Trading, Hedging & Risk Management

1. Trading, Hedging & Risk Management Trading, Hedging & Risk Management 1

2. Bird’s Eye View • Trading Terminology • Financial Risk & Control • Financial Instruments - Forwards, Futures, Swaps, Option Call/Put • Black Scholes Option Pricing, The Greeks • Mark to Market & FASB 133 • Matrix Pricing • Regression Model Trading, Hedging & Risk Management 2

3. Trading Terminology • Front Office • Trading & Marketing • Middle Office • Position & market analysis • Risk measurement • Credit risk management • Back Office • Accounting & reporting • Legal & contract administration • Budgeting, tax & internal auditing Trading, Hedging & Risk Management 3

4. Financial Risk & Control Categories of Financial Risk • Systemic Risk / Catastrophic event • Operational Risk • Market/Systematic Risk • Liquidity Risk • Legal, Compliance, Contract & Regulation • Credit Risk and more Trading, Hedging & Risk Management 4

5. Financial Instruments Financial instrument are contracts between two parties with opposite views on the market, who are willing to exchange certain risks. Risk mitigation instruments: • Linear Instruments • Forward Contract – Physical • Futures Contract – NYMEX • Swap Financial • Non-Linear Instruments • Options Call/Put Trading, Hedging & Risk Management 5

6. Forwards A private agreement between buyer and seller for the future delivery of a commodity at an agreed price. OTC Mostly Physical Delivery Linear Hedging Futures A standardized, exchange-traded contract to make or take delivery of a commodity at an agreed upon place and point in the future. Futures contracts are transferablebetween parties. Exchange Traded Linear Hedging Swaps An agreement by two parties to exchange, or swap, specified cash flows at specified intervals in the future. A swap where exchanged cash flows are dependent on the price of an underlying commodity, interest rate, currency and equity. This is usually used to hedge against the price of a commodity. OTC Financially Settled Linear Hedging Trading, Hedging & Risk Management 6

7. Commodity Swap Swap is an agreement between two parties, called Counterparties, who exchange future cash flows over a period of time • Interest Rate Swaps • Commodity Swap • Currency Swaps and more A commodity producer wishes to fix his income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity. Trading, Hedging & Risk Management 7

8. Call Option An option that gives the buyer the right, but not the obligation, to purchase the underlying security at the strike price on or before the expiration date People buy calls because they expect the underlying stock to go up. If the stock does go up they make a profit either by selling the calls at a higher price, or by exercising their option Trading, Hedging & Risk Management 8

9. Put Option A contract giving the buyer the right, but not the obligation, to sell the underlying asset at a pre-specified price on or before the expiration date If you own stock and you buy put options tied to that stock to protect yourself from a fall in the stock price, you are buying protective puts, which is a different strategy than buying puts without owning the underlying asset Trading, Hedging & Risk Management 9

10. Black Scholes Option Pricing Model The Black-Scholes model is used to calculate a theoretical option price - OP (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. Where: The variables are: S = stock price X = strike price t = time remaining until expiration, expressed as a percent of a year r = current continuously compounded risk-free interest rate v = annual volatility of stock price (the standard deviation of the short-term returns over one year). ln = natural logarithm N(x) = standard normal cumulative distribution function e = the exponential function Trading, Hedging & Risk Management 10

11. Volatility • Volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. • The volatility that produces the "best fit" for all underlying option prices on that underlying stock. Implied volatility is derived by taking actual market prices of options and working backwards in a theoretical option-pricing model to find the assumed volatility. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets. Trading, Hedging & Risk Management 11

12. The Greeks In mathematical finance, the Greeks are the quantities representing the sensitivities of derivatives such as options to a change in underlying parameters on which the value of an instrument or portfolio of financial instruments is dependent. The name is used because the sensitivities are often denoted by Greek letters. Delta is the first derivative of the value, V, of a portfolio of derivative securities on a single underlying instrument, S, with respect to the underlying instrument's price. Since delta measures sensitivity to a small change in the price of the underlying, it may be used to construct an instantaneously riskless portfolio consisting only of cash, a position in the underlying instrument and an offsetting position in any derivative securities on it. Gamma measures the rate of change in the delta. The Γ is the second derivative of the value function with respect to the underlying price. Gamma is important because it corrects for the convexity of delta. Vega, which is not a Greek letter, measures sensitivity to volatility. The vega is the derivative of the option value with respect to the volatility of the underlying. Theta, or "time decay," measures sensitivity to the passage of time (see Option time value). The value of an option is made up of two parts: the intrinsic value (finance) and the extrinsic value (time). The intrinsic value is the amount of money you would gain if you exercised the option immediately. The time value is the worth of having the option of waiting longer when deciding to exercise. Even a deeply out of the money put will be worth something as there is some chance the stock price will fall below the strike. Rho measures sensitivity to the applicable interest rate. The ρ is the derivative of the option value with respect to the risk free rate                    . Trading, Hedging & Risk Management 12

13. Mark to Market (MtM) • Mark-to-market is an accounting methodology of assigning a value to a position held in a financial instrument based on the current market price for the instrument or similar instruments • For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would currently fetch in the open market Trading, Hedging & Risk Management 13

14. FASB 133Financial Accounting Standards Board, Standards Number 133 • Requires all derivatives marked to market and listed on the balance sheet as assets or liabilities, unless they meet criteria for hedge accounting. • Measure degree of hedge effectiveness. Divide the cumulative price (cash flow) change for the hedging instrument by the cumulative price (cash flow) change of the hedged item that is attributable to the risk that is being hedged ∑ ∆derivative value / ∑ ∆hedge item value • To qualify to high effectiveness above calculation must be at minimum between 80% to 125%, If not FASB 133 requires termination of hedge accounting Trading, Hedging & Risk Management 14

15. Hedge Effectiveness Correlation ~ -1 Correlation ~ +1 The hedged item and hedging instrument which belongs to a perfect hedge for balance sheet dates t0 to t3. From t3 to t5 an probably rather theoretical extreme movement in the market value can be observed and from t5 the market values are concurrent which obviously implies the hedge to be ineffective. Trading, Hedging & Risk Management 15

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