Money banking and the financial system 1e by hubbard and OBrien chapter 07

Publishing as Prentice HallDerivatives and Derivative Markets C H A P T E R 7 LEARNING OBJECTIVES After studying this chapter, you should be able to: 7.1 7.2 7.3 Explain what derivatives

R GLENN

HUBBARD

ANTHONY PATRICKO’BRIEN

Money, Banking, and the Financial

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Derivatives and Derivative Markets

C H A P T E R 7

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

7.1 7.2 7.3

Explain what derivatives are and distinguish between using them to hedge and using them to speculate

Define forward contracts Discuss how futures contracts can be used to hedge and to speculate

7.4 7.5

Distinguish between call options and put options and explain how they are used

Define swaps and explain how they can be used to reduce risk

HOW DANGEROUS ARE FINANCIAL DERIVATIVES?

•In 2002, Berkshire Hathaway CEO Warren Buffet called financial derivatives

“time bombs, both for the parties that deal in them and for the economic

system….derivatives are financial weapons of mass destruction.”

•All derivatives derive their value from an underlying asset These assets may

be commodities, such as wheat or oil, or financial assets, such as stocks or bonds

•Despite Buffett’s denunciations, derivatives play a useful role in the financial system

C H A P T E R 7

Derivatives and Derivative Markets

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Key Issue and Question

Issue: During the 2007–2009 financial crisis, some investors,

economists, and policymakers argued that financial derivatives had

contributed to the severity of the crisis

Question: Are financial derivatives “weapons of financial mass

destruction”?

7.1 Learning

Objective

Explain what derivatives are and distinguish between using them to hedge and using them to speculate

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Derivatives, Hedging, and Speculating

Derivative An asset, such as a futures contract or an option contract, that

derives its economic value from an underlying asset, such as a stock or a bond

Hedge To take action to reduce risk by, for example, purchasing a derivative

contract that will increase in value when another asset in an investor’s portfolio decreases in value

• Derivatives can serve as a type of insurance against price changes in

underlying assets Insurance plays an important role in the economic

system: If insurance is available on an economic activity, more of that activity will occur

• Derivatives can also be used to speculate.

Speculate To place financial bets, as in buying futures or option contracts, in

an attempt to profit from movements in asset prices

• Some investors and policymakers believe that “speculation” and

“speculators” provide no benefit to financial markets, but they provide two

useful functions:

1 When a hedger sells a derivative to a speculator, they transfer risk to the

speculator

2 Speculators provide essential liquidity Without speculators, there would

not be a sufficient number of buyers and sellers for the market to operate efficiently

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7.2 Learning

Objective

Define forward contracts

• Forward contracts give firms and investors an opportunity to hedge the risk

on transactions that depend on future prices

• Generally, forward contracts involve an agreement in the present to

exchange a given amount of a commodity, such as oil, gold, or wheat, or a

financial asset, such as Treasury bills, at a particular date in the future for a

set price

Forward contract An agreement to buy or sell an asset at an agreed upon

price at a future time

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Spot price The price at which a commodity or financial asset can be sold at the current date

Settlement date The date on which the delivery of a commodity or financial

asset specified in a forward contract must take place

Counterparty risk The risk that the counterparty—the person or firm on the

other side of the transaction—will default

• Because forward contracts are specific in terms, they tend to be illiquid They are also subject to default risk

Forward Contracts

7.3 Learning

Objective

Discuss how futures contracts can be used to hedge and to speculate

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Futures Contracts

• Futures contracts differ from forward contracts in several ways:

1 Futures contracts are traded on exchanges, such as the Chicago Board

of Trade (CBOT) and the New York Mercantile Exchange (NYMEX)

2 Futures contracts typically specify a quantity of the underlying asset to

be delivered but do not fix the price

• Futures contracts are standardized in terms of the quantity of the

underlying asset to be delivered and the settlement dates for the available contracts

Futures contract A standardized contract to buy or sell a specified amount of a commodity or financial asset on a specific future date

Hedging with Commodity Futures

Short position In a futures contract, the right and obligation of the seller to sell

or deliver the underlying asset on the specified future date

Long position In a futures contract, the right and obligation of the buyer to

receive or buy the underlying asset on the specified

future date

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• Consider the case of a farmer who in March sows seed with the expectation

that it will yield 10,000 bushels of wheat The farmer is concerned that when

she harvests the wheat in July, the price will have fallen below $2.00, so she will receive less than $20,000 for her wheat

• A manager who buys wheat at General Mills is concerned that in July the

price of wheat will have risen above $2.00, thereby raising his cost of

producing cereal The farmer and the General Mills manager can hedge

against an adverse movement in the price of wheat

• Hedging involves taking a short position in the futures market to offset a long

position in the spot market, or taking a long position in the futures market to

offset a short position in the spot market.

Hedging with Commodity Futures

Futures Contracts

• As the time to deliver approaches, the futures price comes closer to the spot price, eventually equaling the spot price on the settlement date.

• To fulfill her futures market obligation, the farmer can engage in either

settlement by delivery or settlement by offset.

• We can summarize the profits and losses of buyers and sellers of futures

contracts:

• Profit (or loss) to the buyer = Spot price at settlement - Futures price at

purchase

• Profit (or loss) to seller = Futures price at purchase - Spot price at settlement

Hedging with Commodity Futures

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Hedging with Commodity Futures

Futures Contracts

Making the Connection

Should Farmers Be Afraid of the Dodd-Frank Act?

