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Chapter 1 Introduction to Derivatives


Risk is the central element that inuences nancial behavior. Robert C. Merton (1999)

he world of nance and capital markets has undergone a stunning transformation in the last 30 years. Simple stocks and bonds now seem almost quaint alongside the dazzling, fast-paced, and seemingly arcane world of futures, options, swaps, and other new nancial products. (The word new is in quotes because it turns out that some of these products have been around for hundreds of years.) Frequently this world pops up in the popular press: Procter & Gamble lost $150 million in 1994, Barings bank lost $1.3 billion in 1995, Long-Term Capital Management lost $3.5 billion in 1998 and (according to some press accounts) almost brought the world nancial system to its knees.1 What is not in the headlines is that, most of the time, for most companies and most users, these nancial products are an everyday part of business. Just as companies routinely issue debt and equity, they also routinely use swaps to x the cost of production inputs, futures contracts to hedge foreign exchange risk, and options to compensate employees, to mention just a few examples.

1.1 W HAT I S A D ERIVATIVE?


Options, futures, and swaps are examples of derivatives. A derivative is simply a nancial instrument (or even more simply, an agreement between two people) which has a value determined by the price of something else. For example, a bushel of corn is not a derivative; it is a commodity with a value determined by the price of corn. However, you could enter into an agreement with a friend that says: If the price of a bushel of corn in one year is greater than $3, you will pay the friend $1. If the price of corn is less than $3, the friend will pay you $1. This is a derivative in the sense that you have an agreement with a value depending on the price of something else (corn, in this case). You might be tempted to say: Thats not a derivative; thats just a bet on the price of corn. So it is: Derivatives can be thought of as bets on the price of something. But .................................
1A readable

summary of these and other infamous derivatives-related losses is in Jorion (2001).

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dont automatically think the term bet is pejorative. Suppose your family grows corn and your friends family buys corn to mill into cornmeal. The bet provides insurance: You earn $1 if your familys corn sells for a low price; this supplements your income. Your friend earns $1 if the corn his family buys is expensive; this offsets the high cost of corn. Viewed in this light, the bet hedges you both against unfavorable outcomes. The contract has reduced risk for both of you. Investors could also use this kind of contract simply to speculate on the price of corn. In this case the contract is not insurance. And that is a key point: It is not the contract itself, but how it is used, and who uses it, that determines whether or not it is risk-reducing. Context is everything. Although weve just dened a derivative, if you are new to the subject the implications of the denition will probably not be obvious right away. You will come to a deeper understanding of derivatives as we progress through the book, studying different products and their underlying economics.

Uses of Derivatives
What are reasons someone might use derivatives? Here are some motives: Derivatives are a tool for companies and other users to reduce risks. The corn example above illustrates this in a simple way: The farmera seller of cornenters into a contract which makes a payment when the price of corn is low. This contract reduces the risk of loss for the farmer, who we therefore say is hedging. It is common to think of derivatives as forbiddingly complex but many derivatives are simple and familiar. Every form of insurance is a derivative, for example. Automobile insurance is a bet on whether you will have an accident. If you wrap your car around a tree, your insurance is valuable; if the car remains intact, it is not.
Risk management Speculation Derivatives can serve as investment vehicles. As you will see later in the book, derivatives can provide a way to make bets that are highly leveraged (that is, the potential gain or loss on the bet can be large relative to the initial cost of making the bet) and tailored to a specic view. For example, if you want to bet that the S&P 500 stock index will be between 1300 and 1400 one year from today, derivatives can be constructed to let you do just that. Reduced transaction costs Sometimes derivatives provide a lower-cost way to effect a particular nancial transaction. For example, the manager of a mutual fund may wish to sell stocks and buy bonds. Doing this entails paying fees to brokers and paying other trading costs, such as the bid-ask spread, which we will discuss later. It is possible to trade derivatives instead and achieve the same economic effect as if stocks had actually been sold and replaced by bonds. Using the derivative might result in lower transaction costs than actually selling stocks and buying bonds. Regulatory arbitrage It is sometimes possible to circumvent regulatory restrictions, taxes, and accounting rules by trading derivatives. Derivatives are often used, for example, to achieve the economic sale of stock (receive cash for it and eliminate the risk of

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What Is a Derivative?

holding it) while still maintaining physical possession of the stock. This transaction may allow the owner to defer taxes on the sale of the stock, or retain voting rights, without the risk of holding the stock. These are common reasons for using derivatives. The general point is that derivatives provide an alternative to a simple sale or purchase, and thus increase the range of possibilities for an investor or manager seeking to accomplish some goal.

