Hedging or speculations

- Tools
o Futures, forwards, options, and swaps
o Insurance
o Diversification
o Match duration of assets and liabilities
o Match sales and expenses across countries (reduce currency risk)
 This is the reason why many businesses set up operations in regions where they
do a lot of business
- Are derivatives efficient tools for risk management or are they financial weapons of mass
destruction?
o View 1: Hedging is irrelevant
 Diversified shareholders don’t care about firm-specific risks
o View 2: Hedging creates value
 Reduces chance of financial distress
 Reduces need for external finance
 Improves performance evaluation and compensation
o Examples
 Homestake Mining: No hedging at all; shareholders will achieve maximum
benefit from such a policy
 American Barrick: Hedges aggressively; To provide stability to investors

Forward and Futures

- Managers regularly buy options on currencies
- Using the Mexico government as example
o A large portion of its revenue comes from Pemex (state-owned oil company)
o The government purchase puts to reduce downside risk
 Bought put options that gave it the right to sell 250 million barrels of oil at an
exercise price of $46
 If the price increases to more than $46, Mexico will reap the full benefits
 If the price falls below $46, the oil will still be sold at $46 (the payoff to the put
option would exactly offset the revenue shortfall)
 The hedge cost 1.25 billion


- Hedging involves taking on one risk to offset another. Potentially removing all uncertainties
- Tools specifically designed for hedging: Forwards, futures, and swaps
o Known as derivative instruments or derivatives as their value depends on the value of
another asset
o Basic types of derivatives
 Forwards and futures: Agree at present to transact at a certain price in the future
 Options: Gives the holder the right to buy (call option) or sell (put option) an
asset at a specified price
 Swaps: An agreement to exchange a series of cashflows at specified prices and
times
- Example of a forward contract
o A forward contract is a commitment to purchase at a future date a given amount of a
commodity or asset at a price agreed on today
 o Northern refineries: producer of heating oil; Arctic Fuel: heating oil distributor
o Arctic oil is afraid that the price of oil may increase; Northern refineries is unsure of the
price of the oil that can be sold for in winter
o Thus, Northern and Arctic signed a contract for the oil to be sold at $2.40 per gallon in
Jan
 * Spot price is the price for immediate delivery
o The 2 parties have entered into a forward contract. The forward price is $2.40 per gallon.
Price is fixed today but payment will only happen later.
 Arctic which had agreed to buy, has the long position in the contract
 Northern which had agreed to sell, has the short position


 Left is asset; right is liability
 The forward contract creates an offsetting short position for northern
and an offsetting long position for arctic
 The offset means that each counterparty ends up locking in a price of
$2.40 regardless of future spot prices
o When prices go up, long position earns a profit
o *This is not an option; the parties do not have the option to back away from the deal
 However, both parties do have to worry about counterparty risk; the risk that
the other party will not perform as promised
o This example glossed over several complications
 The retail price of the oil should move in tandem with the wholesale price.
In this case, the heating-oil distributor is naturally hedged. Locking in costs
with a future contract could make the distributor’s profits more volatile.
 If the future spot price falls way below the forward price  Higher cost of
production compared to competitors who bought it at spot price  great
disadvantage
o Issues with forward contract
 Illiquidity
 Counterparty risk
- For Forward contract the contract itself is worth $0. I.e., one will not be able to sell that piece of
contract for any value
o Assuming rational decisions and perfect information, one will not enter the forward
contract at a loss
o However, the value of the contract does change when the spot rate changes
 E.g., When the spot rate increases to $25, and the forward rate is at $20. This
contract will be worth $5 to prospective buyers. It will be worth -$5 to sellers.
 This will increase the chances for the seller to default

- Futures Exchange
o A futures contract is signed daily
 At the end of each day money will be traded between the buyer and the seller
depending on the movement of the spot rate relative to the futures rate
 A contract will be signed on the following day
 This reduced counterparty risk as the fluctuation per day is small and is unlikely
for either party to back out of the daily contract
o Parties can go to an exchange where standardized forward contracts are traded
 Distributors will buy contracts, refiners will sell contracts
o When a forward contract is traded on an exchange, it becomes a futures contract
 o
- Example of futures contract

o
 If the margin falls below $3,000, the speculator will receive a margin call and is
required to top up to $3,000 by the end of the business day or the contract will
be voided.
- Financial futures  Placing an order to buy or sell a financial asset at a future date
- Mechanics of futures trading
o When one buys or sell contract, the price is fixed but payment will not be made till later
o However, one will be asked to put up margin in the form of cash or treasury bills. As long
as interest is earned on the margined securities, there is no cost.
o Future contracts are marked to market
 Each day, any profits or losses are calculated, and one pays any loss and receive
any profits
 E.g.,
 Jan oil futures contracts at a future price of $2.40 per gallon.
 The next day, price increases to $2.44  the exchange’s clearing house
pays $40,000 ($.04 x 1,000,000) into Arctic’s margin account.
 If the price drops back to $2.42, Arctic’s margin account pays $20,000
to the clearing house
 For Northern (seller of oil), the effects are the opposite
 When price increases to $2.44  Northern loses $.04 x 1,000,000 =
$40,000 and must pay it to the clearing house
 When both parties enter into a futures contract at a future price of $2.40 and the
price rose to $2.60
 Northern suffers a cumulative loss of $.20 x 1,000,000 = $200,000. It
will then sell and deliver the oil at $2.60. Thus, the selling price will
always end up at $2.40
o Taking delivery to and from an exchange can be inconvenient and costly. For example,
the NYMEX calls for delivery in New York Harbor. The 2 companies may be better off
delivering directly to each other. Thus, both parties will close out their futures position
before the end of the contract and take their profits and losses. Nevertheless, the NYMEX
futures contract has allowed them to hedge their risks.
o Basis risk
 An example of basis risk is that the spot prices of the local oil prices and the
price in New York are not perfectly correlated. The local price may experience
an increase but price in New York remains unchanged, then a long position in
NYMEX futures won’t hedge against the increase in local prices.

