4110 3 15

Topic 3: Derivatives and Risk Management
Taejin Kim
CUHK Business School
15-16 September, 2015
Taejin Kim (CUHK Business School)
1 / 37
Learning Objectives
1
Payoffs and Profits of Portfolios
Replication and No Arbitrage
Put-Call Parity
Hedging Strategies Using Derivatives
Basis Risk and Hedge Ratio

Reading : 3, 10.4, 11.2
2 / 37
Example: Payoff and Profit
Portfolios Involving Derivatives
The 6-month interest rate is 2% and use these premiums

for options with 6 months to expiration:
Strike
Call
Put
$950 $120.405 $51.777
1000
93.809
74.201
1050
84.470
84.470
buy the index for $1,000 and buy a 950-strike put
buy a 950-strike call, sell two 1050-strike calls
3 / 37
Replication
Portfolios Involving Derivatives
Sometimes it is possible to replicate a certain payoff

using derivatives
No arbitrage implies that the replicated position
should cost the same as the replicating portfolio
It is one of the standard approaches to derivative
pricing
4 / 37
Arbitrage
No Arbitrage
Cash flows are always nonnegative and positive

sometimes (i.e., with positive probability) =
Arbitrage
Same payoff, Different costs = Arbitrage (violating
the law of one price)
One profit diagram is nowhere below and somewhere
above the other = Arbitrage
We always assume no arbitrage
5 / 37
Put-Call Parity; No Dividends
No Arbitrage
Consider the following 2 portfolios:

Portfolio A: European call on a stock +
zero-coupon bond that pays K at time T
Portfolio C: European put on the stock + the
stock
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Values of Portfolios
No Arbitrage
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The Put-Call Parity Result
No Arbitrage
Both are worth max(ST , K ) at the maturity of

the options
They must therefore be worth the same today.
This means that
c + Ke rT = p + S0
8 / 37
Corporate Finance Application
No Arbitrage
Suppose that company X made an acquisition offer to

the shareholders of company Y:
If the price of Xs stock at deal closing, denoted by SX was
between $29 and $41, Ys shareholders would receive shares
worth $51 for each Y share
If SX was less than $29, Ys shareholders would receive
1.7586(= 51/29) shares for each Y share
If SX was greater than $41, Ys shareholders would receive
1.2439(= 51/41) shares for each Y share
The offer was marketed as a deal worth $51 per share

of Y. Is this right?
9 / 37
Corporate Finance Application, contd
No Arbitrage
The payoff of this offer to Ys shareholders is

SX < $29 $29 SX 41 41 < SX
1.7586S
51
1.2439S
Among many ways, we can replicate the cash flows as
follows:
SX < $29: buy 1.7586 shares of X
$29 SX 41: sell 1.7586 calls with a strike price of 29
41 < SX : buy 1.2439 calls with a strike price of 41
The value of the offer is

1.7586SX0 1.7586c(29) + 1.2439c(41)
10 / 37
Hedging with Futures
Hedging
Do now in the futures market what you expect to do

in the future spot market
A long futures hedge is appropriate when you know
you will purchase an asset in the future and want to
lock in the price
A short futures hedge is appropriate when you know
you will sell an asset in the future and want to lock in
the price
11 / 37
Examples
Hedging
Airline goes long gasoline futures to hedge a future

purchase of jet fuel
Firm that will issue 20-year bonds a year from now
hedges by shorting T-bond futures.
(Producer) Farmer shorts wheat futures to hedge his
sale of wheat in the future.
12 / 37
Opposite to Spot
Hedging
Your position in the futures market should be

the opposite of your position in the spot
market: if long one, short the other.
A portfolio manager hedges via a short position
in stock index futures: spot long, futures short.
13 / 37
Hedging with Options
Hedging
Producers perspective
Insurance: Purchase a put (floor)
Sell a call
Buyers perspective
Insurance: Purchase a call (cap)
Sell a put
14 / 37
Hedging with Options
Hedging
15 / 37
Example
Hedging
XYZ mines copper, with fixed costs of $0.50/lb and variable cost
of $0.40/lb.
ABC, a wire producer, buys copper. One pound of copper can be
used to produce one unit of wire, which sells for the price of
copper plus $5.
DEF installs telecommunications equipment and uses copper wire
from ABC as an input. DEF assigns a fixed revenue of $6.20 for
each unit of wire it uses.
The 1-year forward price of copper is $1/lb. The 1-year (annually
compounded) interest rate is 6%.
One-year option prices for copper with a strike of $1.05 are
$0.0194 for a call and $0.0665 for a put.
16 / 37
Example, contd
Hedging
Consider copper prices in 1 year of $0.95, $1.05, and $1.15.

