Khon Kaen University International College
Business in the Greater Mekong Sub-region
Course number 050 451 - Second semester 2013
Wednesdays at 9:00 in room 823
Lecturer: Michael Cooke
office room 817
E-mail: Michco@kku.ac.th
Web: KKU.AC.TH/Michco

Find a successful industry in GMS, or one which shows potential to be
successful (13 Nov)
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Explore reasons the industry located in GMS
What is the nature of the business (capital or labor intensive, etc)
Any spillover effects?
What was the mode of entry for the businesses?
Study a GMS country in which the industry is successful (4 Dec)
 What are the strengths of that country from a business perspective?
 What are the weaknesses?
 Look for barriers to further business success in the country

How do you see the business evolving (5 Feb)
 Effect of ASEAN or other alliances (trade, labor mobility, etc)
 Relevant demographic, economic, trade projections
 Infrastructure, education, and other changes as a result of government or
business initiatives
 Advice you would give to government units to encourage industry growth
Mekong Watershed
36% of the River’s Volume is from Laos
Mekong River Commission
Secretariat
Resources
• JETRO (Japan External Trade Organization) established 1958 helps small to
medium size Japanese firms maximize their global export potential
• JETRO-Institute of Developing Economies (IDE) Bangkok Research Center links
– http://www.ide.go.jp/English/Links/southeast_asia.html
– Good for links to government and university sites for the GMS countries
• Institute of Developing Economies (IDE) Bangkok Research Center publications
– http://www.ide.go.jp/English/Publish/Download/Brc/
– Relevant and relatively recent research reports
– Examples:
•
•
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•
•
•
•
•
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"Five Triangle Areas in the Greater Mekong Subregion" Edited by ISHIDA Masami / Published in 2013
"Economic Reforms in Myanmar: Pathways and Prospects" Edited by HANK LIM and YASUHIRO YAMADA / Published
2013
"Cause and Consequence of FIRMS' FTA Utilization in Asia" Edited by HAYAKAWA Kazunobu / Published in 2012
"Emerging Economic Corridors in the Mekong Region" Edited by ISHIDA Masami / Published in 2012
"Industrial Readjustment in the Mekong River Basin Countries: Toward the AEC" Edited by Yasushi UEKI AND TEERANA
BHONGMAKAPAT / Published in 2012
"Investment Climate of Major Cities in CLMV Countries" Edited by ISHIDA Masami / Published in 2010
"Economic Relations of China, Japan and Korea with the Mekong River Basin Countries (MRBCs)" Edited by KAGAMI
Mitsuhiro / Published in 2010
"Major Industries and Business Chance in CLMV Countries" Edited by UCHIKAWA Shuji / Published in 2009
"A China-Japan Comparison of Economic Relationships with the Mekong River Basin Countries" Edited by KAGAMI
MItsuhiro / Published in 2009
• Mekong Institute (on the KKU Campus) http://www.mekonginstitute.org/
Mekong Institute Focus on Labor
• http://www.mekonginstitute.org/images/abook_file/policy_bri
ef_labour_supply.pdf
• From a study of a Laos SEZ: “The breakdown in occupational skills indicate
mismatches in supply and demand for specific skills areas such as IT/computer
operators, maintenance mechanics, welders, sewers/dressmakers, gem
lapicides, and others. On the other hand, majority of students at TVET schools
enroll in accountancy and Business management courses.”
•
From a study of a Cambodian SEZ: “The new SEZs that have been set up in the
border areas with Thailand and Vietnam have reduced the pull factor to
migrate to Phnom Penh for work. The preference of students for enrolling in
academic courses such as management and accounting due to the
perception that vocational training will lead to a career of hard labor and
low wages in factories. In Laos, many prefer to migrate to Thailand where
they can earn more even without the necessary educational credentials.”
GMS Corridor Map – East-West
GMS Corridors – High Level
Source: Chiang Mai University
USER 2007
SE Asia
Trade routes from East Asia
to South Asia, the Middle
East, and the Suez Canal
pass through the Straits of
Malacca, northwest of
Singapore. The area is a
haven for pirates. In
November two large tankers
were hijacked there. The
East-West corridor would
connect East Asia to the
Indian Ocean well north of
the Straits.
