1. Chapter 16 Hybrid and Derivative Securities

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-2 Learning Goals 1.Differentiate between hybrid and derivative securities and their roles in the corporation. 2.Review the types of leases, leasing arrangements, the lease versus purchase decision, the effects of leasing on future financing, and the advantages and disadvantages of leasing. 3.Describe the types of convertible securities, their general features, and financing with convertibles.

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-3 Learning Goals (cont.) 4.Demonstrate the procedures for determining the straight bond value, conversion (or stock) value, and market value of a convertible bond. 5.Explain the characteristics of stock purchase warrants, the implied price of an attached warrant, and the values of warrants. 6.Define the options and discuss calls and puts, options markets, options trading, the role of call and put options in fund raising, and hedging foreign currency exposures with options.

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-4 An Overview of Hybrids & Derivatives In their simplest form, bonds are pure debt and common stocks are pure equity. Preferred stocks, on the other hand, are a hybrid of the two. They are like common stocks in that they promise to pay dividends, are perpetual, and represent ownership. They are like bonds in that dividends are fixed like bond interest payments. Other hybrid securities include financial leases, convertible securities, and stock purchase warrants.

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-5 An Overview of Hybrids & Derivatives (cont.) The latter part of this chapter focuses on derivative securities A derivative is a security that is neither debt nor equity but derives its value from an underlying asset that is often another security. Derivative securities are not used by corporations to raise funds. Rather, they serve as a useful tool for managing certain aspects of firm risk.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-6 Leasing Leasing is the process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual, periodic, tax-deductible payments. The lessee is the receiver of the services of the assets under a lease contract. The lessor is the owner of the assets that are being leased.

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-7 Leasing: Operating Leases An operating lease is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an assets services. Generally, the total payments over the term of the lease are less than the lessor’s initial cost of the leased asset. If the operating lease is held to maturity, the lessee returns the leased asset over to the lessor, who may lease it again or sell the asset.

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-8 Leasing: Financial (or Capital) Leases A financial lease is a longer-term lease than an operating lease. Financial leases are non-cancelable and obligate the lessee to make payments for the use of an asset over a predefined period of time. The total payments over the term of the lease are greater than the lessor’s initial cost of the leased asset. Financial leases are commonly used for leasing land, buildings, and large pieces of equipment.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-9 Leasing: Leasing Arrangements A direct lease is a lease under which a lessor owns or acquires the assets that are leased to a given lessee. A sale-leaseback arrangement is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset. A leveraged lease is a lease under which the lessor acts as an equity participant, supplying about 20 percent of the cost of the asset with a lender supplying the balance.

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-10 Leasing: Leasing Arrangements (cont.) Operating leases normally require maintenance clauses requiring the lessor to maintain the assets and to make insurance and tax payments. Renewal options are provisions that grant the lessee the option to re-lease assets at the expiration of the lease. Finally, purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the asset at maturity—usually at a pre-specified price.

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-11 Leasing: The Lease-Versus- Purchase Decision The lease-versus-purchase decision is a common decision faced by firms considering the acquisition of a new asset. This decision involves the application of capital budgeting techniques as does any other asset investment acquisition decision. The preferred method is the calculation of NPV based on the incremental cash flows (lease versus purchase) using the following steps:

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-12 Leasing: The Lease-Versus- Purchase Decision (cont.) Step 1: Find the after-tax cash outflows for each year under the lease alternative. Step 2: Find the after-tax cash outflows for each year under the purchase alternative Step 3: Calculate the present value of the cash outflows from Step 1 and Step 2 using the after- tax cost of debt as the discount rate. Step 4: Choose the alternative with the lower present value of cash outflows.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-13 Roberts Company, a small machine shop, is contemplating acquiring a new machine tool costing $24,000. Arrangements can be made to lease or purchase. The firm is in the 40 percent tax bracket. Lease. The firm would obtain a 5-year lease requiring annual end-of-year payments of $6,000. All maintenance costs will be borne by the lessor, and the lessee would exercise the option to purchase the machine for $4,000 at termination of the lease. Leasing: The Lease-Versus- Purchase Decision (cont.)

