REVIEW OF DERIVATIVES

USING DERIVATIVES TO MANAGE RISK

Using derivatives to manage of a producer-seller Consider a gold-mining firm called Golddiggers. Golddiggers will mine and sell 100,000 ounces of gold over the next year. Fixed cost: $330 per ounce Variable cost: $50 per ounce Total cost: $380 per ounce (The only way to avoid fixed costs is to shut
down the business).

Golddiggers has pricing risk when it sells and it would like to manage its price risk. The price of gold today is $405 per ounce Unhedged net income = S1 380

USING DERIVATIVES TO MANAGE RISK

However, Golddiggers can hedge. They can enter a forward contract for sale at $420 or buy a $420-strike put for $8.77 per ounce. The results are as expected: With no hedge there is a substantial risk from a price drop. With the forward hedge profit is constant. With the put hedge the cost of the put provides insurance for low prices and permits higher profits as the spot price increases.

USING DERIVATIVES TO MANAGE RISK

The most likely choice would probably be to use the $420strike put, although there are even more alternatives. If the $420-strike put is viewed as too expensive, a manager might want to use a cheaper $400-strike put to manage price risk. A manager who is very conservative might want to buy a more expensive $440-strike put to assure a higher profit at a lower price levels.

USING DERIVATIVES TO MANAGE RISK

Using derivatives to manage of a producer-buyer Now consider a manufacturer of gold widgets, Auric. Auric will sell a set number of widgets next year for a fixed price of $800. their fixed cost per widget is $340, and they have no variable costs other than the cost of gold they purchase. If Auric does not hedge, their net income is Unhedged net income = 800 340 S1 = 460 S1

Auric can also hedge, the main choices being a forward contract for purchase at a price of 420 in one year or the purchase of a 420-strike call with premium of 8.77.

USING DERIVATIVES TO MANAGE RISK

As before, there is no single best answer for Auric. Management will choose some strategy based on risk tolerance and personal estimates of what the spot price will be in a year.

USING DERIVATIVES TO MANAGE RISK

Four basic reasons to manage risk:
Hedging Speculation Regulatory arbitrage (including tax avoidance) Reduction of transaction costs

Reasons for Hedging:

Lower taxes Avoid bankruptcy and distress costs. If your company has a large loss, people may be afraid to buy from it since it might go bankrupt. Costly extrenal financing. If your company has a big loss, it looks riskier to banks and other lenders. If they lend to you they will charge a higher interest rate.

USING DERIVATIVES TO MANAGE RISK

Protect debt capacity. Debt capacity is the amount that a firm can borrow. If a loss puts your company in debt, you have used up part of that amount and can now borrow less. Managerial risk aversion Non-financial risk management

Reasons Not to Hedge

There are transaction costs (like commissions) The strategy is complex and might require the firm to hire expensive experts The execution of a hedge involves trading transactions that require substantial managerial control Accounting and tax become much more complicated when you hedge.

USING DERIVATIVES TO MANAGE RISK

Hedging with a Collar A collar is a modified version of a forward sale, so you might expect the result of hedging company profit with a collar to look a bit like the result of the forward hedge. Consider the results of Golddiggers with a collar consisting of a purchased $420-strike put and a sold $440-strike call.
Price 340 360 380 400 420 440 460 480 500 520 540 Sell Income -40 -20 0 20 40 60 80 100 120 140 160 Buy Put 70.79 50.79 30.79 10.79 -9.21 -9.21 -9.21 -9.21 -9.21 -9.21 -9.21 Sell Call Total Profit 2.61 33.40 2.61 33.40 2.61 33.40 2.61 33.40 2.61 33.40 2.61 53.40 -17.39 53.40 -37.39 53.40 -57.39 53.40 -77.39 53.40 -97.39 53.40

USING DERIVATIVES TO MANAGE RISK

Golddiggers could also create a zero cost collar. We have a zro cost collar with the purchased put at a 400.78 strike and the written call at a 440.78.
Price 340 360 380 400.78 420 440.78 460 480 500 520 540 Sell Income -40 -20 0 20.78 40 60.78 80 100 120 140 160 Buy Put 58.31 38.31 18.31 -2.47 -2.47 -2.47 -2.47 -2.47 -2.47 -2.47 -2.47 Sell Call Total Profit 2.47 20.78 2.47 20.78 2.47 20.78 2.47 20.78 2.47 40.00 2.47 60.78 -17.53 60.00 -37.53 60.00 -57.53 60.00 -77.53 60.00 -97.53 60.00

The zero cost collar offers lest protection at a lower price levels but more profit at a higher price levels

USING DERIVATIVES TO MANAGE RISK

The Paylater Strategy The zero cost collar hedge we saw before was inferior to a put hedge at high price levels, since the profit on a put hedge increases without limit as prices increase. However, Golddiggers has to pay the price of a put up front, while the zero cost collar requires no advance payment. Can you create something that works like a put at high price levels, but has zero initial costs? This can be done for Golddiggers by establishing a hedge consisiting of one sold 434.6 put and two purchased 420 strike puts. This has 0 cost, since the premium received for the sold put is 17.55 while the premium paid for each purchased out is 8.775

