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PART 5: RISK MANAGEMENT CHAPTER 15: Hedging Instruments: Futures, Forwards, Options and Swaps FOCUS OF THE CHAPTER This chapter explores some derivative products traded in derivative markets. These include hedging instruments such as futures, forwards, options, and swaps. The chapter begins with important definitions for the study of these instruments and ends with a discussion of the importance of hedging in the financial system. Learning Objectives: Identify how derivatives are created Describe the roles that uncertainty and the desire to reduce risk play in derivative products Explain the crucial difference between a hedger and a speculator Determine how investors can buy or sell a financial asset in the future at a price negotiated today Identify the differences between futures and forward contracts Describe how the values of options are determined and their role in financial markets Explain how swaps function SECTION SUMMARIES Definitions Hedging is the process of protecting oneself against future price changes by assuming two (or more) complementary positions in assets whose returns are to some degree negatively correlated or ideally, perfectly negatively correlated. For example, a farmer who is growing wheat is long in wheat. He or she would profit from a rise in the price of wheat but would lose as a result of a fall in the price. If the farmer took a short position in say, a wheat futures contract, wherein he or she agrees to sell wheat at a predetermined price, the wheat futures contract would rise in value if wheat prices fell (and fall in value if they rose) and the gains on the futures contract would offset some or all of the losses on the wheat crop. The farmer would, however, forfeit the possibility of a gain on rising wheat prices. The farmer is, however, presumably interested from profiting from growing wheat, not in speculating on wheat prices. Hedger is the one who wants to shift risk away from himself or herself by assuming two or more offsetting positions. Speculator is the one who accepts a greater risk, with a view to profit from the change in the asset’s price. The speculator only holds either a long position to profit from a potential rise in price or a short position to profit from a fall in price. Hedge funds represent a pooling of funds from wealthy investors and large institutional investors that use spot and derivative market instruments to reduce investment risk (by combining leverage and short-selling). Margin is the amount of cash (deposit) put up by the investor as a security against the purchase of an asset or used to ensure that a particular contract is fulfilled. The margin is a fraction of the value of the asset. In the case of futures contracts, the margin is simply a performance bond. Financial Futures and Forwards Future contracts are agreements to accept (buy) or make delivery of (sell) an asset on a particular future date at a price struck today. In a spot market (cash market), the asset is delivered at the same time as the determination of price. Future contracts are made both in financial and commodity markets. Financial futures are an innovation of recent decades. Following the post-war system of fixed exchange rates, many countries moved towards deregulation of financial systems in response to the problem of exchange rate variability. This resulted in increased volatility in the prices of all financial assets, leading to the emergence of financial futures. Forward Markets: Forward contracts are made in forward markets. In a forward contract, the seller undertakes to provide the buyer with an amount of an asset at some future date at a price agreed to in advance. Forward and Futures Markets Compared: Forward and futures markets are alike in many ways: both deal in durable storable products; both can be used for hedging; both require estimates of the future from participants. They are different in that: a) the buyer in a forward contract generally intends to take future delivery of the asset, whereas futures market participants typically intend to make offset transactions; b) forward contract participants are directly responsible for ensuring that the terms of agreement are fulfilled, while in a futures contract, an intermediary ensures that the payment and delivery are made; c) forward contracts are concluded over the phone, while futures markets operate in an auction setting (see Table 15.1 in the text); and d) futures contracts are standardized as to the size of the contract and the delivery dates. The Forward Market in Operation: A Canadian importer expects to receive US$2,000,000 worth of widgets in three months. At the current exchange rate (US$1 = C$1.50), the Canadian dollar cost would be C$3,000,000. The importer believes that the exchange rate will change to US$1 = C$1.60 (i.e., the Canadian dollar will depreciate), and that the cost of imports in Canadian dollars will rise, in three months. If this were to happen the cost would be C$3,200,000. To avoid this foreign exchange risk, the importer can arrange with a bank to deliver