Principles of Finance

BS 2100

Hedging & Derivatives Introduction

Pete Hahn
Faculty of Finance Room 5012 Cass Building
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Topics Covered
Introduction to Hedging Tools Forwards, Futures, Swaps Calls, Puts and Shares Derivative Securities Financial Alchemy with Options What Determines Option Values?

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Hedging with Forwards and Futures

All Businesses Have Risk (for example) Intrinsic Risk (of the firm/industry) - variable costs Extrinsic (Market) Risk - Interest rate changes

Goal = Eliminate risk

HOW? Hedging & Forward Contracts
What if you could know and commit to a price for buying and selling in 3 months or 3 years from now?

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Hedging with Forwards and Futures

For example.Kellogg produces breakfast cereal. A major component and cost factor is sugar. Imagine YOU ARE Kellogg Tesco and Sainsbury can order cereal for the next 6 months at todays list price. However, sugar prices could go up next week increasing costs and lowering Kelloggs profit margin when producing cereal to meet orders. To fix your profit margin, you would ideally like to purchase all your sugar today, since you like todays price, and set your price for cereal based on it. But, you cannot. You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today. This contract is called a Forward or a Futures Contract. Kellogs managing its sugar costs is Hedging.
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Hedging with Forwards and Futures

1- Spot Contract - A contract for immediate sale & delivery of an asset. 2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future.

3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.
The intermediary in a Futures contract is a an Exchange and it guarantees all trades & provides a secondary market for the trading in Futures.
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Types of Futures
Commodity Futures -Sugar -Corn -OJ -Wheat -Soy beans -Pork bellies Financial Futures -T-bills -Yen -GNMA -Stocks -Eurodollars Index Futures -S&P 500 -Value Line Index -Vanguard Index
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SUGAR

Commodity Futures

Financial Futures

Futures Contract Concepts

Not an actual sale Always a winner & a loser (unlike stocks) K are settled every day. (Marked to Market) Hedge - K used to eliminate risk by locking in prices Speculation - K used to gamble Margin - not a sale - post partial amount (use leverage)

Hog K = 30,000 lbs (K is a contract) T-bill K = $1.0 mil Valueline Index K = $index x 500
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Futures and Spot Contracts

The basic relationship between futures prices and spot prices for equity securities.

Ft S0 (1 rf y )t Ft futures price on contractof t length S0 Today's spot price rf Risk free rate y Dividend yield

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Futures and Spot Contracts

Example
The DAX spot price is 5,952.38. The interest rate is 3.6% and the dividend yield on the DAX index is 2.0%. What is the expected price of the 6 month DAX futures contract?

Ft S 0 (1 rf y ) t 5,952.38 (1 .018 .01) 6,000

Adjusted for 6 months
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Futures and Spot Contracts

The basic relationship between futures prices and spot prices for commodities.
Ft S0 (1 rf sc cy )t Ft futures price on contractof t length S0 Today's spot price rf Risk free rate cy Convenience yield sc Express storagecost ncy cy sc Net Convenience yield
N.B. ncy can sometimes be positive (negative effect) if supply/demand is changing.

Ft = S0 (1 + rf - ncy)
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Futures and Spot Contracts

Example
In December the spot price for coffee was $1.234 per pound. The interest rate was 5.32 % per year. The net convenience yield was 5.6%. What was the price of the 9 month futures contract?

Ft S0 (1 rf sc cy )t or Ft S0 (1 rf ncy ) with time adjusted r Ft S0 (1 rf ncy ) 1.234(1.0399 0.056) 1.2141

Because the ncy (or benefit to the owner) is higher than the interest rate, the future price is lower than the Spot price.

One changed, why?

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Futures and Spot Contracts

Example
In January the spot price for oil was $41.68 barrel. The interest rate was 0.44 % per year. Given a one year futures price of $58.73, what was the net convenience yield?

Ft = S0 (1 + rf + sc - cy)t 58.73 = 41.68 (1 + 0.0044 - ncy) ncy = -0.405

-0.405 = -40.5% , in other words, it wasnt very valuable to hold oil during this period.

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Annualized Net Convenience Yield, %

Net Convenience Yield

-60.00 10.00 20.00 30.00 0.00

-50.00

-40.00

-30.00

-20.00

-10.00

40.00

01/01/1995 01/08/1995 01/03/1996 01/10/1996 01/05/1997 01/12/1997 01/07/1998 01/02/1999 01/09/1999 01/04/2000 01/11/2000 01/06/2001 01/01/2002 01/08/2002 01/03/2003 01/10/2003 01/05/2004 01/12/2004 01/07/2005 01/02/2006 01/09/2006 01/04/2007 01/11/2007 01/06/2008 01/01/2009

SWAPS
Definition - An agreement between two firms, in which each firm agrees to exchange the interest rate characteristics of two different financial instruments of identical principal
Key points Credit Spread inefficiencies (markets price risk differently) Same notation principal (the basis of deal size) Only interest payments exchanged
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SWAPS
Fixed rate payer (ABC), S&P rated A Floating rate payer (XYZ), Moodys rated Aaa Counterparties Settlement dates (in our example, once per year)

Swap Benefit = reduction in borrowing cost

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SWAPS
example (annually settled) - Borrowing Options for XYZ & ABC XYZ ABC Fixed rate (Bond YTM) 10% 11.5% Floating rate (Bank Loan) LIBOR + .25 LIBOR + .50 Assume LIBOR = 7%, do a swap (assume $1mil face value loans) XYZ issues bond for $1mil @ 10% fixed ABC borrows from bank $1mil @ 7.5% floating The Swap: XYZ pays (ABC) floating (LIBOR) @ 7.00% ABC pays (XYZ) fixed @ 10.25%
We say the swap rate is 10.25%
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Swap Curves
(similar to the term structure)

SWAP Curves for three currencies during March 2009

5-year swap rate in dollars

WHY SWAP?
example - cont Benefit to XYZ floating +7.25 -7.00 fixed +10.25 -10.00 Net gain Benefit ABC floating +7.00 - 7.50 fixed -10.25 + 11.50 net gain
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Net position +.25 +.25 +.50%

Net Position -.50 +1.25 +.75%

XYZ has lowered its floating rate borrowing cost by 0.50%, effectively paying 7.25-0.50 = 6.75% (or L-0.25)

ABC has lowered its fixed rate borrowing cost by 0.75% to 10.75%.

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SWAPS
example - cont
Settlement date (assuming LIBOR doesnt change) ABC pmt 10.25% x 1mil = 102,500 XYZ pmt 7.00% x 1mil = 70,000 net cash pmt by ABC = 32,500 if Libor rises to 9% settlement date ABC pmt 10.25 x 1mil XYZ pmt 9.00 x 1mil net cash pmt by ABC
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= 102,500 = 90,000 = 12,500

XYZ which has changed its cost to floating will pay more
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An Easier Way..
BOND ISSUE

-10%

XYZ
-10

L% 10.25%

BANK BORROW

ABC
-L -.50 +L

-L
-.50%

+10.25
-L -(L-.25%)

-10.25
-10.75

SWAPS
A Forward or a Future? rarely done direct banks = middleman bank profit = part of swap gain example - same continued with a bank in between XYZ & ABC go to bank separately XYZ term = SWAP floating @ LIBOR for fixed @ 10.25% ABC terms = swap floating LIBOR + for fixed 10.50% (was 10.25%) Bank gets 0.25% p.a. (or $2500) for taking each side risk
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Changes
New global banking regulation requires interest rate swaps to done outside of banks in coming years and on financial exchanges with central clearing parties (CCPs). Thus, the majority of interest swaps will become _________ from todays ________.

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Speculation
Example - You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?

Long Own or Buy and will benefit from price rise

Short Sell or will benefit from price fall

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Speculation & Settlement

Example - You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops 0.17 cents per pound ($.0017) what is total change in your position?
30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss

50.63 -$510 50.80

cents per lbs

Since you must settle your account every day, you must give your broker $510.00
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Commodity Hedging
1) In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August.
He knows the cost of seed and fertilizer ($2.60 per bushel or $26,000), but cant be sure of his sale price, it could go up or down.

2) In June, September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price (and his profit, he does not want to risk selling at a loss, 2K=$29,400). Show the futures transactions if the Sept spot price rises to $3.05.
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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price rises to $3.05. Revenue from Crop: 10,000 x 3.05 30,500

June: Short 2K @ 2.94 = 29,400

Sept: Long 2K @ 3.05 = 30,500 Loss on Position------------------------------- ( 1,100 ) Total Revenue
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$ 29,400
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Commodity Speculation
You have lived in London your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncured bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs (pounds weight). Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?

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The Market Needs Speculators -----Why?

Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160 Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290 Loss of 10.23 % = - 5,130 If you were Farmer Smith, and you only planted one of two fields, and you saw that speculators had pushed the price of Sept corn to $3.50, what would you do?
Speculators can influence (provide information to) producers
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Margin
The amount (percentage) of a Futures Contract Value that must be on deposit with a broker (the exchange). Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin. CME margin requirements are 15% Thus, you can control $100,000 of assets with only $15,000.
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Commodity Speculation with margin

Our wealthy London friend now buys.On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?

