Chapter 8
Complex Derivatives
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Introduction to Derivatives
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Complex derivatives became popular in the
1990s.
– Computer advancements led to more detailed
financial analysis.
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Powerful risk management tools
– must be fully understood to be used properly.
– can be as equally harmful as helpful.
 California energy crisis and the collapse of Enron fueled
public fears.
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The Role of Multiple Risks
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Businesses often have more than one risk or
risks embedded within another.
Single risks are risks that are fairly easy to
separate.
Embedded or cloistered risks are risks that are
embedded within another risk and therefore
not easy to separate or keep separated.
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Multiple Single Risk Farming
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Example: Midwest corn farmers are generally
soybean farmers as well.
– This creates multiple risks from corn and soybean price
movements.
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Referring back to the first step of the Risk and
Mitigation Profile of Chapter 2 is to list the financial
risks.
The risk for the typical Midwest farmer is dropping
corn and soybean prices. (See Figure 8-1.)
These two risks are easy to separate and manage.
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A Farm with Cloistered Risks
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Consider the same Midwest corn and soybean
farmer with the two price risks.
This farmer will likely have an operating loan
and land loan.
– Assuming the loans are at a fixed rates, they are
both tied directly to the production of the crops.
– This embeds the risk of price change into the
loans.
– Figure 8-2 exhibits the partial RMP for cloistered
risks.
(continued)
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A Farm with Cloistered Risks (continued)
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The loans have price objectives to obtain
repayment; these objectives may or may not be
attainable with options or futures.
The farmer has more than one option and must
decide upon the consequences of each.
– Figure 8-3 shows the full RMP for the farmer.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Financial Engineering
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Financial Engineering
– The term engineering means to plan and execute
an operation.
– More financial information and risk management
tools allow this to be possible.
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The more appropriate term however is
financial management, as risk management
is not always an exact process.
(continued)
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Financial Engineering (continued)
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Engineering of a derivative (designing and
constructing) is important, but managing the
risk is paramount.
Complex derivatives have two parts:
– designing and construction
– management
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Designing and Constructing
Complex Derivatives
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Proper design and construction of a complex
derivative must begin with a purpose—to meet
a specific risk.
Find the proper derivative for the specific risk
to be mitigated.
If the derivatives selected are inappropriate,
they could increase the risk.
Start with the RMP to define and outline the
risk; do not begin with the derivative.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Abuse of Derivatives
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Zero cost or synthetic hedges (see Chapters 5
and 6)
Synthetic forward—almost unlimited
combinations of strike prices
Stacked derivative—several risks are bundled
together and risk management tools applied to
mitigate risks
– This term is used for multiple single risks.
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Cloistered derivative—embedded or
cloistered risks
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Stacked Derivatives
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See Figure 8-4.
The Midwest corn and soybean farmer wants to
manage the price risk in the early stages of the crops
growth.
Figure 8-5 shows the cost and benefits section of the
RMP and adds standard risk analysis.
The farmer looks more closely at the factors that have
the most variation on the estimated futures target
price—the estimated ending basis.
The farmer could opt to stack with a forward/futures
stack or a futures/futures stack.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Cloistered Derivatives
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A cattle feeder is a good example of a cloistered
derivative as he has the drop of cattle prices and the
rise of feed prices to contend with.
Figure 8-6 shows the RMP of a cattle feeder. The
feeder’s risks are: fed cattle, corn, and soybean meal.
The feeder needs to determine the breakeven price on
the cattle, corn, and soybean meal; the feeder then can
look at his choices.
The feeder must select a combination of futures and
options to create a cloistered hedge. Price forecasting
plays a large role in the feeder’s decision.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Power of the Risk and Mitigation
Profile
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A good RMP must be developed for a
particular situation.
– The user can add or subtract levels of
sophistication.
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The RMP format provides the structure to look
at the tools in conjunction with the identified
risks.
This keeps the problem—price risks—in line
with the risk management tools.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Unwinding
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Once a risk management package is developed, the
user must determine whether it mitigates his risks.
This can be done by unwinding the risk management
package.
For example, take the cattle feeder from Figures 8-6
and 8-7.
Determine whether it meets the minimum price
requirements for the cattle feeder.
– The put mitigates the feeder cattle price risk, but does not
meet the minimum price requirement.
– It makes more sense to hedge with an option that covers the
minimum price requirement.
– The option hedge in this case is better for the cattle feeder
if the price forecast is bullish.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Treasury as a Profit Center
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The treasury or finance department of a business must
manage the accounts payable, receivable, and so on.
Many companies try to operate their treasuries as
profit centers as well.
Doing this takes on risk.
One way a finance department could earn a profit is
through decreasing the rate on loans through swaps.
The problem in the example case in the text was
moving interest rates on a variable rate operation
loan, which were mitigated through a swap.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
A Final Note on Complex Derivatives
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The popularity of complex derivatives peaked in the
1980s and 1990s and unfolded in the twenty-first
century as corrupt accounting practices and
bankruptcies occurred.
Most complex derivatives have vanished from the
marketplace.
The mitigation of a price risk is the most important
issue to be concerned with managing risk. If a complex
derivative is the best tool, then it should be used.
A large problem with complex derivatives is hedging
and speculative strategies bound together.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation