Chapter 17

1. Chapter 17 Contemporary Issues

2. Outline • Introduction • Long Term Capital Management • Value at risk • New product development • Program trading • FAS 133

3. Introduction • Collapse of Long Term Capital Management • Value at risk represents the industry’s efforts to meaningfully measure the risk of a derivatives product • New products appear in response to new risks • Program trading still popular in financial news services • FAS 133 is a new accounting rule resulting in substantial risk management implications

4. Long Term Capital Management • Long Term Capital Management (LTCM) was a hedge fund founded by Wall Street traders • Its rise and fall is already a case study at Harvard Business School • John Meriwether was the driving force behind the fund, which he began promoting in 1993

5. Long Term Capital Management (cont’d) • A hedge fund is a largely unregulated investment portfolio, usually with a substantial minimum investment • Engages in esoteric investment activities unavailable to an individual or small institutional investor • “Shroud of secrecy” with regard to trading strategy and specific activities

6. Long Term Capital Management (cont’d) • LTCM’s practices • Believed that money management was a quantifiable science rather than an art • Began to place bets in early 1998 that market volatility would decline back to its historical average level

7. Long Term Capital Management (cont’d) • LTCM’s practices (cont’d) • Wrote options at an implied volatility of 19% and employed substantial leverage • Eventually had a staggering $40 million riding on each volatility point change in equity volatility in the U.S. and an equivalent amount in Europe

8. Long Term Capital Management (cont’d) • LTCM’s fall • LTCM’s positions were so huge it was unable to move out of them • “When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve”

9. Long Term Capital Management (cont’d) • LTCM’s fall (cont’d) • By mid-September 1998 equity volatility was up to 33%, with each point increase costing the fund $40 million • On September 21, the fund lost one third of its equity ($553 million) • LTCM was leveraged more than 100 to 1

10. Long Term Capital Management (cont’d) • LTCM’s bailout • A consortium of Wall Street banks, facilitated by the New York Fed, arranged a bailout • If LTCM had failed, it would have had catastrophic consequences on markets across the globe • John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent”

11. Value at Risk • Motivation • What is value at risk (VAR)? • Value at risk relationships • VAR calculation

12. Motivation • It is important to understand the consequences of an unusually large price change, even if it is unlikely • If we can draw statistical inferences about changes in market prices, we can draw similar inferences about future values of a portfolio

13. What is Value at Risk? • Value at risk seeks to measure the maximum loss that a portfolio might sustain over a period of time, given a set probability level • Typically, value at risk looks at a 95% probability range over 1 day • Value at risk can be reported either as a dollar amount or as a percentage of fund assets

14. What is Value at Risk? (cont’d) Value At Risk Example A portfolio manager reports that the portfolio has a one-day value at risk (VAR) of $30,000. This means that based on historical data and/or mathematical modeling, 95% of the time the portfolio did not decline in value by more than $30,000.

15. Value at Risk Relationships • Pensions and Investments reported that in early 2000 the median value at risk for the 200 largest corporate-defined benefit plans in the U.S. was 17% of the portfolio value over a one-year period, based on the 95% probability level • Credit Suisse Asset Management found that • Under-funded pension funds tended to have the lowest VAR, meaning they were the most conservative • Over-funded funds tended to have the highest VAR, meaning they were the most aggressive

16. VAR Calculation VAR Calculation Example Suppose we have a six-month call option on a $100 stock. The call is at the money, with volatility equal to 35%, no dividends, and a 4% riskless interest rate. According to the Black-Scholes model, such a call is worth $10.77. Probability theory tells us that in a normal distribution, 95% of the observations lie within 1.96 standard deviations of the mean.

17. VAR Calculation (cont’d) VAR Calculation Example (cont’d) Since there are about 252 trading days in a year, an annual sigma of 35% corresponds to a daily sigma of Multiplying the daily sigma by 1.96, we get 4.31%. If the stock were to fall by 4.31%, its price would be $95.69. If it were to rise by 4.31%, its price would be $104.31.

18. VAR Calculation (cont’d) VAR Calculation Example (cont’d) There is a 95% chance that tomorrow the stock price will be between $95.69 and $104.31.

19. VAR Calculation (cont’d) VAR Calculation Example (cont’d) Suppose someone has 1,000 of these call contracts for a total value of $107,700. If the stock drops by $4.31 and one day passes, the new Black-Scholes value is $8.41. The 1,000-contract position would be worth $84,100. Thus, the one-day, 95% VAR for this long call position is $23,600.

