Transcript Ch 7

Derivatives, Hedging, and Speculating
Warren Buffet (Oracle of Omaha): fin derivatives = fin weapons of mass destruction.
Problems with derivatives (value from underlying asset) not traded on exchanges:
1 Derivatives are thinly traded, and dealers use pricing models that may be inaccurate.
2 Many unregulated and firms may not set aside sufficient reserves to offset losses.
3 Derivatives not traded in exchanges have substantial counterparty risk.
Financial derivatives played an important role in the financial crisis of 2007-2009.
Despite Buffett derivatives provide risk-sharing (hedge/insure), liquidity & info services.
If insurance or hedge is available on an activity, more of that activity will occur.
Hedge is to take action to reduce risk.
But derivatives can also be used to speculate (fin bets to profit from price changes).
Speculation and speculators provide two useful functions:
When hedger sells a derivative to a speculator, they transfer risk to the speculator.
Speculators provide essential liquidity; otherwise, there would not be a sufficient
number of buyers and sellers for the market to operate efficiently.
Forward Contracts
An agreement to buy or sell an asset at an agreed upon price at a future time, provides
an opportunity to hedge the risk on transactions that depend on future prices.
Key features of a forward contract:
Spot price at which a commodity or financial asset can be sold at the current date.
Settlement date for delivery of asset specified in a forward contract at forward price.
Forward contracts are specific in terms (customized) so they are:
- illiquid
- subject to specific default or counterparty risk (other side of the transaction defaults)
Futures Contracts
A standardized contract to trade a specified amount of an asset on a specific future date.
Differences from forward contracts:
- Futures are traded through exchanges or clearinghouses (CBOE Chicago Board
Options Exchange or NYMEX New York Mercantile Exchange).
- Futures contracts specify a quantity of the asset to be delivered but do not fix the price.
- The prices of futures change continually but equals spot price at maturity.
Trading in the Futures Market
Margin requirement is the minimum deposit that an exchange requires from
the buyer or seller of a financial asset.
Example: Futures contracts for U.S. Treasury notes are standardized at a face
value of $100,000 of notes. The CBOT requires that buyers and sellers deposit
a minimum of $1,100 for each contract into a margin account.
Marking to market is a daily settlement in which the exchange transfers funds
from a buyer’s account to a seller’s account or vice versa, depending on
changes in the price of the contract.
Hedging and Speculating with Commodity Futures
Short position: obligation of the seller to deliver the asset on the specified date.
Long position: obligation of the buyer to receive the asset on the specified date.
You plant wheat in May expecting 10,000 bushels yield in August. Spot price is
$2.00 per bushel. You are concerned that August price < $2.00. Manager at
General Mills (produces cereal) is concerned that August price > $2.00.
Hedging involves taking a short position in the futures market to offset a long
position in the spot market or vice versa. In the futures market for wheat, you can
take a short position and the General Mills manager can take a long position.
To fulfill the futures obligation, you can engage in settlement by delivery or by offset.
Profit (loss) to the buyer = Spot price at settlement - Futures price at purchase
Profit (loss) to seller = Futures price at purchase - Spot price at settlement
Investors not connected with the wheat can use futures to speculate.
If you were convinced that August price of wheat will be lower than the current
futures price, sell wheat futures and buy wheat cheaper on or before the settlement.
Hedging with Commodity Futures
During the financial crisis of 2007–2009, some policymakers and economists
argued that the use of derivatives had destabilized the financial system.
The Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) of 2010
places additional restrictions on trading in derivatives.
Farmers were worried that (1) they might have to post more collateral to trade
futures, and (2) small community banks and special agriculture banks might no
longer be allowed to offer forward contracts.
In 2012, firms and cooperatives that used derivatives to hedge risk were exempt
from regulations.
Hedging and Speculating with Financial Futures
Today most futures traded are financial futures: Treasury securities, stock
indexes, and currencies.
An investor who believes that she has superior insight into future interest rates
can use the futures market to speculate.
If you wish to speculate that future interest rates will be lower (or higher) than
expected, you could buy (or sell) Treasury futures contracts.
Financial Futures for 5 year $100,000 T-Note with 6% Coupon
Mar 2013 prices (in x/32) < Dec 2012 => investors expect Treasury rates to rise.
How to Hedge an Investment in T-Notes When Rates Are Low?
After 2007-09 fin crisis rates fell very low. In 2012 investors bought bonds despite
low yields and WSJ article’s warning about a “nasty bear market in bonds.”
a. What does a bear market in bonds mean?
A price decline of at least 20%.
b. What might cause a bear market in bonds?