And why are we talking about this
small American company again?
Thailand is the 2nd largest producer of hard drives; producing over 25% of
total drives made. An ecosystem of component suppliers has formed near the
assembly operations of companies like Seagate and Western Digital.
Nidec makes HDD motors and other small
electric motors at 10 factories in Thailand.
Indigenous Firms as Suppliers
http://www.ide.go.jp/English/Publish/Download/Brc/pdf/12_10.pdf
• Foreign firms experience the highest added productivity when buying from
suppliers of the same nationality in the host country
– An American HDD maker will tend to buy from an American supplier in Thailand
– The HDD supplier, such as Hutchinson, may employ local managers
• Purchasing supplies from indigenous firms adds less value in part due to quality
issues – on average across many developing markets, foreign firms are better
performers
• Host country firms must raise quality of their output to the level of foreign firms
– When indigenous firms raise skills and quality, more foreign firms will invest
– This results in positive spillovers to the host country
– Older overseas affiliates of foreign firms may have higher indigenous firm content
due to better knowledge of local suppliers
– Weak local currency tends to promote higher indigenous content due to price
advantages, especially for firms that intend to export from the host country
• Over time spillovers from foreign firms to indigenous firms occurs
–
–
–
–
Imitating superior products and technologies
Direct skills and technologies transfer
Competition from foreign firms causes indigenous firms to raise standards
Indigenous firms learn how to penetrate export markets
Venezuela’s New President
• Venezuela’s President Nicolas Maduro recently jailed more than 100
“bourgeois” businessmen, in what he calls an “economic war” on alleged
unfair pricing.
– In early November, the president sent soldiers to seize electronic stores he has
accused of unjustified price rises, hoarding and speculation
– Bargain hunters then flooded the shops and some looting was reported.
– Inspectors have been dispatched to about 1,400 other businesses. Mr Maduro
picked out US manufacturer Goodyear, demanding price reductions.
• Promising to step up an “economic offensive”, Mr Maduro said that he
would set caps on business profit margins and extend controls to establish
“fair” prices. “They are barbaric, these capitalist parasites,” he said.
• Mr Maduro inherited economic problems from Hugo Chávez.
– Policy paralysis has led to dwindling hard currency reserves and galloping
inflation of 54 per cent.
– There are rampant shortages of food and goods, which economists attribute
to currency market distortions.
– Price controls and strict currency exchange restrictions have generated a
scarcity of dollars to pay for imports in the oil-rich nation, with
– Venezuelans use the black market for dollars, which cost nearly 10 times the
official rate
• Would businesses have similar risks in the GMS?
Financial Times, Nov 15th, 2013

A carry trade is a strategy in which an investor borrows at a low interest rate to invest
in an asset that is likely to provide a higher return.

In the foreign exchange market an investor sells a currency with a relatively low
interest rate and invests in a different currency with a higher interest rate.
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A person using this strategy attempts to capture the difference between the interest rates, and
often magnifies the difference with leverage used.
Prior to 2007, low interest rates in Japan were a source of carry trade flows
Destinations for carry trade flows were Australia and NZ (where interest rates were high)
When global interest rates converged in 2008 the yen appreciated and the trade diminished
An example of a "yen carry trade":
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◦
Borrow 1,000 Japanese yen from a Japanese bank.
Convert the funds into U.S. dollars and buy a bond for the equivalent amount.
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The risk in a carry trade is the uncertainty of exchange rates.
◦
◦
◦

If the bond pays 4.5% and the Japanese interest rate is set at 0% you make a profit of 4.5% as long as
the exchange rate between the countries does not change.
Professional traders (and Japanese housewives) use this trade because the gains can become very large
with leverage. If the trader in this example uses a common leverage factor of 10:1, then she can stand
to make a profit of 45%.
Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then
the trader would run the risk of losing money.
When the transactions are done with leverage a small movement in exchange rates can result in
huge losses.
From the perspective of a target country borrower, carry trade money is ‘hot money’
A risk for many SE Asian countries is a rise of US interest rates – and the resulting flows
Definition and illustration from: http://www.investopedia.com/terms/c/currencycarrytrade.asp and
the Financial Times
15
Stock Exchange in Cambodia
 The Cambodia Securities Exchange (CSX) opened in April, 2012
 Money had been banned under the Khmer Rouge regime that tore Cambodia apart between 1975 and
1979
 After a $20MM IPO, Phnom Penh Water Supply Authority shares (PPWSA), rose 50 percent in the
inaugural session (six months later the shares were back to the IPO price)
 The launch of the new stock market is similar to that Laos
 The Laos exchange started in 2011 with two listed firms
 Both exchanges are operated as joint ventures with Korea Exchange, Asia's fourth-largest operator
 Vietnam launched their first stock exchange in 2000
 Potential investors see huge risks in frontier emerging markets
 The Cambodian market, with one listed firm, lacks liquidity
 If you want to sell, you may not be able to move large positions," said Morten Kvammen, director of
underwriter SBI Royal Securities
 Some investors remain concerned about corruption, an unclear regulatory framework and the use of the
riel currency for trading on the bourse
 Ninety percent of deposits and credits in Cambodia's banking system are in dollars, so investors worry
about bureaucratic delays and currency fluctuation between transactions and payments
 Bangkok-based director of frontier market fund Dragon Capital, likes the transparency and
management of PPWSA, the first listed firm
 "If Cambodia will continue on its same growth path, will continue to modernize and create wealth then
the capital market will expand and the market's liquidity risk will diminish," the director told Reuters
 In November 2012 Cambodia had 4,000 investor accounts at licensed brokerages, about a third held by
foreigners
From Reuters, April 18th, 2012
SET Becomes the Top ASEAN Exchange
 The Stock Exchange of Thailand (SET) attracted a record number of listings in 2013
 Average daily trading volume overtook SGX, the Singapore exchange
 The SET is now the largest exchange in ASEAN by volume, according to the World
Federation of Exchanges
 The value of total share trading in the first 11 months of 2013 was $320bn on the SET, ahead
of the SGX which notched up $265bn.
 Bursa Malaysia was third most active with $138bn in average daily volume
 The SET plans to change its rules to allow foreign companies to list in Bangkok
 The change shows how exchanges in SE Asia are starting to compete as they outgrow their
domestic markets and seek to capitalize on business from within the ASEAN
 The exchange will focus on expanding to Cambodia, Laos, Myanmar and Vietnam, because
they have high growth potential and high need for funds
 The EVP in charge of listings at the SET said the exchange would allow any foreign
company to list under the new rules, including those from China and Australia
 He said “We feel that Thai growth will probably stagnate one of these days. The expansion in
our neighboring countries is huge and they are growing at a much faster rate than us”
 The move by SET appears aimed at attracting companies that might prefer to list on an
exchange with deeper liquidity, modern trading systems and proven corporate governance
principles.
 Cambodia and Laos each have a stock-exchange. Vietnam has two. According to the FT,
Myanmar has accepted assistance from the Japanese to develop a stock exchange.
Financial Times 23 December, 2013
A New Cambodian Commodities Exchange
 SomYen, director of Malai Trading Co, a Cambodian agricultural products
brokerage for Thai ethanol and flour said that the new commodities exchange
would help promote agricultural produce and sustain prices.
 “At the moment, our agricultural produce such as corn and cassava is sold [to
Thailand] at about 30 percent below the market price,” said SomYen, who collected
about 25,000 tonnes of cassava and corn for export to Thailand last year.
 “If this company realizes this initiative, I believe that farmers will benefit from it and
will gain broader markets for their agricultural produce.”
 Trading in commodities on an official, standardized exchange offers further
evidence that the economy is finally maturing as well as integrating to global
markets.