US$2,000,000 in three months at today’s prevailing forward exchange rate, say US$1 = C$1.55. With this forward contract the cost of imports is fixed at C$3,100,000, which is less than the otherwise anticipated cost of C$3,200,000. This is a simple example which ignores several considerations. The Workings of Futures Markets: In futures markets, an individual who expects that some asset prices will rise (fall) is said to take a long position (short position). The long position is the purchase of an asset that is to be held until it matures or must be sold. The short position is the sale and delivery of an asset in the future, with the intent to buy it at a lower price. Hedging requires one person to take a long position and another to take a short position. It may involve taking one position in the spot market and an opposite position in futures market. The difference between the futures price [F(t)] and the spot price [S(t)] is known as the basis: F(t) - S(t) = basis For commodity futures, basis represents the cost of carry for the time between the date of the futures contract and the delivery or completion date, in effect, the remaining life of the futures contract. The cost of carry is comprised of interest of financing cost, plus insurance and storage costs for the underlying commodity. For commodity futures basis will generally be positive and will diminish as the completion date is approached. For financial futures, basis can be positive or negative depending on whether the cost of financing the asset exceeds or falls short of the interest income from the underlying asset. Futures contracts are mark-to-market or marked-to market, which means that gains and losses are settled at the close of trading each day, not at the end of the contract. The reporting of financial futures differs from that of spot markets. The prices listed are points of 100 percent, not percentages of face value. Brisk trade in futures means that their market price changes almost constantly. There are limits on how much the price of an instrument can vary during any one day. Stock index futures are sold in multiples of the prevailing index. A Long Hedge: A long hedge involves an attempt to reduce the risk of rising financial asset prices due to lower future interest rates. For example, suppose that interest rates are high now and that an investor expects them to fall. The investor also expects to receive $100,000 in three months. If the interest rates do fall, the yield on the asset the investor purchases will be less than the yield the same asset would produce today. This implies a loss of potential interest income. To reduce this risk (or loss), the investor can lock into the current high interest rates by taking a long position in a financial futures contract today. If interest rates do fall as the investor feared, the futures contract will gain value and this gain will offset the loss resulting from the falling returns on his or her future investment. A Short Hedge: A short hedge involves an attempt to reduce the risk of falling financial asset prices due to higher future interest rates. For example, suppose that an investor owns a $100,000, 9% Government of Canada bond due today, and that the bond sells at 87.35 in the spot market. A futures contract is sold at a cash price of 95. The investor expects a fall in bond prices to 86.8 in three months. The investor can reduce the potential loss by selling the equivalent of a $100,000 bond in futures at a cash price of 95, and buying a futures contract at a lower cash price in three months. The Difficulty of Perfect Hedges: The sequence of future market transactions that would produce a gain exactly equal to the loss is called a perfect hedge. A perfect hedge is unlikely for several reasons: 1) it is not always possible to buy and sell the same asset in the futures market; 2) spot and futures prices do not necessarily move in concert; and 3) futures prices in both the spot and futures markets are uncertain. Therefore, hedging cannot eliminate risk entirely. Future Prices and Spot Prices: The futures price [F(t)] is the spot price [S(t)] plus the cost of carry, which is the opportunity cost of carrying the contract until delivery. F(t) = S(t) + [(RS- RL) (-t)/360)S(t)] where RS is the yield on a short-term instrument, RL is the yield on a long-term instrument, is the date of the delivery, t is the today’s date. Note that as the delivery date approaches, the cost of carry approaches zero and F(t) = S(t). Financial Options and Swaps An option is the right (but not the obligation) to buy or sell a given amount of a particular security at a particular price in the cash or futures market before a specified expiration date. The set price of options is called the exercise or strike price. The right to buy a financial asset is a call option. The call price includes the interest and hence is greater than the face value. A put option is the right to sell a financial asset. A call option whose strike price is below (above) the market price is said to be "in the money" ("out of the money"). The buyer of a call option (put