PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 13 pdf

Just as the financial marketplace hasbeen innovative in engineering various types of investment contracts, such asstocks, bonds, preferred stock, and convertible bonds, the financial mar

Uncer-is to maximize the value of the firm by reducing the negative potential impact

of forces beyond the control of management

There are essentially four basic approaches to risk management: riskavoidance, risk retention, loss prevention and control, and risk transfer.1 Sup-pose after a firm has analyzed a risky business venture and weighed both thecosts and benefits of exposure to risk, management chooses not to embark onthe project They determine that the potential rewards are not worth the risks

Such a strategy would be an example of risk avoidance Risk avoidance means

choosing not to engage in a risky activity because of the risks Choosing not to

f ly in a commercial airliner because of the risk that the plane might crash is anexample of risk avoidance

Risk retention is another simple strategy, in which the firm chooses to gage in the project and do nothing about the identified risks After weighingthe costs and benefits, the firm chooses to proceed It is the “damn the torpe-does” approach to risk management For many firms, risk retention is the opti-mal strategy for all risks Investors expect the company’s stock to be risky, andthey do not reward managers for reducing risks Investors cope with business

en-risks by diversifying their holdings within their portfolios, and so they do notwant business managers to devote resources to managing risks within the firm.Loss prevention and control involves embarking on a risky project, yettaking steps to reduce the likelihood and severity of any losses potentially re-sulting from uncontrollable factors In the f lying example, loss prevention andcontrol would be the response of the airline passenger who chooses to f ly, butalso selects the safest airline, listens to the pref light safety instructions, sitsnear the emergency exit, and perhaps brings his or her own parachute Thepassenger in this example has no control over how many airplanes crash in agiven year, but he or she takes steps to make sure not to be on one of them, and

if so, to be a survivor

Risk transfer involves shifting the negative consequences of a risky factor

to another person, firm, or party For example, buying f light insurance shiftssome of the negative financial consequences of a crash to an insurance companyand away from the passenger’s family Should the airplane crash, the insurancecompany suffers a financial loss, and the passenger’s family is financially com-pensated Forcing foreign customers to pay for finished goods in your home cur-rency rather than in their local currency is another example of risk transfer,whereby you transfer the risk of currency f luctuations to your customers If thevalue of the foreign currency drops, the customers must still pay you an agreedupon number of dollars, for example, even though it costs them more to do so interms of their home currency

No one risk management approach is ideal for all situations Sometimesrisk avoidance is optimal; sometimes risk retention is the desired strategy.Recent developments in the financial marketplace, however, have made risktransfer much more feasible than in the past More and more often now, espe-cially when financial risks are involved, it is the most desirable alternative

In recent years there has been revolutionary change in the financial ketplace The very same marketplace that traditionally facilitated the transfer

mar-of funds from investors to firms, has brought forth numerous derivative ments that facilitate the transfer of risk Just as the financial marketplace hasbeen innovative in engineering various types of investment contracts, such asstocks, bonds, preferred stock, and convertible bonds, the financial market-place now engineers risk transfer instruments, such as forwards, futures, op-tions, swaps, and a multitude of variants of these derivatives

instru-Reading stories about derivatives in the popular press might lead one tobelieve that derivative instruments are dangerous and destabilizing—evil crea-tures that emerged from the dark recesses of the financial marketplace The

cover of the April 11, 1994, Time magazine introduced derivatives with the

caption “High-tech supernerds are playing dangerous games with your money.”The use of derivatives has been implicated in most of the financial calamities

of the past decade: Barings Bank, Procter & Gamble, Metallgesellschaft, AskinCapital Management, Orange County, Union Bank of Switzerland, and Long-Term Capital Management, to name a few In each of the cases, vast sums ofmoney quickly vanished, and derivatives seemed to be to blame

WHAT WENT WRONG: CASE STUDIES

OF DER IVATIVES DEBACLES

Derivatives were not responsible for the financial calamities of the 1990s.Greed, speculation, and probably incompetence were But just as derivativesfacilitate risk management, they facilitate greed and accelerate the conse-quences of speculation and incompetence For example, consider the followingcase histories and then draw your own conclusions

Barings Bank

On February 26, 1995, Baring PLC, Britain’s oldest merchant bank and one ofthe most venerable financial institutions in the world collapsed Did this fail-ure follow years of poor management and bad investments Hardly All of thebank’s $615 million of capital had been wiped out in less than four months, byone employee, half way around the world from London It seems that a Bar-ings derivatives trader named Nicholas Leeson, stationed in Singapore, hadtaken huge positions in futures and options on Japanese stocks Leeson’s job

was supposed to be index arbitrage, meaning that he was supposed to take low

risk positions exploiting discrepancies between the prices of futures contractstraded in both Singapore and Osaka Leeson’s job was to buy whichever con-tract was cheaper and sell the one that was more dear The difference would

be profit for Barings When he was long in Japanese stock futures in Osaka, hewas supposed to be short in Japanese stock futures in Singapore, and viceversa Such positions are inherently hedged If the Singapore futures lostmoney, the Japanese futures would make money, and so little money, if any,could be lost

