A LEGO*Approach to Financial Engineering: An Introduction to Forwards, Futures, Swaps, and Options There is general agreement that the increased economic uncertainty first evident in the 1970s has significantly altered the way financial markets func. tion. As financial prices such as foreign exchange rates, interest rates, and commodity prices have be- come more volatile, many corporations have dis. covered that their value is subject to various /inancial rice risks as well as the risk inherent in their core business. Toillustrate the effect of changes in agiven finan- cial price on the value of a company, let's begin by introducing the concept of a risk profile. Figure 1 presents a case in which an unexpected increase in the price P (for example, the Treasury bill rate, the price of oil, or the value of the dollar relative to the yen) decreases the value of the firm (V). FIGURE 1 ma ap TS Charles W. Smithson, Chase Manhattan Bank” In this figure, AP measures the difference between the actual price and the expected price, and AV measures the resulting change in the value of the firm, If APhad remained small,asit did prior tothe 70s, the changes in firm value would have been correspond- ingly small, But, for many companies, the increased volatility of exchange rates, interest rates, and com- modity prices(large A\Ps) in the 70sand 80s has been a major cause of sharp fluctuations in share prices (large AVs). With this significantly greater potential for large swings in value, companies have been ex- ploring new methods for dealing with financial risks. The first, and most obvious, approach was to try to forecast future prices more accurately. If changes in exchange rates, interest rates, and’ commodity Prices could be predicted with ‘confidence, then companies could avoid the swings in value. In the context of Figure 1, if the actual price is completely anticipated, AP equals zero and the value of the firm is thus unchanged. In markets as efficient as the fi nancial markets, however, attempts to outpredict the market are unlikely to be successful. (Indeed, as an economist by trade, I learned that lesson “the hard way" by trying to outforecast the market; but that's another story.) Because forecasting is thus a very unreliable means of eliminating risk, a remaining alternative is, to manage the risks. Financial risk management can be accomplished by using on-balance-sheet trans- actions, For example, when faced with a foreign ex. change exposure resulting from foreign competi. tion, a company could manage such an exposure by Ts ey resus fom my ors to understand oblance ce Fnancing fesiruments and then pass on this undestanding to ices of the Chae Mantatan Bank. tn ths regaré. Lowe 3 debt of pate tomy collages Me Babunovie J Nichola Robinson, Cliford W-Suth and D Sykes Wierd ‘TLEGO isan exciosve wademane of INTERLEGO AG. DENNAR {STARWARS ite reptered and copyrighted tademar of tse id ‘TRANSFORMERS i te repsteted trademark os ine Paste Ri MEd bend Ceppere de Finn Toure ete he 192——— ‘approached forwards, futures, swaps, and options not as four distinct instruments and markets, but rather as four instruments to deal with a single problem—managing risk. borrowing in the competitors’ currency or by mov ing production abroad. But such on-balance sheet ‘methods can be costly and, as Caterpillar discovered recently, inflexible." Alternatively, financial risks can be managed with the use of off-balance-sheet in- struments: forwards, futures, swaps, and options. When I began to examine these financing in- struments, however, 1 was confronted by what seemed an insurmountable barrier to entry. All the market participants and trade publications fencoun- tered seemed to offer a specialized expertise that ‘was applicable in only one market to the exclusion of all the others. Adding to the complexities of the indi- vidual markets themselves was a welter of jar- gon—'ticks,” “collars.” “strike prices,” “straddles and so forth. Indeed, I seemed to find myself ina Nall Street Tower of Babel, with each group of mar- ket specialists speaking a different language—none of which 1 was able to understand. ‘The situation was analogous to one | had faced in my sons’ playroom, Not long ago, the boys were Star Wars® specialists. To play with them required that gain a Star Wars vocabulary and a great deal of Siar Wars knowledge. The problem was that, by the time I became Star Wars specialist, the boys had moved on to Transformers®; and none of my Star Wars knowl- edge was useful in the Transformer “market Iwas determined not to make my playroom mis- take again. I certainly didn't want to make a large in vestment of time and effort to become a swaps speci: alist only to have the market move on toa ‘new instru- Ment. So | approached forwards, futures, swaps, and options not as four distinct instruments and markets, but rather as four instruments to deal with a single problem—managing risk. By taking this approach, 1 also found my playroom analogy to be singularly apt But instead of looking at Star Wars tovs or Trans. formers, I should have been looking at LEGOs, Forward Contracts Of the four instruments we will consider here, the forward contract is the oldest and, perhaps for this reason, the most straightforward. A forward con- tract obligates its owner to buy a given asset on a specified date at a price (known as the “exercise Price”) specified at the origination of the contract. If, at maturity, the actual price is higher than the exer. cise price, the contract owner makes a profit; if the price is lower, he suffers a loss, In Figure 2, the payoff from buying a forward contract is superimposed on the original risk profile. If the actual price is higher than the expected price, the inherent risk will lead to a decline in the value of the firm; but this decline will be exactly offset by the Profit on the forward contract. Hencé, for the risk profile illustrated, the forward contract provides a perfect hedge. (Ifthe risk profile were positively in stead of negatively