Ch19OptionsJones

Ch15OptionsMarketsBKM
DerivativeMarketsderivativesmerelyderivetheirvaluefromothersecurities
TheOptionContract
ACALLoptiongivestheholdertheright (butnottheobligation )topurchase...
anASSETforaspecifiedPRICEonorbeforeaspecifiedDATE
ThisassetisreferredtoastheUNDERLYINGasset.
TheoptionholdermaycallawaytheassetfortheEXERCISEPRICEoftheoption.
Thisisthe"X"inouroptionsnotation.
Forthisright,thebuyeroftheoptionpaysaPREMIUM
Sincetheoptionisacontract,theoriginalselleroftheoptioniscalledtheWRITER
ofthecontract.
ThebuyerofthecontractiscalledaHOLDER,andbecausetheoptionisusually
resellable,theholdermaychange.
Whiletheholderoftheoptionhasarightbutnoobligationtoperformonthe
contract,thewriterISobligated (untilhe/shebuysbackthatrightfromaholder).
WerefertotheholderasLONGacalloption.ThewriterisSHORTacalloption.
Theunderlyingassethasasellingprice"S"thatchangesintime
Whentheoptioncontractiswrittenorbought,thepriceisS0
Later(atexpirationorwhenwewanttovalueit)theoptionhasapriceofST
Thevalueoftheoptionisthesellingpriceoftheunderlyingminustheexerciseprice.
ValueCALL=STX
Thisisnotthe profit oftheoption.
Thenetprofitonthecallisthevalueoftheoptionminusthepriceoriginallypaid
Profit=(STX)PricePaid(usuallytheorignalpremium)

Options

78

HOUSINGExample:
UNDERLYING: Yourneighbor'shouse
EXERCISEPRICE:

100 K

PREMIUM:

10 K

CURRENTPRICE:

100 K

DATE: 1yearfromtoday

OPTIONTYPE:

CALL

Wecouldbrieflydescribethebuyer(holder)ofthisoptionas
Longone$100,000,12monthcalloptiononhis/herneighbor'shouse
Doestheholderhavetoperformanythingonthiscontract?
Howaboutthewriter?

Usingnotation,youmightdescribetheoption:
Asset
X
Time
Type
House
$100 12mos Call

S0
Premium
$ 10 $ 100

Payoffandpotentialprofit?
Underlying
X
Time
House
$100 12mos

Type
Call

ST
Premium
$ 10 $ 130

Whatisthepercentageprofittotheholder?

Options

79

CALLSvs.PUTS
Consideracalloptiona"directionalbet"thattheunderlyingassetwillgoupinvalue
APUTOPTIONisadirectionalbetthattheunderlyingwillDECLINEinvalue
Iftheunderlyingdeclinesinvalue,theholdercan"PUT"theassettothewriter
forthevalueoftheexerciseprice.
Allothertermsapplyasabove,butthedirectionoftheprofitopportunityis
reversedfortheholderofthePUT.
Theholderofaputoptionwantstheassettofallinprice.Thebuyermayalso
wantprotectionfromtheunderlyingdeclininginprice.Thiswouldbeaform
ofINSURANCE,aprotectiveput(mentionedinstrategies,below).

ValuesofOptionsatExpiration(orwheneverwechosetovaluethem)
Becausetheprofitdependsonwhetheryouarelongorshorttheoption,it'simportant
toconsiderbothsidesofthedeal
First,wecanrefertothevalueofanoptionasitsPAYOFF
ButthispayoffdependsonwhetheryouaretheHOLDERortheWRITER.
Payofftocallholder=

S T X ifS T >X;

0ifS T <=X

Payofftocallwriter=

(S T X) ifS T >X;

0ifS T <=X

CALLEX:

$80 call

Payofftocallholder=
Payofftocallwriter=

Options

ST

$85

$5.00
($5.00)

80

VALUEOFAPUT:
Payofftoputholder=

$0

ifS T >=X;

