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January 12, 2018

(1) Assignment 2 is now posted (due February 7). Please note that you will need to obtain various pieces of market information as of the close of trading on Thursday, January 25. You can get these by going to the CME Group exchange website, global-rates.com, the WSJ, and/or WSJ-online.  Also, please give the assignment a quick read prior to coming to our next class so that you can more easily pick up on key thoughts during the lecture.

(2) To briefly recap our first lecture, we began by reviewing key tenets of Finance for purposes of developing a framework for understanding the value proposition of financial risk management.  Following that we introduced a more formal economic framework for analyzing whether a firm's engagement in financial risk management is justifiable from the perspective of its shareholders. Potential channels that we identified through which risk management can enhance firm value included "numerator effects" (that is, the potential of risk management to have effects on future expected net cash flows) due to, for example, the reduction of expected bankruptcy, financial distress, and related business disruption costs; ensuring funding to support the firm's strategic plan; and the reduction of taxes.  Basically, this means that to the extent that the firm employs more debt, has higher growth opportunities, and has significant tax loss carry-forwards or is in the convex region of marginal tax rates, then the firm is more likely to experience greater potential benefits from hedging.

We also referred to "denominator" effects, which refers to the potential of risk management to have an effect on lowering a firm's cost of capital. I also referenced the role of executive compensation and ownership structure on the incentives of managers to engage (or not engage) in risk management.

Following this, we introduced a definition of a derivative, considered a number of common derivative structures (e.g., swaps, forwards, futures, and options), and identified their market venue (both OTC and exchange-trade instruments). In addition, we looked at recent BIS statistics regarding OTC market size including breakdowns according to product and instrument type, and by currency and maturity. We also looked at various market statistics for exchange-traded futures.

We then discussed an early and seminal application of hedging with a "linear" derivative such as futures.  Specifically, we looked at the Salomon Brothers/Merrill Lynch underwriting of an IBM debt offering and the accompanying T-bond futures hedge that was used to control the interest rate risk inherent in the underwriting. In our review, we did some risk analysis and applied a commonly used measure of risk often used in fixed income analysis known as duration. We will use duration, modified duration (MD) and convexity throughout the course as well as related concepts such as DV01 (an industry term that refers to the dollar value of a 1 basis point interest rate movement and is computed according to DV01 = MD x Price x .0001).

Following this, we looked at an application involving "non linear" derivatives such as options. Specifically, we looked at how Household Industries was able to monetize an exposure to a large holding of Time Warner preferred stock through a debt offering that had embedded option features.  This offering provided the firm with down-side risk exposure while at the same time allowing the firm to participate in some of TW's potential upside movements.  By recognizing the nature of these various exposures, we were able to use concepts based on option pricing theory to help price the debt.

Finally, we discussed the concept of natural hedges and how the recognition of natural hedges can mitigate the need to engage in hedging.
 

(3) In our next class, we will begin by reviewing the homework. In one of your assignments you are asked to investigate the risk management practices of your selected firm, its specific uses of derivatives if any, and most importantly developing your thoughts rationalizing or disapproving of their risk management practices based on the economic rationales that we discussed. Be sure to avoid simply saying that because your selected firm faces lots of risk that they can benefit from managing risks. This is not the necessarily so and in some cases can lead to destroying firm value. Rather, take some time to analyze the firms capital structure and get a sense for the amount of debt they have outstanding. Is the firm well-positioned to service the debt or could a shortfall in cash flow or earnings create potential problems? Also, is the firm growing or have growth opportunities that could be impaired due to adverse movements in interest rates, exchange rates, commodity prices, etc?

Following the homework review, we will discuss an important role (in addition to hedging) that futures markets fulfill--facilitating price discovery. We will explore what is price discovery, how futures prices are used commercially for price-basing and improving resource allocation and decision-making, and whether there is a government interest in protecting markets against manipulation. We will introduce the concepts of backwardation and contango, and discuss the implications of these terms for futures prices.

We will then continue with our discussion of the first of our two derivative building blocks: the futures/forward contract. We will discuss similarities and differences between futures and forward contracts. We will cover reading and interpreting futures price quotes and related terms of trade. We will conclude by discussing concepts related to the valuation of futures and forward contracts. Specifically, we will develop a useful pricing model that is based on no-arbitrage principles and illustrate its robustness by applying the model to a variety of futures contracts.

Following this, we will review forward rate estimation, using both bond yield and money market conventions. We will then review contract specs for several of the interest rate futures that we will be using throughout the term (including those for Eurodollars, T-notes, and T-bonds) and begin developing an understanding of their cash market linkages.


(4) Introduction of Mini-Lectures:

Mini-Lectures 1, 2, and 3 Below are a few mini-lectures to clarify concepts used in class.

(ML1) Using LIBOR: First, a brief note about performing calculations with LIBOR interest rates: To determine interest amounts, we will follow standard market practice. Libor uses an actual/360 day count convention, and interest is computed using a "simple" or "add-on" interest method.

For example, if you were to borrow $1mm today and were to repay the loan in 18 days based on a stated Libor rate of 4%, the amount you would repay is computed as $1,000,000*(1+L*days/360) or $1,000,000*(1+.04*18/360)=$1,002,000.  (Note that in today's market environment that short-term Libor rates are more in the range of 60 basis points or .60%; hence in the above calculation you would use .0060 in place of .04.)

(ML2) Volume versus Open Interest: For clarification and your future reference, here is a short summary explanation to help clarify the difference between Volume and Open Interest as relates to futures trading.

Volume is a measure of the number of contracts traded during some specified trading interval, e.g., a trading session, a day, a month, and so on.

Open interest is the number of contracts currently open and outstanding. Volume is related to open interest, but a change in volume can result in an increase, decrease, or leave unchanged open interest.

Consider the following example:

Assume that there are 3 traders, x, y, and z, who are each interested in trading the March 2018 natural gas futures, and which just today assume has been listed for trading for the first time. Thus, volume for the day is initially zero and open interest is also zero since the contract heretofore has never traded.

Trader x sells 1 contract to y, the long. Volume is 1 and open interest is 1.

Trader x next sells 1 contract to z, the long party to this second contract. Volume for the day is 2 and open interest is also 2. Note that x is now short 2 contracts while both y and z are long 1 contract each.

Trader y sells 1 contract to z. Volume is now 3 and open interest remains at 2. Note that z is now long 2 contracts and that y has exited the market. Trader x is still short 2 contracts.

Trader z sells 2 contracts to x. Volume for the day is 5 and open interest is zero as there are now no open contracts.

(ML3) "Production follows Sales": We spoke in class about one strategic response to ongoing currency risk that many firms follow, which is to locate operations close to the point of sale. The result of this is to push more operating costs into the same currency as to which sales are in.  To illustrate how this reduces cash flow volatility, consider the following additional simple example.

Assume a U.S. company has annual sales in Mexico in the amount of 100 pesos. Manufacturing is done in the U.S. where cost of goods sold is $9. The exchange rate is currently 0.10$/peso, but could fluctuate between .08 and .12$/peso. Thus, expected $ revenues are $10 and profit (net cash flow) is $10 - $9 or $1. However, if the dollar strengthens to say 0.08$/peso, $revenues fall to $8 and profit is now a loss of $1. Similarly, if the dollar weakens to say .120 $/peso, $revenues increase to $12 and profit is $3. In sum, profits are expected to be $1, but could range between -$1 and +$3.

Now assume the company produces instead in Mexico. Cost of goods sold is thus 90 pesos (=$9/.1) and profit is 10 pesos (100 - 90) before conversion to dollars. $ profits are expected to still be $1 (10*0.10), but could vary between +$0.80 and +$1.20 (calculated as 10*0.08 and 10*.120). While the expected profit (net cash flow) remains the same at $1, its volatility due to exchange rate movements has been reduced.


 

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December 18, 2017

Welcome all to FI 8200 "Derivative Markets"!

I hope that you will find this course to be a superb and one of your most beneficial experiences at GSU.  I am looking forward to seeing each of you at the first class on January 10.  As a reminder, our class meets at 5:30pm in Room 1215 of the Buckhead Center.

Please check back here for updates throughout the term.  Also, I will be communicating with you through your student.gsu.edu email account so please get in the habit of checking it regularly.  (If you prefer to receive your messages at another email address, please link your gsu student address to it as this is the only email address that is officially recognized by the university for communication to students.)

Please do the following prior to the first day of class:

(1) Review and download the Spring 2018 syllabus (see the "Syllabus/Readings" link)

(2) The textbook is optional, but if you want to get one the ISBN number is 978-1-4051-5049-1.  Note that any used/older edition will also work fine.

(3) Go to www.cmegroup.com, shade "Education" and click on the Education Home link.  This will take you to www.cmegroup.com/education.html and you will see a set of tutorials/presentations that provide a nice introduction to derivatives, exchanges, and futures.  At a minimum please take a few minutes to watch the following video group at: 

(i) Managing Risk at CME Group - How it All Works (there are about 8 chapter videos, each only about 1-2 minutes long).
        http://www.cmegroup.com/education/managing-risk-cme-group-how-it-works.html

(ii) And then at futuresfundamentals.cmegroup.com/, go quickly through the various links under "Get the Basics", "See the Impact", and "Explore the Marketplace".

(4) Important: Please begin to build a spread sheet that will compute duration and modified duration.  Along these lines, you should also go ahead and begin working on Assignment No. 1. I will send it to you via a separate email with instructions.  Note that I will attempt to post all homework exercises under "Assignments" on the course website.  For more information on this, I will send you an email with a couple of short articles attached that provide an excellent primer on calculating duration with examples.

As you have time, please also:

(5) Give a quick review to the assigned chapters for the first day of class and begin reading articles 2 and 3 that are posted under the Syllabus/Readings link.

(6) Here is a brief summary of what we will discuss at our first lecture:

We will begin by developing a working definition of a derivative, and then consider a number of common derivative structures as well as identify their market venue (both OTC and exchange-traded instruments).  We will look at some recently released statistics regarding global market size, including breakdowns according to product and instrument type, and maturity.

In our inspection of the various types of derivatives, we will see that basically all derivatives can be viewed as one or a combination of two basic building blocks: the futures/forward contract and the option contract.

To illustrate both types of contracts, we will review two case studies.  In the first, we will review an early case study regarding the use of financial futures for hedging--the Salomon Bros/Merrill Lynch underwriting of IBM's first public debt offering.  This event is sometimes credited with being the true motivating birth of the financial futures markets. In the second case study, we will look a structured debt security. Using basic financial engineering techniques, we will identify and value embedded options in the product and show how the overall security was priced from a yield perspective.

We will subsequently explore the "why" of financial risk management in which we examine the various channels through which financial risk management can potentially enhance shareholder value.  We will discuss how and under what conditions hedging can reduce financial distress and related business disruption costs, reduce under-investment incentives and adverse selection problems, and reduce taxes.


See all at our first class and please do not hesitate to call me or stop by at any time!


 

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