sloped, the risk would be man- aged by selling instead of buying a forward contract.) serinitiereenaenees eee ed FIGURE 2 w Puyol Profile for Forward Contract In addition to its payoff profile, two features of a forward contract should be noted. First, the default (or credit) risk of the contract is two-sided, The con- tract owner either receives or makes a payment, depending on the price movement of the underlying asset. Second, the value of the forward contract is conveyed only at the contract's maturity: no payment is made either at origination or during the term of the contract. Futures Contracts Although futures contracts on commodities have been traded on organized exchanges since the 1860s, financial furures are relatively new, dating from the introduction of foreign currency futures in 1972. The basic form of the futures contract is identi- cal to that of the forward contract; that is, a futures Contract also obligates its owner to purchase a speci- fied asset ata specified exercise price on the contract 1 Sce"Gucrplars Tape Whammy "Fortune Ocoher 72 Wao| | | | —_—_—_——_ eliminated in a futures market. maturity date, Thus, the payoff profile of a forward contract as presented in Figure 2 could also illustrate the payoff from holding a futures contract. Like the forward contract, the futures contract also has two-sided risk. But, in marked contrast to forwards, credit or default risk can be virtually elimi- nated in a futures market. Futures markets use two devices to manage such risk. First, instead of convey ing the value of a contract through a single payment at maturity, any change in the value of a futures con- tract is conveyed at the end of the day in which it is realized. Look again at Figure 2. Suppose that, on the day after origination, the financial price rises and the financial instrument thus has a positive value. In the case of a forward contract, this value change would not be received until contract maturity. With a futures contract, this change in value is received at the end of the day. In the language of those markets, the futures contract is “cash settled,” or “marked-to. market,” daily. Because the performance period of a futures contract is thus reduced, the risk of default declines accordingly. Indeed, since the value of the futures Contract is paid or received at the end of each day, itis not hard to see why Fischer Black likened a futures contract to "..a series of forward contracts, Each day, yesterday's contract is settled, and today's contract is written,”? That is, a futures contract is like a sequence of forwards in which the “forward” contract written on day 0 is settled on dav’ 1 and is replaced, in effect, with anew”“forward” reflectingthe new day i expecta. tions, This new contract is then itself settled on day 2 and replaced, and so on until the day the contract ends. The second feature of futures contracts which reduces default risk is the requirement that all mar- ket participants—sellers and buvers alike?’—post a 18 In marked contrast to forwards, credit or default risk can be virtually performance bond called the “margin.” If my futures contract increases in value during the trading day this gain is added to my margin account at the day's end. Conversely, if my contract has lost value, this loss is deducted from my margin account. And, if my ‘margin account balance falls below some agreed- upon minimum, I am required to post additional bond; that is, my margin account must be replenished or my position will be closed out.’ Be- cause the position will be closed before the margin account is depleted, performance risk is eliminated.> Note that the exchange itself has not been Proposed as a device to reduce default risk. Daily set- tlement and the requirement of a bond reduce de- fault risk, but the existence of an exchange (or clearinghouse) merely serves to transform risk. More specifically, the exchange deals with the wo- sided risk inherent in forwards and futures by serv- ing as the counterparty to all transactions. If wish to buy or sella futures contract, I buy from or sell to the exchange. Hence, I need only evaluate the credit risk of the exchange, not the credit risk of some specific counterparty. The primary economic function of the exchange is to reduce the costs of transacting in fatures contracts. The anonymous trades made possible by the exchange, together with the homo: geneous nature of the futures contracts—stan. dardized assets, exercise dates (four per year), and contract sizes—enables the futures markets 10 be- come relatively liquid. However, as was made clear by recent experience of the London Metal Exchange, the existence of the exchange does not in and of it- self reduce default risk.” In sum, a futures contract is much like a portfolio of forward contracts. At the close of busi- ness of each day, in effect, the existing forward-like contract is settled and a new one is written ® This dai 2 See Fischer Black “The Pricing of Commodiy Contac” Journal of ‘Financial Economies 3 (19°6) 119 "Keep in mind that if you buy 3 fours contract. you ar aking 2 long ‘postion inthe underhing asset Conversely sling a fatures Contac que Feat o tating «short postion 4: when he contact ongnsed on the US exchanges an “inital mario” {5 requized Subsequent, she margin account balance mst femainabone he “aaintenance margin” Ifthe margin acount balance fall below the mainte nance lve the balance ste restore to teil eve 5 Note tha this discussion as grored dl nit Were aed ition ‘te ovement of itures prices lure changes in expecitons bout the under lngasse can eectivey close the market (The market pens tnediaely moves ‘elim aden eectiveh closedunt te nex Silence these coldest aminsancein which the beaker dessa closeout scustomer spoon bist ablctoinmedacl because the markt experiencingliaitinoves Insuch aes the satement that performance ek eliminate 00 sons ‘6 tnNovembe of 1985. the “tin cartel" dtaltedonconratsfor tin delery ‘onthe London eral Exchange thereby making enchange lable for teks