1
If XYZ sells forward its expected copper production, what is its
estimated profit 1 year from now?
2
Compute estimated profit in 1 year if XYZ buys a put option
with a strike of $1.05.
3
Compute estimated profit in 1 year if XYZ sells a call option with
a strike of $1.05.
4
If DEF hedges the price of wire by buying copper forward, what is
its estimated profit 1 year from now?
5
Compute estimated profit in 1 year if DEF buys a call option with
a strike of $1.05.
17 / 37
Arguments in Favor of Hedging
Hedging
Companies should focus on the main business they are

in and take steps to minimize risks arising from
interest rates, exchange rates, and other market
variables
Better (cheaper, more accurate) for company to hedge
rather than the individual investors (shareholders) to
hedge, since the latter do not know the firms precise
exposure.
Losses might be more harmful than profits are
beneficialtaxes, distress costs, or risk aversion, for
example.
18 / 37
Some Caveats
Hedging
Shareholders are usually well diversified and can make

their own hedging decisions
Firms may have the ability to pass on cost increases to
customers, e.g., gasoline retailer, meat packer.
The firm must pay transaction costs, monitor
derivative transactions, and be prepared for tax and
accounting consequences.
19 / 37
Hedging Short Exposures
Hedging
A chemical producer that uses natural gas as an input

wants to hedge his exposure to natural gas prices. His
break-even cost for natural gas is $2.00 per
MMBtu.
One way is to go long a natural gas futures contract.
If he wants to benefit from price declines while he is
protected from price increases, he can buy a call
option or a cap. See figure (b).
What can he do if he thinks this protection is too
expensive?
20 / 37
Collar
Hedging
One way to lower the cost of insurance to sell the

potential profit. In the example, the producer sells a
put with a lower strike. This position is called a
(written) collar.
Suppose he buys a 2.10 call and sells a 1.80 put. The
call and put premiums are $0.12 and $0.065 per
MMBtu, respectively. What is the range of profit?
If the position is reversed, the collar is purchased
21 / 37
Zero-Cost Collar
Hedging
If the two premiums are the same, a collar costs

nothing. It is called a zero-cost collar.
Suppose an executive owns many shares in her firm.
She decides to put a zero-cost collar on her position in
order to avoid the losses from stock price drops. The
current stock price is $50/share, the volatility of the
stock is 40%, the risk-free rate is 5%, and the stock
pays no dividend. The collar consists of a 3-year 50
put and a 3-year 74.25 call. Both cost $9.40.
22 / 37
Introduction
Basis Risk
Basis is usually defined as the spot price minus

the futures price
Basis risk arises because of the uncertainty
about the basis when the hedge is closed out
23 / 37
Long Hedge for Purchase of an Asset
Basis Risk
Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S2 : Asset price at time of purchase
b2 : Basis at time of purchase
Cost of asset
S2
Gain on Futures F2 F1
Net amount paid S2 (F2 F1 ) = F1 + b2
24 / 37
Short Hedge for Sale of an Asset
Basis Risk
Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is sold
S2 : Asset price at time of sale
b2 : Basis at time of sale
Price of asset
S2
Gain on Futures
F1 F2
Net amount received S2 + (F1 F2 ) = F1 + b2
25 / 37
Choice of Contract
Basis Risk
Choose a delivery month that is as close as possible

to, but later than, the end of the life of the hedge
When there is no futures contract on the asset being
hedged, choose the contract whose futures price is
most highly correlated with the asset price. This is
known as cross hedging.
26 / 37
Optimal Hedge Ratio
Cross Hedging
Proportion of the exposure that should optimally be

hedged is
S
h =
F
where
S is the standard deviation of S, the change in the
spot price during the hedging period,
F is the standard deviation of F , the change in the
futures price during the hedging period
is the coefficient of correlation between S and F .
27 / 37
Regression and Hedge Ratio
Cross Hedging
h is the slope coefficient estimated from a linear

regression of S against F .
The effectiveness of regression is measured by the
coefficient of determination, R 2 . It is the proportion
of the total variation in the dependent variable that is
accounted for by variation in the regressors. In simple
regressions, R 2 = 2 .
Likewise, the hedge effectiveness can be defined as the
proportion of the variance that is eliminated by
hedging, that is, 2
28 / 37
Optimal Number of Contracts
QA :
QF :
VA :
VF :
Cross Hedging
Size of position being hedged (units)