Apparently, Leeson grew impatient taking hedged positions He began totake unhedged bets, selling both call options and put options on Japanesestocks Such a strategy, consisting of written call options and written put op-

tions is called a straddle If the underlying stock price stays the same or does

not move much, the writer keeps all the option premium, and profits somely If, on the other hand, the underlying stock price either rises or fallssubstantially, the writer is vulnerable to large losses Leeson bet and lost Japa-nese stocks plummeted, and the straddles became a huge liability Like a pan-icked gambler, Leeson tried to win back his losses by going long in Japanesestock futures This position was a stark naked speculative bet Leeson lostagain Japanese stocks continued to fall Leeson lost more than $1 billion, andBarings had lost all of its capital The bank was put into receivership

hand-Procter & Gamble

Procter & Gamble, the well-known manufacturer of soap and household ucts, had a long history of negotiating low interest rates to finance operations

prod-Toward this end, Procter & Gamble entered an interest rate swap withBankers Trust in November of 1993 The swap agreement was far from plain-vanilla It most certainly fit the description of an exotic derivative The swap’scash f lows were determined by a formula that involved short-term, medium-term, and long-term interest rates Essentially, the deal would allow Procter &Gamble to reduce its financing rate by four-tenths of 1% on $200 million ofdebt, if interest rates remained stable until May 1994 If, on the other hand,interest rates spiked upward, or if the spread between 5-year and 30-yearrates narrowed, Procter & Gamble would lose money and have to pay a higherrate on its debt.

Even in the rarefied world of derivatives, one cannot expect somethingfor nothing In order to achieve a cheaper financing rate, Procter & Gamblehad to give up or sell something In this case, implicit in the swap, they sold interest rate insurance The swap contained an embedded option, sold by Proc-ter & Gamble If the interest rate environment remained calm, Procter &Gamble would keep a modest premium, thereby lowering its financing costs Ifinterest rates became turbulent, Procter & Gamble would have to make bigpayments Most economists in 1993 were forecasting calm The bet seemedsafe But it was a bet, nevertheless This was not a hedge, this was speculation.And they lost

The Federal Reserve unexpectedly raised interest rates on February 4,

1994 Procter & Gamble suddenly found themselves with a $100 million loss.Rather than lower their financing rate by four-tenths of 1%, they would have topay an additional 14%!

Rather than lick its wounds and retire from swaps, Procter & Gamblewent back for more—with prodding, of course, from Bankers Trust As lossesmounted on the first deal, Procter & Gamble entered a second swap, this onetied to German interest rates German medium-term interest rates are remark-ably stable, and so this bet seemed even safer than the first one Guess whathappened Another $50 million of losses mounted before Procter & Gamble fi-nally liquidated its positions Losses totaled $157 million Procter & Gamblesued Bankers Trust, alleging deception, mispricing, and violation of fiduciaryresponsibilities Procter & Gamble claimed that they did not fully understandthe risks of the swap agreements, nor how to calculate their value BankersTrust settled with Procter & Gamble, just as they settled with Gibson GreetingCards, Air Products and Chemicals, and other companies that lost money insimilar swaps

Metallgesellschaf t

Experts are still divided over what went wrong in the case of gesellschaft, one of Germany’s largest industrial concerns This much is cer-tain: In 1993, Metallgesellschaft had assets of $10 billion, sales exceeding $16billion, and equity capital of $50 million By the end of the year, this industrialgiant was nearly bankrupt, having lost $1.3 billion in oil futures

Metall-What makes the Metallgesellschaft case so intriguing, is that the companyseemed to be using derivatives for all the right reasons An American sub-sidiary of Metallgesellschaft, MG Refining and Marketing (MGRM) had em-barked on an ingenious marketing plan The subsidiary was in the business ofselling gasoline and heating oil to distributors and retailers To promote sales,the company offered contracts that would lock in prices for a period of 10years A variety of different contract types was offered, and the contracts hadvarious provisions, deferments, and contingencies built in, but the importantfeature was a long-term price cap The contracts were essentially forwards.The forward contracts were very popular and MGRM was quite successful atselling them.