Perspectives on Derivatives
How you think about derivatives depends on who you are. In this book we will think about three distinct perspectives on derivatives: End-users are the corporations, investment managers, and investors who enter into derivative contracts for the reasons listed in the previous section: To manage risk, speculate, reduce costs, or avoid a rule or regulation. End-users have a goal (for example, risk reduction) and care about how a derivative helps to meet that goal.
The end-user perspective The market-maker perspective

Market-makers are intermediaries, traders who will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy. In order to make money, market-makers charge a spread: They buy at a low price and sell at a high price. In this respect market-makers are like grocers who buy at the low wholesale price and sell at the higher retail price. Marketmakers are also like grocers in that their inventory reects customer demands rather than their own preferences: As long as shoppers buy paper towels, the grocer doesnt care whether they buy the decorative or super-absorbent style. After dealing with customers, market-makers are left with whatever position results from accommodating customer demands. Market-makers typically hedge this risk and thus are deeply concerned about the mathematical details of pricing and hedging. Finally, we can look at the use of derivatives, the activities of the market-makers, the organization of the markets, the logic of the pricing models, and try to make sense of everything. This is the activity of the economic observer. Regulators must often don their economic observer hats when deciding whether and how to regulate a certain activity or market participant. These three perspectives are intertwined throughout the book, but as a general point, in the early chapters the book emphasizes the end-user perspective. In the late chapters, the book emphasizes the market-maker perspective. At all times, however, the economic observer is interested in making sense of everything.

The economic observer

Financial Engineering and Security Design


One of the major ideas in derivativesperhaps the major ideais that it is generally possible to create a given payoff in multiple ways. The construction of a given nancial product from other products is sometimes called nancial engineering. The fact that this is possible has several implications. First, since market-makers need to hedge their

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w Introduction to Derivatives
positions, this idea is central in understanding how market-making works. The marketmaker sells a contract to an end-user, and then creates an offsetting position which pays him if it is necessary to pay the customer. This creates a hedged position. Second, the idea that a given contract can be replicated often suggests how it can be customized. The market-maker can, in effect, turn dials to change the risk, initial premium, and payment characteristics of a derivative. These changes permit the creation of a product that is more appropriate for a given situation. Third, it is often possible to improve intuition about a given derivative by realizing that it is equivalent to something we already understand. Finally, because there are multiple ways to create a payoff, the regulatory arbitrage discussed above can be difcult to stop. Distinctions existing in the tax code, or in regulations, may not be enforceable, since a particular security or derivative that is regulated or taxed may be easily replaced by one which is treated differently but has the same economic prole. A theme running throughout the book is that derivative products can generally be constructed from other products.

1.2 T HE R OLE OF F INANCIAL M ARKETS


We take for granted headlines saying that the Dow Jones Industrial Average has gone up 100 points, the dollar has fallen against the Yen, and interest rates have risen. But why do we care about these things? Is the rise and fall of a particular nancial index (such as the Dow Jones Industrial Average) simply a way to keep score, to track winners and losers in the economy? Is watching the stock market like watching sports, where we root for certain players and teamsa tale told by journalists, full of sound and fury, but signifying nothing? Financial markets in fact have an enormous, often underappreciated, impact on everyday life. To help us understand the role of nancial markets we will consider the Average family, living in Anytown. Joe and Sarah Average have 2.3 children and both work for the XYZ Co., the dominant employer in Anytown. Their income pays for their mortgage, transportation, food, clothing, and medical care. What is left over goes toward savings earmarked for their childrens college tuition and their own retirement. What role do global nancial markets and derivatives play in the lives of the Averages?

Financial Markets and the Averages


The Averages are largely unaware of the ways in which nancial markets affect their lives. Here are a few: The Averages employer, XYZ Co., has an ongoing need for money to nance operations and investments. It is not dependent on the local bank for funds because it can raise the money it needs by issuing stocks and bonds in global markets.

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The Role of Financial Markets

XYZ Co. insures itself against certains risks. In addition to having property and casualty insurance for its buildings, it uses global derivatives markets to protect itself against adverse currency, interest rate, and commodity price changes. By being able to manage these risks, XYZ is less likely to go into bankruptcy, and less likely to throw the Averages into unemployment. The Averages invest in mutual funds. As a result they pay lower transaction costs than if they tried to achieve comparable diversication by buying individual stocks. Since both Averages work at XYZ, they run the risk that if XYZ does fall on hard times they will lose their jobs. The mutual funds in which they invest own stocks in a broad array of companies, ensuring that the failure of any one company will not wipe out their savings. The Averages live in an area susceptible to tornadoes and insure their home. If their insurance company were completely local, it could not offer tornado insurance because one disaster would leave it unable to pay claims. By selling tornado risk in global markets, the insurance company can in effect pool Anytown tornado risk with Japan earthquake risk and Florida hurricane risk. This pooling makes insurance available at lower rates. The Averages borrowed money from Anytown bank to buy their house. The bank sold the mortgage to other investors, freeing itself from interest rate and default risk associated with the mortgage, leaving that to others. Because the risk of their mortgage is borne by those willing to pay the highest price for it, the Averages get the lowest possible mortgage rate. In all of these examples, particular nancial functions and risks have been split up and parceled out to others. A bank that sells a mortgage does not have to bear the risk of the mortgage. An insurance company does not bear all the risk of a disaster. Risk-sharing is one of the most important functions of nancial markets.

Risk-Sharing
Risk is an inevitable part of all lives and all economic activity. As weve seen in the example of the Averages, nancial markets enable this risk to be shared. To demonstrate how risk may be shared, lets examine one brief time period. Within the span of a few weeks in 1999 earthquakes devastated Turkey and Taiwan, oods ravaged North Carolina, and war loomed in the former Soviet Union, as well as in India and Pakistan. Drought and pestilence destroy agriculture every year in some part of the world. Some economies surge as others falter. On a more personal scale, people are born, die, retire, nd jobs, lose jobs, marry, divorce, and become ill. In the face of this risk, it seems natural to have arrangements where the lucky share with the unlucky. Risk-sharing occurs informally in families and communities. The insurance market makes formal risk-sharing possible. Buyers pay a premium to obtain various kinds of insurance, such as homeowners insurance. Total collected premiums are then available to help those whose houses burn down. The lucky, meanwhile, did

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not need insurance and have lost their premium. The market makes it possible for the lucky to help the unlucky. In the business world, changes in commodity prices, exchange rates, and interest rates can be the nancial equivalent of a house burning down. If the dollar becomes expensive relative to the Yen, some companies are helped and others are hurt. It makes sense for there to be a mechanism enabling companies to exchange this risk, so that the lucky can, in effect, help the unlucky. You might be wondering what this discussion has to do with the notions of diversiable and nondiversiable risk familiar from portfolio theory. Risk is diversiable risk if it is unrelated to other risks. The risk that a lightning strike will cause a factory to burn down, for example, is idiosyncratic and hence diversiable. If many investors share a small piece of this risk, it has no signicant effect on anyone. Risk that does not vanish when spread across many investors is nondiversiable risk. The risk of a stock market crash, for example, is nondiversiable. Financial markets in theory serve two purposes. Markets permit diversiable risk to be widely shared. This is efcient: By denition, diversiable risk vanishes when it is widely shared. At the same time, nancial markets permit nondiversiable risk, which does not vanish when shared, to be held by those most willing to hold it. Thus, the fundamental economic idea underlying the concepts and markets discussed in this book is that the existence of risk-sharing mechanisms benets everyone. A risk-management problem faced by Tokyo Disneyland illustrates how it was able to diversify risk using capital markets. Disney decided that it would prot by opening a theme park in Japan. However, Japan is in a high-earthquake region. This location creates unavoidable risk for a theme park, or any business. Disney had several alternatives. First, it could have self-insured. In this case, Disney shareholders would have absorbed the earthquake risk. Second, Disney could have bought earthquake insurance from an insurance company. Because the insurance companys payout would be large if an earthquake did occur, that insurance company would likely have bought insurance for itself from other insurance companies, in what is called the reinsurance market. (Reinsurance is insurance for insurance companies, and it is one way for insurance risks to become more widely held.) In the end, the shareholders and bondholders of the reinsurance companies would have held the risk. Disney took a third alternative, essentially bypassing intermediaries by issuing earthquake bonds, held directly by investors. The box on page 7 discusses these bonds. All three alternativesself-insurance, conventional insurance, and earthquake bondswould have resulted in risk being held by numerous investors. The earthquake bond allowed earthquake risk to be borne by exactly those investors who wished to bear it.

1.3 D ERIVATIVES IN P RACTICE


Derivatives use and the variety of derivatives have grown over the last 30 years.

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Derivatives in Practice The Tokyo Disneyland Bond

riental Land Co. Ltd. is licensed by the Walt Disney Co. to operate theme parks in Japan, including Tokyo Disneyland. In May 1999, the company issued a $100m 5-year earthquake bond, designed both to raise money and to provide earthquake insurance. The bond is structured so that in the event of a severe earthquake, Tokyo Disneyland is not obligated to repay the entire bond. Bondholders thus suffer a loss if an earthquake occurs. Damage to Tokyo Disneyland would increase with the severity and proximity of the earthquake. The bond was structured to account for this, with the forgiveness of principal linked to the magnitude and location of the earthquake. If an earthquake rated above Richter 7.5 occurs within a 10km radius of the park, the entire bond is forgiven.

There is then a sliding scale down to Richter 6.5, at which point only 25% of the bonds principal is forgiven. The bond also species a middle and outer ring, extending to 75km from the park, with increasingly severe earthquakes necessary to trigger nonpayment of principal. The bond coupon was set to equal the London Interbank interest rate (LIBOR) plus 310 basis points. This deal was the rst in which a private company, rather than a reinsurer, issued a catastrophe bond. The bond is not perfect insurance for Oriental Land Co. since the bond payout is related to the severity of the earthquake, not specically to damage to the park. A second $100m bond called for temporary nonpayment of interest in the event of an earthquake.

Growth in Derivatives Trading


If we examine recent history, the introduction of derivatives has coincided with increases in price risk in various markets. Currencies were ofcially permitted to oat in 1971 when the gold standard was ofcially abandoned. OPECs 1973 reduction in the supply of oil was followed by high and variable oil prices. U.S. interest rates became more volatile following ination and recessions in the 1970s. The market for natural gas has been deregulated gradually since 1978, resulting in a volatile market in recent years. The deregulation of electricity began during the 1990s. Figures 1.1, 1.2, and 1.3 show the changes for oil prices, exchange rates, and interest rates. The link between price variability and the development of derivatives markets is naturalthere is no need to manage risk when there is no risk.2 When risk does exist, we would expect that markets will develop to permit efcient risk-sharing. Investors who have the most tolerance for risk will bear more of it, and risk-bearing will be widely spread among investors. .................................
2 It

is sometimes argued that the existence of derivatives markets can increase the price variability of the underlying asset or commodity. Without some price risk in the rst place, however, the derivatives market is unlikely to exist.

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FIGURE 1.1 Monthly percentage change in the producer price index for oil, 19511999.
% change 40 30 20 10 0 10 20 30 1960 1970 1980 1990 2000

FIGURE 1.2
8

% change

Monthly percentage change in the Deutschemark/dollar exchange rate, 19511999.

6 4 2 0 2 4 6 8 1960 1970 1980 1990 2000

Figure 1.4 depicts contract volume for the three largest U.S. futures exchanges over the last 25 years. Table 1.1 illustrates the kinds of futures contracts traded at these exchanges.3 Futures exchanges are an organized and regulated marketplace for trading .................................
3 The table lists only a fraction of the contracts traded at these exchanges.

For example, in January 2002, the Chicago Mercantile Exchange Web page listed futures contracts on over 75 different underlying assets ranging from butter to a bankruptcy index.

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Derivatives in Practice

FIGURE 1.3 Monthly change in 3-month Treasury bill rate, 19511999.


Change in rate (percentage points) 2 1 0 1 2 3 4 1960 1970 1980 1990 2000

FIGURE 1.4
200 Annual volume, millions of contracts

Millions of contracts traded annually at the Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX).

180 160 140 120 100 80 60 40 20 0 1970

CBT CME NYMEX

1975

1980

1985

1990

1995

2000

Source: CRB Commodity Yearbook.

futures contracts, a kind of derivative, but much commercial derivatives trading occurs in the over-the-counter market, where buyers and sellers transact with banks and dealers rather than on an exchange. It is difcult to obtain statistics for over-the-counter volume. However, in some markets, such as currencies, it is clear that the over-the-counter market is signicantly larger than the exchange-traded market.

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Examples of futures contracts traded on the Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX).

TABLE 1.1

CBT 30-year U.S. Treasury Bonds 10-year U.S. Treasury Bonds Municipal Bond Index Corn Soybeans Wheat Oats

CME S&P 500 Index NASDAQ 100 Index Eurodollars Nikkei 225 Pork Bellies Heating and Cooling Degree-Days Japanese Yen

NYMEX Crude Oil Natural Gas Heating Oil Gasoline Gold Copper Electricity

How Are Derivatives Used?


