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FIN 413RISK MANAGEMENT

Introduction

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Topics to be covered

Derivatives

Types of traders

The risk management process Leverage

Financial engineering

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Suggested questions from Hull

6thedition: #1.4, 1.7, 1.11, 1.18

5thedition: #1.4, 1.7, 1.11, 1.18

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Derivatives

A derivative is a financial instrument whose valuederives from the value of something else.

Question: Is a barrel of oil a derivative?

Consider an agreement/contract between A and B:

If the price of a oil in one year is greater than $50per barrel, A will pay B $10.

If the price of a oil in one year is less than $50, B will

pay A $10.

Question: Is this agreement a derivative?

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Derivatives

Why might A and B make such an agreement?

1. To hedge or reduce risk.

Suppose A is an oil producer and B is arefinery.

A will earn $10 if the price of oil goes down.

B will earn $10 if the price of oil goes up.

2. To speculate on the price of oil.

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Derivatives

Derivative

Derivative security

Derivative asset

Derivative instrument

Derivative product

Underlying(s)

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Derivatives

Example Underlying

Stock option, such as option onthe stock of Nortel Networks

A stock, such as the stock of NortelNetworks

Stock index option, such as anoption on the S&P 100 index A portfolio of stocks, such as theportfolio of stocks comprising theS&P 100 index

Treasury bill futures contract A Treasury bill

Foreign currency forward contract A foreign currency

Gold futures contract Gold

Futures option on gold A gold futures contract

Weather derivative Snowfall at a specified site

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Derivative markets

Have a long history.

Futures markets: date back to the MiddleAges.

Options markets: date back to 17thcenturyHolland.

Last 35 years: extraordinary growth

worldwide. Today: derivatives are used to manage riskexposures in interest rates, currencies,commodities, equity markets, the weather.

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Derivatives

Derivatives are contracts, agreementsbetween two parties: a buyer and a seller.

Buyer Seller

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Forward contract

A forward contract is an agreement betweentwo parties, a buyer and a seller, to exchangean asset at a later date for a price agreed toin advance, when the contract is first enteredinto.

We call this price the delivery price.

Trades in the OTC market.

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Futures contract

A futures contract is an agreement betweentwo parties, a buyer and a seller, to exchangean asset at a later date for a price agreed toin advance, when the contract is first enteredinto.

We call this price the futures price.

Trades on a futures exchange.

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Options

An option gives the buyer the right, but notthe obligation, to buy/sell the underlying at alater date for a price agreed to in advance,when the contract is first entered into.

We call this price the strike/exercise price.

The option buyer pays the seller a sum of

money called the option price or premium. Trades OTC or on an exchange.

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Types of options

Call option: an option to buy the underlyingat the strike price

Put option: an option to sell the underlying atthe strike price

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Pricing derivatives

All current methods of pricing derivativesutilize the notion of arbitrage.

Arbitrage: a trading strategy that has someprobability of making profits without any riskof loss.

Arbitrage pricing methods derive the prices of

derivatives from conditions that precludearbitrage opportunities.

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Uses of derivatives

Derivatives can be used by individuals,corporations, financial institutions, andgovernments to reduce a risk exposure or toincrease a risk exposure.

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Traders of derivatives

Hedgers

Speculators

Arbitrageurs

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RM processphase 1

Decompose corporate assets and liabilities into riskpools: interest rate, foreign exchange, crude oil.

Develop market scenarios and test the impact of

these on the values of the risk pools and on the valueof the company as a whole. This determines thecompanys value at risk.

Develop a target risk profile, which may or may not

include a complete elimination of risk.

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RM processphase 2

This is the implementation phase.

Many companies centralize their risk managementactivities.

This allows for coordination and avoids unnecessarytransactions.

Division 2

Exposed shortto

Japanese interest rates.

Has floating rate loan in

yen.

Division 1

Exposed longto

Japanese interest rates.

Has bank account in

yen.

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RM processphase 3

This is the evaluation phase.

Key questions to consider:

Has the firms risk profile changed? Is the current risk profile still appropriate?

What new economic and market scenariosshould be considered in the next iteration?

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Risk management

Derivatives allow firms to:

Separate out the financial risks that they face.

Remove or neutralize the risk exposures they do not want.

Retain or possibly increase the risk exposures they want.

Using derivatives, firms can transfer, for a price, anyundesirable risk to other parties who either have risks

that offset or want to assume that risk.

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Risk management

Risk management has gained prominence inthe last 35 years:

Increased market volatility. Deregulation of markets.

Globalization of business.

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USD-CAD exchange rate

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91-day Treasury bill rate

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Oil price

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Risk management

The proliferation of derivatives allows firmsto:

Efficiently manage a great variety of risks. To manage those risks in a variety of different

ways.

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Example

Consider a British fund manager with aportfolio of U.S. equities.

If he buys IBM shares, he is exposed to threerisks:

Prices in the U.S. equity market generally.

The price of IBM stock specifically.

The dollar/sterling exchange rate.

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Example

He is bearish about:

The dollars medium-termprospects.

The overall U.S. stockmarket.

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Example

To hedge the currency risk, he could selldollars under the terms of a forward contract.

To hedge the market risk, he could shortfutures contracts on the S&P 500 index.

He would be left with exposure to IBMsshare price only.

