Chapter Outline

1
Chapter Outline

• 13.1 Introduction to Derivatives and Hedging
• Exposure Diagrams Revisited
• Hedging with Call Option Contracts
• Hedging with Put Options
• Cash Settlement versus Physical Delivery
• Basis Risk
• 13.2 Option Pricing
• The Role of Supply and Demand
• Influence of Underlying Asset, Contract, and
  Market Characteristics
• Price of the Underlying Asset
• Volatility
• Exercise Price
• Time to Expiration
• Interest Rate

2
Chapter Outline

• 13.3 Hedging with Forward/Futures Contracts
• Forward Prices
• 13.4 Other Derivative Contracts
• Constructing Other Derivatives
• Swap Contracts
• 13.5 Comparison of Derivative and Insurance
  Contracts
• Market Prices versus Specific Losses
• Basis Risk and Extent of Risk Reduction
• Contracting Costs
• Moral Hazard and Adverse Selection
• Capital Costs
• Liquidity
• Summary

3
Chapter Outline

• 13.6 Markets for Derivatives
• Over the Counter versus Exchange Traded
  Derivatives
• Common Risks that are Hedged with Derivatives
• Foreign Exchange Derivatives
• Interest Rate Derivatives
• Commodity Derivatives
• Equity Derivatives
• 13.7 Reducing Risk Through Internal
  Diversification
• 13.8 Summary

4
Hedging Using Derivatives

• Important part of modern risk management
• Examples of the types of risk that are hedged
• commodity prices
• interest rates
• exchange rates
• Derivative markets are huge
• Integration of insurance and financial markets is
  an important trend

5
Exposure Diagrams Revisited

• The Relation between Oil Prices and NeedOils
  Profits

Profits
1.25 m
100 m
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
0.75 m
14 15 16
6
Hedging Oil Price Risk with Call Options

• NeedOil has oil price risk
• Issue How can it reduce its exposure?
• Solution
• NeedOil signs a contract with OPTCO where OPTCO
  pays NeedOil
• 250,000 x (Poil - 15) if Poil gt 15
• 0 if Poil lt 15
• OPTCO requires a premium equal to 100,000

7
Hedging Oil Price Risk with Call Options

• The Relation between Oil Prices and NeedOils
  Payoff from its contract with OPTCO

NeedOils Payoff from its contract with OPTCO
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
14 15 16
8
Hedging Oil Price Risk with Call Options

• What are NeedOils profits?
• if oil price 14 gt
• profits from operations 1,250,000
• profits from OPTCO contract -100,000
• total profits 1,150,000
• if oil price 15 gt
• profits from operations 1,000,000
• profits from OPTCO contract -100,000
• total profits 900,000
• if oil price 16 gt
• profits from operations 750,000
• profits from OPTCO contract 125,000
• total profits 900,000

9
Hedging Oil Price Risk with Call Options

• The Relation between Oil Prices and NeedOils
  Profits from Operations plus Profits from
  contract with OPTCO

NeedOils Payoff from its contract with OPTCO
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
14 15 16
10
Call Option Contracts

• NeedOils contract with OPTCO is an example of a
  derivative contract, called a call option.
• A Derivative contract is a contract whose payoff
  or value is derived from the value of some other
  asset or index.
• The asset on which the derivative contract is
  based is called the underlying asset
• A call option contract pays the purchaser of the
  option a positive amount if the underlying asset
  exceeds the exercise price.
• The option price is the amount paid for the
  option.
• For every call option buyer, there is a call
  option seller.

11
Selling a Call Option

• Payoff to a Seller (OPTCO) of a Call Option on
  Oil with An Exercise price of 15

NeedOils Payoff from its contract with OPTCO
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
14 15 16
12
Put Options

• Put option contract receives a positive payoff
  only if the value of the underlying asset falls
  below the exercise price

NeedOils Payoff from its contract with OPTCO
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
14 15 16
13
Cash Settlement versus Physical Delivery

• Some options are settled in cash (like the ones
  NeedOil used)
• Other options are settled with the physical
  delivery of the underlying asset
• Example call option on oil 1,000 barrels with
  exercise price of 15
• If oil price at expiration 18, then the option
  buyer would exercise the option to buy 1,000
  barrels for 15 a barrel

14
Basis Risk

• Basis risk refers to the uncertainty in the
  relationship between the variable being hedged
  and the derivative contract payoff being used to
  hedge
• Examples
• firm takes delivery in New Orleans, derivative
  contract is based on New York prices
• grade of the underlying asset used differs from
  the grade on which the contract is based.

15
Determinants of the Price of Call and Put Options

• An Increase in Call Option Price Put Option
  Price
• the value of the
• underlying asset Increases Decreases
• the exercise price Decreases Increases
• the volatility in the
• return of the
• underlying asset Increases Increases
• the time to maturity Increases Increases
• interest rates Increases Decreases

16
Hedging with Forward Contracts

• Alternative method of hedging Contract with F-CO
• F-CO does not demand an upfront premium
• Instead NeedOil pays F-CO if the price of oil
  falls below 15
• F-CO pays 250,000 x (Poil - 15) if Poil gt 15
• F-CO receives 250,000 x (15 - Poil) if Poil lt 15

17
Hedging with Forward Contracts
NeedOils Payoff from its contract with F-CO
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
14 15 16
18
Hedging with Forward Contracts

• A forward contract or a futures contract gives
  the buyer (NeedOil) a symmetric payoff
• equal to the difference between the actual price
  of the underlying asset and some pre-determined
  price
• called the forward price or futures price.