 Thailand’s TFEX and AFET (Ag Futures Exchange of Thailand) have been in
operation since 2004 with focus on SET index futures, gold, and silver; and rice,
rubber, tapioca, and canned pineapple
 TFEX a subsidiary of SET – offers a broader range of products to local investors
 AFET issues with rubber subsidies
Unrest in Thailand and Cambodia
 Thailand’s tourism industry accounts for 7% of economic activity
 In the past, Thailand earned the nickname Teflon Thailand
 Mastercard International predicts Bangkok will become the world’s most
visited city, while Instagram reports Siam Paragon is the most photographed
location in the world
 Planned protests aim to shut down the city January 13th
 Singapore Airlines announces it will cancel 19 flights to Bangkok beginning
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January 14th
First quarter hotel occupancy is predicted to fall 5-10% below the norm
(80%) for this time of year
Airport arrivals fell 15% in early December when protests began
The Thai Chamber of Commerce recommended that member businesses
stockpile goods outside of the city
Multinationals also fear delays in export-import paperwork
 Meanwhile in Cambodia tens of thousands of textile workers have gone
on strike across the nation to seek higher minimum wage
Wall Street Journal 6-1-2014
How Does Unrest in Cambodia Affect Apparel Business?
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Most of the 600 garment factories in Cambodia reopened this week
 They had been shut since due to strikes since Dec. 24th
 Strikers have been seeking a doubling of the minimum wage to $160 per month
 About 60% returned to work this past Monday (January 6th) after the police action against strikers

Garment manufacturing is Cambodia’s biggest export business
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Primary customers are US and European apparel firms
About 600K workers are employed in 800 factories (about 17% of the non-agriculture workforce)
Apparel exports grew 22% last year
Strikes are frequent because of low wages, poor enforcement of labor laws, and working conditions
 Many factories have temporarily shifted production out of Cambodia while others may be
considering a longer-term relocation
 According to McKinsey Consultants in 2011 the most likely destination for apparel buyers
concerned with increasing costs in China was Bangladesh
 They cited prices and capacity as Bangladesh’s key advantages versus gaps in infrastructure and compliance
 The 2013 survey lists labor costs as the biggest advantage of sourcing in Bangladesh, with nearly
all thinking costs in Bangladesh will increase
 A 2013 report listed other countries expected to grow in importance as Vietnam, India, Myanmar, and Cambodia
(in that order)
 Bangladesh has capacity, productivity, and supplier capabilities, and trade agreements that ensure it will remain the
top alternative to China for the next five years
1) Wall Street Journal 7-1-2014; 2) www.mckinsey.de/sites/mck_files/files/2013mckinsey_apparelcposurvey.pdf
Apparel Sourcing in Practice
-Li & Fung is the world’s largest logistics and
sourcing company. It matches poor countries’
factories and affluent countries’ vendors. It
finds the lowest-cost workers, negotiates prices
and manages the logistics for roughly a third of
the biggest retailers found in a typical shopping
mall.
-Li and Fung is based in Hong Kong. It owns no
clothing factories, no sewing machines and no
fabric mills. Its chief asset is the 15,000
suppliers in over 60 countries that make up a
network so sprawling that a massive order for
skirts that once took six months from drawing
board to store shelf now takes six weeks at a
much lower price. (NY Times 7 Aug 2013)
-Sourcing companies find low-cost factories for
clients, and also monitor factory safety
standards. The scale of Li & Fung’s operations
and the speed at which it shifts production
from one site to another give owners little
incentive to improve their factories.
“We definitely are a part of bringing the prices
down, there’s no question about that, because we
are arbitraging factories and countries all the
time,” Bruce Rockowitz said. “But it has to be a
safe factory.”
Bruce Rockowitz, chief executive of Li & Fung (NY Times 7 Aug 2013)
The Environment in Which Apparel Sourcing Companies Operate
 Li and Fung’s Chairman said Bangladesh still has some of the cheapest labor in the world, he
pointed out. For factories to get safer, clothing prices would have to go up, he said. “So far,” he
added, “consumers have just not been willing to accept higher costs.” *
 Factories, which often consist of just sewing machines on tables, can appear and disappear
overnight.