In recent years the U.S. Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) have increased the requirements for corporations to report on their use of derivatives. Nevertheless, surprisingly little is known about how companies actually use derivatives to manage risk. The basic strategies companies use are well-understoodand will be described in this bookbut it is not known, for example, what fraction of perceived risk is hedged by a given company, or by all companies in the aggregate. We frequently do not know a companys specic rationale for hedging or not hedging. We would expect the use of derivatives to vary by type of rm. For example, nancial rms, such as banks, are highly regulated and have capital requirements. They may have assets and liabilities in different currencies, with different maturities, and with different credit risks. Hence banks could be expected to use interest rate derivatives, currency derivatives, and credit derivatives to manage risks in those areas. Manufacturing rms that buy raw materials and sell in global markets might use commodity and currency derivatives, but their incentives to manage risk are less clear-cut because they are not regulated in the same ways as nancial rms.

1.4 B UYING AND S HORT- S ELLING F INANCIAL A SSETS


Throughout this book we will talk about buying and sellingand short-sellingassets such as stocks. These basic transactions are so important that it is worth describing the details. First, it is important to understand the costs associated with buying and

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Buying and Short-Selling Financial Assets

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selling. Second, a very important idea used throughout the book is that of short-sales. The concept of short-selling should be intuitivea short-sale is just the opposite of a purchasebut for almost everyone it is hard to grasp at rst. Even if you are familiar with short sales, spend a few minutes reading this section.

Buying an Asset
Suppose we want to buy 100 shares of XYZ stock. This seems simple: If the stock price is $50, 100 shares will cost $50 100 = $5000. However, this calculation ignores transaction costs. First, there is a commission, which is a transaction fee you pay your broker. A commission for the above order could be $15, or .3% of the purchase price. Second, the term stock price is, surprisingly, imprecise. There are in fact two prices, a price at which you can buy, and a price at which you can sell. The price at which you can buy is called the offer price or ask price, and the price at which you can sell is called the bid price. Where do these terms come from? If you want to buy stock, you pick up the phone and call a broker. If the stock is not too obscure and your order is not too large, your purchase will probably be completed in a matter of seconds. Have you ever wondered where the stock comes from that you have just bought? It is possible that at the exact same moment, another customer called the broker and put in an order to sell. More likely, however, a market-maker sold you the stock. Market-makers do what their name implies: They make markets. If you want to buy, they sell, and if you want to sell, they buy. In order to earn a living, market-makers sell for a high price and buy for a low price. If you deal with a market-maker, therefore, you buy for a high price and sell for a low price. This difference between the price at which you can buy and the price at which you can sell is called the bid-ask spread.4 In practice the bid-ask spread on the stock you are buying may be $49.75 to $50. This means that you can buy for $50/share and sell for $49.75/share. If you were to buy immediately and then sell, you would pay the commission twice, and you would pay the bid-ask spread. Note that when you observe prices in the real world, you will often see them bounce up and down a bit. This can reect bid-ask bounce. If the bid is $49.75 and the ask is $50, a series of buy and sell orders will cause the price at which the stock was last traded to move between $49.75 and $50. The true price has not changed, however, because the bid and ask have not changed.

Example 1.1 Suppose XYZ is bid at $49.75 and offered at $50, and the commission is $15. If you buy 100 shares of the stock you pay ($50 100) + $15 = $5015. If you .................................
4 If

you think a bid-ask spread is unreasonable, ask what a world without dealers would be like. Every buyer would have to nd a seller, and vice versa. The search would be costly and take time. Dealers, because they maintain inventory, offer an immediate transaction, a service called immediacy.

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immediately sell them again, you receive ($49.75 100) $15 = $4960. Your round trip transaction costthe difference between what you pay and what you receive from w a sale, not counting changes in the bid and ask pricesis $5015 $4960 = $55.

Incidentally, this discussion reveals where the terms bid and ask come from. Your rst thought might have been that the terminology is backward. The bid price sounds like it should be what you pay. It is in fact what the market-maker pays; hence it is the price at which you sell. The offer price is what the market-maker will sell for, hence it is what you have to pay. The terminology reects the perspective of the market-maker. One last point: What happens to your shares after you buy them? Generally they are held by your broker. If you read the ne print on your brokerage contract carefully, your broker typically has the right to lend your shares to another investor. Why would anyone want to borrow your shares? The answer to that brings us to the next topic, short-sales. Although we have focused here on shares of stock, there are similar issues associated with buying any asset.

Short-Selling
When we buy something, we are said to have a long position in that thing. For example, if we buy the stock of XYZ, we pay cash and receive the stock. Some time later, we sell the stock and receive cash. This transaction is lending, in the sense that we pay money today and receive money back in the future. The rate of return we receive may not be known in advance (if the stock price goes up a lot, we get a high return; if the stock price goes down, we get a negative return), but it is a kind of loan nonetheless. The opposite of a long position is a short position. A short-sale of XYZ entails borrowing shares of XYZ and then selling them, receiving the cash. Some time later, we buy back the XYZ stock, paying cash for it, and return it to the lender. The idea is to rst sell high and then buy low. (With a long position, the idea is to rst buy low and then sell high.) A short-sale can be viewed, then, as just a way of borrowing money. When you borrow money from a bank, you receive money today and repay it later, paying a rate of interest set in advance. This is also what happens with a short-sale, except that you dont necessarily know the rate you pay to borrow. There are at least three reasons to short-sell:

1. Speculation A short-sale, considered by itself, makes money if the price of the stock goes down. 2. Financing A short-sale is a way to borrow money, and it is frequently used as a form of nancing. This is very common in the bond market, for example. 3. Hedging You can undertake a short-sale to offset the risk of owning the stock or a derivative on the stock. This is frequently done by market-makers and traders.

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These reasons are not mutually exclusive. For example, a market-maker might use a short-sale to simultaneously hedge and nance a position. Because short-sales can seem confusing, here is a detailed example that illustrates how short-sales work.
Example: Short-selling pokey babies

Consider the (hypothetical) pokey-baby phenomenon, in which small dolls representing Japanese cartoon characters become expensive collectors items that are bought and sold worldwide. Suppose, however, that you believe the pokey-baby phenomenon is over and that prices of pokey babies are going to fall. How could you speculate based on this belief? If you believed prices would rise, you would buy pokey babies today and sell later. However, if you believed prices would fall, you would like to do the opposite: Sell today (at the high price) and buy tomorrow (at the low price). How do you actually accomplish this? In order to sell today, you must rst obtain pokey babies to sell. You can do this by borrowing them from a collector. The collector, of course, will want a promise that the pokey babies will be returned at some point, so suppose you agree to return them in one week. Thus, you borrow them and sell them at the market price. After one week, you acquire replacement pokey babies on the market, then return them to the collector from whom you borrowed them. If the price has fallen, you have made money, while if the price has risen you have lost money. Whatever happens to the price, you have just completed a short-sale of pokey babies. The act of buying the pokey baby and returning it to the lender is said to be closing or covering the short position. Note that you really have borrowed money. Initially, you received money from selling the pokey babies, and a week later you pay the money back (you had to buy the pokey babies back to return them). The rate of interest you paid was low if the pokey-baby price was low, and high if the pokey-baby price was high. This example is obviously simplied. We have assumed that It is easy to nd a pokey-baby lender. It is easy to buy, at a fair price, a satisfactory pokey baby to return to the lender. The pokey babies you buy after one week are a perfect substitute for the pokey babies you borrowed. The collector from whom you borrowed is not concerned that you will fail to return the borrowed toy.

Example: Short-selling stock Now consider a short-sale of stock. As with the previous example, when you short-sell stock you borrow the stock and sell it, receiving cash today. At some future date you buy the stock in the market and return it to the original owner. You have cash coming in today, equal to the market value of the stock you shortsell. In the future, you repay the borrowing by buying the asset at its then-current market price and returning the assetthis is like the repayment of a loan. Thus, short-selling a stock is equivalent to borrowing money, except that the interest rate you pay is not known in advance. Rather, it is determined by the change in the stock price. The rate of

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Cash ows associated with short-selling a share of IBM for 90 days. Note that the short-seller must pay the dividend, D, to the share-lender.

TABLE 1.2

Day 0 Action Security Cash Borrow Shares Sell Shares +S0

Dividend Ex-Day D

Day 90 Return Shares Purchase Shares S90

interest is high if the security rises in price and low if the security falls in price. In effect, the rate of return on the security is the rate at which you borrow. With a short-sale, you are like the issuer of a security rather than the buyer of a security. Suppose you want to short-sell IBM stock for 90 days. Table 1.2 depicts the cash ows. Observe in particular that if the share pays dividends, the short-seller must in turn make dividend payments to the share-lender. This issue did not arise with pokey babies! This dividend payment is taxed to the recipient, just like an ordinary dividend payment, and it is tax-deductible to the short-seller. Notice that the cash ows in Table 1.2 are exactly the opposite of the cash ows from purchasing the stock. Thus, short-selling is literally the opposite of buying.

