2002, prentice hall, inc. ch. 21: risk management
TRANSCRIPT
2002, Prentice Hall, Inc.
Ch. 21: Risk
Management
Innovations in Risk Management
• Futures contract: a contract to buy or sell a stated commodity or financial claim at a specified price at some specified future time.
Futures: a simple example
• Suppose a farmer plans to harvest 10,000 bushels of corn in 6 months. The current price is $2.50 per bushel. The farmer sells a futures contract, which will allow him to sell corn at 2.50 per bushel in 6 months.
• If the price of corn falls to $2.00 per bushel, the farmer loses $5,000 ($0.50 x 10,000 bushels) on his corn, but gains $5,000 on his futures contract.
Futures: a simple example
• If the price of corn rises to $3.00 per bushel, the farmer gets $5,000 more for his corn, but loses $5,000 on the futures contract.
• The farmer has effectively locked in a price of $2.50 per bushel and has hedged his risk.
Futures Trading Requires:
• An Organized Exchange - the Chicago Board of Trade is the oldest and largest futures exchange.
• Standardized Contracts - for more frequent trades and greater liquidity.
• A Futures Clearinghouse - stands between all buyers and sellers to guarantee that all trades are honored.
• Daily Resettlement of Contracts - An initial margin of 3% to 10% of the contract’s value is paid up front.
A maintenance margin is required. Any end-of-day losses must be replenished by the contract holder.
Futures Trading Requires:
Types of Futures Contracts
• Commodity Futures - agricultural commodities (corn, wheat, orange juice, etc.) as well as metals, wood products and fibers.
• Financial Futures - futures contracts on Treasury bills, notes and bonds, GNMAs, CDs, Eurodollars, foreign currencies, and stock indices.
Financial Futures
• Interest Rate Futures - used to hedge risks associated with interest rate fluctuations.• For example, Treasury bond
futures may allow a firm to lock in an interest rate for their bond issue.
• Foreign Exchange Futures - used to hedge risks associated with exchange rate fluctuations.
• A firm can use a foreign exchange futures contract to lock in an exchange rate for a future transaction.
Financial Futures
• Stock Index Futures - used to hedge risks associated with equity market fluctuations.
• Investors can buy and sell contracts based on the S&P 500 and other market indices.
Financial Futures
Innovations in Risk Management
• Option contract: gives the owner the right to buy or sell a fixed number of shares of stock at a specified price over a limited time.
Option Contracts
• Call Option: gives the owner the right to buy a fixed number of shares of stock at a specified price over a limited time.
• If you buy a call option on IBM stock, and the stock price rises enough, you can profit on the call option contract.
• If the stock price does not rise enough, or falls, your call option contract expires worthless.
Long Call Option
Profitor Loss
Stock Price $50 exercise price
Long Call Option
Profitor Loss
Stock Price $50 exercise price
Long Call Option
Profitor Loss
Stock Price $50 exercise price
Long Call Option
Profitor Loss
Stock Price $50 exercise price
Short Call Option
Profitor Loss
Stock Price $50 exercise price
Short Call Option
Profitor Loss
Stock Price $50 exercise price
Short Call Option
Profitor Loss
Stock Price $50 exercise price
Short Call Option
Profitor Loss
Stock Price $50 exercise price
Option Contracts• Put Option: gives the owner the
right to sell a fixed number of shares of stock at a specified price over a limited time.
• If you buy a put option on IBM stock, and the stock price falls enough, you can profit on the put option contract.
• If the stock price does not fall enough, or rises, your call option contract expires worthless.
Long Put Option
Profitor Loss
$50 exercise price Stock Price
Long Put Option
Profitor Loss
$50 exercise price Stock Price
Long Put Option
Profitor Loss
$50 exercise price Stock Price
Long Put Option
Profitor Loss
$50 exercise price Stock Price
$50 Stock exercise price Price
Short Put Option
Profitor Loss
$50 Stock exercise price Price
Short Put Option
Profitor Loss
$50 Stock exercise price Price
Short Put Option
Profitor Loss
$50 Stock exercise price Price
Short Put Option
Profitor Loss
Chicago Board Options Exchange
Established in 1973 to provide exchange-listed option trading.
Why?• Standardization of option contracts.
• A regulated central marketplace.
• An options clearinghouse corporation.
• Certificateless trading.
• A liquid secondary market.
Innovations in OptionsOption contracts can be written on:
• Common stocks
• Stock Indices
• Interest rates
• Foreign currency
• Treasury bond futures
Currency Swaps
An exchange of debt obligations in different currencies.
• Example: An American firm and a British firm agree to pay each other’s debt obligation.
• This allows long-term exchange rate risk hedging.
Other Innovations
Long-term Equity Anticipation Securities (LEAPS)
• These are long-term options, both calls and puts, which may not expire for as long as 3 years.
• Can be used to hedge against longer term movements in stocks.