Chapter 17
Contemporary
Issues
1
© 2004 South-Western Publishing
Outline
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Introduction
Long Term Capital Management
Value at risk
New product development
Program trading
FAS 133
Introduction
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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
Long Term Capital Management
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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
Long Term Capital Management
(cont’d)
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A hedge fund is a largely unregulated
investment portfolio, usually with a
substantial minimum investment
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Engages in esoteric investment activities
unavailable to an individual or small institutional
investor
“Shroud of secrecy” with regard to trading
strategy and specific activities
Long Term Capital Management
(cont’d)
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LTCM’s practices
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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
Long Term Capital Management
(cont’d)
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LTCM’s practices (cont’d)
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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
Long Term Capital Management
(cont’d)
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LTCM’s fall
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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”
Long Term Capital Management
(cont’d)
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LTCM’s fall (cont’d)
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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
Long Term Capital Management
(cont’d)
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LTCM’s bailout
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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”
Value at Risk
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Motivation
What is value at risk (VAR)?
Value at risk relationships
VAR calculation
Motivation
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It is important to understand the
consequences of an unusually large price
change, even if it is unlikely
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If we can draw statistical inferences about
changes in market prices, we can draw
similar inferences about future values of a
portfolio
What is Value at Risk?
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Value at risk seeks to measure the
maximum loss that a portfolio might
sustain over a period of time, given a set
probability level
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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
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.
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Value at Risk Relationships
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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
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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
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.
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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
0.35
 0.0220  2.20%
252
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.
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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.
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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.
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New Product Development
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Weather derivatives
Rental caps
Equity swaps
Weather Derivatives
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Introduction
Weather swaps
Weather options
Introduction
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Exchanges’ institutional marketing people
find out what money managers, corporate
treasurers, and other financial
professionals need
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The marketing people then see if they can
construct a product to meet that need
Introduction (cont’d)
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Most existing weather derivatives are
temperature-based options or swaps
A variety of institutions face some weatherrelated risk
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Electric utilities
Ski resorts
Property and casualty insurance companies
Disney World
Weather Swaps
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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
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A heating degree-day is a measure of extent to
which temperatures deviate from some norm
Weather Options
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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
Weather Options (cont’d)
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A zero cost collar involves purchasing a
call and writing a put
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The proceeds from writing the put offset the
cost of the call
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.
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Rental Caps
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Rental caps are an alternative to ordinary
interest rate caps
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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
Equity Swaps
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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
Equity Swaps (cont’d)
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Equity swaps are a popular way to
circumvent local restrictions on the
purchase of stock by foreigners
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The periodic settlement feature
substantially reduces the credit risk
involved
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.
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Program Trading
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Introduction
Implementation
The open outcry and specialist systems
Introduction
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Program trading is a method of exploiting
arbitrage and is “any computer-aided
buying or selling activity in the stock
market”
Introduction (cont’d)
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Program trading has three key
characteristics:
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It is portfolio trading
It is computerized trading
It is computer decision making
Introduction (cont’d)
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Arbitrageurs in the marketplace help to
keep the market efficient and ensure that
prices do not deviate from their proper
values for very long
Implementation
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High-speed, continuously on-line
computers make it much easier to identify
those instances when arbitrage is present
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The New York Stock Exchange’s Designated
Order Turnaround System (DOT)
Implementation (cont’d)
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Program traders normally fall into one of
two groups:
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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
Implementation (cont’d)
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Program trading suffers from a bad name
because:
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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”
The Open Outcry and Specialist
Systems
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The specialist system is used on the
American and Philadelphia Stock
Exchanges
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Marketmakers are used on the Pacific Stock
Exchange and at the Chicago Board
Options Exchange
The Open Outcry and Specialist
Systems (cont’d)
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“The specialist acts at all times to maintain
a fair and orderly market”
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“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”
The Open Outcry and Specialist
Systems (cont’d)
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High-volume markets seem to lend
themselves to the marketmaker system
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Low-volume or recently listed securities are
best traded via the specialist system
FAS 133
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Introduction
Requirements
Criticisms
Implications
Introduction
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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
Requirements
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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
Requirements (cont’d)
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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
Requirements (cont’d)
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Firms must classify derivatives use as
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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
Criticisms
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Marking to market rules will tend to
increase a firm’s earnings volatility, which
means higher risk
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It is not possible to accurately estimate the
value of every derivative before the end of
its life, especially over-the-counter
transactions
Criticisms (cont’d)
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Firms may choose not to use derivatives
because they fear the consequences of
non-compliance with the accounting rules
Implications
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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”