20. New Product Development • Weather derivatives • Rental caps • Equity swaps

21. Weather Derivatives • Introduction • Weather swaps • Weather options

22. Introduction • Exchanges’ institutional marketing people find out what money managers, corporate treasurers, and other financial professionals need • The marketing people then see if they can construct a product to meet that need

23. Introduction (cont’d) • Most existing weather derivatives are temperature-based options or swaps • A variety of institutions face some weather-related risk • Electric utilities • Ski resorts • Property and casualty insurance companies • Disney World

24. Weather Swaps • A temperature swap might be set up with the floating rate side based on the sum of the heating degree-days (HDD) from the effective date of the swap through its termination • A heating degree-day is a measure of extent to which temperatures deviate from some norm

25. Weather Options • A variety of structures are possible • A plain vanilla temperature put provides a payoff to the option holder if the heating degree-days (HDD) or cooling degree-days (CDD) fall below a set level over a period of time at a specific location • A temperature call provides a payoff if the HDD or CDD count is above a set figure

26. Weather Options (cont’d) • A zero cost collar involves purchasing a call and writing a put • The proceeds from writing the put offset the cost of the call

27. Weather Options (cont’d) Catastrophe Futures The Chicago Board of Trade introduced catastrophe futures (CAT futures) in December 1992. The product was geared toward insurance companies that have periodic instances of many policyholder claims all at once because of a hurricane, flood, riot, or some other natural disaster. The product was not successful due to substantial risks, problems with marking to market, and complicated regulatory issues. Also, reinsurance was a well-understood and established alternative.

28. Rental Caps • Rental caps are an alternative to ordinary interest rate caps • Instead of paying an upfront premium, the buyer of a rental cap would make a quarterly premium payment, with the ability to terminate the agreement whenever desired by simply not making a scheduled payment

29. Equity Swaps • An equity swap is an arrangement in which one party buys stock on behalf of another and receives interest from the other party, with the two parties periodically settling up paper gains/losses on the stock

30. Equity Swaps (cont’d) • Equity swaps are a popular way to circumvent local restrictions on the purchase of stock by foreigners • The periodic settlement feature substantially reduces the credit risk involved

31. Equity Swaps (cont’d) Equity Swap Example A U.S. customer (firm A) could enter into an arrangement with another firm (B) that has the ability to buy Indian shares. This swap might involve B buying shares for a set period of time on A’s behalf, with B borrowing the money to acquire them. Firm A would pay LIBOR plus a spread to B to cover the borrowing costs. Every 3 or 6 months there would be a periodic settlement, with B paying A if the stock went up, or A paying B if the stock went down. The payment between the two parties might simply be the gain or loss on the stock.

32. Program Trading • Introduction • Implementation • The open outcry and specialist systems

33. Introduction • Program trading is a method of exploiting arbitrage and is “any computer-aided buying or selling activity in the stock market”

34. Introduction (cont’d) • Program trading has three key characteristics: • It is portfolio trading • It is computerized trading • It is computer decision making

35. Introduction (cont’d) • Arbitrageurs in the marketplace help to keep the market efficient and ensure that prices do not deviate from their proper values for very long

36. Implementation • High-speed, continuously on-line computers make it much easier to identify those instances when arbitrage is present • The New York Stock Exchange’s Designated Order Turnaround System (DOT)

37. Implementation (cont’d) • Program traders normally fall into one of two groups: • Institutions that buy stock index futures and Treasury bills to create the equivalent of an index portfolio • Institutions that combine a well-diversified stock portfolio with short positions in stock index futures to create synthetic Treasury bills

38. Implementation (cont’d) • Program trading suffers from a bad name because: • If the market takes a real tumble, or if it is unusually volatile, someone will blame program trading • The stock specialist needs to match buy and sell orders as they arrive, and if program trading leads to the rapid arrival of many DOT orders at once, the specialist can have difficulty maintaining a “fair and orderly market”

39. The Open Outcry and Specialist Systems • The specialist system is used on the American and Philadelphia Stock Exchanges • Marketmakers are used on the Pacific Stock Exchange and at the Chicago Board Options Exchange

40. The Open Outcry and Specialist Systems (cont’d) • “The specialist acts at all times to maintain a fair and orderly market” • “If a multitude of people [i.e., marketmakers] in a trading crowd are all trying to do different things, the interaction provides a better market than one individual”

41. The Open Outcry and Specialist Systems (cont’d) • High-volume markets seem to lend themselves to the marketmaker system • Low-volume or recently listed securities are best traded via the specialist system

42. FAS 133 • Introduction • Requirements • Criticisms • Implications

43. Introduction • In 1996, the Financial Accounting Standards Board (FASB) issued a proposal for derivatives accounting • The standard is now part of the accounting rules all firms must follow • FASB states that the purpose of the rule is to disclose the market risk potential of derivative contracts

44. Requirements • FAS 133 requires firms to report the “fair value” of any derivatives (assets or liabilities) on the firm’s balance sheet • Derivatives represent rights or obligations that should be disclosed • All derivative transactions should be marked to market when preparing periodic financial statements

45. Requirements (cont’d) • Some hybrid instruments must be dissected into their component parts • Firms must show evidence of the effectiveness of the derivative as a hedge by measuring the fair value of the derivative against the fair value of the asset being hedged

46. Requirements (cont’d) • Firms must classify derivatives use as • A fair value hedge, when used with an asset or liability • A cash flow hedge, when associated with an anticipated transaction, or • A foreign currency value hedge, when associated with an investment denominated in a foreign currency

47. Criticisms • Marking to market rules will tend to increase a firm’s earnings volatility, which means higher risk • It is not possible to accurately estimate the value of every derivative before the end of its life, especially over-the-counter transactions

48. Criticisms (cont’d) • Firms may choose not to use derivatives because they fear the consequences of non-compliance with the accounting rules

49. Implications • Risk magazine reports that a survey of corporate derivative users suggests around a third of them would “seriously reduce their use of derivatives as a result of the new standard”