Individuals will lose money in the market, but that is nothing new. Systemic risk is a valid worry. For now, risk seems to be well diversified, with many more investors involved than at any previous time (for derivatives). Holders of risk tranches should act like the concerned parent watching the toddler at the swimming pool; never letting their eyes stray from their charge. The real challenge for some investors is that they may be two or three moves away from the borrower; this is the best illustration of a recipe with too many ingredients. Many questions remain, regarding credit derivatives and derivatives in general, but one is the following: Will credit derivatives encourage investors to take on more risk? In the sub prime mortgage arena, underwriting standards fell sharply leading to defaults. What will happen if corporate defaults increase and senior tranches are hurt? What will investors be able to recover and how much risk will derivatives actually mitigate? (At the risky end of finance. 2007).

Terms & Concepts

Derivatives: Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds (Davies, 2007, 2). Financial Instruments: Tradeable units of capital; each having their own unique features and form. Fixed Exchange Rate: Also known as a pegged exchange rate, a fixed exchange rate is when the government or central bank links the official exchange rate to another countrys currency or the price of gold. A fixed exchange rate system is meant to keep a countrys currency valued at a specific amount. Floating Exchange Rate: An exchange rate system where the currency value is established by the foreign-exchange market based on the supply and demand for that individual currency compared to other currencies in the market. Forward Contract: A cash market transaction where the product is not delivered until after the contract has been set. The price is established on the first trade date despite the fact that the delivery will be made later. Futures: A term designating the standardized contracts covering the sale of commodities for future delivery on a futures exchange. Hedging: Hedging refers to the strategy of making an investment to reduce the potential risk of disadvantageous price movements in an asset. Investors rely on this strategy when they are uncertain about future market movements. Option: Contracts with a seller and a buyer that give the buyer the right, but not the obligation, to buy or sell the asset.

Conclusion
Fears remain that some investors dont understand this complex instrument and may well be exposed to risk that they dont

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Financial Derivatives

Essay by Carolyn Sprague, MLS

Over-the-Counter: Options are traded between private parties, an instrument is traded over-the-counter (OTC) if it trades under circumstances other than a formal exchange. Swap: A swap can be an agreement to swap interest rates, cash flow streams, or liabilities between two parties. The assets or liabilities being swapped must have equal value; swaps allow companies to reduce risk and/or realign contracts to better suit their investment needs. Underliers: The value(s) from which a derivative derives its value is called its underlier(s).

McMahon, C. (2007). William Brodsky: Writing the rules, shaping the future. Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders, 36, 14-15. Retrieved December 13, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost. com/login.aspx?direct=true&db=buh&AN=27392718&sit e=ehost-live Options/option contracts. (2006). Reference for business. Retrieved December 19, 2007, from http://www.referenceforbusiness.com/encyclopedia/Oli-Per/Options-OptionsContracts.html Ryan, O. (2006). The man who saw the futures. Fortune, 154(12), 114-116. Retrieved December 18, 2007, from EBSCO Online Database Business Source Premier. http:// search.ebscohost.com/login.aspx?direct=true&db=buh&A N=23452144&site=ehost-live Swap. (n.d.) Risk glossary. Retrieved December 26, 2007, from http://www.riskglossary.com/link/swap.htm Stillabower, P. (2007, February 17). The economics of OTC derivatives processing. The Trade News. Retrieved December 26, 2007, from http://www.thetradenews.com/ expert-opinion/530 Van den Berg, B. (2007). Derivatives futures. In B. van den Berg (Ed.), Understanding financial instruments (ch. 6). EagleTraders.com. Retrieved December 18, 2007, from http://www.eagletraders.com/books/afm/afm6.htm Van den Berg, B. (2007). Derivatives options. In B. van den Berg (Ed.), Understanding financial instruments (ch. 7). EagleTraders.com. Retrieved December 18, 2007, from http://www.eagletraders.com/books/afm/afm7.htm

Bibliography
At the risky end of finance. (2007, April 19). Economist.com. Retrieved December 21, 2007, from http://www.economist.com/business/displaystory.cfm?story_id=9033348 Christie, L. (2006, March 22). New way to bet on real estate. CNNmoney.com. Retrieved December 20, 2007, from http://money.cnn.com/2006/03/22/real_estate/playing_the_ home_price_market/ Collins, D. (2007). Richard Sandor: Inventing markets out of thick air. Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders, 36, 12-43. Retrieved December 13, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost. com/login.aspx?direct=true&db=buh&AN=27392717&sit e=ehost-live Credit crunch in U.S. good news for derivatives. (2007). SCTWeek, 12(44), 3. Retrieved December 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bt h&AN=27390759&site=ehost-live Davies, R. (2007). Gambling on derivatives. University of Exeter. Retrieved December 21, 2007, from http://www. projects.ex.ac.uk/RDavies/arian/scandals/derivatives.html Forward and futures contracts. (2007). Financial Web. Retrieved December 20, 2007, from http://www.finweb. com/investing/forward-and-futures-contracts.html Hudgins, M. (2007). Derivatives debut in commercial real estate. National Real Estate Investor, 49(11), 12-13. Retrieved December 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost. com/login.aspx?direct=true&db=buh&AN=27478833&sit e=ehost-live

Suggested Reading
Clary, I. (2007). CME launches S&P futures contracts as Russell exits. Pensions & Investments, 35(16), 14-14. Retrieved December 13, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26247590 &site=ehost-live

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Financial Derivatives

Essay by Carolyn Sprague, MLS

Hintze, J. (2007). OTC vendors see fertile ground in U.S. Securities Industry News, 19(38), 16-22. Retrieved December 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/ login.aspx?direct=true&db=bth&AN=27390759&site=eh ost-live

Kaza, G. (2006). Derivatives regulation of financial derivatives in the US code. Derivatives Use, Trading & Regulation, 11(4), 381-386. Retrieved December 13, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=b uh&AN=20798442&site=ehost-live

Essay by Carolyn Sprague, MLS

Carolyn Sprague holds a BA degree from the University of New Hampshire and a Masters Degree in Library Science from Simmons College. Carolyn gained valuable business experience as owner of her own restaurant which she operated for 10 years. Since earning her graduate degree Carolyn has worked in numerous library/information settings within the academic, corporate and consulting worlds. Her operational experience as a manager at a global high tech firm and more recent work as a web content researcher have afforded Carolyn insights into many aspects of todays challenging and fast-changing business climate.

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