Class 01 Notes

Introduction

Course overview & web site address http://financialriskmanagement.wikidot.com
Individual introductions

History of markets
Early barter markets led to using unified precious metal or items to unify pricing
Coins invented to simplify transactions
Seigniorage Middle age barons, lords, seniors, etc. added their mark to coins to demonstrate their quality. Those more highly regarded consequently traded for more value. Sterling example of silver quality. Minting coins thus generated profits.
Whole bodied money led to representative money.
In turn, representative money led to credit money. Brettonwoods agreement in 1944 tied U.S. dollar to gold and currencies of free world to dollar. Large U.S. monetary expansion of 1960s started inflation & led President Nixon to renounce agreement to exchange gold for dollars. Thus, dollars are only worth what somebody will pay for them.
To deliver contracts were introduced in Middle Age Europe. Sales would be agreed in advance and products delivered later. Forward contracts often used on agricultural products. Chicago (formerly a section of Peoria) emerged as a major agricultural center. Problems grew with enforcing forward contracts. Oversupply of grain encouraged elevator operators to renege on forwards. Counterparties were fully exposed to each other until contract completion. In 1848 Chicago Board of Trade invented futures contracts. These included margin (good faith deposits) and daily marking-to-the-market procedures. Through the 1970s virtually all futures contracts were for agricultural products.
Option contracts similarly have a long history of evolution. They were often used for land, stock shares, and other assets. Options on common stock were the most common applications. Options to buy stock are known as calls and those to sell stock are known as puts. The market was exclusively a primary market. If an option owner wished to eliminate a position before expiration or maturity, it was only possible to obtain the intrinsic value, typically by selling the option back to the broker who originally provided it. In turn, such brokers sometimes advertised these repurchased options for sale in the Wall Street Journal. The Chicago Board of Trade, then the largest commodity exchange in the world, created the Chicago Board Options Exchange in 1973. To create a viable secondary market a number of institutional changes were introduced to the option market. Without an ample supply of a fungible product a secondary market was unlikely to survive.
Standard option expiration dates were established typically at the end of trading on the third Friday of the expiration month. Historically, stock options expired on a scheduled number of days following the day of their creation. Thus, stock options which expired on any random day were replaced with contracts with unified expiration dates.
Unified exercise prices were established to limit the array of alternatives. Before the CBOE the tradition for setting exercise prices was to accept the existing market price for the exercise price. Given that the typical tick size for common stock was 1/8 of a point, an extraordinarily large number of alternative exercise prices was possible. For example, a stock that fluctuated between $40 and $50 per share over an interval of time could have 8 x 10 or 80 different exercise prices for different option contracts. The newly adopted system typically employs three exercise prices over that interval, $40, $45 and $50. Brokers of the earlier era were incapable of adjusting the premium to accommodate exercise prices initially set away from the market price.
Dividend treatment was adjusted from the earlier practice of protecting the contract from its effect. It has always been recognized that when a corporation pays a dividend the practice simply amounts to a transfer from one “pocket” of the stock owner to another of his or her “pockets.” Specifically, wealth is neither created or destroyed by payment of dividends. Thus, a stock trading for a market price of $50 per share that pays a $1 per share dividend will experience an essentially automatic price drop of $1 per share to $49. The shareholder sustains his or her $50 worth attributable to that share, but now owns a stock worth $49 and a dividend worth $1. A call option owner entitled to buy a stock with an exercise price of $50 when the stock sells in the market for $50.75 has an option with an intrinsic value of $0.75 per share. Simply by paying a $1 dividend the stock value drops to $49.75 thereby eliminating the entire intrinsic value of the option. The mechanism used to protect call option holders from this effect was known as dividend protection. Option contracts were written to include an automatic adjustment in the exercise price, equal to the size of the dividend, any time the stock paid a dividend. The CBOE recognized that this practice would potentially lead to multiple new striking prices, often at unusual levels. For example, the above described stock with an exercise price of $50 would after protecting the call owner from the $1 dividend have a new exercise price of $49. Subsequent new contracts entered after the dividend was paid could have an exercise price of $50, making them not fungible with earlier contracts that should be much the same.
Swap contracts have a more storied origin than many other contracts. One explanation attributes their creation to a tax imposed by the labor government in England during the 1970s. At that time many of Britain’s productive resources were owned by the government. Taxes on earnings were exceptionally high. Naturally, productivity was extraordinarily low. British investors realized that they could improve their returns by investing abroad. The Labor government imposed a stiff tax on transferring money out of the country for investment purposes. They hoped to force British investors to invest their money in the stagnant British economy. However, many British residents had long enjoyed a practice of swapping houses for holidays. For example, somebody in Britain wishing to spend a holiday in southern France might swap houses with a French resident who was concurrently traveling to Britain. Thus, neither traveler needed to pay anything to rent a house. It took little ingenuity to extend this practice to swapping currencies. The procedure was implemented as follows.
A British investor wishing to acquire assets in France would locate a French investor wishing to acquire assets in Britain. Frequently these steps might be accomplished by corporate parents wishing to found subsidiaries in the opposite country. Thus, a British parent firm locates a French parent firm and arranged for the French parent to provide funds to the British subsidiary located in France. Concurrently, the British parent firm provides an equivalent value of funds to the French subsidiary located in Britain. In the grand scheme of things, the eventual result was no transfer of money across the national border. However, the British and French firms were each able to locate subsidiaries as desired. Eventually, the tax was repealed, but other benefits realized by participants in these arrangements persisted and the practice was refined, improved and extended.
The alternate explanation for the origin of swap agreements is traced to a practice followed by the former Soviet Union. Since the Ruble was not a hard currency, it was useless for international trade. However, Russia had an ample supply of gold. Thus, Russia regularly entered into agreements to use hard currency and pledged gold to serve as collateral. When the time came for repayment of the hard currency, Russia often simply delivered gold when hard currency funds were inadequate to cover the obligation. Eventually, this notion led to swap type agreements.

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