XS T ifS T <X

Payofftoputwriter=

$0

ifS T >=X;

(XS T )ifS T <X

PUTEX:

$50 put

Payofftoputholder=
Payofftoputwriter=

ST

$45

$5.00
($5.00)

Lastterm:The"moneyness"oftheoptionwerefertoanoptionas

Options

INTHEMONEY

CALL
ifS T >X

PUT
ifS T <X

ATTHEMONEY

ifS T =X

ifS T =X

orOUTOFTHEMONEY

ifS T <X

ifS T >X

81

STOCKExample:
Underlying
X
Time
MSFT
$27.00 5mos

Type
Call

S0
ST
Premium
$ 1.68 $32.26 $26.74

MSFT120421C00027000

Payoff

$5.26

Profit

$3.58

%profit

Moneyness: INthemoney

213%

Whatwouldyouhavemadeifyou'dgonelongtheMSFTinsteadoftheoptions?
Ignoringtransactioncostsandtheuseofmargin
BuyMSFT SellMSFT

$Profit

$26.74 $ 32.26 $5.52

Options

20.6%

82

Optionscontractsarestandardized
Thismeanswhenyoubuyone,youcanselliteasilythroughabrokerandanexchange
Exercisedatesareusuallyonlyonetoseveralmonthsawayfromtoday
LongtermLEAPS(LongtermEquityAnticipationSecuritiesupto3years)

Americanvs.European
EuropeanmaybeexercisedonlyonexpirationdateAmerican,anytimebefore

Optionsonotherthanstock
Indexoptions,Futuresoptions,Currencies,InterestRateoptions

OptionStrategiesnotethatJonesdoesn'tcovermanyofthese
ProtectivePut
CoveredCalls
Straddles
Spreads

BKMreferstoa"Moneyspread"thatIrefertoas,morespecifically,a
"VerticalCallSpread"or"BullCallSpread"
Howdoyoucreateaspreadofthiskind?
Buyacallatastrikepriceatornearthecurrentpriceofthestock
inquestion
IfMSFTistradingat$30.00today,youwouldbuya
callonMSFTstockwitha$30strikeprice.
ThenyouSELL(write)acallonMSFTwitha$35strike
YouthinkMSFTmayrisesoon,butdon'texpectittogomuchbeyond$35
X
PREMIUM
35 Sellinganequivalentnumbercallsat
$35.00 $1.00 CFCALL
reducesthecashoutlaytobuyintothe
profitopportunitythatMSFTmayriseabove
$30duringtheoptionperiod
S0

30 CurrentpriceonMSFT

$30.00 $(2.00) CFCALL

Costto"buy"thespreadforMSFT $(1.00) CFSPREAD

Collars

Options

83

OptionlikeSecurities
Callablebonds
ConvertibleSecurities
Warrants
CollateralizedLoans

ExoticOptions
Asianpayoffdependingonanaverageprice
Barrierunderlyingmustcrossthroughabarrier

Options

84

Sample"OptionsChain"

MSFT

26.74

closeon11/15/11

OptionsExpiringFriday,April20,2012
Calls
Symbol
MSFT120421C00013000
MSFT120421C00014000
MSFT120421C00015000
MSFT120421C00016000
MSFT120421C00017000
MSFT120421C00018000
MSFT120421C00019000
MSFT120421C00020000
MSFT120421C00021000
MSFT120421C00022000
MSFT120421C00023000
MSFT120421C00024000
MSFT120421C00025000
MSFT120421C00026000
MSFT120421C00027000
MSFT120421C00028000
MSFT120421C00029000
MSFT120421C00030000
MSFT120421C00031000
MSFT120421C00032000
MSFT120421C00033000
MSFT120421C00034000
MSFT120421C00035000
MSFT120421C00038000
MSFT120421C00040000

StrikePrice
Last

Change
N/A
13.35
12.1
11.35
N/A
8.35
8.01
7.25
5.5
5.17
4.5
3.55
2.92
2.24
1.68
1.22
0.8
0.56
0.35
0.21
0.13
0.09
0.04
0.02
0.01

