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
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
(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
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
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.
December 18, 2017
Welcome all to FI 8200
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
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
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).
(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
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
Here is a brief summary of what we will discuss at our first lecture:
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.
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
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!