ECO 322 Nov 25, 2013 Dr. Watson

 Cattleman wants less price volatility so he can plan for the future  Meatpacker wants less price volatility so he can plan for the future  Cattleman promise to sell you 100 cattle 6 months from now - $1.70/pound

 Trader showed up and thought, “That’s a really low price. … There was a drought in another province and all their cattle died. The price is going up… Say, meatpacker, can I buy your contract?”  Trader will pay the farmer $1.70 for the cattle 6 months from now  The meatpacker earns some profit.

 Another trader shows up, who thinks the price will be even higher.  He will buy the contract from the first trader.  The first trader makes money off of cattle he never owned.  Suppose there was news – trade restrictions on cattle had been dropped, so we can get all the cattle we want from another country

 What about death?  That’s called the ultimate default risk

 Long – bought  Short – sold  Hedge – Offset risk by buying another asset that will move differently  Offset a long position with a short position in the same area.  Airline – lose money when price of oil goes up, so they buy oil stocks.  Micro hedge – hedge on one asset  Macro hedge – hedge entire portfolio  Counterparty – whoever you’re trading with

 I own $5million in T-bills  If the interest rate goes up, what happens to the value of my T-bills?  I’m going to sell some futures contracts  How much does it cost? $100,000  N = value of the asset / value of the contract  5 million / 100,000 = 50.  Suppose the i was 6%, goes up 8%  My 5 goes down to 4.1  Value of the sale makes up the loss.

 In a forward contract, I am selling a very specific asset  In a futures contract, I am selling something that looks like this  Your bonds will expire in 15 years or more  The Treasury cannot call on them  $5 million  Forward markets are going to be less liquid, more default risk; lower transaction costs

 In a futures market, the seller is selling to a clearinghouse. The buyer is buying from the clearinghouse.  Where does the clearinghouse get its money?  The buyer and seller are both going to make a deposit: margin requirement  If the price of your asset changes, you need to change your margin.  Mark to market  Margin call

 Foreign exchange  You buy $5 million at N155/$ one year from now  You turn around and sell $5million at N165  Profit = N50million  Price of a futures contract today depends on everyone’s expectations  Forward contract - $1million  Futures contract - $125,000

 Time – Investment takes time, gambling is today?  Risk – Hedging is there to reduce your risk; gambling is about increasing your risk  When you invest, you own something  With gambling, you are not creating anything  Is arbitrage is gambling?  Moving across distance – a diaper in my house vs a diaper in another country  Moving across time

 One way to pay your CEO – stock options  You can buy X shares at today’s price … in the future  American option – exercise anytime  European option – exercise only when expires  Call option – option to buy  Put option – option to sell

 Futures often more liquid than the original asset  “in the money” – you could earn profits “out of the money” – the option is not profitable  Lower the “strike price” – higher premium  Longer time period (term) – higher premium  More volatility – higher premium

 Credit option – put (sell) bonds at the current price  Total global GDP: $50 trillion  Total value of credit derivative contracts:  $1200 trillion