Size of one futures contract (units)
Value of position being hedged (= spot price times QA )
Value of one futures contract (= futures price times QF )
Optimal number of contracts

with no tailing adjustment
=
h QA
QF
Optimal number of contracts

after tailing adjustment to
allow for daily settlement of
futures
=
h VA
VF
29 / 37
Example
Cross Hedging
Airline will purchase 2 million gallons of jet fuel in one

month and hedges using heating oil futures
From historical data F = 0.0313, S = 0.0263, and
= 0.928
h = 0.928
0.0263
= 0.7777
0.0313
30 / 37
Example, contd
Cross Hedging
The size of one heating oil contract is 42,000 gallons

The spot price is 1.94 and the futures price is 1.99 (both dollars
per gallon) so that
VA = 1.94 2, 000, 000 = 3, 880, 000
VF = 1.99 42, 000 = 83, 580
Optimal number of contracts assuming no daily settlement
0.7777 2, 000, 000/42, 000 = 37.03
Optimal number of contracts after tailing
0.7777 3, 880, 000/83, 580 = 36.10
31 / 37
Hedging Using Index Futures
Cross Hedging
To hedge the risk in a portfolio the number of

contracts that should be shorted is
VA
VF
where VA is the current value of the portfolio, is its

beta, and VF is the current value of one futures
contract (=futures price times contract size)
32 / 37
Example
Cross Hedging
Futures price of S&P 500 is 1,000

Size of portfolio is $5 million
Beta of portfolio is 1.5
One contract is on $250 times the index
What position in futures contracts on the S&P
500 is necessary to hedge the portfolio?
33 / 37
Changing Beta
Cross Hedging
Change the beta of the portfolio from to :

Long ( ) VVA
F
What position is necessary to reduce the beta

of the portfolio to 0.75?
What position is necessary to increase the beta
of the portfolio to 2.0?
34 / 37
Why Hedge Equity Returns
Cross Hedging
May want to be out of the market for a while.

Hedging avoids the costs of selling and repurchasing
the portfolio
Suppose stocks in your portfolio have an average beta
of 1.0, but you feel they have been chosen well and
will outperform the market in both good and bad
times. Hedging ensures that the return you earn is the
risk-free return plus the excess return of your portfolio
over the market.
35 / 37
Stock Picking
Cross Hedging
If you think you can pick stocks that will

outperform the market, futures contract can be
used to hedge the market risk
If you are right, you will make money whether
the market goes up or down
36 / 37
Stack and Roll
Cross Hedging
We can roll futures contracts forward to hedge future

exposures
Initially we enter into futures contracts to hedge
exposures up to a time horizon
Just before maturity we close them out an replace
them with new contract reflect the new exposure
and so forth
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Topic 3: Derivatives and Risk Management

15-16 September, 2015

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Payoffs and Profits of Portfolios

Replication and No Arbitrage

Hedging Strategies Using Derivatives

Basis Risk and Hedge Ratio

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Example: Payoff and Profit

Portfolios Involving Derivatives

The 6-month interest rate is 2% and use these premiums

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Portfolios Involving Derivatives

Sometimes it is possible to replicate a certain payoff

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Cash flows are always nonnegative and positive

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Put-Call Parity; No Dividends

Consider the following 2 portfolios:

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

The Put-Call Parity Result

Both are worth max(ST , K ) at the maturity of

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Corporate Finance Application

Suppose that company X made an acquisition offer to

The offer was marketed as a deal worth $51 per share

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Corporate Finance Application, contd

The payoff of this offer to Ys shareholders is

The value of the offer is

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Hedging with Futures

Do now in the futures market what you expect to do

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Airline goes long gasoline futures to hedge a future

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015

Your position in the futures market should be

Taejin Kim (CUHK Business School)

Topic 3: Derivatives and Risk Management

15-16 September, 2015