WEB EXTENSION

1A

An Overview of Derivatives

hapter 8 provides a much more detailed discussion of options. We provide an overview here of derivatives and their use in risk management. As noted in the chapter, there are four major classes of derivatives: forward contracts, futures, options, and swaps. Following is a brief explanation of each.

1.1 FORWARD

AND

FUTURES CONTRACTS

Forward contracts are among the oldest derivatives. Consider a farmer who plans to harvest wheat in the fall. If wheat prices are high in the fall, then the farmer will make a lot of money. But if wheat prices are low in the fall, then the farmer might lose so much money that the farm must be sold. To eliminate this risk, he might take a short position in a wheat forward contract, or sell wheat forward. This contract will specify a price, perhaps $3 a bushel, at which the farmer is obligated to sell and deliver wheat on a certain date in the fall (called the delivery date), no matter what the current market price of wheat actually is in the fall; this is called the forward price. Thus, the farmer is using the forward contract to hedge away risk by locking in the price at which the harvest will be sold. A baker who plans to purchase wheat in the fall might also like to reduce risk. To do this, she would take a long position in the contract, or buy wheat forward. This specifies that the baker is obligated to purchase wheat for $3 a bushel on that delivery date in the fall, even if the current market price is lower or higher. Again, the baker is using the forward contract to hedge risk. This example illustrates a couple of points. First, there are two parties to the contract. One takes a short position and one takes a long position. A person taking a short position is said to be selling the contract because it obligates the person to sell (in our example, wheat in the fall). A person taking a long position is said to be buying the contract, because it obligates the person to buy (wheat in the fall). There is an active market for forward contracts for currencies, where businesses are on one side of the contract and large banks are on the other. For example, if a wine importer plans on purchasing French wine in the fall using euros, then the importer could either use dollars now to buy euros or could wait until fall to buy euros. With a forward contract, the importer could lock in today the purchase price for euros in the fall. If all forward contracts had to be made face-to-face, the market would be quite small, because it would be difficult for buyers and sellers to find one another and to evaluate one anothers trustworthiness. Finding an appropriate trading partner can be difficult, and the default risk on these contracts can be large. Since a forward contract must be satisfied in its entirety on the delivery date, there is always the chance of one party defaulting on that date, and this chance increases with the amount of money involved.
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Web Extension 1A: An Overview of Derivatives

To illustrate, suppose that in June the farmer sells forward to the baker 10,000 bushels of wheat at $4.00 per bushel with delivery in September. No money changes hands in June. The farmer is supposed to deliver the 10,000 bushels of wheat in September and receive from the baker $4.00 per bushel for it. However, if the market price of wheat happens to be $5.00 per bushel in September, then the farmer has an incentive to abrogate the contract and sell the wheat on the open market for $5.00 rather than to the baker for the contractual $4.00, earning $10,000 more in the process. If this happened the baker would be worse off by $10,000, since she would now have to buy the 10,000 bushels on the open market for $5.00 per bushel rather than from the farmer for $4.00 per bushel. To resolve this problem, most products are traded using futures contracts rather than forward contracts. Like forward contracts, futures contracts allow sellers and buyers to lock in a price now for delivery at some future time, but they have provisions that make it easier to find trading partners and protect against default. With a futures contract there is usually an institution, called an exchange, that stands between the buyer and seller. For example, the Chicago Board of Trade (CBOT) is an auction market for futures contracts. Brokerage firms typically have memberships at the board, so the farmers broker would actually enter the contract on behalf of the farmer. The farmer would then settle with the broker and the broker would settle with the CBOT. The same is true for the baker, so the farmer and baker would never meet. To minimize risk to the broker and to the exchange, futures contracts are markedto-market. Rather than wait until the delivery date to settle the contract, the contract is essentially settled each day and then automatically renewed. For example, suppose the contract initially specified a price of $4.00, but the price the following day rose to $4.50. The farmer would be obligated to make a payment of $0.50 per bushel, and the baker would receive this amount. If next week the price rose another $0.50 to $5.00, the farmer would have to make another payment of $0.50 per bushel, and the baker would receive this amount. If prices didnt change again, then the farmer would be obligated to sell wheat for the current price of $5.00. But since the farmer had already paid a total of $1.00 per bushel when the contract was marked-to-market, his net receipt would be $4.00 ($5.00 $0.50 $0.50 = $4.00). Notice that the farmers net receipt is equal to the price specified in the initial contract. The net cost to the baker would also be $4.00; she pays $5.00 for the wheat but has already twice received $0.50 per bushel for a net of $4.00 per bushel. Because the contracts are marked-to-market daily, the most either party could lose is the daily change in price. This reduction in risk increases the number of willing participants in the futures markets. Futures contracts are rarely settled by actual delivery. Instead, the farmer probably would enter into a long position just before the contract was due, or expired. When combined with the farmers original short position, the two contracts net out and the farmer would then sell wheat on the open market for $5.00, rather than directly to the baker. Of course, the farmer would still have paid out a total of $1.00 per bushel when his contract was marked-to-market, so his net would still be $4.00 per bushel. Similarly, the baker would enter into an offsetting short position prior to the contracts expiration and purchase wheat on the open market. Derivatives can be used either to reduce risks, as in our example of the farmer, or to speculate. For instance, you could enter into a short position in wheat even if you didnt own a wheat field. You would simply be speculating that the price of wheat would rise. If it did, you would collect the cash payments each day when the contract was marked-to-market. On the other hand, if wheat prices fell, you would be obligated to make payments each time the contract was marked-to-market.

