1. Risk and Derivatives Stephen Figlewski
Professor of Finance
New York University Stern School of Business
Presentation at Tsinghua University
March 27, 2003

2. Derivatives Defined What Are Derivatives?
A Derivative is a financial instrument whose payoff depends directly on (is "derived" from) the value of some underlying economic variable.
Examples:
forward contract
futures contract
option
swap, cap, floor
asset-backed security
structured product

3. Hedging Example
A builder is constructing an apartment building that will be finished in 1 year. Construction cost is $40 million.
The value of the building in 1 year will depend on interest rates at that time. Buyers of apartments must borrow money, and if interest rates go up, they can not pay as high prices for apartments.
The long term interest rate today is 6%
Value of the building for different interest rates in 1 year:
7% $30 million
6% $50 million
5% $70 million
How can the builder protect himself against losing money if interest rates go up?

4. Derivatives provide many different ways to manage interest rate risk.
Hedging Example
Derivatives provide many different ways to manage interest rate risk.
Forward Contract:
Find a buyer today who will agree to buy the building for $50 million in 1 year.
Problems:
locating a buyer
buyer's credit risk (require collateral)

5. Forward Rate Agreement:
Hedging Example
The cause of the risk is that the future interest rate is not known. The builder can protect against this risk by using a derivative contract based on interest rates.
Forward Rate Agreement:
Make a contract with a bank that sets payments as a function of the interest rate in 1 year.
Payoffs on the interest rate contract:
7% $20 million (the bank pays the builder)
6% 0 (neither side pays)
5% -$20 million (the builder pays the bank)
This contract protects the builder against a change in the interest rate.
Total value of building plus interest rate hedge:
7% $50 million ( )
6% $50 million (50 + 0)
5% $50 million ( )

6. Using a derivative contract this way is a hedge.
Hedging Example
Using a derivative contract this way is a hedge.
Things to notice in the example:
The hedge is a separate financial position from the item that is hedged. This makes it much more flexible (easier to find a counterparty, more specific to the kind of risk, easier to change)
The hedge works because the payoff on the derivative is closely correlated with the value of the item that is hedged. Correlation is negative--the payment on the contract is higher when the value of the building is lower.
It does not matter whether there is a profit or a loss on the derivative contract. Only the total matters. Some "derivatives disasters" were simply cases where money was lost on derivatives used in a hedge, but there was an offsetting gain on the item that was being hedged.

7. Hedging Example Futures Contract:
A forward contract can be set up in any way that the two counterparties agree to. But it is still necessary to search for a partner and to worry about whether the partner will fulfill the contract at the end.
A futures contract is a kind of forward contract with standardized terms, that is traded on an organized futures exchange. No search is needed and performance on the contract is guaranteed by the exchange.
There are futures contracts on many different types and maturities of interest rates. One of the most important in the U.S. is the one on long-term Treasury bonds. This contract is widely used to hedge against changes in long-term rates.
Futures Contract:
The builder should take a position in Treasury bond futures that will pay $20 million if the rate goes up to 7%. Like a forward, the futures position will also require a cash payment from the builder, if the rate goes down.

8. Hedging Example Option:
One problem with a forward or futures hedge is that if the interest rate goes down, the builder gives up a nice profit. He can avoid this if he buys an option.
Option:
Make a contract with a bank that specifies that the bank pays the builder if the interest rate rises and there is no payment if the rate falls.
Payoffs
7% $20 million (the bank pays the builder)
6% or below (neither side pays)
The builder would have to pay the bank a fixed fee at the beginning for this contract, maybe $4 million.

9. Other kinds of derivatives
Hedging Example
Other kinds of derivatives
It may take a year to sell the apartments in the building. There will be interest rate risk exposure over the whole year.
It may be better risk management to make four forward rate agreements with maturities every three months, starting in 1 year. This would be a swap.
A sequence of four options would be an interest rate cap. The similar derivative that makes payoffs only if interest rates go down is an interest rate floor.

10. Summary of Different Types of Derivatives
Major Classes of Derivatives
Forward contract:
Contract binding on both buyer and seller to exchange a specific item at a future date.
Futures contract:
Like a forward but traded on an exchange, with standardized terms. Counterparty credit risk is effectively eliminated by the Clearing House and margining system.
Option:
Contract specifying precisely a future transaction that will be executed only if the option holder (buyer) chooses. A call option lets the option holder buy the underlying; a put is an option to sell.
Swap:
Like a bundle of forward contracts with the same terms and sequential maturity dates.

