fm10e ch21

2005, Pearson Prentice Hall

Chapter 21 - Chapter 21 - Risk ManagementRisk Management

Innovations in Risk ManagementInnovations in Risk Management

Futures contractFutures contract: a contract to : a contract to buy or sell a stated commodity buy or sell a stated commodity or financial claim at a specified or financial claim at a specified price at some specified future price at some specified future time.time.

Futures: a simple exampleFutures: a simple example

Suppose a farmer plans to harvest Suppose a farmer plans to harvest 10,000 bushels of corn in six months. 10,000 bushels of corn in six months. The current price is The current price is $2.50$2.50 per bushel. per bushel. The farmer sells a futures contract, The farmer sells a futures contract, which will allow him to sell corn at 2.50 which will allow him to sell corn at 2.50 per bushel in six months. per bushel in six months.

If the price of corn falls to If the price of corn falls to $2.00$2.00 per per bushel, the farmer bushel, the farmer loses $5,000loses $5,000 ($0.50 x ($0.50 x 10,000 bushels) on his corn, but 10,000 bushels) on his corn, but gains gains $5,000$5,000 on his futures contract. on his futures contract.

Futures: a simple exampleFutures: a simple example

If the price of corn rises to If the price of corn rises to $3.00$3.00 per per bushel, the farmer gets $5,000 more bushel, the farmer gets $5,000 more for his corn, but loses $5,000 on the for his corn, but loses $5,000 on the futures contract.futures contract.

The farmer has effectively The farmer has effectively locked inlocked in a a price of price of $2.50$2.50 per bushel and has per bushel and has hedgedhedged his risk. his risk.

Futures Trading Requires:Futures Trading Requires:

An Organized ExchangeAn Organized Exchange - the - the Chicago Board of Trade is the Chicago Board of Trade is the oldest and largest futures oldest and largest futures exchange.exchange.

Standardized ContractsStandardized Contracts - for - for more frequent trades and more frequent trades and greater liquidity. greater liquidity.

A Futures ClearinghouseA Futures Clearinghouse - stands - stands between all buyers and sellers to between all buyers and sellers to guarantee that all trades are honored.guarantee that all trades are honored.

Daily Resettlement of ContractsDaily Resettlement of Contracts - An - An initial margin of 3% to 10% of the initial margin of 3% to 10% of the contract’s value is paid up front.contract’s value is paid up front.

A maintenance margin is required. Any A maintenance margin is required. Any end-of-day losses must be replenished by end-of-day losses must be replenished by the contract holder. the contract holder.

Futures Trading Requires:Futures Trading Requires:

Types of Futures ContractsTypes of Futures Contracts

Commodity FuturesCommodity Futures - agricultural - agricultural commodities (corn, wheat, orange commodities (corn, wheat, orange juice, etc.) as well as metals, wood juice, etc.) as well as metals, wood products, and fibers.products, and fibers.

Financial FuturesFinancial Futures - futures - futures contracts on Treasury bills, notes contracts on Treasury bills, notes and bonds, GNMAs, CDs, and bonds, GNMAs, CDs, Eurodollars, foreign currencies, and Eurodollars, foreign currencies, and stock indices. stock indices.

Financial FuturesFinancial Futures

Interest Rate FuturesInterest Rate Futures - used to - used to hedge risks associated with hedge risks associated with interest rate fluctuations.interest rate fluctuations.

ExampleExample: Treasury bond : Treasury bond futures may allow a firm to futures may allow a firm to lock in an interest rate for lock in an interest rate for their bond issue.their bond issue.

Foreign Exchange FuturesForeign Exchange Futures - - used to hedge risks associated used to hedge risks associated with exchange rate with exchange rate fluctuations.fluctuations.

A firm can use a foreign A firm can use a foreign exchange futures contract to exchange futures contract to lock in an exchange rate for a lock in an exchange rate for a future transaction.future transaction.


Stock Index FuturesStock Index Futures - used to - used to hedge risks associated with hedge risks associated with equity market fluctuations.equity market fluctuations.

Investors can buy and sell Investors can buy and sell contracts based on the S&P contracts based on the S&P 500 and other market indices.500 and other market indices.


Innovations in Risk ManagementInnovations in Risk Management

Option contractOption contract: gives the : gives the owner the right to buy or sell a owner the right to buy or sell a fixed number of shares of fixed number of shares of stock at a specified price over stock at a specified price over a limited time.a limited time.

Option ContractsOption Contracts

Call OptionCall Option: gives the owner the right to : gives the owner the right to buybuy a fixed number of shares of stock a fixed number of shares of stock at a specified price over a limited time.at a specified price over a limited time.

If you buy a call option on IBM stock, and If you buy a call option on IBM stock, and the stock price rises enough, you can the stock price rises enough, you can profitprofit on the call option contract.on the call option contract.

If the stock price does not rise enough, or If the stock price does not rise enough, or falls, your call option contract falls, your call option contract expires expires worthless.worthless.

Long Call OptionLong Call Option

Profitor Loss

Stock Price $50 exercise price

Short Call OptionShort Call Option

Profitor Loss

Stock Price $50 exercise price

Option ContractsOption Contracts

Put OptionPut Option: gives the owner the right to : gives the owner the right to sellsell a fixed number of shares of stock a fixed number of shares of stock at a specified price over a limited time.at a specified price over a limited time.

If you buy a put option on IBM stock, and If you buy a put option on IBM stock, and the stock price falls enough, you can the stock price falls enough, you can profitprofit on the put option contract.on the put option contract.

If the stock price does not fall enough, or If the stock price does not fall enough, or rises, your call option contract rises, your call option contract expires expires worthless.worthless.

Long Put OptionLong Put Option

Profitor Loss

$50 exercise price Stock Price

$50 Stock exercise price Price

Short Put OptionShort Put Option

Profitor Loss

Chicago Board Options ExchangeChicago Board Options Exchange

Established in 1973 to provide Established in 1973 to provide exchange-listed option trading.exchange-listed option trading.

Why?Why? Standardization of option contracts.Standardization of option contracts. A regulated central marketplace.A regulated central marketplace. An options clearinghouse corporation.An options clearinghouse corporation. Certificateless trading.Certificateless trading. A liquid secondary market.A liquid secondary market.

Innovations in OptionsInnovations in Options

Option contracts can be written on:Option contracts can be written on: Common stocksCommon stocks Stock Indices Stock Indices Interest ratesInterest rates Foreign currencyForeign currency Treasury bond futuresTreasury bond futures

Currency SwapsCurrency Swaps

An exchange of debt obligations in An exchange of debt obligations in different currencies.different currencies.

Example:Example: An American firm and a An American firm and a British firm agree to pay each British firm agree to pay each other’s debt obligation.other’s debt obligation.

This allows long-term exchange This allows long-term exchange rate risk hedging.rate risk hedging.

Other InnovationsOther Innovations

Long-term Equity Anticipation Long-term Equity Anticipation Securities (LEAPS)Securities (LEAPS)

These are long-term options, both These are long-term options, both calls and puts, which may not calls and puts, which may not expire for as long as three years.expire for as long as three years.

Can be used to hedge against Can be used to hedge against longer term movements in stocks.longer term movements in stocks.

fm10e ch21

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