ECN 314 - CH 13

CHAPTER 13 - FINANCIAL DERIVATIVES

What are the four main financial markets?

Derivative Markets: forward contracts, futures, options, future options, swaps, etc. Generally, a derivative security "derives" its value from the price movements in some underlying commodity, currency, common stock, stock index, T-bill, interest rate, etc. It is like a "side bet."

Why do derivative markets exist? Largely to facilitate hedging, the derivative markets are largely insurance markets. We saw in the last few chapters how interest rate risk played an important role in the S&L crisis. We also studied the potential adverse effects of currency risk on an international firm's profits. Firms, like individuals, are "risk averse" and would like to protect themselves against the three main types of risk that businesses face: PRICE RISK, CURRENCY RISK and INTEREST RATE RISK.

In this chapter, we look at futures contracts, and study the important role that they play in risk management and risk-sharing by allowing firms to hedge risk. The text focuses specifically on financial derivatives (used to hedge interest rate risk), but we will consider a broader coverage of futures....

SPOT MARKET vs. FORWARD/FUTURES MARKET: In the spot (cash) market, buyers and sellers agree on Price (P) and Quantity (Q) for immediate delivery (or within a few days). Examples: Ford buys 1m German marks in the spot market for currency, or it buys 1m pounds of steel in the cash market for steel. Or Mars Candy Company buys 1m pounds of sugar in the cash market. Northwest Airlines buys 500,000 gallons of gasoline in the spot market.

FORWARD CONTRACTS: private contracts between two parties (buyer and seller) agreeing to an exchange in the future. Buyer and seller agree on Price and Quantity today, for delivery sometime in the future (one month, one year, ten years). Forward contracts are private contracts, and are therefore not marketable securities, there is no secondary market, e.g. like the difference between a bank loan (not marketable) and a bond (marketable). We studied forward rates and forward contracts for foreign exchange in Chapter 7.

Example: Jolly Green Giant Co., or Pepsi Cola, enters into a forward contract in May to purchase corn at harvest time in October, at a guaranteed price, from various farmers for their entire crop. Advantage: buyer (company) and the seller (farmer) have a guaranteed price. They are now protected from price swings in corn, they have eliminated price risk completely by hedging their position, locking in a price with a forward contract.

Example: GM enters into a forward contract for British pounds with Bank One, to either buy pounds or sell pounds, in six months at a guaranteed ex-rate. By locking in, GM has hedged currency risk.

Advantage of Forward Contracts: they are very flexible can be customized to the needs of the parties.

Disadvantages of Forward Contracts:
1) There is not a liquid market for forward contracts, 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.

FUTURES CONTRACTS are the same in principle as a forward contract, where two parties (buyer and seller) agree to trade/exchange something (corn, oil, gold, Tbills, Yen) in the future (one week, one month, one year, ten years), but they agree on P and Q now, for future delivery, using a futures contract from a futures exchange - an organized market for trading futures contracts.

Advantages of futures contracts over forward contracts:
1. Liquid market, lots of buyers and sellers at organized exchanges all over the world (see handout).
2. Active secondary market. Contracts may trade hands many times before expiration.
3. Minimal risk - the futures exchange requires an initial margin requirement to open a position and they enforce daily settlement of all gains and losses to avoid default. There is a maximum price movement, called the daily limit, to minimize large losses. Example: daily price limit for wheat futures contracts is 20 cents per bushel, trading stops for the day.
4. Cash settlement for most futures contracts, instead of settlement in the actual commodity.
5. You can close out your account any time by taking an offsetting position. If your original position is to buy (go long) a futures contract, you can subsequently sell (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.

Disadvantages of futures contracts over forward contract:
1. Less flexible, since futures contracts are for fixed, standard amounts, e.g. corn futures contracts are for 5,000 bushels per contract.
2. Expiration dates are fixed, e.g. Jan, March, May, July, September, and December for corn contracts, so there are only six delivery days per year.

Example: Suppose a corn farmer expects a yield of 7,500 bushels of corn at harvest next October, and wants to use a futures contract to hedge commodity price risk by taking a short position in corn futures. The farmer's amount of corn and the timing of his/her harvest don't perfectly coincide with a standardized corn futures contract. The farmer would have to sell one or two corn futures contracts for either September or December, and would either be under hedged or over hedged.

TWO GENERAL TYPES OF FUTURES CONTRACTS

1. FINANCIAL FUTURES: interest rate contracts (T-bonds, fed funds, Eurodollar, etc.) to manage interest rate risk, stock index contracts (SP500 Index, DJIA) to hedge stock price declines (portfolio insurance), currency contracts (DM, Yen, SF, etc.) to hedge ex-rate risk. See pages 344-345 for a list of financial futures contracts and WSJ handout.