• During the financial crisis of 2007–2009, some policymakers and economists argued that the use of derivatives had destabilized the financial system

• When Congress passed the Dodd-Frank Wall Street Reform and Consumer

Protection Act in July 2010, it contained some restrictions on trading in

derivatives In particular, the act required that some derivatives that had

previously been traded over the counter be traded on exchanges instead

• Farmers were worried that they might have to post more collateral to trade

futures They were also worried that small community banks and special

agriculture banks may no longer be allowed to offer forward contracts

• As of late 2010, the Commodity Futures Trading Commission (CFTC) had

not finished writing the new regulations

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Some investors who are not connected with the wheat market can use wheat

futures to speculate on the price of wheat

If you were convinced that the spot price of wheat was going to be lower in July than current futures price, you could sell wheat futures with the intention of

buying them back at the lower price on or before the settlement date

Notice, though, that because you lack an offsetting position in the spot market,

an adverse movement in wheat prices will cause you to take losses

Speculating with Commodity Futures

Futures Contracts

• Today most futures traded are financial futures Widely traded financial

futures contracts include those for Treasury bills, notes, and bonds; stock

indexes; and currencies

• An investor who believes that he or she has superior insight into the likely

path of future interest rates can use the futures market to speculate

• For example, if you wanted to speculate that future interest rates will be

lower (or higher) than expected, you could buy (or sell) Treasury futures

contracts

Hedging and Speculating with Financial Futures

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Hedging and Speculating with Financial Futures

Futures Contracts

Making the Connection

Reading the Financial Futures Listings

• An example of interest-rate futures on U.S Treasury securities appears above The quotation is for a standardized contract of $100,000 in face value of notes paying a 6% coupon

• The first column states the contract month for delivery The next five columns present price information

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Solved Problem 7.3

Hedging When Interest Rates Are Low

During the financial crisis of 2007–2009, interest rates on Treasury bills,

notes, and bonds and on many corporate and municipal bonds fell to very

low levels Jane Williams is a financial adviser and chief executive officer

of Sand Hill Advisors in Palo Alto, California In early 2010, an article in the

Wall Street Journal quoted Williams as arguing that “bonds could be

among the worst-performing investments this year .”

a What would make bonds a bad investment?

b How might it be possible to hedge the risk of investing in bonds?

Futures Contracts

Solved Problem 7.3

Hedging When Interest Rates Are Low

Solving the Problem

Step 1 Review the chapter material.

Step 2 Answer part (a) by explaining when bonds make a bad investment

Bonds are a bad investment when interest rates rise because higher market interest rates cause the prices of existing bonds to decline.

Step 3 Answer part (b) by explaining how it is 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 for bonds by selling futures contracts.

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• For instance, on the CBOT, futures contracts for U.S Treasury notes are

standardized at a face value of $100,000 of notes, or the equivalent of 100

notes of $1,000 face value each The CBOT requires that buyers and sellers

of these contracts deposit a minimum of $1,100 for each contract into a

margin account

Trading in the Futures Market

Margin requirement In the futures market, the minimum deposit that an

exchange requires from the buyer or seller of a financial asset; reduces default

risk

Marking to market In the futures market, 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

Futures Contracts

Trading in the Futures Market

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7.4 Learning

Objective

Distinguish between call options and put options and explain how they are used

Option A type of derivative contract in which the buyer has the right to buy or

sell the underlying asset at a set price during a set period of time

Call option A type of derivative contract that gives the buyer the right to buy

the underlying asset at a set price during a set period of time

Strike price (or exercise price) The price at which the buyer of an option has

the right to buy or sell the underlying asset

Put option A type of derivative contract that gives the buyer the right to sell the

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Why Might You Buy or Sell an Option?

• Suppose that Apple stock has a current price of $200 per share, but you

believe the price will rise to $250 in the coming year

• You could buy call options that would allow you to buy Apple at a strike price

of, say, $210 The price of the options will be much lower than the price of

the underlying stock In addition, if the price of Apple never rises above

$210, you can allow the options to expire, which limits your loss to the price

of the options

• If Apple’s stock is selling for $200 per share and you are convinced it will

decline in price, you could engage in a short sale With a short sale, you

borrow the stock from your broker and sell it now, with the plan of buying it

back—and repaying your broker—after the stock declines in price

• If, however, the price of Apple rises rather than falls, you will lose money by

having to buy back the stock—which is called “covering a short”—at a price

that is higher than you sold it for

Options

Figure 7.1 (1 of 2)

Payoffs to Owning Options

on Apple Stock Payoff

In panel (a),we illustrate the profit from buying a call option with a strike price of $210.

When the price of Apple stock

is between zero and $210, the owner of the option will not exercise it and will suffer a loss equal to the $10 price of the option.

As the price of Apple rises above $210 per share, the owner of the option will earn a

Why Might You Buy or Sell an Option?

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Figure 7.1 (2 of 2)

Payoffs to Owning Options

on Apple Stock Payoff

In panel (b),we illustrate the profit from buying a put option with a strike price of $190

The owner of a put option earns

a maximum profit when the price of Apple is zero As the price of Apple stock rises, the payoff from owning the put option falls.

At a price of $180, the owner of the put would just break even For prices above the $190 strike price, the owner of the put option would not exercise it and would suffer a loss equal to the option price of $10 •

Options

Why Might You Buy or Sell an Option?

Why Might You Buy or Sell an Option?

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Option Pricing and the Rise of the “Quants”

• The price of an option is called an option premium

• Sellers of options lose if the option is exercised The size of the option

premium reflects the probability that the option will be exercised The option

premium is divided into two parts:

1 Intrinsic value, or the payoff to the buyer of the option from exercising it

immediately

An option that has a positive intrinsic value is said to be in the money A call

option is in the money if the market price of the underlying asset is greater

than the strike price, and a put option is in the money if the market price is

less than the strike price

If the market price of the underlying asset is below the strike price, a call

option is out of the money, or underwater If the market price of the

underlying asset is above the strike price, a put option is out of the money If

the market price equals the strike price, a call option or a put option is at the

money.

Options