 “Li & Fung is your insurance policy for when logistics go wrong,” said Mr. Hertzman, of
Sourcing Journal. *
 When street protests delay a shipment of khakis bound for Gap and the factory says it cannot
afford to move the items by air, it is companies like Li & Fung that will have to cover the cost of
the plane, he said.
 Li & Fung and other sourcing companies track harvesting schedules because many factories rely
on migrant workers. They watch weather reports to advise drivers.
 In Dhaka, Bangladesh’s capital, sourcing agents check in daily with political and labor officials
who can offer warnings about demonstrations that could shut down production.
 They send undercover informants into factories to check for blocked fire exits, for example, or
arrive early for scheduled factory inspections to check for child labor violations.
 Sourcing companies also insulate retailers from reputation risks when bad things happen
 After more than 280 workers vomited and fainted in a three-day period in 2011 at the King
Fashion Garment Company factory in Phnom Penh, Cambodia, Li & Fung asked the plant to
upgrade ventilation and improve wastewater drainage.
 Clients with brand equity, such as H&M, were insulated from the bad press
* (NY Times 7 Aug 2013)
Measuring Risk
Diversification - Strategy designed to reduce risk
by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.” Much of the variation of most
stocks is from systemic causes.
7-23
Performance of Harvard’s Endowment Fund
October, 2009: Endowment Value Declines 29.5% as Investment
Return Is - 27.3% (S&P 500 = -24.3% dividends reinvested)
2007
2008
2009
Endowment Value
($billions)
$34.9
$36.9
$26.0
Annual rate of return
on investments
23.0%
8.6%
(27.3)%
Source: Harvard University Financial Report. FY June.
Component Performance Harvard Endowment
2008- 2009
Public equities (1/3)
Private equities
Hedge funds
Real assets (1/4)
Fixed income (1/8)
TOTAL HMC
HMC
(28.3)%
(31.6)
(18.6)
(37.7)
( 4.1)
(27.3)
Benchmark
(28.5)%
(23.9)
(13.2)
(38.5)
( 3.4)
(25.2)
Note: Mohamed A. El-Erian was CEO of Harvard Management Company from 2005-2007
Relative
0.2%
(7.7)
(5.4)
0.8
(0.7)
(2.1)
Harvard’s Explanation
• The “policy portfolio,” the model that HMC uses to
diversify its assets, returned negative 25.2 percent as
measured by the investment benchmarks for each
asset class—2.1 percent better than HMC’s actual
performance. *
• During the depths of the financial crisis and then
recession last autumn and winter, Harvard’s managers
worried that losses in private-equity and real-estate
investments might drive even deeper declines in the
endowment overall.
• Among investment factors, the internally managed
domestic fixed-income portfolio, had exposure to some
of the less-tradable structured credit securities that
were most impacted as the market imploded.
* Investments portfolios are often compared to returns on similar classes of assets
Toward Liquidity
• At the end of 2008, HMC had $11 billion of commitments to outside managers.
– Many outside managers impose holding periods on the investments they make,
creating the problem of “strategies with long holding periods” among even liquid
asset classes.
– Harvard had a lack of ready liquidity in the portfolio to meet obligations as
private-equity, hedge-fund, and other asset managers slowed or stopped
distributions of funds back to HMC.
– The University had its own credit problems in late 2008—necessitating sales of
liquid assets at a time when HMC might have preferred not to do so.
• Changes to address the problems.
– Increase the flexibility and control Harvard has in managing the funds
– Greater concentration “in areas where HMC has unique competitive strengths”
(note: value of expertise)
– Harvard is looking to increase the share of internally managed assets under the right
conditions.
• Control advantages and feel for the market realized through internal money-management
expertise
• HMC personnel managed about 30 percent of the portfolio in 2009, down from 70 percent
early in the decade
– Reduce leverage (keep cash on hand appropriate to circumstances)
• The policy portfolio for years called for a negative 5 percent cash position (borrowing to boost
investment returns).
