Derivatives, Hedging, and Speculating Warren Buffet (Oracle of Omaha): fin derivatives = fin weapons of mass destruction. Problems with derivatives (value from underlying asset) not traded on exchanges: 1 Derivatives are thinly traded, and dealers use pricing models that may be inaccurate. 2 Many unregulated and firms may not set aside sufficient reserves to offset losses. 3 Derivatives not traded in exchanges have substantial counterparty risk. Financial derivatives played an important role in the financial crisis of Despite Buffett derivatives provide risk-sharing (hedge/insure), liquidity & info services. If insurance or hedge is available on an activity, more of that activity will occur. Hedge is to take action to reduce risk. But derivatives can also be used to speculate (fin bets to profit from price changes). Speculation and speculators provide two useful functions: When hedger sells a derivative to a speculator, they transfer risk to the speculator. Speculators provide essential liquidity; otherwise, there would not be a sufficient number of buyers and sellers for the market to operate efficiently.

Forward Contracts An agreement to buy or sell an asset at an agreed upon price at a future time, provides an opportunity to hedge the risk on transactions that depend on future prices. Key features of a forward contract: Spot price at which a commodity or financial asset can be sold at the current date. Settlement date for delivery of asset specified in a forward contract at forward price. Forward contracts are specific in terms (customized) so they are: - illiquid - subject to specific default or counterparty risk (other side of the transaction defaults) Futures Contracts A standardized contract to trade a specified amount of an asset on a specific future date. Differences from forward contracts: - Futures are traded through exchanges or clearinghouses (CBOE Chicago Board Options Exchange or NYMEX New York Mercantile Exchange). - Futures contracts specify a quantity of the asset to be delivered but do not fix the price. - The prices of futures change continually but equals spot price at maturity.

Trading in the Futures Market Margin requirement is the minimum deposit that an exchange requires from the buyer or seller of a financial asset. Example: Futures contracts for U.S. Treasury notes are standardized at a face value of $100,000 of notes. The CBOT requires that buyers and sellers deposit a minimum of $1,100 for each contract into a margin account. Marking to market is 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.

Short position: obligation of the seller to deliver the asset on the specified date. Long position: obligation of the buyer to receive the asset on the specified date. You plant wheat in May expecting 10,000 bushels yield in August. Spot price is $2.00 per bushel. You are concerned that August price $2.00. Hedging involves taking a short position in the futures market to offset a long position in the spot market or vice versa. In the futures market for wheat, you can take a short position and the General Mills manager can take a long position. To fulfill the futures obligation, you can engage in settlement by delivery or by offset. Profit (loss) to the buyer = Spot price at settlement - Futures price at purchase Profit (loss) to seller = Futures price at purchase - Spot price at settlement Investors not connected with the wheat can use futures to speculate. If you were convinced that August price of wheat will be lower than the current futures price, sell wheat futures and buy wheat cheaper on or before the settlement. Hedging and Speculating with Commodity Futures

Hedging with Commodity Futures During the financial crisis of 2007–2009, some policymakers and economists argued that the use of derivatives had destabilized the financial system. The Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) of 2010 places additional restrictions on trading in derivatives. Farmers were worried that (1) they might have to post more collateral to trade futures, and (2) small community banks and special agriculture banks might no longer be allowed to offer forward contracts. In 2012, firms and cooperatives that used derivatives to hedge risk were exempt from regulations.

Hedging and Speculating with Financial Futures Today most futures traded are financial futures: Treasury securities, stock indexes, and currencies. An investor who believes that she has superior insight into future interest rates can use the futures market to speculate. If you wish to speculate that future interest rates will be lower (or higher) than expected, you could buy (or sell) Treasury futures contracts.

Financial Futures for 5 year $100,000 T-Note with 6% Coupon Mar 2013 prices (in x/32) investors expect Treasury rates to rise. How to Hedge an Investment in T-Notes When Rates Are Low? After fin crisis rates fell very low. In 2012 investors bought bonds despite low yields and WSJ article’s warning about a “nasty bear market in bonds.” a. What does a bear market in bonds mean? A price decline of at least 20%. b. What might cause a bear market in bonds? Investors expecting higher inflation => higher nominal rates => lower bond prices. c. How might it be 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 by selling futures contracts.

Holder has the right but no obligation to buy (call - bullish) or sell (put - bearish) underlying asset at strike (exercise) price at any time up to the expiration (American) or only on the expiration (European), while writer has the obligation. Suppose Apple currently trades at $600. Investor believing price will rise to $650 (fall to $550) in the next year could buy a call option with strike price of $610 (put option with exercise price of $590) for $10 premium. If price stays below $610 (above $590) call (put) option holder allows it to expire. Profits for call and put option holder are illustrated below. Option is in/at/out of money if payoff for option holder >=< 0 if exercised. Options

Option Pricing Option price (premium) reflects probability that it will be exercised. It has two parts: 1. Intrinsic value is the payoff to the buyer from exercising it immediately. Because buyer does not have to exercise option, its intrinsic value is always > Time value is determined by option’s expiration date and asset price’s volatility: The further away in time an option’s expiration date, the larger the option premium. The greater the price volatility of the underlying asset, the larger the option premium. The Black-Scholes formula for option pricing led to an explosive in options trading. “Rocket scientists” or “quants” evaluate and price new securities on Wall Street. Using Options to Manage Risk Options (max loss = premium with unlimited gain on call) are more expensive than futures (locks value of portfolio consisting of original contract and hedge position). Many hedgers buy options, not on the underlying asset, but on a futures on that asset.

The October contract Last price is $ The Volume show the number of contracts traded, and the Open Interest show the number of contracts not yet exercised. a.Why are the call options selling for higher prices than the put options? Because all call options are in the money and the puts are all out of the money. b. Why does the April call sell for a higher price than the October call? The further the expiration, the greater the chance that intrinsic value will increase. c. If you buy the April call, would you exercise it immediately. No since current price - strike - premium = $ $245 - $33 = -$17.53 loss. d. What is profit from buying the November call when Amazon stock trades at $300. Earn = current price - strike - premium = $300 - $245 - $22.05 = $32.95 profit. e. What is profit from buying the April put if Amazon stock remains at $ Since selling at strike = $245 put out of money. You would let put expire and take a loss equal to the option’s price of $ Options Listings for Amazon.com Currently Trading at $260.47

How Much Volatility Should You Expect in the Stock Market? CBOE’s Market Volatility Index is based on put and call prices on S&P 500 index: Investors expecting higher stock price volatility increase demand for options. During fin crisis VIX reached record following collapse of Lehman Brothers To hedge against increase in stock price volatility buy VIX futures sold by speculator who bets on a decrease in market volatility.

Agreements between two or more counterparties to exchange cash flows. Unlike futures and options, swap terms are flexible, offer more privacy, are not subject to government regulation, and can be written for long periods. However, check the creditworthiness of partners, for swaps are less liquid than futures and options. Under interest-rate swaps counterparties agree to swap interest payments over a specified period on a fixed dollar amount (notional principal) to transfer interest-rate risk to parties more willing to bear it. The interest rate is often based on LIBOR. Swaps Wells Fargo bets LIBOR (representing inflation) stays below 2%. If inflation increase and LIBOR = 3% WF owes IBM 700,000 = 10,000,000( ). IBM owes WF 600,000 = 10,000,000×.06. Generally, parties exchange only the net payment and WF pays 100,000 to IBM.

Currency Swaps Counterparties agree to exchange principals denominated in different currencies. Both parties can borrow cheaply at home and swap loans. A basic currency swap has 3 steps: 1.The two parties exchange the principal amount in the two currencies. 2.The parties exchange periodic interest payments over the life of the agreement. 3.The parties exchange the principal amount again at the conclusion of the swap. Credit Swaps Interest-rate payments are exchanged, with the intention of reducing default risk. Banks with difficulty diversifying portfolios, reduce risk by swapping loan payments. Credit Default Swaps Requires seller to pay buyer if price of underlying asset declines. During fin crisis most widely used along with mortgage-backed securities and collateralized debt obligations (CDOs). Issuer of credit default swap on mortgage-backed security receives payments from the buyer in exchange for promise to pay buyer if the security goes into default. The heavy losses that American International Group (AIG) and others suffered on credit default swaps deepened the financial crisis and led more regulations.