2. 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, seafood, electricity). These contracts allow participants to hedge against commodity price risk.

Chicago Board of Trade started commodity futures trading in 1848 for agricultural products: grains, beef, pork bellies, etc. Chicago Mercantile Exchange started in 1874 as a rival exchange to CBT, and specialized originally in butter futures contracts.

Now there are many futures exchanges: CBT, CME, NYM, CSCE (Coffee, Sugar and Cocoa Exchange), CTN (NY Cotton), TFE (Toronto Futures Exchange), MPLS (Mpls Grain Exchange), NYFE (NY Futures exchange), ME (Montreal Exchange), see WSJ handout.

Futures contracts helped to stabilize volatile agricultural prices. Prices dropped sharply after harvest and then rose sharply when shortages developed later.

About 2/3 of futures contracts are now for financial futures - bonds, stock indexes and currency and the other 1/3 is for agricultural commodities, metals and energy. Recent ranking of individual contracts by size (contracts traded): U.S. T-Bonds, S&P500 Stock Index, Eurodollars, Oil, Gold, Corn. Risk that markets are most worried about? Interest rate risk.

FUTURES TERMS: BUY = GO LONG and SELL = GO SHORT. Example: In WSJ, July 2001 corn futures are trading at 238 cents per bushel, or $2.38/bushel. You can buy corn or sell corn at that price for delivery in July 2001, in units of 5,000 bushel per futures contract. If you buy a July 2001 corn futures contract, you are "going long" on corn. If you sell a July 2001 corn futures contract, you are "going short" on corn.

FUTURES PAYOFF DIAGRAM:

PROFTIT/LOSS FROM FUTURES CONTRACT:

1. For the person SELLING CORN @ $2.38/bushel (short position), they will make a PROFIT when the spot/cash price of corn GOES BELOW $2.38/bushel and they will suffer a LOSS when the cash price GOES ABOVE $2.38/bushel.

Reason: They have a contract to sell corn at $2.38/bu to the futures contract buyer (long position), and if corn goes to $2 in the cash market, they could theoretically buy low at the spot price ($2) and sell high at the contract price of $2.38 and make money. If corn goes to $3.00 bushel in the cash market, they would now have to buy high at $3/bu and sell low at $2.38, for a loss $0.62/bushel.

2. For the person BUYING CORN @ $2.38/bu (long position), they will make a PROFIT when the spot/cash price of corn GOES ABOVE $2.38/bu and they will suffer a LOSS when the cash price GOES BELOW $2.38/bushel.

Reason: They have a contract to buy corn at $2.38/bu from the futures contract seller (short position), and if the spot/cash price goes to $3, they can buy low at $2.38 from the seller, and then sell high at $3 in the cash market and make money ($0.62/bu). However, if the cash/spot price goes to $2/bushel, they now have to buy high at $2.38 and sell low at $2.00, for a loss of $0.38/bushel.

POINT: Futures markets are ZERO SUM trades, meaning that for every contract there is a winner and a loser and the winner wins the same amount as the loser loses, NET OUTCOME = 0 (+$1 winner, -$1 loser, ZERO SUM OUTCOME). For example, if spot prices for corn go up to $3/bushel, the long position makes $.62 profit and the short position loses $.62. If the cash price falls to $2, the short position makes $.32 profit per bushel and the long position has a loss of $.32 per bushel.

TWO TYPES OF FUTURES MARKETS PARTICIPANTS:

1) HEDGERS - futures traders who have a personal or business interest in the future commodity price, ex-rate or interest rate, e.g. importers/exporters, corporations buying and selling in the future, farmers, portfolio managers, firms expecting to borrow money in the future, firms/investors expecting to invest money in the future, etc.

Examples - farmers (sellers) and producers are worried about the price of their product going down in the future. They can use futures contract to lock in price now for future output of oil, corn, sugar, steel, gold, beef, pork, lumber, etc. by going SHORT on contracts for their product.

Buyers of commodities are worried about the prices of the products they buy going up in the future, they can protect against price risk by going LONG on commodities, e.g. GM going long on steel, Northwest Airlines going long on oil or gas contracts.

Exporters (importers) receiving foreign currency (paying in foreign currency) can hedge risk by going short (long) on currency futures.

A firm borrowing money in the future is worried about interest rates going up, bond prices going down, they would hedge interest rate risk by going short on TBond futures contracts. A firm investing money in the future is worried about interest rates going down, bond prices going up, they would hedge by going long on TBond futures.