• That allocation is now modeled as positive 2 percent
Harvard Magazine October 2009
The Lessons for Us
• Harvard’s portfolio was fully diversified and in many
instances hedged
– You can not diversify away systemic risk
– Hedges are imperfect and normally have high cost
• Harvard faced liquidity problems when they needed
liquidity
– Be wary of leverage, especially when macro conditions change
– Understand your ability to raise cash or exit markets when
conditions change
• Expertise in investment categories has value independent
of diversification
• Remember Warren Buffett’s words about the value of
expertise
Ch 5 -28
Hedge Fund Performance
• A recent analysis conducted by Goldman Sachs shows that the typical
hedge fund has returned just 4 percent this year through August 9 —
poor compared to the 20 percent return on the S&P 500 (including
dividends).
– Last year hedge funds returned 8 percent return compared to a 16
percent total return for the S&P 500
– The time-tested message is clear: hedging produces underwhelming
results during long market rallies.
• Hedge funds typically try to compensate for possible losses on long
positions by taking counter-balancing short positions. This strategy
can produce superior results during periods of market uncertainty
when equity valuations are volatile.
– However stock valuations have pretty much done nothing but go up
since the financial crisis.
– This has heaped rewards on those with long positions, and punished
those with aggressive short positions, including many hedge funds.
• The Goldman Sachs report shows that fewer than 5 percent of hedge
funds have managed to outperform the S&P 500 this year to date,
and 25 of them have actually posted losses.
• Talent moves from fund to fund, and over time strategies are copied.
Global Diversification
• In the early 1990s Japanese stocks had negative beta
• Beta changes over time (beta is a measure of market risk)
• Worldwide, stock markets now share similar patterns
– The MSCI is an index of 23 developed country stock
markets
• From 1997-2006 the USA had beta of .98 relative to the MSCI
• Japan had beta of .86 relative to the MSCI
• The beta of German stocks relative to MSCI was .65
– In 2008 the MSCI was down 40% including dividend
reinvestment
– The US NASDAQ was down 40%
– The S&P 500 was down 37% including dividend
reinvestment
– Emerging markets did not ‘decouple’ in 2008
Ch 5 -30
International Diversification
EME is emerging markets, EAFE is developed markets excl North America
Some Basic Concepts
• Options – the right but not the obligation to buy or to sell at a
specified price on or before a specified date
– Call option – right to buy an asset at a specified exercise price on or
before a specified exercise date
– Put option – right to sell an asset at a specified exercise price on or
before a specified exercise date
– Price of an option is determined by volatility and time to maturity;
stock price and exercise price
– Options written on volatile assets are worth more than those
written on safe assets (the opposite of capital investments)
• Forward contract – a commitment between two parties (to buy
and to sell). These involve counterparty risk.
• Futures contract – a standardized commitment to buy a
security or a commodity at a price that is fixed today. Traded
on an exchange.
• Employee Stock Options – compensation in the form of stock
options on volatile shares is worth more than on stable shares
Risk Reduction
 Risks to a business
–
–
–
–
–
–
–
Cash shortfalls
Financial distress
Agency costs
Variable costs
Currency fluctuations
Political instability
Weather changes
26-33
Insurance
Most businesses face the possibility of a
hazard that can bankrupt the company in an
instant.
These risks are neither financial or business
and can not be diversified.
The cost and risk of a loss due to a hazard,
however, can be shared by others who share
the same risk.
26-34
Insurance
26-35
Example
An offshore oil platform is valued
at $1 billion. Expert meteorologist
reports indicate that a 1 in 10,000
chance exists that the platform may
be destroyed by a storm over the
course of the next year.
? How can the cost of this hazard
be shared
Insurance
26-36
Example - cont
An offshore oil platform is valued at $1 billion. Expert
meteorologist reports indicate that a 1 in 10,000 chance exists that
the platform may be destroyed by a storm over the course of the
next year.