19
Hedging with Forward Contracts

• Payoff to a F-CO, the Seller of a Forward
  Contract

F-COs Payoff
Possible oil prices in six months in New Orleans
for the grade of oil NeedOil uses (/barrel)
14 15 16
20
Forward Prices

• Demand and supply of contracts determines the
  forward price
• People will always demand more contract or supply
  more contracts unless
• Cost of carry relationship is true
• forward price spot price at time t cost of
  carry,

21
Example of the Cost of Carry Relationship

• Assume
• spot price of oil is 16 a barrel,
• the interest rate equals 9,
• cost of storing and insuring oil for one year is
  1
• 1-yr forward price 16 16 x (0.09 0.01)
• 17.60

22
Example of the Cost of Carry Relationship

• Suppose the 1-yr forward price 18.00 and the
  cost of carry equals 17.60
• Then, you could sell (take a short position) a
  forward contract (agree to sell oil in one year)
  at the 18.00 price.
• Simultaneously,
• buy oil today
• store and insure the oil for 1 year for a total
  of cost of 17.60 a barrel
• at the end of the year, you would make 0.40
  regardless of what happens to the price of oil
  (i.e., there is no risk).
• Therefore, 18.00 is not a price that will clear
  the market

23
Derivatives Building Box
Buy a Forward
Buy a Call
Buy a Call
Buy a Call
Buy a Call
Buy a Call
24
Constructing Desired Payoffs
25
Constructing Desired Payoffs
26
Swap Contracts

• Swap contracts are a series of forward contracts
• Description of an Oil Swap
• Let Pt price of oil at time t
• 6 Mnths 12 Mnths 18 Mnths 24 Mnths
• Payoff (P6 mnths - 15) (P1 yr - 15) (P18
  mnths - 15) P2 yrs - 15)
• to NeedOil x 250,000 x 250,000 x 250,000 x
  250,000
• Payoff to (15 - P6 mnths) (15 - P1 yr) (15
  - P18 mnths) (15 - P2 yrs) SWAPCO x 250,000 x
  250,000 x 250,000 x 250,000

27
Swap Contracts

• 2-year Interest Rate Swap Contract between
  NeedOil and SWAPCO
• rt one-year T-bill rate at time t
• each entry is multiplied by 1 million
• 6 Mnths 12 Mnths 18 Mnths 24 Mnths
• Payoff
• to NeedOil (r6 mnths - 5) (r1 yr - 5) (r18
  mnths - 5) (r2 yrs - 5)
• Payoff
• to SWAPCO (5 - r6 mnths) (5 - r1 yr) (5 -
  r18 mnths) (5 - r2 yrs)

28
Comparison Of Derivatives Insurance

• Derivative contracts
• Usually used to hedge risk arising from
  unexpected changes in market prices
• Note market prices affect many firms
• Insurance contracts
• Usually for risk arising from losses specific to
  the insured.

29
Comparison Of Derivatives Insurance

• Influence a particular firm has on payoffs from
• Derivative contracts - little, if any
• Insurance contracts
• Considerable, through its loss control activities
• gt greater moral hazard problems with insurance
• gt more investigation and monitoring costs must
  be incurred with insurance contracts than with
  derivatives
• gt contracts with retention (deductibles,
  limits, etc)

30
Comparison Of Derivatives Insurance

• Contracts based on firm specific factors (as
  opposed to market prices or indices) have less
  basis risk.
• Derivative markets generally are more liquid than
  insurance markets.
• A liquid market exists when someone can sell or
  buy an asset quickly with little price
  concession.
• Factors affecting liquidity
• Moral hazard problems
• Is creditworthiness involved?

31
Comparison Of Derivatives Insurance

• When prices change, there tend to be winners and
  losers
• gt firm values often are negatively correlated
• gt risk can be reduced with just two parties
• In contrast, the liability and property losses
  tend to be independent across firms.
• gt reduce risks by diversification with many
  participants

32
Comparison Of Derivatives Insurance

• Summary of Main Differences
• Characteristics Derivatives Insurance
• Type of risk hedged Market price risk Firm
  specific risk
• Contracting costs
• (due to moral
• hazard, illiquidity) Low High
• Basis risk High Low

33
Institutional Material

• Over-the-Counter versus Exchange Traded
  Derivatives
• An over-the-counter (OTC) transaction resembles a
  privately negotiated contract between two firms.
• Exchange traded derivatives are standardized
  contracts with the terms established by the
  exchanges.
• tend to be more liquid

34
Institutional Material

• The greater liquidity also is due in part to the
  method used to ensure performance.
• With OTC contracts, firms assess the default risk
  (or credit risk)
• With exchange traded contracts, default risk is
  reduced by using
• performance bonds, called margin
• daily marking to market

35
Institutional Material

• Example
• required margin 20 of the positions value
• value of position 1,000.
• you must post margin
• if futures price falls so the value equals 900
• amount lost on position is subtracted from margin
  
• gt you must add
• Margin and marking to market imply that you can
  trade anonymously, which increases liquidity.

36
Main Types of Risk Hedged with Derivatives

• Foreign exchange rates
• break-down of the Bretton-Woods system of fixed
  exchange rates in 1973
• Interest rates
• high level of interest rates in the 1970s and
  1980s
• 1979 change in FED policy
• Commodity prices
• Equity prices

37
Reducing Risk Through Internal Diversification

• Synergy exists when the combination of the parts
  has greater value than the sum of the individual
  values.
• A potential source of synergy is the benefit from
  reducing firm risk.
• Internal diversification is also costly