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-14 Leasing: The Lease-Versus- Purchase Decision (cont.) Purchase. The firm would finance the purchase of the machine with a 9%, 5-year loan requiring end -of-year installment payments of $6,170. It would be depreciated under MACRS using a 5-year recovery period. The firm would pay $1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. The firm plans to keep the machine and use it beyond its 5-year recovery period.

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-15 Leasing: The Lease-Versus- Purchase Decision (cont.) Step 1: Find the after-tax cash outflows for each year under the lease alternative. The after-tax cash outflow from the lease payments can be found as follows: A-T Outflow from Lease = $6,000 x (1 - t) =$6,000 x (1 -.40) =$3,600 In the final year, the $4,000 cost of the purchase option would be added to the $3,600 lease outflow to get a year 5 outflow of $7,600 ($3,600 + $4,000).

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-16 Leasing: The Lease-Versus- Purchase Decision (cont.) Step 2: Find the after-tax cash outflows for each year under the purchase alternative. First, the annual interest component of each loan payment must be determined since only interest can be deducted for tax purposes as shown in Table 16.1 on the following slide. Second, the A-T outflows must be computed as shown in Table 16.2.

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-17 Leasing: The Lease-Versus- Purchase Decision (cont.)

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-18 Leasing: The Lease-Versus- Purchase Decision (cont.)

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-19 Leasing: The Lease-Versus- Purchase Decision (cont.) Step 3: Calculate the present value of the cash outflows from Step 1 and Step 2 using the after-tax cost as the discount rate. This is shown in Table 16.3 on the following slide.

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-20 Leasing: The Lease-Versus- Purchase Decision (cont.)

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-21 Leasing: The Lease-Versus- Purchase Decision (cont.) STEP 4: Choose the alternate with the smaller present value of cash outflows. Because the present value of cash outflows for leasing ($18,151) is lower than that for purchasing ($19,539), the leasing alternative is preferred—resulting in an incremental savings of $1,388.

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-22 Leasing: Effects of Leasing on Future Financing FASB No. 13 requires explicit disclosure of financial lease obligations on the firm’s balance sheet. It must be show as a capitalized lease, meaning that the present value of all payments are included as an asset and corresponding liability. An operating lease on the other hand, need not be capitalized, but must be reported in the footnotes. Because the consequences of missing financial lease payments are the same as that of missing the principal payment on debt, a financial analyst must view the lease as a long-term debt payment.

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-23 Leasing: Advantages of Leasing The firm may avoid the cost of obsolescence if the lessor fails to accurately anticipate the obsolescence of assets and sets the lease payment too low. A lessee avoids many of the restrictive covenants that are normally included as part of a long-term loan. Leasing—especially operating leases—may provide the firm with needed financial flexibility. Sale-leaseback arrangements may permit the firm to increase its liquidity by converting an existing asset into cash, which may then be used as working capital.

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-24 Leasing: Advantages of Leasing (cont.) Leasing allows the lessee, in effect, to depreciate land, which is prohibited if the land were purchased. Because it results in the receipt of service from an asset possibly without increasing the assets or liabilities on the firm’s balance sheet, leasing may result in misleading financial ratios. Leasing provides 100 percent financing. When the firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is 3 years of lease payments, and the lessor gets the asset back.

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-25 Leasing: Disadvantages of Leasing A lease does not have a stated interest cost. At the end of the term of the lease agreement, the salvage value of an asset, if any, is realized by the lessor. Under a lease, the lessee is generally prohibited from making improvements on the leased property or asset without approval of the lessor. If a lessee leases an asset that subsequently becomes obsolete, it must still make lease payments over the remaining term of the lease.

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-26 Convertible Securities A conversion feature is an option that is included as part of a bond or preferred stock issue that allows its holder to change the security into a stated number of shares of common stock. The conversion feature typically enhances the value of the issue.

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-27 Convertible Securities: Types of Convertible Securities A convertible bond can be changed into a specified number of shares of common stock. It is almost always a debenture—an unsecured bond—with a call feature. Because the conversion feature provides the purchaser with the possibility of becoming a shareholder on favorable terms, convertible bonds are generally less a expensive form of financing than similar-risk nonconvertible or straight bonds.