? How can the cost of this hazard be shared
Answer
A large number of companies with similar risks can each
contribute pay into a fund that is set aside to pay the
cost should a member of this risk sharing group
experience the 1 in 10,000 loss. The other 9,999 firms
may not experience a loss, but also avoided the risk of
not being compensated should a loss have occurred.
Insurance
Example - cont
An offshore oil platform is valued at $1 billion. Expert
meteorologist reports indicate that a 1 in 10,000 chance exists that
the platform may be destroyed by a storm over the course of the
next year.
? What would the cost to each group member be
for this protection.
Answer
1,000,000,000
 $100,000
10,000
26-37
Insurance
26-38
Why would an insurance company not offer
a policy on this oil platform for $100,000?
– Administrative costs – such as legal fees
– Adverse selection – bad risks are most eager to
take insurance
– Moral hazard(owner may be less careful to
take precautions when insured)
Insurance
• The loss of an oil platform by a storm may be 1 in
10,000. The risk, however, is larger for an
insurance company since all the platforms in the
same area may be insured, thus if a storm
damages one in may damage all in the same area.
The result is a much larger risk to the insurer
• Reinsurance is transferring portions of risk
portfolios to other parties in order to reduce the
likelihood of having to pay a large insurance claim.
The reinsurer gets some portion of the premiums
in return for accepting part of the risk.
Reducing Risk with Options
How options protected Mexico against a fall in oil prices.
Revenue, $billions
a. Sell 330 million barrels of oil at market price = $23.1BB revenue
23.1
$70
Price per barrel
26-40
Reducing Risk with Options
How options protected Mexico against a fall in oil prices.
Revenue, $billions
b. Buy put options with $70 exercise price. Payoff rises as oil prices
falls below $70 (right to sell at $70).
23.1
$70
Price per barrel
26-41
Reducing Risk with Options
How options protected Mexico against a fall in oil prices.
Revenue, $billions
c. Lock in minimum price of $70 a barrel. For each $1 oil price rise
above $70/barrel, revenue rises $330MM. This “put” cost about
$1.5BB (6.4%)
23.1
$70
Price per barrel
26-42
Hedging with Forwards and Futures
26-43
Ex - Kellogg produces cereal. A major component and cost
factor is sugar.
 Forecasted income & sales volume is set by using a fixed
selling price.
 Changes in cost can impact these forecasts.
 To fix your sugar costs, you would ideally like to purchase all
your sugar today, since you like today’s price, and made your
forecasts based on it. But, you can not.
 You can, however, sign a contract to purchase sugar at
various points in the future for a price negotiated today.
 This contract is called a “Futures Contract.”
 This technique of managing your sugar costs is called
“Hedging.”
Hedging with Forwards and Futures
1- Spot Contract - A contract for immediate sale & delivery of
an asset.
2- Forward Contract - A contract between two people for the
delivery of an asset at a negotiated price on a set date in the
future.
3- Futures Contract - A contract similar to a forward contract,
except there is an intermediary that creates a standardized
contract. Thus, the two parties do not have to negotiate the
terms of the contract.
The intermediary is the Commodity Clearing Corp (CCC). The
CCC guarantees all trades & “provides” a secondary market
for the speculation of Futures.
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Types of Futures
Commodity Futures
-Sugar -Corn
-Wheat -Soy beans
-Orange Juice
-Pork bellies
Financial Futures
-T-bills
-Yen
-Stocks
-Eurodollars
Index Futures
-S&P 500
-Value Line Index
-Vanguard Index
SUGAR
Commodity Futures
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Financial Futures
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Futures Contract Concepts
Not an actual sale – price is fixed but payment made later
Margin - post partial amount as assurance of ability to pay
No counterparty risk –exchange guarantees payment
Always a winner & a loser (unlike stocks)
Contracts are “settled” every day. (Marked to Market)
Hedge - Contracts used to eliminate risk by locking in prices
Speculation - Contracts used to gamble
Hog K = 30,000 lbs
T-bill K = $1.0 mil
Value line Index contract = $index x 500
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Ex - Settlement & Speculate
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Example - You are speculating in Hog Futures. You think that the
Spot Price of hogs will rise in the future. Thus, you go Long on
10 Hog Futures. If the price drops .17 cents per pound ($.0017)
what is total change in your position?
