CHAPTER 14 - FINANCIAL DERIVATIVES
Four main financial markets?
Derivative Markets: forward contracts, futures, options
Forward contracts: private contracts, no secondary market,
non-marketable.
Example: Jolly Green Giant Co., or Pepsi-Cola, enter into a
forward
contract to purchase corn at harvest time, at a guaranteed price,
from
various farmers. Advantage: buyer (company) and the seller
(farmer) have
a guaranteed price. They are now protected from price swings,
they have
eliminated price risk by hedging their position.
Advantage of Forward Contracts: very flexible. Parties can create
a customized
agreement.
Disadvantages: 1) Not liquid market, no secondary market. Might
be hard
to match up the two parties to the transaction.
2) High default risk. No outside party guaranteeing the
transaction, like
there is in the futures market.
3) Requires actual delivery to complete the contract.
Advantages of futures contracts:
1. Liquid market, lots of buyers and sellers, organized exchanges
all over
the world.
2. Active secondary market. Contracts may trade hands many times
before
expiration.
3. Minimal risk - exchanges require initial margin requirement
and enforce
daily settlement of all gains and losses to avoid default. Max
price movement,
daily limit, minimizes large losses.
4. Cash settlement of most contracts. You can close out your
account by taking an offsetting position. If you go long, you go short to
close out
your position, and vice-versa. You are basically agreeing to sell
the contract
to yourself, so you can cash out without having to make or
receive delivery.
Always ask: What is the party worried about? What do they want to
insure
against? What position do they take?
Buyer: worried that P will go up in future. ( go long, buy
forward)
Seller: worried that price will go down in future. (go short,
sell forward)
Exporter, receiving foreign currency: worried that foreign
currency will
depreciate in future. (go short, sell foreign currency
forward)
Importer, paying in foreign currency: worried that dollar will
depreciate
in future.(go long, buy foreign currency forward)
Borrower, taking a loan in the future: worried that int rates
will rise,
bond P fall. (go short, sell Tbonds forward using Tbond futures
contracts)
Saver/Bank, lending money in future: worried that int rates will
fall,
bond P rise. (go long, buy Tbonds forward using Tbond futures
contracts)
Derivative market: Insurance Market. Allows firms to manage,
predict and
control their revenue and expenses by locking in prices ahead of
time,
to eliminate or minimize ex-rate, price or interest rate risk.
Financial futures: interest rate contracts, stock index
contracts, currency
contracts
Commodity futures: grains (corn, oats, soybeans, wheat, barley),
metals
(copper, gold, silver, platinum) livestock (hogs, cattle, pork
bellies),
foods and fibers (sugar, coffee, cotton, orange juice, rice),
petroleum
(crude oil, natural gas, heating oil, gasoline, propane),
miscellaneous
(lumber)
Chicago Board of Trade started in 1848. Commodities traded -
grain, beef,
pork bellies, etc.
Rival exchange - Chicago Mercantile Exchange
started in
1874 - specialized originally in butter.
Now there are many futures exchanges: CBT, CME, NYM, CSCE (coffee,
sugar
and cocoa exchange), CTN (NY cotton), TFE (Toronto futures), MPLS
(Mpls
grain exchange), NYFE (NY futures exchange), ME (Montreal
exchange), etc.
Helped to stabilize volatile agricultural prices. Prices dropped sharply after harvest and then rose sharply when shortages developed later.
62% of futures are now for financial futures - bonds, stock indexes and currency. The largest single futures market is for Bonds. Risk that markets are most worried about? Int rate risk.
Example: S&Ls exposed to int rate risk. Assets = Long-term mortgages, Liabilities = Short-term deposits. Value = PV Assets - PV Liab. If int rates go up, the PV of assets falls more than PV of liab.
Worried?: Int rates going up, bond prices going
down. Position:
go short on (sell) T-bond futures contracts to protect against int rate
risk. If
int rates go up, the Value of the bank fall, but the bank makes
money on
the futures contract to offset some or all of the loss. If int
rates fall,
the value of the bank goes up, but there is a loss on the futures
contract.
In either case, the value of the bank is stabilized, protected
from large
fluctuations.
Futures contract are agreements to buy or sell a specific amount
of a commodity
at an agreed upon price at an agreed upon date in the future.
Contracts
can be from 1 month to ten years, depends on commodity.
Agricultural commodities
- one year. Financial futures (bonds, SP500 Index), precious metals,
petroleum
products, etc are longer.
Example of contract - corn Sept 99 @ 245 in WSJ. $2.45/bu for 5000 bu per contract. Over 6000 contracts outstanding. Open interest. 145,000 contracts outstanding for Dec 98.