USING FUTURES CONTRACTS FOR HEDGING RISK, i.e. "BUYING INSURANCE"

To understand what position someone takes, always ask this question: What is the party worried about? What event do they want to insure against? What would represent an adverse price, currency or interest rate movement for that party? Once you identify what they are worried about, that determines the futures position they will take to protect against possible loss.

PRICE RISK
Buyer: worried about what? _____________ Futures Position: _____________
Seller: worried about what? _____________ Futures Position: _____________

CURRENCY RISK
Exporter: receiving foreign currency, worried? _______ Futures_____________
Importer: paying in foreign currency, worried?________ Futures_____________

INTEREST RATE RISK
Borrower: borrowing in the future, worried?________ Futures _____________
Lender: lending money in future, worried? _________ Futures _____________

Derivative markets are actually insurance markets, and allows firms to manage, predict and control their revenue and expenses by locking in prices, interest rates and ex-rates ahead of time, to eliminate or minimize currency, price or interest rate risk. The future is uncertain, unpredictable and risky for businesses, and they can use futures contracts to hedge risk of future uncertainties.

2) SPECULATORS - have no personal or business interest in the commodity or currency, they are trading futures contracts as a purely speculative investment or gamble. For example, an investor could take a position on a corn futures contract for July 2001 @ $2.38/bushel, and they are not in the corn business, they have no interest in actually receiving or delivering corn at expiration, they are just taking a position on the price of corn in the future. Derivative concept, the corn futures contract "derives" its value from the price movements in an underlying commodity, e.g. corn, and actual delivery of corn never actually takes place. Speculators can participate in futures trading because actual delivery is not required.

For example, if a speculator thinks the cash price of corn will go above $2.38/bushel sometime between now and July 2001, they take a LONG POSITION, and buy corn futures contracts. They are speculating that the P > $2.38, and will make money if that happens. They buy @$2.38/bu, and hope to "sell" at a price > $2.38/bushel, they make money at P > $2.38. Speculator is gambling (betting) that the price of corn will be > $2.38.

If the speculator thinks the cash price of corn will go below $2.38/bushel, they take a SHORT POSITION, and sell corn futures. They will make money if the
P < $2.38/bushel, they are betting that the price of corn will fall.

What would be the advantages of having speculators in the futures markets, in addition to hedgers?

EXAMPLE OF USING FUTURES CONTRACT TO HEDGE PRICE RISK: -

July 2001 corn is trading @ 238 in the WSJ (settle price), quoted in cents per bushel, so the futures price is currently $2.38/bu for July 2001 corn, and one contract is for 5,000 bushels of corn. The "open interest" is listed as 52,890, meaning there are almost 53,000 contracts outstanding right now for July 2001 corn. At the price of $2.38, you can either buy (go long) at that price or sell (go short) at that price. For each outstanding contract, there is a buyer (long) and a seller (short) who have agreed to buy or sell July 2001 corn. If you took a position today, you would either agree to buy or sell at $2.38/bushel.

Identifying the positions: Corn farmer, as a seller of corn, is worried about what? ________ What position do they take? ___________ Pepsi Cola, as a large corn buyer is worried about what? __________ What position do they take? ______________

HEDGING STRATEGY: Corn seller is worried about corn prices falling, so they take a SHORT POSITION on corn, to put themselves in a position to make money on a futures contract if there is an adverse price movement (falling prices). Corn buyer is worried about corn prices rising, so they take a LONG POSITION on corn, to make money on a futures contract if the worst case scenario develops: rising corn prices.

Example: Suppose the corn farmer expects a crop of 100,000 bushels and is worried that the price of corn will fall below $2.38 by next July. Farmer protects his 100,000 bushel corn crop with 20 futures contracts by going short on corn futures and locks in a price of $2.38/bu. for next July.

Payoff diagram for farmer's short position:

Important Point: 98% of futures contract gets settled in cash, not the commodity, corn in this example! If the farmer had a forward contract for $2.38, he/she would make actual delivery of the corn to the buyer. But for a futures contract, the farmer DOES NOT deliver the corn, they settle the futures contract in cash, NOT corn. The farmer will therefore have two separate transactions at harvest:

1. Cash transaction: Sell 100,000 bushels of corn in July 2001 at the spot (cash) price at that time.
2. Futures contract: Settle the futures contract in cash in July 2001.

The farmer uses the futures contract like an insurance contract to guarantee/lock-in a price of $2.38/bu and revenue of $238,000, but DOES NOT actually sell the corn for $2.38. The farmer sells corn at the spot price and uses the futures contract to guarantee a net price of $2.38 per bushel.