Bid
0
0
0
0
0
0
0
0
0
0
0

Up0.02
Up0.19
Up0.18
Up0.12
Up0.11
Up0.01
Up0.03
Up0.02
0
Up0.03
Up0.01
0
0 N/A
0 N/A

Ask
12.6
12.35
11.4
10.45
9.5
8.55
7.8
6.9
6.05
5.15
4.3
3.5
2.82
2.18
1.63
1.17
0.81
0.53
0.33
0.2
0.12
0.07
0.04

Volume
14.5
13.6
12.05
11.05
10.1
9.15
8.2
7.15
6.15
5.25
4.4
3.6
2.87
2.22
1.67
1.2
0.83
0.55
0.35
0.22
0.14
0.09
0.06
0.03
0.01

0
10
1
200
0
0
5
0
4
30
1
6
62
2,684
378
387
458
66
15
12
155
5
20
0
50

OpenInt
0
1
8
0
0
11
6
923
466
694
942
1,452
3,744
10,138
16,371
10,557
20,790
24,130
7,631
3,915
646
1,375
1,579
2
564

$13.00
$14.00
$15.00
$16.00
$17.00
$18.00
$19.00
$20.00
$21.00
$22.00
$23.00
$24.00
$25.00
$26.00
$27.00
$28.00
$29.00
$30.00
$31.00
$32.00
$33.00
$34.00
$35.00
$38.00
$40.00

Puts
Symbol
Last
MSFT120421P00013000
0.1
MSFT120421P00014000
N/A
MSFT120421P00015000
0.15
MSFT120421P00016000
0.22
MSFT120421P00017000
0.18
MSFT120421P00018000
0.29
MSFT120421P00019000
0.3
MSFT120421P00020000
0.38
MSFT120421P00021000
0.47
MSFT120421P00022000
0.57
MSFT120421P00023000
0.81
MSFT120421P00024000
0.97
MSFT120421P00025000
1.24
MSFT120421P00026000
1.62
MSFT120421P00027000
2.07
MSFT120421P00028000
2.55
MSFT120421P00029000
3.15
MSFT120421P00030000
4.2
MSFT120421P00031000
4.8
MSFT120421P00032000
6.8
MSFT120421P00033000
6.6
MSFT120421P00034000
N/A
MSFT120421P00035000
N/A
MSFT120421P00038000
N/A
MSFT120421P00040000
13.75

Change

Bid
0
0
0
0
0
0
0

Up0.05
Down0.09
Down0.12
0
Down0.06
Down0.03
Down0.11
Down0.13
Down0.01
Down0.54
Up0.30
0
0
0
0
0
0
0

Ask
0.08
0.09
0.12
0.15
0.18
0.22
0.27
0.35
0.45
0.58
0.75
0.98
1.26
1.62
2.06
2.6
3.2
3.95
4.75
5.4
6.3
7.2
8.2
9.95
11.7

Volume
0.1
0.13
0.14
0.18
0.19
0.24
0.29
0.37
0.47
0.6
0.77
1
1.29
1.65
2.11
2.65
3.3
4.05
4.85
5.85
6.95
7.9
8.85
13.35
15.45

32
0
20
0
7
55
100
10
10
20
5
81
125
2,300
282
132
61
25
6
0
2
0
0
0
0

OpenInt
130
0
2,547
316
836
3,191
2,181
3,657
5,723
9,987
18,922
16,783
9,824
14,286
17,783
1,704
2,844
1,173
491
90
2
0
0
0
1

85

Ch19OptionsJones
Ch16OptionValuation
OptionvaluationIntrinsicandTimeValues
Timevalueisnotrelatedtotimevalueofmoney
Thinkofitasmorevolatilityvalue

Asintrinsicvaluerises,timevaluedropsbecausethelikelihood
oftheoptionbeingexercisedbecomesacertainty
X
$50.00

