 2002, Prentice Hall, Inc. Ch. 21: Risk Management

Innovations in Risk Management Futures contract: a contract to buy or sell a stated commodity or financial claim at a specified price at some specified future time.

Futures: a simple example Suppose a farmer plans to harvest 10,000 bushels of corn in 6 months. The current price is $2.50 per bushel. The farmer sells a futures contract, which will allow him to sell corn at 2.50 per bushel in 6 months. If the price of corn falls to $2.00 per bushel, the farmer loses $5,000 ($0.50 x 10,000 bushels) on his corn, but gains $5,000 on his futures contract.

Futures: a simple example If the price of corn rises to $3.00 per bushel, the farmer gets $5,000 more for his corn, but loses $5,000 on the futures contract. The farmer has effectively locked in a price of $2.50 per bushel and has hedged his risk.

Futures Trading Requires: An Organized Exchange - the Chicago Board of Trade is the oldest and largest futures exchange. Standardized Contracts - for more frequent trades and greater liquidity.

A Futures Clearinghouse - stands between all buyers and sellers to guarantee that all trades are honored. Daily Resettlement of Contracts - An initial margin of 3% to 10% of the contract’s value is paid up front. A maintenance margin is required. Any end-of-day losses must be replenished by the contract holder. Futures Trading Requires:

Types of Futures Contracts Commodity Futures - agricultural commodities (corn, wheat, orange juice, etc.) as well as metals, wood products and fibers. Financial Futures - futures contracts on Treasury bills, notes and bonds, GNMAs, CDs, Eurodollars, foreign currencies, and stock indices.

Financial Futures Interest Rate Futures - used to hedge risks associated with interest rate fluctuations. For example, Treasury bond futures may allow a firm to lock in an interest rate for their bond issue.

Foreign Exchange Futures - used to hedge risks associated with exchange rate fluctuations. A firm can use a foreign exchange futures contract to lock in an exchange rate for a future transaction. Financial Futures

Stock Index Futures - used to hedge risks associated with equity market fluctuations. Investors can buy and sell contracts based on the S&P 500 and other market indices. Financial Futures

Innovations in Risk Management Option contract: gives the owner the right to buy or sell a fixed number of shares of stock at a specified price over a limited time.

Option Contracts Call Option: gives the owner the right to buy a fixed number of shares of stock at a specified price over a limited time. If you buy a call option on IBM stock, and the stock price rises enough, you can profit on the call option contract. If the stock price does not rise enough, or falls, your call option contract expires worthless.

Long Call Option Profit or Loss Stock Price $50 exercise price

Long Call Option Profit or Loss Stock Price $50 exercise price

Long Call Option Profit or Loss Stock Price $50 exercise price

Long Call Option Profit or Loss Stock Price $50 exercise price

Short Call Option Profit or Loss Stock Price $50 exercise price

Short Call Option Profit or Loss Stock Price $50 exercise price

Short Call Option Profit or Loss Stock Price $50 exercise price

Short Call Option Profit or Loss Stock Price $50 exercise price

Option Contracts Put Option: gives the owner the right to sell a fixed number of shares of stock at a specified price over a limited time. If you buy a put option on IBM stock, and the stock price falls enough, you can profit on the put option contract. If the stock price does not fall enough, or rises, your call option contract expires worthless.

Long Put Option Profit or Loss $50 exercise price Stock Price

Long Put Option Profit or Loss $50 exercise price Stock Price

Long Put Option Profit or Loss $50 exercise price Stock Price

Long Put Option Profit or Loss $50 exercise price Stock Price

$50 Stock exercise price Price Short Put Option Profit or Loss

$50 Stock exercise price Price Short Put Option Profit or Loss

$50 Stock exercise price Price Short Put Option Profit or Loss

$50 Stock exercise price Price Short Put Option Profit or Loss

Chicago Board Options Exchange Established in 1973 to provide exchange-listed option trading. Why? Standardization of option contracts. A regulated central marketplace. An options clearinghouse corporation. Certificateless trading. A liquid secondary market.

Innovations in Options Option contracts can be written on: Common stocks Stock Indices Interest rates Foreign currency Treasury bond futures

Currency Swaps An exchange of debt obligations in different currencies. Example: An American firm and a British firm agree to pay each other’s debt obligation. This allows long-term exchange rate risk hedging.

Other Innovations Long-term Equity Anticipation Securities (LEAPS) These are long-term options, both calls and puts, which may not expire for as long as 3 years. Can be used to hedge against longer term movements in stocks.