Forward/futures And Insurance And Mergers

Front 1

Forward Contracts

Back 1

A contract that requires one party to buy and the other to sell a designated quantity and quality of the underlying at a pre-agreed price on some future date

Example: Car Purchase
Early September. You want a new car.
Go to the dealer and specify the exact features of your car and set the price.
You can place a deposit today and receive delivery in three months.

Agree on price now, trade later.

Front 2

Forward Contracts Risks/Rewards

Example: Car Purchase
Early September. You want a new car.
Go to the dealer and specify the exact features of your car and set the price.
You can place a deposit today and receive delivery in three months.

Back 2

Risks
-Price of car may go down in next three months
-Dealer won’t deliver on time or will go out of business

Rewards
-Price of car may go up in next three months

Front 3

Why Enter in a Forward Contract?

Back 3

1. Hedging
Farmer: Produces Corn
Miller: Grinds Corn
Today’s price is $30
Price could be $15, $30, or $45 on July 1, 2011
->If price is $45, corn seller is happy, miller is sad.
->If price is $15, corn seller is sad, miller is happy.
->If price is $30, no difference
2. Risk Aversion
->People will trade some upside gain for protection against downside losses (insurance slides)
->Agree to a sale on a future date of $30. Both parties are better off.
->Corn seller forfeits potential upside ($45), but rids himself of the downside risk ($15)
->Miller forfeits potential upside ($15), but rids himself of the downside risk ($45).

Front 4

Long and Short Positions

Back 4

Corn Seller is long in corn market (he has corn); So, to hedge, he sells a forward contract (shorts). He sells the right to buy corn at $30. The forward contract is valuable to him when the price of corn goes down.

Miller is hurt when the price of corn goes up. So, to hedge, he buys a forward contract (takes long position).That is, he buys the right to buy at $30.

Front 5

Futures

Back 5

A fully standardized, exchange-traded forward contract

Front 6

Futures/Forward Contracts - History

Back 6

In 1865, the CBOT introduced the first modern futures contract -- a grain agreement that standardized:
-The quality of grain
-The quantity of grain
-Date and location of delivery

In the US, an active market in forward contracts on agricultural products began in the 1840’s
-producer made agreements to sell a commodity to a buyer at a price set today for delivery on a date following the harvest
arrangements between individual producers and buyers -- contracts not traded
-by 1870’s these forward contracts had become standardized (grade, quantity and time of delivery) and began to be traded according to the rules established by the Chicago Board of Trade (CBOT)

Key point -- commodity futures (evolving from forward contracts) developed in response to an economic need by suppliers and users of various agricultural goods initially and later other goods/commodities - e.g metals and energy contracts

Financial futures - fixed income, stock index and currency futures markets were established in the 70’s and 80’s - facilitated the sale of financial instruments and risk (of price uncertainty) in financial markets

Front 7

Short Hedge
In the cash market..
So in futures market...
Resulting hedge...

Back 7

In the cash market...Are long because hold the asset
So in futures market..Go short – I.e. sell futures contracts
Resulting hedge..Offsetting positions cancel out. Loss of cash position offset by futures gain, vice versa

Front 8

Long Hedge
In the cash market..
So in futures market...
Resulting hedge...

Back 8

In the cash market...Are short because need to buy commodity
So in futures market..Go long – I.e. buy futures contracts
Resulting hedge..Offsetting positions cancel out. Increase in cash market offset by futures gain, vice versa

Front 9

Speculating w/ Futures
Expect prices to rise, so . . .
Expect prices to fall, so . . .

Back 9

Expect prices to rise, so . . .Go long. Buy Futures.
Expect prices to fall, so . . .Go short. Sell futures

Front 10

Futures Markets

Back 10

-Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity.
-Buyers/sellers deal with the futures exchange, not with each other.
-Delivery seldom made. Either party can liquidate its futures position prior to the scheduled delivery date.
-Futures contracts expire on specific dates.
-Futures contracts require their owners to post margin money to take account of gains and losses accruing from daily price movements.

Front 11

Initial Margin v. Variation/Maintenance Margin

Back 11

Initial Margin
-small percentage deposit required to trade a futures contract.
-Usually 5-10% of the contract value deposited with the clearinghouse
Variation/Maintenance Margin
-Contracts marked to market daily
-If losses occur, extra margin required

Front 12

Margin Call

Back 12

requires an investor to add money to his/her futures margin to offset his/her losses.

Front 13

Regulation of the Futures Market

Back 13

-The Commodity Futures Trading Commission (CFTC)
--5 member Federal Commission
--Formed in 1974
-Shares regulatory authority with the Securities Exchange Commission (SEC).
-Exchanges impose self-regulation with rules of conduct for members.

Front 14

Futures Exchanges

Back 14

-Competition between exchanges is keen.
-Contract innovation is common.
-Exchanges advertise and promote heavily.
-Financial exchanges develop contracts they believe traders want

Front 15

Futures v. Forwards

Back 15

Futures
-Exchange Traded
-Clearing House
-Margin and mark to mkt
-Standardized
-Cash settled
-Transparent, liquid

Forward
-OTC
-Private, two-party K
-Individually negotiated
-Customized
-Physical delivery
-Not transparent, illiquid

Front 16

Credit Default Swap

Back 16

-Bank makes a loan of 10 million dollars to a company (say, GM)
-The loan lays on a large amount of risk. If things go bad, bank makes nothing.
-Bank enters into a credit default swap with, say, a hedge fund.
-On the swap, the bank is paid money if GM goes under and loses money if GM is successful.
-The bank has hedged its default risk. If GM goes under, the bank makes money on the swap and loses money on the initial loan. If GM is successful, it loses money on the swap, but gets paid back on the loan
-Largely unregulated (changing)

Front 17

Credit Default Swap Benefits

Back 17

-Hedging benefits
-No more need to form a syndicate of lenders for large loans (transaction costs)
-Hedging can (maybe) reduce contagion, a single loss won’t put the bank under water.
-Create lots of different risk portfolios (bear firm risk, but not industry risk, enter into default that pays off is other firms in industry go down)
-More liquid debt markets, because bank can lend at lower rates (due to less risk)

Front 18

Credit Default Swap Costs

Back 18

-Diminished incentive for the bank to monitor
-Bank makes money off of default (on the swap): bank might not to restructure the debt.
-Force bankruptcy, even if the firm still has value.

Front 19

Collateral Debt Obligation

Back 19

-a type of asset-backed security and structured credit product.
-CDOs are constructed from a portfolio of fixed-income assets.
-These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated).
-Losses are applied in reverse order of seniority
--Thus, junior tranches offer higher coupons (interest rates) to compensate for the added default risk.
-Some news and media commentary blame our current economic woes on complexity of CDO products, and the failure of models used by credit rating agencies to value these products.
-Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows.
-As many CDO products are held on a mark to market basis, the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs beginning in 2007.
-Major loss of confidence in the validity of process used by ratings agencies to assign credit ratings to CDO tranches occurred and persists today.

Front 20

CDO Basic Structure

Back 20

-A Special Purpose Vehicle (SPV) acquires a portfolio of credits
-The SPV issues different classes of bonds and equity and the proceeds are used to purchase the portfolio of credits
-The bonds and equity are entitled to the cash flows from the portfolio of credits, in accordance with the Priority of Payments set forth in the transaction documents.
-The senior notes are paid from the cash flows before the junior notes and equity notes.
-In this way, losses are first borne by the equity notes, next by the junior notes, and finally by the senior notes.
-The senior notes, junior notes, and equity notes thus offer distinctly different combinations of risk and return, while each reference the same thing.

Front 21

CDOs and Subprime Crisis

Back 21

From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds.

In 2006, $200 billion in mezzanine ABS CDOs (mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds) were issued with an average exposure to subprime bonds of 70%.

As delinquencies and defaults on subprime mortgages continue to rise to record levels, CDOs backed by significant mezzanine subprime collateral experienced severe rating downgrades and losses.

As the mortgages underlying the CDO's collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings.

The pricing challenge arises because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses

Investors have criticized S&P, Fitch, & Moody's, saying their ratings on bonds backed by U.S. mortgages to people with limited credit didn't reflect the increasing default rate.
-They often gave top ratings to CDO securities.
-Some bonds have lost more than 50 cents on the dollar while their credit ratings didn't change.

Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners trying to refinance out of existing mortgages (e.g. adjustable-rate mortgages with rising interest rates).