MGRM understood that the forward contracts subjected the company tooil price risk MGRM now had a short position in oil If oil prices rose, thecompany would experience losses, as it would have to buy oil at higher pricesand sell it at the lower contracted prices to the customers To offset this risk,MGRM went long in exchange-traded oil futures The long position in futuresshould have hedged the short position in forwards Unfortunately, things didnot work out so nicely

Oil prices fell in 1993 As oil prices fell, Metallgesellschaft lost money onits long futures, and had to make cash payments as the futures were marked tomarket The forwards, however, provided little immediate cash, and their ap-preciation in value would not be fully realized until they matured in 10 years.Thus, Metallgesellschaft was caught in a cash crunch Some economists arguethat if Metallgesellschaft had held on to its positions and continued to makemargin payments the strategy would have worked eventually But time ran out.The parent company took control over the subsidiary and liquidated its posi-tions, thereby realizing a loss of $1.3 billion

Other economists argue that Metallgesellschaft was not an innocent tim of unforeseeable circumstances They argue that MGRM had designed theentire marketing and hedging strategy, just so they could profit by speculatingthat historical patterns in oil prices would persist Traditionally, oil futuresprices are lower than spot prices, so the general trend in oil futures prices isupward as they near expiration MGRM’s hedging plan was to repeatedly buyshort-term oil futures, holding them until just before expiration, at which pointthey would roll over into new short-term futures If the historical pattern hadrepeated itself, MGRM would have profited many times from the rolloverstrategy It has been alleged that the futures was the planned source of profits,while the forward contracts with customers was the hedge against oil pricesdropping

vic-Regardless of MGRM management’s intent, the case teaches at leasttwo lessons First, it is important to consider cash f low and timing when con-structing a hedge position Second, when a hedge is working effectively, itwill appear to be losing money when the position it is designed to offset isshowing profits Accounting for hedges should not be independent of the po-sition being hedged

Ask in Capital Management

Between February and April 1994, David Askin lost all $600 million that hemanaged on behalf of the investors in his Granite Hedge Funds Imagine thesurprise of the investors Not only had they earned over 22% the previous year,but the fund was invested in mortgage-backed securities—instruments guaran-teed by the U.S government not to default The lesson from the Askin experi-ence, is that in the age of derivatives, investments with innocuous names mightnot be as safe and secure as they sound

The particular type of mortgage-backed securities that Askin purchased

were collateralized mortgage obligations (CMOs), which are bonds whose

cash f lows to investors are determined by a formula The formula is a function

of mortgage interest rates and also of the prepayment behavior of home ers Since the cash f low to CMOs is a function of some other economic vari-able, interest rates in this case, these instruments are categorized asderivatives Some CMOs rise in value as interest rates rise, others fall Askin’sCMOs were very sensitive to interest rates Askin’s portfolio rose in value asinterest rates fell in 1993 When interest rates began to rise again in February

buy-1994, his portfolio suffered Interest rate increases alone, however, were notthe sole cause of Askin’s losses As interest rates rose and CMO prices fell,CMO investors everywhere got scared and sold CMO prices were doubly bat-tered as the demand dried up It was a classic panic Prices fell far more thanthe theoretical pricing models predicted Eventually, calm returned to themarket, investors trickled back, and prices rebounded But it was too late forAskin He had bought on margin, and his creditors had liquidated his fund atthe market’s bottom

Orange County, California

Robert Citron, treasurer of Orange County, California, in 1994, fell into thesame trap that snared Procter & Gamble and David Askin He speculated thatinterest rates would remain low The best economic forecasts at the time sup-ported this outlook Derivatives allowed speculators to bet on the most likelyscenario Small bets provided modest returns Big bets promised sizable re-turns What these speculators did was akin to selling earthquake insurance inNew York City The likelihood of an earthquake there is very small, so insurerswould almost certainly get to keep the modest premiums without having to payout any claims If an earthquake did hit New York, however, the losses to theinsurers would be enormous

Citron bet and lost The earthquake that toppled his portfolio was the expected interest rate hikes beginning in February 1994 Citron had borrowedagainst the bonds Orange County owned, and he invested the proceeds in deriv-ative bonds called inverse-f loaters, whose cash f low formulas made them extrasensitive to interest rate increases Citron lost about $2 billion of the $7.7 billion

un-he managed, and Orange County filed for bankruptcy in December 1994

Union Bank of Switzerland

What happened at Union Bank of Switzerland (UBS) in 1997 would be funny

if it weren’t so sad Imagine a bakery that sells cakes and cookies for less thanthe cost of the ingredients Business would no doubt be brisk, but eventuallythe bakers would discover that they were not turning a profit This is essen-tially what happened to UBS UBS manufactured and sold derivatives to cor-porate customers Unfortunately, there was an error in their pricing model,and they were selling the derivatives for too low a price By the time theyfound the mistake, they had managed to lose over $200 million Swiss bankingofficials concluded that losses sustained by the Global Equity DerivativesBusiness arm of UBS amounted to 625 million Swiss francs (about $428 mil-lion), but these losses stemmed not only from the pricing model error, but alsofrom unlucky trading, an unexpected change in British tax laws, and marketvolatility Some speculate that these losses forced the merger of UBS withSwiss Bank Corporation, a merger that was arranged exactly when the deriv-atives losses were discovered