Investors expecting higher inflation => higher nominal rates => lower bond prices.
c. How might it be possible to hedge the risk of investing in bonds?
Investors who own bonds are long in the spot market for bonds, so the appropriate
hedge calls for them to go short in the futures market by selling futures contracts.
Options
Holder has the right but no obligation to buy (call - bullish) or sell (put - bearish)
underlying asset at strike (exercise) price at any time up to the expiration
(American) or only on the expiration (European), while writer has the obligation.
Suppose Apple currently trades at $600. Investor believing price will rise to $650 (fall
to $550) in the next year could buy a call option with strike price of $610 (put option
with exercise price of $590) for $10 premium. If price stays below $610 (above $590)
call (put) option holder allows it to expire.
Profits for call and put option holder are illustrated below. Option is in/at/out of
money if payoff for option holder >=< 0 if exercised.
Option Pricing
Option price (premium) reflects probability that it will be exercised. It has two parts:
1. Intrinsic value is the payoff to the buyer from exercising it immediately.
Because buyer does not have to exercise option, its intrinsic value is always > 0.
2. Time value is determined by option’s expiration date and asset price’s volatility:
The further away in time an option’s expiration date, the larger the option premium.
The greater the price volatility of the underlying asset, the larger the option premium.
The Black-Scholes formula for option pricing led to an explosive in options trading.
“Rocket scientists” or “quants” evaluate and price new securities on Wall Street.
Using Options to Manage Risk
Options (max loss = premium with unlimited gain on call) are more expensive than
futures (locks value of portfolio consisting of original contract and hedge position).
Many hedgers buy options, not on the underlying asset, but on a futures on that asset.
Options Listings for Amazon.com Currently Trading at $260.47
The October contract Last price is $16.50. The Volume show the number of contracts
traded, and the Open Interest show the number of contracts not yet exercised.
a. Why are the call options selling for higher prices than the put options?
Because all call options are in the money and the puts are all out of the money.
b. Why does the April call sell for a higher price than the October call?
The further the expiration, the greater the chance that intrinsic value will increase.
c. If you buy the April call, would you exercise it immediately.
No since current price - strike - premium = $260.47 - $245 - $33 = -$17.53 loss.
d. What is profit from buying the November call when Amazon stock trades at $300.
Earn = current price - strike - premium = $300 - $245 - $22.05 = $32.95 profit.
e. What is profit from buying the April put if Amazon stock remains at $260.47.
Since selling at strike = $245 < $260.47 = current price => put out of money.
You would let put expire and take a loss equal to the option’s price of $18.65.
How Much Volatility Should You Expect in the Stock Market?
CBOE’s Market Volatility Index is based on put and call prices on S&P 500 index:
Investors expecting higher stock price volatility increase demand for options.
During 2007-09 fin crisis VIX reached record following collapse of Lehman Brothers
To hedge against increase in stock price volatility buy VIX futures sold by speculator
who bets on a decrease in market volatility.
Swaps
Agreements between two or more counterparties to exchange cash flows.
Unlike futures and options, swap terms are flexible, offer more privacy, are not subject
to government regulation, and can be written for long periods. However, check the
creditworthiness of partners, for swaps are less liquid than futures and options.
Under interest-rate swaps counterparties agree to swap interest payments over a
specified period on a fixed dollar amount (notional principal) to transfer interest-rate
risk to parties more willing to bear it. The interest rate is often based on LIBOR.
Wells Fargo bets LIBOR (representing inflation) stays below 2%.
If inflation increase and LIBOR = 3% WF owes IBM 700,000 = 10,000,000(.03+.04).
IBM owes WF 600,000 = 10,000,000×.06.
Generally, parties exchange only the net payment and WF pays 100,000 to IBM.
Currency Swaps
Counterparties agree to exchange principals denominated in different currencies.
Both parties can borrow cheaply at home and swap loans.
A basic currency swap has 3 steps:
1. The two parties exchange the principal amount in the two currencies.
2. The parties exchange periodic interest payments over the life of the agreement.
3. The parties exchange the principal amount again at the conclusion of the swap.
Credit Swaps
Interest-rate payments are exchanged, with the intention of reducing default risk.
Banks with difficulty diversifying portfolios, reduce risk by swapping loan payments.
Credit Default Swaps
Requires seller to pay buyer if price of underlying asset declines.
During 2007-09 fin crisis most widely used along with mortgage-backed securities and
collateralized debt obligations (CDOs).
Issuer of credit default swap on mortgage-backed security receives payments from the
buyer in exchange for promise to pay buyer if the security goes into default.
The heavy losses that American International Group (AIG) and others suffered on
credit default swaps deepened the financial crisis and led more regulations.