Front 22

Why do ppl by Insurance

Back 22

-Insurance changes the “payout” when different events happen
-Preferences for and against risk
Probability distribution: list of different outcomes, with a chance at each one.
-“Fire” with probability, p
-“No Fire” with probability, 1-p

Front 23

Insurance Examples

Back 23

$100 in initial wealth
Lottery ticket, costs $5, pays out $200 if the number 13 comes up
Two possible events
(1) 13 comes up
(2) 13 doesn’t up

If ticket is not purchased
-If 13 comes up, wealth is $100
-If 13 does not come up, wealth is $100

If ticket is purchased
-If 13 comes up, wealth is $300-$5=$295
-If 13 doesn’t come up, wealth is $100-$5=$95

Purchase of the ticket altered the payouts in the different states of the world (and we will see, being able to do this transformation has economic value)

Ex 2: Bob’s initial Wealth is $35,000
-With probability p, there is a fire, which costs $10,000
-Before insurance, Bob faces the following distribution of payoffs
--With probability, p, wealth is $25,000
--With probability, 1-p, wealth is $35,000

Suppose Bob fully insures: he buys $10,000 worth of insurance and it costs him, say, $100

Now look at his distribution of payoffs
With probability p, Bob’s wealth is
-$35,000-$10,000+$10,000-$100=$34,900
With probability, 1-p, Bob’s wealth is
-$35,000 -$100 = $34,900
Insurance has allowed him to maintain the same wealth across states of nature

Front 24

Why is stabilizing income across states of nature desirable?

Back 24

-Economist speak in terms of “utility”--this is just the “happiness” derived from consuming goods. It is representation of preferences
--U(x) – utility associated with consuming x units of a good. One central idea is that marginal utility is decreasing. Indeed, we will show that this idea is interchangeable with “risk aversion”
-Risk aversion is sufficient to create the demand for insurance.
-Insurance has the key property of stabilizing income across uncertain states of nature

Front 25

Expected Utility

Back 25

-prob{fire)*U(Fire)+(1-prob{fire})*U(No Fire)
-Under some assumptions, we can represent preferences in this way.
-Diminishing marginal utility implies that stabilized income stream is better than variable income stream with the same expected payoff

Which does the agent prefer?
Lottery of .5 chance of 5 and .5 chance of 15, expected value of 10
-10 for sure..U(10)>.5U(5)+.5U(15)
Happens because the curve is concave

Front 26

Suppose you had $1 million dollars, would you stake it on a 50-50 bet for $ 2 million?

Back 26

No. Then the first million is worth more to you.
If the income is equal across states of nature, the additional value of the dollar is equal, which means that person can’t do better by shifting dollars from one state to the other (and that’s what insurance does).

Front 27

Theory Implies That Risk Averse Folks Fully Insure
Real World Doesn’t Look Like That

Back 27

Deductibles
Co-Payments
Loss of coverage provisions
Denials of coverage

Front 28

Prob Insurers Face: Moral hazard (Hidden Action)

Back 28

What if the insured can take an action (or fail to an action) that increases the chance that the “bad state” will occur?

Smoking in bed. Failing to exercise and eat right! Insurer might condition coverage to provide incentives; but if the action is “hidden” very hard to do. Insurer survives by cross subsidization. Health insurance pool has to include healthy people and sick people

Tradeoff: Too little insurance leads to better care decisions because people bear the full cost of their actions. But too insurance imposes risk, which people don’t like.

Front 29

Prob Insurers Face: Adverse Selection (Hidden Information)

Back 29

Offer “Full Coverage” only people who are sick will buy it.

Insurance for bicycle theft
Looks at the regions and offers a rate equal based on the average theft rate

Insurer will go broke in a hurry

Why? People in regions with low crime rates won’t buy. People in regions with high crime rates will buy.

Insurer will offer rates for the population that is likely to buy (high risk folks). Low risk folks will not be served.

Increase efficiency by requiring all to buy insurance

Front 30

The Insurance Business
A Life Insurance Company Makes Money by..
Legal Issues...

Back 30

A Life Insurance Company Makes Money by
(1) Investing Premiums
(2) Diversifying the risk across a wide range of folks

Legal Issues
(1) Do you have an insurable interest? Spouses, yes, Corporations can buy on high level employees, yes. Can’t buy on random folks. Money or Blood

Moral Hazard: take a policy and kill the guy
-icky factor, not compensating for a loss, but providing a gamble

Front 31

Types of Life Insurance

Back 31

Term Insurance: Fixed payoff upon death of insured. No investment component; Cost of premiums go up over time.

Whole Life
-Death benefit, plus premiums are constant. Build up of some cash value (like a forced savings account)
-Borrow against this value; one can also recoup the value upon death or surrender of the policy.
-Cash buildup occurs more later in the life of the policy.
-Life insurance is an investment. Can be assigned to a creditor.

Front 32

Assumptions about Expected Utility

Back 32

Only one outcome will occur (fire or not).
Concerned with three things: wealth now, wealth after fire, wealth with no fire.

Decision independent wealth now and wealth after fire. The wealth with no fire shouldn’t play a role.

Two things, value of third matters . . Coffee, tea might depend on the amount of cream. But if you are rolling a dice to get either coffee or tea or cream, the amount of cream should not affect choice between coffee and tea.

Front 33

Why merge two companies?

Back 33

-Displace inefficient managers – market for corporate control limits agency costs
-Badly run firms – declining share prices – profit opportunity.
-Acquisition for synergy (movie studio and magazine publisher and a internet service provider)
Solve holdup problems? Alter the make or buy decision, vertically integrate.
-Merge to create market power
-Merge to diversify (huh?)
-Build an empire

Front 34

Statutory and Non-Statutory Techniques

Back 34

Merger: Company A combines with Company B.
-They file an articles of merger with state official (just like with incorporation).
-The surviving entity takes, as a matter of law, all assets, liability, rights, and obligations of the two corporations.

Front 35

Merger Ex

Back 35

Company A (100 airplanes, each with a secured lender)

Company B (100 airline hangers, no debt)

Merge Company A into Company B

Company B now has 100 airplanes, with a secured lender and 100 airline hangers).

Front 36

How to Achieve a Merger: Friendly

Back 36

-Plan of merger drafted by board of directors
-The plan of merger is placed to a vote of the shareholders
-The merger is achieved with a vote of a simple majority of the outstanding shares

Front 37

Sales of Substantially All of Corporate Assets

Back 37

-Board of directors has unconstrained authority to sell, mortgage or lease corporation equipment
-If the sale is of substantially all the assets shareholder vote is required.
-Not entirely clear what is “substantially all” of the assets.

Front 38

Friendly Merger or Asset Sale

Back 38

-Friendly merger title to property automatically passes to the surviving corporation; consideration passes to nondissenting shareholders.
-Surviving entity takes liabilities with a merger, not so, absent agreement, with an asset sale
-Asset sale, purchasing company shareholders usually don’t have to vote. Merger, approval by target and purchaser shareholders.

Front 39

Appraisal Rights

Back 39

-Majority of shareholders of A and a majority of shareholders of B approve the merger.
-Minority object. They have a right to ask for an appraisal remedy.
-Valuation problems.

Front 40

Hostile TakeOvers

Back 40

-Bypass the board of directors
-Own 50.1 percent of shares, shareholder gets to elect the board of directors.
-Buy up shares. Disclosure is required.
-Tender offer

Front 41

Tender offer

Back 41

-Acquirer makes offer for a fixed period of time (at a price over the current stock price).
-Shareholders can tender.
-Tender a majority, freezeout merger of the remaining minority.
-Raider makes a tender offer.
-Garners 50 percent of the shares. He now holds a majority of the shares in the target company. He can replace the board of directors.
-Raider sets up another corporation, corporation X.
-He then “approves” a merger between corporation X and the target. The consideration for the target’s shares is less than what was paid in the tender offer.

Ex:
Target has 110 outstanding shares, trading at $10.
-Raider believes that the shares could be worth $20.
-Raider owns 10 shares.
-Wage a proxy contest (convince others to replace the board, makes $100).
-Tender at $19 a share.
-50 percent tender. Merger and pay, say, $19 to the minority shareholders.
-Pay $19 for a company worth $20 a share. Raider can capture gains from replacing bad management.
-Raider can also, via the freezeout, eliminate minority shareholders.

Front 42

Options def and Two Types

Back 42

One type of “derivative.” Called a derivative because its value derives from another asset.

Two Types
1. Call option – Right (but not the obligation) to buy an asset at a specific price in the future.
-Warranty is a call option: Written by a firm, not an individual. Usually an equity Kicker, issued with a bond.
2. Put option – Right (but not the obligation) to sell an asset at a set specific price in the future.

Front 43

Call Option Example

Back 43

Disney has an option on a building. The option will say:

(1) Exercise price: Right to buy for, say, $1 million
(2) Expiration date: Right must be exercised on or before May 1, 2011.
(3) Price: what Disney pays the owner of the building for the option.

Purchase an option to buy 100 shares of IBM at an exercise price of $150. The option expires on or before July 15, 2011.

What is the payoff at the expiration?

Hockey Stick

Front 44

Two Kinds of Call Options

Back 44

1. American: Right to buy on or before the expiration date.
2. European: Right to buy “on” the expiration date.
We will concern ourselves with American call options on stocks

Front 45

Put Option

Back 45

Right (but not the obligation) to sell an asset at a certain price on or before a certain date.

Buy a put on IBM stock. Exercise Price is $50. Suppose the price is $40 at expiration. Put owner can go into market, buy at $40 and resell on the put at $50. The profit:$50-$40=$10

Suppose the price is $60 at expiration. The put option holder “loses” if he exercises. Selling a share for $50 on the put, when he could sell it at $60 on the market. Won’t exercise.

Reverse Hockey Stick

Front 46

Synthetic Stock: Combining Puts and Calls

Back 46

Strategy A
-Buy share of stock
-Buy a put option

Strategy B
-Buy a zero coupon bond (give, for sure, $50 at the expiration date; cost the present value of the strike price).
-Buy a call option

Strategy A and Strategy B give the same payout. So, they must have the same cost (think about M-M, proposition I). If they didn’t profit opportunity in the making.

No need to be an equity holder to get the same return as an equity holder
Rearranging
Price of stock=Price of call-Price of Put+PV of exercise price.

Front 47

Put-Call Parity

Back 47

Price of Stock+Price of Put=Price of Call+Present Value of Exercise Price

Front 48

Holder v. Writer
Rts/Obligations
Call
Put
Premium
Exercise
Max Loss
Max Gain

Back 48

Buyer/Holder
Rts/Obligations- Rights, no obligations
Call- right to buy
Put- right to sell
Premium- Paid
Exercise-Buyers decision
Max Loss-Cost of Premium
Max Gain- Unlimited

Seller/Writer
Rts/Obligations- obligations, no rights
Call- obligation to sell
Put- obligation to buy
Premium-received
Exercise-seller cannot influence
Max Loss-unlimited
Max Gain- price of premium

Front 49

The Black-Scholes-Merton Option Pricing Model

Back 49

K, the strike price specified in the option contract
r, the risk-free interest rate over the life of the option contract
T, the time remaining until the option contract expires
, the price volatility of the underlying stock

Front 50

The Current Stock Price:
What happens to a call/put when the current stock price increases?

Back 50

Calls: As the current stock price goes up, the higher the probability that the call will be in the money.
Result = the call price will increase.

Puts: Effect is in opposite direction for a put.
As the stock price goes up, there is a lower probability that the put will be in the money.
Result = put price will decrease.

Front 51

Exercise Price
What happens to a call/put when the exercise price increases?

Back 51

Calls: The higher the exercise price (or strike price), the lower the probability that the call will be in the money.
So, holding maturity constant, call price decreases as exercise price increases.

Puts: For the put, the effect runs in the opposite direction. A higher exercise price means that there is higher probability that the put will be in the money.
So put price increases as the exercise price increases.

Front 52

Time to Expiration
What happens to a call/put when as time to expiration is bigger?

Back 52

A complicated effect.
General rule = both call and put price increase with time to expiration, as there is more time for a big move in underlying price (i.e. increased volatility).
But, as time to expiration increases, other factors (e.g. present value of the exercise price, effect of cash dividend) operate differently on put and call prices in ways that we will not cover.

Front 53

Volatility (σ)

Back 53

-A measure of the rate of fluctuation in the underlying price
-Most important pricing input
-Measures only price changes, unconcerned with direction of movement

Front 54

Volatility and Price
Higher volatility =

Back 54

Higher option value
Rat: downside limited, but increased chance of finishing in the money