R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN

R. GLENNHUBBARDANTHONY PATRICKO’BRIEN Money,Banking, andthe Financial System

Derivatives and Derivative Markets 7 C H A P T E R LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain what derivatives are and distinguish between using them to hedge and using them to speculate 7.1 Define forward contracts 7.2 Discuss how futures contracts can be used to hedge and to speculate 7.3 Distinguish between call options and put options and explain how they are used 7.4 Define swaps and explain how they can be used to reduce risk 7.5

Derivatives and Derivative Markets 7 C H A P T E R • 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.

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”?

7.1 Learning Objective Explain what derivatives are and distinguish between using them to hedge and using them to speculate.

Derivatives, Hedging, and Speculating DerivativeAn 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. SpeculateTo place financial bets, as in buying futures or option contracts, in an attempt to profit from movements in asset prices.

Some investors and policymakers believe that “speculation” and “speculators” provide no benefit to financial markets, but they provide two useful functions: • 1. When a hedger sells a derivative to a speculator, they transfer risk to the speculator. • 2. 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

7.2 Learning Objective Define forward contracts

Forward Contracts 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.

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

7.3 Learning Objective Discuss how futures contracts can be used to hedge and to speculate.

Futures Contracts Futures contract A standardized contract to buy or sell a specified amount of a commodity or financial asset on a specific future date. • Futures contracts differ from forward contracts in several ways: • Futures contracts are traded on exchanges, such as the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX). • Futures contracts typically specify a quantity of the underlying asset to be delivered but do not fix the price. • Futures contracts are standardized in terms of the quantity of the underlying asset to be delivered and the settlement dates for the available contracts.

Hedging with Commodity Futures Short position In a futures 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 to receive or buy the underlying asset on the specified future date. Futures Contracts

Hedging with Commodity Futures • Consider the case of a farmer who in March sows seed with the expectation that it will yield 10,000 bushels of wheat. The farmer is concerned that when she harvests the wheat in July, the price will have fallen below $2.00, so she will receive less than $20,000 for her wheat. • A manager who buys wheat at General Mills is concerned that in July the price of wheat will have risen above $2.00, thereby raising his cost of producing cereal. The farmer and the General Mills manager can hedge against an adverse movement in the price of wheat. • Hedging involves taking a short position in the futures market to offset a long position in the spot market, or taking a long position in the futures market to offset a short position in the spot market. Futures Contracts

Hedging with Commodity Futures • As the time to deliver approaches, the futures price comes closer to the spot price, eventually equaling the spot price on the settlement date. • To fulfill her futures market obligation, the farmer can engage in either settlement by delivery or settlement by offset. • We can summarize the profits and losses of buyers and sellers of futures contracts: • Profit (or loss) to the buyer = Spot price at settlement - Futures price at purchase • Profit (or loss) to seller = Futures price at purchase - Spot price at settlement Futures Contracts

Hedging with Commodity Futures Futures Contracts

Making the Connection Should Farmers Be Afraid of the Dodd-Frank Act? • During the financial crisis of 2007–2009, some policymakers and economists argued that the use of derivatives had destabilized the financial system. • When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010, it contained some restrictions on trading in derivatives. In particular, the act required that some derivatives that had previously been traded over the counter be traded on exchanges instead. • Farmers were worried that they might have to post more collateral to trade futures. They were also worried that small community banks and special agriculture banks may no longer be allowed to offer forward contracts. • As of late 2010, the Commodity Futures Trading Commission (CFTC) had not finished writing the new regulations. Futures Contracts

Speculating with Commodity Futures Some investors who are not connected with the wheat market can use wheat futures to speculate on the price of wheat. If you were convinced that the spot price of wheat was going to be lower in July than current futures price, you could sell wheat futures with the intention of buying them back at the lower price on or before the settlement date. Notice, though, that because you lack an offsetting position in the spot market, an adverse movement in wheat prices will cause you to take losses. Futures Contracts

Hedging and Speculating with Financial Futures • Today most futures traded are financial futures. Widely traded financial futures contracts include those for Treasury bills, notes, and bonds; stock indexes; and currencies. • An investor who believes that he or she has superior insight into the likely path of future interest rates can use the futures market to speculate. • For example, if you wanted to speculate that future interest rates will be lower (or higher) than expected, you could buy (or sell) Treasury futures contracts. Futures Contracts

Hedging and Speculating with Financial Futures Futures Contracts

Making the Connection Reading the Financial Futures Listings • An example of interest-rate futures on U.S. Treasury securities appears above. The quotation is for a standardized contract of $100,000 in face value of notes paying a 6% coupon. • The first column states the contract month for delivery. The next five columns present price information. • Futures prices are lower for December 2010 than for September 2010, telling you that futures market investors expect long-term Treasury interest rates to rise. Futures Contracts

7.3 Solved Problem Hedging When Interest Rates Are Low During the financial crisis of 2007–2009, interest rates on Treasury bills, notes, and bonds and on many corporate and municipal bonds fell to very low levels. Jane Williams is a financial adviser and chief executive officer of Sand Hill Advisors in Palo Alto, California. In early 2010, an article in the Wall Street Journal quoted Williams as arguing that “bonds could be among the worst-performing investments this year. . . .” a. What would make bonds a bad investment? b. How might it be possible to hedge the risk of investing in bonds? Futures Contracts

7.3 Solved Problem Hedging When Interest Rates Are Low Solving the Problem Step 1Review the chapter material. Step 2Answer part (a) by explaining when bonds make a bad investment. Bonds are a bad investment when interest rates rise because higher market interest rates cause the prices of existing bonds to decline. Step 3Answer part (b) by explaining how it is possible to hedge the risk of investing in bonds. Investors who own bonds are long in the spot market for bonds, so the appropriate hedge calls for them to go short in the futures market for bonds by selling futures contracts. Futures Contracts

