BUSM 411: Derivatives and Fixed Income

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1 BUSM 411: Derivatives and Fixed Income 1. Introduction to derivatives In the last 30 years, derivatives have become increasingly important in finance. Futures and options are actively traded on many exchanges throughout the world. Many different types of forward contracts, swaps, options, and other derivatives are entered into by financial institutions, fund managers, and corporate treasurers in the over-the-counter market. Derivatives are added to bond issues, used in executive compensation plans, embedded in capital investment opportunities, used to transfer risks in mortgages from the original lenders to investors, and so on. If you plan to work in any area of finance, you need to understand how derivatives work, how they are used, and how they are priced What is a derivative? Options, futures, and swaps are examples of derivatives. A derivative is a financial instrument that is, and agreement or contract between two people to exchange money whose value depends (or is derived from) the value of other, more basic, underlying variables. For example, a frozen, trimmed pork belly is not a derivative; is is a commodity. It s value is whatever the market price of pork bellies is at the time. However, you may strike an agreement with a friend to sell him a 13-lb pork belly in November for a price of $3 per pound. The value of this agreement depends on what the market price of pork bellies turns out to be in November. If the market price in November turns out to be $2 per pound, you will have made a dollar per pound $13. If the market price turns out to be $4 per pound, you will have lost (and your friend gained) $13. This agreement between you and a friend is a derivative (a forward, in particular). The value of the forward agreement depends on the price of the underlying commodity (pork bellies). [SHOW VIDEO HERE] You may point out that your agreement is essentially a bet on the price of pork bellies. It is, at least in isolation. But suppose that you raise hogs, while your friend operates a meat processor that produces bacon. Mmm...bacon. If the price of pork bellies falls, that hurts your business because get less money from selling your hogs. But the gain you receive from the forward contract offsets that loss. Likewise, if the price of pork bellies rises, it hurts your friend s business for which pork bellies are an input, but that loss is offset by his gains from the forward contract. Derivatives can thus be either a pure gamble, or a means of eliminating risk, depending on the context in which they are used The role of financial markets Financial markets and households What is the role of financial markets? What benefit do they bring to society. From a big-picture macroeconomic standpoint, at the end of the day we care about the welfare of households in our society. Here are some of the important ways in which households benefit from the existence of financial markets: In the typical household the father and/or mother is employed by a firm. The firm has an ongoing need for capital (money) in order to fund its operations and continue to 1

2 exist. It can raise the money it needs by selling claims on its future profits (i.e. issuing stocks and bonds) to investors in global financial markets The firm can insure itself against certain risks. In addition to traditional insurance for to protect against unexpected liabilities and losses, it can use global derivatives markets to protect itself against adverse currency, interest rate, and commodity price changes. By managing these risks, the firm is less likely to go into bankruptcy Households can invest in mutual funds, allowing them to achieve broad diversification in their portfolio of financial assets at low transaction costs. Since the typical household depends on their employer for income, they run the risk that the company fails and they lose their jobs. The ability to accumulate diversified financial wealth (mutual fund holdings, etc) ensures that the failure of a single company would not wipe out all of their wealth. Households can insure against natural disasters such as tornadoes, earthquakes, and floods. A strictly local insurance company could not offer such disaster insurance, because a single disaster would wipe out the insurance company. By selling the local disaster risk in global markets, the insurance company can effectively pool the risk of independent disasters across the world, making insurance possible and available at the lower rates. If a household borrows money to finance the purchase of a home, the bank will typically sell the mortgage to other investors, so that it does not have to bear the interest rate and default risk associated with holding the mortgage. Because the risk of the mortgage is borne by those willing to pay the highest price for it, households get the lowest possible mortgage rate Risk sharing The common theme through all of these benefits of financial markets is that particular financial functions and risks are split up and parceled out to others. That is, risks are pooled and widely shared to make everyone better off. Risk is an inevitable part of our lives and of all economic activity. But not all of us face the same risks, and particular outcomes may affect different people or firms in different ways. Some are lucky, while others are unlucky, and financial markets provide arrangements that allow us to share risk among ourselves, so that those who are lucky can help out the unlucky. Since we don t know ahead of time who will be lucky and who will be unlucky, so we make contracts ex ante that stipulate the transfer of wealth from the lucky to the unlucky. Those of us that have cars face the risk of being involved in an accident, which could result in very costly damage to our cars, or to the people riding in those cars. Not all of us will have an accident, but it could be devastating if you do, so it makes sense that we share that risk. So we get car insurance, paying premiums into a big pool that will go to pay for the accidents of those who are unlucky. 2

3 Businesses face risk from changes in exchange rates, interest rates, and commodity prices. But they don t all face the same risks in the same direction. Financial markets, and derivatives markets in particular, allow firms to exchange those risks to everyone s benefit. Two big ideas: By pooling and sharing risk, we can eliminate the individual risks that are unique to each person or firm (idiosycratic risk). However, risk sharing can never eliminate risk that is common to everyone (systematic risk) At the same time, markets permit the systematic risk to be held by those most willing to hold it. Everyone wins! 1.3. Derivatives Markets Exchange-traded markets A derivatives exchange is a market where individuals can trade standardized derivatives contracts that have been defined by the exchange. Chicago Board of Trade (CBOT) established in 1848 to bring farmers and merchants together, and to standardize quantities and qualities of grains traded Soon after, the first futures-type contract, called a to-arrive contract was introduced. Speculators soon became interested, and found trading the contract to be an attractive alternative to trading the grain itself. A rival exchange, the Chicago Mercantile Exchange, was established in 1919, and the two later merged into a group that also includes the New York Mercantile Exchange Chicago Board Options Exchange (CBOE) started trading call optionson 16 stocks back in 1973 (coincides with publication of Black-Scholes option-pricing formula). Now trades options on over 2500 stocks and many indices. Trading was traditionally done in an open outcry system, but is increasingly moving to electronic trading systems Over-the-counter markets Not all trading is done on exchanges. Most, in fact is done over-the-counter. Trades are done over the phone, between two financial institutions, or between a financial institution and a client (e.g. corporate treasurer or fund manager) Financial institutions often act as market makers for more commonly traded instruments, always prepared to quote a bid or offer price. Advantage of over-the-counter market is flexibility. Participants are not limited to the specific contracts defined by the exchange, but are free to negotiate a mutually beneficial deal with any other party. Disadvantages are illiquidity and credit risk 3

4 1.4. Buying and short-selling financial assets Buying an asset What does it cost to purchase a stock? Commission: fee paid to the broker for executing a trade Stock price is not a single number. The offer or ask price is the price at which you can buy the asset; the bid price is the price at which you can sell. When you buy a stock, where does it come from? Market maker. Bid-ask bounce: series of buy and sell orders will cause the price to bounce between bid and ask prices What happens to your shares after you buy them? Short-selling A short sale is the opposite of buying an asset Buying a financial asset = lending; short-selling = borrowing Three reasons to short-sell: 1. Speculation 2. Financing 3. Hedging Short sale of a stock: Borrow the stock and sell it, receiving cash today In the future, repay the borrowing by purchasing the stock and returning it to the owner (like repaying a loan) Equivalent to borrowing money, except that the interest rate is determined by the change in price on th asset, rather than set in advance Must pay any dividends the stock pays out to the owner of the stock. Why? Lease rate of an asset: Financial assets generally provide periodic income. Bonds make coupon payments, stocks pay dividends, etc. If you are borrowing an asset, you must pay to the owner whatever income he should have received from holding the asset (e.g. dividends, coupon payments, some rate of interest, etc) This is called the lease rate of an asset, and will be a key concept throughout our discussion of derivatives and how they are priced. 4

5 Credit risk Short-seller has an obligation to return the asset. How can the lender insure hat you will actually return the asset? Borrower has to post collateral. Lender will hold the proceeds from the short sale (or some other set of assets belonging to the borrower, such as Treasuries), to be released when the borrower returns the asset What if the price goes up? What if you just decide not to return the asset for a certain loss? To account for this risk, lenders often require more collateral than the proceeds of the sale. This extra amount is called a haircut. Mortgage loan-to-value example Scarcity When you return the asset from the short-sale, you are going to want your money (collateral) back plus interest. Why? How much interest will the lender pay you? Generally less than what you can earn from investing the collateral, with the difference considered as a fee paid to the lender for being willing to lend ou the asset. It depends on how many people wan to borrow the particular asset, and how many people are willing to lend it (supply and demand) The rate paid on collateral is called the repo rate in the bond market, and the short rebate in the bond market. The difference between it and the market rate of interest is a cost to executing a short sale. 5