Risk Management

Innovations in Risk Management

Futures contract: a contract to

buy or sell a stated commodity
or financial claim at a specified
price at some specified future
time.
 Futures: a simple example
 Suppose a farmer plans to harvest
10,000 bushels of corn in six months.
The current price is $2.50 per bushel.
The farmer sells a futures contract,
which will allow him to sell corn at 2.50
per bushel in six months.
 If the price of corn falls to $2.00 per
bushel, the farmer loses $5,000 ($0.50 x
10,000 bushels) on his corn, but gains
$5,000 on his futures contract.
 Futures: a simple example
 If the price of corn rises to $3.00 per
bushel, the farmer gets $5,000 more
for his corn, but loses $5,000 on the
futures contract.
 The farmer has effectively locked in a
price of $2.50 per bushel and has
hedged his risk.
 Futures Trading Requires:

 An Organized Exchange - the

Chicago Board of Trade is the
oldest and largest futures
exchange.
 Standardized Contracts - for
more frequent trades and
greater liquidity.
 Futures Trading Requires:

 A Futures Clearinghouse - stands

between all buyers and sellers to
guarantee that all trades are honored.
 Daily Resettlement of Contracts - An
initial margin of 3% to 10% of the
contract’s value is paid up front.
A maintenance margin is required. Any
end-of-day losses must be replenished by
the contract holder.
 Types of Futures Contracts

 Commodity Futures - agricultural

commodities (corn, wheat, orange
juice, etc.) as well as metals, wood
products, and fibers.
 Financial Futures - futures
contracts on Treasury bills, notes
and bonds, GNMAs, CDs,
Eurodollars, foreign currencies, and
stock indices.
 Financial Futures

 Interest Rate Futures - used to

hedge risks associated with
interest rate fluctuations.
 Example: Treasury bond
futures may allow a firm to
lock in an interest rate for their
bond issue.
 Financial Futures
 Foreign Exchange Futures -
used to hedge risks associated
with exchange rate
fluctuations.
 A firm can use a foreign
exchange futures contract to
lock in an exchange rate for a
future transaction.
 Financial Futures

 Stock Index Futures - used to

hedge risks associated with
equity market fluctuations.
 Investors can buy and sell
contracts based on the S&P
500 and other market indices.
Innovations in Risk Management

 Option contract: gives the owner

the right to buy or sell a fixed
number of shares of stock at a
specified price over a limited time.
 Option Contracts
Call Option: gives the owner the right to
buy a fixed number of shares of stock
at a specified price over a limited time.
 If you buy a call option on IBM stock, and
the stock price rises enough, you can profit
on the call option contract.
 If the stock price does not rise enough, or
falls, your call option contract expires
worthless.
 Long Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Long Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Long Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Long Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Short Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Short Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Short Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Short Call Option

Profit
or Loss

Stock Price
$50
exercise price
 Option Contracts
Put Option: gives the owner the right to
sell a fixed number of shares of stock at
a specified price over a limited time.
 If you buy a put option on IBM stock, and
the stock price falls enough, you can profit on
the put option contract.
 If the stock price does not fall enough, or
rises, your call option contract expires
worthless.
 Long Put Option

Profit
or Loss

$50
exercise price Stock Price
 Long Put Option

Profit
or Loss

$50
exercise price Stock Price
 Long Put Option

Profit
or Loss

$50
exercise price Stock Price
 Long Put Option

Profit
or Loss

$50
exercise price Stock Price
 Short Put Option

Profit
or Loss

$50 Stock
exercise price Price
 Short Put Option

Profit
or Loss

$50 Stock
exercise price Price
 Short Put Option

Profit
or Loss

$50 Stock
exercise price Price
 Short Put Option

Profit
or Loss

$50 Stock
exercise price Price
Chicago Board Options Exchange

Established in 1973 to provide

exchange-listed option trading.
Why?
 Standardization of option contracts.
 A regulated central marketplace.
 An options clearinghouse corporation.
 Certificateless trading.
 A liquid secondary market.
 Innovations in Options

Option contracts can be written on:

 Common stocks
 Stock Indices
 Interest rates
 Foreign currency
 Treasury bond futures
 Currency Swaps

An exchange of debt obligations in

different currencies.
 Example: An American firm and a
British firm agree to pay each
other’s debt obligation.
 This allows long-term exchange
rate risk hedging.
 Other Innovations

Long-term Equity Anticipation

Securities (LEAPS)
 These are long-term options, both
calls and puts, which may not
expire for as long as three years.
 Can be used to hedge against
longer term movements in stocks.