Web Extension 1A: An Overview of Derivatives

Futures contracts exist for a wide variety of assets: agricultural commodities (such as corn, wheat, and ethanol), livestock (including cattle, pork bellies, etc.), metals (including gold, silver, and copper), currencies (including yens, pounds, and euros), stock indexes, interest rates (in the form of bonds and other interest-bearing securities), and energy (such as oil, gasoline, and natural gas).

1.2 OPTIONS
A call option gives its owner the right to buy some asset for a fixed price on or before a certain date. A put option gives its owner the right to sell some asset for a fixed price on or before a certain date. That date is called the expiration date. If the option can be exercised only on that date, it is called a European option. If it can be exercised at any time prior to the expiration date, it is called an American option. The specified price is called the exercise price. Sometimes the exercise price and expiration date are called the strike price and strike date, respectively. As with futures, there are two parties to an option. But unlike a futures contract, in which no money changes hands when it is entered into, the option is itself sold and purchased. For example, someone might write on a piece of paper that the holder of the paper has the right to buy from the writer a share of IBM stock for $50 at any time on or before September 18, 2010. You might buy that piece of paper from the writer if you thought IBMs price was going to rise higher than $50 before the expiration date. The writer would have a short position in the contract since the writer has promised to sell you a share of IBM. You would have a long position since you can buy the stock. Unlike with a futures contract, you have the right but not the obligation to buy the stock. If IBM is less than $50 when the option expires, you would just let it expire. Also, there is no marking-to-market with options. If you were really trading options, then you and the writer would not deal faceto-face but would go through brokers, who would then go through an exchange, like the Chicago Board Options Exchange (CBOE). There are standardized options on many assets. These include stocks, indexes, futures contracts (yes, you can buy an option on a futures contract!), and currency. Most options have expiration dates of less than a year, although some stock options have longer expiration dates; these are called LEAPS, short for Long-term Equity AnticiPation Securities.

1.3 SWAPS
Sometimes the issuers of securities will agree to swap their obligations. For example, a U.S. company might have issued a bond with interest payments denominated in dollars. A French company might have issued a bond with interest payments denominated in euros. Suppose that the U.S. company anticipates future sales in Europe with payments made in euros and that the French company anticipates future sales in the United States with payments made in dollars. To avoid exchange rate risk, the U.S. company might like to use the euros it receives from its sales to pay the interest on its debt. Similarly, the French company might like to use the dollars it generates from U.S. sales to pay the interest on its debt. Therefore, the two parties might agree to swap their obligations, and both would have reduced their risk. Swaps are also often made between an issuer with an obligation to make fixed interest payments and an issuer with an obligation to make variable-rate interest payments. Unlike futures or options, most swaps are between private parties, although some banks now offer somewhat standardized contracts.