Example: a) Suppose the cash price for corn falls to $2.00/bu. by next July.
1. Farmer gets only $200,000 cash in the spot market from sale of crop, 100,000 bushels @ $2/bu. = $200,000 cash.
2. Farmer makes $38,000 profit on his/her short position in the corn futures contract. ($2.38 - $2.00) x 100,000 = $38,000. Logic: Farmer has a contract to sell 100,000 bu of corn at a price of $2.38 to the buyer (long), and they could theoretically now go out an buy it at the cash price of $2 and sell at $2.38, for a $0.38/bu profit.

Result:
1. Cash Proceeds from the sale @ cash price of $2/bu = $200,000
2. Cash Profit from short position on futures contract = $38,000
FARMER'S NET REVENUE = $238,000 for 100,000 bushels

Therefore, the farmer nets the guaranteed price of $2.38 per bushel, $2 from the cash market, and 38 cents per bushel profit from the short position in the futures market.

b) Now suppose prices rise to $2.68/bu in the cash market by July 2001. Farmer now gets $268,000 cash from spot price for corn, but loses $30,000 from the short position on the futures contract. ($2.38 - 2.68) x 100,000 = -$30,000.

Result:
1. Proceeds from sale @ cash price of $2.68/bu = $268,000
2. Loss from short position on futures contract = ($30,000)
FARMER'S NET REVENUE = $238,000 for 100,000 bushels.

Again, the farmer gets the guaranteed price of $2.38 per bushel, $2.68 in the cash market, minus the $0.30 loss on the futures contract.

POINT: Prices and go up or down, but the farmer has hedged price risk and locked in a price of $2.38 by going short on corn futures contracts. The farmer locks in a price of $2.38 and locks in total revenue of $238,000, and gives up the additional profit and revenue if corn actually goes up to $2.68, which would generate $268,000. However, the farmer is also protected against the worst case scenario of $2 per bushel and only $200,000 of revenue. Without the futures contract, the realized price for the farmer could range between $2 and $2.68/bushel, a 34% price spread; with the futures contract, the farmer gets a guaranteed, certain price of $2.38 per bushel. Farmer is in the farming business, not in the risk taking business.

Example of hedging for buyer: Royal Caribbean Cruise Lines uses futures contracts for June 2002 oil at $25/bbl. What are they worried about? _______ What position do they take? __________

Payoff Diagram for
RCCL Futures Contract:

Suppose spot prices go to $30/bbl by June 2002.
1. Gain on futures contract: ____________
2. Price in spot market: ________________
NET PRICE: __________________

Suppose spot prices go to $20/bbl by June 2002.
1. Loss on futures contract: _____________
2. Price in spot market: ________________
NET PRICE: __________________

Interest Rate Hedging Example:

Example: Corporation is going to issue $10m worth of 15 year bonds in 60 days. Long term bond yields 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 $25,000/yr in additional interest expense ($10m x .25%). The PV of the additional interest expense to the corporation over the next 15 years would be $179,772 as follows: n = 15, i = 11, PMT = $25,000, FV = 0, PV = ?

Worried about what???__________________________________

Hedging Strategy to protect against interest rate risk: Sell Tbond futures short for a 60 day maturity. If interest rates do rise and bond prices fall, you make money on the futures contract. If interest rates increase by .25%, you will make enough on the Tbond futures to cover the extra interest.

Example: S&Ls were and still are exposed to interest rate risk. Assets = Long-term mortgages, Liabilities = Short-term deposits. Value of S&L = PV Assets -PV Liab.
If interest 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 interest 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.

CROSS-HEDGING - The corporate bond case above 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, but they may not always move perfectly together (e.g. the Treasury yield curve has been downward sloping recently) Perfect hedging is not always possible here because futures contracts are not traded for corporate bonds, only TBonds. Also, bond issue date may not match perfectly with future contract dates. (There are currently Tbond futures contracts for December, March and June only).

PARTIAL HEDGE: strategy where you only hedge part of the risk, e.g. hedge only $5m or $8m worth of bonds instead of the entire $10m.
Farmer: hedge only 50,000 bu instead of 100,000.

USING FUTURES CONTRACTS TO HEDGE CURRENCY 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.

STOCK INDEX FUTURES CONTRACTS: 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 for portfolio risk: ______________________

MECHANICS OF FUTURES 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 your favor and increase to $4.12/bu, a 3% increase (12 cents) within one month or even a few days. You make $600 (5000 bu x $0.12) for a return of 100% in one month:

($600 profit /$ 600 investment) x 100 = 100% yield (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 and wheat can only move by 20 cents a bushel, up or down, before trading is discontinued for the day.

Review problems 1-5 on page 362.