Options, Futures and Structured Products

Transcription

1 Options, Futures and Structured Products Jos van Bommel Aalto Period Class 8 Weather Derivatives (a brief introduction) A bit of history The first weather derivatives were brokered in 1997, by Enron and a Co. called Trade Resources ECT). The underlying was chosen to be Heating Degree Days (HDD), a term already used to measure the energy needs of buildings. The HDD on a particular day is max(0, avet baset), where avet = the average between the daily high and the daily low during that day, and baset is a benchmark, typically chosen to be 65 o Fahrenheit ( 18 o Celsius). The HDD during a period (e.g. a Winter ) is the sum of the daily HDDs. Similarly CDD are defined as cooling degree days. Since then, the weather derivatives market has been growing ever since. In 1999 the CME listed its first weather futures (based on HDD), and later also options on those futures. 1

2 Weather Underlyings Contract underlyings need to be very objectively measured. The reference temperature, rainfall or windspeeds are defined physically near airports or weather stations, where they are documented by a third independent party. Underlyings are, apart from HDD and CDDs, Frost days, snow inches (and cms), rainfall and rain days, hurricane index from the National Weather service, sunshine hours. The sky is the limit.. Contracts are mostly OTC, offered by specialist Private Equity funds, (Speedwell, Coriolis, Axis) who see their business grow with double digit numbers every year. Government economists estimate that as much as a third of the U.S. economy is sensitive to the weather. What businesses would like to hedge against adverse weather? Utilities Real Estate Management Companies Farmers Themeparks, beach resorts, ski resorts Insurance companies Airlines Beer brewers? 2

3 What contracts are available? Floors and Caps A Floor as considered by PNW, offers the buyer a protection (= offers compensation) against a drop (in HDD, or CDD). It s like a put option, or a put spread. A Cap offers the buyer protection against an increase. It s like a Call or Call spread. A Collar would be a combination of the two, where the buyer is protected against a drop or a fall.. A Swap, where a company receives compensation per month or day, in return of a fixed leg. Futures Contracts, CME traded: You can buy month city HDDs, for several months in the future. The future price thus gives an indication of the expected HDD in a given months in a given place.. They are marked to market. The CME also lists Options on those futures. Case question 1. Why do they call these contracts derivatives? Where is the optionality? 3

4 Case question 2. Payoff diagram of the contract presented in exhibit 1 (Floor) Strike amount: 400 Notional amount $20,000 per HDD Maximum payout $800,000 Case question 3. Deconstruct the options embedded in the contract. Are they puts or calls? Are the positions long or short from PNW s standpoint? The contract is like a put spread. PNW is long a put with X = 400 HDD, and it is short a put with X = 360 (because the maximum payout was $800,000) One could also say that PNW is short HDDs. From only the contract s point of view, PNW hopes that the realized HDDs (on Seattle Tacoma Airport) falls below Of course the contract is a (limited) hedge for PNW. Its energy business is long HDD. The contract is a protection against a warm winter..: Net Income NI hedged against warm winter HDDs this winter 4

5 Case question 4. Pros and cons of weather protection with the floor contract? + reduce downside risk + lower volatility of PNW s stockprice. Lower Cost of Capital. + Better bond rating. Cheaper debt financing + Reduce overall cost of financing, of planning, and create incentives better aligned with efforts. However.. The protection is limited.. (it s a put spread) The premium must be paid. Enron is unlikely to lose money on this..there s no free lunch. Case question 5. Why is Enron in this situation? What does Enron stand to gain? Enron initiates the transaction and probably engineered it to its advantage, in expected value, or in a hedged position. It probably makes offsetting contracts with other parties or otherwise hedges its exposure of a warm winter.. Who would be interested in selling a floor (and pay when HDDs are low, while receiving a premium if HDDs are high) Airlines? 5

6 Case question 6. How should Mary Watts proceed? Should she buy weather protection? It s just another investment decision.. So, look at the Net Present Value!! Do scenario analysis, with probabilities (that she knows) and also take the premium (to be paid to Enron) into account. Questions? 6

7 Questions!! Some typical exam questions: Suppose the 3 month LIBOR (continuously compounded) on the USD is 0.98% and the 3 month EURO LIBOR (Euribor) is 0.21%. The Spot rate is 1 USD = Euro. What should be the three month forward rate? Gold is currently trading at $1233 per Ounce. The continuously compounded interest rate is 1.19% per year. The one year forward price for Gold is $1253 per Ounce. Explain how you can arbitrage, if storage costs are zero. What continuously compounded storage cost would eliminate the arbitrage opportunity? Questions!! Other numerical questions may be about: A simple binomial model question. A simple question about marking to market. A simple question about the netting cashflow in a Forward Rate Agreement. A simple question about a net cashflow in a Swap. All will come directly from the lectures and slides. 7

8 Questions!! Simple qualitative questions (possibly multiple choice) Describe how you would estimate the value of a structured product with Monte Carlo? What are the advantages of Monte Carlo valuation? How was Credit Suisse able to offer a protection on the S&P 500? How does a tranched CDO work? What are the advantages of securitizing loans and other cashflow streams? Explain. What is a hanging convertible? What effect does it have on a company s stock? Questions!! Possibly a short case question.. E.g. on a structured product.. What makes this product attractive for the client? What makes this product attractive for the bank? Is the XXX feature good or bad for the value of the product? How would you value this product? 8