Long-Term Capital Management

The most surprising of the derivatives debacles is also one of the most recent

It is the saga of Long-Term Capital Management (LTCM) LTCM was a pany founded by John Meriwether, and joined by Myron Scholes and RobertMerton Meriwether had a reputation for being one of the savviest traders onWall Street Scholes and Merton are Nobel prize laureates, famous for invent-ing the Black-Scholes option pricing model.2 Unlike the folks at Procter &Gamble, these individuals cannot plead ignorance They were without a doubtamong the smartest players in the financial marketplace Paradoxically, it mayhave been their intellectual superiority that did them in Their overconfidenceengendered a false sense of security that seduced investors, lenders, and theportfolio managers themselves into taking enormous positions The story ofLTCM is a classic Greek tragedy set on modern Wall Street

com-LTCM was organized as a “hedge fund.” A hedge fund is a limited nership, that in exchange for limiting the number and type of investors who canbuy in, is not required to register with the Securities and Exchange Commis-sion, and is not bound by the same regulations and reporting standards imposed

part-on traditipart-onal mutual funds Investors must be rich A hedge fund can acceptinvestments from no more than 500 investors who each have net worth of atleast $5 million, or no more than 99 investors if they each have net worth of

at least $1 million A hedge fund is essentially a private investment club, tered by the rules designed to protect the general public

unfet-Ironically, hedge funds are generally unhedged Most hedge funds ulate, aiming to capture profits by taking risks LTCM was a little different, and for them the moniker “hedge fund” appeared to fit Capitalizing on theirbrainpower, LTCM sought to exploit market inefficiencies That is, with an

spec-understanding of what the prices of various financial instruments should be,

LTCM would identify instruments that were priced too high or too low Oncesuch an opportunity was identified, they would buy or sell accordingly, hedg-ing long positions with matching shorts As the prices in the financial market-place trended toward the fair equilibrium dictated by the financial models,the prices of the assets held long would rise, and the prices of the instru-ments sold short would fall, thereby delivering to LTCM a handsome profit.LTCM’s deals were generally not naked speculation, but hedged exploitation

of arbitrage opportunities With price risk thought to be hedged out, LTCMand their investors felt comfortable borrowing heavily to lever up the impact

of the trades on profits The creditors, banks and brokerages mostly, happilyobliged

LTCM opened its doors in 1994, with an initial equity investment of $150million from the founding partners, and an investment pool of $1.25 billion inclient accounts Success was immediate and pronounced They thrived in thetumultuous market of the mid-1990s Apparently, as some of the institutionsdescribed above lost fortunes during this period, it was LTCM that managed to

be on the receiving end The fund booked a 28% return in 1994, a whopping59% in 1995, followed by another 57% return in 1996 Word of this successspread, and new investors were clamoring to get into LTCM.3

LTCM could be picky when it came to choosing investors This was not afund for your typical dentist or millionaire next door Former students of minewho have gone on to jobs at some of the world’s largest banks and investmentcompanies have confided to me that their firms subcontracted sizable portions

of their portfolios to LTCM By the end of 1995, bolstered by reinvested its and by newly invested funds, LTCM managed $3.6 billion of invested funds.However, the portfolio was levered 28 to 1 For every $1 a client invested, thefund was able to borrow $28 from banks and brokerage houses Consequently,LTCM managed positions worth over $100 billion Moreover, because of thenatural leverage inherent in the derivatives they bought, these positions werecomparable to investments of a much larger magnitude, estimated to be in the

prof-$650 billion range

By 1997, however, when the fund’s capital base peaked at $7 billion,managers realized that profitable arbitrage opportunities were growing scarce.The easy pickings of the early days were over The partners began to intention-ally shrink the fund by returning money to investors, essentially forcing themout Performance was sound in 1997, a 25% return, but with the payout of cap-ital, the fund’s capital base fell to $4.7 billion

Things unraveled disastrously in 1998 Each of LTCM’s major ment strategies failed Based on sophisticated models and historical data,LTCM gambled that (1) stock market volatility would stay the same or fall,(2) swap spreads—a variable used to determine who pays whom how much ininterest rate swaps, would narrow, (3) the spread of the interest rate onmedium-term bonds over long-term bonds would f latten out, (4) the credit

invest-spread—the interest rate differential between risky bonds and high-gradebonds, would narrow, and (5) calm would return to the financial markets ofRussia and other emerging markets However, in each case the opposite hap-pened Equity volatility increased Swap spreads widened The yield curve re-tained its hump Credit spreads grew Emerging markets deteriorated.

