423 13 FINANCIAL MANAGEMENT OF RISKS Steven P. Feinstein For better or worse, the business environment is fraught with risks. Uncer- tainty is a fact of life. Profits are never certain, input and output prices change, competitors emerge and disappear, customers’ tastes constantly evolve, techno- logical progress creates instability, interest rates and foreign-currency values and asset prices fluctuate. Nonetheless, managers must continue to make deci- sions. Businesses must cope with risk in order to operate. Managers and firms are often evaluated on overall performance, even though performance may be affected by risky factors beyond their control. The goal of risk management is to maximize the value of the firm by reducing the negative potential impact of forces beyond the control of management. There are essentially four basic approaches to risk management: risk avoidance, risk retention, loss prevention and control, and risk transfer. 1 Sup- pose after a firm has analyzed a risky business venture and weighed both the costs and benefits of exposure to risk, management chooses not to embark on the project. They determine that the potential rewards are not worth the risks. Such a strategy would be an example of risk avoidance. Risk avoidance means choosing not to engage in a risky activity because of the risks. Choosing not to fly in a commercial airliner because of the risk that the plane might crash is an example of risk avoidance. Risk retention is another simple strategy, in which the firm chooses to en- gage in the project and do nothing about the identified risks. After weighing the costs and benefits, the firm chooses to proceed. It is the “damn the torpe- does” approach to risk management. For many firms, risk retention is the opti- mal strategy for all risks. Investors expect the company’s stock to be risky, and they do not reward managers for reducing risks. Investors cope with business 424 Planning and Forecasting risks by diversifying their holdings within their portfolios, and so they do not want business managers to devote resources to managing risks within the firm. Loss prevention and control involves embarking on a risky project, yet taking steps to reduce the likelihood and severity of any losses potentially re- sulting from uncontrollable factors. In the flying example, loss prevention and control would be the response of the airline passenger who chooses to fly, but also selects the safest airline, listens to the preflight safety instructions, sits near the emergency exit, and perhaps brings his or her own parachute. The passenger in this example has no control over how many airplanes crash in a given year, but he or she takes steps to make sure not to be on one of them, and if so, to be a survivor. Risk transfer involves shifting the negative consequences of a risky factor to another person, firm, or party. For example, buying flight insurance shifts some of the negative financial consequences of a crash to an insurance company and away from the passenger’s family. Should the airplane crash, the insurance company suffers a financial loss, and the passenger’s family is financially com- pensated. Forcing foreign customers to pay for finished goods in your home cur- rency rather than in their local currency is another example of risk transfer, whereby you transfer the risk of currency fluctuations to your customers. If the value of the foreign currency drops, the customers must still pay you an agreed upon number of dollars, for example, even though it costs them more to do so in terms of their home currency. No one risk management approach is ideal for all situations. Sometimes risk avoidance is optimal; sometimes risk retention is the desired strategy. Recent developments in the financial marketplace, however, have made risk transfer much more feasible than in the past. More and more often now, espe- cially when financial risks are involved, it is the most desirable alternative. In recent years there has been revolutionary change in the financial mar- ketplace. The very same marketplace that traditionally facilitated the transfer of funds from investors to firms, has brought forth numerous derivative instru- ments that facilitate the transfer of risk. Just as the financial marketplace has been innovative in engineering various types of investment contracts, such as stocks, bonds, preferred stock, and convertible bonds, the financial market- place now engineers risk transfer instruments, such as forwards, futures, op- tions, swaps, and a multitude of variants of these derivatives. Reading stories about derivatives in the popular press might lead one to believe that derivative instruments are dangerous and destabilizing—evil crea- tures that emerged from the dark recesses of the financial marketplace. The cover of the April 11, 1994, Time magazine introduced derivatives with the caption “High-tech supernerds are playing dangerous games with your