Tài chính doanh nghiệp - Chapter 17: Contemporary issues

© 2004 South-Western Publishing1Chapter 17Contemporary Issues2OutlineIntroductionLong Term Capital ManagementValue at riskNew product developmentProgram tradingFAS 1333IntroductionCollapse of Long Term Capital ManagementValue at risk represents the industry’s efforts to meaningfully measure the risk of a derivatives productNew products appear in response to new risksProgram trading still popular in financial news servicesFAS 133 is a new accounting rule resulting in substantial risk management implications4Long Term Capital ManagementLong 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 SchoolJohn Meriwether was the driving force behind the fund, which he began promoting in 19935Long Term Capital Management (cont’d)A hedge fund is a largely unregulated investment portfolio, usually with a substantial minimum investmentEngages in esoteric investment activities unavailable to an individual or small institutional investor“Shroud of secrecy” with regard to trading strategy and specific activities6Long Term Capital Management (cont’d)LTCM’s practicesBelieved that money management was a quantifiable science rather than an artBegan to place bets in early 1998 that market volatility would decline back to its historical average level7Long Term Capital Management (cont’d)LTCM’s practices (cont’d)Wrote options at an implied volatility of 19% and employed substantial leverageEventually had a staggering $40 million riding on each volatility point change in equity volatility in the U.S. and an equivalent amount in Europe8Long Term Capital Management (cont’d)LTCM’s fallLTCM’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”9Long 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 millionOn September 21, the fund lost one third of its equity ($553 million)LTCM was leveraged more than 100 to 110Long Term Capital Management (cont’d)LTCM’s bailoutA consortium of Wall Street banks, facilitated by the New York Fed, arranged a bailoutIf LTCM had failed, it would have had catastrophic consequences on markets across the globeJohn Maynard Keynes: “Markets can remain irrational longer than you can remain solvent”11Value at RiskMotivationWhat is value at risk (VAR)?Value at risk relationshipsVAR calculation12MotivationIt is important to understand the consequences of an unusually large price change, even if it is unlikelyIf we can draw statistical inferences about changes in market prices, we can draw similar inferences about future values of a portfolio13What 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 levelTypically, value at risk looks at a 95% probability range over 1 dayValue at risk can be reported either as a dollar amount or as a percentage of fund assets14What 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. 15Value at Risk RelationshipsPensions 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 levelCredit Suisse Asset Management found thatUnder-funded pension funds tended to have the lowest VAR, meaning they were the most conservativeOver-funded funds tended to have the highest VAR, meaning they were the most aggressive16VAR CalculationVAR 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.17VAR 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 $104.31.18VAR 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. 19VAR 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. 20New Product DevelopmentWeather derivativesRental capsEquity swaps21Weather DerivativesIntroductionWeather swapsWeather options22IntroductionExchanges’ 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 need23Introduction (cont’d)Most existing weather derivatives are temperature-based options or swapsA variety of institutions face some weather-related riskElectric utilitiesSki resortsProperty and casualty insurance companiesDisney World24Weather SwapsA 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 terminationA heating degree-day is a measure of extent to which temperatures deviate from some norm25Weather OptionsA variety of structures are possibleA 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 locationA temperature call provides a payoff if the HDD or CDD count is above a set figure26Weather Options (cont’d)A zero cost collar involves purchasing a call and writing a putThe proceeds from writing the put offset the cost of the call27Weather 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. 28Rental CapsRental caps are an alternative to ordinary interest rate capsInstead 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 payment29Equity SwapsAn 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 stock30Equity Swaps (cont’d)Equity swaps are a popular way to circumvent local restrictions on the purchase of stock by foreignersThe periodic settlement feature substantially reduces the credit risk involved31Equity 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. 32Program TradingIntroductionImplementationThe open outcry and specialist systems33IntroductionProgram trading is a method of exploiting arbitrage and is “any computer-aided buying or selling activity in the stock market”34Introduction (cont’d)Program trading has three key characteristics:It is portfolio tradingIt is computerized tradingIt is computer decision making35Introduction (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 long36ImplementationHigh-speed, continuously on-line computers make it much easier to identify those instances when arbitrage is presentThe New York Stock Exchange’s Designated Order Turnaround System (DOT)37Implementation (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 portfolioInstitutions that combine a well-diversified stock portfolio with short positions in stock index futures to create synthetic Treasury bills38Implementation (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 tradingThe 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”39The Open Outcry and Specialist SystemsThe specialist system is used on the American and Philadelphia Stock ExchangesMarketmakers are used on the Pacific Stock Exchange and at the Chicago Board Options Exchange40The 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”41The Open Outcry and Specialist Systems (cont’d)High-volume markets seem to lend themselves to the marketmaker systemLow-volume or recently listed securities are best traded via the specialist system42FAS 133IntroductionRequirementsCriticismsImplications43IntroductionIn 1996, the Financial Accounting Standards Board (FASB) issued a proposal for derivatives accountingThe standard is now part of the accounting rules all firms must followFASB states that the purpose of the rule is to disclose the market risk potential of derivative contracts44RequirementsFAS 133 requires firms to report the “fair value” of any derivatives (assets or liabilities) on the firm’s balance sheetDerivatives represent rights or obligations that should be disclosedAll derivative transactions should be marked to market when preparing periodic financial statements45Requirements (cont’d)Some hybrid instruments must be dissected into their component partsFirms 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 hedged46Requirements (cont’d)Firms must classify derivatives use asA fair value hedge, when used with an asset or liabilityA cash flow hedge, when associated with an anticipated transaction, orA foreign currency value hedge, when associated with an investment denominated in a foreign currency47CriticismsMarking to market rules will tend to increase a firm’s earnings volatility, which means higher riskIt is not possible to accurately estimate the value of every derivative before the end of its life, especially over-the-counter transactions48Criticisms (cont’d)Firms may choose not to use derivatives because they fear the consequences of non-compliance with the accounting rules49ImplicationsRisk 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”