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Preferred derivatives

Type of Risk PreferredDerivative

Foreign exchangerisk Forward contracts

Interest rate risk Swaps

Commodity price

risk

Futures contracts

Stock market risk Options

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Leverage

Leverage is the ability tocontrol large dollar amountsof an underlying asset with acomparatively small amount

of capital. As a result, small price

changes can lead to largegains or losses.

Leverage makes derivatives:

Powerful and efficient

Potentially dangerous

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Leveraging with futures

A speculator believes interest rates are going to fall. To realize a gain, she might:

Buy bonds worth, say, $1 million. Buy Treasury bond futures for the purchase of $1 million of

Treasury bonds.

To buy the bonds, she needs $1 million.

To buy the Treasury bond futures, she needs initialmargin of about $15,000.

She gains the same exposure in both cases. That is,she stands to realize an equivalent gain/loss shouldinterest rates fall/rise.

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Leveraging with options

It is May.

The price of Nortel Networks stock is $28.30.

A December call option on Nortel stock with a $29strike price is selling for $2.80.

A speculator thinks the stock price will rise.

To make a profit, the speculator might:

Buy, say, 100 shares of Nortel stock for $2,830.

Buy 1,000 options (10 option contracts) for $2,800, (roughlythe same amount of money).

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Leveraging with options

Suppose the speculator is wrong. The stock pricefalls to $27 by December.

(($28.30 $27) 100

$130

Strategy Loss

Buy the stock

Buy options $2,800

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Barings Bank

British investment bank, founded in 1763.

1803: Negotiated the purchase of Louisiana by theU.S. from Napoleon.

Queen of England was a client.

1995: was wiped out when a trader (Nick Leeson)ran up losses of close to $1 billion trading derivatives.

Lesson: Monitor employees/traders closely.

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Long-Term Capital Management

A hedge fund that sought very high returns byundertaking investments that were often highly risky.

Bet: yield spreads would narrow

( )

( )

I G

D G

y y

y y

High yield

Lower quality

Low yield

Higher quality

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Long-Term Capital Management

August 1998: Russian government default

Flight to quality and spreads widened

Highly leveraged positions lead to large losses, about

$4 billion Bail out

Lessons:

Do not ignore liquidity risk.

Beware when everyone else is following the same tradingstrategy.

Carry out scenario analysis and stress tests.

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National Post, March 1, 2006

U.S. central bankers are again getting nervous aboutthe huge US$300-trillion global derivatives markets.

Until recently, derivatives held mainly by banks.

Hedge funds becoming major players. Trade in the OTC market.

Trades are largely unregulated.

Concerns:

Closing out positions when markets are under stress. Potential damage to banking system.

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Amaranth Advisors LLC

September 2006: The Connecticut-based hedgefund lost about $6.5 billion trading natural gasderivatives.

In 2005, the fund had made considerable money onnatural gas spread trades:

A cold winter in 2004.

An active hurricane season in 2005.

Political instability in oil-producing countries.

In 2006, a similar scenario did not materialize.

Fuelled concern about regulatory black hole.

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Bank of Montreal

May 2007: Reported losses of $680 million betting onthe natural gas market.

BMO reported:

Its commodity trading team did not operate according tostandard BMO business practices.

In the future in the (commodity) portfolio we will onlyengage in the amount of market-making activity required tosupport the hedging needs of our oil and gas producing

clients. the bank has revised its risk management procedures.

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Financial engineering

Weather derivatives

Steel futures

Canadian crude futures

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Weather derivatives

Introduced in 1997.

Hull, chapter 22

Chicago Mercantile Exchange began tradingweather futures and options in 1999.

www.cme.com

http://www.cme.com/http://www.cme.com/

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Steel futures

National Post, October 30, 2002: London MetalExchange (LME) assessing interest in steelfutures contract:

Boasting a global market of more than 800 million tons annually steelmight seem a natural fit for a futures contract of its own.

Gold and copper each have one. So does nickel. In fact, commoditytraders broker billions worth of contracts for everything from porkbellies and orange juice to lumber and palladiumthat curious metal

found in your vehicles exhaust system.But lonely steel never joined the exchange-traded commodities club, even

though the idea has been tossed about for years.

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Steel futures

Issues:

1. Many types of steelpresents difficulties in

defining the underlying asset.2. Fewer supply shocks as compared to gold

and oil. Hence the price of steel is morestable. Implies less demand from hedgers

and lower speculative profits to be earnedfrom trading the contract.

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Steel futures

Update, spring 2007:

LME continues to assess interest in the contract.

Since the LME last considered steel futures in 2003, the steel

industry has gone through a number of changes which havefurther highlighted the need for reliable price risk managementsolutions.

The industry has undergone radical restructuring; it has becomemore global, more efficient and more financially viable. Eventshave resulted in high prices, supply disruptions and increasedvolatility, all elements which the existence of futures contractscan help the industry to manage.

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Canadian crude futures

In late 2004, four Canadian producersEnCana,Petro-Canada, Canadian Natural Resources Ltd., andTalisman Energy Inc.created a heavy oil blendcalled Western Canadian Select.

They entered into negotiation with NYMEX for aheavy crude futures contract.

Crude production from Albertas oil sands is expectedto triple to 3 million barrels a day by 2015.

June 2007: Calgary-based NetThruPut Inc.announced that, in July, it would offer basis swapcontractsfor: Canadian light, sweet synthetic crude.

Western Canadian Select.

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