The Finance and Investment Column This column provides informative commentary on financial matters and is written by Patrick van Beek, managing Proprietor of Caribbean Actuarial & Financial Services.
In recent times oil prices have been oft quoted as being at record highs. The prices being quoted are futures prices; that is a price agreed today for settlement at a future point in time (typically 3 months to a year). This is distinct from the spot price which is the price it would cost to buy the same barrel of oil for delivery today. An oil future is just one example of a derivative, any financial contract whose payoff depends on the value of something else.
Of all the instruments traded in the financial markets, derivatives are perhaps the least understood and as a consequence have developed a reputation for being extremely risky. In fact, derivatives were originally developed to reduce risk, not increase it. It is when derivatives are used for speculation that the potential for catastrophic failures arises which usually come to light when it turns out a bet has gone badly wrong.
Derivative literally means derived from, and the name springs from the concept that the payoff from ??????is derived from the value of something else. Value in this respect usually indicates something which has financial value but it could just as easily be the temperature recorded on the roof of the Bank of Guyana at midday.
The simplest derivatives are called forwards; this is when the price is agreed today for the exchange of something at a future point in time. Many people enter into forward contracts when they agree a price now to buy something which will not be delivered and paid for until later. Consider a vehicle importer who is prepared to bring in a particular model on special order. The customer will not be paying until the vehicle has arrived so if the price is set when the vehicle is ordered the customer has entered into a forward agreement to buy the vehicle at the set price and the seller has agreed to sell the vehicle forward at the set price. Of course the dealer will often want to protect themselves if the buyer defaults, so in all likelihood will request a deposit which is non-refundable in the case the customer decides not to go ahead with the deal.
Perhaps the most widely used forwards in practice are the currency markets. Here a bank agrees to an exchange rate today which it will convert at a future point in time. The de facto currency for many importers in Guyana is the US$, so it is quite likely if G$/US$ currency forwards were offered there would be a large demand to buy US$ at future points in time at guaranteed rates. Unfortunately, there does not seem to be such a case to put forward for those wanting to sell US$ and buy G$ forward. If a bank enters into forwards to buy and sell at the same time, short of one of default by one of the parties the bank's position is covered - it will simply exchange the funds between the two parties and pick up any spread. Without a corresponding party to buy US$ forward from a bank selling US$ forward to, an importer will face a position of having to collect G$ in let's say a year's time in exchange for paying out US$ (note the bank's position is opposite to the importers - so if the importer wants to buy US$ the bank is selling them). If the bank does not hedge its position, when the forward expires it thus faces the risk that it must buy US$ in the market at a worse rate than it agreed to sell them for. To hedge its exposure it may have to tie up large amounts of capital buying US$. This is perhaps why the commercial banks have not rushed out to develop a G$/US$ forward market.
A future is similar in concept to a forward in that it is a contract to trade something at a future point in time except it is a standardised trade on a recognised exchange and the exchange will determine the terms of payment and delivery eg location and quality of goods (if a commodity is being delivered). The key difference between a forward is that the contract does not necessarily need to be (and in fact rarely is) settled by the two parties that entered into the future. Because it is possible to both buy (also called holding a long position) and sell (holding a short position) futures contracts, in theory it is possible for an investor to hold both a long and a short position, which means in effect they are have entered into an agreement to both buy and sell the same thing. Since their net economic position is now zero, what happens in practice is that the two contracts are cancelled and the investor is said to have closed out their position.
This mechanism allows speculators to make a bet on which way the price of a commodity such as oil will move, without ever owning a barrel. Once they have achieved a satisfactory profit the speculator enters into an offsetting position and walks away with the profit. It is interesting to note that shortly after oil futures hit record highs the price backed off by several dollars. Likely this was due in part to speculators who held long positions who were unwilling or unable to take delivery of large quantities of crude oil. Once the move to close out their positions started, like most markets the futures price dropped, as the number of sellers outweighed the buyers.
Another difference between a forward and future is that the exchange acts as a guarantor to all futures transactions thereby virtually eliminating the risk of default. It can do this because it requires both sides to deposit payments which can be called upon in the event of default called margin??. The exchange will require additional margin payments to be deposited if the price moves against either of the parties. Failure to do so will mean the party's position will automatically be closed out. Similarly as the price moves in the other party's favour they may be able to withdraw margin payments. As only the initial margin is required to enter a futures contract it is possible to gain tremendous economic exposure for a small initial investment. This is what ultimately caused the collapse of Barings, at the time the oldest private bank in the world. Nick Leeson, Barings' futures trader in Singapore, exceeded his authority and entered into such large positions that when the price moved against them the margin requirements exceeded the available resources of the bank. By the time the positions had finally been closed the accumulated losses ran to some £830 million.
In the following two articles I will take a look at options and examine how derivatives can be used to reduce risk.
Easy money or a mug's game?
Derivatives Part II- options
Friday, September 17th 2004
The Finance and Investment Column
This column provides informative commentary on financial matters and is written by Patrick van Beek, managing Proprietor of Caribbean Actuarial & Financial Services.
Over the years I have had financial options described to me as the way to really make money on the stock exchange and also described as a mug's game. This week I will explain how the features of options lead to these widely differing points of view.
A financial option is the right, but not the obligation to buy or sell something at a specified price during a particular time period.
Options readily fall into two classes; those which give the holder the right to buy, called 'call' options and those that give the holder the right to sell, called 'put' options. Options are available on many financial instruments and commodities. A typical example might be a call option on Microsoft Corp struck at US$29 which gives the holder the right to buy a specified number of Microsoft Corp shares for $29 in three month's time. To utilise this option would mean going to the person who sold it to you and notifying them that you are exercising your right to buy.
The seller is then obligated to sell you the stock for the agreed price of US$29. This process is referred to as 'exercising' the option. The final terminology used to classify options is whether or not the option can be exercised only at the end of the period specified, called 'European', or at any time before that point, called 'American.'
In the above case the holder of the option can only go to the seller at the end of the period, so this is an example of a European option.
Note that the terms 'European option' and 'American option' do not relate to the markets in which they are traded; it is possible to trade American options in London and European options in New York.
Readers of last week's article might question the difference between buying forward and buying a call option (or selling forward and buying a put option). The crucial difference is that a party in a forward transaction is obligated to trade at the agreed price. An option-holder can always walk away from the deal without exercising their right.
Unlike a forward or futures contact, which is essentially free to enter, in order to buy a put or a call option, one will have to pay the seller that you are buying the option from; this payment is called the option premium. Options on many popular stocks and indices are traded on recognised exchanges. For traded options the premiums are determined by supply and demand. Still, further options are traded over-the-counter or 'OTC' which means they are tailor made and sold directly usually by large investment banks. Exchange traded options provide protection in the event of default of the option-writer by requiring the writers of options to make margin payments. In contrast an option bought over-the-counter is subject to the credit- worthiness of the writer.
The way to really make money
Consider a hypothetical option to buy Banks DIH shares at G$6.0 in one year's time (thus this is a European call option). Based on the current share price of G$4.7, a dividend yield of 3.8%, a one year T-bill rate of 3.39% after tax and volatility of changes in share price since trading commenced of 23% pa, it is possible to come up with a theoretical price this option should trade in a deep liquid market.
Of course Guyana is not a deep liquid market, so if anyone were to offer an option of this type the premium would likely be higher to cover the writer for the extra uncertainty. However, bearing the previous caveats in mind the theoretical model would give an option premium of just under 8 cents. (The examples below ignore dealing costs.)
Imagine we have G$100,000 dollars to invest and we can buy the stock or options on the stock. We can either buy 21,276 shares or the option to buy 1.25 million shares for G$6.0. Suppose now that the share price finishes above G$6.0. If we exercise the option we can sell the stock straight away in the market for more than we paid for it. In fact we make a dollar on every option for every dollar the price finishes above G$6.0. All figures in the tables are in Guyana Dollars. Note the stockholder would also have received dividends during the year; these are not included in the figures below.
Remember both of these investments cost G$100,000 to enter - but the owner of the options stands to make 525% on their investment if the price rises 38% (which is the capital return to someone who buys the stock in that scenario.)
Options are a mug's game
Now consider the same example where the value ends up at $6.0 or less. What is the return to both parties?
If the price finishes at G$6 or less the option expires worthless. There is no point exercising an option to buy something for G$6.0 if you can buy it in the market for less in any case. So while the owner of the stock could see a 6% or 28% return if the price goes up to G$5.0 and G$6.0 respectively the option-holder has seen the loss of their entire G$100,000. The option has the potential to provide spectacular returns and it also provides opportunity for the ultimate financial disaster - a complete loss of all capital invested.
Next week I'll examine how options and futures can be used to manage risk, rather than increase it!
In the last two articles I've examined the features of forwards, futures and options with some examples of how they can be used to speculate and the consequences if things go wrong. This week I will explain how derivatives can be used for the opposite of speculating, that is hedging or the process of reducing risk.
The case of the rice farmer
Perhaps of some relevance to Guyana is the case of the hedging price of rough rice or paddy. Paddy prices have seen some resurgence in recent times, as the chart below shows. Futures prices are some 88% up over this time two years ago and at one point were almost three times their 2002 level. This recovery in prices might encourage local farmers to start growing the crop, but what if, following the heavy investment to get started, the price drops back as it did in 1997? Say it costs US$100 on average to cultivate one metric ton of paddy. At current futures prices this paddy could be sold for US$166 per ton. Even allowing for the possible failure of 20% of the crop this probably would provide returns sufficient to justify the investment. But what, if, following the investment, prices were to fall back to the lows of June 2002? A loss of $18 dollars per ton would result and that is assuming a 100% yield. Certainly the risk is large enough to make anyone think hard about entering the market.
Chicago Board of Trade (CBOT) rough rice futures prices
What if you could fix the price you could sell your paddy for now, rather than having to wait until the rice is farmed? With the use of futures contracts you can come close to doing so. Futures contracts traded on the Chicago Board of Trade (CBOT) are quoted in cents per cwt for delivery of 2000 cwt which is around 90 metric tons. To find out what the equivalent price per ton on one contract is worth we need to convert:
So if the current futures price is $7.52, by selling one futures contract a farmer can effectively lock in the price at which they sell 90 tons at US$166 per ton. Here is how it works: Say the final price a farmer gets for his paddy is only US$100 per ton. If the movement in the futures contract mirrors the movement in price he is getting for his paddy then the futures contract would close at US$4.54. Assuming the contract is closed out prior to delivery - due to the way futures operate in practice - as the futures price falls over the period the farmer would make (US$7.52-US$4.54)*2,000 = US$5,960. This gets pretty close to the US$14,940-US$9,000 = US$5,940 which has been lost because the 90 tons of paddy can only be sold for US$100 per ton not US$166 per ton. So the farmer has hedged his selling price and will be happy he will receive the price they wanted to begin with.
Of course if the price rises say to $250 per ton, the farmer will not cash in on this - he will have lost (US$11.32-US$7.52)*2,000 = US$7,600 on the futures contract which will offset the US$22,500 - US$14,940 = US$7,560 he will make through selling the 90 tons of paddy at US$250 per ton and not US$166 per ton. Of course the farmer still gets US$14,900, which is what he wanted to begin with, but it may still be painful to know that if he did not hedge he would have ended up with US$22,500.
Perhaps the reason the use of futures has not been popular is the fact that if the futures price moves against the farmer in this way he would have had to deposit an additional $7,600 in margin payments. This is a vast amount of money compared with the US$9,000 required to cultivate 90 tons! It could be that having to meet these liquidity requirements would force the farmer to close out the contract before he ever saw the US$22,500, which then exposes him if the price subsequently falls.
Another reason that this strategy may not work exactly as described above is due to what is called basis risk - that is the spot price at which the paddy is actually being sold does not move exactly in line with the futures price. The future is traded in Chicago for a specific grade of rice, which may not reflect the price received in Guyana for local paddy of a different grade. Another problem may be that the term of the futures contract is not long enough to cover the lead in time to get into the market and grow the paddy - the longest contract at the moment is for May 2005. Though it is possible to roll futures over as longer contracts become available, the prices of the new contract need not necessarily be the same as the old one so a profit or loss could result each time the contract rolls over. Finally, the contract must be closed out before delivery, otherwise the rice must be delivered to the specified place in the USA. Since futures prices only converge to spot prices at delivery there is another source of uncertainty due to the futures price being away from the spot price at the time the contract is closed.
Given the above it remains to be seen whether Guyanese farmers can use futures to lock into the relatively high prices seen recently.
The Rice Miller
The rice miller faces the opposite problem - they are exposed if the price of paddy goes up but their finished product, milled rice does not. They can lock in to the price at which they buy paddy if prices are low now, by buying a future. If the price of paddy goes up, they will make a profit on the future which offsets the additional price they have to pay for their paddy. Conversely if the price goes down, they will lose on the future what they gain through lower paddy prices.
In theory, if there was a futures market for milled rice then the miller could also lock into the price of the finished product by selling futures on this market. However, I could not find a futures contract for milled rice.
The portfolio investor seeking to cover a loss
One use of options is to purchase portfolio insurance. Here the idea is to buy a put option which will cover any shortfall if the stock falls below a certain price. The idea is simple - if the stock falls below the strike price of the option, the pay-off from the option matches the fall in the stock price. The easiest way to see this is with some examples, so for a hypothetical stock consider the situation where a put option is bought to protect against a fall in the stock below $80. I'll then examine what happens in each of three scenarios, where the price moves generally upwards, generally downwards and where there is a sharp fall followed by a recovery.
In all cases the cost to buy the option to begin with is $2.12, so some of the portfolio must be sold to buy the options. The stock value at the time the portfolio insurance is taken out is $92.62. In all cases the value of the un-hedged portfolio is the same as the stock price.
Price moves generally upwards
Here the option value tails to zero since there is no intrinsic value to the option at any time during the stock's life - at no point does the stock fall below $80. At expiry the strategy has resulted in a loss of $2.29 compared with an un-hedged strategy which corresponds to the option premium paid together with the lost return over the period on the stock sold to buy the option.
Price moves generally downwards
Note different scales have been used. Here the stock price gradually falls until it ends below $80. Thus there is a sudden increase in the option value as it becomes in the money towards the end of the option life. The un-hedged portfolio ends at some $4.63 lower than the hedged portfolio - so the insurance has held the hedged portfolio value at close to $80.
Fall then recovery
Perhaps the most dramatic impact of the portfolio insurance can be seen when there is a sudden fall in the share price. Here the un-hedged portfolio falls almost below $65 before recovering at the last moment. The option thus becomes a long way into the money which balances out the fall in the value of the stock. As the stock price recovers there is a corresponding offset in the value of the option, until finally the option expires worthless. However, during the period the value of the hedged portfolio is almost a straight line.
It is interesting to see that in all cases how volatile the option price is, (it is shown on a different scale but shows as much movement as the stock price on a large scale!), however when taken together with the stock, the combined effect is to smooth out nearly all the volatility while the stock price is less than $80.