The Lease Rate of an Asset


We have seen that when you borrow an asset it may be necessary to make payments to the lender. Dividends on short-sold stock are an example of this. We will refer to the payment required by the lender as the lease rate of the asset. This concept will arise frequently, and, as we will see, provides a unifying concept for our later discussions of derivatives. The pokey-baby example did not have a lease payment. But under some circumstances it might be necessary to make a payment to borrow a pokey baby. Pokey babies do not pay an explicit dividend, but they do pay an implicit dividend if the owner enjoys seeing them on the shelf. The owner might thus require a payment in order to lend a pokey baby. This would be a lease rate for pokey babies.

Risk and Scarcity in Short-Selling


The preceding examples were simple illustrations of the mechanics and economics of short-selling, and demonstrate the ideas you will need to understand our discussions of derivatives. It turns out, however, that some of the complexities we skipped over are easy to understand and are important in practice. In this section we return to the pokey-baby example to illustrate some of these practical issues.

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Buying and Short-Selling Financial Assets


Credit risk

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As the short-seller, you have an obligation to the pokey-baby lender to return the toys. The pokey-baby lender fears that you will renege on this obligation. This concern can be addressed with collateral: After you sell the pokey babies, the pokey-baby lender can hold the money you received from selling the pokey babies. You have an obligation to return the toy; the lender keeps the money in the event that you dont. Holding on to the money will help the lender feel more secure, but after thinking the matter over, the lender will likely want more from you than just the value of the pokey babies. Suppose you borrow $5000 worth of pokey babies. What happens, the lender will think, if the price of the pokey babies rises to $6000 one week later? This is a $1000 loss on your short-sale. In order to return the toys, you will have to pay $6000 for toys you just sold for $5000. Perhaps you cannot afford the extra $1000 and you will fail to return the borrowed toys. The lender, thinking ahead, will be worried at the outset about this possibility and will ask you to provide more than the $5000 the pokey babies are worth, say an extra $1000. This extra amount is called a haircut, and serves to protect the lender against your failure to return the toys when the price rises.5 In practice, short-sellers must have fundscalled capital to be able to pay haircuts. The amount of capital places a limit on their ability to short-sell.
Scarcity As the short-seller, do you need to worry about the short-sale proceeds? The lender is going to have $6000 of your money. Most of this, however, simply reects your obligation, and we could imagine asking a trustworthy third party, such as a bank, to hold the money so the lender cannot abscond with it. However, when you return the toys, you are going to want your money back, plus interest. This raises the question: What rate of interest will the lender pay you? Over the course of the short-sale, the lender can invest your money, earning, say, 6%. The lender could offer to pay you 4% on the funds, thinking to keep as a fee the 2% difference between the 6% earned on the money and the 4% paid to you. What happens if the lender and borrower negotiate? Here is the interesting point: The rate of interest the lender pays on the collateral is going to depend on how many people want to borrow pokey babies and how many are willing to lend them! As a practical matter, it may not be easy to nd a lender. If there is high demand for borrowed pokey babies, the lender will offer a low rate of interest, essentially earning a fee for being willing to lend something that is scarce. However, if no one else wants to borrow the toys, the lender might conclude that a small fee is better than nothing and offer you a rate of interest close to the market rate. The rate paid on collateral is called different things in different markets, the repo rate in bond markets and the short rebate in the stock market. Whatever it is called, the difference between this rate and the market rate of interest is another cost to your short-sale.

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5 Note that the lender is not concerned about your failure to perform when the price goes down because

the lender has the money!

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w Introduction to Derivatives

C HAPTER S UMMARY
Derivatives are nancial instruments with a payoff determined by the price of something else. They can be used as a tool for risk management, for speculation, to reduce transaction costs, or to avoid taxes or regulation. One important function of nancial markets is to facilitate optimal risk-sharing. The growth of derivatives markets over the last 50 years has coincided with an increase in the risks evident in various markets. Events such as the 1973 oil shock, the abandonment of xed exchange rates, and the deregulation of energy markets have created a new role for derivatives. A short-sale entails borrowing a security, selling it, making dividend (or other cash) payments to the security lender, and then returning it. A short-sale is conceptually the opposite of a purchase. Short-sales can be used for speculation, as a form of nancing, or as a way to hedge. Many of the details of short-selling in practice can be understood as a response to credit risk of the short-seller and scarcity of shares that can be borrowed. Short-sellers typically leave the short-sale proceeds on deposit with lenders, along with additional capital called a haircut. The rate paid on this collateral is called the short rebate, and is less than the interest rate.

F URTHER R EADING
The rest of this book provides an elaboration of themes discussed in this chapter. However, certain chapters are directly related to the discussion. Chapters 2, 3, and 4 introduce forward and option contracts, which are the basic contracts in derivatives, and show how they are used in risk management. Chapter 13 discusses in detail how derivatives marketmakers manage their risk, and Chapter 15 explains how derivatives can be combined with instruments such as bonds to create customized risk-management products. The various derivatives exchanges have websites which list their contracts. The websites for the exchanges in Figure 1.4 are www.cbot.com (Chicago Board of Trade), www.cme.com (Chicago Mercantile Exchange), and www.nymex.com (New York Mercantile Exchange). Jorion (1995) examines in detail one famous derivatives disaster: Orange County in California. Bernstein (1992) is a history of the development of nancial markets, and Bernstein (1996) discusses the concept of risk measurement and how it evolved over the last 800 years. Miller (1986) discusses origins of past nancial innovation, and Merton (1999) provides a fascinating academic perspective on possible future developments in nancial markets. Froot and OConnell (1999) and Froot (2001) examine the market for catastrophe reinsurance. DAvolio (2001) explains the economics and practices associated with short-sales. Finally, Lewis (1989) is a classic, funny, insiders account of investment banking, offering a different (to say the least) perspective on the mechanics of global risk-sharing.

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Problems

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P ROBLEMS
1.1. Heating degree-day and cooling degree-day futures contracts make payments based on whether the temperature is abnormally hot or cold. Explain why the following businesses might be interested in such a contract:
a. Soft-drink manufacturers. b. Ski-resort operators. c. Electric utilities. d. Amusement park operators.

1.2. Suppose the businesses in the previous problem use futures contracts to hedge their temperature-related risk. Who do you think might accept the opposite risk? 1.3. ABC stock has a bid price of $40.95 and an ask price of $41.05. Assume there is a $20 brokerage commission.
a. What amount will you pay to buy 100 shares? b. What amount will you receive for selling 100 shares? c. Suppose you buy 100 shares, then immediately sell 100 shares with the bid and ask prices being the same in both cases. What is your round-trip transaction cost?

1.4. Repeat the previous problem supposing that the brokerage fee is quoted as 0.3% of the bid or ask price. 1.5. Suppose a security has a bid price of $100 and an ask price of $100.12. At what price can the market-maker purchase a security? At what price can a marketmaker sell a security? What is the spread in dollar terms when 100 shares are traded? 1.6. Suppose you short-sell 300 shares of XYZ stock at $30.19 with a commission charge of 0.5%. Supposing you pay commission charges for purchasing the security to cover the short-sale, how much prot have you made if you close the short-sale at a price of $29.87? 1.7. Suppose you desire to short-sell 400 shares of JKI stock, which has a bid price of $25.12 and an ask price of $25.31. You cover the short position 180 days later when the bid price is $22.87 and the ask price is $23.06.
a. Taking into account only the bid and ask prices (ignoring commissions and interest), what prot did you earn? b. Suppose that there is a 0.3% commission to engage in the short-sale (this is the commission to sell the stock) and a 0.3% commission to close the short-sale (this is the commission to buy the stock back). How do these commissions change the prot in the previous answer?

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w Introduction to Derivatives
c. Suppose the 6-month interest rate is 3% and that you are paid nothing on the short-sale proceeds. How much interest do you lose during the 6 months in which you have the short position?

1.8. When you open a brokerage account, you typically sign an agreement giving the broker the right to lend your shares without notifying or compensating you. Why do brokers want you to sign this agreement? 1.9. Suppose a stock pays a quarterly dividend of $3. You plan to hold a short position in the stock across the dividend ex-date. What is your obligation on that date? If you are a taxable investor, what would you guess is the tax consequence of the payment? (In particular, would you expect the dividend to be tax deductible?) Suppose the company announces instead that the dividend is $5. Should you care that the dividend is different from what you expected? 1.10. Short interest is a measure of the aggregate short positions on a stock. Check an online brokerage or other nancial service for the short interest on several stocks of your choice. Can you guess which stocks have high short interest and which have low? Is it theoretically possible for short interest to exceed 100% of shares outstanding? 1.11. Suppose that you go to a bank and borrow $100. You promise to repay the loan in 90 days for $102. Explain this transaction using the terminology of short-sales. 1.12. Suppose your banks loan ofcer tells you that if you take out a mortgage (i.e., you borrow money to buy a house) you will be permitted to borrow no more than 80% of the value of the house. Describe this transaction using the terminology of short-sales.

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