option) is protected against unexpected price increases (decreases), while the buyer of a put option is protected against unanticipated decreases in price. The Mechanics of an Option: Two Illustrations: Suppose a Canadian exporter expects future exports earnings in US dollars, and wants to protect the Canadian dollar value of those export earnings from falling due to future exchange rate changes. The exporter can purchase a put option at a certain strike price (say, C$1.45 per US$1), and thereby protect against the exchange rate falling below the strike price. A call option can be used to protect against the exchange rate rising above the strike price. Figure 15.1 shows how a put option places a minimum value on the US dollar and how a call option places a maximum value on the US dollar. Figure 15.2 shows how options narrow the distribution of asset returns and reduce interest rate risk. The Value of Options: The value of a call at expiration (Call) is given by: Call = MAX {0, S-E} where S is spot price, E is exercise price, and MAX means maximum. The value of a put option (Put) is given by: Put = MAX{0, E-S} where S is spot price, E is exercise price, and MAX means maximum. The values determined by the above formulas are actually referred to as intrinsic values. Options will always trade in the market at prices that are at least equal to their intrinsic values. However, options also have a time value which, according to the Black-Scholes options pricing model, includes at least three other factors, the anticipated volatility of an underlying asset’s price, the interest on a riskless asset, and the time until the exercise date. The value of the options is the sum of its intrinsic value and its time value. A Numerical Example: This example shows how a British company which wants to purchase C$2,000,000 in 90 days, and anticipates an appreciation of the Canadian dollar, protects itself from a possible increase in the cost of purchasing Canadian dollars by purchasing a call option. Speculating with Options: Options are an attractive method of speculating. Purchasers of call options can speculate on a rise in the price of a stock without buying the stock. They are therefore, highly leveraged. This does, however, imply considerable risk. Puts are an alternative to selling short. Hedging with Options: As discussed above, hedging involves the assumption of two positions in different securities whose returns are negatively correlated. An investor who owns a particular stock who is worried about a short term decline in market value (but doesn’t want to sell the stock) can use a put to offset the losses from a possible decline in price. An investor who has taken a short position in a stock can offset some of his or her risk by purchasing a call option. Swaps: Interest rate swaps and foreign exchange swaps are derivatives designed to protect lenders and borrowers from unfavourable changes in interest rates and exchange rates. A swap is an agreement to exchange, for a pre-agreed period into the future, a series of interest payments or foreign exchange at fixed rates for a series of available interest payments or for foreign currency at a variable exchange rate. Note that, in the case of swaps, the ownership of the underlying asset does not change. The Importance of Hedging in the Financial System The dollar value of futures and options is difficult to measure since they appear as offbalance sheet items in the financial statements of chartered banks. Banks, large corporations, and small businesses all use derivatives to hedge against unfavourable changes in interest rates and exchange rates. Globally, hedging instruments have spread rapidly. Among the derivative products, swaps pose relatively less "systematic risk" in the financial system than do other derivative products. MULTIPLE-CHOICE QUESTIONS 1. The process of protecting oneself against future price changes by taking both a long and a short position is called a) speculation. b) hedging. c) portfolio diversification. d) portfolio management. 2. A speculator is an individual a) who holds only a long or a short position with respect to a particular asset. b) who wants to shift risk away from him/herself. c) who is a risk averter. d) who is a money market dealer. 3. A deposit placed as security against the purchase of an asset is called a) principal. b) value of the option. c) margin. d) face value. 4. An agreement entered into by two parties to buy and sell an asset at a specified future date at a price struck today a) is a futures contract. b) is a forward contract. c) is neither a futures contract nor a forward contract. d) is a spot market transaction. 5. Futures are similar to forward contracts except that a) they are standardized as to contract size and delivery date. b) they are exchange traded. c) a clearing house assumes the opposite position to each trader. d) all of the above. 6. A typical futures market participant a) is likely to engage in offset transactions before the delivery date. b) is unlikely to engage in offset transactions before the delivery date. c) could be a speculator or hedger. d) a) and c). 7. A speculator who takes a long position in a futures contract a) hopes and expects the underlying asset price to rise in future. b) hopes and expects the underlying asset price to fall in future. c) expects the underlying asset price to rise in future but hopes that it falls. d) expects the underlying asset price to fall in future but hopes that it rises. 8. A hedger who takes a long position in a futures contract a) is worried that the underlying asset price will rise in future. b) is worried that the underlying asset price will fall in future. c) expects the underlying asset price to rise in future but hopes that it falls. d) expects the underlying asset price to fall in future but hopes that it rises. 9. An individual who takes a short position in a financial futures contract a) expects interest rates and asset prices to rise in future. b) expects interest rates and asset prices to fall in future. c) expects interest rates to rise and asset prices to fall in future. d) expects interest rates to fall and asset prices to rise in future. 10. In a futures contract, basis is a) the sum of the spot price and the futures price of the asset. b) the futures price divided by the spot price of the asset. c) the futures price multiplied by the spot price of the asset. d) the difference between the futures price and the spot price of the asset. 11. A perfect hedge produces a) gains in excess of losses. b) gains twice the losses. c) only gains and not losses. d) gains exactly equal to losses. 12. The intrinsic value of a put option is given by (where E is the exercise price and S is the spot price) a) Put = MAX{0, E-S}. b) Put = MIN{0, E-S}. c) Put = MAX{0, S-E}. d) Put = MAX{0, E+S}. 13. Derivative products such as futures, options, and swaps a) are risk-free assets in the financial system. b) reduce the systematic risk in the financial system. c) increase the systematic risk in the financial system. d) do not increase or decrease the systematic risk in the financial system. PROBLEMS 1. A Canadian asset holder can purchase a US security for $1200 and sell it for $1350 one year later. a) What is the yield on the US security? b) If the spot exchange rate is $1.20 (i.e., C$1.20 = US$1.00) and $1.30 one year later, what will be the effective yield to the Canadian investor? c) If the spot exchange rate is $1.20 (i.e., C$1.20 = US$1.00) and $1.00 one year later, what will be the effective yield to the Canadian investor? 2. Suppose that you need 500,000 US dollars in 90 days and expect the US dollar to appreciate. The spot rate is C$1.20 and the exercise price on a call 90 days from today is C$1.30. Each option is for the purchase of US$100,000. Suppose also that you have to purchase the call option at a premium of C$0.02 per US$1. Would you exercise the option if the spot rate 90 days from today increased to C$1.35? 3. Suppose that silver sold for $10/oz in the spot market. Futures can be bought for $7.50/oz and sold for $10.90/oz. What would be the net cost of financing 5000 oz? Explain. 4. Explain the difference between each of the following pairs. a) hedger and speculator b) forward market and futures market c) call option and put option ANSWER SECTION Answers to multiple-choice questions: 1. 2. 3. 4. 5. 6. b a c b d d (see page 290) (see page 290) (see page 290) (see page 291) (see pages 291-292) (see pages 292-293) 7. 8. 9. 10. 11. 12. 13. a a c d d a c (see page 295) (see page 295-296) (see pages 296-297) (see page 298) (see page 297) (see page 302) (see pages 305) Answers to problems: 1. (a) (1350-1200)/1200 = 0.125 (or 12.5%). (b) The yield in Canadian dollars can be calculated as follows: [(1350 x 1.30) - (1200 x 1.20)]/(1200 x 1.20) = (1755-1440)/1440 = 0.21875 (or 21.875%) (c) The yield in Canadian dollars can be calculated as follows: [(1350 x 1.00) - (1200 x 1.20)]/(1200 x 1.20) = (1350-1440)/1440 = -0.0625 (or -6.25%) 2. Cost of exercising the option = C$1.30 x 500,000 + C$0.02 x 500,000 = C$650,000.00 + C$10,000.00 = C$660,000.00 Cost at the spot rate 90 days from today = C$1.35 x 500,000 = C$575,000.00 Therefore, exercising the option is relatively less costly. 3. If unhedged, the cost of the unhedged purchase would be $10 x 5000 = $50,000. If hedged, the purchase cost would be $7.50 x 5000 = $37,500; sales revenue would be $10.90 x 5000 = $54,500, and profit generated would be $(54,000-37,000) = $17,000. The net cost, therefore, would be $(50,000-17,000) = $33,000. 4.a) A hedger is one who wants to shift risk away from him/herself. A speculator is one who accepts a greater risk with a view to profit from the change in an asset’s price. b) A futures contract is a contract to buy or sell an asset at a specified future date. A forward contract is a contract according to which a seller agrees to sell an amount of an asset to a buyer at a future date at a price agreed upon in advance. c) A call option is the right, but not obligation, to buy an asset at a particular price during a stipulated period. A put option is the right, but not obligation, to sell an asset at a particular price during a stipulated period.