Trading and pricing Financial Futures Contracts

- When one forecast that the French stock will outperform other markets and predicts a 10% six-
month return. He can
 o Buy French stocks or
o Buy future contracts of French stocks
 The position is marked to market, if the price of the stock goes up, profits will
be put into his margin account; if the price falls, the margin accounts fall too
- When one wants to purchase a security, he has 2 choices
o Buy for immediate delivery at spot price
o Buy forward: by placing an order for future deliveries at the futures price
 If you buy forward, you can:
 Earn interest on the purchase price
 But you will miss out on any dividends paid in the meantime

 Ft is the futures price for a contract lasting t period
 S0 is today’s spot price, rf is the risk-free interest rate
 Y is the dividend yield
 E.g.,
 6-month CAC futures contract trades at 5,000; current spot CAC is
5,045.41. The interest rate is 1% per year (.5% over 6 months) and the
dividend yield is 2.8% (1.4% over 6 months).

 The numbers fit perfectly cause
 (1): purchasing CAC index for 5,045.41 today
o In 6 months, you will own the index and dividend of 70.64
(.014 x 5,045.41)
 (2): purchasing a futures contract for $5,000
o In 6 months, your balance will be 5,070.64 (5,054.41 x 1.005)
o You will be able to purchase the index at $5,000 and have just
enough to cover the dividend you missed (70.64)
- Commodities
o Buying commodities futures is more complicated
 (1) payment is delayed, buyer of the future can earn interest on her money
 (2) does not need to store commodities. Thus, saves warehouse costs wastage
etc.
 (3) No convenience yield, which is the value of owning the real thing (instead of
a futures contract)
 Ft = S0(1 + r + storage costs – convenience yield)t
 Convenience yield plays the same role as dividends or interest forgone
on securities
 Normally, it is difficult to observe storage cost or convenience yield.
But one can infer the differences by comparing the spot and future
prices.
o The difference (convenience yield less storage cost) is called
the net convenience yield.
o E.g.,
 The spot price of crude oil is $57.57, and the 6-month futures price was $56.91.
The six months interest rate was about 1.2%


 Net convenience yield is positive  convenience yield from the having
crude oil > storage cost
 o
 Annualized convenience yield for crude oil
 When there are shortages or fears of an interruption of supply, traders may be
prepared to pay a premium for the convenience of having inventories of crude
oil
o However, it is important to note that some commodities cannot be stored at all. For
example, electricity.
- Forward contracts
o Non-standard and traded over the counter (not on exchanges)
o No money changes hands till maturity (unlike futures contracts)
o Futures contracts are standardized and mature on a limited number of dates each year
o One may also be able to buy/sell a tailor-made forward contract.
 The main forward market is in foreign currency
o Forward interest rate contract
 E.g., You know that at the end of three months you will need a six-month loan.
You are worried that the interest rate will rise over the next 3 months.
 You can lock in the interest rate on the loan by buying a forward rate
agreement (FRA) from a bank
 You may buy a 3-against-9-month FRA at 7%
o Means that the forward rate agreement is for a 6-month loan in
3 months’ time
 If the interest rate rises above 7%, the bank will make up the difference
- Homemade forward contract
o Allows one to fix a future rate at which they lend / borrow
o If you borrow short and lend long


 You essentially fixed the forward rate at 14.04%


o If you want to fix today the rate that you borrow at next year
 You can borrow long and lend the money until you need it next year

Determining Forwards and Futures prices

-
o t = Date when the contract is priced at
o T = Settlement date
o
 -
o Assuming that one borrows money to purchase the asset outright  cash flow given on
the right
o $S0(1 + r)T is the interest + the principal amount paid in the future
o Since both results in having the assets at time T  both cashflow should be the same

Financial futures
- One has a million dollars and decides to invest in the S&P 500
- 2 ways to achieve this
o Buy the 500 stocks, weights proportional to their market cap
o Buying a futures contract
 Put the money in the margin account
 To have an exposure of $1 million
 The notional value of the contract is 250 times the value of the index
 Suppose the index is $1,000  the value of each contract will be
$250,000 ($1,000 x 250)
 He/she will thus buy 4 contracts to get an exposure of $1million

o
 The futures portfolio fluctuates the same that the cash portfolio fluctuates
 The price of the index moves in tandem with the S&P 500 cash portfolio
- If you have $5 million worth of stocks. You are confident that the market will do well in the long
term, but you want to hedge against short term price decreases
o You can sell 25% of the portfolio
o You can short sell the 25% of the portfolio


 Short selling 5 contracts (while owning 5 million worth of S&P 500
portfolio; equivalent to 20 contracts) (each contract is $250,000)
 Since only 25% is hedged  the effect of fluctuation is only
dampened, not eliminated