Time
Type
0.25 Call

IntrinsicValue $
TimeValue $ 5.26

CallPrem0

S0

$ 5.26 $ 50.00

50.00%

rf
5.00%

Moneyness: ATthemoney

Determinantsofcalloptionvalues
Ifthisincreases

theCallOption

$50.00 StockPrice,S

Increases

$50.00 ExercisePrice,X

Decreases

50.00% Volatility,

Increases

0.2500 TimetoExpiration,T

Increases

5.00% InterestRate,r f

Increases

Dividendpayouts

OptionsValuation

Decreases

86

WhydoessomethinglikehigherVolatilityincreasethevalueofanoption?
Let'sassumeweareinterestedinvaluingoptionsontwocompaniescurrentlypriced
at$30pershare.X=$30aswell.Onestock'spriceishighlyvolatile.Theotherisnot.
X= $30.00
Highvolatilitystock/scenario
Expfuturestockprice
$10
$20
Optionpayoff
0.00
0.00

$30
0.00

$40
10.00

$50
20.00

Lowvolatilityscenario
Expfuturestockprice
$20
Optionpayoff
0.00

$30
0.00

$35
5.00

$40
10.00

$25
0.00

Forsimplicity,let'sassumeequalprobabilities(p)foreachoutcome
Stockprice
20%
20%
20%
20%
20%

Thenwewouldweighteachoptionpayoffby"p"togetanexpectedpayoff:
HighvolatilityScenario
Weightedpayoff $
$
$
$ 2.00 $4.00

E(payoff)
$ 6.00

Lowvolatilityscenario
Weightedpayoff $
$

E(payoff)
$ 3.00

$ 1.00 $2.00

Withahigherexpectedpayoff,ithashighervalue.

BinomialOptionPricing
wewillskipthismodel

OptionsValuation

87

BlackScholesMertonOptionValuation
DevelopedbyBlack,ScholesandMertonearningthemaNobelPrize.
We'veseenwhatdirectlyimpactsthevalueofanoption.

C0=S0eTN(d1)XerTN(d2)
d 1 =[ln(S 0 /X)+(r+ 2 /2)T]/(T)
d 2 =d 1 T
C0=currentcalloptionvalue
S0=currentstockprice
N(d)=theprobability(roughly)thattheoptionwillexpireinthemoney
X=exerciseprice
e=naturallogfunction(seebelow,ifyou'renotfamiliarwithit)*
=annualdividendyieldoftheunderlying
r=riskfreerateasadecimal,annualized
T=timeremainingtoexpirationinyears
ln=naturallogfunction
=annualstandarddeviationoftheunderlying,expressedasadecimal

X
$50.00

Time
Type
0.2972 Call
d1
0.086746

d2

$ 5.47 $ 48.89
N(d1)

0.216145 0.5345632

IntrinsicValue $
TimeValue $ 5.47

S0

Prem0

55.56%

rf
0.96%

N(d2)

CallPrice
0.4144372 $5.47

Moneyness: OUTofthemoney

NOTE:forpurposesofthisclass,Connectdoesnotprovidegoodpracticeproblemsusing
BlackScholes.Iwillprovidesomefortheexam.Youwillneedtocalculatethis,
however, muchofthecomplexmath(e.g.theprobabilities)can'tbedoneonmany
calculators.Youwillbeprovidedwiththosevalues.

OptionsValuation

88

PutCallParity

Payoffofcallheld
MinusPayoffofputwritten
Total

S T <=X

S T >X

0
(XS T )
S T X

S T X
0
S T X

i.CP=S0XerT
ii.P=CS0+PV(X)+PV(dividends)
iii.PutoptionvaluationviaBlackScholes(skip)

BecauseofPutCallParity,whenwehavethepriceofthecall,wecanvaluethe
putcontract,andviceversa.
Aputoptiononastockwithacurrentpriceof$31hasanexercisepriceof$38.Theprice
ofthecorrespondingcalloptionis$2.05.Accordingtoputcallparity,iftheeffective
annualriskfreerateofinterestis8%andtherearethreemonthsuntilexpiration.
Whatshouldbethevalueoftheput?

OptionsValuation

89

*Whatise ?
e= 2.7182818285
"Euler'snumber"(notEuler'sConstant),e ,isamathematicalconstant,likepi,thatisusedin
certainmathematicalcalculations,especiallyinexponentialcalculations.Infact,the
x
"exponentialfunction"isusuallyjuste .Likepi ,e isirrational,havinganonterminating
decimalvalue.
Infinance,itisusedfrequentlyforcompoundinterestcalculations.
Accessthisfunctionorconstantasfollows:
Example:Ifyouneedtocalculatea10%annualpercentage
ratewithcontinuouscompounding
".1",2ND,then"ex"then"1"
TIBAII+
x

".1"ENTER,"g"then"e "then"1"then""
=exp(.1)1

HP12c
MSExcel

Allthreeoftheseshouldproduceavalueof

0.10517092

TheAPR,annualpercentagerate,maydiffermateriallyfromtheEAR,oreffectiveannual
rate,basedontheperiodofcompounding.Using"e"allowsustocalculatetheeffectiverate
easilyandinsuresweareusingthesameinterestordiscountratesinourcalculations.
Notehowasimple10%APRchangesbasedontheperiodofcompounding,butthe
EARrapidlyconvergesonthecontinuouslycompoundingvalueusinge.
CompoundingtosmallerandsmallerperiodsuntilCONTINUOUScompounding

10%

Comp.
Period

Rateper
Effective
NperYear period(N) AnnualRate

Year

10.0000%

10.000000%

Qtr

2.5000%

10.381289%

Month

12

0.8333%

10.471307%

Week

52

0.1923%

10.506479%

365

0.0274%

10.515578%

Day
Hour

8760

0.001142%

10.517029%

Minute

525600

0.0000190%

10.517091%

Second

31536000

0.00000032%

10.517092%

Wecanuse"e" tocalculatetheinterestratewithcontinuousor
instantaneous compounding.*
EAR=e r 1=e^.101=

2.71828^.101
0.10517092
10.517092%

OptionsValuation

90

Ch20FuturesContracts
Ch17TheFuturesMarkets&RiskManagement(i.e.Hedging)
Thepricesthatproducersreceivefortheircommoditiesfluctuate.
CORN: Afarmermayproducecornon500acresinIowa
HemightselltoalocalgraneryoncehiscropisharvestedinOctober
(IowacornisnormallyharvestedlateSepttoearlyNovember)
Ifthefarmerwaitsuntilharvesttosellhiscrop,pricevolatilitycouldmeanthe
wholeseasonshiftsfromareasonableprofittoasteeploss.
Hemightwanttosecureabuyerforhiscropashe'splantingit.

AFORWARDcontractcouldbecreatedbetweenthetwoparties,but
thisinvolvesrisksforallparties:
Thegraneryownermaynotwanttocommitattoohighaprice
Apartfromasmallmarketbeing"lessliquid"(fewerparticipants),
thecontracthasalimitedresalemarket(ifitistransferableatall).
Thismayfurtherlimithowmuchthegraneryowneriswillingtopay.
Thefarmerisatriskthatthegraneryownermightreneg

Astandardizedfuturescontractaddressestheseconcerns.

Futures

91

WSJ:2/19/2009

Futures

92

FUTURESTerminology,PricingandMarktoMarket
First,afuturescontractisgenerallyanagreementtobuyorsellagoodatafuturedateand
price.
ThepersonbuyingthecontractisLONGthecontractandagreestopurchase
theasset.Thisisalsoreferredtoas"takingdelivery."
ThepersonsellingthecontractisSHORTandagreesto"makedelivery."
Eachpartyhasafirmcommitmenttomakegoodontheirsideofthe
contract.
HOWEVER,mostcontracts(asmany98+%onsomefutures)
NEVERexistlongenoughtobe"delivered."
Bothpartiesusuallycloseouttheirlong/shortpositionsby
"offsetting"them.
IftheyboughtafuturescontractandareLONG,theysellacontract,
andthisoffsetsthepreviousobligation.Theresultingcontractdisappears
fromthe"OpenInterest"inthecontract.Itnolongerexists.
Atmaturity,orwhensoldpriortomaturity,theprofit(loss)onthecontractis
ProfittoLong=SpotpriceatmaturityOriginalfuturesprice=STF0
ProfittoShort=OriginalfuturespriceSpotpriceatmaturity=F0ST

Second,thepricingoffutureswillinclude
Theriskfreeratetheminimumrateweexpectanassettochangeinvalueovertime.
NOTE:forphysicalcommodities,thiscanalsoincludeafeefor"storage."
F0/(1+rf)T=S0

F0=S0(1+rf)T

Dividendsbecausethepaymentofdividendswillreducethepriceofthestockor
securityifitisonethepaysoutdividends.
F0=S0(1+rfd)T

Futures

93

Third,thesizeofthecontract,whichrelatestothetotalmoneyatrisk,willvarybycontract
type.
Commoditieswillbeinhundredsofounces,orthousandsofbushels,andyouneedto
convertthesevaluesfromthe"spot"priceofacommodity(perouceorbushel)
intothetotalamountatriskinthefuturesinvestment.
Financialfutureswillbeinastatedcontractsize,oftenreferredtoasa"multiplier"on
anpublishedindex.Thisisn'talwaysthecase,butitquitecommon.

Fourth,asapartofcommittingtoafuturescontract,bothpartiesarerequiredtoputup
"margin"withtheirbrokers.
Thismeansthatanindividualisabletouseextremeleverageintradingfutures
e.g.$5000could"control"$100,000worthofanunderlyingasset.
Thishasmanyadvantages.Italsohasmanyrisks.
Example:"MarktoMarket"onSilvercontract
Assumeafuturescontractis$12.10fordeliveryin5days
F0=
$12.10
Thepricesofthefuturescontractareasfollowsoverthenext5days
Day

FuturesPrice
12.10 purchase
12.20
12.25
12.18
12.18
12.21 delivery,the"spot"pricemustequalthispricedueto
"convergence"iftheywereunequal,therewouldbearbitrage
Daily(MarkedtoMarket)
Day
FuturesPrice
Changeinprice
proceeds
Margin
0 12.10
$21,600
1 12.20
0.83% 0.10
$ 500
$22,100
2 12.25
0.41% 0.05
$ 250
$22,350
3 12.18
0.57% (0.07)
$(350)
$22,000
4 12.18
0.00%
$
$22,000
5 12.21
0.25% 0.03
$ 150
$22,150
sum $550
0.91%
profit
InitialMargin $21,600 $ 550
2.5%
Apr2011Initialmargin $11,745 $ 550
4.7%
5000ozcontract
0
1
2
3
4
5

2.31%
1.13%
1.57%
0.00%
0.68%
2.55%

http://online.wsj.com/article/SB10001424053111903791504576589221715678498.html

Futures

94

Example: An Iowa Corn Farmer

Field Name
Farmer John, SomewhereIn, Iowa

Seed, chemicals, etc.

Total

Labor
Total
Land
Cash rent equivalent
Total fixed, variable and all costs
Per acre
Per bushel
All acres

Net returns

FuturesCorn

Total Cost
All Acres
$21,300
----

$341.92

$341.92

$170,958

$40.63
$20,313

$69.50
$34,748

$110.12
$55,060

$55,060
----

$33.06

$0.00

$33.06

$16,530

$215.00

----

$215.00

$107,500

$742.70
$4.50
$371,348

$371,348
-------

Return per Acre Over

Variable Costs
All Costs

Return
All Acres

----

Harvest machinery
Total per acre
Total all acres

Cost per Acre

Variable
$21.20
$10,600

$310.09 $432.61
$1.88
$2.62
$155,043 $216,306

$5.00

$0.00

165 bu./acre
500

Total
$42.60
$21,300

Fixed
$21.40
$10,700

Preharvest machinery
Total per acre
Total all acres

Gross returns
Expected selling price
Government payments
Direct payment
Counter Cyclical pymt.
Expected LDP rate
Total returns