Trading in the Futures Market Margin requirement In the futures market, the minimum deposit that an exchange requires from the buyer or seller of a financial asset; reduces default risk. • For instance, on the CBOT, futures contracts for U.S. Treasury notes are standardized at a face value of $100,000 of notes, or the equivalent of 100 notes of $1,000 face value each. The CBOT requires that buyers and sellers of these contracts deposit a minimum of $1,100 for each contract into a margin account. Marking to market In the futures market, a daily settlement in which the exchange transfers funds from a buyer’s account to a seller’s account or vice versa, depending on changes in the price of the contract. Futures Contracts

Trading in the Futures Market Futures Contracts

7.4 Learning Objective Distinguish between call options and put options and explain how they are used.

Options OptionA type of derivative contract in which the buyer has the right to buy or sell the underlying asset at a set price during a set period of time. Call option A type of derivative contract that gives the buyer the right to buy the underlying asset at a set price during a set period of time. Strike price (or exercise price)The price at which the buyer of an option has the right to buy or sell the underlying asset. Put option A type of derivative contract that gives the buyer the right to sell the underlying asset at a set price during a set period of time.

Why Might You Buy or Sell an Option? • Suppose that Apple stock has a current price of $200 per share, but you believe the price will rise to $250 in the coming year. • You could buy call options that would allow you to buy Apple at a strike price of, say, $210. The price of the options will be much lower than the price of the underlying stock. In addition, if the price of Apple never rises above $210, you can allow the options to expire, which limits your loss to the price of the options. • If Apple’s stock is selling for $200 per share and you are convinced it will decline in price, you could engage in a short sale. With a short sale, you borrow the stock from your broker and sell it now, with the plan of buying it back—and repaying your broker—after the stock declines in price. • If, however, the price of Apple rises rather than falls, you will lose money by having to buy back the stock—which is called “covering a short”—at a price that is higher than you sold it for. Options

Why Might You Buy or Sell an Option? Figure 7.1 (1 of 2) Payoffs to Owning Options on Apple Stock Payoff In panel (a),we illustrate the profit from buying a call option with a strike price of $210. When the price of Apple stock is between zero and $210, the owner of the option will not exercise it and will suffer a loss equal to the $10 price of the option. As the price of Apple rises above $210 per share, the owner of the option will earn a positive amount from exercising it. For prices above $220, the owner earns a profit. Options

Why Might You Buy or Sell an Option? Figure 7.1 (2 of 2) Payoffs to Owning Options on Apple Stock Payoff In panel (b),we illustrate the profit from buying a put option with a strike price of $190. The owner of a put option earns a maximum profit when the price of Apple is zero. As the price of Apple stock rises, the payoff from owning the put option falls. At a price of $180, the owner of the put would just break even. For prices above the $190 strike price, the owner of the put option would not exercise it and would suffer a loss equal to the option price of $10.• Options

Why Might You Buy or Sell an Option? Options

Option Pricing and the Rise of the “Quants” • The price of an option is called an option premium. • Sellers of options lose if the option is exercised. The size of the option premium reflects the probability that the option will be exercised. The option premium is divided into two parts: • 1. Intrinsic value, or the payoff to the buyer of the option from exercising it immediately. • An option that has a positive intrinsic value is said to be in the money. A call option is in the money if the market price of the underlying asset is greater than the strike price, and a put option is in the money if the market price is less than the strike price. • If the market price of the underlying asset is below the strike price, a call option is out of the money, or underwater. If the market price of the underlying asset is above the strike price, a put option is out of the money. If the market price equals the strike price, a call option or a put option is at the money. Options

Option Pricing and the Rise of the “Quants” • The option premium has a time value, which is determined by how far away the expiration date is and by how volatile the stock price has been in the past. • The further away the expiration date, the greater the chance that the intrinsic value of the option will increase. • All else being equal, the further away in time an option’s expiration date, the larger the option premium. • Similarly, all else being equal, the greater the volatility in the price of the underlying asset, the larger the option premium. • In 1973, the Black-Scholes formula provided a better tool for the optimal pricing of options and led to an explosive growth in options trading. People who evaluate and price new securities came to be known in Wall Street as “rocket scientists,” or “quants.” Options

Making the Connection Reading the Options Listings • The August contract listed in the first row has a Last price of $1.64. The Volume column provides information on how many contracts were traded that day, and the Open Interest column provides information on the number of contracts outstanding—that is, not yet exercised. • The higher prices of the call options reflect the fact that because the strike price is below the underlying price, so the call options are all in the money, while the put options are out of the money. For both the call options and the put options, the further away the expiration date, the higher the price. Options

7.4 Solved Problem Interpreting the Options Listings • Why are the put options selling for higher prices than the call options? • b. Why does the April call sell for a higher price than the January call? • c. Suppose you buy the April put. Briefly explain whether you would exercise it immediately. • d. Suppose you buy the November call at the price listed and exercise it when the price of Amazon stock is $122. What will be your profit or loss? • e. Suppose you buy the April call at the price listed, and the price of Amazon stock remains $93.60. What will be your profit or loss? Options

7.4 Solved Problem Solving the Problem Step 1Review the chapter material. Step 2Answer 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 3Answer 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

7.4 Solved Problem Solving the Problem Step 4 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 5 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 6 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

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

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

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

7.5 Learning Objective Define swaps and explain how they can be used to reduce risk.

Swaps SwapAn 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.

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

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

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

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

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

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.

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.

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.

R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN