Risk Transfer E-Book

Christopher L. Culp

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 861

Veröffentlichungsjahr: 2011

Beschreibung

Based on an enormously popular "derivative instruments and applications" course taught by risk expert Christopher Culp at the University of Chicago, Risk Transfer will prepare both current practitioners and students alike for many of the issues and problems they will face in derivative markets. Filled with in-depth insight and practical advice, this book is an essential resource for those who want a comprehensive education and working knowledge of this major field in finance, as well as professionals studying to pass the GARP FRM exam. Christopher L. Culp, PhD (Chicago, IL), is a Principal at CP Risk Management LLC and is also Adjunct Professor of Finance at the University of Chicago. He is the author of Corporate Aftershock (0-471-43002-1) and The ART of Risk Management (0-471-12495-8).

Leseprobe

Contents

Preface: The Demonization of Derivatives

Introduction and Structure of the Book

Mathematical Notation

Part One: The Economics of Risk Transfer

Chapter 1: The Determinants of Financial Innovation

The Economic and Financial Systems

“Beneficial” and “Successful” Financial Innovation

The Timing of Innovation

The Financial-Innovation Spiral

Notes

Chapter 2: Risk, Uncertainty, and Profit

Risk, Uncertainty, and the Firm

Risk, Uncertainty, and Profit

Risk and Uncertainty in the Theory of Corporate Finance

Notes

Chapter 3: Methods of Controlling Risk and Uncertainty

Retention

Reduction

Consolidation

Specialization and Risk Transfer

Notes

Chapter 4: Risk Transfer and Contracting Structures

Risk Transfer Arrangements and Payoff Functions

Mechanics of Risk Transfer

Notes

Chapter 5: The Evolution of Derivatives Activity

Time as the Essential Feature of Derivatives

Early Antecedents of Derivatives

The Origin of Traditional Forward Contracting: Babylonian Grain Lending

The Medici Bank

Evolution of Organized Futures Markets, Chicago Style

Over-the-Counter Derivatives and the Swap Market Today

Determinants of a Successful Exchange-Traded Derivatives Contract

Notes

Chapter 6: Derivatives Trading, Clearance, and Settlement

Trading

Clearance and Netting Schemes

Final Settlement for Asset Transfers

Final Settlement for Funds Transfers

Recent Issues in Clearing and Settlement

Revisiting the Distinctions Between OTC and Exchange-Traded Derivatives

Settlement Lags

Notes

Part Two: Derivatives Valuation and Asset Lending

Chapter 7: Principles of Derivatives Valuation

At-Market Versus off-Market Derivatives and “Derivatives Valuation”

Absolute Versus Relative Pricing

Economic Intuition for Valuing Uncertain Cash Flow Streams

The Fundamental Value Equation

Understanding Systematic Risk

Diversification, Hedging, and Special Investors

The CAPM and CCAPM

Multifactor Models

ICAPM

Fixed Income and Commodities

Arbitrage and Near-Arbitrage Pricing

Beyond Arbitrage: A Little Bit of Absolute Pricing Goes a Long Way

Notes

Chapter 8: Own Rates of Interest and the Cost of Carry Model

Derivatives, Asset Lending, and Own Rates of Interest

The Cost of Carry Model

Basic Formulation of the Model

The Cost of Carrying Some Specific Assets

The Cost of Carry when the Own Interest Rate is Stochastic

Heterogeneous Firms and Own Rates of Interest

A Summary of Terminology

Notes

Chapter 9: The Supply of Storage and the Term Structure of Forward Prices

The Supply of Storage

The Forward-Spot Relation and the Supply of Storage

Term Structure of Forward/Futures Prices

Supply of Storage for Financial Assets

Notes

Chapter 10: The Term Structure of Interest Rates

Capital Theory

The Rate of Interest

Where do we Get These Rates?

Notes

Chapter 11: Basis Relations and Spreads

Basis and the Cost of Carry Model

Spreads

Notes

Part Three: Speculation and Hedging

Chapter 12: Speculation and the Speculative Risk Premium

Speculation: Motivations and Sources of Expected Profits

Forward Purchase Price Bias and Risk

Theory of Normal Backwardation

Deficiencies with the Theory of Normal Backwardation

Alternative Characterizations of the Speculative Risk Premium

Systematic Risk Revisited

Notes

Chapter 13: Hedging Objectives

Risk Management Strategy and Sources of Gains from Hedging

Types of Commercial Hedging

Defining a Hedging Objective

Notes

Chapter 14: Hedge Ratios

Principal-Matched, Quantity-Matched, or One-to-One Hedges

Cash Flow-Matched Hedges

Hedging the Sensitivity of an Exposure to Small Price Changes

Hedging the Sensitivity of an Exposure to Changes in Multiple Risk Factors

Variance-Minimizing Hedge Ratios

A Warning About “Optimal” Hedge Ratios and Model Risk

Notes

Chapter 15: Quality Basis Risk

Imperfect Substitutes

Transportation and Distribution Basis Risk

Delivery and Location Basis Risk

Timing of Delivery

Switching Underlyings and Contract Pricing for Physically Settled Futures

Managing Quality Basis Risk

Chapter 16: Calendar Basis Risk

Calendar Basis Risk and Spreads

Rollover Risk

Hedging Long-Term Exposures with Short-Dated Derivatives

Metallgesellschaft

Summary

Notes

Part Four: Appendixes

Appendix 1: Economic Theory and Equilibrium

Appendix 2: Derivation of the Fundamental Value Equation

Appendix 3: Relation between the Cost of Carry Model and the Fundamental Value Equation

References

Index

Additional Praise for Risk Transfer

“Culp provides us with a thought-provoking and extremely valuable contribution to risk management literature. His analysis gives insight into using derivatives for risk transfer. High-powered theory translated into cutting-edge practice.”

—Rudolf Ferscha, CEO, Eurex

“Christopher Culp has written a thorough, yet accessible, guide to modern financial risk management. The text presents a well-balanced blend of theory and application, highlighting many practical lessons gleaned from Culp’s years of experience in the field.”

—James Overdahl, Author of Financial Derivatives

“Chris Culp’s Risk Transfer is an extraordinary book for the addressed reader, simply because it masterfully links the theoretical aspects of risk with the practical aspects used in the financial world to obtain control over risk. The interrelationship among risk, uncertainty, and the expected outcome, profit, are dependent on business decisions, influenced by the correct implementation of the appropriate use of derivative instruments to ‘complete the market.’ All this is shown in this book to be not only viable but mostly necessary. Risk, being inherent to business transactions, cannot itself be eliminated. The objective ought to be to achieve the appropriate (partial or full) transfer of risk. Culp gives us an excellent review of this vital subject.”

—Rodolfo H. Ibáñez, Head of Investment Research and Asset Management, BBVA (Switzerland) Ltd.

“Christopher Culp has written an outstanding book about risk transfer. He derives his ideas from both a historical and a general economic perspective. This enables him to demystify derivative instruments and to show their true value. He combines financial innovation and practical experience to develop modern concepts of risk transfer using derivative instruments.”

—Cuno Pümpin, Professor of Management, University of St. Gallen (Switzerland)

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Copyright © 2004 by Christopher L. Culp. All rights reserved.

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Library of Congress Cataloging-in-Publication Data:

Culp, Christopher L.

Risk transfer : derivatives in theory and practice / Christopher L. Culp.

p. cm.

ISBN 0-471-46498-8 (cloth)

1. Derivative securities. 2. Risk management. I. Title.

HG6024 .A3C85 2004

332.64′57—dc22

2003020245

Acknowledgments and Dedication

This book is based on a graduate course I teach every autumn at the University of Chicago’s Graduate School of Business (GSB) entitled “Futures, Forwards, Options, and Swaps: Theory and Practice”—a.k.a. B35101 (formerly B339). I am grateful to all the students who have survived my course over the years, many of whom provided honest feedback that has helped me refine and refocus both the course and this book. I also am grateful to Professors Terry Belton and Galen Burgardt, who teach the winter and spring quarter sections respectively, of B35101, for their consistent willingness to share both their materials and expertise. Although our three sections of B35101 have many differences, the basic themes explored are the same, and I am grateful to them for sharing with me their insights and expertise about those themes.

I also owe a significant debt of gratitude to my predecessor, Professor Todd E. Petzel, whose section of B35101 I took over when he left the city of Chicago in 1998. I originally took B35101 from Todd when I was a Ph.D. student, and I then served as his teaching assistant for the class for six years. Todd is a brilliant University of Chicago-trained economist and was then a senior executive at the Chicago Mercantile Exchange; his blend of theory and practice was unique and made for a fantastic class. Many of the ideas and concepts that Todd emphasized in his course are still alive and well in mine, and in this book. I am very grateful to Todd for all that he has taught me and for his friendship.

Several other friends and colleagues have also provided me with helpful comments and insights about this particular subject and work. My thanks in that regard go to Keith Bockus, John Cochrane, George Constantinides, Ken French, J. B. Heaton and Barb Kavanagh. Thanks also to Rotchy Barker and Keith Bronstein, both exceptional traders, for sharing with me over time a wealth of practical insights on how derivatives really work.

I am especially appreciative of the effort and time spent by Andrea Neves, who read and commented thoughtfully on the entire manuscript. Her suggestions and insights were tremendously valuable. Those same types of insights and ideas have made Andrea one of my most valued professional colleagues over the past decade, and I remain grateful to have her as both a professional collaborator and a very good friend.

I am as grateful as ever to Bill Falloon and Melissa Scuereb at John Wiley & Sons. Their professionalism and skill have once again been matched only by their thoughtful suggestions and seemingly infinite patience.

As things turned out, much of the last part of this book was written—and the entire book was copyedited—during several periods when I was in London. Special thanks to Michael, Tony, Andy, Paul, Ron, and Roy—the Hall Porters at The Ritz Hotel in London—for their infinite patience and tireless efforts in helping me bring this book to completion. Their dedication to service is exceeded only by their enthusiasm and efficiency.

Finally, this book would never have come into existence without the years of instruction, guidance, and advice I have received from Professor Steve H. Hanke. As a freshman in college at Johns Hopkins, I first encountered concepts like “backwardation” and “own interest rates” and first read the writings of economists like Pierro Sraffa and Holbrook Working in Professor Hanke’s “Economics of Commodity Markets” class. I continued to learn from Professor Hanke as his research assistant at Hopkins, and later as his co-author on a variety of eclectic topics ranging from the Hong Kong monetary system to inflation hedging with commodity futures. He is now a partner at Chicago Partners LLC, where we both consult together on projects regularly. We continue to write together, and it is highly unusual for even a week to pass without at least one lengthy phone conversation between the two of us. He taught me the true meaning of a “full-court press,” so it is not at all unusual for that phone call to occur around five o’clock on a Saturday morning, when we are both in our respective offices already at work.

I am also quite fortunate that Professor Hanke—and his brilliant and delightful wife Lilliane—are both also among my closest personal friends and confidants. I cannot imagine a major decision I would make about much of anything in my life—career or personal—without first soliciting and then seriously considering their opinions.

Steve Hanke’s fingerprints are all over this book in pretty much every way possible. He is an exceptional economist and a true example for me to follow as an academic, a trader, a public policy advocate, a gentleman, and a scholar. He is more than a mentor and more than a friend, and he has indelibly shaped the way I think about derivatives. I take great pleasure in dedicating this work to Professor Hanke.

I would be remiss, however, in not adding the usual disclaimer that all remaining errors of omission and commission here are my responsibility alone. Furthermore, the views expressed here do not necessarily represent the views of any institution with which I am affiliated or any clients by whom I am regularly engaged.

CHRISTOPHER L. CULP

London

July 26, 2003

Preface: The Demonization of Derivatives

In his March 2003 letter to Berkshire Hathaway shareholders, investment guru Warren Buffett described derivatives as “financial weapons of mass destruction, carrying dangers that . . . are potentially lethal.” George Soros has similarly argued that derivatives serve no useful purpose but to encourage destabilizing speculation. Indeed, more than 200 proposals to prohibit, limit, tax, or regulate derivatives have appeared in the United States in the past century. Freddie Mac’s massive derivatives accounting restatement and Enron’s active participation in derivatives have recently exacerbated popular fears of these products. What’s all the fuss about?

DERIVATIVES: FICTION AND REALITY

“Derivatives” are financial instruments whose payoffs are based on the performance of some specific underlying asset, reference rate, or index. Popular types include futures, forwards, options, and swaps. Futures and options on futures are standardized, traded on organized exchanges, margined and marked to market at least daily, and settled through a central counterparty called a clearinghouse. At the end of 2002, the Bank for International Settlements reports 28.2 million futures contracts and 55.2 million option contracts outstanding on the world’s major organized exchanges. At the same time, $141.8 trillion in notional principal was outstanding in over-the-counter (OTC) derivatives such as swaps. That amount is not ever exchanged and thus is not a measure of capital at risk, but it does provide some indication of the popularity of swaps.

Many portrayals of derivatives characterize them as excessively complex by-products of modern financial engineering that dupe their users and expose the financial system to unjustified systemic risks. These portrayals are misleading.

Derivatives are hardly novel and are usually remarkably simple. One of the oldest and most versatile derivatives is a simple forward contract in which A agrees to buy some asset such as corn or wheat from B at a fixed price on some date in the future. As Chapter 5 discusses in more detail, derivatives like that can be traced to Babylonian and Assyrian agribusiness from 1900 to 1400 b.c.—the famed Code of Hammurabi even includes an explicit reference to derivatives. Since then, long periods of sustained derivatives activity have regularly resurfaced. The Medici Bank, for example, relied extensively on derivatives during the fourteenth and fifteenth centuries. A handful of the Medici’s derivatives were fairly complex, but most were plain-vanilla forward agreements used to promote trade finance.

Nor are derivatives financial weapons of mass destruction. In fact, derivatives are more akin to smart bombs with which corporations can apply laserlike accuracy and precision to remove unwanted risks. In most cases, the risks to which a business is naturally exposed are greater than the risks that shareholders perceive as essential to running that business. Derivatives can be used like smart bombs to target those nonessential risks and surgically remove them.

The historical appeal of derivatives is that they do hit their marks—their payoffs can be defined very precisely to eliminate highly specific risks. That derivatives correctly hit their marks does not mean, of course, that the right marks are always painted. In the mid-1990s, for example, a number of corporate treasurers used derivatives to bet that short-term interest rates would stay low relative to long-term rates. When short rates rose instead, the derivatives performed just as they were designed to, but the companies lost hundreds of millions of dollars by aiming at the wrong interest rate target. And, for that matter, remember that a misidentified target can be destroyed by sticks and stones as well as a misguided smart bomb.

THE BENEFITS OF DERIVATIVES TO CORPORATIONS

Perhaps most importantly, derivatives can help firms manage the risks to which their businesses expose them but to which shareholders of the firm may be unable to fully diversify away on their own or at a reasonable cost. Specifically, derivatives can be used as a means of engaging in risk transfer, or the shifting of risk to another firm from the firm whose business creates a natural exposure to that risk.

Derivatives can be used to facilitate the transfer of multiple risk types. By far the most popular are market and credit risk. Consider some common examples of how derivatives can be used to engage in market risk transfer: A firm that has issued fixed-rate debt can protect itself against interest rate declines by entering into a pay-fixed swap or can go long a strip of Eurodollar futures; a firm that has issued floating-rate debt can protect itself against interest rate increases by entering into a pay-floating swap or can go short a strip of Eurodollar futures; a firm concerned about the cost of issuing new equity in the future to honor the eventual exercise of a stock options program could manage its equity price risk by entering into equity forwards; a multinational can protect its revenues from unanticipated exchange rate fluctuations with currency derivatives; a chocolate candy manufacturer can lock in its profit margin by using derivatives as a hedge against rising cocoa purchase costs; an oil refinery can lock in the refining spread by using derivatives to hedge crude oil purchased at variable prices for refining into heating oil and gasoline for sale at variable prices; and so on.

A very important benefit of derivatives is their flexibility. Different firms have different strategic risk management objectives. In any given transaction, a firm may be focused on reducing the risk of its assets and/or liabilities, its capital or net worth, its per-period cash flows, its economic profit margin, or its accounting earnings. Although the mechanics of hedging each of these risks may differ, derivatives can be used to accomplish any of these specific risk management goals.

A second important benefit of derivatives traces to the economic and functional equivalent of derivatives as asset loans—borrowing cash to buy an asset today and storing it for 90 days is economically equivalent to entering into a forward contract today for the purchase of an asset 90 days hence at a price that is paid in 90 days but that is negotiated today. The absence of arbitrage and a competitive equilibrium ensure that derivatives are priced to make firms essentially indifferent at the margin to owning the asset now or in the future. This means that firms can also use derivatives to engage in what is known as “synthetic” asset purchases or sales—buying or selling the asset economically without buying or selling it physically.

Suppose, for example, that a corporate pension plan has a long-term target of 80 percent large-cap U.K. stocks and 20 percent cash, but that it is worried about a temporary correction in the stock market and prefers a 60 percent/40 percent asset mix for the next three months. The pension plan could sell stocks now and repurchase them later—likely for huge transaction costs—or could short stock index futures to reduce synthetically its equity position for three months. Similarly, consider a bank whose assets (fully funded) and liabilities have a duration of seven and five years on average, respectively. If the bank is worried about short-term rate increases eroding its net interest income, the bank could increase the duration of its liabilities by incurring new longer-dated liabilities or could synthetically immunize its duration gap with interest rate derivatives. And so on.

Third, derivatives can help corporations hedge their economic profits when price and quantity are correlated and shifts to one imply shifts in the other. Risk management programs of that kind can be directed at managing the costs of input purchases, the revenues of output sales, or both.

All of these potential benefits of derivatives relate in some way to helping firms manage their risks—that is, to achieve an expected return/risk profile that is in line with shareholder preferences. In the world of perfect capital markets that many of us were introduced to in business school, however, corporate risk management was largely a matter of indifference to the company’s stockholders. Because such investors could diversify away the risks associated with fluctuations in interest rates or commodity prices simply by holding well-diversified portfolios, they would not pay a higher price-earnings (P/E) multiple (or, what amounts to the same thing, lower the cost of capital) for companies that chose to hedge such risk. So if hedging was unlikely to affect a firm’s cost of capital and value, then why do it?

Two decades of theoretical and empirical work on the issue of “why firms hedge” have produced a number of plausible explanations for how risk management can increase firm value—that is, how it can increase the firm’s expected cash flows even after taking account of the costs of setting up and administering the risk management program. Summarized briefly, such research suggests that risk management can help companies increase (or protect) their expected net cash flows mainly in the following ways:

By reducing expected tax liabilities when the firm faces tax rates that rise with different levels of taxable income.By reducing the expected costs of financial distress caused by a downturn in cash flow or earnings, or a shortfall in the value of assets below liabilities. Although such costs include the out-of-pocket expenses associated with any formal (or informal) reorganization, more important considerations are the diversion of management time and focus, loss of valuable investment opportunities, and potential alienation of other important corporate stakeholders (customers, suppliers, and employees) that can stem from financial trouble.By reducing potential conflicts between a company’s creditors and stockholders, including the possibility that “debt overhang” results in the sacrifice of valuable strategic investments.By overcoming the managerial risk aversion that (in the absence of hedging) could lead managers to invest in excessively conservative projects to protect their annual income and, ultimately, their job security—or vice versa for managers who like to take risks.By reducing the possibility of corporate underinvestment that arises from unexpected depletions of internal cash when the firm faces costs of external finance that are high enough to outweigh the benefits of undertaking the new investment.

As this list suggests, value-increasing risk management has little to do with dampening swings in reported earnings (or even, as many academics have suggested, minimizing the variance of cash flows). For most companies, the main contribution of risk management is likely to be its role in minimizing the probability of a costly financial distress. In this sense, a common use of derivatives is to protect a firm against worst-case scenarios or catastrophic outcomes. And even when the company has relatively little debt, management may choose to purchase such catastrophic insurance to protect the company’s ability to carry out the major investments that are part of its strategic plan. In the process of ensuring against catastrophic outcomes and preserving a minimal level of cash flow, companies will generally discover that they can operate with less capital (or at least less equity capital) than if they left their exposures unmanaged. And to the extent that hedging proves to be a cheap substitute for capital, risk management is a value-adding proposition.

THE ANTIDERIVATIVES CRUSADE

Despite their enormous popularity and numerous potential benefits, public outcries toward derivatives like those voiced by Messrs. Buffett and Soros—generally followed by demands for stricter derivatives regulation—are the historical rule rather than the exception. In the 1930s, politicians initially sought to blame “speculative excesses” for the Great Depression. Included in the post-Depression political response was legislation that banned financial contracts called “privileges,” which we now know as “options.” Senator Arthur Capper, a sponsor of the Grain Futures Act regulating futures markets in 1921, referred to the Chicago Board of Trade as a “gambling hell” and “the world’s greatest gambling house.” In 1947, President Harry S Truman claimed that futures trading accounted for the high prices of food and that “the government may find it necessary to limit the amount of trading.” He continued, “I say this because the cost of living in this country must not be a football to be kicked about by gamblers in grain” (Smith, 2003).

In the 1990s, politicians trained their sights on OTC derivatives like swaps following the widely publicized losses supposedly involving derivatives at firms like Procter & Gamble, Gibson Greetings, Air Products, Metallge–sellschaft, Barings Bank, and the Orange County Investment Pool. Representative Henry Gonzalez characterized swaps activity as a “gambling orgy” in the business world. He criticized the very names of the products—“swaps, options, swaptions, futures, floors”—as nothing more than “gambler’s language” (Smith, 2003). One of my own corporate clients one day went so far as to say he thought that derivatives “were sent to the earth by the Devil to destroy corporate America.”

On the heels of the so-called swap-related losses in the 1990s, numerous government agencies and private groups undertook studies of derivatives to determine whether they were inherently dangerous, in need of greater regulation, or both. Similarly, the failure of Long-Term Capital Management in 1998 led to cries for the regulation of derivatives in the hedge fund world. And of course, let us not forget the 2001 collapse of Enron—the bankruptcy of this major energy derivatives dealer has spawned the latest round of calls for greater supervision and regulation of derivatives.

Such a long track record of controversy and enmity naturally begs the question whether derivatives are, indeed, the instruments of Satan on earth—or whether these concerns are perhaps simply misplaced and unfounded. But if the latter is true, then why are derivatives repeatedly subject to such a firestorm of controversy?

First, although derivatives have “social benefits” such as promoting a more resilient financial system and helping firms avoid risks that are not core to their primary businesses, derivatives are at the transactional level zero-sum games. For every dollar one party makes, the counterparty loses. Unlike a bull stock market in which everyone (except the shorts) wins, a bull market in derivatives always means one of the two parties is a loser. When those losses get big enough, a loud chorus of whining derivatives losers can arise with stunning alacrity. Derivatives were not, of course, the reason for the firms’ losses, merely the instrument. Nevertheless, it is often easier to blame the messenger than admit the firm’s fundamental hedging or trading strategy was wrong. In short, derivatives don’t kill companies, Mr. Buffett, people kill companies.

Second, derivatives markets do sometimes attract speculators—firms and individuals that enter into derivatives to bet on future prices. Despite assertions of the kind made by Mr. Soros that speculation is destabilizing, most empirical evidence shows that speculators provide a stabilizing influence on balance because they increase market liquidity, lower trading costs, and enhance market depth.

Finally, derivatives are not unique in their condemnation by critics. In fact, most novel financial innovations are pilloried and criticized when they are first introduced. People have consistently clung to the status quo under the mistaken belief that it is safer. In fact, though, one of the greatest risks to a society or to a company is the risk of too little innovation. The risk of stagnation can be far greater than the risk of change (Smith, 2003).

Firms like Enron have been castigated not only for allegedly defrauding and misleading investors but for their development of increasingly novel financial instruments, including derivatives. What few people realize, however, is that most of Enron’s fraud and deception came from its accounting and disclosure practices, not its use of derivatives. In other words, the financial innovations themselves were not to blame either for Enron’s bankruptcy or for its deception. The inappropriate way that Enron booked and disclosed those activities has little to do with the inherent legitimacy of the activities themselves (Culp and Niskanen, 2003).

RISKS AND COSTS OF DERIVATIVES

Like any other financial activity, derivatives do expose their corporate users to various risks. Because derivatives are themselves used to manage some risks, you can often think of derivatives as trading one type of risk for another. Derivatives often involve trading market risk for credit risk, for example. If a firm enters into a swap to manage the interest rate risk on its outstanding debt, it has reduced its interest rate risk in return for bearing credit risk that the swap counterparty will not perform. A firm can then use credit derivatives or insurance to manage the credit risk of nonperformance on the interest rate swap, but that original credit risk has really just been exchanged for credit risk to the credit derivatives or insurance counterparty. And so on.

Derivatives also expose users to operational risks, such as the potential for abuse of derivatives by a rogue trader. Or to the risk that a contract might be declared legally unenforceable. Or to the risk that the cash flow servicing requirements on a marked-to-market futures hedge depletes a firm’s cash reserves. But recognize that none of these risks are unique to derivatives. Most financial activities already expose firms to these sorts of risks. Provided a firm has in place a judiciously designed risk management process that is properly aligned with the firm’s strategic risk management and business objectives, the risks of using derivatives—and all other financial instruments—can be controlled fairly effectively.

Some critics of derivatives, however, argue that certain derivatives risks are “systemic” in nature and thus beyond the control of individual firms. Most recently, some have voiced the concern that the exit by a single large swap dealer would cause liquidity in the market to dry up, making it impossible for users of derivatives to implement their hedging programs. This risk is not a particularly compelling one, however. Different market participants pursue different hedging objectives and have different exposures, thus generally leading to plenty of supply. Dealers intermediate that supply, but do not usually take on the full force of a counterparty’s risk exposure. And if the dealer’s intermediation activities do not result in a relatively neutral risk position, the dealers themselves may turn to other related markets that are more than deep enough to absorb net hedging needs. True, the exit of a dealer from one market will reduce liquidity in that market, but provided liquidity is deep enough in the related markets (on which the derivatives themselves are usually based), the market could resiliently weather the storm of a dealer exit decision.

A gloomier take on systemic risk holds that the failure of a major derivatives dealer with numerous linkages to others could turn into a global payment gridlock. This is, frankly, a very plausible horror scenario. But it is just that—a horror scenario. The failures of large firms like Bankhaus Herstatt, Drexel Burnham Lambert, Barings, and Enron all resulted in relatively little disruption to the global financial market. Indeed, in the failures of firms like Drexel and Enron, the role of derivatives was generally to help mitigate the impact of the failure, not exacerbate it. Concerns about systemic risk likely will remain a favorite justification for calls for greater political regulation of financial markets, but these concerns play much more on fear than on any actual empirical evidence legitimating the concern.

CONCLUSION

Because innovation will continue to be met with skepticism and because derivatives remain an explosive source of financial innovation, criticisms of derivatives by policy makers and whining losers should be expected to continue. But firms should not be blinded by these often vacant accusations and negative characterizations. Derivatives are an essential weapon in the corporate arsenal for managing risk, controlling cost, and increasing shareholder value. They are not weapons of mass destruction, but rather smart bombs that can be very precisely targeted at specific risks or areas of concern.

Misfires involving derivatives will occur—some of the Medici Bank customers did use derivatives to circumvent deceptively the medieval church’s prohibition on usury, Barings did blow up, Freddie Mac did restate its derivatives book, and so on. But caution must be exercised not to confuse flaws in corporate risk management, internal controls, and governance that lead to bad management decisions or poorly selected risk targets with flaws in derivatives themselves.

Indeed, perhaps the greatest risk of derivatives to a firm is the risk of not using them when it is appropriate to do so. Firms would then be forced to bear all the risks to which their businesses expose them, leaving shareholders scrambling to manage those risks on their own, or, worse, leaving shareholders vulnerable to the full impact of nearly any adverse financial market event. In that world, every single precipitous market move could become a financial weapon of mass destruction. Far from being such a weapon, derivatives may well be a corporation’s best defense against them.

Portions of this Preface are based on Culp (2003a, 2003b, 2003c).

Introduction and Structure of the Book

As Sir John Hicks emphasized in his 1939 treatise, Value and Capital, the essential feature of derivatives that distinguishes them from traditional agreements to purchase or sell a physical or financial asset on the spot is the explicit treatment in derivatives contracts of time and space. A spot transaction is the purchase or sale of an asset for immediate delivery by the seller to the purchaser, whereas derivatives involve the purchase or sale of an asset at a specified place and time that differ from the here and now. As a result, derivatives are essentially contracts to facilitate asset loans over space and time.

Derivatives originated historically as alternatives to explicit commodity loans—for example, a farmer might borrow wheat to feed his family and workers until his actual harvest came in. Unlike a money loan, such commodity-backed loans were subject to the risk of fluctuations in commodity prices and production levels. This meant that when the payoff of a commodity loan was viewed in isolation, it was highly correlated with the price and quantity risk associated with the underlying commodity business. In turn, this made it possible for firms to combine derivatives with existing assets and liabilities to achieve a net reduction in their risks—a “transfer” of risk, as it were, to other firms in the marketplace.

Without a firm understanding of how derivatives are related to and can be viewed as asset loan markets, it is very difficult for users to take full advantage of their numerous applications for risk transfer. Accordingly, this book develops this single central theme—that the capacity of firms to transfer certain risk to other firms using derivatives is inextricably related to the economic foundations of derivatives as asset lending instruments.

This book emphasizes the economic and financial foundations of derivatives. It is not a manual about products and contract specifications. It is not an introduction to option pricing techniques. It is not a menu or technical guide for trading strategies on a product-by-product or market-by-market basis. Nor is the book an economic theory text. Rather, the book builds a bridge between how the underlying theory of derivatives as asset loan instruments affects the theory and practice of using derivatives for risk transfer.

ORGANIZATION OF THE BOOK

The book is divided into three parts. Part One is largely theoretical and presents the micro and macro foundations underlying risk transfer as a financial activity and derivatives as an efficient—often the most efficient—means of exploiting risk transfer opportunities. Chapter 1 begins by reviewing the functions performed by an economic system in general and a financial system more specifically. We will see in particular that most financial innovations—including the evolution of many derivatives over time—do not enable firms to do “new things.” Most innovation either enables firms to perform one of a constant set of functions of the financial system in a more efficient manner than was possible without the innovation or enables firms to avoid the costs of unexpected changes in taxes and regulations. As a result, financial institutions and products are constantly changing and evolving to meet consumers’ needs, but the functions performed by these institutions and products are relatively stable over time.

Chapter 2 presents a discussion of the foundational distinctions in economic theory between risk and uncertainty and how those distinctions are related to the elusive but critically important notions of “profit” and “equilibrium.” Heavy use of the history of economic thought is made in this chapter to illustrate these somewhat abstract but essential concepts that lie at the base of questions like: “When should firms consider hedging?” “What sources of randomness are essential drivers of corporate profits, and which ones can be shifted to other firms without significantly attenuating the bottom line?” “How do speculators make money?” The ideas developed in Chapter 2 are used throughout the book.

We then consider in Chapter 3 the methods by which firms can control risk and uncertainty that they have decided to reduce. We emphasize that of four methods available to firms, only one—risk transfer—involves the explicit agreement by some other firm to help the original firm manage its risks. But this method is a crucial one.

Chapter 4 discusses in general terms how risk transfer can be accomplished using contracts like derivatives. Risk is not simply moved from one firm to another by decree. We develop the notion that the payoff function of financial contracts plays an essential role in the degree to which risk transfer is possible, even when the payoff of a contract is not explicitly designed to facilitate risk transfer. We also consider for the first time—but hardly the last—the cost of risk transfer.

We conclude Part One in Chapters 5 and 6 with a discussion of how derivatives evolved historically, emphasizing the migration of derivatives along two dimensions: from asset lending contracts into risk transfer mechanisms, and from bilateral contracts into traded financial instruments. Chapter 6 then explores the mechanics of the derivatives “supply chain”—trading, clearing, and settlement.

In Part Two of the book, we explore in significant detail the function of derivatives as intertemporal and interspatial resource allocation markets. We begin in Chapter 7 with an examination of derivatives in a general equilibrium setting. Using the modern theory of financial asset valuation, we see how derivatives can be used to shift resources from states of nature in which higher consumption is relatively less valuable into states of nature in which a small increase in consumption is particularly highly valued. We explore the implications of this for the valuation of derivatives payoffs and the compensation of firms for bearing systematic risk associated with derivatives.

In Chapter 8, we reconcile the modern general equilibrium view of derivatives valuation with historical conceptions of derivatives as commodity loan markets. We develop the concept of an own or commodity interest rate—the cost of carry—for physical and financial assets, and we see how that concept acts as the central linkage between derivatives as risk transfer instruments and the basic microeconomics of derivatives as asset loans.

In Chapter 9, we consider in more detail the element of time in derivatives. We develop concepts of the term structure of futures and forward prices and see how those concepts relate to physical asset storage, inventory management, and the rationing of scarcity over time.

Chapter 10 explores briefly the term structure of interest rates and how this can be viewed as a special case of the term structure of forward prices for an asset called money. Basic similarities between money and derivatives are presented. We illustrate the application of these historical concepts to the more contemporary London Interbank Offered Rate (LIBOR) swap curve.

In Chapter 11 we introduce the concept of basis or spread relations. We define the basis as the price of transforming an asset over time and/or space, and review some of the most common basis and spread relations in derivatives.

Part Three explores the practical aspects of speculation and hedging in light of the theoretical foundations laid in Parts One and Two. We consider in Chapter 12 the role of speculators, including their sources of perceived profits and whether they demand a risk premium over and above the systematic risk premium to engage in risk transfer with hedgers. We then explore in Chapter 13 the rich array of concepts implied by the term hedging. Chapter 14 then presents a discussion of how firms determine their specific hedge ratios in the context of the hedging objectives a firm sets forth along the lines presented in Chapter 13. Chapters 15 and 16 illustrate the concepts of quality and calendar basis risk—that is, how basis relations can lead to imperfections in risk transfer strategies.

RELATION TO OTHER BOOKS

This is my third full-length sole-authored book. The first—The Risk Management Process: Business Strategy and Tactics (Wiley, 2001)—explored when and how risk management as a process may be value-enhancing for corporations. The second—The ART of Risk Management: Alternative Risk Transfer, Capital Structure, and the Convergence of Insurance and Capital Markets (Wiley, 2002)—emphasized the risk finance and risk transfer aspects of a corporation’s risk management process. As the title suggests, the emphasis in the second book was on alternative risk transfer (ART) products, representing the convergence of insurance, derivatives, and securities. The second book also emphasized the inherent symmetry between corporate financing and risk management decisions.

Both of my earlier books took very much a “corporate finance” perspective. They considered risk management as a part of corporate finance, and emphasized how any individual firm should analyze and undertake risk management decisions. In sharp contrast, this book deals much more with a macro-market or microeconomic perspective of risk transfer. Whereas the other books were written from the bottom-up perspective of single firms, this book is written with a top-down perspective of the broad risk transfer and derivatives marketplace. With the exception of a brief part of Chapter 13 (a discussion of hedging objectives by value-maximizing firms), there is essentially no overlap in this book with my other two.

In terms of where this book stands relative to what others have written, everyone has their favorite bookshelf items. Far be it from me to try to propose some ideal reading list, thus both imposing my preferences on you and insulting other able authors by the inevitable omissions from such a list. Nevertheless, mainly to clarify further by example what this book does and does not cover in terms of subject matter, allow me to comment on a few other offerings in the market. Specifically, allow me to comment on things that this book is not.

First, this book is not a substitute for a general textbook introduction to derivatives. On the contrary, this book actually assumes you have already digested or are concurrently digesting such a general text. For a first course on derivatives, the excellent new book by Robert MacDonald (Derivatives Markets, 2003) is the one to beat. Or, for derivatives with a risk management emphasis, try the new text by René Stulz (Risk Management and Derivatives, 2003). The texts by John Hull (Options, Futures, and Other Derivatives, 2003) and Robert Jarrow and Stuart Turnbull (Derivative Securities, 1999) also remain reliable introductions to both the institutional aspects and the valuation of derivatives. And, of course, there are others well worth reading but too numerous to list here.

All the books just mentioned place a heavy emphasis on the analytical aspects of derivatives pricing. For those wishing a slightly less technical and more institutional introduction to derivatives, the third edition of Financial Derivatives by Robert Kolb and Jim Overdahl (Wiley, 2003) is very nice. If you want a heavier mixture of product information with a current and thorough treatment of tax and regulatory issues, see Andie Kramer’s Financial Products: Taxation, Regulation and Design (2003). And if you want more of a focus on how derivatives fit into practical hedging and trading strategies, Todd Petzel’s Financial Futures and Options (1989) will never disappoint.