Expected Yield
Acres

----

$825.00

$412,500

-------------

$0.00
$0.00
$0.00
$825.00

$0
$0
$0
$412,500

$82.30

$41,152

$392.39

95

Season-average Price Calculator - 2011

Marketing year month

Sept. 2011
Oct. 2011
Nov. 2011
Dec. 2011
Jan. 2012
Feb. 2012
Mar. 2012
Apr. 2012
May 2012

Actual U.S. monthly

farm price
Soy
beans
Corn
6.37
12.20
5.92
11.90

Jun. 2012
Jul. 2012
Aug. 2012

Monthly farm prices are available from USDA here.

FuturesCorn

Current futures price by trading contract

Soy
beans

Corn
Sept. 2011
Dec. 2011
Mar. 2012
May 2012
Jul. 2012
Sept. 2012

6.47
6.59
6.65
6.69
6.26

Sept. 2011
Nov. 2011
Jan. 2012
Mar. 2012
May 2012
Jul. 2012
Aug. 2012
Sept. 2012

12.08
12.17
12.27
12.36
12.46
12.44
12.34
p

CME Group Corn

Futures

Soybean

Estimated season-average prices

Corn
Soybeans

6.22
11.80

96

ApplicationsAirlineexample:
SupposeyouaretheCFOofamajorairline.Afteryourlaborcosts,yournextlargestcostof
doingbusinessisfuel.Petroleumisclearlyvolatileinprice.Thiscreatesasignificantriskto
yourfirm'sbottomlineandyourabilitytoproduceconsistentreturnsforyourshareholders.
Youcan'tremovealltheexposureyourcompanyhastochangesinoilandgasprices,butyou
canmoderateit.
Ifanairlinesellsticketsinadvance(whichtheytendtodo),doesitknowhow
muchgasitwillneedNOWfortheflightsalreadypurchased?
Doesitknowhowmanyflightsitexpectstofly6monthsfromnow?Howabout
12monthsfromnow?
Sinceit'sagoingconcern,itprobablyknowsprettywellhowmuchgasitwill
needforyearsinthefuture.
You,theCFO,believethecurrentpriceof$50oilwillriseintheforeseeablefuture.
Thiswilldirectlyaffectgasandjetfuelprices.Youuseapproximately1billiongallonsof
jetfuelayear(or23.8millionbarrelsat42gallonsperpetroleumbarrel).
WhatcouldyoudoasCFOofthisairline?

FuturesAirline

97

CreditDefaultSwaps
CDSsareaderivativecontractbasedontheperformanceofanissuerofdebt(e.g.acompany).
Thebuyerofprotectionisbasicallybuyinginsurancethatthedebtonitsbooksisinsuredin
casethereisa"defaultevent."

Abankorinvestorin
LehmanBrothers
bonds

BuyerofProtectionin
theeventLehman
failstomakebond
payments

AIG:Aninsurance
company

$
Paymentsmadeasbasis
pointsontheloan

Sellerofprotection.
IfLehmandoesn't
pay,AIGhasto.
(Thisisbasicallyan
unregulated,insurance
product.)

Intheeventofdefault$$$$$$$$$$$$$$$$$$$$$
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$

Intheeventofdefault,theselleroftheCDS,
paystheowneroftheCDS.Thisisbycontract
butisusuallytheparvalueoftheloan.
Atthetimeofthefinancialcrisis,AIGwas
obligatedtoover$400billioninCDScontracts
significantlymorethanthewholecompanywas
worth.
Creditdefaultswapsstartedasawaytoreducerisk. Theylaterbecameawaytomanufacture
risk(intentionallyornot).