Ex - Settlement & Speculate
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Example - You are speculating in Hog Futures. You think that the
Spot Price of hogs will rise in the future. Thus, you go Long on
10 Hog Futures. If the price drops .17 cents per pound ($.0017)
what is total change in your position?
30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss
50.6
3
$510
50.80
cents
per lbs
Since you must settle your account every day, you must give your
broker $510.00
Hedging
Hypothetical plot of past
changes in the price of the
farmer’s wheat against
changes in the price of
Kansas City wheat
futures. A 1% change in
the futures price implies,
on average, an .8%
change in the price of the
farmer’s wheat.
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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September corn
futures are selling for $2.94 per bushel (1K = 5,000 bushels).
Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price drops to $2.80.
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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September corn
futures are selling for $2.94 per bushel (1K = 5,000 bushels).
Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price drops to $2.80.
Revenue from Crop: 10,000 x 2.80
28,000
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 2.80 = 28,000
.
Gain on Position------------------------------- 1,400
Total Revenue
$ 29,400
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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000
bushels of corn during the month of August. In June,
the September corn futures are selling for $2.94 per
bushel (1K = 5,000 bushels). Farmer Smith wishes
to lock in this price.
Show the transactions if the Sept spot price rises to
$3.05.
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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September corn
futures are selling for $2.94 per bushel (1K = 5,000 bushels).
Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price rises to $3.05.
Revenue from Crop: 10,000 x 3.05
30,500
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 3.05 = 30,500
.
Loss on Position------------------------------- ( 1,100 )
Total Revenue
$ 29,400
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Commodity Speculation
You have lived in NYC your whole life and are independently
wealthy. You think you know everything there is to know
about pork bellies (uncurred bacon) because your butler
fixes it for you every morning. Because you have decided to
go on a diet, you think the price will drop over the next few
months. On the CME, each PB K is 38,000 lbs. Today, you
decide to short three May Ks @ 44.00 cents per lbs. In Feb,
the price rises to 48.5 cents and you decide to close your
position. What is your gain/loss?
Nov: Short 3 May K (.4400 x 38,000 x 3 ) =
+ 50,160
Feb: Long 3 May K (.4850 x 38,000 x 3 ) =
- 55,290
Loss of 10.23 % =
- 5,130
Margin
The amount (percentage) of a Futures
Contract Value that must be on deposit with
a broker.
Since a Futures Contract is not an actual
sale, you need only pay a fraction of the
asset value to open a position = margin.
CME margin requirements are 15%
Thus, you can control $100,000 of assets
with only $15,000.
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Commodity Speculation with margin
You have lived in NYC your whole life and are independently wealthy. You
think you know everything there is to know about pork bellies (uncurred
bacon) because your butler fixes it for you every morning. Because you have
decided to go on a diet, you think the price will drop over the next few months.
On the CME, each PB K is 38,000 lbs. Today, you decide to short three May
Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide
to close your position. What is your gain/loss?
Nov: Short 3 May K (.4400 x 38,000 x 3 )
=
+ 50,160
Feb: Long 3 May K (.4850 x 38,000 x 3 )
=
- 55,290
Loss =
Loss
-----------Margin
=
5130
-------------------- =
50160 x.15
5130
- 5,130
------------ = 68% loss
7524
What is the Difference Between Hedging, Speculation,
and Arbitrage?
 Hedging consists of utilizing financial instruments or
contracts to reduce or eliminate the risk from fluctuating
interest rates, exchange rates, and/or prices.
 The purpose of speculation is to profit from a change in
future rate or price.
 Arbitrage is the process of buying in one market and
simultaneously selling in another market in order to earn a
risk-free profit.
Web Resources
Click to access web sites
Internet connection required
www.cme.com
www.nymex.com
www.lme.com
www.eurexchange.com
www.euronext.com
www.bis.org
www.commoditytrader.net
www.isda.org
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