Graph:
Long position will make money when P > $2.45. Short position will make money when P < $2.45. Potential gains and losses are unlimited. Can be very risky.
Two types of futures participants:
1)Hedgers - have a personal or business interest in the future price.
Example - corn farmer (seller) is worried about P going down. Can use futures contract to lock in price now for his/her future crop.
Pepsi-Cola (buyer) is worried about P going up in the future. Can lock in future price now.
2) Speculators - no personal/business interest in the commodity. Pure investment or gamble.
Important point: Futures contracts are usually settled in cash, not the commodity. Cash payment/receipt is used to hedge position.
Example: Farmer protects his 100,000 bu crop with futures contracts. Locks in a price of $2.45/bu. Worried? spot prices falling. Futures Position: goes short to hedge against price declines.
Guarantees revenue of $245,000 no matter what
happens
to prices. Suppose prices fall to $2.00/bu. Gets only $200,000
cash in spot market from sale of crop, but makes $45,000 on
futures contract. (2.45-2.00) x 100,000 = $45,000. Future contract is
settled separately IN CASH.
Proceeds from sale @ cash price = $200,000
NET REVENUE = $245,000
Suppose prices rise to $2.95/bu, he/she now gets
$295,000 cash from spot price for corn, but loses $50,000 from futures
contract. ($2 - 2.50) x 100,000 = -$50,000
Proceeds from sale @ cash price = $295,000
NET REVENUE = $245,000.
IMPORTANT POINT:Futures contracts are settled in CASH, not the
actually commodity. In some cases, like SP500 Index futures contract,
there is really no way to actually deliver anything. In the example
above, the farmer 1) sells his/her corn at the CASH/SPOT price,
Farmer eliminates additional profit opportunity
for the
safety/guarantee of no losses. Assume that costs of production
are $2.00/bu
or $200,000. Corn @ $2.45 guarantees a profit of $45,000. Willing
to give
up potential windfall profit ($2.95/bu) to lock in a guaranteed
price of
$2.45. Farmer is in the farming business not in the risk-taking
business. Corn at $2/bu would mean a $10,000 loss.
Speculators make the market more liquid, thicker
and more
efficient! MECHANICS OF COMMODITIES CONTRACTS Hypothetical investment. It is May and we
consider a Dec
wheat contract at $4/bu. Contracts are for 5000 bu so the total
contract
is worth $20,000. We can control $20,000 of wheat with a small
investment.
Highly leveraged. Highly risky. Margin requirement: the amount that has to be
put up.
Ranges from 2-10 percent depending on the contract. Wheat
requires a $600
margin, or 3% of the total value of the contract. Much more
highly leveraged
than stock trading on margin - 50% requirement. Margin maintenance requirements - like a minimum
balance
requirement. Usually 60-80% of the initial margin. For wheat, we
assume
that it is $400. Daily settlement - accounts are settled daily to
protect
investors. If your account goes below $400, you need to put up
additional
money to cover the losses and get the margin account back to
$600. Assume that you take a long position. You buy
wheat (go
long) at $4, hoping that the price goes up. A 4 cent reduction in wheat, from $4 to $3.96,
would result
in a loss of $200 (5000 x .04 = $200). Any additional movement
would require
additional margin funds. You would get a call from broker asking
for additional
margin funds. You could either close out your account or keep
putting up
money. 4 cents is a 1% movement, so you money can disappear very
quickly.
A 3% movement would wipe out your entire
investment (3%
= $0.12 x 5000 = $600). On the other hand, assume that prices move in
you favor
and increase to $4.12/bu, a 3% increase within one month. You
make $600
(5000 x .12) for a return of 100% in one month: 600/600 x 100 = 100% (1200%
annualized) There is still five months to go on contract.
You can
cash out by reversing your position (going short cancels your
long position),
let the contract continue or double up and buy another one. The
$600 gain
is enough to buy another contract. Price limits To protect investors against losses and to
minimize volatility,
there are daily price limits on futures contracts. Example, corn
can only
move by 10 cents a bushel, up or down, before trading is
discontinued for
the day. Financial Futures - latest innovation,
development in
futures trading. Three categories: currency futures,
interest-rate futures
and stock index futures. Currency futures: used by international
businesses to
hedge ex- rate risk. Example:. U.S. exporter agrees to ship beef to UK
in 6
months for a fixed amount of British pounds. Exporter will
exchange pounds
for dollars in 6 months. Worried?: British pound will depreciate.
You can
hedge and lock in a price today by selling British pound futures.
Example: Exporter agrees to sell 1 lb beef = 1
British
pound. At current rates of $1.50/Br Pound, the US exporter would
get $1.50/beef.
