Δευτέρα 21 Απριλίου 2014

RISK MANAGEMENT: PART III of III




In this last section we will look at hedging with options contracts. In the last two sections of risk management we discussed forwards, futures and swaps. All are similar in that two parties agree to make a transaction on a future date and are obligated to complete the transaction. An option contract on the other hand, is an agreement that gives the owner the right but not the obligation to buy or sell, depending on the option type, an underlying asset at a specified future date.

There are two types of options, calls and puts. The owner of the call option has the right but not the obligation to buy an underlying asset at a fixed price, called the strike or exercise price. The owner of the put option has the right, but not the obligation, to sell an underlying asset at a fixed price. The act of buying or selling an underlying asset is known as exercising the option.
There are American options and European options, and they only refer to when exercising the option takes place. For example, in the American options, they can be exercised any time up to the expiration date. In the European options, they can only be exercised on the expiration date, not before.

So the buyer of the call option has the right to buy the underlying asset, like a stock, by paying the strike price. The seller of the call is obligated to deliver the asset and accepts the strike price from the buyer, if the buyer chooses to exercise the right. By the same token, a buyer of a put option has the right to sell the underlying asset and receive the strike price. The seller of the put must accept the underlying security and pays the strike price.
In forward contracts both parties are obligated to make the transaction, one delivers the asset the other pays. With options, the transaction occurs only if the owner chooses to exercise it. With forward contracts no money changes hands, with options; the buyer of a contract gains a valuable right and pays the seller an option premium.


Above we see the payoff profile for a call option from the point of view of the owner. The horizontal axis shows the difference between the asset’s value and the strike price on the option. If the price of the underlying rises above the strike price, the owner will exercise the option. The stock price is > the strike price then essentially the buyer buys an asset for $100 that is actually worth >$100.
The following graph shows the payoff profile for on a call option from a seller’s point of view. Call options are a zero sum game, in that , the seller’s payoff profile is the opposite of the buyer’s.


Suppose a company has a risk profile that looks like the graph below. If the company wishes to hedge against adverse stock price movements then it can buy a put option as shown in the following graph. By buying a put option the company has eliminated the downside risk in adverse price movements.

In the previous part we discussed that there are futures contracts on commodities.  There are options contracts on these commodities, like futures options. When such a contract is initiated, on say wheat, the owner receives the current futures price. The second thing is the difference between strike price of the option and the current futures price. The table provided from the Wall Street Journal depicts futures options for the S&P 500 stock index, and the Eurodollar options. Notice that the first column is the strike price. The next three columns are call option prices for three different months of expiration.


In conclusion we can say that the motivation for risk management stems from the fact that firms will frequently come across to undesirable risk. Because there is volatility today in many financial variables, such as interest rates, exchange rates, and commodity prices, the firm has tools available to reduce this risk.
























Σάββατο 12 Απριλίου 2014

RISK MANAGEMENT: PART II



In our second part we will be talking about managing financial risk and how volatility in recent years has increased the necessity of managing this risk, especially for companies that have exposure due to the nature their operations.
To measure a firm’s exposure to financial risk it would be helpful to depict it graphically, and this is done by the risk profile.  First, in its basic format, the risk – return comparison is a graph that in the vertical axis you have return, and in the horizontal, risk, or standard deviation. We observe the different risks, and for holding only cash, our risk is small compared to the return, whereas, up to the right, stocks have a higher risk, and a higher return.


To measure a firm’s exposure to risk is the risk profile. In the accompanying graph, we see a steep in slope, and a plot showing the relationship between changes in price for some good, and changes in the value of the firm. Wheat is a very common example because wheat prices can be volatile at times. Thus it is a good depiction of the company’s exposure to wheat price fluctuations. From the slope of the line, and due to the fact that it is steep, a company can benefit from increase in wheat prices. But on the other hand, if wheat prices fluctuate the company may want to protect itself, because a decrease in prices, will have an adverse effect on the value of the firm.