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-28 Convertible Securities: Types of Convertible Securities (cont.) A convertible preferred stock is a preferred stock that can be changed into a specified number of shares of common stock. It can normally be sold with a lower stated dividend than a similar-risk nonconvertible stock. This is because the convertible preferred holder is assured of the fixed dividend payment and also may receive the appreciation resulting from increases in the market price of the underlying common stock.

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-29 Western Wear Company, a manufacturer of denim products, has outstanding a bond with a $1,000 par value and convertible into 25 shares of common stock. The bond’s conversion ratio is 25. The conversion price for the bond is $40 per share ($1,000 ÷ 25). Convertible Securities: General Features of Convertibles The conversion ratio is the ratio at which a convertible security can be exchanged for common stock and can be state in two ways: – in terms of a given number of shares of common

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-30 Convertible Securities: General Features of Convertibles (cont.) The conversion ratio is the ratio at which a convertible security can be exchanged for common stock and can be state in two ways: – in terms of a given number of shares of common – by dividing the par value of the convertible by the conversion price Mosher Company, a franchisor of seafood restaurants, has outstanding a convertible 20-year bond with a par value of $1,000. The bond is convertible at $50 per share into common stock. The conversion ratio is 20 ($1,000 ÷ $50).

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-31 Convertible Securities: General Features of Convertibles (cont.) The conversion or stock value is the value of the convertible measured in terms of market price of the common stock into which it can be converted. McNamara Industries, a petroleum processor, has outstanding a $1,000 bond that is convertible into common stock at $62.50 per share. The conversion ratio is therefore 16 ($1,000 ÷ $62.50). Because the current market price of the common stock is $65 per share, the conversion value is $1,040 (16 x $65). Because the conversion is above the bond value of $1,000, conversion is a viable option for the owner.

32. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-32 Basic EPS are calculated without regard to contingent securities. They are found by dividing earnings available to common stockholders by the number of shares of common stock outstanding. Convertible Securities: Effect on Earnings The presence of contingent securities, which include convertibles, warrants, and stock options, affects the reporting of the firm’s EPS. Firms with contingent securities that if converted would dilute EPS are required to report earnings in two ways—basic EPS and diluted EPS.

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-33 Diluted EPS are calculated under the assumption that all contingent securities are converted, and are therefore common stock. Convertible Securities: Effect on Earnings (cont.) The presence of contingent securities, which include convertibles, warrants, and stock options, affects the reporting of the firm’s EPS. Firms with contingent securities that if converted would dilute EPS are required to report earnings in two ways—basic EPS and diluted EPS.

34. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-34 Convertible Securities: Financing With Convertibles Convertible securities can be used as a form of deferred common stock financing. Convertible securities can be used as a sweetener by giving the purchaser an opportunity to share in the firm’s success by converting to common stock. Convertibles can normally be sold with lower interest rates than non-convertibles. Convertibles can be sold with fewer restrictive covenants than non-convertibles. Convertibles can be used to raise cheap funds temporarily.

35. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-35 Duncan Company, a southeastern discount chain, has just sold a $1,000 par value, 20-year convertible with a 12% coupon rate. Interest will be paid at the end of each year, and the principal will be repaid at maturity. A straight bond could have been sold with a 14% coupon but the conversion feature compensates for the lower rate on the convertible. The straight value could be calculated as: Convertible Securities: Determining the Value of a Convertible Bond The straight bond value of a convertible bond is the price at which it would sell in the market without the conversion feature. The straight value is typically the floor, or minimum, price at which it would be traded.

36. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-36 Convertible Securities: Determining the Value of a Convertible Bond (cont.) The straight bond value of a convertible bond is the price at which it would sell in the market without the conversion feature. The straight value is typically the floor, or minimum, price at which it would be traded.

37. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-37 Convertible Securities: Determining the Value of a Convertible Bond (cont.) The straight bond value of a convertible bond is the price at which it would sell in the market without the conversion feature. The straight value is typically the floor, or minimum, price at which it would be traded. This value, $867.76, is the minimum price at which the convertible is expected to sell.

38. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-38 Duncan Company’s convertible bond described earlier is convertible at $50 per share. Each bond can therefore be converted into 20 shares of common stock. The conversion values of the bond when the stock is selling at $30, $40, $50, $60, $70, and $80 are shown as follows: Convertible Securities: Conversion (or Stock) Value The conversion value of a convertible is the value of the convertible measured in terms of the market price of the common stock into which the security can be converted. When the market price of the common stock exceeds the conversion price, the conversion value exceeds the par value.

39. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-39 Convertible Securities: Conversion (or Stock) Value (cont.)

40. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-40 Convertible Securities: Conversion (or Stock) Value (cont.) When the market price of the common stock exceeds the $50 conversion price, the conversion value exceeds the $1,000 par value. Because the straight bond is $876.76, the bond will never sell for less than this amount regardless of how low its conversion value is. If the market price were $30, the bond would still sell for $876,76—not $600—because its value as a bond would dominate.

41. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-41 Convertible Securities: Market Value The market value of a convertible bond is likely to be greater than its straight value or conversion value. The amount by which its market value exceeds its straight or conversion value is called the market premium. This relationship can be described graphically as shown in Figure 16.1

42. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-42 Convertible Securities: Market Value (cont.)

43. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-43 Stock Purchase Warrants A stock purchase warrant is a security that gives its holder the right to purchase a certain number of shares of common stock at a specified price over a certain period of time. Warrants are like stock rights (described in Chapter 7) in that holders of warrants earn no income from them until they are exercised or sold. They also bear some similarity to convertibles in that they provide for the injection of additional equity capital into the firm at some future date.

44. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-44 Stock Purchase Warrants: Key Characteristics Warrants are often attached to debt issues as “sweeteners” to add to the marketability of the issue and lower the required interest rate. The price at which warrant holders can purchase a specified number of common shares is normally referred to as the exercise (or option) price which is normally set at 10 to 20 percent above the market price of the common stock at the time of issuance. Warrants normally have a life of no more than 10 years although some have infinite lives.

45. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-45 Stock Purchase Warrants: Key Characteristics (cont.) Warrants are usually “detachable” meaning that the bondholder may sell the warrant without selling the underlying security and are often listed and actively traded. Like rights, warrants provide a form of deferred equity financing. Unlike rights, warrants are exercisable for a period of years and are issued at a price above the prevailing market price of the firm’s common stock.

46. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-46 Stock Purchase Warrants: The Implied Price of an Attached Warrant When attached to a bond, the implied price of a warrant can be found by using the following equation. The straight bond value is found in a fashion similar to that found using convertible bonds. Dividing the implied price of all warrants by the number of warrants attached to each bond results in the implied price of each warrant.

47. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-47 Martin Marine Products, a manufacturer of marine drive shafts and propellers, just issued a 10.5% coupon, $1,000 par value, 20-year bond paying annual interest and having 20 warrants attached for the purchase of common stock. The bonds were initially sold at $1,000, and when issued, were selling to yield 12%. The straight value of the bond would be the present value of its payments discounted at the 12% yield on similar-risk straight bonds. Stock Purchase Warrants: The Implied Price of an Attached Warrant (cont.)

48. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-48 Stock Purchase Warrants: The Implied Price of an Attached Warrant (cont.) Substituting the $1,000 price of the bond with warrants attached and the $888 straight bond value into equation 18.1, we get an implied price of all warrants of $112 as follows:

49. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-49 Stock Purchase Warrants: The Implied Price of an Attached Warrant (cont.) Dividing the implied price of all warrants by the number of warrants attached to each bond—20 in this case —we find the implied price of each warrant. Therefore, by purchasing Martin Marine Products’ bond with warrants attached for $1,000, one is effectively paying $5.60 for each warrant. Implied price of all warrants = $1,000 - $888 = $112 Implied price of each warrant = $112 ÷ 20 = $5.60

50. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-50 Stock Purchase Warrants: The Value of Warrants Like a convertible, a warrant has both a market value and theoretical value. The difference between these values—the warrant premium—depends largely on investor expectations and the ability of investors to get more leverage from the warrants than from the underlying stock. The theoretical value of a warrant is the amount one would expect the warrant to sell for in the marketplace as shown in equation 16.2.

51. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-51 Stock Purchase Warrants: The Value of Warrants (cont.)

52. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-52 Stock Purchase Warrants: The Value of Warrants (cont.) Dustin Electronics, a major producer of transistors, has outstanding warrants that are exercisable at $40 per share and entitle holders to purchase three shares of common stock. The warrants were initially attached to a bond issue to sweeten the bond. The common stock of the firm is currently selling for $45 per share. Substituting P0 = $45, E = $40, and N = 3 into Equation 18.2 yields a theoretical value of $15 [($45 - $40) x 3].

53. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-53 Stock Purchase Warrants: The Value of Warrants (cont.) The market value of a warrant is generally above its theoretical value. Only when the theoretical value is very high, or the warrant is near its expiration date are the market value and theoretical values close. The warrant premium is the amount by which market value exceeds theoretical value and results from both positive expectations and the ability to trade them. These concepts can be described graphically as shown in Figure 16.2.

54. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-54 Stock Purchase Warrants: The Value of Warrants (cont.)

55. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-55 Options An option is an instrument that provides its holder with an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration date. Options are probably the most popular type of derivative security. Three basic forms of options are rights, warrants, and calls and puts. This section will focus on calls and put options.

56. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-56 Options: Calls and Puts A call option is an option to purchase a specified number of shares of stock (typically 100) on or before a specified future date at a stated price. They usually have initial lives of 1 to 9 months. The striking price is the price at which the holder of a call can buy the stock at any time prior to the option’s expiration date. The striking price is usually set at or near the prevailing market price of the stock at the time it is issued.

57. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-57 Options: Calls and Puts (cont.) A put option is an option to sell a specified number of shares of common stock on or before a specified future date at a stated striking price. Like the call option, the striking price is set close to the market price at the time it is issued.

58. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-58 Options: Options Markets One way of making an options transaction is through one of about 20 call and put options dealers with the help of a stockbroker. A more popular method of investing is through the organized options exchanges. The dominant exchange is the Chicago Board of Options Exchange (CBOE). Others include the AMEX, NYSE, and other, regional exchanges. One option is typically for 100 shares of stock.

59. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-59 Cindy Peters pays $250 for a 3-month call option on Wing Enterprises with a striking price of $50. This means she is entitle to purchase 100 shares of Wing at $50 per share at any time during the next 3 months. The stock must climb $2.50 per share to $52.50 to cover the cost of the option ignoring brokerage fees and dividends. If Wing were to rise to $60 per share, Cindy’s net profit would be $750 [(100 shares x $60/share) - (100 shares x $50/share) - $250]. Options: Options Trading Call options are typically purchase with the expectation that the market price of the underlying price will rise by more than enough to cover its cost resulting in a profit.

60. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-60 Don Kelley pays $325 for a 6-month option on Dante United at a striking price of $40. The stock must drop by $3.25 per share ($325 x 100 shares) to $36.75 per share to cover the cost of the option ignoring brokerage fees and dividends. If the stock price were to drop to $30 per share, Don’s profit would be $675 [(100 shares x $40/share) - (100 shares x $30/share) - $325]. Options: Options Trading (cont.) Put options are typically purchase with the expectation that the market price of the underlying price will fall by more than enough to cover its cost resulting in a profit.

61. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-61 Options: The Role of Calls and Puts in Fund Raising Although they are popular investment vehicles, call and put options play not direct role in the fund-raising activities of the financial manager. Since options are issued by investors and not by the firm, they are not a source of financing for companies. The presence of options trading in the firm’s stock could—by increasing trading activity— stabilize the firm’s stock in the marketplace, but financial managers have no control over whether this is the case.

62. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-62 Options: Hedging Foreign Currency Exposures with Options Options offer the key benefit of hedging, which involves offsetting or protecting against the risk of adverse price movements, while simultaneously preserving the possibility of profiting from favorable price movements. The disadvantage of using is their relatively high cost compared to more traditional futures and forward contracts.