Lecture 5 - Derivatives Flashcards
1
Q
Risk Management
A
Financial transactions undertaken only to reduce risk + not add value in perfect and efficient markets
2
Q
Hedging
A
Is a risk management strategy to mitigate potential losses arising from adverse unexpected price movements in financial markets such as in currency exchange rates, interest rates or commodity prices
3
Q
What does hedging do?
A
- Hedging reduces the variability of expected cash flows around the mean of the distribution
- This reduction of distribution variance is a reduction of risk
4
Q
Derivatives
A
- The Company has established a variety of programs including the use of derivative instruments and other financial instruments to manage the exposure to financial market risks as to minimize volatility of financial results
- Derivative financial instruments are used within the Company for hedging purposes
- The Company holds derivative financial instruments to hedge its foreign currency + interest rate risk exposures
5
Q
To Hedge or not
A
- Hedging is a zero sum game
- Investors ‘do it yourself’ alternative
6
Q
Hedging is a zero sum game
A
- Hedging does not eliminate risk but simply passes the risk to another party
- In competitive and efficient markets where all parties have the same info they negotiate the terms of the hedging + reach a fair agreement (zero NPV)
7
Q
Investors ‘do it yourself’ alternative
A
- Corporations do not need to manage financial risks + incur the cost of hedging
- Investors can diversify their portfolios on their own
- This holds if individuals and firms have the same investment opportunities, info, transaction costs and tax rates (perfect capital market)
8
Q
1 - Research on risk management:
A
- Lower variability of expected cash flows makes financial planning simpler, reduces the risk of financial distress and the risk of missing out on valuable investment opportunities and helps keep track of and
motivate managers better - Hedging can increase the value of the firm in highly geared firms as it eliminates the risk of bankruptcy
- Similarly, evidence suggests that hedging allows firms to reduce costs of financial distress ➜ to increase their debt capacity
9
Q
2 - Research on risk management:
A
- Factors affecting why and how a real company manages its “foreign exchange exposure through the use of internal firm documents, discussions with managers and data on 3,110 foreign exchange derivative transactions”
- Motivations for firm’s risk management programme:
➜‘Earnings smoothing’: minimizing the impact of changes in foreign exchange rates on cashflow and reported earnings and presenting linear earnings’ growth
➜Competitiveness: allow the firm to undertake competitive pricing in the
output market without significantly reducing margins. Especially when the firm’s primary target is to maintain margins
➜Facilitation of internal contracting: internal planning and evaluation
10
Q
3 - Research on risk management:
A
- The role of risk management is to ensure that a company has the cash available to make value-enhancing investments
- Multinational companies must recognize that foreign exchange risk affects not only cash flows but also investment opportunities
11
Q
4 - Research on risk management:
A
- Hedging allows investors assess managers’ performance as it clears the noise in cash flows and earnings that is not due to managers’ actions
- But hedging might also increase temptation to managers for speculation with shareholders especially when the firm gets closer to financial distress
12
Q
What is insurance?
A
Insurance is a contractual arrangement where an individual or entity pays a premium to an insurer in exchange for financial protection against specified risks such as damage, loss, illness, or death
13
Q
Key points about Insurance:
A
- In the event of a covered occurrences the insurance compensates the policyholder according to the terms of the policy
- Risk is transferred to the insurance company
- When a company purchases insurance, it is effectively shifting the risk to the insurance provider
- Insurance companies have developed expertise which allows them to estimate probabilities of loss and hence can price risk more effectively
- Additionally they offer guidance on steps a company can take to mitigate risk
- An insurance company can pool risks by holding a diversified portfolio of policies
- The claims on an individual policy can be uncertain but claims on a portfolio of policies is more stable
14
Q
How are premium prices determined?
A
- Administrative costs
- Adverse selection
- Moral hazards
15
Q
Administrative Costs
A
- An insurance company incurs a variety of admin costs in arranging the insurance policies and its operations
- E.g. include staff salaries, rent for office space, utilities, technology and software expenses, marketing and advertising costs, legal fees, regulatory compliance expenses, customer service resources and overhead expenses related to maintaining physical and digital infrastructure
- All these costs are reflected in the premiums charged
16
Q
Adverse Selection
A
- Unless an insurance company can distinguish between good and bad risks, the latter who have a higher risk of making claims are more likely to purchase insurance
- Insurers increase premiums to compensate or require owners to share any losses
- If individuals with a history of accidents or traffic violations are more likely to purchase insurance, the insurer will face a higher probability of claims from these high-risk drivers
- To offset this increased risk, the insurer may raise premiums for all policyholders, including those with clean driving records
- As a result, individuals with low risk may end up paying higher premiums due to adverse selection driving up overall costs for the insurer
17
Q
Moral Hazard
A
- Once the risk has been insured, the owner may be tempted to take fewer precautions against damage
- Consider an individual with comprehensive coverage for their vehicle (insurance company will cover the cost of repairs for any damages, regardless of fault)
- This individual might become less cautious when driving or parking because they know that their insurance will cover the costs of any damage
- As a result, they may engage in riskier behavior, such as speeding or parking in high-risk areas increasing the likelihood of insurer’s payout frequency and consequently their overall costs
- To compensate for this increased risk, the insurer may raise premiums for all policyholders, including those who are careful drivers, thus passing on the cost of moral hazard to all insured individuals through higher premiums
18
Q
Risks
A
- When the costs of administration, adverse selection and moral hazard are high, insurance premiums are high and thus a costly way to protect against risk
- Insuring against jump risks or systematic risks can be very costly to insurance companies
19
Q
Systematic risks
A
- Also known as market risks or undiversifiable risks, are inherent to the entire market or a particular segment of the market
- These risks affect all assets within the market and are typically driven by macroeconomic factors such as interest rate changes, inflation, geopolitical events, or systemic financial crises
20
Q
Jump risks
A
- Jump risk refers to the risk associated with sudden and significant price movements or “jumps” in the value of an asset or security
- They occur due to various factors such as unexpected news events, changes in market sentiment or sudden shifts in supply and demand dynamic
21
Q
Risk sharing
A
- Along risk pooling the industry uses risk sharing which distributes a fixed amount of risk among many investors
- As more and more policies are pooled together, they are shared by ever-more investors thus preventing any individual’s total risk from growing with the number of policies
22
Q
Financial options
A
- Firms may use financial options to set a limit on the losses that they can suffer from an adverse change in the price of an asset (real and financial)
- Option buyers pay a premium for the right to buy (in the case of call options) or sell (in the case of put options) the underlying asset at a specified price within a certain timeframe
23
Q
What is a financial option?