USING DERIVATIVES TO MANAGE RISK

You can see from the table that at prices of $434.6 and higher, the paylater hedge gives the full profit sale due to its zero cost. For the paylater hedge, nothing is paid to start but if there is a price below $420 the paylater hedge provides less protection. This loss of protection is Golddiggers payment for not paying in advance it is the paylater amount.
Price 340 360 380 400 420 434.6 460 480 500 520 540 Sell Income -40 -20 0 20 40 54.6 80 100 120 140 160 Sell Put Buy 2 puts Total Profit -77.05 142.45 25.40 -57.05 102.45 25.40 -37.05 62.45 25.40 -17.05 22.45 25.40 2.95 -17.55 25.40 17.55 -17.55 54.60 17.55 -17.55 80.00 17.55 -17.55 100.00 17.55 -17.55 120.00 17.55 -17.55 140.00 17.55 -17.55 160.00

FINANCIAL FORWARDS AND FUTURES

Notation
: the compounded dividend rate r : the continuously compounded rate

Four ways to buy a stock

Outright purchase. You have the price in cash and buy the stock for 0 in cash today. Fully leveraged purchased. You borrow the price in cash and buy the stock today. The loan will be repaid at time T, and you must pay 0 that time. Prepaid forward contract. You pay for the stock now at time 0 but receive it at a specified time T in the future. Forward contract. You receive the stock and pay for it at a specified time T in the future.

PRICING PREPAID FORWARD CONTRACTS

0, : the price of a prepaid forward for receipt at time T

This price depends on whether or not dividend are to be paid on the stock.
Pricing prepaid forward contracts for a stock with no dividends Pricing by analogy. Same position at time T as someone who buys the stock now for 0 and holds it until time T. Pay 0 now for the prepaid forward. Pricing by discounting present value. Interest rate r, expected stock appreciation . 0 = 0 0, = 0 = 0

PRICING PREPAID FORWARD CONTRACTS

Pricing by arbitrage. You have an arbitrage if you can make money with no risk by simultaneously buying and selling related assets.
a) The prepaid forward price is higher than the forward price. 0, > 0 . Buy the index for 0 and simultaneously sell a prepaid forward for 0, . b) The prepaid forward price is lower than the current price. 0, < 0 . Sell the index short for 0 and simultaneously buy a prepaid forward for 0, . Since it is not possible that 0, > 0 or 0, < 0 , the price must be 0, = 0 . Arguments such as the above are sometimes called no-arbitrage arguments. Such arguments justify a price by showing that any other price would lead to an arbitrage.

PRICING PREPAID FORWARD CONTRACTS

Princing prepaid forward contracts for a stock with dividends. In general, the price paid for a prepaid forward contract will be the stock price less the present value of the dividends to be paid over the life of the contract
Discrete dividends If n dividends 1 , 2 , , are paid over n periods at times 1 , 2 , , and the continuously compounded interest rate per period is r, the price of the prepaid forward for delivery at time T will be

0, = 0

=1

PRICING PREPAID FORWARD CONTRACTS

Continuous dividends Suppose that dividends are paid on a stock index at the continuous rate . The continuous dividend model assumes that all dividends are reinvested in the stock index. To have only one share at time T, you should buy shares now. If the current price of the index is 0 , you could be assured of having one share of the index by paying 0 . So, pricing by analogy: 0, = 0 The purchase of shares to assure 1 share at time T is called tailing your position.

FORWARD CONTRACS ON STOCK OR STOCK INDICES

Finding the forward price It is equal to the future value at the continuous rate r of the prepaid forward price which would be paid today. , =
No dividends Discrete dividends 0, = 0
=1

, = 0

Continuous dividends 0, = 0 = 0

FORWARD CONTRACS ON STOCK OR STOCK INDICES

Forward premium. Ratio of the forward price to the stock price. 0, = 0 Annualized Forward Premium =
If 0, = 0
1 ln 0, 0

, the annualized forward premium is: 1 ln 0, 0

=r

CREATING SYNTHETIC STOCKS, FORWARDS AND BONDS

Stock at time T = Long Forward + zero-coupon bond To have the stock at time T: buy a forward and a zero coupon bond for the amount of a tailed position. 1) At time 0, invest 0 in a bond with yield rate r and maturity at T. 2) At time 0, enter into a zero-cost forward for the forward price of 0, = 0 . 3) At time T, collect the bond proceeds of 0 = 0 . 4) At time T, use the bond proceeds to buy the stock for the forward price of 0

CREATING SYNTHETIC STOCKS, FORWARDS AND BONDS

Forward = Stock zero coupon bond To create the equivalent of a forward contract for time T: buy the stock and sell a zero-coupon bond for the amount of a tailed position. 1) Borrow 0 at time 0. 2) Use the borrowed amount 0 to buy a tailed position in the stock at zero cost. 3) At time T, you will have the stock worth 4) Repay the loan by paying 0 = 0, . This will leave with 0, , the payoff of a long forward contract,

CREATING SYNTHETIC STOCKS, FORWARDS AND BONDS

Zero-coupon bond = Stock forward To create a zero-coupon bond with maturity T: buy a tailed position in the stock and sell a forward contract.

1) Invest 0 to buy the tailed position in the stock at time 0. 2) Sell a forward obligating you to sell the stock at time T for 0, = 0 . 3) At time T, you will sell the stock for 0 = 0 . 4) Thus you have invested 0 at time 0 and been paid 0 at time T. this is zero-coupon bond paying the risk-free rate r.