money.” The use of derivatives has been implicated in most of the financial calamities of the past decade: Barings Bank, Procter & Gamble, Metallgesellschaft, Askin Capital Management, Orange County, Union Bank of Switzerland, and Long- Term Capital Management, to name a few. In each of the cases, vast sums of money quickly vanished, and derivatives seemed to be to blame. Financial Management of Risks 425 WHAT WENT WRONG: CASE STUDIES OF DERIVATIVES DEBACLES Derivatives were not responsible for the financial calamities of the 1990s. Greed, speculation, and probably incompetence were. But just as derivatives facilitate risk management, they facilitate greed and accelerate the conse- quences of speculation and incompetence. For example, consider the following case histories and then draw your own conclusions. Barings Bank On February 26, 1995, Baring PLC, Britain’s oldest merchant bank and one of the most venerable financial institutions in the world collapsed. Did this fail- ure follow years of poor management and bad investments. Hardly. All of the bank’s $615 million of capital had been wiped out in less than four months, by one employee, half way around the world from London. It seems that a Bar- ings derivatives trader named Nicholas Leeson, stationed in Singapore, had taken huge positions in futures and options on Japanese stocks. Leeson’s job was supposed to be index arbitrage, meaning that he was supposed to take low risk positions exploiting discrepancies between the prices of futures contracts traded in both Singapore and Osaka. Leeson’s job was to buy whichever con- tract was cheaper and sell the one that was more dear. The difference would be profit for Barings. When he was long in Japanese stock futures in Osaka, he was supposed to be short in Japanese stock futures in Singapore, and vice versa. Such positions are inherently hedged. If the Singapore futures lost money, the Japanese futures would make money, and so little money, if any, could be lost. Apparently, Leeson grew impatient taking hedged positions. He began to take unhedged bets, selling both call options and put options on Japanese stocks. Such a strategy, consisting of written call options and written put op- tions is called a straddle. If the underlying stock price stays the same or does not move much, the writer keeps all the option premium, and profits hand- somely. If, on the other hand, the underlying stock price either rises or falls substantially, the writer is vulnerable to large losses. Leeson bet and lost. Japa- nese stocks plummeted, and the straddles became a huge liability. Like a pan- icked gambler, Leeson tried to win back his losses by going long in Japanese stock futures. This position was a stark naked speculative bet. Leeson lost again. Japanese stocks continued to fall. Leeson lost more than $1 billion, and Barings had lost all of its capital. The bank was put into receivership. Procter & Gamble Procter & Gamble, the well-known manufacturer of soap and household prod- ucts, had a long history of negotiating low interest rates to finance opera tions. 426 Planning and Forecasting Toward this end, Procter & Gamble entered an interest rate swap with Bankers Trust in November of 1993. The swap agreement was far from plain- vanilla. It most certainly fit the description of an exotic derivative. The swap’s cash flows were determined by a formula that involved short-term, medium- term, and long-term interest rates. Essentially, the deal would allow Procter & Gamble to reduce its financing rate by four-tenths of 1% on $200 million of debt, if interest rates remained stable until May 1994. If, on the other hand, interest rates spiked upward, or if the spread between 5-year and 30-year rates narrowed, Procter & Gamble would lose money and have to pay a higher rate on its debt. Even in the rarefied world of derivatives, one cannot expect something for nothing. In order to achieve a cheaper financing rate, Procter & Gamble had to give up or sell something. In this case, implicit in the swap, they sold interest rate insurance. The swap contained an embedded option, sold by Proc- ter & Gamble. If the interest rate environment remained calm, Procter & Gamble would keep a modest premium, thereby lowering its financing costs. If interest rates became turbulent, Procter & Gamble would have to make big payments. Most economists in 1993 were forecasting calm. The bet seemed safe. But it was a bet, nevertheless. This was not a hedge, this was speculation. And they lost. The Federal Reserve unexpectedly raised interest rates on February 4, 1994. Procter & Gamble suddenly found themselves with a $100 million loss. Rather than lower their financing rate by four-tenths of 1%, they would have to pay an additional 14%! Rather than lick its wounds and retire from swaps, Procter & Gamble went back for more—with prodding, of course, from Bankers Trust. As losses mounted on the first deal, Procter & Gamble entered a second swap, this one tied to German interest rates. German medium-term interest rates are remark- ably stable, and so this bet seemed even safer than the first one. Guess what happened. Another $50 million of losses mounted before Procter & Gamble fi- nally liquidated its positions. Losses totaled $157 million. Procter & Gamble sued Bankers Trust, alleging deception, mispricing, and violation of fiduciary responsibilities. Procter & Gamble claimed that they did not fully understand the risks of the swap agreements, nor how to calculate their value. Bankers Trust settled with Procter & Gamble, just as they settled with Gibson Greeting Cards, Air Products and Chemicals, and other companies that lost money in similar swaps. Metallgesellschaft Experts are still divided over what went wrong in the case of Metall- gesellschaft, one of Germany’s largest industrial concerns. This much is cer- tain: In 1993, Metallgesellschaft had assets of $10 billion, sales exceeding $16 billion, and equity capital of $50 million. By the end of the year, this industrial giant was nearly bankrupt, having lost $1.3 billion in oil futures. Financial Management of Risks 427 What makes the Metallgesellschaft case so intriguing, is that the company seemed to be using derivatives for all the right reasons. An American sub- sidiary of Metallgesellschaft, MG Refining and Marketing (MGRM) had em- barked on an ingenious marketing plan. The subsidiary was in the business of selling gasoline and heating oil to distributors and retailers. To promote sales, the company offered contracts that would lock in prices for a period of 10 years. A variety of different contract types was offered, and the contracts had various provisions, deferments, and contingencies built in, but the important feature was a long-term price cap. The contracts were essentially forwards. The forward contracts were very popular and MGRM was quite successful at selling them. MGRM understood that the forward contracts subjected the company to oil price risk. MGRM now had a short position in oil. If oil prices rose, the company would experience losses, as it would have to buy oil at higher prices and sell it at the lower contracted prices to the customers. To offset this risk, MGRM went long in exchange-traded oil futures. The long position in futures should have hedged the short position in forwards. Unfortunately, things did not work out so nicely. Oil prices fell in 1993. As oil prices fell, Metallgesellschaft lost money on its long futures, and had to make cash payments as the futures were marked to market. The forwards, however, provided little immediate cash, and their ap- preciation in value would not be fully realized until they matured in 10 years. Thus, Metallgesellschaft was caught in a cash crunch. Some economists argue that if Metallgesellschaft had held on to its positions and continued to make margin payments the strategy would have worked eventually. But time ran out. The parent company took control over the subsidiary and liquidated its posi- tions, thereby realizing a loss of $1.3 billion. Other economists argue that Metallgesellschaft was not an innocent vic- tim of unforeseeable circumstances. They argue that MGRM had designed the entire marketing and hedging strategy, just so they could profit by speculating that historical patterns in oil prices would persist. Traditionally, oil futures prices are lower than spot prices, so the general trend in oil futures prices is upward as they near expiration. MGRM’s hedging plan was to repeatedly buy short-term oil futures, holding them until just before expiration, at which point they would roll over into new short-term futures. If the historical pattern had repeated itself, MGRM would have profited many times from the rollover strategy. It has been alleged that the futures was the planned source of profits, while the forward contracts with customers was the hedge against oil prices dropping. Regardless of MGRM management’s intent, the case teaches at least two lessons. First, it is important to consider cash flow and timing when con- structing a hedge position. Second, when a hedge is working effectively, it will appear to be losing money when the position it is designed to offset is showing profits. Accounting for hedges should not be independent of the po- sition being hedged. 