A
Is a contract that gives the holder the right but not the obligation to buy or sell a specified asset at a predetermined price within a specified timeframe
24
Q
2 main types of options:
A
- Call options: which give the holder the right to buy the underlying asset
- Put options: which give the holder the right to sell the underlying asset
25
What is the premium?
The premium is the price that the option buyer pays to the option seller for granting them this right
26
American style option
Is an option that can be exercised on any date before its expiry
27
European style option
Is an option that can exercised only at expiry
28
Flexibility
Options provide flexibility: they allow a company to protect itself against adverse market movements while at the same time it retains the ability to profit from favourable options
29
Forward Contract
- Is a customized agreement between two parties to buy or sell an asset at a predetermined price on a specified future date
- Unlike financial options it involves no initial payment and is binding, obligating both parties to fulfil the terms of the contract at maturity
30
Forward price
- Is the agreed upon price in a forward contract at which the underlying asset will be bought or sold in the future
- It is determined at the outset and remains fixed until the contract's expiration, regardless of changes in the market price of the underlying asset
31
Spot price
Is the price for immediate delivery
32
Key features of forward contracts
- The counterparty which has agreed to buy the underlying at maturity has a long position in the contract and the counterparty which is selling has the short position
- Forward contracts are tailor made to meet the requirements of the parties
- Flexibility on the amounts and delivery dates
- Forwards are not traded on an organized exchange but are ‘over the counter instruments’: private agreements outside the regulation of an exchange
33
The cost of forward hedge
- While the cost of purchase/sale proceeds is locked at the outset, the cost of hedging can only be determined ex-post as it depends on the future spot price prevailing on the settlement date of the forward contract (which is unknown on the day we agree to the forward contract)
- Counterparties in a forward agreement are exposed to counterparty risk of default i.e. the risk that the other party will not deliver on the agreement
- We need to compare the cost of purchase/sales with and without hedging
- The real cost of hedging is an opportunity cost
34
What is a futures contract?
Is a standardised agreement between two parties to
buy or sell a specified asset (such as commodities, currencies, or financial
instruments) at a predetermined price on a specified future date
35
Key features of a futures contract
- Unlike forward contracts, futures contracts are traded on regulated exchanges
- With futures you are committed and are unable to back away like you do in options
- The price of a futures contract is fixed today but payments are made in the
future
- To ensure that both parties can meet their financial obligations as the contract's value fluctuates, the clearing house operates a margining
system by which the futures’ buyers and sellers must provide in cash or securities an initial margin
36
Margin
- Refers to the initial deposit of funds or securities required by both buyers and sellers to initiate a futures position
- It is not a ‘down payment’ for the underlying but it stays with the clearing house
- It is refunded when the futures position is close
37
Futures trading
- Eliminates counterparty risk because contracts are cleared through a central clearinghouse which guarantees both sides of the trade
- Even if one party defaults, the clearinghouse steps in to fulfill the contract,
preventing any financial loss to the other party
- The clearing house takes
on a large amount of credit risk
- The buyer and the seller of a futures contract do not transact with each other
directly
- The clearing house (a financial intermediary) becomes the formal
counterparty to every transaction
- This reduces the risk of non-compliance with the contract
38
Marked to Market
Futures contracts are marked-to-market: each day, any profits or losses on the contract are calculated and you pay the exchange’s clearing house any losses
and receive any profits and each member’s margin account change accordingly
39
Maintenance Margin
The following morning the losing counterparty receives a margin call to inject more cash to cover the loss if the money in the account has fallen below a threshold level called the maintenance margin
40
Why might the traders not fulfil their obligations?
- If prices drop, seller fears that seller may default on the agreement
- It is cheaper to buy in the spot market
- If prices rise, buyer fears that seller may default on the agreement
- They will make more money selling it at the spot price
- So the clearinghouse collects funds upfront, ensuring it has a financial buffer to cover potential losses and by settling up profits/losses each day eliminates counterparty risk
- It is assumed that counterparties must keep all the initial margin throughout the duration
of futures contract as a buffer
41
Variation Margin
The daily changes to counterparties’ margin accounts are known as variation margin
42
Focus on Commodities Futures Contracts
- The delayed payment by entering a futures contract allows you to earn interest on the money that you would have committed if you did buy for immediate delivery
- Commodities require storage costs
- When buying forward you save these costs
- Futures contracts give no convenience yield, which is the value of being able to quickly access the asset for consumption or production purposes
43
Backwardation
Net convenience yields are typically positive and futures are below spot prices
44
Contango
But in case of high storage costs and ample supply of physical commodity,
futures price can be above spot and market is said to be in contango
45
Price Discovery
In the stock market refers to the process by which the
market determines the fair value of a security, such as a stock, based on the collective actions of buyers and sellers
