Money banking and the financial system 1e by hubbard and OBrien chapter 07

R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER Derivatives and Derivative Markets LEARNING OBJECTIVES After studying this chapter, you should be able to: 7.1 Explain what derivatives are and distinguish between using them to hedge and using them to speculate 7.2 Define forward contracts 7.3 Discuss how futures contracts can be used to hedge and to speculate 7.4 Distinguish between call options and put options and explain how they are used 7.5 Define swaps and explain how they can be used to reduce risk © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER Derivatives and Derivative Markets HOW DANGEROUS ARE FINANCIAL DERIVATIVES? •In 2002, Berkshire Hathaway CEO Warren Buffet called financial derivatives “time bombs, both for the parties that deal in them and for the economic system….derivatives are financial weapons of mass destruction.” •All derivatives derive their value from an underlying asset These assets may be commodities, such as wheat or oil, or financial assets, such as stocks or bonds •Despite Buffett’s denunciations, derivatives play a useful role in the financial system •An Inside Look at Policy on page 214 discusses how legislation in 2010 made significant changes to the market for financial derivatives © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: During the 2007–2009 financial crisis, some investors, economists, and policymakers argued that financial derivatives had contributed to the severity of the crisis Question: Are financial derivatives “weapons of financial mass destruction”? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Learning Objective Explain what derivatives are and distinguish between using them to hedge and using them to speculate 7.1 © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Derivative An asset, such as a futures contract or an option contract, that derives its economic value from an underlying asset, such as a stock or a bond Hedge To take action to reduce risk by, for example, purchasing a derivative contract that will increase in value when another asset in an investor’s portfolio decreases in value • Derivatives can serve as a type of insurance against price changes in underlying assets Insurance plays an important role in the economic system: If insurance is available on an economic activity, more of that activity will occur • Derivatives can also be used to speculate Speculate To place financial bets, as in buying futures or option contracts, in an attempt to profit from movements in asset prices Derivatives, Hedging, and Speculating © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 • Some investors and policymakers believe that “speculation” and “speculators” provide no benefit to financial markets, but they provide two useful functions: When a hedger sells a derivative to a speculator, they transfer risk to the speculator Speculators provide essential liquidity Without speculators, there would not be a sufficient number of buyers and sellers for the market to operate efficiently Derivatives, Hedging, and Speculating © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Learning Objective Define forward contracts 7.2 © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Forward contract An agreement to buy or sell an asset at an agreed upon price at a future time • Forward contracts give firms and investors an opportunity to hedge the risk on transactions that depend on future prices • Generally, forward contracts involve an agreement in the present to exchange a given amount of a commodity, such as oil, gold, or wheat, or a financial asset, such as Treasury bills, at a particular date in the future for a set price Forward Contracts © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Spot price The price at which a commodity or financial asset can be sold at the current date Settlement date The date on which the delivery of a commodity or financial asset specified in a forward contract must take place • Because forward contracts are specific in terms, they tend to be illiquid They are also subject to default risk Counterparty risk The risk that the counterparty—the person or firm on the other side of the transaction—will default Forward Contracts © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 50 Solved Problem 7.4 Solving the Problem Step Review the chapter material Step Answer part (a) by explaining why the put options are selling for higher prices than the call options Notice that the strike price of $105.00 is greater than the stock price of $93.60 So, the put options are all in the money—buy at $93.60 and sell to the put seller at $105.00 The calls are all out of the money because you could buy a share in the market for $93.60 Therefore, the calls have zero intrinsic value Step Answer part (b) by explaining why the April call sells for a higher price than the January call The price of an option represents the option’s intrinsic value plus its time value The further away the expiration date, the greater the chance that the intrinsic value of the option will increase, and the higher the price of the option Therefore, because the two call options have the same strike price, the April call will have a higher price than the January call Options © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 50 Solved Problem 7.4 Solving the Problem Step Answer part (c) by explaining whether you would exercise the April put immediately The price of the put is $17.30, so you would not buy the put to exercise it immediately You would buy the put only if you expected that before the expiration date of the put, the price of Amazon would fall sufficiently that the intrinsic value of the put would be greater than $17.30 Step Answer part (d) by calculating your profit or loss from buying the November call and exercising it when the price of Amazon stock is $122 If you exercise the November call, which has a strike price of $105.00, when the price of Amazon stock is $122, you will earn $17.00 minus the option price of $1.73, for a profit of $15.27 Step Answer part (e) by calculating your profit or loss from buying the April call if the price of Amazon remains at $93.60 If the price of Amazon fails to rise and remains at $93.60, the April call will remain out of the money Therefore, you will not exercise it, instead taking a loss equal to the option’s price of $6.70 Options © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 50 Using Options to Manage Risk • Firms, banks, and individual investors can use options, as well as futures, to hedge the risk from fluctuations in commodity or stock prices, interest rates, and foreign currency exchange rates • Options are more expensive than futures, but have the important advantage that an investor who buys options will not suffer a loss if prices move in the opposite direction to that being hedged against • A firm or an investor has to trade off the generally higher cost of using options against the extra insurance benefit that options provide • As an options buyer, you assume less risk than with a futures contract because the maximum loss you can incur is the option premium • The options seller does not have a limit on his or her losses The seller of a put option is still obligated to buy at the strike price, even if it is far above the current market price • Many hedgers buy options, not on the underlying asset, but on a futures contract derived from that asset Options © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 50 Making the Connection Vexed by the VIX! • One way to measure the degree of volatility that investors can expect in the future is by using the prices of options and isolating the part of the prices that represents the investors’ forecast of volatility • The Chicago Board Options Exchange (CBOE) constructed the Market Volatility Index, called the VIX, using the prices of put and call options on the S&P 500 index • When investors expect volatility in stock prices to increase, they increase their demand for options, thereby driving up their prices and increasing the value of the VIX, also known as the “fear gauge.” • During the financial crisis of 2007-2009, the VIX reached record levels following the collapse of Lehman Brothers investment bank • An investor who wanted to hedge against an increase in volatility in the market would buy VIX futures Similarly, a speculator who wanted to bet on an increase in market volatility would buy VIX futures A speculator who wanted to bet on a decrease in market volatility would sell VIX futures Options © 2012 Pearson Education, Inc Publishing as Prentice Hall 39 of 50 Making the Connection Vexed by the VIX! The VIX index provides a handy tool for gauging how much volatility investors are anticipating in the market and for hedging against that volatility Options © 2012 Pearson Education, Inc Publishing as Prentice Hall 40 of 50 Learning Objective Define swaps and explain how they can be used to reduce risk 7.5 © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 50 Swap An agreement between two or more counterparties to exchange sets of cash flows over some future period Unlike futures and options, the terms of swaps are flexible Interest-Rate Swaps Interest-rate swap A contract under which counterparties agree to swap interest payments over a specified period on a fixed dollar amount, called the notional principal • With swaps, the interest rate is often based on the rate at which international banks lend to each other This rate is known as LIBOR, which stands for London Interbank Offered Rate • Why might firms and financial institutions participate in interest-rate swaps? One motivation is transferring interest-rate risk to parties that are more willing to bear it Swaps © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 50 Interest-Rate Swaps Figure 7.2 Payments in a Swap Transaction Wells Fargo bank and IBM agree on a swap lasting five years and based on a notional principal of $10 million IBM agrees to pay Wells Fargo an interest rate of 6% per year for five years on the $10 million In return, Wells Fargo agrees to pay IBM a floating interest rate In this example, IBM owes Wells Fargo $600,000 ($10,000,000 × 0.06), and Wells Fargo owes IBM $700,000 ($10,000,000 × (0.03 + 0.04)) Netting the two payments, Wells Fargo pays $100,000 to IBM Generally, parties exchange only the net payment. Swaps â 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 50 Currency Swaps and Credit Swaps Currency swap A contract in which counterparties agree to exchange principal amounts denominated in different currencies • A basic currency swap has three steps: The two parties exchange the principal amount in the two currencies The parties exchange periodic interest payments over the life of the agreement • The parties exchange the principal amount again at the conclusion of the swap • Why might firms and financial institutions participate in currency swaps? One reason is that firms may have a comparative advantage in borrowing in their domestic currency With a swap, both parties may be able to borrow more cheaply than if they had borrowed directly in the currency they needed Swaps © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 50 Currency Swaps and Credit Swaps Credit swap A contract in which interest-rate payments are exchanged, with the intention of reducing default risk • For example, if two banks have difficulty diversifying their portfolios, they can reduce their risk by swapping payment streams on some of their loans Swaps © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 50 Credit Default Swaps Credit default swap A derivative that requires the seller to make payments to the buyer if the price of the underlying security declines in value; in effect, a type of insurance • During the financial crisis of 2007–2009, they were most widely used in conjunction with mortgage-backed securities and collateralized debt obligations (CDOs), which are similar to mortgage-backed securities • The issuer of a credit default swap on a mortgage-backed security receives payments from the buyer in exchange for promising to make payments to the buyer if the security goes into default • The heavy losses that American International Group (AIG) and other firms and investors suffered on credit default swaps deepened the financial crisis and led policymakers to consider imposing regulations on these derivatives Swaps © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 50 Making the Connection Are Derivatives “Financial Weapons of Mass Destruction”? • Derivatives can play an important role in the financial system, but Warren Buffett points to three problems, particularly with derivatives that are not traded in exchanges: These derivatives are thinly traded In addition, dealers use prices predicted by models that may be inaccurate Many of these derivatives are not regulated and firms may not set aside sufficient reserves to offset potential losses The fact that these derivatives are not traded in exchanges means that they involve substantial counterparty risk Swaps © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 50 Answering the Key Question At the beginning of this chapter, we asked the question: “Are financial derivatives ‘weapons of financial mass destruction’?” We have seen that futures and exchange-traded options play an important role in the financial system and provide the important service of risk sharing Warren Buffett has argued that some derivatives that are not exchange traded contributed significantly to the financial crisis While not all derivatives are weapons of financial mass destruction, policymakers have enacted new regulations that are intended to ensure that use of some derivatives does not destabilize the financial system © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 50 AN INSIDE LOOK AT POLICY Traders Uncertain about Impact of New Derivatives Rules WALL STREET JOURNAL, Focus Intensifies on Adverse Impact of Derivatives Overhaul Key Points in the Article • In July 2010, the derivatives market came under new financial regulations passed by Congress • Nonfinancial firms could still end up paying more as banks try to pass on the higher costs they will incur • The bill did not define important terms, such as “major swap participant,” and did not specify which trades would be eligible for central clearing The deliberations continue • The Securities and Exchange Commission and the Commodities Futures Trading Commission, who were charged with monitoring derivatives markets, began preparing to address dozens of topic areas for rulemaking © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 50 AN INSIDE LOOK AT POLICY • There were over $614 trillion worth of over-the-counter derivatives trades outstanding in 43 countries in December 2009 This total refers to the nominal, or principal, value of deals concluded and not yet settled © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 50 ... Key Issue and Question Issue: During the 2 007 2009 financial crisis, some investors, economists, and policymakers argued that financial derivatives had contributed to the severity of the crisis... specific in terms, they tend to be illiquid They are also subject to default risk Counterparty risk The risk that the counterparty the person or firm on the other side of the transaction—will... contract, the right and obligation of the seller to sell or deliver the underlying asset on the specified future date Long position In a futures contract, the right and obligation of the buyer