Though LTCM had spread its bets over a wide variety of positions, theyseemed to gain no diversification benefit Everything went wrong at once Re-cent research has shown that diversification does not protect speculative posi-tions when markets behave erratically Markets tend to go awry in tandem

In August 1998 alone, the fund suffered losses of $1.9 billion Losses forthe year so far were 52% Fund managers were confident that their strategieswere sound, and that time would both prove them right and reward their pre-science But time is not a friend to a levered fund losing money Banks and bro-kerages itched for their loans back How ironic, Long-Term Capital Managementfaced a short-term liquidity crunch

Leverage amplified LTCM’s remaining $2.28 billion of equity into aged assets of $125 billion If the market continued to move against them,LTCM would be wiped out in short order, and that is essentially what hap-pened On September 10, LTCM lost $145 million The next day, they lost $120million The following three trading days brought losses of $55 million, $87million, and $122 million, respectively On one day alone, Monday, September

man-21, 1998, LTCM lost $553 million By now traders at other firms could guesswhat LTCM’s positions were, and by anticipating what LTCM would have toeventually sell, they could gauge which securities were good bets to short Thisselling pressure added to LTCM’s losses and woes

At this point, in September 1998, any of several banks could bankruptLTCM by calling in its loans The Federal Reserve, which is the central bank ofthe United States, and is responsible for guarantying the stability of the Amer-ican banking system, monitored the predicament Though LTCM’s equity wasshrinking precipitously, on account of their borrowed funds and the inherentleverage of their derivatives positions, the notional principal of their positionswas about $1.4 trillion To put this quantity into perspective, the gross nationalproduct of the United States was about $8.8 trillion in 1998 Total bank assets

in the United States stood at $4.3 trillion It was feared that if LTCM wentbankrupt, they would probably default on their derivative positions, triggering

a domino effect of defaults and bankruptcies throughout the world’s financialmarkets It was decided, that LTCM was too big too fail

The Federal Reserve orchestrated a plan for LTCM’s creditors to buy thecompany’s portfolio Each of 14 banks ponied up money in exchange for a slice

of the portfolio The $3.65 billion paid by the bank syndicate for the portfoliowas clearly greater than the value of the portfolio by then, but this infusion ofcapital prevented defaults that would have cost the banks much more Themoney was used to pay off debts and shore up the trading accounts so that ex-isting positions would perform without default Very little was left over for the

original partners who were required to run the fund until it was ultimately uidated in 1999 The bottom line is that LTCM had lost $4.5 billion since thestart of 1998 These losses included the personal fortunes amassed so quickly

liq-by the founding partners, which totaled $1.9 billion at one point but were pletely wiped out by the end

com-Moral of the Stor y

The lesson from these case studies should now be obvious Risk management isnot the art of picking good bets Bets no matter how good are speculation.Speculation increases risk, and subjects corporations, investors, and even mu-nicipalities to potential losses Derivatives are powerful tools to shed risk, butthey can also be used to take on risk The root causes of the debacles described

in these cases are greed, speculation, and in some cases incompetence, not rivatives But just as derivatives facilitate risk management, they facilitategreed and speculation Anything that can be done with derivatives, can bedone slower the old fashioned way with positions in traditional financial instru-ments Speculators have always managed to lose large sums With the aid of de-rivatives they now can lose larger sums faster

de-Superior intellect and sophistication cannot protect the speculator As theLong-Term Capital Management story illustrates, when you are smarter thanthe market, you can go broke waiting for the market to wise up

Government regulation is not the answer either The benefits of tion must be weighed against the costs Derivatives, properly used, are too im-portant in the modern financial marketplace to be severely restricted Abuse

regula-by a few does not warrant constraints on all users A better solution to preventrepetition of the past debacles is full information disclosure by firms, portfoliomanagers, and municipalities Investors and citizens should demand to knowhow derivatives are being used when their money is at stake Better informa-tion and oversight is the most promising approach to prevent misuse of deriva-tives while retaining the benefits

Derivatives can be dangerous, but they can also be tremendously useful.Dynamite is an appropriate analogy Misused, it is destructive; handled withcare, it is a powerful and constructive tool

Derivatives are tools that facilitate the transfer of risk Interest rate rivatives enable managers to shed business exposure to interest rate f luctua-tions, for example But when one party sheds risk, another party necessarilymust take on that very exposure And therein lies the danger of derivatives.The same instrument that serves as a hedge to one firm, might be a destabiliz-ing speculative instrument to another Without a proper understanding of de-rivatives, a manager who intends to reduce risk, might inadvertently increase

de-it This chapter aims to provide the reader with a basic understanding of atives so that they can be used appropriately to manage financial risks This un-derstanding should help the reader avoid the common pitfalls that have proveddisastrous to less informed managers

deriv-SIZE OF THE DER IVATIVE MAR K ET

AND WIDESPR EAD USE

A derivative is a financial instrument whose value or contingent cash f lows pend on the value of some other underlying asset For example, the value of astock option depends on the value of the underlying stock Derivatives as aclass comprise forwards, futures, options, and swaps Numerous hybrid instru-ments, combining the features of these basic building blocks have also beenengineered The first thing the interested manager must understand about de-rivatives is that the business in these instruments is now huge, and their use ispervasive Since the initiation of trading in the first stock index futures con-tract in December of 1982—the Standard & Poor’s 500 futures contract—thedaily volume of stock index futures has grown so that it now rivals the dailyvolume in all trading on the New York Stock Exchange (Volume of futures is

de-measured in terms of notional principal, which is a measure of exposure.) On

just one typical day in the 1990s, Tuesday, January 21, 1996, the notional ume of the Standard & Poor’s 500 futures contract was just shy of $40 billion.The volume on the NYSE that same day was approximately $23 billion On thatday, therefore, just one specific futures contract was greater than the entireBig Board stock market in terms of trading volume More recently, however,the tables have turned, and the New York Stock Exchange daily trading volumeonce again regularly beats that of the S&P 500 futures contract Still the mag-nitudes are comparable, and futures trading is firmly established as a signifi-cant segment of financial market activity

vol-Similarly, the swaps market has revolutionized banking and finance Thenotional principal of outstanding swaps today, is greater than the sum total ofall assets in banks worldwide The Bank for International Settlements reportsthat the sum total of all assets in banks around the world was approximately

$12 trillion in June 2000 At that same time, according to the same source, thenotional principal of outstanding swaps was over $50 trillion Measured thisway, the swaps business is now bigger than traditional banking

The volume of the derivatives market ref lects how widespread tives use has become in business Almost all major corporations now use them

deriva-in one form or another Some use derivatives to hedge commodity price risks.Some use them to speculate on price movements Some firms reduce their ex-posures to volatile interest rates and foreign exchange Other firms take on exposures via derivatives in order to potentially increase profits Some firmsuse derivatives to secure cheaper financing Many corporations use derivatives

to reduce the transaction costs associated with managing a pension fund, rowing money, or budgeting cash Some firms implement derivative strategies

bor-to reduce their tax burdens Many companies offer sbor-tock options, a derivative,

as employee compensation Some investment funds enhance returns by ing traditional portfolios with what are called synthetic portfolios—portfolioscomposed in part of derivatives Some investment funds buy derivatives thatact as insurance contracts, protecting portfolio value Since their emergence in

replac-the early 1980s, derivatives have touched every aspect of corporate finance,banking, the investments industry, and arguably business in general.

THE INSTRUMENTS

The major derivative instruments are forwards, futures, options, and swaps.Also available today are hybrid instruments, exotics, and structured or engi-neered instruments The hybrids, exotics, and engineered instruments are con-tracts that combine features of the basic building blocks: the options, futures,forwards, and swaps Consequently, familiarity with the basic building blocksgoes a long way toward understanding the whole mélange of derivative instru-ments available today We will begin with forwards

Forwards

Imagine the following nearly idyllic scenario It is late summer You are a wheatfarmer in Kansas The hard work of sowing and tending your acreage is about topay off You expect a bumper crop this year, and the harvest is just a few weeksaway The weather is expected to remain favorable The crops have beensprayed to protect them from pests In fact, you may even have purchased cropinsurance to protect against crop damage

Still, you cannot relax One major uncertainty is keeping you awake atnight You figure that if you are expecting a bumper crop, the likelihood thatyour neighbors are also expecting a bumper crop is high If the market is

f looded with wheat, prices will plummet If prices drop, you will receive littlerevenue for your harvest, and perhaps you will show a loss for the year A worsecase scenario might be that prices fall so low, that you cannot make the mort-gage payments on your land or the machinery you bought You very well mightlose the farm—and through no fault of your own You farmed well, but if pricesfall, you will fail nevertheless

Meanwhile, at the same time, another group of businesspeople is feelingsimilar anxiety A baked goods company has recently built a new cookie bak-ery The company identified its market niche as a provider of inexpensive,mass produced, medium quality cookies The project analysis that led to thego-ahead for the new bakery assumed that wheat prices would stay fixed attheir current levels If wheat prices should rise, it is altogether possible thatthe firm will not be able to sell its cookies for a profit The new bakery willappear to be a failure

In these scenarios, both the farmers and the bakers are exposed to wheatprice risk The farmers worry that wheat prices will fall The bakers worry thatprices will rise A forward contract is the obvious solution for both parties.The farmers and bakers can negotiate a deferred wheat transaction Thefarmers will deliver wheat to the bakers, one month from now, for a price cur-rently agreed upon Such a contract for a deferred transaction is a forward

contract A forward contract specifies an underlying asset to be delivered, aprice to be paid, and the date of delivery The specified transaction price iscalled the forward price The party that will be selling wheat (the farmer) isknown as the “short” party; the party that will be buying wheat (the baker)

is known as the “long” party In the jargon of the derivatives market, the longparty is said to “buy” the forward, and the short party “sells” the forward.Note, however, that when the deal is initially struck, no money changes handsand no one has yet bought or sold anything The “buyer” and “seller” haveagreed to a deferred transaction