If we have two different companies say one wheat producer, and the other a wheat processor, then price volatility will have opposite effects for the two companies. The two can come together engage in a contract so one can lock in a low price to deliver, and the other lock in a set price to pay; hence both are protected from price fluctuations. Thus both have hedged against future risk, but there will not always be a total elimination of risk.  For example if a company is a wheat grower, knowing exactly the quantity before the crop season is impossible, so some portion may be not hedged.
Unforeseen events like temporary changes in prices in the short run are also reasons to hedge. Sudden increases in oil prices are one such example to due to political risk. Such short term shocks are known as transitory changes. In the short run, such sudden changes in prices can cause a company to have a short run financial distress, even though in the long run it may be healthy. 

This sudden increase in prices cannot be absorbed by the company because it cannot pass it on the customers. So in a case where a company is faced with a negative cash flow, it has to find ways to hedge so that it will not come against being unable to meet its short term obligations.
Consider the case where a company is not totally free of debt, and has a bond due soon. What if interest rates are not known with certainty at a time the bonds is due payable. This is a typical transaction exposure firms face in the short run.
Price fluctuations also occur in the long run especially due to macroeconomic conditions. This is economic exposure so hedging is very hard to predict. In the case of wheat, it is impossible to predict what the long term future price of wheat will be.
This gave rise to forward contracts which is a binding agreement between two parties calling for the sale of an asset in the future, at a price agreed upon today. One party delivers the goods, the other party accepts, on a certain date called the settlement date.
The buyer of the forward contract has the obligation to take delivery and pay, the seller has the obligation to make delivery and accept payment. The buyer benefits from the forward contract if prices increase, because he has already locked in a lower price. The seller also benefits if prices fall because a higher selling price has been locked in the contract. One party can win at the expense of the other, so that is why is called a zero sum game.

If we look at the payoff profile which is essential in understanding forward contracts, it shows the gains and losses on the contract that could result from price swings. Since oil, besides wheat, is also a product traded, the buyer of the forward contract is obligated to accept delivery at a future date at a set price. The graph on the left shows the long position, where K is the strike price, but I do not want to go into further detail. For now, at prices above K, we see profits. As oil prices rise, the buyer of the forward contract benefits because he has locked in a lower price to pay, than the market. If oil prices fall, the buyer loses because he ends up paying more.

 Looking at the payoff profile on the right, for the seller, things are reversed. This can also be applied to a utility company that uses oil to generate power. If the utility buts a forward contract (long) then its exposure to unexpected oil price changes will be eliminated. The graph shows that for the utility company, the net effect is zero because if oil prices rise, the benefits from lower oil prices (solid line) will offset the losses on the forward contract (broken line).


In the forward contract there is no money changing hands at the initiation. The contract is an agreement to transact in the future so there is no upfront cost. There is a credit risk though when the settlement date approaches. The party that has lost has an incentive to default on the agreement.
To diminish this risk, Futures contracts came into existence.  They are exactly the same as a Forward contract, except that in the forwards, gains and losses are realized at expiration. With Futures, they are daily settled so the next day the broker puts up new margin for the investor, if the investor wishes, and has the money, otherwise the broker closes the account. The broker bears absolutely no risk.  This daily settlement is called marking to market. The risk is greatly reduces compared to forwards.
With Futures contracts there are two types that are traded: commodity futures and financial futures. With financial, the underlying goods are financial assets like bonds, stocks, currencies. With commodities, the underlying goods are crude oil, heating oil agricultural products, copper. Upon research looking into types of future contracts, I came across the Intercontinental Exchange, which is part of the NYSE EURONEXT.
If one follows the path Markets,  ICE ENDEX, futures markets, there are futures contracts for “Established in 2013 in conjunction with N.V. Nederlandse Gasunie, a leading European gas infrastructure company, ICE Endex provides transparent and widely accessible markets for trading natural gas and power derivatives, gas balancing markets and gas storage services in Europe and is based in Amsterdam.” There are Futures contracts available for “Belgian Power Baseload futures” and the description says “Contracts are for physical delivery of power to and from the high voltage grid of Belgium. Delivery is made equally each hour throughout the delivery period from 00:00 (CET) on the first day of the month until 24:00 (CET) on the last day of the month.”
In the Chicago Mercantile Exchange, there are futures contracts for metals, interest rates, currency futures, energy futures. An interesting table was found with contracts traded in the CME. If one notices the Open Interest column, it is the number of contracts open until expiration.
 

























Globex Open OutCry Clear Port Volume Open Interest
EXCHANGE




EXCHANGE 12,575,554 1,245,806 928,270 14,749,630 91,313,374
EXCHANGE FUTURES 10,978,211 102,308 360,195 11,440,714 47,926,680
EXCHANGE OPTIONS 1,597,343 1,143,498 567,927 3,308,768 43,362,083
OTC CLEARED ONLY 0 0 148 148 24,611






FUTURE, OPTIONS, & FORWARDS



Agriculture 979,065 113,320 26,600 1,118,985 7,953,089
Energy 1,355,323 22,698 245,358 1,623,379 28,776,602
Equities 4,252,199 83,107 4,354 4,339,660 7,539,218
FX 516,667 2,442 5,018 524,127 1,686,177
Interest Rate 5,205,836 1,009,562 627,246 6,842,644 42,662,863
Metals 266,464 14,677 19,694 300,835 2,676,641
Real Estate 0 0 0 0 94
Weather 0 0 0 0 18,675






FUTURES




Agriculture 898,506 36,900 25,316 960,722 4,106,779
Energy 1,273,090 1,632 142,918 1,417,640 19,876,214
Equities 3,411,215 5,258 4,354 3,420,827 3,722,220
FX 485,778 209 5,018 491,005 1,232,116
Interest Rate 4,655,215 52,480 172,046 4,879,741 18,147,596
Metals 254,407 5,829 10,543 270,779 839,796
Real Estate 0 0 0 0 94
Weather 0 0 0 0 1,850






OPTIONS




Agriculture 80,559 76,420 1,174 158,153 3,822,656
Energy 82,233 21,066 102,402 205,701 8,899,431
Equities 840,984 77,849 0 918,833 3,816,998
FX 30,889 2,233 0 33,122 454,061
Interest Rate 550,621 957,082 455,200 1,962,903 24,515,267
Metals 12,057 8,848 9,151 30,056 1,836,845
Real Estate 0 0 0 0 0
Weather 0 0 0 0 16,825






FORWARD SWAPS



Agriculture 0 0 110 110 23,654
Energy 0 0 38 38 957
Equities 0 0 0 0 0
FX 0 0 0 0 0
Interest Rate 0 0 0 0 0
Metals 0 0 0 0 0






OPTIONS FORWARD SWAPS



Agriculture 0 0 0 0 0
Energy 0 0 0 0 0
Equities 0 0 0 0 0
FX 0 0 0 0 0
Interest Rate 0 0 0 0 0
Metals 0 0 0 0 0






DIVISION




CBOT DIVISION 3,852,274 367,138 244,083 4,463,495 18,533,613
CME  DIVISION 63,329 9,127 0 72,456 754,586
COMEX  DIVISION 252,704 14,632 16,937 284,273 2,495,931
GEM  DIVISION 35,354 267 213 35,834 191,963
IMM  DIVISION 2,762,502 38,880 49,265 2,850,647 11,942,032
IOM  DIVISION 4,240,910 793,019 369,695 5,403,624 28,445,299
KCBT DIVISION 0 0 0 0 0
NYMEX  DIVISION 1,368,481 22,743 248,077 1,639,301 28,949,950








Sometimes due to the large amounts of futures contracts available companies do not find the right contract suited for them, so they have to settle for something close the contract desired. For example oil, there are so many different grades. Using a related contract is known as cross hedging. The company does not want to buy or sell  the underlying by cross – hedging. It means that if it sells a contract to hedge, it will buy the same at a later date. There are also issues with maturities. A company may want to hedge for a long period and there are only short maturity contracts available. In this case it will have to roll over short term contracts but there is inherent risk.
An example is the German firm Metallgesellschaft, which went bankrupt in 1993 after losing $1 billion in the oil markets through derivatives. A US subsidiary company, called MG Corporation, began marketing gasoline, heating oil, and diesel. It entered into contracts to supply products for fixed prices for 10 years. If prices rose the company would lose money. The mistake made by MG was that it entered into short term contracts. If prices rose the derivatives gained in value. Not so, since oil prices fell in the short run, and MG incurred huge losses.  It was hedging long term contracts with short term.
There are also SWAPS in interest rates and currencies. Currency Swap is where two companies wish to hedge and exchange specific amount of currency of another in order to obtain debt financing. Interest rate Swaps is where two companies wish to exchange interest rates. One has a fixed rate and wishes to exchange for a floating. Commercial banks usually are in the Swap market to protect  from a rising interest rates.





















Κυριακή 6 Απριλίου 2014

RISK MANAGEMENT: PART I



Prices of goods and services now days and in the past have become volatile. One needs to look back at the oil crisis and its implications on GDP in many economies of the world to understand that sudden or unexpected shifts in operating activities resulting from economic shocks will disrupt operating activities of firms.

In this article I will try to bring out the idea of financial risk management which is very interesting, goes back many years back, and is part of modern finance. If a company contemplates on reducing risk exposure or protect itself from price fluctuations is called hedging. Risk management in corporations involves buying and selling derivative securities. A derivative security is a financial asset that represents a claim to another financial asset. For example, a stock option gives one the right to buy or sell a stock, therefore, a stock option is a derivative security

Price volatility has a historical perspective and it is useful to look back and see volatility in oil prices, for example, as I did here for crude oil prices dating back to 1861 to 2009. One observes the peaks, especially after 1920. In 1929 during the US depression, GDP dropped 30% and unemployment skyrocketed to 25%.

 If we look  the decades of the 70’s we see another peak and it was during 1972 that President Richard Nixon imposed a price and wage control  to control inflation. He lifted the ban a year later only to see the prices go up again. This was an example of a cost push inflation, where an immediate jump in raw material prices drove up production costs, and shift the supply curve inward to the left. We see that Aggregate supply shifts from AS to AS2, prices increase and output drops.



Among the various volatility firms face are interest rate risk, exchange rate risk, and commodity prices. As far as interest rate risk, debt is an important source of financing for corporations and an important component of the firm’s cost of capital. In the graph I found from Google, we see the federal reserve interest rates from 1950 to 2010, versus the home price index.

 An interest point here is the home price index between 2005 and 2010, how it has jumped particularly close to the home mortgage crisis in the US.  We see the various peaks in the FED interest rates how they vary , so these peaks are what firms are encountering. If the FED raises its overnight lending cost to member banks, then it would shrink the supply of credit, and banks in turn, would raise interest rates or reduce lending to companies. My point here is that this volatility has limited the confidence of prediction of a stable interest rate environment for companies.
Companies are in international operations and in the business of imports and exports. Exchange rate volatility have become increasingly important. An interesting story here that explains this increased volatility is the breakdown of the Breton Woods accord, where the exchange rates were partially fixed. Partially fixed exchange rates were allowed to adjust to reflect changes in the currency values. This was known as adjusting the peg. In 1971 the Nixon administration abandoned the dollar standard and Breton Woods, which meant that the dollar would no longer be redeemable for gold. Under the Breton Woods, exchange rates were stable for the most part, so importers and exporters could predict with certainty what these rates would be in the future. Today, exchange rates are determined by market forces, and thus, unpredictable.

As far as commodity prices as we mentioned above, oil is one of the most important and responsible for many economic recessions. Hence volatility has increased. This nice graph shows a historical diagram with oil and its impact on inflation.

 Besides these risks we have financial risks, with the two most recent ones in the USA, the Savings and Loans, where the US government came to rescue of these thrift institutions so that it can preserve the confidence in the US banking system. Before interest rates became volatile, these banks profited from the spread. That is, short term interest rates were lower than long term. So they borrowed short and lend long. The second was due to the mortgage loans, where banks essentially loaned low - income people to purchase a home, but they were not capable of paying off the mortgage.

In the upcoming second part we will discuss how to manage financial risk.