428 Planning and Forecasting Ask in Capital Management Between February and April 1994, David Askin lost all $600 million that he managed on behalf of the investors in his Granite Hedge Funds. Imagine the surprise of the investors. Not only had they earned over 22% the previous year, but the fund was invested in mortgage-backed securities—instruments guaran- teed by the U.S. government not to default. The lesson from the Askin experi- ence, is that in the age of derivatives, investments with innocuous names might not be as safe and secure as they sound. The particular type of mortgage-backed securities that Askin purchased were collateralized mortgage obligations (CMOs), which are bonds whose cash flows to investors are determined by a formula. The formula is a function of mortgage interest rates and also of the prepayment behavior of home buy- ers. Since the cash flow to CMOs is a function of some other economic vari- able, interest rates in this case, these instruments are categorized as derivatives. Some CMOs rise in value as interest rates rise, others fall. Askin’s CMOs were very sensitive to interest rates. Askin’s portfolio rose in value as interest rates fell in 1993. When interest rates began to rise again in February 1994, his portfolio suffered. Interest rate increases alone, however, were not the sole cause of Askin’s losses. As interest rates rose and CMO prices fell, CMO investors everywhere got scared and sold. CMO prices were doubly bat- tered as the demand dried up. It was a classic panic. Prices fell far more than the theoretical pricing models predicted. Eventually, calm returned to the market, investors trickled back, and prices rebounded. But it was too late for Askin. He had bought on margin, and his creditors had liquidated his fund at the market’s bottom. Orange County, California Robert Citron, treasurer of Orange County, California, in 1994, fell into the same trap that snared Procter & Gamble and David Askin. He speculated that interest rates would remain low. The best economic forecasts at the time sup- ported this outlook. Derivatives allowed speculators to bet on the most likely scenario. Small bets provided modest returns. Big bets promised sizable re- turns. What these speculators did was akin to selling earthquake insurance in New York City. The likelihood of an earthquake there is very small, so insurers would almost certainly get to keep the modest premiums without having to pay out any claims. If an earthquake did hit New York, however, the losses to the insurers would be enormous. Citron bet and lost. The earthquake that toppled his portfolio was the un- expected interest rate hikes beginning in February 1994. Citron had borrowed against the bonds Orange County owned, and he invested the proceeds in deriv- ative bonds called inverse-floaters, whose cash flow formulas made them extra sensitive to interest rate increases. Citron lost about $2 billion of the $7.7 billion he managed, and Orange County filed for bankruptcy in December 1994. Financial Management of Risks 429 Union Bank of Switzerland What happened at Union Bank of Switzerland (UBS) in 1997 would be funny if it weren’t so sad. Imagine a bakery that sells cakes and cookies for less than the cost of the ingredients. Business would no doubt be brisk, but eventually the bakers would discover that they were not turning a profit. This is essen- tially what happened to UBS. UBS manufactured and sold derivatives to cor- porate customers. Unfortunately, there was an error in their pricing model, and they were selling the derivatives for too low a price. By the time they found the mistake, they had managed to lose over $200 million. Swiss banking officials concluded that losses sustained by the Global Equity Derivatives Business arm of UBS amounted to 625 million Swiss francs (about $428 mil- lion), but these losses stemmed not only from the pricing model error, but also from unlucky trading, an unexpected change in British tax laws, and market volatility. Some speculate that these losses forced the merger of UBS with Swiss Bank Corporation, a merger that was arranged exactly when the deriv- atives losses were discovered. Long-Term Capital Management The most surprising of the derivatives debacles is also one of the most recent. It is the saga of Long-Term Capital Management (LTCM). LTCM was a com- pany founded by John Meriwether, and joined by Myron Scholes and Robert Merton. Meriwether had a reputation for being one of the savviest traders on Wall Street. Scholes and Merton are Nobel prize laureates, famous for invent- ing the Black-Scholes option pricing model. 2 Unlike the folks at Procter & Gamble, these individuals cannot plead ignorance. They were without a doubt among the smartest players in the financial marketplace. Paradoxically, it may have been their intellectual superiority that did them in. Their overconfidence engendered a false sense of security that seduced investors, lenders, and the portfolio managers themselves into taking enormous positions. The story of LTCM is a classic Greek tragedy set on modern Wall Street. LTCM was organized as a “hedge fund.” A hedge fund is a limited part- nership, that in exchange for limiting the number and type of investors who can buy in, is not required to register with the Securities and Exchange Commis- sion, and is not bound by the same regulations and reporting standards imposed on traditional mutual funds. Investors must be rich. A hedge fund can accept investments from no more than 500 investors who each have net worth of at least $5 million, or no more than 99 investors if they each have net worth of at least $1 million. A hedge fund is essentially a private investment club, unfet- te red by the rules designed to protect the general public. Ironically, hedge funds are generally unhedged. Most hedge funds spec- ulate, aiming to capture profits by taking risks. LTCM was a little different, and for them the moniker “hedge fund” appeared to fit. Capitalizing on their brainpower, LTCM sought to exploit market inefficiencies. That is, with an 430 Planning and Forecasting understanding of what the prices of various financial instruments should be, LTCM would identify instruments that were priced too high or too low. Once such an opportunity was identified, they would buy or sell accordingly, hedg- ing long positions with matching shorts. As the prices in the financial market- place trended toward the fair equilibrium dictated by the financial models, the prices of the assets held long would rise, and the prices of the instru- ments sold short would fall, thereby delivering to LTCM a handsome profit. LTCM’s deals were generally not naked speculation, but hedged exploitation of arbitrage opportunities. With price risk thought to be hedged out, LTCM and their investors felt comfortable borrowing heavily to lever up the impact of the trades on profits. The creditors, banks and brokerages mostly, happily obliged. LTCM opened its doors in 1994, with an initial equity investment of $150 million from the founding partners, and an investment pool of $1.25 billion in client accounts. Success was immediate and pronounced. They thrived in the tumultuous market of the mid-1990s. Apparently, as some of the institutions described above lost fortunes during this period, it was LTCM that managed to be on the receiving end. The fund booked a 28% return in 1994, a whopping 59% in 1995, followed by another 57% return in 1996. Word of this success spread, and new investors were clamoring to get into LTCM. 3 LTCM could be picky when it came to choosing investors. This was not a fund for your typical dentist or millionaire next door. Former students of mine who have gone on to jobs at some of the world’s largest banks and investment companies have confided to me that their firms subcontracted sizable portions of their portfolios to LTCM. By the end of 1995, bolstered by reinvested prof- its and by newly invested funds, LTCM managed $3.6 billion of invested funds. However, the portfolio was levered 28 to 1. For every $1 a client invested, the fund was able to borrow $28 from banks and brokerage houses. Consequently, LTCM managed positions worth over $100 billion. Moreover, because of the natural leverage inherent in the derivatives they bought, these positions were comparable to investments of a much larger magnitude, estimated to be in the $650 billion range. By 1997, however, when the fund’s capital base peaked at $7 billion, managers realized that profitable arbitrage opportunities were growing scarce. The easy pickings of the early days were over. The partners began to intention- ally shrink the fund by returning money to investors, essentially forcing them out. Performance was sound in 1997, a 25% return, but with the payout of cap- ital, the fund’s capital base fell to $4.7 billion. Things unraveled disastrously in 1998. Each of LTCM’s major invest- ment strategies failed. Based on sophisticated models and historical data, LTCM gambled that (1) stock market volatility would stay the same or fall, (2) swap spreads—a variable used to determine who pays whom how much in interest rate swaps, would narrow, (3) the spread of the interest rate on medium-term bonds over long-term bonds would flatten out, (4) the credit Financial Management of Risks 431 spread—the inter est rate differential between risky bonds and high-grade bonds, would narrow, and (5) calm would return to the financial markets of Russia and other emerging markets. However, in each case the opposite hap- pened. Equity volatility increased. Swap spreads widened. The yield curve re- tained its hump. Credit spreads grew. Emerging markets deteriorated. Though LTCM had spread its bets over a wide variety of positions, they seemed to gain no diversification benefit. Everything went wrong at once. Re- cent research has shown that diversification does not protect speculative posi- tions when markets behave erratically. Markets tend to go awry in tandem. In August 1998 alone, the fund suffered losses of $1.9 billion. Losses for the year so far were 52%. Fund managers were confident that their strategies were sound, and that time would both prove them right and reward their pre- science. But time is not a friend to a levered fund losing money. Banks and bro- kerages itched for their loans back. How ironic, Long-Term Capital Management faced a short-term liquidity crunch. Leverage amplified LTCM’s remaining $2.28 billion of equity into man- aged assets of $125 billion. If the market continued to move against them, LTCM would be wiped out in short order, and that is essentially what hap- pened. On September 10, LTCM lost $145 million. The next day, they lost $120 million. The following three trading days brought losses of $55 million, $87 million, and $122 million, respectively. On one day alone, Monday, September 21, 1998, LTCM lost $553 million. By now traders at other firms could guess what LTCM’s positions were, and by anticipating what LTCM would have to eventually sell, they could gauge which securities were good bets to short. This selling pressure added to LTCM’s losses and woes. At this point, in September 1998, any of several banks could bankrupt LTCM by calling in its loans. The Federal Reserve, which is the central bank of the United States, and is responsible for guarantying the stability of the Amer- ican banking system, monitored the predicament. Though LTCM’s equity was shrinking precipitously, on account of their borrowed funds and the inherent leverage of their derivatives positions, the notional principal of their positions was about $1.4 trillion. To put this quantity into perspective, the gross national product of the United States was about $8.8 trillion in 1998. Total bank assets in the United States stood at $4.3 trillion. It was feared that if LTCM went bankrupt, they would probably default on their derivative positions, triggering a domino effect of defaults and bankruptcies throughout the world’s financial markets. It was decided, that LTCM was too big too fail. The Federal Reserve orchestrated a plan for LTCM’s creditors to buy the company’s portfolio. Each of 14 banks ponied up money in exchange for a slice of the portfolio. The $3.65 billion paid by the bank syndicate for the portfolio was clearly greater than the value of the portfolio by then, but this infusion of capital prevented defaults that would have cost the banks much more. The money was used to pay off debts and shore up the trading accounts so that ex- isting positions would perform without default. Very little was left over for the 432 Planning and Forecasting original partners who were required to run the fund until it was ultimately liq- uidated in 1999. The bottom line is that LTCM had lost $4.5 billion since the start of 1998. These losses included the personal fortunes amassed so quickly by the founding partners, which totaled $1.9 billion at one point but were com- pletely wiped out by the end. Moral of the Story The lesson from these case studies should now be obvious. Risk management is not the art of picking good bets. Bets no matter how good are speculation. Speculation increases risk, and subjects corporations, investors, and even mu- nicipalities to potential losses. Derivatives are powerful tools to shed risk, but they can also be used to take on risk. The root causes of the debacles described in these cases are greed, speculation, and in some cases incompetence, not de- rivatives. But just as derivatives facilitate risk management, they facilitate greed and speculation. Anything that can be done with derivatives, can be done slower the old fashioned way with positions in traditional financial instru- ments. Speculators have always managed to lose large sums. With the aid of de- rivatives they now can lose larger sums faster. Superior intellect and sophistication cannot protect the speculator. As the Long-Term Capital Management story illustrates, when you are smarter than the market, you can go broke waiting for the market to wise up. Government regulation is not the answer either. The benefits of regula- tion must be weighed against the costs. Derivatives, properly used, are too im- portant in the modern financial marketplace to be severely restricted. Abuse by a few does not warrant constraints on all users. A better solution to prevent repetition of the past debacles is full information disclosure by firms, portfolio managers, and municipalities. Investors and citizens should demand to know how derivatives are being used when their money is at stake. Better informa- tion and oversight is the most promising approach to prevent misuse of deriva- tives while retaining the benefits. Derivatives can be dangerous, but they can also be tremendously useful. Dynamite is an appropriate analogy. Misused, it is destructive; handled with care, it is a powerful and constructive tool. Derivatives are tools that facilitate the transfer of risk. Interest rate de- rivatives enable managers to shed business exposure to interest rate fluctua- tions, for example. But when one party sheds risk, another party necessarily must take on that very exposure. And therein lies the danger of derivatives. The same instrument that serves as a hedge to one firm, might be a destabiliz- ing speculative instrument to another. Without a proper understanding of de- rivatives, a manager who intends to reduce risk, might inadvertently increase it. This chapter aims to provide the reader with a basic understanding of deriv- atives so that they can be used appropriately to manage financial risks. This un- derstanding should help the reader avoid the common pitfalls that have proved disastrous to less informed managers. [...]... combining the features of these basic building blocks have also been engineered The first thing the interested manager must understand about derivatives is that the business in these instruments is now huge, and their use is pervasive Since the initiation of trading in the first stock index futures contract in December of 1982—the Standard & Poor’s 500 futures contract—the daily volume of stock index... replacing traditional portfolios with what are called synthetic portfolios—portfolios composed in part of derivatives Some investment funds buy derivatives that act as insurance contracts, protecting portfolio value Since their emergence in 434 Planning and Forecasting the early 1980s, derivatives have touched every aspect of corporate finance, banking, the investments industry, and arguably business in. .. will not collect on this insurance policy, and the initial premiums will be lost Pricing Options At this point the reader may wonder how the initial price of an option is determined Option pricing is no trivial exercise, and a thorough treatment of option pricing is beyond the scope of this chapter Some basic principles, however, can be explained here First, an option’s “intrinsic value” prior to expiration... it were invested in Treasury bills Synthetic Stock A company’s pension fund is invested primarily in Treasury bills The stock market has been rising rapidly in recent weeks, and the pension fund manager wishes to participate in the boom One strategy would be to sell the T-bills and invest the proceeds in equities A more economical strategy would be to leave the value parked in T-bills, and gain exposure... general THE INSTRUMENTS The major derivative instruments are forwards, futures, options, and swaps Also available today are hybrid instruments, exotics, and structured or engineered instruments The hybrids, exotics, and engineered instruments are contracts that combine features of the basic building blocks: the options, futures, forwards, and swaps Consequently, familiarity with the basic building blocks... asymmetric way, insuring against losses on the downside while maintaining the potential for upside appreciation An asymmetric instrument, a put option, would be the appropriate hedge instrument in this case, since an asymmetric instrument converts a symmetric risk into an asymmetric exposure An automobile leasing company is an example of a commercial venture that faces an asymmetric risk If interest rates... for hedging and not for speculation Auditing systems should be in place to oversee that futures are used appropriately Futures and Forwards Summar y As the above examples illustrate, futures and forwards are useful tools for hedging a wide variety of business and financial risks Futures and forward contracts essentially commit the two parties to a deferred transaction No money changes hands initially... their standardization and how they are traded, futures are very liquid, and their associated transaction costs are very low Another feature differentiating futures from forwards is the process of marking-to-market All day and every day, futures traders meet in trading pits at the exchanges and cry out orders to buy and sell futures on behalf of clients The forces of supply and demand determine whether... remaining in the option’s life, it is possible that an outof-the-money option can go in- the-money An in- the-money option can go further in the money, and has more upside potential than downside A call option’s value is a function of the underlying stock price, the strike price, the amount of time remaining to expiration, the interest rate, the stock’s dividend rate, and the volatility of the underlying... continues for a specified number of years H will benefit if rates fall; M will benefit if rates rise This interest rate swap is depicted in Exhibit 13. 6 Examples of Hedging Interest Rate Exposure with a Swap The Keating Computer Company assembles and markets computer hardware systems In the past several years Keating Computer has been one of the fastest EXHIBIT 13. 6 An interest rate swap Fixed 10% interest . first thing the interested manager must understand about de- rivatives is that the business in these instruments is now huge, and their use is pervasive. Since the initiation of trading in the. something for nothing. In order to achieve a cheaper financing rate, Procter & Gamble had to give up or sell something. In this case, implicit in the swap, they sold interest rate insurance their holdings within their portfolios, and so they do not want business managers to devote resources to managing risks within the firm. Loss prevention and control involves embarking on a risky