Adefiningproblemforbanksisinmanagingtheirowncreditrisks.Theyconstantlystrivetoaddress
thisageoldproblem.Theycan:
1)Makelowriskloansonly,butthislimitstheopportunityforbusiness,OR
2)abankcouldtakeonriskierloansandpossiblyshareinorpasstheriskofftoother
financialinstitutions.
Derivativesareidealtodothis.Onepartywishestoreduceacertaintypeofrisk.
Thecounterpartyiswillingtotakeonthatrisk
toinvestintheriskforareasonable,negotiatedreturnonthatinvestment.

CreditDefaultSwaps

98

Usingcommoditiesasanexample:
Afarmerusesderivativestohedgehisriskintheeventthatthepriceofcorndeclinesbeforehis
harvest.Anairlinemaywishtolockinpricesforitsjetfuel.
Therearecounterpartiesontheothersideofthesetransactionspeoplewillingtotakeonthe
riskthatcornwillfallinpriceoroilpriceswillrise.
Abankiswillingtoloanalargecorporationagreatdealofmoneybutwishestoreducetheriskoftheloan
onitsbooks.Acounterpartytothistransactionmightbewillingtoaccepttheriskofthebanksdebt
insureit,toacertaindegree.
Thisisacreditdefaultswap.

AccordingtoPart1oftheFrontlinevideo,"Money,Power&WallStreet,"
http://www.pbs.org/wgbh/pages/frontline/moneypowerwallstreet/
1.

InJune1994,whichinvestmentbankcreatedthecreditdefaultswapandonwhatcompany's
debtwasitbased?

2.

HowisitthataCDSinthiscasereducedrisk?
Thisisthe"definingproblem"forbanksmentionedabove.Theycouldeithermakeloans
thatwerelessrisky,ortheycouldpassrisksbetweeninstitutions.
Thelatteroptionmeantsellingthewholeloan,orperhapstheycouldsellsomeofthe
risk.

3.

Whatdocreditdefaultswapshavetodowiththebank'scapitalreserves?

ThebankinthevideothensoldCDScontractsonaportfolioofdebtfor306companiesitheld.
ItcouldcustomizetheCDSbasedupontherisktheclientwantedinsocalled"tranches."
Butthebankwaslimited,inthiscase,tothedebtofcompaniesithadonthebooks.

Youshouldbeabletoanswerthethreequestionsaboveforaquizorexam.

CreditDefaultSwaps

99

ThisledtothecreationofSYNTHETICCOLLATERLIZEDDEBTOBLIGATIONS.
(MakesureyouunderstandwhatthedifferenceisbetweenaCDS andasyntheticCDO .)

Thesameexampleastheoneabove,butnowtheinvestorisaSPECULATOR.
SheisnothedgingtheriskofLehmanbonds.Shedoesn'townanyofthem.
She'sjustbettingthatLehmanbondswilldefault.

Speculatorin
syntheticCDOs

Buyerofthesynthetic
CDOisdoingsoasa
wagerthatLehman
hasa"defaultevent"
onitsdebt

AIG:Aninsurance
company

$
Paymentsmadeasbasis
pointsontheloan

Sellerofprotection.
IfLehmandefaults,
AIGpaysasmuchas
theparvalueofthe
bonds"insured."

The"defaultevent"triggers$$$$$$$$$$$$$$$$$$
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$

Becausethisisnotahedgedtransaction,therecouldbemanymore
CDOcontractsouttherethanthereareactualbonds.
Thiscreated massivesystematicrisk,andmoreimportantly,becausethese
derivativeproductswerenotregulated,theamountofriskouttherewasnot
onlynotunderstood,thetotalsizeofallthecontractswasn'tevenknown.

Averygoodbookthatdelvesinto
themortgageCDS/CDOmarketis
"TheBigShort"
MichaelLewisfocusesonthesmall
numberofpeoplewhosawthe
mortgagemeltdowncomingand
wereabletoprofitfromit.

CreditDefaultSwaps

100