RiskManagement,Speculation,and DerivativeSecuritiesRiskManagement,Speculation,and DerivativeSecuritiesGeoffrey PoitrasFaculty of Business AdministrationSimon Fraser UniversityBurnaby, B.C., CanadaAmsterdam Boston London New York Oxford ParisSan Diego San Francisco Singapore Sydney TokyoTo my students: past, present, and future.CONTENTSPreface xvAcknowlegments xixPA RT IDerivative Securities, Risk Management,and Speculation1 Derivative SecuritiesI. Denitions and Other Basic Concepts 3A. What are Derivative Securities? 3B. Some Denitions 6C. Futures Versus Forward Contracts: Basic Issues 11D. The Exchange 14E. The Futures Contract 16F. Margins 19G. OTC Versus Exchange Trading: Policy Issues 22II. History of Derivatives 25A. The Development of U.S. Derivative Markets 32B. A Canadian Perspective 37C. The U.S. Experience with Options 40III. Recent Derivatives Debacles 46A. The Hunt Silver Manipulation (19791980) 47B. Portfolio Insurance and the Stock Market Crash of October 1987 52C. Metallgesellschaft AG and RollingStack Hedges (1993) 58D. Index Option Straddles and the Collapse of Barings Bank (1995) 60viiE. The Collapse of Long-Term Capital Management (1998) 64F. Lessons from the Recent Derivatives Debacles 67IV. Characteristics of Users of Derivative Securities 70A. Sources of Information 70B. Available Information on Derivative Usage byFinancial Firms 71C. The Wharton Survey of Nonnancial Derivative Users 74D. Other Surveys and Studies 76V. Regulations, Exchanges, and Available Contracts 79A. Information on the Internet 79B. Regulations 80C. The U.S. Exchanges, the OTC, and Foreign Markets 85D. Available Contracts 90E. Specically on Options 91VI. Questions 96VII. Suggestions for Essay Topics 972 Risk-Management ConceptsI. Prot Functions and Expected Utility Maximization 99A. The Wealth Process 103B. The Expected Utility Function 106C. Expected Utility and Moment Preference 109D. A Stylized Risk-Management Decision Problem 111II. Measuring Risk and Exposure 116A. Risk and Uncertainty 116B. Types of Risks to be Managed 120C. What is Value at Risk? 122D. VaR for the One-Asset Case 124E. Value at Risk, Normality, and Options 126III. Risk Management and Speculation 129A. What is Risk Management? 129B. Hedgers Versus Speculators: The Cargill Corn Case 132C. Speculation and Manipulation 135IV. Strategic Risk Management 139A. What is Strategic Risk Management? 139B. Arguments Against the Use of Derivatives in Corporate RiskManagement 142C. Arguments in Favor of Using Derivatives in Corporate RiskManagement 148D. A Simple Guide to Designing a Risk-ManagementPhilsosphy 151E. Measuring Corporate Economic Currency Exposure 156F. Natural Hedging of Corporate Currency Exposure 158G. Purchasing Power Parity Arguments 161viii Contents3 Speculative Trading StrategiesI. Speculative Efciency? 165A. The Study of Speculation 165B. Theories of Pure Speculative Efciency 166C. Convenience Yield and the Supply of Storage 169D. The Theory of Normal Backwardation 171II. Basic Speculative Trading Strategies 176A. Trading Naked 176B. Basics of Spread Trading 177C. Tailing the Spread 181III. Basis Relationships 191A. Types of Basis 191IV. Speculation and Hedge Funds 200A. What is a Hedge Fund? 200B. History of Hedge Funds 205C. Regulation of Hedge Funds 207D. Hedge Funds and Speculation 209V. Questions 210PA RT IIFutures and Forward Contracts4 Arbitrage and the BasisI. The Cash-and-Carry Arbitrage 213A. Cash-and-Carry Arbitrage: The Case of Gold 213B. Factors Impacting the Basis: Generalized Cash-and-CarryArbitrage Conditions 220C. The Term Structure of Futures Prices 223II. Covered Interest Arbitrage 224A. Early Forward Exchange Markets 224B. Covered Interest Arbitrage 226C. ForwardForward Arbitrage and Swap Arbitrage 240D. Designing Speculative Trading Strategies 243E. Long-Term Forward Exchange Rates 245III. When-Issued Arbitrage 251A. The When-Issued Market for Government of CanadaTreasury Bills 251B. The When-Issued Cash-and-Carry Arbitrage 254IV. Stock Index Arbitrage 257V. Questions 260Contents ix5 The Mechanics of Spread TradingI. Butteries, Tandems, Turtles, and Stereos 263A. Butteries 263B. Tandems and Stereos 265C. Turtles and Stereos 267II. Metal Turtles 269A. Trade Triggers 271B. Calculating the Tail and Hedge Ratio: Golden Turtle 272C. Silver Turtle 274D. Copper Turtle 274III. TED Tandems and Currency Tandems 276A. The TED Spread 276B. The Cash-and-Carry Arbitrages for Money Market Futures 279C. TED Spread and TED Tandem Trading Strategies 282D. Currency Tandem 284IV. Synthesizing Foreign Interest Rates 286V. Questions 2906 Risk Management: Hedging and DiversicationI. Transactions Hedging and Optimal Hedging 293A. Risk Management Objectives 293B. Price Risk Versus Basis Risk 296C. Transaction Hedging Example: Issuing Commercial Paper 299D. Transaction Hedging: Using a Eurodollar Futures Strip Hedge 302E. Transactions Hedging: Using a Eurodollar FuturesStack Hedge 304F. Choosing Between a Strip Hedge and a Stack Hedge 305G. Multivariate Optimal Hedge Ratio Estimation 309H. Optimal Hedge Ratios for Different Utility Functions 314I. Determining the Dynamic Hedge Ratio 321J. The Farmer's Hedging Problem 325II. Currency Hedging for International Activities 329A. Transaction Hedging Example: Managing Currency Exposure 329B. When is Hedging Foreign Assets Effective? 333C. The Optimal Hedge Ratio for a Single Foreign Asset 338D. Optimal Hedge Ratio for the Domestic/Foreign Portfolio 342III. Mean Variance Analysis and Optimal InternationalDiversication 343A. Benets of International Diversication 343B. The Markowitz Model 346C. Criticism of Mean-Variance Portfolio Analysis 348D. Eun and Resnick (1994) 350E. The CAPM and International Diversication 357x ContentsIV. Currency Swaps and Fully Hedged Borrowing 360A. History of Currency Swap Trading 360B. The Mechanics of Swap Trading 362C. Fully Hedged Borrowings and Currency Swaps 369V. Questions 373PA RT IIIOptions Contracts7 Option ConceptsI. Basic Option Properties 375A. Some Distribution-Free Properties of Options 375B. Expiration Date Prot Diagrams 382C. Evaluation of Different Positions 383D. Hedging with Options and Hedging for Options 389E. Do Replicated Positions Differ? 391II. PutCall Parity 393A. European PutCall Parity without Dividends 393B. European PutCall Parity with Dividends 396C. European PutCall Parity for Options on Forward andFutures Contracts 398D. American PutCall Parity 401E. Using PutCall Parity to Estimate the Early Exercise Premium 402III. Spread Trades and Strategies 404A. Straddles, Straps, and Strangles 404B. Vertical and Horizontal Spreads 406C. Butteries, Sandwiches, and Other Trades 409D. Caps, Floors, and Collars 411IV. Real Options, Insurance, and the Demand for Put Options 412A. Real Options 412B. Insurance and Option Pricing 414C. Skewness Preference and the Demand for Put Options 415D. The Farmer's Terminal Wealth Function 417E. Mean-Variance Skewness and the Optimal Demand for Put Options 420V. Questions 4228 Option ValuationI. Mathematical Background 425A. Stochastic Processes: Basic Denitions 425B. Types of Diffusions 428C. The ChapmanKolmogorov Equations 433Contents xiD. Univariate Ito's Lemma 434E. Multivariate Ito's Lemma 436II. Deriving the BlackScholes Option Pricing Formula 438A. Deriving the Formula 438B. Interpreting the Formula 444C. Implied Volatility 445III. Solving the BlackScholes PDE 451A. Possible Methods of Solving BlackScholes 451B. The Original BlackScholes Solution 453C. Risk-Neutral Valuation 457IV. Extending the BlackScholes Model 459A. Incorporating Dividends 459B. Options on Futures and Forward Contracts 462C. American Options 464D. Option Valuation with Alternative Diffusion Processes 467V. Foreign Currency Options 474A. The Currency Options Pricing Formula 474B. PutCall Parity and Early Exercise for Currency Options 477C. Empirical Studies of Currency Options 479VI. Questions 4809 Application of Option Valuation TechniquesI. Portfolio Management: Delta, Theta, and Gamma 483A. Basic Denitions 483B. Delta 485C. Gamma 488D. Theta 492E. Rho and Vega 495F. Verifying the BlackScholes Solution 497II. Hedge Portfolios, Spread Trades, and Other Strategies 499A. Riskless Hedge Portfolios 499B. Delta Plus Gamma Hedge Portfolios 503C. Vertical Spreads and Butteries 505D. Straddles, Straps, and Strangles 508III. Portfolio Insurance 511A. The History of Portfolio Insurance 511B. Properties of Insured Portfolios 513C. Types of Portfolio Insurance 514D. Insuring Portfolios with Foreign Assets 523IV. Optimal Stopping and Perpetual Options 524A. Perpetual Options 524B. Stopping Rules 525C. Pricing Perpetual Options 526V. Questions 528xii ContentsAppendix I: Basic Mathematics and StatisticsI. Notation for Present Value Calculation 529II. Taylor Series Expansion 530III. Restrictions on the Taylor Series Coefcients ofthe Expected Utility Function 532IV. The Prakash et al. (1996) Claim 533V. Relationship of Continuous Time and Discrete Interest Rates 535VI. Background on Statistical Concepts 535Appendix II: Money Market CalculationsI. Fixed-Income Calculations 541Appendix III: Mathematics for Option ValuationI. Results for Probability Distributions and Densities 545II. Greeks for BlackScholes Call Options 547A. Delta 547B. Gamma 547C. Theta 547D. Vega 548III. Greeks for the Bachelier Call Option 548A. Delta 548B. Gamma 548C. Theta 548ReferencesI. General Background and Introductory Texts onDerivative Securities 549II. General Books on Financial Futures 550III. General Books on International Financial Management 550IV. General Books on Investments 551V. Journals and Magazines 551A. Journals Dedicated to Derivatives 551B. Journals with Derivatives Content 551C. Important Magazines and Newspapers 552VI. References 552Index 583Contents xiiiPREFACEThis book covers the following general topics: (1) the advanced application ofrisk management products; (2) assessment of methods for managing andevaluating risk; and (3) the use of derivative securities for maximizing rmvalue. Using selected chapters and sections, it is possible to use this book as atext in advanced courses on