If B Pound weakens and goes to $1.25/BP, the exporter will only
get $1.25.
It could strengthen and go to $1.75/BP, but that creates massive
uncertainty.
Assume a futures contract is available for $1.50/BP, exporter
locks in
at $1.50/lb. Worried? Pound falling. Goes short on British pound.
If worse case happens, and pound falls to
$1.25/BP, the
exporter loses .25 on beef income, but gains .25 on the futures
contract,
offsetting one another. Importer: agrees to buy German wine in six
months for
a fixed amount of DMs, 10 DMs per bottle. Will take dollars and
buy DMs
in 6 months. At the current rate of $.65/DM, that would be
$6.50/bottle.
Worried about? The dollar getting weaker, the DM getting
stronger. For
example, if the ex-rate goes to $.75/DM, the cost would be
$7.50/bottle,
over a 15% increase. The importer would hedge by buying/going
long on DM
futures contracts. Summary: Exporters: receiving foreign currency in
future,
worried about foreign currency getting weaker (dollar
strengthening), sell
currency futures. Importers: paying in foreign currency in future,
worried
about dollar getting weaker, foreign currency getting stronger,
buy currency
futures. Interest Rate Futures - to protect against
interest rate
risk. Logic: You will borrow money in the future, you are worried
about
interest rates rising, bond prices falling. You will invest money in the future, you are
worried about
interest rates falling in the future, bond prices rising.
T-bonds. Contracts = $100,000. Prices are quoted
as percentages.
A Dec Tbond futures is now 116.25 or 116 and 25/32% of $100,000 =
$116,781.30
face value. The margin requirement is about $2400 with a $1750
margin requirement.
If you go long (buy) you hope that interest rates decline and the
price
of the contract goes up. Suppose that interest rates fall by .6
percent
or 60 basis points. The price would rise by 1 17/32, from bond
table, or
$1532 ( 1 17/32 x 100000). Your return would be 1531/2400 or
63.8%. Hedging Example: Corp has a $10m, 15 yr bond to be issued in 60
days. Long
term rates are currently at 10.75% and there is concern that
rates will
increase to 11% by the time the bonds are issued. The extra 1/4%
would
translate to an extra $25000/yr in additional interest expense.
(10,000,000
x .25%) The PV would be $179,775 as follows: n=15 i=11 PV=?
PMT=25,000
FV=0 Worried about? Int rate rising, bond prices
falling. Hedge: Sell Tbond futures short for a 60 day
maturity.
If int rise and bond prices fall, you make money. Assume that
Tbond futures
are selling at 92 (92% of 100,000). Face value is 92,000 per
contract.
Sell 109 contracts to cover the $10m. (109 x 92,000 =
10,028,000). If interest
rates increase by .25%, you will make enough on the Tbond futures
to cover
the extra interest. Cross-hedging - This is an example of
cross-hedging because
Tbond futures are being used to hedge against interest risk for
corporate
bonds. We assume that interest rates on Tbonds and corporate
bonds move
together. May not always hold exactly. Perfect hedging is not
always possible.
Example: maturity dates of bond issues may not match and/or bond
issue
date and future contract expiration dates may not match. (There
are currently
Tbond futures contracts for Sept, Dec 1996, Mar, June 1997).
Partial hedge - only hedge against part of the
risk. Example
above: hedge only $5m or $8m. Farmer: hedge only 50,000 bu instead of 100,000.
Hedging with Interest-Rate Futures Examples 1-5 on page 385. STOCK INDEX FUTURES - used to hedge against stock
market
declines, like buying portfolio insurance. Contracts includes SP500 Index
futures, DJIA futures, SP400 Midcap Index futures, Russell 2000, NASDAQ
index futures, etc. Hedging strategy: Sell SP500 Index futures contracts,
go SHORT. Relationship between Spot Price (P) and Futures
Price
(F). (possible arbitrage) F = P + CC (carrying cost). Example: RCCL needs oil in one year. They have
two options: 1. Buy today at P and store at a cost of CC. CC
= storage
costs, insurance, spoilage/leakage, opportunity cost of tying up
its funds
for one year. Example: P = $18/bbl CC = $1/bbl/yr and F = $20.
Strategy = buy spot at $18, incur the storage
cost of
$1, sell futures at 20, make $1/bbl. If F < P + CC, then you should buy futures
and sell
spot. Example: P = $18 CC = $1/bbl/yr and F=$18.50.
Strategy: sell spot at $18 now, buy futures at
$18.50
and save $.50/bbl.
2. Buy at F. Compare F vs. P + CC. If P + CC is
< F, you
can make money by buying spot and storing for one year and
selling futures.