11. Summary of Different Types of Derivatives
Major Classes of Derivatives, continued
Cap, floor:
Like a swap, but consisting of a bundle of options rather than forwards. A cap gives the buyer a sequence of call options; a floor is a bundle of put options.
Asset-backed Security:
A security that gives the holder the right to a portion of the payout from an underlying portfolio of assets, such as mortgage loans.
Structured product:
Custom-designed financial instrument that may contain elements of several different types of derivative and underlying securities. Structured products often involve setting up a new corporation (a "Special Purpose Corporation") that owns the underlying assets and issues new kinds of securities.

12. Hedging, Speculation, and Security Design
Hedging and Derivatives Risk
What kinds of risk can be hedged with derivatives?
Anything that two counterparties can agree on, and that can be measured precisely so that they can write a contract: interest rates, security prices, exchange rates, indexes of prices, default on a corporate bond, average temperature, quantity of commodity produced or consumed, insurance losses in a given region, stock market volatility, etc.
Where does the risk go?
Total risk is not created or eliminated by hedging (the value of the building still goes down if interest rates rise). The hedge transfers this interest rate risk from the hedger (the builder) to the counterparty (the bank).
Accepting risk by entering into a derivatives contract with a hedger is speculation.
Speculation is necessary for hedging to be possible.

13. Hedging, Speculation, and Security Design
Speculation and Derivatives Risk
Hedging works because the speculator is able to manage the risk better than the hedger.
The speculator may
have more capital than the hedger
understand the risk better
diversify the risk by holding other investments
share the risk with other investors
hedge the risk in some way (for example, by using exchange-traded derivatives)
An important point: Trading in derivatives is a zero-sum game. Total profits to all parties sum up to zero.
On average, speculators should earn a profit on derivatives (compensation for bearing risk) and hedgers should have losses (the cost of insuring against risk)
Speculation with no information or special ability to manage risk is just gambling.
For the whole economy, derivatives losses are less serious than losses on ordinary securities, because for every loss there are always other traders who have made profits.

14. Hedging, Speculation, and Security Design
Derivatives and Security Design
Derivatives are extremely flexible and versatile. Derivatives allow the user to transform the characteristics of an asset from what they are naturally into what the user wants them to be.
With derivatives, one can
own an asset but not bear its risk (example: the builder gets rid of the interest rate risk of his construction project)
create exposure to the risk and return of an asset that you do not own (example: create a bank deposit whose payoff depends partly on the stock market)
set up the same effective position in several different ways and choose the best one (example: if you want to borrow dollars at a fixed interest rate, you might
borrow at a fixed rate in the U.S.
borrow at a floating interest rate in Japan, then hedge the exchange rate risk with forward contracts on the $/yen exchange rate, and use a interest rate swap to turn the floating interest rate into a fixed rate
change a specific characteristic of an asset
market price risk exposure
currency exposure
default risk
loan prepayment risk
tax treatment
bank capital requirements
event risk

15. Risk in Derivatives Trading
Derivatives Dangers
The derivative contract is not a purchase or sale when it begins. It is an agreement to make a transaction at a future date. Risk is transferred at the beginning, but money does not have to be paid until later. It is possible to take a derivatives position with a lot of risk that is not easy to see because no cash changes hands at first.
Potential Trading Problems
Leverage: A trader with small capital can take a lot of risk using derivatives.
Nonlinear risk exposure: Option positions may have risk exposure that rapidly increases when the market moves against the trader (example: the bank that sells an option to the builder receive $4 million but might lose $20 million)
Rogue trader: A trader may take positions that involve too much risk for his firm without his supervisors knowing it.
Accounting Problems
It is very hard for outside investors or regulators to understand the risk exposure of a firm that has derivatives positions.
When are the profits or losses on the derivative contract recorded?
ideal: when the profit or loss on the item being hedged is recorded. This is not always easy.
possibility for manipulation: Enron and other recent cases have shown this.

16. Conclusion
Conclusions
Derivatives are extremely useful for managing risk.
Derivatives are extremely flexible.
Derivatives will continue to be an important and growing part of a modern financial market system.
Derivatives present some challenges for risk managers in financial firms, regulators and accountants.
Derivatives are not easy to understand.
It is therefore important to have a lot of finance professors and to pay them very well.