Second, this book is not a product manual. It provides neither an overview of major products by asset class—MacDonald and the others noted earlier do that nicely—nor an in-depth focus on any single product or market. If you are looking for product-specific depth, you will not be disappointed by the numerous high-quality offerings in the market today.

In the interest rate area, look to Galen Burghardt. The 1991 Eurodollar book by Burghardt, Belton, Lane, Luce, and McVey (1991) is dated but remains a classic. Happily, Burghardt recently undertook a complete revision and update of that early offering that culminated in his new Eurodollar Futures and Options Handbook (2003). No serious practitioner of derivatives can justify not owning this one. Together with Terry Belton, Professor Burghardt has also given us the book on bond futures and options, The Treasury Bond Basis.

For currency products, J. Orlin Grabbe’s International Financial Markets (1996) provides a balanced mixture of monetary history, economics, financial products (down to pips and bid/ask quote conventions), and strategies. For a deeper look at currency derivatives in particular, David DeRosa’s Currency Derivatives (1998) and Options on Foreign Exchange (2000) are the deserved frontrunners.

Equity derivatives represent a more difficult area in which books tend to be highly subspecialized. At the overview level, probably the best bets are the new edition of Francis, Toy, and Whittaker’s edited volume The Handbook of Equity Derivatives (Wiley, 1999) and Harry Kat’s Structured Equity Derivatives (Wiley, 2001). Beyond those, it depends on whether your interest lies in convertibles, structured products, futures and swaps, or other products. Fortunately, there is no shortage of material in any of these specific areas.

A standard reference for anyone on the commodities side is still the Chicago Board of Trade’s Commodity Trading Manual. I also recommend getting a used copy of Jeff Williams’s The Economic Function of Futures Markets. Cambridge University Press should be chastised for letting this gem of a book go out of print. In addition, try to obtain from the Chicago Board of Trade the Selected Readings in Futures Markets Research series edited by Anne Peck. The collected works of Holbrook Working are especially commendable to commodity derivatives aficionados.

When you get into more specialized commodity products—natural gas, oil, weather, electricity, and so on—the choices get more limited and harder to find. But there is a lot of good stuff out there; you just have to look around and be sure to choose judiciously.

Finally, in the rapidly emerging area of credit derivatives, you’ll find more choices than you can shake a stick at. As in any “hot” area, some of the books are great, whereas others are more opportunistic and won’t last long. Fortunately, the former outnumber the latter in this area. My own personal favorite is the recent contribution by one of the true gurus of derivatives, Charles Smithson. His Credit Portfolio Management (Wiley, 2003) provides a balanced mixture of analytics, economics, products, and strategies. (His Managing Financial Risk is also still well worth owning.)

AUDIENCE

Those most likely to find this book interesting are researchers and practitioners of derivatives (including traders and corporate risk managers) with an interest in learning more about the theoretical underpinnings of derivatives as risk transfer instruments. This book is not a recipe book or a how-to guide; nor is it pure theory for the sake of theory. The book strives to draw explicit connections between theory and practice in derivatives and thus is intended to appeal to those with an interest in both.

Please note that a book like this, which attempts to take theory and practice equally seriously, will not suit people at either extreme. If you are looking for how-tos, you will be disappointed in this book. It doesn’t present gift–wrapped solutions to anything—it provides you with a way of thinking about the issues. If you are a research specialist or academic, you will be equally disappointed. The literature surveyed here is not intended to be complete, and the models of speculation and hedging presented are a small fraction of the current academic literature. But if you are looking to straddle these two worlds and see how theory and practice meet, I hope you will find the book of some value.

Finally, students and instructors may find this book useful either as a supplementary text to a first course on derivatives or as the sole text for a more specialized second course on derivatives. A suggested curriculum for a second MBA-level derivatives course relying on this book plus a packet of supplementary readings can be found on my Web site at http://gsb.uchicago.edu/fac/christopher.culp/—go to the “Teaching” section and choose “Business 35101.”

ERRATA AND WEB SITE

Errors inevitably survive the edits of even the most conservative publishers and meticulous authors. They are facts of life in publishing. Accordingly, I will maintain an updated errata list on my Web site under the “Research” section for those interested. Similarly, those who spot errors in need of correction are encouraged to send me e-mail—my address is also listed on my Web site.

Mathematical Notation

PART ONE

The Economics of Risk Transfer

CHAPTER 1

The Determinants of Financial Innovation

The range of financial products and instruments available today is quite literally mind-boggling. Corporate securities no longer include only plain-vanilla stocks, bonds, and convertibles, but all manner of preferred stock, commodity- and equity-indexed debt, amortizing principal notes, and more. Depository instruments, once limited to fixed-interest demand and term deposits, now encompass products that pay interest based on stock market returns, election results, and other eclectic variables. And with the advent of alternative risk transfer (ART), insurance solutions now transcend their traditional role and provide indemnity against risks like exchange rate shifts, credit downgrades, and investment losses.

Perhaps nowhere has the sheer breadth of financial products grown more than in the area of derivatives activity. The conventional definition of a “derivative” is a bilateral contract that derives its value from one or more underlying asset prices, indexes, or references rates.1 As we will see again throughout the text, the definition of derivatives that will prove most useful for our purposes is a contract for the purchase or sale of some asset (or its cash equivalent) in which time and space are explicitly defined and differ in some way from the here and now.