Nov: Short 3 May K (.4400 x 38,000 x 3 ) =

+ 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) =

Loss = Loss
-----------=

- 55,290
- 5,130

5130
-------------------=

5130
------------ =

68% loss

Margin

50160 x.15

7524

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Option Terminology
Call Option Right to buy an asset at a specified exercise price on or before the exercise date.

Put Option Right to sell an asset at a specified exercise price on or before the exercise date.
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Option Obligations

Call option Put option

Buyer Right to buy asset Right to sell asset

Seller Obligation to sell asset Obligation to buy asset

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Options
Terminology Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.) Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time. Call Option - The right to buy a security at a specified price within a specified time. Put Option - The right to sell a security at a specified price within a specified time. Option Premium - The price paid for the option, above the price of the underlying security. Intrinsic Value - Diff between the strike price and the stock price Time Premium - Value of option above the intrinsic value
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Options
Terminology Exercise Price - (Striking Price) The price at which you buy or sell the security. Expiration Date - The last date on which the option can be exercised. American Option - Can be exercised at any time prior to and including the expiration date. European Option - Can be exercised only on the expiration date. All options usually act like European options because you make more money if you sell the option before expiration (vs. exercising it). 3 vs. 70-68=2
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Google Stock
Selected prices for puts and calls September 2008

Colgate-Palmolive Stock
Selected prices for puts and calls June 2011
Exercise Date or Option Maturity
September 2011

Exercise Price
$70 75 80 85 90 $70 75 80 85 90 $70 75 80 85 90

Price of Call Option

$14.30 9.90 6.50 3.70 1.90 $15.10 12.20 9.00 6.20 4.10 $20.50 18.00 14.90 12.00 9.90

Price of Put Option

$0.75 1.40 2.75 5.10 8.70 $2.20 2.65 4.60 7.70 9.46 $4.30 5.70 7.30 10.40 12.70

Share price is $80.00

December 2011

March 2012

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Option Value
The value of an option at expiration is a function of the stock price and the exercise price. Example - Option values given an exercise price of $80

Stock Price $60 Call Value Put Value

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70 0 10

80 0 0

90 10 0

100 20 0

110 30 0
39

0 20

Option Value
Call option value (position diagram) given a $80 exercise price, for the buyer of the call option. Call option value

$15

80 Share Price
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Option Value
Put option value given a $80 exercise price, for the buyer of the option. Put option value

$10 70 80 Share Price

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Option Value
Call option payoff (to seller or writer) given an $80 exercise price. Call option $ payoff

$0

80 Share Price
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Option Value
Put option payoff (to seller) given a $80 exercise price.

Put option $ payoff

80 Share Price
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Option Value
Call buyer profit assume strike of $80 and option price of $9.00 (a profit diagram)
Long call Position Value
Break even

- 9.00

80

89

Share Price
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Option Value
Put seller profit assume strike of $80 and option price of $4.60

Position Value

Break even

Short put
+4.60

75.40 80

Share Price
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Option Value
Protective Put - Long stock and long put
Long Stock Position Value Protective Put

Long Put Share Price

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Option Value
Straddle - Long call and long put - Strategy for profiting from high volatility
Long put Position Value Long call

Straddle

Share Price
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Option Value
Components of the Option Price 1 - Underlying stock price = Ps 2 - Striking or Exercise price = S 3 - Volatility of the stock returns (standard deviation of annual returns) = v 4 - Time to option expiration = t = days/365 5 - Time value of money (discount rate) = r 6 - PV of Dividends = D = (div)e-rt
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Time Decay Chart

Option prices decline, ceribus paribus, when the time to expiration declines.

Option Price

90 days to expiration

30 days to expiration

60 days to expiration

Stock Price

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Option Value
The greater the distribution of possible outcomes, relative to the final price of the stock, the higher the value of the option. This is due to the greater potential for profit. Thus, Y will have a higher option price, ceribus paribus. Share Y has a higher or has more risk (volatility). Option value goes up with volatility. Why?

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Topics Covered
Introduction to Hedging Tools Forwards, Futures, Swaps Calls, Puts and Shares Derivative Securities Financial Alchemy with Options What Determines Option Values? Well review next week
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TRY THIS..
BOND ISSUE

-7.5%

XYZ

L% 7.75%

BANK BORROW

ABC

-L
-.50%

Ans: ABC pays 8.25%.......

See you next week

We will review options at the beginning of next weeks lecture.

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