? 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,