derivative securities, nancial risk management,and international nancial management. Yet, taken as a whole, this book goesbeyond a textbook-level discussion. The primary focus of the book is peda-gogical, to provide instruction on the important but often overlooked connec-tion between risk management and speculation. A central theme is todemonstrate that effective risk management requires an in-depth understand-ing of speculative strategies.To this end, this book aims to provide a unied treatment of importantconcepts and techniques useful in applying derivative securities in both riskmanagement and speculative trading. Some of the techniques examined arewell known, such as the Black-Scholes option pricing methodology. However,the extensions to specic situations, such as speculative trading strategies, arenot. Other techniques examined in the book are either ignored or given toobrief a treatment in conventional texts. This book is not intended to provide acomprehensive introduction to derivative securities. There are many excellentsources that contain the relevant background material. This book aims toproceed beyond an introductory treatment of derivative securities in orderto have additional space and time to deal with more advanced topics. Bydesign, this involves approaching the subject matter from a somewhat differ-ent perspective.Much of the discussion revolves around the complementarity of the riskmanagement decision problem and the speculative trader's decision problem.More precisely, it is demonstrated that optimal risk management decisionsxvinvolve a speculative component; optimal risk management involves makingspeculative decisions. Hence, understanding of optimal strategies for specula-tive trading can assist in formulating appropriate risk management solutions.In turn, optimal speculation can be approached as a form of risk managementdecision problem, where the risk being managed arises from the speculativetrading strategy. (As a practical illustration, this is the essence of the strategiesemployed by numerous hedge funds.) All this requires that careful attentionbe given to establishing a preliminary connection between risk managementand speculation before proceeding to details of specic activities.The book is divided into three parts. The rst part deals with the generalframework for risk management and speculation using derivative securities.The second and third parts deal with specic applications to forward contractsand options. Supplemented with components from the other two parts, eachpart is approximately equal to the material that can be contained in a onesemester, senior undergraduate or Master's level course. A considerableamount of investments background is assumed at various points up to, say,the level of Alexander and Sharpe's book, Investments (1990). While at somepoint in the Options chapters (and associated Appendices) specialized math-ematical knowledge is assumed, in general only basic algebra and calculus areneeded to understand the discussion. Basic concepts are usually reviewed butwithout considerable explanation.While this book is aimed at providing material relevant for academicpresentations of derivative securities, the subject matter is also selected withthe practitioner in mind. A substantial amount of the material covered isillustrated by practical applications involving what are, in many cases, compli-cated arbitrage-based trading strategies. Considerable discussion is given todesigning derivative security trading strategies based on the underlying arbi-trage relationships. Specic attention is given to covered interest arbitrage andcash-and-carry arbitrages for metals. In order to accurately understand theconcepts, numerous price quotes are used to illustrate the main concepts.RELATION TO OTHER BOOKS IN THE FIELDThe title of the book can be used to make a useful connection to where thisbook ts within the academic landscape. The subject of risk managementspans a range of disciplines, including Management Science, Actuarial Studies,Strategic Management, Finance, Environmental Studies, and Medical Science.The inclusion of derivative securities in the title is intended to restrict thediscussion to risk management situations where derivative securities can beused. This extends the scope beyond nancial risk management to includestrategic business risk management but would not include, say, industrialxvi Prefaceengineering and biomedical applications. This permits the complementarity inthe various theoretical approaches used to model the risk management processto be examined. Yet, even by restricting comparisons to books on nancial riskmanagement, there is still a considerable number and variation of textsavailable for comparison. Within this range are books on managing creditrisk, e.g., Shaeffer (2000); value at risk, e.g., Jorion (2001); nancial engineer-ing, e.g., Mason et al. (1995) and Stulz (2001); as well as the more generaltexts on derivative securities, e.g., Wilmott (1998) and Hull (2000).Books on nancial risk management can be roughly divided between thosedealing with specic subjects in nancial risk management, e.g., the value atrisk books, and those dealing with nancial risk management from a moregeneral perspective, albeit motivated by specic examples. Risk Management,Speculation, and Derivative Securities aims to cover the subject from the generalperspective. The benchmark text for the general approach to managing nan-cial risk is, arguably, the book entitled Managing Financial Risk by Smithson,Smith, and Wilford (1995). This popular text is a combination of introductorytheoretical analysis and practical illustration. However, the analytical treat-ment is relatively elementary. The strength of the presentation lies with thepractical applications. This book can be contrasted with others, such asDoherty (1985), that have a strong theoretical motivation but give a somewhatarticial treatment of practical applications. Another benchmark text is Casesin Financial Engineering by Mason et al. (1995) which takes a case approach tothe subject matter, dealing with practical issues in a sophisticated manner, butlargely submerging the theoretical discussion in the case analysis.In terms of these texts, this book has a theoretical treatment of corporaterisk management at a level similar to Doherty, though without taking the sameapproach to the subject matter. The treatment of practical applications differssignicantly from the case intensive approach of Mason et al. (1995). Theapproach of Smithson, Smith, and Wilford is a closer approximation. Yet, thesetexts all suffer from being too narrowly focused on nancial risk management.Extending the eld of view to include strategic business risk management,e.g., Oxelheim and Wihlborg (1997), is both natural and compelling. Theadvanced techniques of nance can be integrated with the strategic notion thatbusiness risks are interrelated and, in general, cannot be effectively analyzedin isolation from a range of other business risks. As a consequence, the marketfor this book will include both nance and strategic management.In addition to texts dealing with nancial and strategic risk management,this book also has substantial overlap with books on derivative securities. Thenumber of excellent books on derivative securities is daunting. Starting in theearly 1980's with Cox and Rubinstein (1985) and continuing to the presentwith Hull (2000), Jarrow and Turnbull (2000), and Wilmott (1998), thesubject of derivative securities has produced efforts by many of the leadingPreface xviischolars in nancial economics. It is difcult to carve a niche anywhere in thismarket. Yet, these texts are quite similar in content and approach: sophisti-cated treatments of derivative security valuation are the primary focus withrisk management applications of secondary importance. To appeal to theacademic textbook market for derivatives, these books devote considerableattention to describing the details of pricing various derivative securities. Thisleaves relatively little space to develop an advanced treatment of practical riskmanagement applications.An excellent example for comparison is the book entitled Derivatives byWilmott (1998). This book is 739 pages long, an impressive effort. Yet, onlypages 529612 are dedicated to Risk Management and Measurement. A simi-lar number of pages is dedicated to exotic options, a topic that is interestingmathematically but not of central importance to practical applications. Almost20 pages of the risk management section are dedicated to the portfoliomanagement problem, compared to 10 pages on value at risk. There isscattered treatment of practical issues elsewhere in Derivatives that also illus-trates the comparison. Eighteen pages are dedicated to static hedging, which isapproached from the viewpoint of an options market maker seeking to hedgean options book. Again, this is theoretically interesting but not of much directuse to those seeking guidance on implementing or improving nancial riskmanagement within the practical context of maximizing rm value.Geoffrey PoitrasBurnaby, B.C., Canadaxviii PrefaceACKNOWLEDGMENTSThe preparation of this book required permission to reproduce material fromjournal articles, newspapers, books, and magazines. The sources requiringpermissions include the Wall Street Journal, Toronto Globe and Mail, Manage-ment Science, Financial Management, Journal of Derivatives, Canadian Journal ofEconomics, Journal of Financial and Quantitative Analysis, and Journal of Port-folio Management. Permission was also obtained from Pearson Educational toreprint material from Cox and Rubinstein's book entitled Options Markets(1985), Thompson Learning to reprint material from Futures and Options(1993) by Stoll and Whalley, and from Oxford University Press to reprintmaterial from Derivatives: Valuation and Risk Management (2002) by Dubofskyand Miller. Though permission was not required, material from a number ofgovernment publications was used including the Bank of Canada Review andthe Federal Reserve Bank of Atlanta, Economic Review. Useful information hasalso been obtained either directly or from the websites of the Bank forInternational Settlements, International Financing Corporation, InternationalSwap and Derivatives Association, Chicago Board of Trade, Chicago Mercan-tile Exchange, Commodity Futures Trading Commission, Winnipeg Commod-ity Exchange, New York Board of Trade, and the Chicago Board OptionsExchange.Because this book is based on lecture notes prepared by the author startingaround 1980 and continuing until the present, there have been numerousunnamed student contributions aimed at improving the exposition. Intellec-tual contributors I have been acquainted with either as a student or colleagueinclude Phoebus Dhrymes, Bernard Dumas, Franklin Edwards, Howard Sosin,Marcus Hutchins, Frank Jones, Mark Powers, Suresh Sundaresan, DavidModest, Don Chance, Lance Smith, Micheal Adler, and John Heaney. Amongthose I never had the opportunity to meet but whose writings had consider-xixable inuence include T. Hieronymous, H. Working, R. Leuthold, John Cox,Mark Rubinstein, Fischer Black, Philippe Jorion, Hans Gerber, and Hans Stoll.Finally the anonymous reviewers for the book also provided helpful insightsand corrections. Last, but by far not least, are all the people at Academic Presswho contributed many hours and much effort in getting the book into print,including Scott Bentley, Paul Gottehrer, and Debbie Bicher.xx AcknowledgmentsPART IDerivative Securities,Risk Management, andSpeculationCHAPTER 1Derivative SecuritiesI. DEFINITIONS AND OTHER BASIC CONCEPTSA. WHAT ARE DERIVATIVE SECURITIES?It is difcult to speak generally about derivative securities. It is possible toobserve that a derivative security involves a contingent claim; it is a securitythat has some essential feature, typically the price, that is derived from somefuture event. This event is often, though not always, associated with a securityor commodity delivery to take place at a future date. The contingent claim canbe combined with other security features or traded in isolation. This denitionis not too helpful because nancial markets are riddled with contingentclaims. Sometimes the contingent claim is left bundled with the spot com-modity, in which case the derivative security is also the spot commodity (e.g.,mortgage-backed securities). Yet, the term ``derivative security'' is usuallyrestricted further to only include cases where the contingent claim is unbun-dled and traded as a separate security, effectively forwards, futures, options,and swaps. In what follows, this class of unbundled contingent claims will bereferred to as derivatives securities.3Derivative securities trading is denitely not a modern development. Theimplicit and explicit embedding of derivative features was common in thetypes of securities traded in early markets. Early examples of securities withderivative features include claims on the 14th century Florentine mons thathad a provision for redemption at 28% of par, though that provision wasseldom exercised; 16th-century bills of exchange that combined a loan witha forward foreign exchange contract; and 18th century life annuities thatfeatured terms to maturity dependent on specic life contingency provisions(Poitras, 2000). The ``to arrive'' contracts traded on the Antwerp bourse duringthe 16th century may be the rst instance where a contingent claim wasunbundled and traded as a separate security on an exchange. Previous tothis time, such derivative security transactions had been limited to privatedeals between two signatories executed using escripen or notaries.In addition to securities with embedded derivative features, early nancialmarkets can be credited with beginning exchange trading in modern deriva-tive security contracts.1Though the precise beginnings of option trading aredifcult to trace, it is likely that there was trading in options, as well as ``toarrive'' contracts, on the Antwerp bourse during the early 16th century(Poitras, 2000). By the mid-17th century, trade in options and forward con-tracts was denitely an integral activity on the Amsterdam bourse (de la Vega,1688). Trading in both options and forward contracts was an essential activityin London's Exchange Alley by the late 17th century (e.g., Houghton, 1694).The emergence of exchange trading of futures contracts can be traced to either19th century Chicago (Hieronymous, 1977) or 18th century Japan (Schaede,1989).From these early beginnings, modern markets have achieved full securitiza-tion of a wide range of derivative securities. The modern Renaissance inderivative security trading has posed considerable problems for the account-ing profession (e.g., Gastineau, 1995; Perry, 1997). In order to address theaccounting problems raised by the use of derivative securities by rms for riskmanagement and other purposes, the notion of ``free standing derivatives'' wasintroduced. This reference to free standing derivatives is precise accountingterminology borrowed from the nancial accounting standard FAS 133 (FASB,1998). Being ``free standing'', derivative securities pose fundamental problemsfor conventional methods of preparing accounts. This point has not been loston the accounting profession, which has been engaged in ongoing attempts to1Numerous historical sourcesfor example, Barbour (1950), Posthumus (1929), and Neal(1990)make reference to trading ``futures'' contracts, instead of using the more correct referenceto trading of ``forward'' contracts, for example, Hieronymous (1977, ch. 3). The term ``futurescontracts'' has a precise modern meaning that the contracts of the 15th18th centuries did notsatisfy, though the Japanese rice market did come close to trading contracts that could qualify asfutures contracts.4 Chapter 1: Derivative Securitiesproduce a set of standards that permit an accurate nancial presentation ofthe accounts of the rm and do not permit substantial discretionary variationin the accounts. In a perfect world, two otherwise identical rms, both in-volved with using derivative securities, would not be able to present accountsthat were substantively different, based on discretionary accounting choices,such as the method used to recognize gains or losses on the offsetting spotposition.The accounting profession is acutely aware of the question: What arederivative securities? The main difculty for accountants is that the deriva-tives are free standing.2When the contingent claim is unbundled from theunderlying transaction, it is difcult to attach that security backto the transaction that motivated the derivative security position. For obviousreasons, derivative securities require mark-to-market accounting. Yet, account-ing for cash positions can be exible: book value or market value, dependingon the situation. Because of the potential for substantial discretionary manipu-lation of the accounts, accounting standards such as FAS 133 and 138 havebeen introduced. Under recent standards, the narrow class of unbundledcontingent claims is now classied as free standing derivatives. As such,more exible rules have been introduced to ensure that there is accuratehedge accounting for rms using these securities. This category excludesxed income securities with embedded derivative features, such as mort-gage-backed securities and callable or convertible bonds.3A key implicationof all this for non-accounting professionals is that, due to the introduction ofFAS 133, substantially enhanced information about derivatives positions isnow available in annual reports and other sources of nancial information forpublicly traded companies (e.g., 10-Ks).This approach to dening derivative securities is not without conceptualdifculties. An essential feature of the free standing derivative securities is theaction of setting a price today for a transaction to take place at a date in thefuture. However, this feature is also present in other types of nancial secur-ities. A bond, for example, sets a price today for a sequence of xed cash ows2Another problem posed by derivatives is the ability to replicate a derivative payoff usingdynamic trading in cash securities. For example, portfolio insurance replicates the payoff on a putoption by actively trading a portfolio of stocks and bonds.3There are numerous instances of explicit and implicit call or conversion provisions inhistorical security issues. For example, the Venetian prestiti had a call provision that allowedfor principal value to be repaid at par, as nances permitted. Various 18th century governmentdebt restructuring plans involved the introduction of conversion provisions. For example,there was the conversion of English government life annuities, issued under William III andQueen Anne, into long annuities, or John Law's Mississippi scheme which introduced conver-sion provisions for exchanging French government debt obligations into Compagnie des Indesstock.I. Denitions and Other Basic Concepts 5that will be received in the future. Even a common stock sets a price today fora sequence of uncertain cash ows that will be received in the future. Oneelement that distinguishes free standing derivative securities from nancialsecurities such as bonds is the timing of the settlement. A forward contractinvolves settlement and delivery at maturity, while a bond involves settlementtoday with delivery in the form of payments at future maturity dates. Usingthis approach, an option contract is somewhat anomalous, requiring a pay-ment today to acquire the right to make a settlement at a price that is set today.The distinction between the various cases actually lies with the respective cashows.B. SOME DEFINITIONSAt this point, some of the jargon that characterizes derivatives trading will beintroduced. For practical purposes, an attempt has been made to use theterminology of the marketplace. The occasionally colorful language is oftentransparent in intent but confusing in application. For example, in futures andforward markets it is conventional to use the following:A short position involves the sale of a commodity for future delivery.A long position involves the purchase of a commodity for future delivery.However, in options markets a long position refers to the purchase of a call orput option, while a short position refers to the writing of a call or put option.This terminology applies even though purchasing a put option involves payinga premium for the right to sell for future delivery. In turn, a short position inthe spot commodity market involves borrowing the commodity under a shortsale agreement which is then sold in the spot market, generating a cash inow.A long position in the spot commodity would involve a current cash outow inexchange for possession of the physical commodity.The use of analytical concepts such as prot functions requires introducingsome notation that will be used throughout the book:F(t,T): The forward or futures price observed at time t for delivery at time T.S(t) St: The cash or spot or physical price of the deliverable commodityobserved at time t.For consistency, it has to be that T ! N ! t. In much of what follows, theassumption, F(T,T) S(T) is made in order for the price of a futures contractobserved on the delivery date t T to be equal to the price of the deliver-able commodity. In effect, the spot commodity is taken to be the deliverablecommodity. This condition is readily satised for forward contracts but re-quires assuming away the possibility of cross hedging if futures contracts are6 Chapter 1: Derivative Securitiesinvolved. Conventional time dates that will be used are t 0 and t 1 with Nfor contracts that are nearby or closer to delivery and T for contracts that aredeferred or farther from delivery.Using a strictly legal denition, it is possible to be reasonably precise aboutwhat constitutes a futures contract. However, differences in the legal denitionof futures contracts across jurisdictions would create problems. For presentpurposes, a brief summary of a futures contract is all that is required:A futures contract is an exchange traded agreement between two parties, guar-anteed by the clearinghouse, that commits one party to sell a standardized gradeand standardized quantity of a commodity, asset, or security to the other party at agiven price and specied location at a future point in time.While useful, this brief summary disguises important features of futurestrading. For example, one of the signicant limitations of forward contractingis the requirement that precise specication of the grade and quantity of thecommodity be determined by the parties to the contract. This procedure raisesthe problem of how to ascertain whether the commodity delivered meets thegrade and quantity requirements. Because forward contracts typically requiredelivery of the commodity, this procedure is an essential feature of forwardcontracting. Because futures markets deal in a standardized commodity forwhich delivery can be avoided by taking an offsetting position prior to deliv-ery, futures contracting avoids this problem.Like futures, options have a specialized nomenclature. To understand thisjargon, the essential notions of an option must be identied:An option contract is an agreement between two parties in which one party, thewriter, grants the other party, the purchaser, the right, but not the obligation, toeither buy or sell a given security, asset, or commodity at a future date under statedconditions.Options almost always involve the purchaser making some type of premiumpayment to the writer. The timing and form of the premium payment dependson the specics of the contract. For exchange-traded options and many over-the-counter (OTC) options, the premium is paid up front, when the optionagreement is initiated. It is essential to recognize that an option does notrepresent an ownership claim. Rather, an option is a claim against ownershipunder prespecied conditions. While it is not necessary that options beexchange traded, many option contracts do originate on exchanges.Given this, two types of options can identied:A call option gives the option buyer the right to purchase the underlyingasset or commodity from the option seller at a given price.A put option gives the option buyer the right to sell the underlying asset orcommodity to the option seller at a given price.I. Denitions and Other Basic Concepts 7The seller of the option is often referred to as the option writer. An optionpurchaser makes a payment to the option writer referred to as the optionpremium. Once the premium has been paid, the purchaser has no furtherliability.The following notation will be used for options:C[S,t,X] price of a European callCA[S,t,X] price of an American call4P[S,t,X] price of a European putPA[S,t,X] price of an American putX is the exercise priceT is the expiration datet T t, where T ! tThe notation for time is handled in a somewhat nonstandard fashion, where tand t are often used in preference to t and T. This is to specically indicate thattime is being counted backwards and the unit of measurement for t isfractions of a year. Hence:t (T t)=365 t=365t is the fraction of the year remaining on the security, where T t is thenumber of days from settlement to expiration, with T being the expirationdate and t the settlement date. The seemingly redundant use of the variablet is to emphasize cases where time counts backward: At any time t, t T tand, as t increases to T, t is reduced to where, on the expiration dateT, t 0.Various features for exchange traded option contracts can be identied.Some or all of these features may apply to other types of option transactions.In order to be accurately specied, option contracts require an exercise orstrike price as well as an expiration date on which the right is terminated. Theexercise price is the contractually specied price at which the purchaser isallowed to buy (for a call) or sell (for a put) the underlying asset or commod-ity. When the exercise price is below (above) the current underlying price, thecall (put) option is said to be in the money. When the exercise price is above(below) the underlying price, the call (put) option is out of the money. An atthe money option has the exercise price and underlying asset or commodityprice approximately equal. Exercising an option involves completion of therelevant transaction specied in the option contract. Options that can beexercised prior to the stated expiration date are referred to as Americanoptions, in contrast to options that can only be exercised on the expiration4The notation selected to designate Americans with the subscript A should not be confusedwith the general notational convention used to identify subscripts with partial derivatives.8 Chapter 1: Derivative Securitiesdate, commonly referred to as European options.5Depending on the type ofoption, either a spot delivery (physical settlement) or a net dollar valuetransaction (cash settlement) may be required to satisfy the conditions ofexercise. Finally, the option contract will typically contain other adjustmentprovisions (e.g., handling of dividend payments, stock splits, and mergers forstock options).6Of particular importance, modern exchange-traded Americanstock options are not dividend payout protected; that is, the call option purchaseris not entitled to receive cash dividends paid on the underlying stock duringthe time between purchase and exercise.In addition to exchange-traded options, there are numerous other examplesof options. In corporate nance, important types of options arise with war-rants, rights offerings, convertible bonds, preferred stock, and executive com-pensation packages.7It is even possible to interpret the rm's common stockor outstanding debt in terms of options. A warrant is an option issued by acorporation granting the purchaser the right to acquire a number of shares ofits common stock at a given exercise price for a given time. When a warrant isexercised, the transaction results in a cash inow to the corporation inexchange for a new issue of common shares, invariably resulting in a dilutionof the outstanding common stock. Warrants are often exercisable prior tomaturity, being ``long term'' at primary issue (e.g., 5 years or more). Occasion-ally, perpetual warrants with no xed maturity date are offered. Given the longexpiration dates, warrant exercise prices are usually set more than slightlyabove the current stock price. The precise conditions surrounding a warrantissue are contained in the warrant agreement that outlines the handling ofstock splits, future new stock issues, and callability. Despite this, terms laidout in a warrant agreement are not always unambiguous. In effect, warrantsare not as standardized as exchange-traded options.Preemptive rights issues, sometimes called subscription warrants, are an-other form of option designed to facilitate sale of common stock.8However,5This terminology can create confusions. For example, the bulk of options traded in Europe areactually American options. While European options are not as commonly traded, this form is oftenused for the analytical simplications provided. Another confusion is the use of ``cash settlement'' torefer to satisfaction of the option exercise requirements with a net dollar value transaction. In effect,the use of ``cash'' here does not refer to the spot commodity, but rather to actual cash.6While exchange traded stock options contain provisions for adjustment in the face of stocksplits, mergers, and stock dividends, these options are not adjusted for cash dividends. In otherwords, exchange-traded stock options are not cash dividend payout protected.7An important group of options is concerned with the various conversion features and callablefeatures that are attached to a rm's debt issues. It is also possible to consider all the rm'ssecurities as options, e.g., the common stock is an option on the unlevered portion of the rm'svalue while the outstanding debt is an option on the levered portion of rm assets.8The specic procedures regarding rights issues vary across jurisdictions (e.g., Bae and Levy,1994; Hietala, 1994; Poitras, 2001a).I. Denitions and Other Basic Concepts 9unlike warrants that often support sales of stocks at a much later date, rightsissues are short-dated; a 2- to 10-week duration period is typical.9In addition,rights issues are granted, on a pro rata basis to existing shareholders of recordat the ex-rights date. In effect, shareholders receive the right to purchase afraction of a new common stock issue equal to the fraction of the currentoutstanding common stock the shareholders of record own. Rights are valu-able because the exercise price is usually set more than slightly below thecurrent stock price, giving the right a denite market value.10Many rightsissues are tradable, either on the OTC or centralized stock exchanges. Unlikerights issues and warrants, executive compensation options are usually nottradeable. These warrants are used to provide a bonus system to encouragesenior management to pursue the interests of shareholders. Typically, theseoptions are given (not sold) to the employee. The usefulness of this form ofcompensation in achieving its stated objective has been the subject of consid-erable debate and research.From these basic types, there are numerous variations, both theoretical andpractical. Options, for example, feature a bewildering array of possible theoret-ical variations, such as digital barrier options, knock-out Russian options,perpetual Bermuda options, and so on. One specialized derivative contract thatpossesses cash ows which can theoretically be replicated with a bundle of for-ward contracts is a swap. Such transactions can be dened in general terms as:A swap is an exchange of cash ows deemed to be of equal value at the timethe swap is initiated.While the future exchange of future cash ows is common to all swaptransactions, certain types of swaps also include an exchange of current cashows.Swap transactions can be conceived as bundles of forward contracts. Earlyexamples of such transactions occurred in foreign exchange (FX) markets,where the swap involved combining spot and forward FX transactions; forexample, at t 0 domestic funds are exchanged for foreign funds with anadditional agreement that the foreign funds will be exchanged for domestic, atthe current swap rate, at t 1. While, in general, the cash ows involved in aswap can originate from any security, asset, or commodity, there are two9The length of the period between the rights issue date and the exercise date is determined bya number of factors, including local stock exchange rules and rm preferences (e.g., Poitras,2001a).10This follows because of the value associated with immediate exercise of the right. The stockcan be purchased and immediately sold at a higher price. The terminology intrinsic value is oftenused to refer to that component of an option's value that is associated with the immediate exercisevalue. However, even when the intrinsic value is zero, the option can still have a non-zero timevalue component.10 Chapter 1: Derivative Securitiesimportant types of swaps: interest rate swaps and currency swaps. These swaptypes are a securitization of common underlying nancial market transactions.In a ``plain vanilla'' interest rate swap (Abken, 1991), the cash ows involvexed-to-oating interest rates. In a currency swap, the cash ows are crosscurrency. A plain vanilla interest rate swap does not involve an exchange oft 0 cash ows, while a currency swap will exchange the t 0 cash ows.There is a substantial number of variations for swap structures.C. FUTURES VERSUS FORWARD CONTRACTS:BASIC ISSUES11Futures and forward contracts both facilitate a fundamental market transac-tion: xing a price today for a commodity transaction designated to take placeat a later date. Unlike a futures contract, which is securitized and exchangetraded, forward contracts come in a variety of forms. Some forward contracts,such as those traded on the foreign exchange markets, have many of theessential features of futures contracts. Other types of forward contracts aremore complicated, such as the forward contracting provisions that wereembedded in the Metallgesellschaft (MG) long-term oil delivery contracts.In some respects, futures contracts represent an evolution of forward trading.12Yet, much of the modern progress in derivatives contracting has come in OTCtrading, the home of forward contracting.Some of the practical differences between forward and futures contractingmethods are illustrated in Table 1.1. Considerable variation is observed in therelative use of forward or futures contracting across commodity markets. Forexample, in currency markets, the large value and volume of individual tradeshave the bulk of transactions conducted in OTC forward and short-dated FXswap markets. Exchange-traded currency derivatives are an insignicant frac-tion of total trading volume. As trading in forwards is closely integrated withcash market transactions, direct trading in forward FX contracts is restrictedto the signicant spot market participants, effectively the large banks andnancial institutions. Because currency forward and swap contracts do nothave regular marking to market, restricting participation is needed to controldefault risk.Currency forward and swap contracts have many features of futures con-tracts. For other commodities, forward contracts can take a variety of forms.11Telser and Higinbotham (1977) provide a discussion of a number of the issues raised in thisSection.12The use of Eurodollar strips as a method of implementing or pricing interest rate swaps hasreceived considerable attention. Dubofsky and Miller (2002) offers a textbook discussion of strips.I. Denitions and Other Basic Concepts 11TABLE 1.1 Comparison of Futures and Forward ContractsForwards FuturesContract amount Depends on buyer and seller StandardizedPrice movementrestrictionsNo limit Varies; can be restricted by theexchange with provisions forincrease or decreasePosition limits Market determined Set by exchanges and regulatorsDelivery date Depends on buyer and seller StandardizedMarket location Decentralized, often atelephone/computer networkof dealers, brokers, and othermembersCentralized exchange oor wheretrading is executed by openoutcry between exchangeparticipantsClearing No direct, separate clearingmechanismThe exchange clearinghouseSettlement By delivery of goods asspecied in contractMarking-to-market daily using amargin system; some deliveries byspecialized tradersRegulation Self-regulation, contract law,general securities lawExchange rules, CommodityExchange Act, CFTC, stateregulators, specic legislationConsider the industrial and precious metals for which active trading in bothfutures and forward contracts is observed. In the metals markets, the mostimportant derivatives exchanges, the London Metals Exchange and the Com-modity Exchange (COMEX), also play an important role in providing cashmarket supplies through the exchange delivery process. In other commodities,such as crude oil, due to the wide variation in deliverable grades, there aresignicant practical differences between the forward and futures contracts.Yet, despite requiring delivery of a standardized grade of oil, the New YorkMercantile Exchange (NYMEX) crude oil futures contract still plays a key rolein the cash market both as a pricing benchmark and as a delivery contract. Formany agricultural commodities, such as grains and livestock, futures contractsare also the pricing benchmarks.In general, forward trading is carried out in conjunction with cash marketactivity. This effectively excludes participation by traders not involved inthe cash market. In some instances, the size of trades is so large that evensmaller cash market traders are also excluded from directly participating inthe forward market. These traders must access the cash market by placing andclearing trades with the larger market participants. This exclusivity is inkeeping with the structure of cash deals that require an element of marketrecognition and implied creditworthiness in order to reduce riskiness. This12 Chapter 1: Derivative Securitiesfeature of restricting direct access to forward trading has decided advantages,particularly in nancial commodities such as currencies and debt instrumentswhere large numbers of trades, involving millions of dollars per trade, aredone each trading day. Much of this business is done through brokers, wherecredit lines in forward positions are imposed in order to further limit theintrinsic riskiness of forward contracting.The intent of most forward trading is, ultimately, to deliver the spotcommodity on the maturity date. As a rule, because forward contracts requiresettlement by spot delivery, it is somewhat difcult for purely speculativetrading to occur. In addition, speculative interest is also deterred becauseforward contracts are not readily transferable. As a result, in order to offset aforward position for which the delivery is no longer desired, the trader musttypically initiate another offsetting forward contract for the same grade,amount, delivery date, and delivery location.13The two offsetting positionsare then settled by crossing the trade at delivery. For example, to offset along forward position with Bank A for $10 million Canadian dollars deliveredon June 12, the trader will enter a short forward contract with Bank B, also for$10 million Canadian dollars and delivery on June 12. On the deliverydate, the trade will be crossed by taking delivery from Bank A on the longposition and using the $10 million Canadian to make delivery on the shortposition with Bank B. The prot on the trade will be the difference in theprice of the short and long positions. This process is decidedly differentthan in futures markets where trades are, effectively, done with the clearing-house and the futures position is canceled when a trader takes the offsettingposition.For some commodities, lack of liquidity in forward contracts makes itdifcult for hedgers and other traders to nd compatible grades, deliverydates, and delivery locations. In these situations, canceling the forward pos-ition by crossing in the cash market is difcult. Such complications willincrease the attractiveness of using futures contracts. With the agreement ofthe counter-party, the forward agreement could be structured to have variationin the allowable grades and amounts or to be transferable under certainconditions. For forward agreements that do not contain such conditions, thebest method of offsetting the forward position may be to engage in cashmarket transactions on the delivery date. For example, a metal renery thathas a forward contract to deliver copper cathodes but, for some reason, isunable to make delivery from current production, can enter the cash marketfor cathodes and purchase the copper necessary to settle the contract. The13In certain cases, the forward position is transferable and the position can be sold to a thirdparty that will be responsible for delivery. The risk to the seller of default by the third partyillustrates the difculties of forward contracting.I. Denitions and Other Basic Concepts 13costs of engaging in such cash market transactions will vary according to thespecics of the situation.The differences in the functioning of futures and forward markets impactsthe specic method of contracting selected for conducting commodity trans-actions. For example, in contrast to forward trading, futures markets aredesigned to encourage participation by small speculative traders. The in-creased participation of speculators not directly involved in the spot marketprovides an important source of additional liquidity to futures markets notavailable in forward markets. In order to achieve this liquidity, certain restric-tions are imposed on trading, such as ling requirements and limits onposition sizes. By restricting participation to large players in the spot market,many of the restrictions required for the functioning of futures markets are notpresent in forward markets. For hedgers, the underlying commodity for afutures contract does not, in many instances, have precisely the same charac-teristics as the hedger's spot commodity. Futures contracts are often enteredinto with the intention of closing out the position on the maturity date of thehedge and then covering the spot transaction in the cash market.D. THE EXCHANGEAnother signicant difference between futures and forward contracts arisesbecause futures are exchange traded, while most forward contracts are createdby individual parties operating in a less centralized market. Because a futurescontract originates on an exchange, the traders originating the contract actu-ally use the exchange clearinghouse as the counter-party to their trade.14Whileboth a short and a long trader are required to create a futures contract, bothtraders execute the trade with the clearinghouse. This allows a futures con-tract to be created without the problems associated with forward contractingwhich typically depends on the creditworthiness of the counter-party. Bydesign, futures contracts are readily transferable via the trading mechanismsprovided by the exchange. Because forward contracts depend on the perform-ance of the two original parties to the contract, these contracts are oftendifcult to transfer. One practical implication of this difference is that if afutures trader wants to close out a position, an equal number of offsetting14Brinkman (1984) provides a useful overview of clearinghouse operations. While clearing-house members must also belong to the exchange, not all exchange members belong to theclearinghouse. There is a screening process to ensure that nancial integrity and other require-ments are satised. In turn, clearinghouse membership can be protable for a number of reasons.For example, on most exchanges clearing members post margin on the net clearing position, oftenusing stock in the clearing corporation as collateral for part of the balance. This permits marginmoney from client accounts to be used for other purposes.14 Chapter 1: Derivative Securitiescontracts for that commodity month is purchased and the original position iscanceled. Forward contracts can be canceled by creating an offsetting forwardcontract with terms as close as possible to those in the original contract.Unless the forward contracts provide a method for cash settlement at delivery,this will potentially involve two deliveries having to be matched in the cashmarket.Typically, trading on a futures exchange is conducted on an exchange oorwith each commodity having a designated ``pit'' or trading area. The largestgroup of oor traders or locals in the pit are oor brokers, lling orders forspeculators and hedgers acting through commission house accounts. Somebrokers work for commission houses, some for their own account. The nexttype of pit traders are the speculators, usually trading for their own account.This group breaks down into one of three not mutually exclusive types oftraders. These participants can be referred to by a number of possible names.Perhaps the most useful terminology is scalpers, day traders, and positiontraders. Scalpers attempt to prot from the bid/offer spread, sometimes calledthe edge, in effect playing the role of market maker. The scalper attempts topredict short-run, intra-day price movements. While scalpers typically holdpositions for as short a period as possible, depending on the level of marketactivity, these traders and other speculators will take larger intra-day positions,holding them for a longer period. The skilled oor trader will be able toidentify situations that arise both in the regular course of business (e.g., a largehedging order needs lling) and due to special circumstances (e.g., a rushof orders from an unexpected government report). These speculators areessential to the liquidity of futures markets.15Scalpers and day traders addsubstantially to the volume of trade, without having to post any margin,because trades are closed out prior to the last trade of the day. As a conse-quence, these traders do not have any direct impact on open interest.Futures exchange market activity is more difcult to measure than, say, forstock exchanges, where transactions volume is sufcient. In order to provide ameasure of trading activity that is independent of the activities of the marketmakers and day traders, the notion of open interest is used which indicates thenumber of contracts outstanding at the beginning of the trading day. Openinterest represents the number of contracts that are being carried from onetrading day to another. Because every futures contract that is created requires along and a short position, open interest can only increase if both a new longand a new short position are created. If a new long (short) position is created15Silber (1984) provides a useful analysis of the role of scalpers. The nal group of speculatorsis the position traders, effectively professional speculators involved in taking large positions heldfor at least several days. These individuals provide a portion of the market for exchange seatrentals. The nal group of pit traders is the employees of the large commercial rms using thefutures market for hedging and speculation.I. Denitions and Other Basic Concepts 15with a short (long) position that is closing out a previous position, openinterest is unchanged. If both long and short positions are being closed out,open interest will decrease. This process is illustrated in Table 1.2. Becausescalpers and day traders do not usually carry positions overnight, the activitiesof these traders only affect volume, not open interest. As a result, a moreaccurate indication of the participation of (position trader and other off-exchange) speculative activity would be to measure, say, the ratio of maximumopen interest to contract deliveries.E. THE FUTURES CONTRACTTo facilitate exchange trading, futures contracts possess a number of features;most important for present purposes are the features of standardization andmarking to market. The essential elements of standardization have been recog-nized and emphasized for years. For example, Fowke (1957) identies theessential elements involved in futures contract standardization:The elements of standardization provided by the futures contract and by therules and regulations of the exchange governing such contracts may be identiedunder the following headings: (1) the commodity, (2) the quantity, (3) the range ofquality within which delivery is permissible, (4) the month of delivery, (5) thenature of the option concerning specic grade and date of delivery, that is, whetherit is a seller's or a buyer's option, and, nally, (7) the price.Standardization is achieved by making each contract for a given commodityidentical to all other contracts except for price and the delivery month, whichis xed according to a bi-monthly or quarterly schedule.16As a result, futuresare a basis contract, with the actual price being for the commodity that ischeapest to deliver under the terms of the contract.In order to be a viable instrument, futures contracts written for deliverablespot commodities require adequate supply of the commodity for deliverypurposes. In order to ensure adequate supply, many contracts permit substan-tial variation in the commodity grade delivered or in the delivery location. Theoption for selecting the specic grade or delivery location is usually a seller'soption. As a result, contracts that permit a range of deliverables will have onespecic grade that is cheapest to deliver. Some contracts, such as the T-bondcontract, have a number of different delivery options available (see AppendixII). Forward contracts differ widely in the degree of standardization. Forexample, forwards for nancial commodities such as the major currencies or16Commodities with bimonthly delivery dates (e.g., metals) usually require an active deliverymonth contract. In this case, a set number of months (3 for COMEX contracts) prior to the naldelivery date for the alternative months a contract for delivery is initiated so that there is always adelivery contract for any given month.16 Chapter 1: Derivative SecuritiesTABLE1.2OpenInterest,FuturesTrading,andtheAssociatedCashFlowsDateTrans.No.BuyerSellerVolumeContractsoutstandingOpeninterestPrice1/11AB1103.002CA213.033CD322.964BC412.965DC503.006EF1053.107GH15103.10(Close)8FE1873.002/17Prot(markingtomarket)fromtradingon1/1ABCDEFGH1502001502002500250025002500Marginaccountandmarkingtomarketcashowfor1/1ABCDEFGHInitialmarginpaymentcredit(receivabletoclearinghouse)7507507507503750375037503750Markingtomarketfor1/1

150

200150200250025002500

2500Adjustmenttomarginbalancefromclosingouttheposition900950600550Marginbalanceatendoftrading1/1ABCDEFGH00001250625012506250Assumptions:Contractisfor5000unitsandinitialmargindepositis$750percontract,withamaintenancemarginof$500.Gisrequiredtodepositanadditional$1250inordertosatisfythemaintenancemarginlevelof(500)(5)

$2500;otherwise,thetradewillbeclosedoutattheopen.GandHhave5contractsO/S;EandFhave2contractsO/S.Openintereston2/1

7contracts.Government of Canada securities are de facto standardized,17indicating thatthe benets associated with standardization are also important for some typesof forward trading. In the absence of a clearinghouse, forward markets capturedefault risk efciencies by excluding many of the potential, largely speculativeparticipants who require standardization in order to participate effectively inthe market. As with futures, standardization is an important support to marketliquidity.In addition to standardization, forwards and futures also differ in howchanges in the value of the contract over time are handled. For futures, dailysettlement, also known as marking-to-market, is required. In effect, a newfutures contract is written at the start of every trading day with all gains orlosses settled through a margin account at the end of trading for that day. Thismethod of accounting also requires the posting of a ``good faith'' initial margindeposit combined with an understanding that, should the value in the accountfall below a maintenance margin amount, funds will be transferred into theaccount to prevent the contract from being closed out. On the other hand,settlement on forward contracts occurs by delivery of the commodity at thematurity of the contract or, in certain cases, a cash settlement at maturity basedon the difference between the forward price that was agreed upon and theprevailing spot price for the relevant commodity specication. Hence, futureshave cash owimplications during the life of the contract while forwards do not.Numerous studies on the difference between futures and forwards areavailable (e.g., Cox et al., 1981; Richard and Sundaresan, 1981). Considerableinterest has centered on the marking-to-market feature of futures. Assumingthat the cost of commissions, good faith deposit, etc. are ignored, then thevalue of both futures and forwards contracts can be taken to be equal to zeroupon creation. (This does mean that the price of the contracts is zero.) Thisfollows from the derivative nature of contracting for future delivery; becauseno actual investment of funds is required to establish a position, only futurechanges in the value of the commodity will produce value. Absent marking tomarket, forwards involve settlement requiring one lump payment or deliveryat maturity. In comparison, due to marking-to-market, futures contracts willinvolve a stream of payments over time. As a consequence, the value of thefutures over its life will depend not only on the behavior of the price of the cashcommodity but also on the covariance of the cash price with interest rates overthe time path. In addition to theoretical analysis of this point, there are alsonumerous empirical papers which, for identical or nearly identical deliverable17In contrast, many of the early interest rate swaps and forward (interest) rate agreements werenot standardized. However, with the explosive growth of the swap market in the 1980s, theInternational Swap Dealers Association (ISDA) was formed by important market participants.The ISDA has contributed signicantly to the standardization of swap agreements. (The ISDA hasevolved into the International Swap and Derivatives Association.)18 Chapter 1: Derivative Securitiescommodities, compare futures and forward price behavior. While, in somecases, there are some minor differences that cannot be explained by transac-tions costs, on balance futures and forward prices for the same commodity aremore-or-less identical.Due to the nature of futures and forwards, it is understandable that themechanisms for delivery will also differ. Because forwards are usually initiatedwith the object of taking delivery in mind, participants in forward markets willinvariably be capable of completing a delivery. This is denitely not the case infutures markets where the demands of delivery are compounded by thestandardized grades and delivery locations that are required. As a result ofthe considerable cost in establishing and maintaining an operation capable ofmaking deliveries, the futures delivery process is dominated by a relativelysmall number of specialist rms capable of capturing the sometimes signi-cant prot opportunities that emerge during the delivery period. These rmsare also often clearinghouse members. Because much of what follows will notbe concerned with so-called delivery arbitrage activity, it will be convenient toassume that both futures and forward contracts obey the condition that theprice of the contract on the delivery date is equal to the cash price of thedeliverable commodity even though, in certain practical situations, this maynot be precisely correct.F. MARGINS18An essential feature of the futures contract is the marking-to-market processinherent in margin system. The amount of margin deposited represents a ``goodfaith deposit'' that ensures a party to the futures contract meets his obligations.The margin deposit is not an investment in a commodity position. All that hasbeen transacted is an agreement to buy or sell a given amount of the commodityat a future date for a prespecied price. This is decidedly different than marginsfor equity where the deposit is in partial payment for securities purchased in thecash market. Margin deposits for futures are only required to ensure sanctity ofthe contract in the face of uctuations in its value. Given this, it is under-standable that there are different types of margin requirements depending onthe individual's position in the exchange process. The three general types ofmargin requirements are (1) clearinghouse margins, (2) exchange (but not18The discussion of margins focuses on futures. There are numerous studies on the impact ofchanges in futures margin requirements on cash price volatility (e.g., Goldberg, Lawrence, andHachey, 1992; Telser, 1981). For forward contracts, margins can appear in various guises, often asa ``haircut'' requirement that requires the posting of some fraction of the principal value of thecontract. However, there is substantial variation of margining practices in the forward market,both across commodities and, in some cases, for forward contracts traded on the same commodity.I. Denitions and Other Basic Concepts 19clearinghouse) member margins, and, (3) commission house margins. Specicdetails depend on the exchange and commodities involved and whether thetrader is classied as a hedger or speculator. Acceptable collateral for deposit ina margin account also differs in much the same way.In practice, clearinghouse members will typically receive the lowest marginrequirements. Even though clearinghouse and other exchange members havethe same stated requirements for each individual trading ticket generated, onalmost all exchanges margin is assessed on a clearing member's net position,calculated by netting the number of short and long positions for a givencommodity delivery month on the clearing member's books at the end oftrading. While larger than effective clearinghouse margins, exchange membermargins are small relative to the value of the underlying physical commoditybeing traded. For example, on August 31, 2001, the gold contract traded onthe Commodity Exchange (COMEX) in New York had nonmember hedger,exchange member and clearing member margins of $1000, for both initial andmaintenance margins. Nonmember margins for speculators were $1350 forinitial and $1000 for maintenance margin. Margins are also given for calendarspreads, specic intercommodity spreads, and written options. Table 1.3provides a summary list of speculator/nonexchange member margins forsome of the important contracts as of November 1, 2001. Depending on theclearing member that is handling the trader's account, up to 25% of thismargin must be met in cash. The remaining margin can be satised with awide variety of acceptable collateral: warehouse receipts (with a ``haircut'' ormarkup), government securities, corporate and municipal bonds, equities,and, in the case of clearinghouse members, letters of credit. For one-to-onegold spreads, there is a decidedly lower, if somewhat more complicated, set ofrequirements. Specically, there is a at rate of $120 per spread up to 100spreads and $200 per spread for all spreads above 100. There is also a perspread rate of $40 plus $20 per month of spread leg. Of these, the leastexpensive method is selected, depending on the type of trade involved.19The highest margin requirements usually have to be satised by customersof commission houses who are not members of the exchange and have to usean exchange member to execute their trades. The actual margins vary fromcustomer to customer and from commission house to commission house. Forlarge active accounts, margin can typically be met with interest-bearing collat-eral such as treasury bills. Alternatively, margin balances may be deposited onbehalf of the client in the dealer's money market account. Small, low-activity19Spreads also receive favorable execution cost treatment. The commission cost structureparallels that for margins; that is, clearinghouse commissions are nominal or negligible, exchangemember transactions fees are nominal, and commission house fees (brokerage) are highest andvary from customer to customer. Because scalpers and daytraders do not carry positions overnight,these traders do not usually have to worry about posting margin.20 Chapter 1: Derivative SecuritiesTABLE 1.3 Margins for Speculative/Non-Member Accounts: Selected CommodityFutures ContractsaOutright Positions Calendar SpreadsbCommodity Initial Maintenance Initial MaintenanceGrainsCorn $405 $300 $65 $50Oats $675 $500 $135 $100Soybeans $945 $700 $338 $250Soybean meal $945 $700 $405 $300Soybean oil $405 $300 $135 $100Wheat $743 $550 $270 $200Stock indexesS&P 500 Index $21,563 $17,250 $188 $150Nasdaq 100 $26,250 $21,000 $250 $200Nikkei 225 $6,250 $5,000 $125 $100Russell 2000 $21,750 $17,400 $157 $125CurrenciesCanadian dollar $608 $450 $34 $25Euro FX $2,025 $1,500 $68 $50Japanese yen $2,025 $1,500 $68 $50British pound $1,485 $1,100 $34 $25Swiss franc $1,350 $1,000 $34 $25AgriculturalsLive cattle $810 $600 $270 $200Feeder cattle $979 $725 $709 $525Pork bellies $1,620 $1,200 $608 $450Hogs $1,080 $800 $486 $360Butter $5,400 $4,000 $3,240 $2,400Interest RatesEurodollar $810 $600 $169 $125Libor (1 month) $608 $450 $135 $100US Treasury bonds $2,160 $1,60010 year Treasury note $1,620 $1,200aMargins are exchange minimums for speculative accounts as calculated by the SPAN1(StandardPortfolio Analysis of Risk) system which is used to calculate margins at the major futuresexchanges. Initial and maintenance margins for hedgers and exchange members are typical byequal to the maintenance margin level for non-member speculative accounts.bMany commodities feature a wide range of spread margins, depending on the type of trade beingexecuted. The calendar spread margins for grains are for old crop/new crop spreads, for porkbellies are for new crop/new crop spreads; and for Eurodollar are for nearby spreads in consecu-tive delivery dates.Source: Chicago Board of Trade and Chicago Mercantile Exchange websites.accounts may be required to deposit cash. For example, to trade the COMEXgold contract, small commission house accounts may be required to put up$3000$5000 cash in a money market account or deposit a $10,000 securityI. Denitions and Other Basic Concepts 21such as a treasury bill and meet cash-ow requirements on an ongoing basis.To understand the precise nature of the cash ows involved requires making adistinction between the two types of margin requirements: initial margin andmaintenance margin. Up to this point, the discussion has implicitly focused oninitial margin: the dollar value of the acceptable collateral that must bedeposited in the margin account in order for the contract to be created. Inturn, maintenance margin is the dollar value of the acceptable collateral thatmust be in the margin account at the beginning of a trading day. To avoidundue administrative hassles, for speculative traders this margin level is set atsome fractionusually between 70 and 85%of the initial margin level.Even though the implications of margin buying are well known, it is usefulto review the implications of the leverage that futures trading provides. If themargin deposit is crudely treated as funds invested in the position, theleverage provided by futures is signicantly greater than that provided byequities. To see this, assume that initial margin on a one-lot (or one contract)customer trade of the 100-oz COMEX gold contract has been assessed at$4000 with maintenance margin at $3000. If the price of August gold istaken to be, say, $400, then the underlying value of the gold being purchasedis $40,000. If the trader goes long August gold at $400 and, in the next tradingday, the price falls to $385, then the value of the position has fallen to$38,500a loss of $1500. At the end of trading, this loss is debited from themargin account, leaving $2500, a value that is below the maintenance marginlevel. As this point, the commission house broker will call the customer with a``margin call,'' notifying the customer that if the margin account is not broughtup above the maintenance margin level, the contract will be closed out. Thepayment that must be made to bring the margin account to an appropriatelevel is known as variation margin. At this point the customer must assess hisposition. A $15 move in the price of gold over one trading period has resultedin a 37.5% loss (i.e., $1500/$4000), in the value of the funds on margindeposit. Variation margin cash ows played a key role in a number of therecent debacles to be examined in Section III (e.g., for Metallgesellschaft andthe Hunt brothers).G. OTC VERSUS EXCHANGE TRADING:POLICY ISSUESThe strategic direction of derivative security regulation, both in the UnitedStates and internationally, is almost incoherent. The difculties associatedwith bringing greater clarity and direction are considerable. There are numer-ous unresolved theoretical issues that need to be identied and analyzedbefore practical implications can be drawn. One of the key theoretical issues22 Chapter 1: Derivative Securitiesto be addressed concerns the method of contracting (e.g., Abken, 1994). Whatis the best mix of OTC versus exchange trading for a particular commodity? Itis possible to argue that OTC contracting needs to be legislatively discouragedin order to direct liquidity to futures and options exchanges where activity canbe more closely monitored and the gains of concentrated liquidity and mark tomarket accounting can be captured. Others could argue that futures exchangesare little more than vestiges of an old transactions technology, extracting rentsfrom a legislatively sanctioned monopoly.The incoherence of strategic direction is apparent in the layering of regula-tion associated with the different methods of contracting. The resulting com-petition among the various regulatory bodies almost certainly imposes realeconomic costs. For example, a U.S. nancial rm has a range of regulatorsconcerned with monitoring and regulating derivative trading activity, from theCommodities and Futures Trading Commission (CFTC) to the Board ofGovernors to the Securities and Exchange Commission (SEC). There is alsoan array of less formal regulators, including the Bank for International Settle-ments (BIS), as well as the exchanges and trading associations.20Each of theseregulatory entities requires resources, derived from the rm being monitored,in order to verify that there is compliance with the rules. Yet, a fragmentedregulatory structure has only limited resources to dedicate for each individualregulator to verify that rms actually are in compliance with the particularpart of the overall rules which that regulator is responsible for monitoring. Allthis is complicated by an extremely uid market situation where new productsand ideas are being introduced at a rapid pace.To see the quandaries arising from this layering of regulation, consider thecase of Barings Bank. This rm was an English merchant banking group.Though Barings had an impressive pedigree, in England the bank was mid-sized and considered relatively conservative. Faced with the competitivepressures surrounding the Big Bang in London's nancial markets in 1986,the bank's strategy was to expand activities offshore in Asia, where Barings hada considerable market presence, with the Barings Securities afliate being thetop Western securities rm in Japan during the incredible runup in theJapanese equity market during the 1980s. Barings was acknowledged to have20Examples of such associations include the International Swap and Derivatives Association(ISDA), the Counterparty Risk Management Policy (CRMP) Group, and the Derivaties PolicyGroup (DPG). The DPG ``was formed by six major Wall Street rms in August 1994, to respond tothe public policy issues raised by the OTC derivatives activities of unregulated afliates of SEC-registered broker-dealers and CFTC-registered futures commission merchants. The DPG is avoluntary framework designed to provide the SEC and CFTC with information and analysesthat would permit them to more systematically and rigorously evaluate the risks associated withOTC derivative products'' (PWGFM, 1999, pp. 7677). The CRMP is described in PWGFM (1999,Appendix F).I. Denitions and Other Basic Concepts 23special status on a number of Asian exchanges, due to the sizable amount ofbusiness that Barings transacted. Barings was a clearing member of a numberof Asian futures and options exchanges. Which regulatory body or individualwas ultimately responsible for monitoring the activities that led to the bank'scollapse? Possible candidates include English banking regulators, the Singa-pore International Monetary Exchange (SIMEX), the Monetary Authority ofSingapore, and the internal banking auditors.The explosion in derivatives trading has exhibited a number of trendstoward increased trade using OTC contracting methods. These trends includethe migration to international markets, the increasing growth of OTC deriva-tive trading relative to exchange trading, and the emergence of sophisticatedrisk-management products. All this has been amplied by the revolution ininformation technology. Yet, little seems to have changed since Abken (1994,p. 19) summarized the regulatory status quo on OTC contracting:The central policy issue in derivatives regulation is whether further federalregulation is appropriate or whether the existing structure can oversee thesemarkets. The six federal banking and securities regulators believe that the currentregulatory structure is capable of supervising the OTC derivatives markets. Policymakers need to be cautious about changing regulatory structures because suchalterations often bring unintended and unforeseen consequences.As it turns out, regulatory denial conveniently sustains a status quo solution. Itseems as though the desired regulatory outcome is whether the current regula-tory structure is sufcient to prevent severe market disruptions. For pragmaticreasons, public deliberations about the optimal regulatory structure appear tobe out of order.Central issues in the debate over appropriate regulatory structure are notnew. Increased regulation aimed at channeling market activity into one venueor the other runs the risk of imposing costs greater than the associatedbenets, running the risk of inhibiting the innovation and development ofnew products and practices. A guiding assumption underlying the currentregulatory structure seems to be that the self-interest of market participants,combined with benevolen