Notice that the wheat forward reduces risk for both the farmers and thebakers In this transaction, both parties are hedgers—that is, they are usingthe forward to reduce risk Forward contracts are “over-the-counter” instru-ments, meaning that they are negotiated between two parties and custom-tailored, rather than traded on exchanges

Suppose after one month, when the forward expires and the wheat is ered, the current, or spot, price of wheat has risen dramatically The farmer mayhave some regret that he entered into the contract Had he not sold forward, hewould have been able to receive more for his wheat by selling on the spot mar-ket He may feel like a loser The bakers, on the other hand, will feel like win-ners By contracting forward they insulated themselves from the rising wheatprice When spot prices rise, the long party wins while the short party loses Alittle ref lection, however, will convince the farmer that although he lost somemoney relative to what he could have gotten on the spot market, going short inthe forward was indeed a worthwhile strategy He had piece of mind over theone month He was guaranteed a fair price, and he did not have to fear losing thefarm Though there was an opportunity loss, he benefited by shedding risk Thefarmer probably never regrets that he has never collected on his life insuranceeither He similarly should not regret that the forward contract represents an op-portunity loss He would be well advised to go short again next year

deliv-The wheat forward contract can be used by speculators as well ashedgers An agent who anticipates a rise in wheat prices can profit from thatforesight by going long in the forward contract By going long in the contract,the speculator agrees to buy wheat at the fixed forward price Upon expiration

of the contract, the speculator takes delivery of the wheat, pays the forwardprice, and then sells the wheat on the spot market for the higher spot price.The profit is the difference between the spot and forward prices Of course, ifthe speculator’s forecast is wrong, and the wheat price falls, the speculatorwould suffer losses equal to the difference between the forward and spotprice For example, suppose the initial spot price is $3 per bushel, and the for-ward price is $3.50 per bushel If the spot price upon expiration is $4.50 perbushel, the long speculator would earn a profit of $1 per bushel The profit isthe terminal spot of $4.50 minus the $3.50 initial forward price If, alterna-

tively, the terminal spot price is $3.25, the speculator would lose 25 cents per

bushel—that is, $3.25 minus $3.50 Notice that the $3 initial spot price is evant in both cases

irrel-Speculators play important roles in the derivatives markets For one,speculators provide liquidity If farmers wish to short forward contracts butthere are no bakers around who want to go long, speculators will step in andoffer to take the long side when the forward price is bid down low enough.Similarly, they will take the short side when the forward price is bid up highenough Speculators also bring information to the marketplace The existence

of derivatives contracts and the promise of speculative profits make it while for speculators to devote resources to forecasting weather conditions,crop yields, and other factors that impact prices Their forecasts are madeknown to the public as they buy or sell futures and forwards

worth-Futures

Futures contracts are closely related to forward contracts Like forwards,futures are contracts that spell out deferred transactions The long partycommits to buying some underlying asset, and the short party commits tosell The differences between futures and forwards are mainly technical andlogistical Forward contracts are custom-tailored, over-the-counter agree-

ments, struck between two parties via negotiation Futures, alternatively, are

standardized contracts that are traded on exchanges, between parties whoprobably do not know each other The exact quantity, quality, and deliverylocation can be negotiated in a forward contract, but in a futures contractthe terms are dictated by the exchange Because of their standardization andhow they are traded, futures are very liquid, and their associated transactioncosts are very low

Another feature differentiating futures from forwards is the process ofmarking-to-market All day and every day, futures traders meet in trading pits

at the exchanges and cry out orders to buy and sell futures on behalf of clients.The forces of supply and demand determine whether futures prices rise or fall.Marking-to-market is the process by which at the end of each day, losers paywinners an amount equal to the movement of the futures price that day For ex-ample, if the wheat futures price at Monday’s close is $4.00 per bushel, and theprice rises to $4.10 by the close on Tuesday, the short party must pay the longparty 10 cents per bushel after trading ends on Tuesday If the price had fallen

10 cents, then long would pay short 10 cents per bushel Both long and shortparties have trading accounts at the exchange clearinghouse, and the transfer

of funds is automatic The purpose of marking-to-market is to reduce thechance of default by a party who has lost substantially on a futures position.When futures are marked-to-market, the greatest possible loss due to a defaultwould be an amount equal to one day’s price movement

Futures are marked-to-market every day When the contract expires, thelast marking-to-market is based on the spot price For example, suppose twodays prior to expiration the futures price is $4.10 per bushel On the second tolast day the futures price has risen to $4.30 Short pays long 20 cents perbushel Suppose at the end of the next day, the last day of trading, the spot

price is recorded at $4.55 The last mark-to-market payment is from short tolong for 25 cents per bushel, equal to the difference between the spot priceupon expiration and the previous day’s futures price.

Upon expiration, the futures contract might stipulate that the short partynow deliver to the long party the specified quantity of wheat The long party

must now pay the short party the spot price for this wheat Yes, the spot price,

not the original futures price! The difference between the terminal spot priceand the original futures price has already been paid via marking-to-market Anumerical example will make the mechanics of futures clearer, and show howsimilar futures are to forwards

Suppose with five days remaining until expiration, the wheat futuresprice is $4.00 per bushel A baker “buys” a futures contract in order to lock in apurchase price of $4.00 Suppose the futures prices on the next four days are

$4.10, $3.90, $4.00, and $4.25 The spot price on the fifth day, the expirationday, is $4.30 Given those price movements, short pays the long baker 10 centsthe first day The long baker pays short 20 cents on the second day On thethird day, short pays long 10 cents, followed by a payment from short to long of

25 cents on the fourth day, and a payment from short to long of 5 cents on thelast day On net, over those five days, short has paid long 30 cents When longnow pays the spot price of $4.30 to short for delivery of the wheat, long indeed

is paying $4.00 per bushel, net of the 30 cents profit on the futures contract.Recall that $4.00 was the original futures price Thus, the futures contract dideffectively lock in a fixed purchase price for the wheat

A contract that stipulates a spot transaction in which the underlying modity is actually delivered at expiration, is called a “physical delivery” con-tract Many futures contracts do not stipulate such a final spot transaction withactual delivery of the underlying asset After the last marking-to-market, thegame is over No assets are delivered Contracts that stipulate no terminal spottransaction are called “cash settled.” It should make little difference to traderswhether a contract is cash settled or physical delivery A cash settled contractcan be turned into a physical delivery deal simply by choosing to make a spottransaction at the end Likewise, a physical delivery contract can be turnedinto a cash settled deal by either making an offsetting spot transaction at theend, or by exiting the futures contract just before it expires

com-Examples of the Use of Forwards and

Futures in Risk Management

A wide variety of underlying assets is covered by futures and forwards tracts these days For example, exchange-traded futures contracts are available

con-on stocks, bcon-onds, interest rates, foreign currencies, oil, gasoline, grains, stock, metals, cocoa, coffee, sugar, and even orange juice Consequently, theseinstruments are versatile risk management tools in a wide variety of situations.The most actively traded futures, however, are those that cover financial risks.Consider the following examples

live-A Foreign Currency Hedge

Suppose an American electronics manufacturer has just delivered a large ment of finished products to a customer in France The French buyer hasagreed to pay 1 million French francs in exactly 30 days The manufacturer isworried that the French franc may be devalued relative to the American dollarduring that interval If the franc is devalued, the dollar value of the promisedpayment will fall and the American manufacturer will suffer losses The Amer-ican manufacturer can shed this foreign currency exposure by going short in afranc forward contract or a franc future The contract will specify a quantity

ship-of francs to be exchanged for dollars, at a fixed exchange rate, 30 days in thefuture The contract locks in the terms at which the deferred franc revenuecan be converted to dollars No matter what happens to the franc-dollar ex-change rate, the American manufacturer now knows exactly how many dollars

he will receive

A Short-Term Interest Rate Hedge

Suppose a manufacturer of automotive parts has just delivered a shipment offinished products to a client Business has been growing, and the companyhas approved plans to expand capacity next year The manufacturer expects

to receive payment from the customer in 60 days, but will need to use thosefunds for the planned capital expenditure 90 days after that The plan is toinvest the revenue in three-month Treasury bills as soon as the revenue is re-ceived Interest rates are currently high Managers worry that by the timethe receivables are collected from the customer, however, interest rates willfall, resulting in less interest earned on the invested funds The company canhedge against this risk by buying a Treasury bill futures contract, which es-sentially locks in the price and yield of Treasury bills to be purchased 60days hence

Longer-Term Interest Rate Hedge

A manufacturer of speed boats notices that when interest rates rise, sales fall,and the value of the firm’s stock gets battered The correlation is easy to un-derstand Customers buy boats on credit, and so when rates rise, the boats ef-fectively become more expensive to buy In order to insulate the company’sfortunes from the vicissitudes of interest rates, the company could enter a con-tract that pays money when rates rise A short position in a Treasury bondfutures contract would pay off when rates rise and could thus be a desirablehedge Each time the futures contract expires, the company can roll over into anew contract The size of the position in the futures should be geared to the

f luctuation in sales resulting from changes in interest rates The Treasury bondhedge can reduce the volatility in the firm’s net income, and the volatility ofthe firm’s equity value